BLACKPEARL RESOURCES INC. MANAGEMENT S DISCUSSION AND ANALYSIS, FINANCIAL STATEMENTS AND NOTES

Transcription

1 BLACKPEARL RESOURCES INC. MANAGEMENT S DISCUSSION AND ANALYSIS, FINANCIAL STATEMENTS AND NOTES FOR THE YEAR ENDED DECEMBER 31, 2011

2 Management s Discussion and Analysis The following is Management s Discussion and Analysis (MD&A) of the operating and financial results of BlackPearl Resources Inc. ( BlackPearl or the Company ) for the year ended December 31, These results are being compared with the year ended December 31, The MD&A should be read in conjunction with the Company s audited consolidated financial statements for the year ended December 31, 2011, together with the accompanying notes. All dollar amounts are referenced in thousands of Canadian dollars, except where otherwise noted. The consolidated financial statements, formerly prepared under Canadian GAAP, have been prepared in accordance with International Financial Reporting Standards (IFRS), as is required for Canadian public entities with year ends beginning on or after January 1, Throughout this MD&A the calculation of barrels of oil equivalent (boe) is based on a conversion rate of six thousand cubic feet (mcf) of natural gas to one barrel of oil. Boe may be misleading, particularly if used in isolation. A boe conversion ratio of 6 mcf:1 bbl is based on an energy equivalence conversion method primarily applicable at the burner tip and is not intended to represent a value equivalence at the wellhead. The following is a summary of the abbreviations that may have been used in this document: Oil and Natural Gas Liquids Natural Gas bbl barrel Mcf thousand cubic feet bbls/d barrels per day MMcf million cubic feet Mbbls/d thousand barrels per day Mcf/d thousand cubic feet per day MMbbls million barrels Bcf billion cubic feet NGLs natural gas liquids MMBtu Million british thermal units boe barrel of oil equivalent GJ Gigajoule boe/d Barrel of oil equivalent per day WTI West Texas Intermediate (a light oil reference price) WCS Western Canadian Select (a heavy oil reference price) SAGD Steam Assisted Gravity Drainage (a thermal recovery process) ASP Alkali, Surfactant, Polymer This report includes terms commonly used in the oil and natural gas industry, such as cash flow and cash flow from operations which represent cash flow from operating activities expressed before changes in non-cash working capital, as well as cash flow per share and operating netback. These terms are used by the Company to analyze operating performance, leverage and liquidity and to provide shareholders and investors with additional information to measure the Company s performance and efficiency and its ability to fund a portion of its future activities and to service any long-term debt if incurred in the future. These terms do not have standardized meanings prescribed by GAAP and therefore may not be comparable with the calculation of similar measures by other entities. Consequently, these are referred to as non-gaap measures. Additional information relating to the Company, including its Annual Information Form, is available on SEDAR at This MD&A contains forward-looking information and statements. At the end of this MD&A is an advisory on forward-looking information and statements. The effective date of this MD&A is February 24, blackpearl resources inc. / 2011 Financial report

3 Management s Discussion and Analysis OVERVIEW BlackPearl is a Canadian-based oil and natural gas company whose common shares are traded on the Toronto Stock Exchange (TSX) under the symbol PXX. The Corporation s Swedish Depository Receipts trade on the NASDAQ OMX First North market under the symbol PXXS. BlackPearl s primary focus is on heavy oil and oil sands projects in Western Canada. BlackPearl s current core properties are: Onion Lake, Saskatchewan conventional heavy oil and, in the future, thermal SAGD recovery; Mooney, Alberta conventional heavy oil using horizontal drilling and polymer flooding; and Blackrod, Alberta heavy oil/bitumen using the SAGD recovery process. These core properties provide the Company with a combination of short-term cash flow generation, medium-term reserves and production growth, and long-term reserves growth on multi-phase low decline projects using thermal recovery processes. Under BlackPearl s current business plan, management intends to sell the Company s non-core assets. During 2011, the Company disposed of properties containing minimal reserves. Additional non-core asset sales are planned; however, additional work will be undertaken on these remaining properties prior to bringing them to market SIGNIFICANT EVENTS Capital expenditures during 2011 were $192.6 million, with approximately $32 million spent at Blackrod, $82 million at Onion Lake and $70 million at Mooney. The focus of the 2011 capital program was to complete the SAGD pilot facilities at Blackrod, complete the first phase of the polymer flood at Mooney and continue conventional drilling at Onion Lake. Oil and gas sales during 2011 were $179.4 million and cash flow from operations was $76.7 million. Net income was $18.9 million for the year ended December 31, in 2011, BlackPearl completed non-core asset sales in the amount of $6.1 million. The assets sold included heavy oil properties in Saskatchewan, natural gas properties in southern Alberta as well as the polymer pilot facilities used at Mooney. The Company did not undertake any equity issuances in 2011; however, 1,586,624 common shares were issued pursuant to the exercise of stock options and warrants during the year. At December 31, 2011, BlackPearl had working capital of $37.8 million and no long-term debt. BlackPearl increased its proved plus probable reserves by 44% to 35.8 million barrels of oil equivalent and its best estimate contingent resources from its three core properties increased to 752 million barrels of oil equivalent. These amounts were determined, as at December 31, 2011, by BlackPearl s independent reserve evaluators, Sproule Unconventional Limited. 3 blackpearl resources inc. / 2011 Financial report

