Advantage Oil & Gas Ltd.
Annual Report 2010

Plain-text annual report

2010 A Annual l Repo ort Financial ($00 indicated) 00, except as ot therwise e royalties (1) Revenue befor (2) per share ( per boe Funds from op perations (2) per share ( per boe Net income (lo oss) (2) per share ( Expenditures o on fixed assets al deficit(3) ness bentures (face v ding at end of ye d average shares Working capita Bank indebtedn Convertible de Shares outstand Basic weighted Operating Daily Productio on as (mcf/d) Natural ga and NGLs (bbl Crude oil /d @ 6:1 Total boe g (including hed Average pricing as ($/mcf) Natural ga and NGLs ($/b Crude oil Proved plus pr robable reserves as (bcf) Natural ga & NGLs (mbbl Crude oil oe Total mbo fe index (years) Reserve li ls) (4) value) ear (000) (000) s/d) dging) bbl) 2010 ecember 31 Year ended De Y 8 2008 7 2007 2009 06 200 364, 501 2.23 2 41 1.38 139 175, 1 1.07 19 9.88 (44,2 208) 0.27) (0 223,3 308 64,4 290,6 148,5 164,0 163,4 452 657 544 092 467 101,5 7,2 24, 562 202 129 5 5.45 61 1.85 1,24 36,7 244, 45.2 760 291 27.5 2 429, ,492 2.80 2 3.70 43 ,675 197, 1.29 0.11 20 ,426) (86, (0 0.56) ,066 169, 48, 250, 218, 162, 153, ,809 ,262 ,471 ,746 ,140 104, ,527 ,508 9, ,929 26, 6.24 6 5.16 55 1,14 43, 233, 40.2 ,266 ,292 28.2 2 741 1,962 5.32 6 62.82 361 1,087 2.59 30.58 3 (20 0,577) ( (0.15) 255 5,591 62 587 219 142 139 2,959 7,404 9,195 2,825 9,483 122 11 32 2,878 1,793 2,273 8.14 87.08 8 7 704.3 57 7,386 174 4,767 15.2 557 7,358 19,727 41 5.18 4.66 48.41 50.97 5 14,758 21 1,143 271 2.65 2.22 24.78 24.79 2 49,814 4 7,535) (7 (0.06) 8,725 148 2,754 22 7,426 547 4,612 224 8,269 138 9,604 119 0.62 59,487 15 41,191 4 41 10,574 18 80,730 10 05,390 80,958 8 94,074 9 6,998 116 8,075 0,462 10 23,754 2 9,962 29 7.21 65.38 6 6.86 62.44 442.7 546.4 5 4 47,524 61 1,131 21,317 12 2,203 152 12.1 11.4 (1) includes realiz ed derivative gains and losses (2) based on basic c weighted average g shares outstanding (3) working capita al deficit includes a accounts receivable , prepaid expenses and deposits, accou unts payable and ac ccrued liabilities, di istributions payable e, and the current po ortion of capital leas se obligations (4) based on fourt th quarter average production rates CONTENTS Message to Shareholders ........................................................................................................................................................................................... 3 Reserves ....................................................................................................................................................................................................................... 6 Management’s Discussion & Analysis ................................................................................................................................................................... 10 Consolidated Financial Statements ........................................................................................................................................................................ 34 Consolidated Balance Sheets .......................................................................................................................................................................... 37 Consolidated Statements of Loss, Comprehensive Loss and Deficit ....................................................................................................... 38 Consolidated Statements of Cash Flows ....................................................................................................................................................... 39 Notes To Consolidated Financial Statements .............................................................................................................................................. 40 ANNUAL GENERAL MEETING Advantage Oil & Gas Ltd. is pleased to invite its shareholders and other interested parties to its Annual General Meeting to be held in the Lecture Theatre Room at the Metropolitan Centre, 333 – 4th Avenue SW, Calgary, Alberta on Wednesday, May 25, 2011 commencing at 10:00 a.m. We ask those shareholders unable to attend the meeting to please complete and return your Form of Proxy. Advantage Oil & Gas Ltd. - 2 MESSAGE TO SHAREHOLDERS Production Growth, Hedging and Reduced Costs Deliver Solid Financial and Operating Results (cid:190) Production for the fourth quarter of 2010 averaged 24,308 boe/d, an increase of 18% as compared to the fourth quarter of 2009, after adjusting for non-core asset dispositions. Advantage’s daily production for 2010 exited at approximately 25,000 boe/d, exceeding our guidance of 24,000 boe/d due to stronger than expected well performance at Glacier. The Glacier gas plant expansion is now completed with production exceeding 100 mmcf/d and corporate production at approximately 30,000 boe/d. (cid:190) Funds from operations for the fourth quarter of 2010 increased 6% to $40.7 million or $0.25 per share, as compared to the $38.5 million or $0.23 per share for the third quarter of 2010. For the year ended December 31, 2010, funds from operations was $175.1 million or $1.07 per share, a decrease from $197.7 million or $1.29 per share during 2009 attributed primarily to asset dispositions completed during the last two years. (cid:190) For the three months and year ended December 31, 2010, our hedging program contributed a net gain of $9.8 million and $45.1 million to funds from operations, respectively. Advantage’s hedging program has helped to stabilize and enhance our cash flow for capital reinvestment requirements. (cid:190) Operating costs for the fourth quarter of 2010 were $10.64/boe, a decrease of 3% as compared to $11.01/boe during the fourth quarter of 2009. Operating costs per boe for 2010 was $10.66/boe, a decrease of 12% as compared to $12.11/boe during 2009. Operating costs per boe have decreased considerably over the last several years as a result of the increasing contribution of low cost production from Glacier, the disposition of higher cost non-core assets, and the continued optimization of our other properties. We anticipate corporate operating costs will decline further in 2011 as a result of increased production at Glacier. (cid:190) The royalty rate for 2010 as a percentage of revenue was 14.0% as compared to 14.3% in 2009. For the fourth quarter of 2010, Advantage’s royalty rate was 12.2% as compared to 13.8% for the fourth quarter of 2009. We anticipate that our corporate royalty rate will decline further due to increased production from Glacier where the effective royalty rate for a new Glacier Montney well is anticipated to be approximately 5% over the life of the well. (cid:190) Significant reductions in the average bank indebtedness during the last twelve months have led to a 31% decrease in total interest expense as compared to the prior year. (cid:190) As at December 31, 2010, Advantage’s bank debt was $290.7 million on a credit facility of $525 million with an unutilized capacity of approximately $231.4 million. A total of $148.5 million of convertible debentures remain outstanding of which $62.3 million will mature in December 2011 and the balance of $86.2 million will mature in January 2015. (cid:190) Capital expenditures during the fourth quarter of 2010 amounted to $68.9 million for a total of $223.3 million for the year ended December 31, 2010. Approximately 86% of our 2010 capital program has been invested at Glacier where we successfully completed Phase II of our development program in the second quarter of 2010. The second half 2010 capital spending has been focused on our Phase III development program at Glacier which consisted of drilling 28 net (28 gross) horizontal wells and expanding our Glacier gas plant and gathering system capacity to 100 mmcf/d. (cid:190) Additional capital activities during 2010 included 3 net (3 gross) oil wells at Eyehill, 2.8 net (3 gross) oil and gas wells at Nevis, and 2.1 net (3 gross) oils wells at Sunset. Glacier Production Exceeding 100 mmcf/d with Additional 100 mmcf/d of Production Capacity (cid:190) Production performance at Glacier has been higher than anticipated with natural gas production averaging 53.3 mmcf/d for the fourth quarter of 2010 and exiting 2010 at 60 mmcf/d (10,000 boe/d), which exceeded our guidance. (cid:190) Phase III activities at Glacier are now substantially complete and production is exceeding 100 mmcf/d, which has progressed ahead of schedule and on-budget. (cid:190) An additional 100 mmcf/d (16,667 boe/d) of production capacity currently exists and additional wells will be brought on- stream as required to offset declines and maintain production. (cid:190) Optimization of drilling and completion practices combined with improved geological knowledge at Glacier has significantly increased the horizontal well test rates through each of our development phases. The average test rate of the Upper Montney wells for Phase III was 8.4 mmcf/d with an average of 13 fracs per well, surpassing our expectations. Advantage Oil & Gas Ltd. - 3 Impressive Glacier Netbacks Enhanced by Low Cost Structure (cid:190) Operating costs at Glacier are forecast to decrease from the $2.85/boe ($0.48/mcf) during the fourth quarter of 2010 to $1.80/boe ($0.30/mcf) at 100 mmcf/d due to efficiencies created by increasing the production rate through Advantage’s 100% owned Glacier gas plant and the utilization of multi-well production well pads on our contiguous land block which simplifies field operations. (cid:190) All Montney horizontal wells drilled at Glacier after May 1, 2010 qualify for a royalty incentive of $2.7 to $3.4 million based on a typical Glacier Montney horizontal well (total length of 4,200 to 4,500 metres). As a result, the effective royalty rate for a new Glacier Montney well is anticipated to be approximately 5% over the life of the well. (cid:190) The attractive royalty rates and low operating costs significantly enhances the netback and drilling economics of all of our Glacier Montney drilling locations as indicated below: Revenue (realized price) Royalties (5% royalty rate) Operating costs Netback* $/mcf $4.00 (0.20) (0.30) $3.50 $/mcf $5.00 (0.25) (0.30) $4.45 Operating netbacks exceed 87% of revenue Well Drilling Economics pre-tax rate of return * >39% *Note: assumes 4.5 mmcf/d IP, 5 Bcf reserves & $5.5 million per well with total Glacier production of 100 mmcf/d >66% (cid:190) Based on netbacks of $3.50/mcf and $4.45/mcf, annualized cash flows are projected to be approximately $128 million and $162 million respectively, which are in excess of estimated capital requirements to maintain a 100 mmcf/d production rate at Glacier. (cid:190) In summary, Glacier is a unique asset which provides the opportunity for Advantage to develop a large, scalable natural gas resource play which contains decades of drilling inventory and with one of the lowest cost structures in the Western Canadian Sedimentary Basin. Commodity Hedging Program (cid:190) Advantage’s hedging program includes 25% of our forecast net natural gas production for 2011 hedged at an average price of Cdn$6.30 AECO per mcf and 34% of forecast net crude oil production for 2011 at Cdn$88.90 per bbl. (cid:190) Additional details on our hedging program are available at our website at www.advantageog.com. Creation of Longview Oil Corp. (cid:190) On March 7, 2011, Advantage announced that Longview Oil Corp. (“Longview”), a wholly-owned subsidiary of the Corporation, filed a preliminary prospectus on March 4, 2011 for an initial public offering (the “Offering”), which is targeted to raise gross proceeds of $150 million prior to an over-allotment option of up to 15% of the base offering size, exercisable 30 days following the closing of the Offering. The closing of the Offering is expected to occur in April, 2011. Concurrent with closing of the Offering, Longview will purchase certain oil-weighted assets from Advantage with fourth quarter 2010 average production of 6,220 boe/d (74% oil & NGLs), proved reserves of 20.1 mmboe and proved plus probable reserves of 36.9 mmboe. (cid:190) Advantage will receive consideration comprised of the net proceeds of the Offering, common shares of Longview and proceeds of $100 million to be drawn from an independent Longview credit facility to be established at closing. Advantage plans to use the cash proceeds from the transaction to reduce outstanding bank indebtedness. Advantage will retain an equity ownership interest of approximately 68% of the common shares of Longview (approximately 63% if the over-allotment option is exercised in full). The transaction is conditional upon customary industry conditions including the approval of the Board of Directors of Advantage. As a result of the successful completion of the transaction, historical financial and operating performance as well as forward-looking information may not be indicative of actual future performance. (cid:190) For further details, please refer to the press release issued by Advantage on March 7, 2011 and the preliminary prospectus filed by Longview on March 4, 2011, which are available at www.sedar.com and Advantage’s website www.advantageog.com. Advantage Oil & Gas Ltd. - 4 Looking Forward (cid:190) Drilling results at our cornerstone Glacier property have demonstrated that our Montney development is among the top tier natural gas resource developments in North America. The attractive cost structure at Glacier which includes low operating costs and low royalty rates combined with a multi-decade drilling inventory provides a strong foundation to drive future development beyond 100 mmcf/d of production. (cid:190) With the expansion of Glacier to 100 mmcf/d now completed, a review of well performance, facility capacity and actual costs will be undertaken by Advantage to assess the timing and capital requirements for the next phase of growth at Glacier. (cid:190) Advantage will provide additional corporate guidance and communicate future development plans on or about mid-year 2011. Advantage Oil & Gas Ltd. - 5 Reserves Advantage engaged our independent qualified reserves evaluator Sproule Associates Ltd. (“Sproule”) to update the reserves analysis for the Company in accordance with National Instrument 51-101 and the COGE Handbook. Reserves and production information included herein is stated on a Company Interest basis (before royalty burdens and including royalty interests receivable) unless noted otherwise. This report contains several cautionary statements that are specifically required by NI 51-101. In addition to the detailed information disclosed in this press release, more detailed information on a net interest basis (after royalty burdens and including royalty interests) and on a gross interest basis (before royalty burdens and excluding royalty interests) will be included in Advantage's Annual Information Form ("AIF") and will be available at www.advantageog.com and www.sedar.com in the coming weeks. Highlights - Company Interest Reserves (Working Interests plus Royalty Interests Receivable) December 31, 2010 December 31, 2009 Proved plus probable reserves (mboe) Present Value of 2P reserves discounted at 10%, before tax ($000)(1) Net Asset Value per Share discounted at 10%, before tax (2) Reserve Life Index (proved plus probable - years) (3) Reserves per Share (proved plus probable) (2) Bank debt per boe of reserves (4) Convertible debentures per boe of reserves (4) 244,291 $2,515,972 $13.63 27.5 1.48 $1.18 $0.61 233,292 $2,773,428 $15.07 28.2 1.43 $1.06 $0.94 (1) Assumes that development of each property will occur, without regard to the likely availability to the Company of funding required for that development. (2) Based on 164.092 million Shares outstanding at December 31, 2010, and 162.746 million Shares outstanding as December 31, 2009. (3) Based