4 Management s Discussion and Analysis ANNUAL FINANCIAL INFORMATION ($000s, except where noted) (2) Total revenues 179, ,867 89,637 Net income (loss) 18,911 (86) (47,315) Per share basic ($) (0.19) Per share diluted ($) (0.19) Cash flow from operations (1) 76,681 62,606 29,004 Per share basic and diluted ($) Capital expenditures 192,634 95,829 27,878 Total assets (end of period) 606, , ,309 Common shares outstanding (000s) (end of period) 284, , ,961 (1) Cash flow from operations before working capital changes and cash flow per share do not have standardized meanings prescribed by Canadian GAAP and therefore may not be comparable to similar measures used by other companies. Cash flow from operations before working capital changes includes all cash flow from operating activities and is calculated before changes in non-cash working capital. Cash flow from operations before working capital changes is reconciled with net earnings (loss) in the consolidated statements of cash flows. Management uses these non-gaap measurements for its own performance measures and to provide its shareholders and investors with a measurement of the Company s efficiency and its ability to fund a portion of its growth expenditures. (2) Information for 2009 has been presented in accordance with previous Canadian GAAP and has not been restated to IFRS. SELECTED QUARTERLY INFORMATION ($000s, except where noted) Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31 Production (boe/d) 8,734 8,113 6,545 7,015 7,307 6,646 7,163 6,685 Revenue ($/boe) Oil and natural gas sales 58,160 44,564 42,044 34,675 38,743 33,421 34,274 36,429 Production costs 14,014 13,665 10,337 11,122 8,670 8,297 9,306 10,552 Net income (loss) 15,504 (51) 2, (4,832) (1,443) 5,155 1,034 Per share, basic and diluted ($) (0.02) (0.01) Capital expenditures 56,974 40,499 57,040 38,121 38,033 19,926 5,687 34,181 Cash flow from operations (1) 27,165 18,924 18,834 11,754 19,413 14,136 13,926 14,987 Per share, basic ($) Per share, diluted ($) Total assets (end of period) 606, , , , , , , ,753 Weighted average shares outstanding, basic (000s) 284, , , , , , , ,057 Weighted average shares outstanding, diluted (000s) 300, , , , , , , ,739 (1) Cash flow from operations is a non-gaap measure. It represents cash flow from operating activities before changes in working capital. Fluctuations in quarterly revenues and net earnings over the last eight quarters are due primarily to the volatility in oil and natural gas prices and changes in sales volumes due to production growth through successful drilling activity, principally in the Onion Lake area. Decreased production in Q and Q was primarily a result of asset dispositions during the last fifteen months. The increased production in the second half of 2011 is a result of new production from Onion Lake wells drilled in the first half of Fluctuations in quarterly net income in 2010 and 2011 are primarily a result of gains and losses recorded on property dispositions during those periods. The significant increase in net income in Q is a result of an increase in prices as well as a significant deferred tax recovery. The continued improvement in heavy oil prices led to a significant increase in BlackPearl s capital program in blackpearl resources inc. / 2011 Financial report

5 Management s Discussion and Analysis BUSINESS ENVIRONMENT Commodity Prices Average Crude Oil Prices West Texas Intermediate (WTI) (US$/bbl) Western Canadian Select (WCS) (Cdn$/bbl) Differential WCS/WTI (Cdn$/bbl) Differential WCS/WTI (%) 18% 18% Average Natural Gas Prices AECO gas (Cdn$/GJ) Foreign Exchange (Cdn$ to US$) Crude oil prices strengthened during 2011, with the West Texas Intermediate (WTI) reference price averaging US$95.05 per barrel compared with US$79.48 per barrel in Demand for crude oil is generally tied to global economic growth, but is also influenced by factors such as political instability, market uncertainty, weather conditions and government regulations. In 2011, the political instability in several Middle Eastern and North African countries contributed to the increase in crude oil prices. The uncertainty related to the debt crisis in the US and several European countries and the potential effect on global economic growth also contributed to the volatility in oil prices in The WTI forward strip price for 2012 is currently approximately US$109. The majority of BlackPearl s production revenues are derived from the sale of heavy oil, which receives a lower price than light oil due to increased processing requirements for heavy oil. The difference between the reference price of light oil and the reference price of heavy oil is commonly referred to as the light/heavy differential. The differential can be volatile due to supply and demand, refinery margins, seasonal fluctuations and transportation issues. The differential averaged 18% in both 2011 and Oil prices in Canada are also affected by the Canada/U.S. dollar exchange rate since the WTI reference price of oil is in U.S. dollars. During 2011, the Canadian dollar strengthened slightly against the U.S. dollar, averaging US$1.011 to Cdn$1 compared with US$0.971 to Cdn$1 in The strengthening of the Canadian dollar partially offsets the increased WTI benchmark pricing experienced during In 2011, natural gas prices decreased significantly from As a result of asset dispositions during 2010 and the first quarter of 2011, BlackPearl s natural gas production currently represents only about 2% of total production and therefore changes in natural gas prices have a minor impact on the Company s current operations. 5 blackpearl resources inc. / 2011 Financial report