on Q4 average production and company interest reserves. (4) Using boe's may be misleading, particularly if used in isolation. In accordance with NI 51-101, a boe conversion ratio for natural gas of 6 mcf: 1 bbl has been used which is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Company Interest Reserves (Working Interests plus Royalty Interests Receivable) Summary as at December 31, 2010 Proved Developed Producing Developed Non-producing Undeveloped Total Proved Probable Total Proved + Probable Light & Medium Oil Heavy Oil (mbbl) (mbbl) Natural Gas Liquids (mbbl) Natural Gas (mmcf) Oil Equivalent (mboe) 10,540 751 2,795 14,086 10,289 24,375 1,447 150 95 1,692 2,853 4,545 4,464 129 621 5,214 2,626 7,840 208,206 28,672 499,788 736,666 508,519 1,245,185 51,152 5,809 86,809 143,770 100,521 244,291 Advantage Oil & Gas Ltd. - 6 Gross Working Interest Reserves (Working Interest only) Summary as at December 31, 2010 Proved Developed Producing Developed Non-producing Undeveloped Total Proved Probable Total Proved + Probable Light & Medium Oil Heavy Oil (mbbl) (mbbl) Natural Gas Liquids (mbbl) Natural Gas (mmcf) Oil Equivalent (mboe) 10,319 749 2,795 13,862 10,182 24,044 1,417 147 90 1,654 2,833 4,487 4,432 129 621 5,181 2,615 7,796 207,695 28,562 499,783 736,040 507,929 1,243,969 50,783 5,785 86,803 143,371 100,285 243,656 Present Value of Future Net Revenue using Sproule price and cost forecasts (1)(2) ($000) Proved Developed Producing Developed Non-producing Undeveloped Total Proved Probable Total Proved + Probable 0% $ 1,408,498 158,270 1,653,020 3,219,789 3,410,239 $ 6,630,028 Before Income Taxes Discounted at 10% $ 819,727 89,107 525,190 1,434,024 1,081,948 $ 2,515,972 15% $ 690,677 73,543 304,641 1,068,861 741,772 $ 1,810,633 (1) Advantage’s crude oil, natural gas and natural gas liquid reserves were evaluated using Sproule’s product price forecast effective December 31, 2010 prior to the provision for income taxes, interests, debt services charges and general and administrative expenses. It should not be assumed that the discounted future revenue estimated by Sproule represents the fair market value of the reserves. (2) Assumes that development of each property will occur, without regard to the likely availability to the Company of funding required for that development. Sproule Price Forecasts The present value of future net revenue at December 31, 2010 was based upon crude oil and natural gas pricing assumptions prepared by Sproule effective December 31, 2010. These forecasts are adjusted for reserve quality, transportation charges and the provision of any applicable sales contracts. The price assumptions used over the next seven years are summarized in the table below: Year 2011 2012 2013 2014 2015 2016 2017 WTI Crude Oil ($US/bbl) 88.40 89.14 88.77 88.88 90.22 91.57 92.94 Edmonton Light Alberta AECO-C Crude Oil ($Cdn/bbl) 93.08 93.85 93.43 93.54 94.95 96.38 97.84 Natural Gas ($Cdn/mmbtu) 4.04 4.66 4.99 6.58 6.69 6.80 6.91 Henry Hub Natural Gas ($US/mmbtu) 4.44 5.01 5.32 6.80 6.90 7.00 7.11 Exchange Rate ($US/$Cdn) 0.932 0.932 0.932 0.932 0.932 0.932 0.932 Advantage Oil & Gas Ltd. - 7 Net Asset Value using Sproule price and cost forecasts (Before Income Taxes) The following net asset value ("NAV") table shows what is normally referred to as a "produce-out" NAV calculation under which the current value of the Company’s reserves would be produced at forecast future prices and costs. The value is a snapshot in time and is based on various assumptions including commodity prices and foreign exchange rates that vary over time. ($000, except per Share amounts) Net asset value per Share (1) - December 31, 2009 Present value proved and probable reserves Undeveloped acreage and seismic (2) Working capital (deficit) and other Convertible debentures Bank debt Net asset value - December 31, 2010 Net asset value per Share (1) - December 31, 2010 Before Income Taxes Discounted at 0% $ 45.55 6,630,028 199,800 (41,839) (148,544) (288,852) 6,350,593 38.70 $ $ $ 10% $ 15.07 2,515,972 199,800 (41,839) (148,544) (288,852) 2,236,537 13.63 $ $ $ 15% $ 10.09 1,810,633 199,800 (41,839) (148,544) (288,852) 1,531,198 9.33 $ $ $ (1) Based on 164.092 million Shares outstanding at December 31, 2010, and 162.746 million Shares outstanding at December 31, 2009. (2) Internal estimate Gross Working Interest Reserves Reconciliation Proved Opening balance Dec. 31, 2009 Extensions Improved recovery Infill Drilling Discoveries Economic factors Technical revisions Acquisitions Dispositions Production Light & Medium Oil (mbbl) 15,602 345 - 176 - (93) (430) - (167) (1,570) Heavy Oil (mbbl) 2,466 3 - 233 - (8) (49) - (709) (282) Natural Gas Liquids (mbbl) 5,266 42 - 91 - (67) 678 16 (68) (776) Natural Gas (mmcf) 507,206 141,744 - 5,916 - (40,732) 178,521 213 (19,758) (37,070) Oil Equivalent (mboe) 107,868 24,014 - 1,485 - (6,957) 29,952 52 (4,237) (8,807) Closing balance at Dec. 31, 2010 13,862 1,654 5,181 736,040 143,371 Proved + Probable Opening balance Dec. 31, 2009 Extensions Improved recovery Infill Drilling Discoveries Economic factors Technical revisions Acquisitions Dispositions Production Light & Medium Oil (mbbl) 29,125 795 - 230 - (154) (4,121) - (260) (1,570) Heavy Oil (mbbl) 5,836 4 - - - (13) (41) - (1,017) (282) Natural Gas Liquids (mbbl) 7,749 46 - 138 - (89) 802 25 (99) (776) Natural Gas (mmcf) 1,137,322 209,799 - 7,959 - (33,158) (11,766) 331 (29,448) (37,070) Oil Equivalent (mboe) 232,264 35,811 - 1,694 - (5,782) (5,321) 80 (6,284) (8,807) Closing balance at Dec. 31, 2010 24,044 4,487 7,796 1,243,969 243,656 Advantage Oil & Gas Ltd. - 8 Finding, Development & Acquisitions Costs (“FD&A”) (1)(2)(3) 2010 FD&A Costs – Gross Working Interest Reserves excluding Future Development Capital Capital expenditures ($000) Acquisitions net of dispositions ($000) Total capital ($000) Total mboe, end of year Total mboe, beginning of year Production, mboe Reserve additions, mboe FD&A costs ($/boe) 2010 2009 Three year average F&D costs ($/boe) 2010 2009 Three year average Proved $ 223,308 (69,676) 153,632 $ 143,371 107,868 8,807 44,310 $ $ $ $ $ $ 3.47 (4.55) 4.32 4.60 10.46 6.42 Proved + Probable $ $ 223,308 (69,676) 153,632 243,656 232,264 8,807 20,199 $ $ $ $ $ $ 7.61 (1.08) 2.78 8.46 2.49 4.17 NI 51-101 2010 FD&A Costs – Gross Working Interest Reserves including Future Development Capital Capital expenditures ($000) Alberta Drilling Incentives ($000) Acquisitions net of dispositions ($000) Net change in Future Development Capital ($000) Total capital ($000) Reserve additions, mboe FD&A costs ($/boe) 2010 2009 Three year average F&D costs ($/boe) 2010 2009 Three year average Proved $ 223,308 (3,258) (69,676) 339,907 490,281 44,310 11.06 22.50 17.13 11.55 10.58 16.43 $ $ $ $ $ $ $ Proved + Probable $ $ $ $ $ $ $ $ 223,308 (3,258) (69,676) 69,493 219,867 20,199 10.89 10.14 13.24 10.97 9.82 12.43 (1) Under NI 51-101, the methodology to be used to calculate FD&A costs includes incorporating changes in future development capital ("FDC") required to bring the proved undeveloped and probable reserves to production. For continuity, Advantage has presented herein FD&A costs calculated both excluding and including FDC. (2) The aggregate of the exploration and development costs incurred in the most recent financial year and the change during that year in estimated future development costs generally will not reflect total finding and development costs related to reserves additions for that year. Changes in forecast FDC occur annually as a result of development activities, acquisition and disposition activities and capital cost estimates that reflect Sproule’s best estimate of what it will cost to bring the proved undeveloped and probable reserves on production. (3) In all cases, the FD&A number is calculated by dividing the identified capital expenditures by the applicable reserve additions. Boes may be misleading, particularly if used in isolation. A boe conversion ratio of 6 MCF:1 BBL is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Advantage Oil & Gas Ltd. - 9 Management’s Discussion & Analysis The following Management’s Discussion and Analysis (“MD&A”), dated as of March 22, 2011, provides a detailed explanation of the financial and operating results of Advantage Oil & Gas Ltd. (“Advantage”, the “Corporation”, “us”, “we” or “our”) for the three months and year ended December 31, 2010 and should be read in conjunction with the audited consolidated financial statements. The consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) and all references are to Canadian dollars unless otherwise indicated. All per barrel of oil equivalent (“boe”) amounts are stated at a conversion rate of six thousand cubic feet of natural gas being equal to one barrel of oil or liquids, based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Boes maybe misleading, particularly if used in isolation. Forward-Looking Information This MD&A contains certain forward-looking statements, which are based on our current internal expectations, estimates, projections, assumptions and beliefs. These statements relate to future events or our future performance. All statements other than statements of historical fact may be forward-looking statements. Forward-looking statements are often, but not always, identified by the use of words such as "seek", "anticipate", "plan", "continue", "estimate", "expect", "may", "will", "project", "predict", "potential", "targeting", "intend", "could", "might", "should", "believe", "would" and similar or related expressions. These statements are not guarantees of future performance. In particular, forward-looking statements included in this MD&A include, but are not limited to, statements with respect to spending and capital budgets; capital expenditure programs; the focus of capital expenditures; availability of funds for our capital program; effect of asset dispositions in 2010 on financial performance; effect on production once current facilities and infrastructure expansion work in Glacier, Alberta have been completed; expected production from Phase III of the Glacier development project; our future operating and financial results; supply and demand for oil and natural gas; effect of natural gas prices on drilling activity and supply levels; projections of market prices and costs; effect of natural gas and oil prices on the Corporation's financial performance; the size of, and future net revenues from, reserves; the performance characteristics of our properties; effect on revenue of the Corporation's derivative and hedging activities; the Corporation's hedging strategy; effect of the Corporation's risk management activities; projected royalty rates; average royalty rates; plans to improve operating cost structure and effect on corporate operating costs; the amount of general and administrative expenses; terms of the Corporation's credit facility; estimated tax pools; terms of the transaction with Longview Oil Corp., including the timing of completion thereof; and the effect of implementation of International Financial Reporting Standards on financial results and the timing of implementation. In addition, statements relating to "reserves" or "resources" are deemed to be forward-looking statements, as they involve the implied assessment, based on certain estimates and assumptions, that the resources and reserves described can be profitably produced in the future. These forward-looking statements involve substantial known and unknown risks and uncertainties, many of which are beyond our control, including changes in general economic, market and business conditions; stock market volatility; changes to legislation and regulations and how they are interpreted and enforced; changes to investment eligibility or investment criteria; our ability to comply with current and future environmental or other laws; actions by governmental or regulatory authorities including increasing taxes, changes in investment or other regulations; changes in tax laws, royalty regimes and incentive programs relating to the oil and gas industry; the effect of acquisitions; our success at acquisition, exploitation and development of reserves; unexpected drilling results, changes in commodity prices, currency exchange rates, capital expenditures, reserves or reserves estimates and debt service requirements; the occurrence of unexpected events involved in the exploration for, and the operation and development of, oil and gas properties; hazards such as fire, explosion, blowouts, cratering, and spills, each of which could result in substantial damage to wells, production facilities, other property and the environment or in personal injury; changes or fluctuations in production levels; competition from other producers; the lack of availability of qualified personnel or management; individual well productivity; ability to access sufficient capital from internal and external sources; credit risk; failure to complete the transaction with Longview Oil Corp.; and failure to receive all required regulatory approvals for the transaction with Longview Oil Corp. Many of these risks and uncertainties are described is available at www.sedar.com and www.advantageog.com. Readers are also referred to risk factors described in other documents Advantage files with Canadian securities authorities. in the Corporation’s Annual Information Form which With respect to forward-looking statements contained in this MD&A, Advantage has made assumptions regarding: conditions in general economic and financial markets; effects of regulation by governmental agencies; current commodity prices and royalty regimes; future exchange rates; royalty rates; future operating costs; availability of skilled labour; availability of drilling and related equipment; timing and amount of capital expenditures; the impact of increasing competition; and receipt of all required regulatory approvals for the transaction with Longview Oil Corp. Advantage Oil & Gas Ltd. - 10 Management has included the above summary of assumptions and risks related to forward-looking information provided in this MD&A in order to provide shareholders with a more complete perspective on Advantage's future operations and such information may not be appropriate for other purposes. Advantage’s actual results, performance or achievement could differ materially from those expressed in, or implied by, these forward-looking statements and, accordingly, no assurance can be given that any of the events anticipated by the forward-looking statements will transpire or occur, or if any of them do so, what benefits that Advantage will derive there from. Readers are cautioned that the foregoing lists of factors are not exhaustive. These forward-looking statements are made as of the date of this MD&A and Advantage disclaims any intent or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or results or otherwise, other than as required by applicable securities laws. This MD&A discusses historical financial and operating performance as well as forward-looking information for the Corporation excluding any potential impacts that may occur due to the successful completion of the transaction with Longview Oil Corp. (see section “Creation of Longview Oil Corp.”). As a result, historical financial and operating performance as well as forward-looking information may not be indicative of actual future performance. Non-GAAP Measures The Corporation discloses several financial measures in the MD&A that do not have any standardized meaning prescribed under GAAP. These financial measures include funds from operations and cash netbacks. Management believes that these financial measures are useful supplemental information to analyze operating performance and provide an indication of the results generated by the Corporation’s principal business activities prior