6 Management s Discussion and Analysis Oil and Natural Gas Production, Pricing and Revenue Daily production / sales volumes (1) Oil (bbls/d) 7,403 6,375 Natural gas (Mcf/d) 960 3,455 Combined (boe/d) 7,563 6,951 Bitumen Blackrod (bbls/d) 57 7,620 6,951 Product pricing Oil ($/bbl) Natural gas ($/Mcf) Combined ($/boe) Sales ($000s) Oil and natural gas revenue gross 179, ,867 Royalties (45,531) (36,798) Oil and natural gas revenue net 133, ,069 (1) Natural gas production converted at 6:1 (for boe figures) Oil and natural gas revenue increased 26% in 2011 to $179.4 million from $142.9 million in The increase in revenue is attributable to a 9% increase in production (on a boe basis) and a 15% increase in average product prices. The increase in 2011 oil production is primarily a result of new production from 83 Onion Lake wells drilled during During 2011, we commenced the first phase of our polymer injection project at Mooney. Initially, this results in a decrease in sales volumes from the area as we convert a number of producing wells into polymer injectors. Once we repressurize the field production sales volumes are expected to increase. It is likely this response from the polymer injection will begin in late The decrease in natural gas sales volumes in 2011 is a result of the disposition of our southern Alberta gas properties in the first quarter. Production by Area (boe/d) Onion Lake 6,272 5,039 Mooney ASP flood area Non-flood areas John Lake Other Blackrod 57 7,620 6,951 On a boe basis, 98% of the Company s oil and natural gas production in 2011 was heavy oil. The Onion Lake area accounted for 83% of total production in Our average wellhead price received in 2011 increased to $65.64 per barrel compared to $58.86 per barrel in The higher wellhead prices in 2011 reflects the general increase in prices in the crude oil markets, partially offset by wider heavy oil differentials. BlackPearl did not enter into any oil price hedging arrangements in 2011 and, at the present time, does not anticipate hedging any of its production in blackpearl resources inc. / 2011 Financial report

7 Management s Discussion and Analysis In 2011, BlackPearl commenced operations of its SAGD pilot project at Blackrod. The pilot includes a single horizontal well pair and associated steam and water handling facilities. The pilot is being undertaken to provide operating data to design the commercial development of the Blackrod lands. All revenues and expenses from the pilot are being recorded as an adjustment to the capitalized costs of the project until the technical feasibility and commercial viability of the project is established. In 2011, the net revenues capitalized was a loss of $2.9 million. Royalties Royalties ($000s) 45,531 36,798 Per boe ($) As a percentage of revenue 25% 26% Royalties increased by 24% from $36.8 million in 2010 to $45.5 million in The increase reflects higher revenues during Generally, royalty rates in western Canada vary based on volumes produced by individual wells, prices received and the area the production is derived from. Provincial governments have established royalty incentive programs to encourage producers to initiate secondary and tertiary recovery schemes on existing fields. The Mooney ASP flood has been approved for one of these incentive programs and therefore, during the pre-payout period, royalties in the flood area at Mooney will have a royalty burden of 10% or less. In addition, the horizontal wells drilled at Mooney on the non-flood areas will have a 5% crown royalty rate for the first 12 months of production. Transportation Costs Transportation costs ($000s) 1,430 2,734 Per boe ($) Transportation costs are incurred to move marketable crude oil and natural gas to their selling points. Changes in transportation costs, on a boe basis, are generally related to moving crude oil to different sales points to capture better marketing opportunities, or as a result of production being shipped as emulsion rather than clean marketable oil. Costs related to trucking emulsion are classified as production expenses rather than transportation costs. In an effort to reduce chemical and other costs incurred to eliminate water and other impurities from produced oil, in 2011, more of the Onion Lake production was shipped as emulsion and therefore our transportation costs to ship clean oil was lower. Production Costs Production costs ($000s) 49,138 36,824 Per boe ($) Production expenses increased 33% to $49.1 million in 2011 compared to $36.8 million in On a boe basis, production expenses increased 23% to $17.80 per barrel from $14.51 in The increase in production expenses is attributable to increased production volumes, maturity of the major operating areas which tend to result in higher workover and well servicing expenses, as well as changes in field operating characteristics. At Onion Lake, we elected to reduce infield tank treating (and therefore reduce initial capital costs for each well) which resulted in higher emulsion trucking and third party treating expenses. The higher costs associated with treating and trucking emulsion that is included in production expenses is partially offset by lower transportation costs. We also drilled 83 new wells at Onion Lake and these wells will generally have higher sand disposal costs during the first six to twelve months of production. In addition, although the incremental costs of initially re-pressurizing the reservoir on the Mooney ASP flood are being capitalized, the fixed operating costs continued with lower production levels (since half the wells were converted to injectors) for This contributed to higher operating costs on a per barrel basis. 7 blackpearl resources inc. / 2011 Financial report