to the consideration of how those activities are financed or how the results are taxed. Investors should be cautioned that these measures should not be construed as an alternative to net income, cash provided by operating activities or other measures of financial performance as determined in accordance with GAAP. Advantage’s method of calculating these measures may differ from other companies, and accordingly, they may not be comparable to similar measures used by other companies. Funds from operations, as presented, is based on cash provided by operating activities before expenditures on asset retirement and changes in non-cash working capital. Cash netbacks are dependent on the determination of funds from operations and include the primary cash revenues and expenses on a per boe basis that comprise funds from operations. Funds from operations reconciled to cash provided by operating activities is as follows: Three months ended December 31 Year ended December 31 ($000) Cash provided by operating activities Expenditures on asset retirement Changes in non-cash working capital Funds from operations 2010 55,268 1,811 (16,335) 40,744 $ $ $ $ 2009 39,383 947 7,951 48,281 % change 40 % 91 % (305) % (16) % 2010 202,494 6,275 (33,630) 175,139 $ $ 2009 170,889 5,437 21,349 197,675 $ $ % change 18 % 15 % (258) % (11) % Advantage Oil & Gas Ltd. - 11 Overview Cash provided by operating activities ($000) Funds from operations ($000) per share (1) per boe Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ $ $ 55,268 40,744 0.25 18.21 $ $ $ $ 39,383 48,281 0.29 23.24 % 40 % (16) % (14) % (22) $ $ $ $ 202,494 175,139 1.07 19.88 $ $ $ $ 170,889 197,675 1.29 20.11 % 18 % (11) (17) % % (1) (1) Based on basic weighted average shares outstanding. Our financial and operating results during 2009 and 2010 have been impacted by dispositions completed during these years. In July 2009 we closed two major asset dispositions for net proceeds of $242.1 million representing production of approximately 8,100 boe/d. On May 31 and June 3, 2010, we closed two additional asset dispositions of non-core natural gas weighted properties for net proceeds of $66.5 million and representing production of approximately 1,700 boe/d. The net proceeds from the various dispositions were utilized to reduce outstanding debt. As a result of the dispositions, total funds from operations decreased for the three months and year ended December 31, 2010 compared to the same periods of 2009 with all revenues and expenses generally impacted. For the year ended December 31, 2010 we continued to realize significant gains on derivatives which amounted to $45.1 million that has helped to offset the continued weak natural gas prices and positively impact funds from operations. Hedging gains in 2010 were lower than 2009 as we had a lower percentage of natural gas production hedged at lower average prices. Funds from operations has also benefited during this year from higher crude oil prices and continued cost reductions, such as operating costs and interest expense. Unfortunately, natural gas prices still remain weak and pose a continuing challenge to the entire natural gas industry. When comparing the current quarter to the third quarter of 2010, our funds from operations per boe increased 6% to $18.21/boe from $17.19/boe as both production and crude oil prices increased, partially offset by the impact of lower natural gas prices. Funds from operations per share decreased from 2009 due to the decrease in total funds from operations and the increase in shares outstanding attributable to 17 million shares issued in July 2009 as a result of an equity offering. Cash provided by operating activities has increased during 2010 as compared to the prior year due to the decrease in funds from operations being more than offset by increases in working capital deficit. As a result of asset dispositions completed in 2009 and 2010 and changes in commodity prices, historical financial and operating performance may not be indicative of actual future performance. The primary factor that causes significant variability of the Corporation’s cash provided by operating activities, funds from operations, and net income is commodity prices. Refer to the section “Commodity Prices and Marketing” for a more detailed discussion of commodity prices and our price risk management. Revenue Three months ended December 31 Year ended December 31 2010 $ 34,081 12,871 46,952 ($000) Natural gas excluding hedging Realized hedging gains Natural gas including hedging Crude oil and NGLs excluding hedging Realized hedging gains (losses) Crude oil and NGLs 39,060 including hedging Total revenue (1) 86,012 (1) Total revenue excludes unrealized derivative gains and losses. $ $ 42,140 (3,080) $ $ 2009 $ $ 33,281 20,325 53,606 % change % 2 % (37) % (12) 2010 146,572 55,360 201,932 $ $ 2009 154,889 83,162 238,051 $ $ % change % (5) % (33) % (15) $ 49,229 (4,053) (14) (24) % % $ 172,796 (10,227) $ 188,116 3,325 % (8) % (408) $ $ 45,176 98,782 (14) (13) % % $ $ 162,569 364,501 $ $ 191,441 429,492 (15) % % (15) Revenue, excluding hedging, was negatively impacted for the three months and year ended December 31, 2010, as compared to 2009, primarily due to lower production attributable to our asset dispositions that closed in the third quarter of 2009 and the second quarter of 2010. Production net of asset dispositions increased 16% for the year ended December 31, 2010 as compared to 2009 as a result of Advantage Oil & Gas Ltd. - 12 our successful exploration and development activities. Natural gas revenue for 2010 benefited from significant increases to production at our Montney natural gas resource play at Glacier, Alberta where we have increased production capacity by 140% since December 31, 2009. Additional increases in production have been realized now that our facilities and infrastructure expansion work have been completed in the first quarter of 2011. Total revenue was also positively impacted by crude oil and NGLs prices, excluding hedging, that have been higher for 2010 as compared to 2009 and partially offset reduced production from asset dispositions. However, revenue has continued to be adversely impacted by natural gas prices that have been weak during the last two years due to many factors, including the recession in the North American economy that has generally reduced energy demand and higher North American natural gas production, both of which have maintained relatively high natural gas inventory levels. Given the low natural gas price environment, our commodity price risk management program has delivered realized natural gas hedging gains of $12.9 million and $55.4 million for the three months and year ended December 31, 2010, respectively. As crude oil prices continued to strengthen throughout 2010, we realized crude oil hedging losses of $3.1 million and $10.2 million for the three months and year ended December 31, 2010, respectively. The Corporation enters derivative contracts whereby realized hedging gains and losses partially offset commodity price fluctuations, which can positively or negatively impact revenue. The realized natural gas hedging gains have been significant and helped us stabilize cash flows and ensure that our capital expenditure program is substantially funded by such cash flows. Production Natural gas (mcf/d) Crude oil (bbls/d) NGLs (bbls/d) Total (boe/d) Natural gas (%) Crude oil (%) NGLs (%) Three months ended December 31 Year ended December 31 2010 106,125 4,886 1,734 24,308 73% 20% 7% % change 26 % % (18) % (31) % 8 2009 84,466 5,985 2,503 22,566 62% 27% 11% 2010 101,562 5,076 2,126 24,129 70% 21% 9% % change % (3) % (30) % (7) % (10) 2009 104,527 7,225 2,283 26,929 65% 27% 8% Average daily production during the fourth quarter of 2010 increased 8% above the same period of 2009, with natural gas production increasing 26% while being offset by decreases in crude oil and NGLs production. Production from the fourth quarter of 2009 also included approximately 1,990 boe/d related to assets disposed in 2010. After excluding production from these asset dispositions, Advantage’s average daily production for the fourth quarter of 2010 increased approximately 18%, as compared to the same period of 2009. Average daily production for the fourth quarter of 2010 was comparable to the 24,287 boe/d reported in the third quarter of 2010 and our exit daily production rate for December 31, 2010 was approximately 25,000 boe/d, exceeding our guidance of exiting the year at 24,000 boe/d. Average annual production for 2010 was lower than 2009 due to the impact of asset dispositions which was partially offset by production growth at Glacier, Alberta. During the second quarter of 2010 our new 100% working interest gas plant (“Glacier gas plant”) was brought on-stream ahead of schedule with production rates exceeding 50 mmcf/d (8,300 boe/d). Due to stronger than expected well performance, we were able to further increase Glacier production ending the year exceeding 60 mmcf/d (10,000 boe/d). This year represented another milestone in the development of our significant Montney reserves and resource potential at Glacier by increasing production capacity 140%. Phase III of our Glacier development project has progressed ahead of schedule and on-budget with production now exceeding 100 mmcf/d (16,667 boe/d). We have been very active in drilling, testing and completing wells at Glacier during the last half of 2010 and into 2011. An additional 100 mmcf/d (16,667 boe/d) of production capacity currently exists and additional wells will be brought on- stream as required to offset declines and maintain production. We expect corporate production to average approximately 26,600 to 27,200 boe/d for the first half of 2011 since completing the 100 mmcf/d Glacier gas plant expansion. Advantage Oil & Gas Ltd. - 13 Commodity Prices and Marketing Natural Gas ($/mcf) Realized natural gas prices Excluding hedging Including hedging AECO monthly index Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ $ 3.49 4.81 3.58 $ $ $ 4.28 6.90 4.18 (18) (30) (14) % % % $ $ $ 3.95 5.45 4.12 $ $ $ 4.06 6.24 4.12 % (3) (13) % % - Realized natural gas prices, excluding hedging, were 18% lower for the three months ended and 3% lower for the year ended December 31, 2010 as compared to the same periods of 2009. Our realized natural gas prices, excluding hedging, for this quarter decreased 1% from the $3.51/mcf realized during the third quarter of 2010. Although natural gas prices have continued to remain weak, our commodity hedging strategy has resulted in realized natural gas prices, including hedging, that well exceed current market prices. Our realized natural gas prices, including hedging, have decreased during 2010 as compared to 2009 as we have less natural gas production hedged for this year at lower average prices. Nevertheless, our hedging program has significantly mitigated the negative impact from lower natural gas prices and has reduced the volatility of our cash flows. During 2009 and 2010, natural gas prices have remained low from continued high US domestic natural gas production that has increased supply and the ongoing weaker North American economy that has negatively impacted demand. These factors have resulted in generally higher inventory during these years and has placed considerable downward pressure on natural gas prices. Heading into the 2009/2010 winter season, we saw strong inventory withdraws which helped to modestly strengthen prices relative to the prior lows experienced during the majority of 2009. However, as we exited the winter, natural gas prices significantly decreased and have remained weak throughout 2010. During the 2010/2011 winter we have seen respectable storage withdraws that has helped to reduce natural gas inventory to approximately the five-year average. Nevertheless, natural gas prices continue to remain weak as we exit the winter. We continue to believe in the longer-term price support for natural gas as reduced drilling for new resource based natural gas supplies and conventional natural gas will eventually reduce the supply levels. We continue to monitor these market developments closely and will be proactive in implementing an appropriate hedging strategy to mitigate the volatility in our cash flow as a result of fluctuations in natural gas prices. Crude Oil and NGLs ($/bbl) Realized crude oil prices Excluding hedging Including hedging Realized NGLs prices Excluding hedging Realized crude oil and NGLs prices Excluding hedging Including hedging WTI ($US/bbl) $US/$Canadian exchange rate Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ 74.76 67.91 $ $ 70.86 63.50 % % 6 7 $ $ 72.80 67.28 $ $ 59.29 60.55 23 % 11 % $ 53.50 $ 44.34 % 21 $ 48.88 $ 38.10 28 % $ $ $ $ 69.19 64.14 85.18 0.99 $ $ $ $ 63.04 57.85 76.17 0.95 % 10 % 11 % 12 % 4 $ $ $ $ 65.74 61.85 79.55 0.97 $ $ $ $ 54.20 55.16 61.93 0.88 21 % 12 % 28 % 10 % Realized crude oil and NGLs prices, excluding hedging, increased 10% and 21% for the three months and year ended December 31, 2010, as compared to the same periods of 2009. As compared to the third quarter of 2010, realized crude oil and NGLs prices, excluding hedging, have increased 12% for the fourth quarter of 2010. Advantage’s realized crude oil price may not change to the same extent as West Texas Intermediate (“WTI”), due to changes in the $US/$Canadian exchange rate and changes in Canadian crude oil differentials relative to WTI. The price of WTI fluctuates based on worldwide supply and demand fundamentals. There has been significant price volatility experienced over the last several years whereby WTI reached historic high levels in the first half of 2008, followed by a record decline in the latter half of the year and into early 2009, the result of demand destruction brought on by the global recession. There was Advantage Oil & Gas Ltd. - 14 improvement during the last half of 2009 which continued during 2010 and significantly escalated into 2011 primarily influenced by middle-east civil unrest, with WTI currently trading at approximately US$104/bbl. However, we have also seen a constant strengthening of the $US/$Canadian exchange rate during these years such that our increase in realized price has been less than the improvement in WTI. We continue to believe that the long-term pricing fundamentals for crude oil will remain strong with supply management by the OPEC cartel and strong relative demand from many developing countries, such as China and India. Commodity Price Risk The Corporation’s financial results and condition will be dependent on the prices received for oil and natural gas production. Oil and natural gas prices have fluctuated widely and are determined by economic and political factors. Supply and demand factors, including weather and general economic conditions as well as conditions in other oil and natural gas regions, impact prices. Any movement in oil and natural gas prices could have an effect on the Corporation’s financial condition and performance. Advantage has an established financial hedging strategy and may manage the risk associated with changes in commodity prices by entering into derivative contracts. Although these commodity price risk management activities could expose Advantage to losses or gains, entering derivative contracts helps us to stabilize cash flows and ensures that our capital expenditure program is substantially funded by such cash flows. To the extent that Advantage engages in risk management activities related to commodity prices, it will be subject to credit risk associated with counterparties with which it contracts. Credit risk is mitigated by entering into contracts with only stable, creditworthy parties and through frequent reviews of exposures to individual entities. In addition, the Corporation only enters into