8 Management s Discussion and Analysis Operating Netback ($/boe) Revenue $ $ Royalties Transportation costs Production costs Netback per boe $ $ The 2011 netback of $30.19 per boe is a 15% increase from the $26.22 per boe reported in The increase is primarily attributable to the increase in realized crude oil prices in General and Administrative Expenses (G&A) (000s, except per boe) Gross G&A expense 9,719 8,715 Operator recoveries (2,853) (1,740) 6,866 6,975 Per boe ($) G&A, in absolute terms, was comparable from 2010 to Gross general and administrative expenses have increased in 2011 principally due to higher compensation costs as we add staff to manage the next stage of development of each of our core projects. Overhead recoveries in 2011 were also higher than 2010 as a result of increased capital spending this year. Looking forward, with the anticipated increase in production, the cost per boe of production is expected to be comparable or slightly lower than in previous periods. Stock-Based Compensation Stock-based compensation ($000s) 6,353 3,995 Per boe ($) Stock-based compensation costs are non-cash charges which reflect the estimated value of stock options granted. The Company uses the fair value method of accounting for stock options granted to directors, officers, employees and consultants whereby the fair value of all stock options granted is recorded as a charge to operations over the period from the grant date to the vesting date of the option. The fair value of common share options granted is estimated on the date of grant using the Black-Scholes options pricing model. The increase in stock-based compensation expense in 2011 reflects additional options previously granted, as well as a higher option value assigned to each grant of options. In 2011, 1,231,500 options were exercised. Depletion and Depreciation Depletion and depreciation ($000s) 61,318 57,789 Per boe ($) Depletion and depreciation expense increased by 6% to $61.3 million or $22.21 per boe for the year ended 2011 from $57.8 million or $22.78 per boe for The increase in depletion is a result of increased production in The lower depletion rate per boe is a result of an increase in proved and probable reserves recognized in 2011 at lower finding and development costs than our historical average. 8 blackpearl resources inc. / 2011 Financial report

9 Management s Discussion and Analysis Interest Income Interest income ($000s) 1, Interest income consists of interest earned on excess cash held by the Company. Interest income has increased as a result of higher interest rates earned in 2011, as well as high average cash balances maintained by the Company compared to Other Income Other income ($000s) 3,132 Other income in 2010 consists mainly of net cash received as part of a drilling incentive program offered by the Alberta government to encourage drilling activity within the province. These drilling credits received were acquired from third parties that did not have sufficient production to utilize the credits. No credits were purchased in The program expired on March 31, Income Taxes Deferred tax recovery ($000s) (5,347) The corporate effective tax rate for 2011 is approximately 26 percent; however, BlackPearl did not pay income taxes in 2011 and does not expect to pay income taxes in 2012 as we have sufficient tax pools to shelter expected income. The Company has the following estimated tax pools as at December 31: ($000s, except left-hand column) Rate % Canadian exploration expenses 100 $ 28,255 $ 14,459 Canadian development expenses , ,634 Canadian oil and gas property expenses 10 14,726 18,964 Undepreciated capital costs , ,237 Non-capital losses (various expiry dates) , ,625 Share issuance costs 5 years 2,824 6,015 $ 533,795 $ 458,934 BlackPearl has certain deductible temporary differences (more deductions for calculating taxable income than deductions available for calculating financial statement income) that were not previously recognized in our financial statements based on management s assessment of the likelihood of generating sufficient taxable income to utilize these deductions. In 2011, based, in part, on updated oil and gas reserve evaluations, management believes there is a high likelihood of utilizing these tax pools in the future and, accordingly, have recognized a deferred tax asset of $6.1 million in 2011, $5.3 million of which was applied to the consolidated statement of income (the remainder was applied to share capital). Gain (loss) on Disposition of Petroleum and Natural Gas Properties Gain (loss) on disposition of petroleum and natural gas properties ($000s) 3,375 (1,042) During 2010 and 2011, BlackPearl recorded gains and losses on the disposition of certain petroleum and natural gas properties in southern Alberta, Saskatchewan and the polymer pilot facilities in the Mooney area. The Company expects to sell additional non-core assets over the next 12 to 24 months. 9 blackpearl resources inc. / 2011 Financial report

10 Management s Discussion and Analysis Revaluation of Investments Revaluation of investments ($000s) During 2010 and 2011, BlackPearl revalued its investment in MAV II Notes to represent the fair value of the investment. RESULTS OF OPERATIONS ($000s, except where noted) Net income (loss) 18,911 (86) Per share, basic ($) Per share, diluted ($) For the year ended December 31, 2011, the Company generated net income of $18.9 million compared to a net loss of $86,000 in The substantial income in 2011 is primarily a result of improved heavy oil prices, a gain recognized on the disposition of various oil and gas properties as well as the recognition of certain deferred tax benefits. ($000s, except where noted) Cash flow from operations 76,681 62,606 Per share, basic ($) Per share, diluted ($) Cash flow from operations increased in 2011 to $76.7 million from $62.6 million in The increase in cash flow in 2011 reflects higher wellhead sales prices, as well as higher production volumes. LIQUIDITY AND CAPITAL RESOURCES At December 31, 2011, BlackPearl had working capital of $37.8 million compared to $144.0 million at December 31, The decrease is mainly a result of capital expenditures of $192.6 million offset by $76.7 million in operating cash inflows. In addition to its working capital, BlackPearl also has an undrawn $25 million credit facility. The amount available under the credit facility is based on the value of oil and natural gas reserves. BlackPearl renewed its existing credit facility during 2011 and the next review of the Company s credit facility is scheduled to be completed by May 29, The only financial covenant in the facility is to maintain a working capital ratio of 1:1 at the end of each fiscal quarter. Working capital ratio is defined as current assets plus unutilized credit under the credit facility compared to current liabilities. The Company had a working capital ratio of 2.3:1 at December 31, 2011 and was in compliance with these covenants throughout The Company expects capital spending for 2012 to be between $125 and $135 million. This will be financed from working capital and anticipated operating cash flows. The Company does not expect to utilize its credit facility to fund this program other than to issue letters of credit periodically to secure delivery of goods and services. At December 31, 2011, there is a $3 million letter of credit outstanding against the facility. The Company can adjust its 2012 capital program if required to maintain its financial flexibility. On a longer-term basis, the December 31, 2011 oil and natural gas reserves evaluation and contingent resource studies, prepared by Sproule Unconventional Limited, indicates that the Company will require significant capital investment to fully develop the Company s three major projects which include the Blackrod SAGD project, the Mooney polymer flood and continued development of Onion Lake, including future SAGD development. The Company will require additional external financing to fund development of these projects. We do not expect to have the financial capacity to proceed with all three projects concurrently. As a result, we are evaluating development timetable scenarios for each of our projects which will lead to our capital allocation plan between these projects and establish the amount of additional financing required. Possible financing alternatives include making use of the Company s existing credit facility, acquiring additional debt financing, further 10 blackpearl resources inc. / 2011 Financial report

11 Management s Discussion and Analysis equity offerings, using proceeds from the disposition of additional non-core properties or potentially selling one of the three core projects. To ensure funding for our capital projects to the end of 2013, the Company intends to expand its bank credit facilities and sell one or more of our non-core properties. We believe our existing producing assets could support a facility in the range of $100 - $150 million and proceeds from non-core assets sales over the next 12 months could provide up to $50 million of funding. CAPITAL EXPENDITURES BlackPearl s capital program is focused on heavy oil opportunities. During 2011, capital spending was higher than in 2010, totaling $192.6 million, an increase from the $95.8 million spent in The focus of the 2011 capital program has been to complete the SAGD pilot facilities at Blackrod, complete the first phase of the polymer facilities at Mooney and drill conventional heavy oil wells at Onion Lake. In addition, in 2011 we completed drilling 10 delineation wells at Blackrod to support the commercial development application which is expected to be submitted in 2012, began drilling horizontal wells on additional Mooney lands that will eventually be converted to a polymer flood, as well as drilling in some of our non-core areas. During 2011, the Company completed the sale of certain minor oil and natural gas properties in the amount of $6.1 million. ($000s) Land 9,109 5,168 Seismic 2,160 2,906 Drilling and completion 105,939 39,712 Equipment 75,293 26,791 Other Total 192,634 74,829 Property acquisitions 21,000 Total capital expenditures 192,634 95,829 Property dispositions (6,100) (41,969) Net capital expenditures 186,534 53,860 CONTRACTUAL OBLIGATIONS AND COMMITMENTS The Company has a number of financial obligations in the ordinary course of business. The following table summarizes the outstanding contractual obligations and commitments of the Company as at December 31, 2011: ($000s) Thereafter Operating leases (1) $ 1,211 $ 1,336 $ 1,587 $ 1,587 $ 1,282 $ Electrical service agreement (2) 2,969 Drilling rig commitment (3) 4,480 Decommissioning liabilities (4) ,709 29,489 $ 8,864 $ 1,511 $ 1,898 $ 2,413 $ 2,991 $ 29,489 (1) The Company has 57 months remaining on an operating lease for office space as at December 31, The Company s office lease was executed jointly with another party. Under the terms of the lease, BlackPearl and the other party are joint and severally liable for the obligations pursuant to the lease. Accordingly, if the other party or any of the subtenants of a portion of the space are unable to fulfill their lease obligation, BlackPearl would be required to pay a maximum additional $17.4 million (including an estimate for operating costs) over the next 57 months. (2) The Company entered into an agreement whereby an electrical service connection will be installed at a facility over the next year. (3) The Company has contracted drilling rig services over the next year. In the event that the Company does not utilize the minimum contracted days, the Company would be obligated to pay the rig operator a variable rate based on days not utilized under the contracts. The commitment amount included herein assumes no drilling days used. (4) The Company has ongoing obligations related to the abandonment and reclamation of well sites and facilities which have reached the end of their economic lives. The undiscounted estimated obligations associated with the retirement of the Company s oil and gas properties were $32.7 million as at December 31, Remediation programs are undertaken regularly in accordance with applicable legislative requirements. These obligations are expected to be funded from operating cash flow. 11 blackpearl resources inc. / 2011 Financial report