derivative contracts with major banks that are members of our credit facility syndicate and international energy firms to further mitigate associated credit risk. Our credit facilities also prohibit the Corporation from entering into any derivative contract where the term of such contract exceeds three years. Further, the aggregate of such contracts cannot hedge greater than 60% of total estimated petroleum and natural gas production over two years and 50% over the third year. We have historically been active in entering financial contracts to protect future cash flows and currently the Corporation has the following derivatives in place: Description of Derivative Term Volume Average Price Natural gas - AECO Fixed price Fixed price Fixed price Fixed price Crude oil – WTI Fixed price Fixed price April 2010 to January 2011 January 2011 to December 2011 January 2011 to December 2011 January 2011 to December 2011 18,956 mcf/d 9,478 mcf/d 9,478 mcf/d 9,478 mcf/d Cdn$7.25/mcf Cdn$6.24/mcf Cdn$6.24/mcf Cdn$6.26/mcf April 2010 to January 2011 January 2011 to December 2011 2,000 bbls/d 1,500 bbls/d Cdn$69.50/bbl Cdn$91.05/bbl Advantage Oil & Gas Ltd. - 15 The derivative contracts have allowed us to fix the commodity price on anticipated production, net of royalties, as follows: Commodity Natural gas - AECO January to March 2011 April to June 2011 July to September 2011 October to December 2011 Total 2011 Crude Oil - WTI January to March 2011 April to June 2011 July to September 2011 October to December 2011 Total 2011 Approximate Production Hedged, Net of Royalties (1) Average Price 34% 22% 21% 22% 25% 41% 30% 32% 32% 34% Cdn$6.43/mcf Cdn$6.24/mcf Cdn$6.24/mcf Cdn$6.24/mcf Cdn$6.30/mcf Cdn$84.42/bbl Cdn$91.05/bbl Cdn$91.05/bbl Cdn$91.05/bbl Cdn$88.90/bbl (1) Approximate production hedged is based on our estimated average production by quarter, net of estimated royalty payments. For the year ended December 31, 2010, we recognized in income a net realized derivative gain of $45.1 million (December 31, 2009 - $86.5 million net realized derivative gain) on settled derivative contracts as a result of average market prices decreasing below our established average hedge prices. Our net realized derivative gain has decreased during 2010 as compared to 2009 as we have less natural gas production hedged for this year at lower average prices and we realized losses on our crude oil hedges as WTI prices increased. However, our successful commodity price risk management program continued to realize significant gains on derivatives for the year ended December 31, 2010 that has helped to offset the continued weak natural gas prices and positively impact funds from operations. As at December 31, 2010, the fair value of the derivative contracts outstanding and to be settled was a net asset of approximately $22.6 million, an increase of $5.4 million from the $17.2 million net asset recognized as at December 31, 2009. For the year ended December 31, 2010, this $5.4 million increase was recognized in income as an unrealized derivative gain (December 31, 2009 – $23.7 million unrealized derivative loss). The valuation of the derivatives is the estimated fair value to settle the contracts as at December 31, 2010 and is based on pricing models, estimates, assumptions and market data available at that time. As such, the recognized amounts are not cash and the actual gains or losses realized on eventual cash settlement can vary materially due to subsequent fluctuations in commodity prices and foreign exchange rates as compared to the valuation assumptions. The Corporation does not apply hedge accounting and current accounting standards require changes in the fair value to be included in the consolidated statements of income (loss) and comprehensive income (loss) as an unrealized derivative gain or loss with a corresponding derivative asset and liability recorded on the balance sheet. These derivative contracts will settle in 2011 corresponding to when the Corporation will receive revenues from production. Advantage Oil & Gas Ltd. - 16 Royalties Royalties ($000) per boe As a percentage of revenue, excluding hedging Three months ended December 31 Year ended December 31 2010 $ $ 9,313 4.16 12.2% 2009 $ $ 11,390 5.49 13.8% % change (18) (24) (1.6) % % % 2010 $ $ 44,640 5.07 14.0% 2009 $ $ 49,010 4.99 14.3% % change % (9) % 2 % (0.3) Advantage pays royalties to the owners of mineral rights from which we have leases. The Corporation currently has mineral leases with provincial governments, individuals and other companies. Royalty expense includes the impact of gas cost allowance (“GCA”), which is a reduction of royalties payable to the Alberta Provincial Government to recognize capital and operating expenditures incurred in the gathering and processing of their share of natural gas production and does not generally fluctuate with natural gas prices. Total royalties paid and royalties as a percentage of revenue decreased for the three months ended December 31, 2010 compared to the same period of 2009 due to lower natural gas prices. For the year ended December 31, 2010, total royalties paid decreased due to lower revenue from reduced production attributable to our asset dispositions while royalties as a percentage of revenue was comparable. Our average corporate royalty rates are significantly impacted by the Alberta Provincial Government’s royalty framework that was revised effective January 1, 2009 for conventional oil, natural gas and oil sands whereby Alberta royalties are affected by depths, well production rates, and commodity prices. Additionally, the Alberta Provincial Government implemented a number of drilling incentive programs with reduced royalty rates over a period of time for qualifying wells. The majority of our wells brought on production since April 1, 2009 qualify and benefit from a 5% royalty rate on the first 500 mmcf produced or one-year, whichever occurs first, and a drilling credit of $200 per metre drilled that reduces capital spending. The drilling credit incentives are effective for qualifying wells drilled and brought on production from April 1, 2009 to March 31, 2011 while the reduced 5% royalty rate program was made a permanent incentive as of May 1, 2010. The Alberta Provincial Government also made changes in the Natural Gas Deep Drilling Program (“NGDDP”) which reduces the vertical depth requirement to 2,000 metres (from 2,500 metres) and makes the program permanent. As a result, all of our Montney horizontal wells at Glacier drilled after May 1, 2010 will qualify for the NGDDP which is estimated to provide an additional royalty incentive of $2.7 to $3.4 million for a typical horizontal well (a typical Advantage horizontal well at Glacier is 4,200 to 4,500 metres in total length). This royalty incentive results in an estimated 5 to 7% royalty rate for all Montney horizontal wells for the life of the well. This significantly lowers the natural gas price threshold required to drill economic wells and substantially improves the value of future reserves and upside potential at Glacier. We expect our corporate royalty rate to be in the range of 13% to 15% for the first half of 2011. Alberta royalty rates will continue to fluctuate based on commodity prices, individual well productivity, and our ongoing capital development plans. Operating Costs Operating costs ($000) per boe Three months ended December 31 Year ended December 31 2010 $ $ 23,787 10.64 2009 $ $ 22,847 11.01 % change % % 4 (3) 2010 $ $ 93,875 10.66 2009 119,022 12.11 $ $ % change (21) (12) % % Total operating costs increased 4% for the three months ended December 31, 2010 and decreased 21% for the year ended December 31, 2010 as compared to the same periods of 2009. The reduction in total operating costs for 2010 has been primarily due to the sale of higher cost assets, increased production from Glacier and benefits of our ongoing optimization program. Total operating costs increased modestly during the fourth quarter of 2010 as compared to the same period of 2009 due to an 8% increase in corporate production and the impact of cold weather operations. Operating costs per boe decreased 12% from 2009 to 2010 and we anticipate corporate operating costs will decline further in 2011 as a result of increasing production at Glacier. Operating costs at Glacier during the fourth quarter of 2010 decreased to approximately $2.85/boe ($0.48/mcf) which has significantly improved the netbacks realized from our Montney gas production. We estimate that operating costs at Glacier will be further reduced to a target of approximately $1.80/boe ($0.30/mcf) at 100 mmcf/d due to the efficiencies created by increasing the production rate through our 100% owned Glacier gas plant. We will seek further opportunities to improve our operating cost structure and expect corporate operating costs for the first half of 2011 to be between $8.50 and $9.00/boe. Advantage Oil & Gas Ltd. - 17 General and Administrative General and administrative Cash expense ($000) per boe Non-cash expense ($000) per boe Employees at December 31 Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ $ $ 6,141 2.75 2,039 0.91 $ $ $ $ 8,613 4.15 2,270 1.09 (29) (34) (10) (17) % % % % $ $ $ $ 24,701 2.80 12,877 1.46 128 $ $ $ $ 29,162 2.97 10,173 1.03 129 (15) % % (6) % 27 42 % % (1) Cash general and administrative (“G&A”) expense for the three months and year ended December 31, 2010 has decreased as compared to the same periods of 2009 due to incremental costs incurred in 2009 associated with the asset dispositions (approximately $1.8 million for severance costs) and costs incurred for our corporate conversion and reorganization (approximately $2.5 million). Non-cash G&A expense for the three months ended December 31, 2010 decreased 10% but increased 27% for the year ended December 31, 2010, as compared to the same periods of 2009. Non-cash G&A expense is primarily comprised of Advantage’s Restricted Share Performance Incentive Plan (“RSPIP” or the “Plan”) as approved by the shareholders with the purpose to retain and attract employees, to reward and encourage performance, and to focus employees on operating and financial performance that results in lasting shareholder return. The Plan authorizes the Board of Directors to grant restricted shares to service providers of the Corporation, including directors, officers, employees and consultants. The number of restricted shares granted is based on the Corporation’s share price return for a twelve-month period and compared to the performance of a peer group approved by the Board of Directors. The share price return is calculated at the end of each and every quarter and is primarily based on the twelve-month change in the share price. If the share price return for a twelve-month period is positive, a restricted share grant will be calculated based on the return. If the share price return for a twelve-month period is negative, but the return is still within the top two-thirds of the approved peer group performance, the Board of Directors may grant a discretionary restricted share award. Compensation cost related to the Plan is recognized as equity-based compensation expense within G&A expense over the service period and incorporates the share grant price, the estimated number of restricted shares to vest, and certain management estimates. For the year ended December 31, 2010, we granted 2,547,020 restricted shares at an average grant price of $6.93 per restricted share and recognized $16.1 million of equity-based compensation expense, including a non-cash amount of $13.4 million, related to restricted shares granted to service providers. During the year ended December 31, 2010 we issued 1,346,481 shares to service providers in accordance with the vesting provisions of the Plan. As at December 31, 2010, 2,925,868 restricted shares remain unvested and will vest to service providers over the next two years with a total of $8.1 million in compensation cost to be recognized over the future service periods. Management Internalization Three months ended December 31 Year ended December 31 Management internalization ($000) per boe 2010 $ - $ - 2009 $ - $ - % change % % - - 2010 $ - $ - 2009 $ $ 1,724 0.18 % change (100) (100) % % In 2006, Advantage Energy Income Fund (the “Fund”) and Advantage Investment Management Ltd. (the “Manager”) reached an agreement to internalize a pre-existing management contract arrangement. As part of the agreement, the Fund agreed to purchase all of the outstanding shares of the Manager pursuant to the terms of the arrangement, thereby eliminating the management fee and performance incentive effective April 1, 2006. The Trust Unit consideration issued in exchange for the outstanding shares of the Manager was placed in escrow for a three-year period and was deferred and amortized into income as management internalization expense over the specific vesting periods. As of June 23, 2009, the final Trust Units held in escrow vested and there is no subsequent management internalization expense recognized. Advantage Oil & Gas Ltd. - 18 Interest on Bank Indebtedness Interest expense ($000) per boe Average effective interest rate Bank indebtedness at December 31 ($000) Three months ended December 31 2010 $ $ 3,414 1.53 4.9% 2009 $ $ 5,066 2.44 4.5% % change (33) (37) 0.4 % % % Year ended December 31 2010 2009 $ $ 13,545 1.54 5.0% 290,657 $ $ $ 19,752 2.01 4.9% 250,262 $ % change (31) (23) 0.1 16 % % % % Total interest expense decreased 33% for the three months and 31% for the year ended December 31, 2010 as compared to 2009. During the first half of 2009, Advantage experienced significantly lower average interest rates as bank lending rates declined in response to rate reductions enacted by central banks to stimulate the economy. This reduced interest expense was partially offset by additional interest expense on a higher average debt balance during that period. In June 2009 our credit facility was renewed and was subject to generally higher basis point and stamping fee adjustments as was typically applied by financial institutions at that time. Therefore, our average effective interest rate during 2010 has been slightly higher than 2009; however, this was significantly offset by lower interest expense on the reduced average bank indebtedness that resulted from proceeds on various asset dispositions and both the equity financing and convertible debenture issuance during the periods. Bank indebtedness has increased in the fourth quarter of 2010 as expected due to progress of the Phase III capital expenditure program at Glacier. Our revolving credit facility was renewed in June 2010 and is subject to basis point and stamping fee adjustments ranging from 1.25% to 3.75%, depending on the Corporation’s debt to cash flow ratio. The Corporation’s interest rates are primarily based on short term bankers acceptance rates plus a stamping fee. We monitor the debt level to ensure an optimal mix of financing and cost of capital that will provide a maximum return to our shareholders. Our current credit facilities have been a favorable financing alternative with an effective interest rate of 5.0% for the year ended December 31, 2010. Interest and Accretion on Convertible Debentures Interest on convertible debentures ($000) per boe Accretion on convertible debentures ($000) per boe Convertible debentures maturity value at December 31 ($000) Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ 2,303 1.03 $ $ 2,344 1.13 % % (2) (9) $ $ 11,486 1.30 $ $ 13,676 1.39 (16) % % (6) $ $ 939 0.42 $ $ 379 0.18 148 133 % % $ $ 4,097 0.47 $ $ 2,354 0.24 74 96 % % $ 148,544 $ 218,471 (32) % Interest on convertible debentures for the three months and year ended December 31, 2010 has decreased compared to 2009 due to the maturity of the 8.25% debentures on February 1, 2009, the 8.75% debentures on June 30, 2009, the 7.50% debentures on October 1, 2009, and the 6.50% debentures on June 30, 2010. The reduced interest has been partially offset by additional interest on our 5.00% convertible debentures that were issued on December 31, 2009. Accretion on convertible debentures has increased for the three months and year ended December 31, 2010 as compared to the same periods of 2009 due to the higher accretion expense on the 5.00% convertible debentures as a result of the greater value assigned to the equity component of the debenture representing the conversion option available to debentureholders. Advantage Oil & Gas Ltd. - 19 Depletion, Depreciation and Accretion Depletion, depreciation and accretion ($000) per boe Three months ended December 31 Year ended December 31 2010 2009 % change 2010 2009 % change $ $ 46,762 20.91 $ $ 52,284 25.18 (11) (17) % % $ $ 215,780 24.50 $ $ 256,882 26.13 (16) % % (6) Depletion and depreciation of petroleum and natural gas properties is provided on the “unit-of–production” method based on total proved reserves. Accretion represents the increase in the asset retirement obligation liability each reporting period due to the passage of time. The depletion, depreciation and accretion (“DD&A”) provision has decreased for the three months and year ended December 31, 2010 compared to 2009 due to reduced production from the asset dispositions that closed during the periods and a lower average rate of DD&A per boe. Our DD&A rate per boe has decreased considerably during 2010 as compared to 2009 due to a higher proportion of proved reserves as compared to capital expenditures and future development capital. This change has occurred primarily due to our successful exploration and development activities, particularly at Glacier, that contributed to a 33% increase in corporate proved reserves. Taxes Current taxes paid or payable for the year ended December 31, 2010 amounted to $1.3 million, comparable to the expense for the same period of 2009. Current taxes primarily represent Saskatchewan resource surcharge, which is based on the petroleum and natural gas revenues earned within the province of Saskatchewan. Future income taxes arise from differences between the accounting and tax bases of our assets and liabilities. For the year ended December 31, 2010, the Corporation recognized a total future income tax reduction of $8.2 million compared to a future income tax reduction of $10.9 million for the same period of 2009. The future income tax reduction for 2010 is comparable to 2009, although the loss before taxes for the prior year was significantly higher, due to a $23.0 million future income tax expense impact recognized in the third quarter of 2009 related to the corporate conversion that was completed during that period. As at December 31, 2010, the Corporation had a total future income tax liability balance of $35.3 million, compared to $43.5 million at December 31, 2009. Canadian generally accepted accounting principles require that a future income tax liability be recorded when the book value of assets exceeds the balance of tax pools. The Corporation has approximately $1.6 billion in tax pools and deductions at December 31, 2010, which can be used to reduce the amount of taxes payable by Advantage. The estimated tax pools in place at December 31, 2010 are as follows: December 31, 2010 Estimated Tax Pools ($ millions) Undepreciated Capital Cost Canadian Oil and Gas Property Expenses Canadian Development Expenses Canadian Exploration Expenses Non-capital losses Other $ 413 138 331 44 633 11 1,570 $ Advantage has a federal non-capital loss carry forward balance of approximately $633 million (December 31, 2009 - $508 million). These losses expire between 2023 and 2030. Advantage Oil & Gas Ltd. - 20 Net Loss Three months ended December 31 Year ended December 31 Net loss ($000) per share - basic and diluted 2010 (18,169) (0.11) $ $ 2009 (14,213) (0.09) $ $ % change 28 22 % % 2010 (44,208) (0.27) $ $ 2009 (86,426) (0.56) $ $ % change (49) (52) % % Net loss and net loss per share increased for the three months ended December 31, 2010 but decreased for the year ended December 31, 2010, as compared to the same periods of 2009. During the third quarter of 2009 and the second quarter of 2010 we completed several asset dispositions that generally reduced all revenues and expenses as compared to the prior year. However, with our new 100% working interest Glacier gas plant that came on-stream during the second quarter of 2010, our corporate natural gas production has increased 26% as compared to the fourth quarter of 2009 thereby exceeding disposed production. Revenue for 2010 was positively impacted by higher crude oil prices as compared to 2009 but our major challenge continues to be the natural gas price environment that has remained weak and adversely impacts revenue, which generally results in our recognized net loss regardless of other significant positive accomplishments during the year. Low revenues were partially mitigated by our commodity hedging program that resulted in a net realized derivative gain of $45.1 million for the year ended December 31, 2010 and a non-cash unrealized derivative gain of $5.4 million relating to the valuation of commodity hedging contracts outstanding as at December 31, 2010 that will not settle until 2011. Our realized derivative gain has decreased during 2010 as compared to 2009 as we have less natural gas production hedged for this year at lower average prices and we realized losses on our crude oil hedges as WTI prices increased. We continue to experience low royalty rates due to weak natural gas prices and Alberta Provincial royalty reduction incentive plans relative to our capital development program. Operating costs have continued to improve through increased production volumes at Glacier, divestment of higher cost non-core assets and an aggressive optimization program that continues to demonstrate positive benefits. We anticipate that corporate operating costs will further improve as a result of lower cost production from our Glacier property that is currently producing in excess of 100 mmcf/d. Our net loss for 2010 is also lower relative to 2009 due to significant costs incurred during the third quarter of 2009 attributed to the corporate conversion, including the recognition of several one-time costs in G&A expense and a future income tax expense of $23.0 million. Cash Netbacks Revenue Realized gain on derivatives Royalties Operating costs Operating General and administrative (1) Interest (2) Interest on convertible debentures (2) Income and capital taxes Funds from operations and cash netbacks Three months ended December 31 Year ended December 31 2010 2009 2010 2009 $ $ $000 76,221 9,791 (9,313) (23,787) 52,912 (6,141) (3,376) (2,303) (348) 40,744 $ $ per boe 34.08 $ 4.38 (4.16) (10.64) 23.66 (2.75) (1.51) (1.03) (0.16) 18.21 $ $ $ $000 82,510 16,272 (11,390) (22,847) 64,545 (8,613) (5,003) (2,344) (304) 48,281 $ $ per boe 39.74 $ 7.84 (5.49) (11.01) 31.08 (4.15) (2.41) (1.13) (0.15) 23.24 $ $ $ $000 319,368 45,133 (44,640) (93,875) 225,986 (24,701) (13,346) (11,486) (1,314) 175,139 $ $ per boe 36.26 $ 5.12 (5.07) (10.66) 25.65 (2.80) (1.52) (1.30) (0.15) 19.88 $ $ $ $000 343,005 86,487 (49,010) (119,022) 261,460 (29,162) (19,667) (13,676) (1,280) 197,675 $ $ per boe 34.90 $ 8.80 (4.99) (12.11) 26.60 (2.97) (2.00) (1.39) (0.13) 20.11 $ (1) General and administrative expense excludes non-cash G&A and non-cash equity-based compensation expense. (2) Interest excludes non-cash accretion expense. Funds from operations decreased in total for the three months and year ended December 31, 2010 compared to the same periods of 2009 primarily due to our asset dispositions completed in the third quarter of 2009 and the second quarter of 2010 that generally impacted all revenues and expenses. However, funds from operations have been positively impacted during 2010 due to completion of the Glacier gas plant whereby we have realized production rates exceeding 50 mmcf/d (8,300 boe/d). Due to stronger than expected well performance, we were able to exit 2010 with Glacier production exceeding 60 mmcf/d (10,000 boe/d). Funds from operations per boe or cash netbacks decreased when compared to 2009 primarily due to lower realized derivative gains as we have less natural gas production hedged for 2010 at lower average prices. However, our successful commodity price risk management program has still enabled us to realize significant gains on derivatives of $45.1 million for the year ended December 31, 2010 that has helped to offset Advantage Oil & Gas Ltd. - 21 the continued weak natural gas prices and positively impact funds from operations. Funds from operations has also benefited during this year from higher crude oil prices and continued cost reductions. Unfortunately, natural gas prices still remain weak and pose a continuing challenge to the entire natural gas industry. Operating costs per boe decreased as we continue to realize benefits from our divestment of higher cost assets and the addition of lower cost production due to the completion of our Glacier gas plant. Interest expense has also continued to decrease as we utilized proceeds from the various asset dispositions and both the equity financing and convertible debenture issuance during the periods to repay bank indebtedness and maturing convertible debentures. When comparing the current quarter to the third quarter of 2010, our funds from operations per boe increased 6% to $18.21/boe from $17.19/boe as both production and crude oil prices increased, partially offset by the impact of lower natural gas prices. Contractual Obligations and Commitments The Corporation has contractual obligations in the normal course of operations including purchases of assets and services, operating agreements, transportation commitments, sales contracts, bank indebtedness and convertible debentures. These obligations are of a recurring and consistent nature and impact cash flow in an ongoing manner. The following table is a summary of the Corporation’s remaining contractual obligations and commitments. Advantage has no guarantees or off-balance sheet arrangements other than as disclosed. ($ millions) Building leases Pipeline/transportation Capital lease obligations Bank indebtedness (1) Convertible debentures (2) Total contractual obligations $ $ $ Total 10.8 34.2 0.8 290.7 148.5 485.0 $ $ Payments due by period 2013 2.5 8.1 - - - 10.6 2012 3.4 8.4 - 290.7 - 302.5 $ $ 2011 3.5 8.3 0.8 - 62.3 74.9 $ $ $ 2014 1.4 7.3 - - - 8.7 2015 $ - 2.1 - - 86.2 88.3 $ (1) The Corporation’s bank indebtedness does not have specific maturity dates. It is governed by a credit facility agreement with a syndicate of financial institutions. Under the terms of the agreement, the facility is reviewed annually, with the next review scheduled in June 2011. The facility is revolving, and is extendible at each annual review for a further 364 day period at the option of the syndicate. If not extended, the credit facility is converted at that time into a one-year term facility, with the principal payable at the end of such one-year term. Management fully expects that the facility will be extended at each annual review. (2) As at December 31, 2010, Advantage had $148.5 million convertible debentures outstanding (excluding interest payable during the various debenture terms). Each series of convertible debentures are convertible to shares based on an established conversion price. All remaining obligations related to convertible debentures can be settled through the payment of cash or issuance of shares at Advantage’s option. Liquidity and Capital Resources The following table is a summary of the Corporation’s capitalization structure. ($000, except as otherwise indicated) Bank indebtedness (long-term) Working capital deficit (1) Net debt Shares outstanding, representing shareholders' equity Shares closing market price ($/share) Market capitalization (2) Convertible debentures maturity value (current and long-term) Total capitalization $ $ December 31, 2010 290,657 64,452 355,109 164,092,009 6.76 1,109,262 148,544 1,612,915 $ $ $ $ (1) Working capital deficit includes accounts receivable, prepaid expenses and deposits, accounts payable and accrued liabilities, and the current portion of capital lease obligations. (2) Market capitalization is a non-GAAP measure. Advantage Oil & Gas Ltd. - 22 Advantage monitors its capital structure and makes adjustments according to market conditions in an effort to meet its objectives given the current outlook of the business and industry in general. The capital structure of the Corporation is composed of working capital, bank indebtedness, convertible debentures, capital lease obligations and shareholders’ equity. Advantage may manage its capital structure by issuing new shares, repurchasing outstanding shares, obtaining additional financing either through bank indebtedness or convertible debenture issuances, refinancing current debt, issuing other financial or equity-based instruments, declaring a dividend, implementing a dividend reinvestment plan, adjusting capital spending, or disposing of assets. The capital structure is reviewed by Management and the Board of Directors on an ongoing basis. Management of the Corporation’s capital structure is facilitated through its financial and operational forecasting processes. The forecast of the Corporation’s future cash flows is based on estimates of production, commodity prices, forecast capital and operating expenditures, and other investing and financing activities. The forecast is regularly updated based on new commodity prices and other changes, which the Corporation views as critical in the current environment. Selected forecast information is frequently provided to the Board of Directors. This continual financial assessment process further enables the Corporation to mitigate risks. The Corporation continues to satisfy all liabilities and commitments as they come due. The current economic situation has placed considerable pressure on commodity prices. Natural gas prices have remained weak throughout 2009 and 2010 due to the ailing economy as well as high inventory levels with AECO gas presently trading at approximately $3.80/mcf. Crude oil has improved since early 2009 and has continued to increase with WTI at approximately US$104/bbl. The outlook for the Corporation from prolonged weak natural gas prices would be reductions in operating netbacks and funds from operations. Management has partially mitigated this risk through our commodity hedging program but the lower natural gas price environment has still had a significant negative impact. In order to strengthen our financial position and balance our cash flows, in 2009 we completed an equity financing, two asset dispositions, and issued 5.00% convertible debentures and in 2010 we completed two additional asset dispositions. These steps have allowed us to repay significant bank indebtedness and maturing convertible debentures and also enabled us to focus capital spending on our Glacier Montney natural gas resource play. However, we continue to be very cognizant of improving our financial flexibility in the current environment and have initiated a process to sell certain oil-weighted assets to Longview with an anticipated closing date in April, 2011. The net proceeds from the Transaction will be utilized to further repay bank indebtedness. We believe that Advantage has implemented strategies to protect our business as much as possible in the current industry and economic environment. We have implemented a strategy to balance funds from operations and our capital program expenditure requirements. A successful hedging program was also executed to help reduce the volatility of funds from operations. However, we