12 Management s Discussion and Analysis FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The financial instruments on the Company s balance sheet include cash, accounts receivable, investment in MAV II Notes and accounts payable. The Company manages its risk through its policies and processes, but generally has not used derivative financial instruments to manage these risks. The carrying value of cash, accounts receivable and accounts payable approximates their fair value due to the short-term nature of these instruments. The fair value of the investment in MAV II Notes has been determined by quoted prices that were determined outside of what would be considered an active market. Commodity Price Risk Commodity price risk is the risk that future cash flows will fluctuate as a result of changes in the price of oil and natural gas. Commodity prices are impacted by world economic events that affect supply and demand, which are generally beyond the Company s control. Changes in crude oil prices may significantly affect the Company s results of operations, costs generated from operating activities, capital spending and the Company s ability to meet its obligations. The majority of the Company s production is sold under short-term contracts; consequently, BlackPearl is exposed to risk of near-term price movements. The Company manages this risk by constantly monitoring commodity prices and factoring them into operational decisions, such as contracting or expanding its capital expenditure program. Foreign Currency Risk Foreign currency risk is the risk that a variation in exchange rates between the Canadian dollar and the U.S. dollar will affect the Company s operating and financial results. As at December 31, 2011, the Company held US$3,490,000 in cash and shortterm deposits. As at December 31, 2011, if the Cdn$-US$ exchange rates had been $0.10 lower with all other variables held constant, after tax earnings for the period would have been approximately $348,000 higher, due to a decreased foreign exchange loss. An equal opposite impact would have occurred to net earnings had exchange rates been $0.10 higher. The Company does not hedge its foreign currency risk. Credit Risk Credit risk is the risk that a third party fails to meet its contractual obligations in a way that could result in the Company incurring a loss. The Company s credit risk is primarily related to its holdings of cash, accounts receivable and investment in MAV II Notes. As at December 31, 2011, the Company held $59.7 million in cash at various major financial institutions throughout Canada and the United States. At December 31, 2011, three Canadian financial institutions held approximately 99 percent of BlackPearl s cash and short-term deposits. Cash balances in excess of the Company s day-to-day requirements are invested in short-term deposits of less than 30 days. The Company s accounts receivable are primarily with oil and natural gas marketers and joint venture partners. Receivables from oil and natural gas marketers are generally collected on the 25th day of the month following production. The Company attempts to mitigate this risk by assessing the financial strength of its counterparty and entering into relationships with larger purchasers with established credit history. The Company typically does not obtain collateral or security from its joint venture partners or oil and natural gas marketers. The carrying amounts of accounts receivable represent the maximum credit exposure. 12 blackpearl resources inc. / 2011 Financial report

13 Management s Discussion and Analysis The Company is not the operator of certain oil and natural gas properties in which it has an ownership interest. The Company is dependent on such operators for the timing of activities related to such properties and will largely be unable to direct or control the activities of the operators. In addition, the Corporation s activities may be impacted by the ability, expertise, judgment and financial capability of the operators. Interest Rate Risk Interest rate risk is the risk that future cash flows of a financial instrument will fluctuate due to changes in interest rates. The Company is exposed to interest rate risk primarily related to its cash and the revolving credit facility, which remained undrawn throughout 2011 and is undrawn at this time. Cash is held in highly liquid, short-term investments and therefore the risk to changes in interest rates is low. At December 31, 2011, if interest rates had been one percentage point (100 basis points) higher, with all other variables held constant, after-tax earnings for the period would have been approximately $542,000 higher. At December 31, 2011, the Company had not drawn on its credit facility and therefore the interest rate risk at that time was NIL. Liquidity Risk Liquidity risk is the risk the Company is unable to meet its financial obligations as they come due. The Company uses operating cash flows, credit facilities and equity offerings to fund its capital requirements. The Company currently manages this risk by maintaining a conservative balance sheet with minimal use of long-term debt. Liquidity risk is currently low due to BlackPearl s large cash position. As at December 31, 2011, the Company had working capital of $37.8 million and an undrawn $25.0 million credit facility. The Company believes it has sufficient funding from these sources to meet its foreseeable obligations. For more detailed information, see note 11 to the consolidated financial statements. OFF-BALANCE-SHEET ARRANGEMENTS The Company has no off-balance-sheet arrangements. RELATED-PARTY TRANSACTIONS There were no related-party transactions during OUTSTANDING SHARE DATA As at February 24, 2012, the Company had 285,152,678 common shares outstanding, 9,645,196 vested warrants outstanding and 16,127,665 stock options outstanding under its stock-based compensation program. PROPOSED TRANSACTIONS As of February 24, 2012, the Company does not have any significant pending transactions. 13 blackpearl resources inc. / 2011 Financial report

14 Management s Discussion and Analysis CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements requires management to make estimates and assumptions that affect reported assets and liabilities, disclosure of contingencies and revenues and expenses. Management is also required to adopt accounting policies that require the use of significant estimates. Actual results could differ materially from those estimates. A comprehensive discussion of the significant accounting policies adopted by BlackPearl can be found in notes 2 and 3 to the consolidated financial statements. Management believes the most critical accounting policies, including judgments in their application, which may have an impact on the Company s financial results, relate to the accounting for property, plant and equipment, and decommissioning liabilities. The rate at which the Company s assets are depreciated or otherwise written off and the decommissioning liability provided for, with the associated accretion expensed to the income statement, are subject to a number of judgments about future events, many of which are beyond management s control. In addition, recognition of reserves is central to much of the accounting for an oil and natural gas company, as described below. The following areas contain significant estimates made by management: (i) Oil and natural gas reserves - Estimating reserves is a subjective process. It requires significant judgments using geological, engineering and economic data. The important assumptions made in preparing an estimate of oil and gas reserves include expected reservoir performance, future rates of production, oil and natural gas price forecasts, future operating and development costs, timing of expenditures and future fiscal regimes. These estimates can change substantially as additional data from ongoing development activities and production performance becomes available and as economic conditions change. The Company s oil and natural gas reserves are evaluated by Sproule Unconventional Limited, an independent reserves evaluator. Reserves estimates can have a significant impact on net earnings, as they are a key component in the calculation of depletion and impairment testing as discussed below. The reserve estimates are also used in determining the Company s borrowing base for its credit facilities. (ii) Depletion and depreciation expense BlackPearl tracks all capital costs for development projects at the area asset level (unit-of-account). The aggregate of the capitalized costs and future development costs is amortized on the unit-of-production method based on estimated proved and probable reserves. Changes in estimated proved and probable reserves or future development costs have a direct impact on depletion and depreciation expense. Certain costs related to exploration and evaluation assets (E&E) have been excluded from costs subject to depletion. These costs remain primarily to the Blackrod property and will continue to be classified as E&E until reserves have been established and management determines that the projects are technically feasible and commercially viable or that their value is impaired. At December 31, 2011, $106.5 million has been excluded from depletion and has been shown separately on the Company s balance sheet. (iii) Impairment testing BlackPearl is required to review the carrying value of all property, plant, and equipment (PPE) for potential impairment. Throughout the year, the Company analyzes the carrying value of its PPE at the cash generating unit level (CGU), and considers potential indicators of impairment such as, among other things, current market conditions, current and forecasted heavy oil prices and the profitability of each CGU. Each CGU is explicitly tested for impairment, at a minimum, on an annual basis. The impairment test is based on estimates of reserves prepared by qualified independent evaluators, production rate, crude oil and natural gas prices, future costs and other relevant assumptions. By their nature, reserve estimates are subject to measurement uncertainty and the impact of impairment test calculations on the consolidated financial statements of changes to reserve estimates could be material. 14 blackpearl resources inc. / 2011 Financial report

15 Management s Discussion and Analysis At December 31, 2011, the carrying values of each of the Company s CGUs were compared to the net present value of proved and probable reserves, before tax, discounted at a rate of 10%. In all cases, the net present value exceeded the carrying value of the CGU and, as a result, no write-down was required. in addition, the Company tested its E&E assets for impairment, separately from PPE, by comparing the carrying value of the assets to the net present value of the contingent resources study, prepared by Sproule Unconventional Limited, discounted at 10%. No write-down was required. (iv) Decommissioning liability the decommissioning liability is estimated based on existing laws, contracts or other policies. The fair value of the liability is based on estimated future costs for abandonment and reclamation, discounted at a risk-free rate. The costs are included in property, plant and equipment and amortized over their useful life. The liability is adjusted each reporting period to reflect the passage of time, with the accretion charged to earnings and for revisions to the estimated future cash flows. The estimates or assumptions required to calculate the decommissioning liability includes, among other items, abandonment and reclamation amounts, inflation rates, risk-free discount rates and timing of retirement of assets. These assumptions are assessed annually, at a minimum, for reasonability and are revised when required to provide a more accurate estimate of the liability. By their nature, these estimates are subject to measurement uncertainty and the impact on the financial statements could be material. The following significant assumptions were used for the purpose of estimating the decommissioning liability: Undiscounted abandonment costs ($000s) $ 32,714 $ 27,482 Risk-free rate 2.25% 3.75% Inflation rate 2% 2% Average years to reclamation 9 12 (v) Income taxes the Company records deferred tax assets and liabilities based on temporary differences between the carrying value and tax basis of the Company s assets and liabilities. Deferred tax provisions require estimating the timing of these temporary differences and estimating whether tax assets will be realized before expiry. The determination of the Company s income and other tax liabilities requires interpretation of complex laws and regulations often involving multiple jurisdictions. All tax filings are subject to audit and potential reassessment after the lapse of considerable time. Accordingly, the actual income tax liability may differ significantly from that estimated and recorded. In addition, the Company is required to estimate whether it will be able to utilize all of its existing tax pools before their expiry. (vi) Stock-based compensation The Company uses the fair value method to account for stock options. The determination of the amounts for stock-based compensation is based on estimates of stock volatility, risk-free interest rates and the expected lives of the option. By their nature, these estimates are subject to measurement uncertainty and a change in these estimates would impact the valuation of the option and could result in a different amount for stockbased compensation expense. (vii) Other estimates a. The Company is required to make certain estimates for revenues, royalties, operating costs and capital expenditures as at a specific reporting date if actual amounts for these items have not been received. b. The decision to transfer exploration and evaluation assets to property, plant and equipment is based on management s determination of an area s technical feasibility and commercial viability based partially on proved and probable reserves. c. The estimated fair value of the Company s financial assets and liabilities, are by their nature, subject to measurement uncertainty. 15 blackpearl resources inc. / 2011 Financial report