are still exposed to risks as a result of the current economic situation. We continue to closely monitor the possible impact on our business and strategy, and will make adjustments as necessary with prudent management. Shareholders’ Equity and Convertible Debentures Advantage has utilized a combination of equity, convertible debentures and bank debt to finance acquisitions and development activities. As at December 31, 2010, the Corporation had 164.1 million shares outstanding. During 2010 we have issued 1,346,481 shares to employees in accordance with the vesting provisions of the RSPIP. As at March 22, 2011, shares outstanding have increased to 164.5 million. The Corporation had $148.5 million convertible debentures outstanding at December 31, 2010 that were immediately convertible to 13.0 million shares based on the applicable conversion prices (December 31, 2009 - $218.5 million outstanding and convertible to 15.8 million shares). During the year ended December 31, 2010, there were no conversions of debentures. The principal amount of 6.50% convertible debentures matured on June 30, 2010 and was settled with $69.9 million in cash. As at March 22, 2011, the convertible debentures outstanding have not changed from December 31, 2010. We have $62.3 million of 7.75% and 8.00% debentures that mature in December 2011 and $86.2 million of 5.00% debentures that mature in January 2015. These obligations can be settled through the payment of cash or issuance of shares at Advantage’s option. Bank Indebtedness, Credit Facility and Other Obligations At December 31, 2010, Advantage had bank indebtedness outstanding of $290.7 million. Bank indebtedness has increased $40.4 million since December 31, 2009, primarily the result of our significant capital expenditure program during this year. The Corporation’s credit facility is $525 million, comprised of a $20 million extendible revolving operating loan facility and a $505 million extendible revolving loan facility (the “Credit Facilities”). The Credit Facilities are collateralized by a $1 billion floating charge demand debenture covering all assets of the Corporation. As well, the borrowing base for the Corporation’s credit facilities is determined through utilizing our regular reserve estimates. The banking syndicate thoroughly evaluates the reserve estimates based upon their own commodity price expectations to determine the amount of the borrowing base. Revisions or changes in the reserve estimates and Advantage Oil & Gas Ltd. - 23 commodity prices can have either a positive or a negative impact on the borrowing base of the Corporation. The next annual review is scheduled to occur in June 2011. There can be no assurance that the $525 million credit facility will be renewed at the current borrowing base level at that time. Advantage had a working capital deficiency of $64.5 million as at December 31, 2010. Our working capital includes items expected for normal operations such as trade receivables, prepaids, deposits, trade payables and accruals as well as the current portion of capital lease obligations. Working capital varies primarily due to the timing of such items, the current level of business activity including our capital expenditure program, commodity price volatility, and seasonal fluctuations. Our working capital deficiency is usually higher at the end of the year, as would be expected, due to accounts payable and accrued liabilities associated with our capital expenditure program. We do not anticipate any problems in meeting future obligations as they become due given the level of our funds from operations. It is also important to note that working capital is effectively integrated with Advantage’s revolving operating loan facility, which assists with the timing of cash flows as required. Advantage has a capital lease obligation on various equipment used in its operations. The total amount of principal obligation outstanding at December 31, 2010 is $0.8 million, bearing interest at an effective rate of 5.8%, and is collateralized by the related equipment. The lease expires in 2011 at which time title of the equipment will transfer to Advantage. Capital Expenditures ($000) Land and seismic Drilling, completions and workovers Well equipping and facilities Other Property dispositions Net capital expenditures Three months ended December 31 2010 $ 2009 $ 1,023 55,902 11,896 97 68,918 (226) 68,692 $ $ (186) 33,566 24,615 51 58,046 34 58,080 $ $ Year ended December 31 2010 2009 $ $ 4,309 169,814 48,782 403 223,308 (69,676) 153,632 $ $ 2,080 105,618 61,155 213 169,066 (245,150) (76,084) $ $ Advantage’s exploitation and development program is focused primarily at Glacier, Alberta where we are developing a significant natural gas resource play. Our preference is to operate a high percentage of our properties such that we can maintain control of capital expenditures, operations and cash flows. Advantage’s acquisition strategy has been to acquire long-life properties with strong drilling opportunities while retaining a balance of year round access and risk. For the year ended December 31, 2010, the Corporation spent a net $153.6 million and drilled a total of 50.2 net (63 gross) wells at a 98% success rate. Total capital spending included $192.4 million at Glacier, $5.3 million at Sunset, $3.9 million at Nevis, $4.5 million in Saskatchewan, and the remaining balance at other areas. However, we continue to focus on development of our Montney natural gas resource play at Glacier where Advantage will continue to employ a phased development approach. Phase II was completed during the second quarter of 2010 and costs incurred were lower than anticipated due to our successful drilling program which demonstrated well productivities that exceeded internal expectations and reduced drilling and completion costs. Construction of our facilities and gas gathering system expansions were completed ahead of schedule and on-budget leading to an earlier than anticipated commissioning of Advantage’s 100% working interest gas plant in March 2010. The Glacier gas plant has been operating at its design capacity with throughput rates between 50 and 55 mmcf/d. Due to stronger than expected well performance, we were able to further increase Glacier production ending the year exceeding 60 mmcf/d (10,000 boe/d). Our Phase III expansion began at the end of the second quarter of 2010 and included the drilling of 28 net (28 gross) horizontal wells and the fabrication of a new processing train to facilitate expansion of our Glacier gas plant to its current production capacity of 100 mmcf/d. In addition to the current production rate of 100 mmcf/d, we currently have an incremental 100 mmcf/d (16,667 boe/d) of production capacity available and additional wells will be brought on-stream as required to offset declines and maintain production. The amount of excess field production capacity above our current plant capacity is a result of our successful drilling program which demonstrated well test rates that exceeded expectations and proved up a large portion of our undrilled acreage at Glacier. On May 31 and June 3, 2010, we closed two additional asset dispositions of non-core natural gas weighted properties for net proceeds of $66.5 million and representing production of approximately 1,700 boe/d. During 2010 we had a number of other minor dispositions that were successfully completed. The net proceeds from the dispositions were utilized to reduce outstanding debt. Advantage Oil & Gas Ltd. - 24 Sources and Uses of Funds The following table summarizes the various funding requirements during the year ended December 31, 2010 and 2009 and the sources of funding to meet those requirements: ($000) Sources of funds Funds from operations Property dispositions Increase in bank indebtedness Decrease in working capital Units issued, net of costs Convertible debentures issued, less costs Uses of funds Expenditures on fixed assets Convertible debenture maturities Expenditures on asset retirement Reduction of capital lease obligations Decrease in bank indebtedness Distributions to Unitholders Increase in working capital Year ended December 31 2010 2009 $ $ 175,139 69,676 41,068 15,002 - - 300,885 223,308 69,927 6,275 1,375 - - - 300,885 $ $ $ $ $ $ 197,675 245,150 - - 96,770 82,515 622,110 169,066 82,107 5,437 2,299 336,933 23,481 2,787 622,110 Funds from operations decreased during the year ended December 31, 2010 compared to 2009, due to reduced production attributed to asset dispositions and lower realized derivative gains from less natural gas production hedged for this year at lower average prices. However, funds from operations were positively impacted during 2010 from an improvement in crude oil prices and continued cost reduction efforts. Significant asset dispositions were completed in both 2010 and 2009 with proceeds utilized to generally repay bank indebtedness and convertible debenture maturities. During the second quarter of 2010 our 6.50% convertible debentures matured and were settled with $69.9 million in cash. Bank indebtedness increased in 2010 as would be expected due to our very active capital expenditure program that included finalizing our Glacier Phase II program and commencing Phase III that comprised expanding the Glacier gas plant to 100 mmcf/d and drilling 28 wells. We have focused on balancing our funds from operations and expenditures on fixed assets to maintain a strong balance sheet and preserve financial flexibility. Advantage Oil & Gas Ltd. - 25 Annual Financial Information The following is a summary of selected financial information of the Corporation and the Fund for the years indicated. Total revenue (before royalties) ($000) Net loss ($000) per share - basic and diluted Total assets ($000) Long term financial liabilities ($000) (1) Distributions declared per Trust Unit (2) Year ended Dec. 31, 2010 $ 364,501 $ (44,208) $ (0.27) $ 1,842,571 $ 363,675 $ - Year ended Year ended Dec. 31, 2009 Dec. 31, 2008 741,962 $ (20,577) $ $ (0.15) 2,302,746 $ 718,511 $ 1.40 $ $ $ $ $ $ $ 429,492 (86,426) (0.56) 1,927,241 383,797 0.08 (1) Long term financial liabilities exclude asset retirement obligations and future income taxes. (2) On March 18, 2009 Advantage annouced the discontinuance of distributions. Total revenue (before royalties) was significantly higher in 2008 as compared to 2009 and 2010 due to much stronger commodity prices and higher production. However, a net loss was still experienced in 2008 as we recognized a $120.3 million impairment of goodwill. For 2009 and 2010, total revenue (before royalties) decreased significantly as a result of considerably reduced commodity prices and lower production resulting from various asset dispositions completed in these years. The lower commodity prices also primarily contributed to the net losses recognized. Total assets have continually decreased from 2008 through 2010 due to the asset dispositions and depletion, depreciation and accretion expense that has exceeded capital spending activity. From 2008 to 2010 we have also experienced significant decreases in long term financial liabilities due to our concerted efforts to reduce debt, including utilizing net proceeds from significant asset dispositions, an equity financing, and a convertible debenture issuance. We also suspended all distributions in March 2009 and completed our conversion to a corporation in July 2009. Quarterly Performance ($000, except as otherwise indicated) Daily production 2010 2009 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Natural gas (mcf/d) Crude oil and NGLs (bbls/d) Total (boe/d) 106,125 6,620 24,308 104,714 6,835 24,287 107,821 7,395 25,365 87,346 7,975 22,533 84,466 8,488 22,566 91,200 8,431 23,631 124,990 10,212 31,044 117,968 10,942 30,603 Average prices Natural gas ($/mcf) Excluding hedging Including hedging AECO monthly index Crude oil and NGLs ($/bbl) Excluding hedging Including hedging WTI ($US/bbl) Total revenues (before royalties) Net income (loss) per share - basic - diluted Funds from operations Distributions declared $ $ $ 3.49 4.81 3.58 $ $ $ 3.51 4.80 3.72 $ $ $ 3.81 5.58 3.86 $ $ $ 5.26 6.87 5.35 $ $ $ 4.28 6.90 4.18 $ $ $ 2.89 6.10 3.03 $ $ $ 3.56 5.63 3.66 $ $ $ 5.36 6.52 5.64 $ 69.19 $ 64.14 $ 85.18 $ 86,012 $ (18,169) $ (0.11) $ (0.11) $ 40,744 $ - $ 61.84 $ 59.01 $ 76.21 $ 83,335 $ (16,915) $ (0.10) $ (0.10) 38,450 $ $ - $ 64.66 $ 61.80 $ 77.98 $ 96,377 $ (22,279) $ (0.14) $ (0.14) 45,605 $ $ - $ 67.23 $ 62.42 $ 78.79 $ 98,777 13,155 $ $ 0.08 $ 0.08 50,340 $ $ - $ 63.04 $ 57.85 $ 76.17 $ 98,782 $ (14,213) $ (0.09) $ (0.09) 50,083 $ $ - $ 56.99 $ 54.02 $ 68.29 $ 93,101 $ (53,293) $ (0.33) $ (0.33) 42,213 $ $ - $ 55.89 $ 54.51 $ 59.62 $ 114,659 $ (37,810) $ (0.26) $ (0.26) 51,590 $ $ - $ $ $ $ $ $ $ $ $ 43.41 54.54 43.21 122,950 18,890 0.13 0.13 55,591 17,266 The table above highlights the Corporation’s and Fund’s performance for the fourth quarter of 2010 and also for the preceding seven quarters. Production decreased modestly in the first quarter of 2009 as we experienced freezing conditions from early cold weather. Production increased in the second quarter of 2009 due to recovery from these cold weather conditions and additional production from a number of wells drilled during the first quarter of 2009 but delayed until after March 31, 2009 such that we could benefit from the 5% Alberta Provincial royalty rate available on such wells. We experienced a significant decrease in production during the third Advantage Oil & Gas Ltd. - 26 quarter of 2009 as we completed asset dispositions that closed in July 2009. The disposed properties represented approximately 8,100 boe/d of production. As the third quarter of 2009 still included 1,725 boe/d from the disposed properties, production in the fourth quarter of 2009 actually increased 3% from the prior quarter due to a few new wells, partially offset by some natural declines and cold weather conditions that typically cause production interruptions. An extended third party facility outage at our Lookout Butte property that began in 2008 resulted in 1,100 boe/d of reduced production that continued through much of 2009 but was completed and our production came back on in November 2009. Production for the first quarter of 2010 was comparable to the fourth quarter of 2009 but increased dramatically during the second quarter of 2010 as our new gas plant was completed and production from Glacier was increased to between 50 and 55 mmcf/d. We completed two additional asset dispositions during the end of the second quarter of 2010 representing approximately 1,700 boe/d that resulted in modestly lower production. The full impact of these recent dispositions resulted in the decrease in production for the third quarter of 2010 with our production remaining consistent during the fourth quarter of 2010. Our financial results, particularly revenues and funds from operations, have declined since 2008, as commodity prices decreased in response to the financial crisis that materialized in the fall of 2008 and commodity prices continued on a downward trend through to the third quarter of 2009. We experienced improvements in commodity prices during the fourth quarter of 2009 and the first quarter of 2010 that increased our revenues and funds from operations; however, natural gas prices still remained low. During the remainder 2010, natural gas prices weakened again, which has decreased our corresponding revenues and funds from operations. Weak commodity prices, particularly natural gas, have generally resulted in the recognized net losses for 2009 through 2010. Advantage did report net income in the first quarter of 2009 as we recognized both significant realized and unrealized gains on our derivative contracts and moderately lower expenses, including operating costs. Natural gas prices worsen during