16 Management s Discussion and Analysis ACCOUNTING STANDARDS ISSUED BUT NOT YET APPLIED IFRS 10: Consolidated Financial Statements In 2011, the IASB issued IFRS 10 which provides additional guidance to determine whether an investee should be consolidated. The guidance applies to all investees, including special purpose entities. The standard is required to be adopted for periods beginning January 1, IFRS 11: Joint Arrangements In 2011, the IASB issued IFRS 11 which presents a new model for determining whether an entity should account for joint arrangements using proportionate consolidation or the equity method. An entity will have to follow the substance rather than legal form of a joint arrangement and will no longer have a choice of accounting method. The standard is required to be adopted for periods beginning January 1, IFRS 12: Disclosure of Interests in Other Entities In 2011, the IASB issued IFRS 12 which aggregates and amends disclosure requirements included within other standards. The standard requires a company to provide disclosures about subsidiaries, joint arrangements, associates and unconsolidated structured entities. The standard is required to be adopted for periods beginning January 1, IFRS 13: Fair Value Measurement In 2011, the IASB issued IFRS 13 to provide comprehensive guidance for instances where IFRS requires fair value to be used. The standard provides guidance on determining fair value and requires disclosures about those measurements. The standard is required to be adopted for periods beginning January 1, IAS 1: Presentation of Items of Other Comprehensive Income In 2011, the IASB issued amendments to IAS 1 Presentation of Financial Statements to split items of other comprehensive income (OCI) between those that are reclassed to income and those that are not. The standard is required to be adopted for periods beginning on or after July 1, IAS 27: Separate Financial Statements The IASB issued amendments to IAS 27 Separate Financial Statements to coincide with the changes made in IFRS 10, but retains the current guidance for separate financial statements. IAS 28: Investments in Associates and Joint Ventures The IASB issued amendments to IAS 28 Investments in Associates and Joint Ventures to coincide with the changes made in IFRS 10 and IFRS 11. IFRS 7: Financial Instruments: Disclosures In 2011, the IASB issued amendments to IFRS 7 Financial Instruments: Disclosures relating to disclosure requirements for the offsetting of financial assets and liabilities when offsetting is permitted under IFRS. The disclosure amendments are required to be adopted retrospectively for periods beginning January 1, The Company is currently analyzing the impact, if any, that the adoption of these standards will have on its financial statements. 16 blackpearl resources inc. / 2011 Financial report

17 Management s Discussion and Analysis RISKS AND UNCERTAINTIES The Company is exposed to a number of risks and uncertainties inherent in exploring for, developing and producing crude oil and natural gas. These risks and uncertainties include, but are not limited to, the following: Risk of fluctuating oil, natural gas prices and the cost of diluent; Operational risk of finding and producing reserves economically; uncertainties associated with estimating the quantity of reserves and resources; Risk associated with securing the needed capital to carry out the Company s operations; Changes in global economic conditions, particularly in Canada and the U.S.; Risk from aboriginal claims; Risk of changes in government policies, especially related to royalty legislation, income tax laws, incentive programs, operating practices and environmental protection, social instability or other political, economic or diplomatic developments in its operations; Environmental and safety risks related to its oil and gas properties; Competition for, among other things, capital, undeveloped land, skilled labour and equipment; Reliance on third parties for pipeline and other infrastructure; Risk of fluctuating foreign currency exchange rates; Credit or counterparty risk with respect to non-performance by counterparties to financial instruments; Risk of changes to interest rates; Marketing oil production at acceptable prices; uncertainty associated with obtaining drilling licenses and other regulatory consents and approvals; and uncertainties of the SAGD bitumen and ASP flood recovery processes. Further information regarding these risks may be found under Risk Factors in the Company s Annual Information Form. Many of the previously mentioned risks are beyond the Company s control and it is impossible to ensure that any exploration drilling program or piloting program will ultimately result in commercial operations. The Company does not currently utilize derivative instruments to hedge its commodity price, foreign currency exchange or interest rate risks. BlackPearl strives to minimize and manage these risks in a number of ways, including: Employing qualified professional and technical staff; Maintaining a healthy balance sheet that minimizes the use of debt; Carrying insurance to provide a reasonable amount of protection from risk of loss; Concentrating in areas with long-life reserves to reduce the risk associated with commodity price cycles; Monitoring price trends and establishing relationships with creditworthy counterparties; utilizing the latest technology for finding and developing reserves; Constructing high-quality, environmentally sensitive and safe production facilities; and Maximizing operational control of drilling and producing operations. 17 blackpearl resources inc. / 2011 Financial report