the second and third quarters of 2009 resulting in the recognition of net losses for the periods. The third quarter 2009 net loss was also impacted by additional costs incurred related to the corporate conversion, including a $23.0 million future income tax expense, and increased depletion and depreciation expense from a higher DD&A rate per boe that resulted from the asset dispositions. The net loss decreased during the fourth quarter of 2009 as commodity prices marginally improved. Partially offsetting the net losses experienced during 2009 has been the continuing reduction in costs including royalties and operating costs. We recognized net income during the first quarter of 2010 with improved crude oil prices and realized and unrealized gains on our derivative contracts associated with weak natural gas prices. Natural gas prices worsened during the remainder of 2010, resulting in the continued net losses during these quarters. Critical Accounting Estimates The preparation of financial statements in accordance with GAAP requires Management to make certain judgments and estimates. Changes in these judgments and estimates could have a material impact on the Corporation’s financial results and financial condition. Management relies on the estimate of reserves as prepared by the Corporation’s independent qualified reserves evaluator. The process of estimating reserves is critical to several accounting estimates. The process of estimating reserves is complex and requires significant judgments and decisions based on available geological, geophysical, engineering and economic data. These estimates may change substantially as additional data from ongoing development and production activities becomes available and as economic conditions impact crude oil and natural gas prices, operating costs, royalty burden changes, and future development costs. Reserve estimates impact net income through depletion and depreciation and impairment of petroleum and natural gas properties. The reserve estimates are also used to assess the borrowing base for the Corporation’s credit facilities. Revision or changes in the reserve estimates can have either a positive or a negative impact on net income and the borrowing base of the Corporation. Management’s process of determining the provision for future income taxes, the provision for asset retirement obligation costs and related accretion expense, the fair values initially assigned to the convertible debentures liability and equity components, and the fair values assigned to any acquired company’s assets and liabilities in a business combination is based on estimates. These estimates are significant and can include proved and probable reserves, future production rates, future petroleum and natural gas prices, future costs, future interest rates, future tax rates and other relevant assumptions. Revisions or changes in any of these estimates can have either a positive or a negative impact on asset and liability values and net income. In accordance with GAAP, derivative assets and liabilities are recorded at their fair values at the reporting date, with unrealized gains and losses recognized directly into net income and comprehensive income in the same period. The fair value of derivatives outstanding is an estimate based on pricing models, estimates, assumptions and market data available at that time. As such, the recognized amounts are non-cash items and the actual gains or losses realized on eventual cash settlement can vary materially due to subsequent fluctuations in commodity prices and foreign exchange rates as compared to the valuation assumptions. Advantage Oil & Gas Ltd. - 27 International Financial Reporting Standards In February 2008, the Canadian Institute of Chartered Accountants (“CICA”) confirmed that Canadian GAAP for publicly accountable enterprises will be replaced by International Financial Reporting Standards (“IFRS”) for the fiscal years beginning on or after January 1, 2011. Accordingly, the conversion from Canadian GAAP to IFRS will be applicable to the Corporation’s reporting for the first quarter 2011, for which the current and comparative information will be prepared under IFRS. We expect the transition to IFRS will impact accounting, financial reporting, processes, internal controls over financial reporting, taxes, and information systems. Management has engaged its key personnel responsible and developed an overall plan to address IFRS implementation. We anticipate no impact on the Corporations operations or business strategy from conversion to IFRS. Phase one of our plan consisted of a high level assessment to identify key areas of Canadian GAAP versus IFRS differences that would most likely impact the Corporation. This assessment was completed in early 2009. Phase two commenced in the third quarter of 2009 and involved the detailed assessment, from an accounting, financial reporting and business perspective, of the changes that would be caused by the conversion to IFRS. Specific accounting processes and policy review included: property, plant and equipment, exploration and evaluation costs, depreciation, impairment of assets, decommissioning liabilities and provisions, deferred income taxes, financial reporting and information systems. The deliverables for this phase include specific accounting policies for the above mentioned topics and also includes IFRS transitional choices. This phase is currently still in progress but is being finalized. The most significant change identified for Advantage, as with many companies in the oil and gas industry, will be associated with accounting for property, plant and equipment (“PP&E”). During the early stages of this phase, we had concentrated on the accounting for PP&E and have now primarily completed our assessments with key policy choices to be approved and finalized. We have now also evaluated most other accounting issues identified whereby differences between Canadian GAAP and IFRS exist for Advantage and have completed preliminary assessments and developed draft accounting policies. Phase three involves the execution of the work completed in phase two, by making changes to business and accounting processes and supporting information systems, as well as the formal documentation of the final approved accounting policies and procedures compliant with IFRS. This phase is progressing well and is expected to be completed in early 2011. Details surrounding the collection of comparative financial and other data in 2010 are currently being finalized in this phase. We are also in the process of finalizing our accounting policies and determining the financial impacts. We have completed our initial draft IFRS transitional balance sheet as of January 1, 2010 and our first three quarters of 2010 financial statements based on preliminary selected accounting policies. Our external auditors have been conducting their audit work of our transitional balance sheet and review of our first and second quarters of 2010 financial statements. Their work is not yet completed and we will have ongoing discussions with them through the entire process. We have now started to prepare draft IFRS financial statements for the fourth quarter of 2010 and believe we are on schedule to complete the conversion within the required deadline. The draft transitional balance sheet and quarterly financial statements are subject to change depending upon the finalization and approval of accounting policies. Education and training of key financial employees has been primarily completed. Training of other staff, management, and the Board is ongoing throughout the conversion project. Advantage views education and training as critical to our financial reporting controls and is a permanent process that we will continue. We will begin an education program for key stakeholders upon finalizing the impacts of the IFRS conversion project. The Corporation has identified the following areas as having the greatest potential impact on the accounting policies, financial reporting and information systems requirements upon conversion to IFRS. Differences between IFRS and Canadian GAAP in addition to those referred to below, may still be identified based on further detailed analysis and other changes in IFRS prior to conversion in 2011. Advantage has not yet finalized all of its accounting policies or transitional choices and as such is unable to quantify all of the impacts on the financial statements of adopting IFRS at this time. Any accounting policy selections or potential impacts referred to below are preliminary and are not finalized until all policies have been selected, approved by the Board of Directors, and completion of the corresponding audit and reviews by our external auditors. We continue to monitor other IFRS developments that may impact our choice of accounting policies. a) Property, plant and equipment The Corporation, like many Canadian oil and gas reporting issuers, applies the “full cost” concept in accounting for its oil and gas assets. Under full cost, capital expenditures are maintained in a single cost centre for each country, and the cost centre is subject to a single depletion and depreciation calculation and impairment test. IFRS will require the Corporation to make a much more detailed assessment of its oil and gas assets that will impact depreciation and impairment calculations. Included in this assessment is an ongoing appraisal of exploration and evaluation expenditures (“E&E”). Under Canadian GAAP, it is necessary to track costs associated with unproved properties that would be excluded from depletion and depreciation calculations. Under IFRS, a company may choose to expense E&E associated costs or capitalize such costs without recording depreciation expense until the expenditures are determined to Advantage Oil & Gas Ltd. - 28 represent technically feasible and commercially viable projects at which time the costs are moved to development properties. Advantage currently anticipates that it will select to capitalize E&E costs except for costs incurred before the acquisition of rights to explore, and to begin depreciating when technically feasible and commercially viable. We do not anticipate this to have a material impact on our financial results other than to the extent that expenditures may be incurred related to unsuccessful wells or projects that will be expensed in the period incurred. b) Depreciation For Canadian GAAP purposes, the full cost method of accounting for oil and gas properties requires a single calculation of depletion and depreciation of the carrying value of PP&E based on proved reserves. However, IFRS requires an allocation of the amount recognized as PP&E to each significant identified component and each component depreciated separately, utilizing an appropriate method of depreciation. This component depreciation of PP&E will result in an increased number of calculations of depreciation expense and may impact the amount of depreciation expense recognized. IFRS also permits the option of using either proved or proved and probable reserves in the depreciation calculation. Advantage has tentatively concluded at this time to utilize proved and probable reserves which we would expect to decrease annual depreciation expense between $90 and $110 million. c) Impairment of Assets Under Canadian GAAP, impairment calculations are prepared according to a two-step test generally conducted at a country level. Step one involves a comparison of the PP&E carrying value to the undiscounted net cash flows of proved reserves. If a company should fail step one, step two is completed to measure the amount of impairment whereby the PP&E carrying value is compared to a calculated fair value with any excess carrying value above the fair value recognized as an impairment loss. Impairment losses recognized under Canadian GAAP are not subsequently reversed. Under IFRS, impairment testing is completed at an individual asset group or “Cash Generating Unit” level (“CGU”) when indicators suggest there may be impairment. A CGU is defined as the smallest group of assets that produce independent cash flows. Impairment of assets at a CGU level use a one-step approach for testing and measuring asset impairment, with asset carrying values compared to the higher of “Value in Use” and “Fair Value less Costs to Sell”. The IFRS methodology may result in the possibility of more frequent impairments in the carrying value of PP&E. However, under IFRS previous impairment losses (except for goodwill) must be reversed where circumstances change such that the previously recognized impairment has been reduced. Advantage has completed an initial assessment of CGU’s as of the transition date and has determined there to be 12 CGU’s. The number of CGU’s is subject to change as Advantage’s portfolio of assets may change through development activities, acquisitions or dispositions. d) Decommissioning Liabilities Both Canadian GAAP and IFRS require a company to provide for a liability related to decommissioning PP&E. Both methodologies are similar and we have determined there to be no significant difference for Advantage, other than a potential difference related to discount rates. Canadian GAAP requires that the decommissioning liability be discounted at a credit-adjusted risk-free rate while IFRS requires that the decommissioning liability be discounted at an appropriate rate with either the cash flows or rate adjusted for risks. As a result, there currently is the possibility of using a risk-free rate or a credit-adjusted risk-free rate. Advantage has tentatively selected to use the risk-free rate for discounting purposes, currently determined to be approximately 4%, and we expect this would increase the decommissioning liability at transition date between $100 and $110 million. e) Deferred Income Taxes Future income taxes under Canadian GAAP and deferred income taxes under IFRS are similar for Advantage and we are continuing to evaluate this complex area. However, any differences in decommissioning liabilities and PP&E, including depreciation, will impact the carrying value as reported on the balance sheet and therefore result in a difference in the balance of deferred taxes reported under IFRS. f) First Time Adoption of International Financial Reporting Standards IFRS 1 provides the framework for the first time adoption of IFRS and specifies that an entity shall apply the principles under IFRS retrospectively. IFRS 1 also specifies that the adjustments that arise on retrospective conversion to IFRS from other GAAP should be directly recognized in retained earnings. Certain optional exemptions and mandatory exceptions to retrospective application are provided under IFRS 1. Advantage has chosen to apply an exemption that allows an entity that used full cost accounting, at adoption of IFRS, to measure exploration and evaluation assets at the amount measured under its previous GAAP for those assets. The entity may also measure its oil and gas assets in the development and production phases, by allocating the amount determined under the entities previous GAAP to the underlying assets and areas pro rata using reserve volumes or reserve values as of that date. Advantage has made a preliminary allocation based on proved and probable reserves values discounted at 10%. The allocation process had no impact on Advantage’s carrying value of PP&E. As a result of applying this exemption, Advantage will also be required to complete an Advantage Oil & Gas Ltd. - 29 impairment test under IFRS on the transition date. A preliminary impairment test has been completed for the tentatively determined CGU’s and there is currently no impairment at transition date. Advantage has also elected not to reevaluate prior completed business combinations under Canadian GAAP and has simply reviewed such prior business combinations accounting to ensure that no assets were recognized that would be inappropriate under IFRS. We have not found any such items and there will be no impact from choosing this exemption. g) Financial Reporting The adoption of IFRS will result in different presentation and additional disclosure requirements in the financial statements. Draft IFRS financial statements including notes have been prepared and are being reviewed with our external auditors and Board of Directors. We anticipate that review and discussion of the presentation and disclosures will continue until the first interim financial statements are released for the quarter ended March 31, 2011. h) Information Systems The adoption of IFRS will have an impact on information systems requirements. We have evaluated our financial reporting systems and have made current changes to accommodate IFRS. We will continue assessing the need for additional system upgrades or modifications to ensure an efficient conversion to IFRS and to improve ongoing processes. i) Internal Controls In accordance with the Corporations approach to certification of internal controls required under Canadian Securities Administrators’ National instrument 52-109 and SOX 302 and 404, all entity level, information technology, disclosures and business process controls will require updating and testing to reflect changes arising from our conversion to IFRS. Upon review with internal audit, we have determined there to be minimal updating of processes, controls and documentation required. We will work on updating our processes, controls and documentation during the final phase of IFRS conversion. Controls and Procedures The Corporation has established procedures and internal control systems to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Management of the Corporation is committed to providing timely, accurate and balanced disclosure of all material information about the Corporation. Disclosure controls and procedures are in place to ensure all ongoing reporting requirements are met and material information is disclosed on a timely basis. The Chief Executive Officer and President and Chief Financial Officer, individually, sign certifications that the financial statements, together with the other financial information included in the regular filings, fairly present in all material respects the financial condition, results of operations, and cash flows as of the dates and for the periods presented in the filings. The certifications further acknowledge that the filings do not contain any untrue statement of a material fact or omit to state a material fact required to be stated or that is necessary to make a statement not misleading in light of the circumstances under which it was made, with respect to the period covered by the filings. Evaluation of Disclosure Controls and Procedures The Corporation has established a Disclosure Committee consisting of the executive members with the responsibility of overseeing the Corporation’s disclosure practices and designing disclosure controls and procedures, as specified under Canadian and US securities law, to provide reasonable assurance that information required to be disclosed by the Corporation in its annual filings, interim filings or other reports filed or submitted by the Corporation under applicable securities legislation is recorded, processed, summarized and reported within the time periods specified in applicable securities legislation and that all material information relating to the Corporation is made known to them by others, particularly during the period in which the Corporation’s annual and interim filings are being prepared. All written public disclosures are reviewed and approved by at least one member of the Disclosure Committee prior to issuance. Additionally, the Disclosure Committee assists the Chief Executive Officer and President and Chief Financial Officer of the Corporation in making certifications with respect to the disclosure controls of the Corporation required under applicable regulations and ensures that the Board of Directors is promptly and fully informed regarding potential disclosure issues facing the Corporation. Management of Advantage, including our Chief Executive Officer and President and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the disclosure controls and procedures as of December 31, 2010. Based on that evaluation, our Chief Executive Officer and President and Chief Financial Officer have concluded that the disclosure controls and procedures are effective as of the end of the period, in all material respects. It should be noted that while the Chief Executive Officer and President and Chief Financial Officer believe that the Corporation’s design of disclosure controls and procedures provide a reasonable level of assurance that they are effective, they do not expect that the disclosure controls and procedures or internal control Advantage Oil & Gas Ltd. - 30 over financial reporting will prevent all errors and fraud. A control system does not provide absolute, but rather is designed to provide reasonable assurance that the objective of the control system is met. Management’s Report on Internal Controls over Financial Reporting The Corporation’s Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the rules of the United States Securities and Exchange Commission and the Canadian Securities Administrators. The Corporation’s internal control over financial reporting is a process designed, under the supervision and with the participation of executive and financial officers of the Corporation, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external reporting purposes in accordance with GAAP. The Corporation’s internal control over financial reporting includes policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Corporation; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation’s assets that could have a material effect on the financial statements. The Corporation’s internal control over financial reporting may not prevent or detect all misstatements because of inherent limitations. Additionally, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with the Corporation’s policies and procedures. The Corporation’s management assessed the design and effectiveness of the internal control over financial reporting as of December 31, 2010, based on the framework established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, the Chief Executive Officer and President and Chief Financial Officer concluded that the Corporation maintained effective internal control over financial reporting as of December 31, 2010. During the year ended December 31, 2010, there has been no change in the Corporation’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting. Corporate Governance The Board of Directors’ mandate is to supervise the management of the business and affairs of the Corporation. In particular, all decisions relating to: (i) the acquisition and disposition of properties for a purchase price or proceeds in excess of $5 million; (ii) the approval of annual operating and capital expenditure budgets; and (iii) the establishment of credit facilities and the issuance of additional shares, will be made by the Board. The Board of Directors meets regularly to review the business and affairs of the Corporation to make any required decisions. The Board of Directors consists of nine members, seven of whom are unrelated to the Corporation. The Independent Reserve Evaluation Committee has four members, the Audit Committee has four members, and the Human Resources, Compensation and Corporate Governance Committee has three members. All members of the various committees are independent. One member of the Audit Committee has been designated a “Financial Expert” as defined in applicable regulatory guidance. In addition, the Chairman of the Board is not related and is not an executive officer of the Corporation. The Board of Directors approved and Management implemented a Code of Business Conduct and Ethics. The purpose of the code is to lay out the expectation for the highest standards of professional and ethical conduct from our directors, officers and employees. The code reflects our commitment to a culture of honesty, integrity and accountability and outlines the basic principles and policies with which all employees are expected to comply. Our Code of Business Conduct and Ethics is available on our website at www.advantageog.com. As a foreign private issuer listed on the New York Stock Exchange (the "NYSE"), Advantage is not required to comply with most of the NYSE rules and listing standards and instead may comply with domestic Canadian requirements. Advantage is, however, required to comply with the following NYSE Rules: (i) Advantage must have an audit committee that satisfies the requirements of Rule 10A-3 under the United States Securities Exchange Act of 1934, as amended; (ii) the Chief Executive Officer must promptly notify the NYSE in writing after an executive officer becomes aware of any material non-compliance with the applicable NYSE Rules; (iii) submit an executed annual written affirmation to the NYSE, as well as an interim affirmation each time certain changes occurs to the audit committee; and (iv) provide a brief description of any significant differences between its corporate governance practices and those followed by U.S. domestic issuers listed under the NYSE. Advantage has reviewed the NYSE listing standards and confirms that its corporate governance practices do not differ significantly from such standards. A further discussion of the Corporation’s corporate governance practices can be found in the Management Proxy Circular. Advantage Oil & Gas Ltd. - 31 Creation of Longview Oil Corp. On March 7, 2011 Advantage announced that Longview Oil Corp. (“Longview”), a wholly-owned subsidiary of the Corporation, filed a preliminary prospectus on March 4, 2011 for an initial public offering (the “Offering”), which is targeted to raise gross proceeds of $150 million prior to an over-allotment option of up to 15% of the base offering size, exercisable 30 days following the closing of the Offering. The closing of the Offering is expected to occur in April, 2011. Longview was created to acquire certain oil-weighted assets (the “Acquired Assets”) located in West Central Alberta, Southeast Saskatchewan and the Lloydminster area of Saskatchewan with fourth quarter 2010 average production of 6,220 boe/d (74% crude oil and NGLs, proved reserves of 20.1 mmboe and proved plus probable reserves of 36.9 mmboe, based on a report prepared by Sproule & Associates Limited on the Acquired Assets for Advantage and Longview with an effective date of December 31, 2010. Longview’s business strategy is to provide shareholders with attractive long-term returns that combine both growth and yield by exploiting the Acquired Assets in a financially disciplined manner, acquiring additional long-life oil and gas assets of a similar nature and through the payment of a monthly dividend. Concurrent with closing of the Offering, Longview will purchase the Acquired Assets from Advantage (the “Transaction”), with consideration comprised of the net proceeds of the Offering, common shares of Longview and proceeds of $100 million to be drawn from an independent Longview credit facility (which is anticipated to be $200 million) to be established at closing. Advantage plans to use the cash proceeds from the Transaction to reduce outstanding bank indebtedness. The Transaction is conditional upon customary industry conditions including the approval of the Board of Directors of Advantage. Advantage will retain an equity ownership interest of approximately 67% of the common shares of Longview (approximately 62% if the over-allotment option is exercised in full). Concurrent with closing of the Offering, Advantage will enter into a Technical Services Agreement (the “TSA”) with Longview. Under the TSA, Advantage will provide the necessary personnel and technical services to manage Longview's business and Longview will reimburse Advantage on a monthly basis for its share of administrative charges based on respective levels of production. Longview will have an independent board of directors with three initial members. The officers of Longview will provide services to Longview under the TSA but will remain as employees of Advantage. As a result of the successful completion of the Transaction, historical financial and operating performance as well as forward-looking information may not be indicative of actual future performance. Outlook During the first half of 2010, we successfully completed our Phase II Montney development program at Glacier which involved drilling horizontal wells to build production inventory and delineate our land block. Construction on Advantage’s 100% working interest gas plant and gathering system expansion was completed ahead of schedule and on-budget leading to an earlier than anticipated commissioning during March 2010. The Glacier gas plant has since been operating at its design capacity with throughput rates between 50 and 55 mmcf/d. Due to stronger than expected well performance, we were able to further increase Glacier production ending the year exceeding 60 mmcf/d (10,000 boe/d). Phase III of our Glacier development project began at the end of the second quarter of 2010 and included the drilling of 28 net (28 gross) horizontal wells and the fabrication of a new processing train to facilitate expansion of our Glacier gas plant to a production capacity of 100 mmcf/d. At this time, in addition to the 100 mmcf/d of current production, we have an incremental 100 mmcf/d (16,667 boe/d) of production capacity available and additional wells will be brought on-stream as required to offset declines and maintain production. The amount of excess field production capacity above our current plant capacity is a result of our successful drilling program which demonstrated well test rates that exceeded expectations and proved up a large portion of our undrilled acreage at Glacier. Drilling results at our cornerstone Glacier property have demonstrated that our Montney development is among the top tier natural gas resource developments in North America. The attractive cost structure at Glacier which includes low operating costs and low royalty rates combined with a multi-decade drilling inventory provides a strong foundation to drive future development beyond 100 mmcf/d of production. With the expansion of Glacier to 100 mmcf/d now completed, a review of well performance, facility capacity and actual costs will be undertaken by Advantage to assess the timing and capital requirements for the next phase of growth at Glacier. Advantage will provide additional corporate guidance and communicate future development plans on or about mid-year 2011. Advantage Oil & Gas Ltd. - 32 Sensitivities The following table displays the current estimated sensitivity on funds from operations and funds from operations per share to changes in production, commodity prices, exchange rates and interest rates for 2011 including our hedging activities. Impact on Annual Funds from Operations $000 per share Natural gas AECO monthly price change of $1.00/Mcf Production change of 6.0 mmcf/d Crude oil and NGLs WTI price change of US$10.00/bbl Production change of 1,000 bbls/d $US/$Canadian exchange rate change of $0.01 Interest rate change of 1% $31,400 $7,500 $13,100 $24,800 $2,700 $3,400 $0.19 $0.05 $0.08 $0.15 $0.02 $0.02 Additional Information Additional information relating to Advantage can be found on SEDAR at www.sedar.com and the Corporation’s website at www.advantageog.com. Such other information includes the annual information form, the annual information circular – proxy statement, press releases, material contracts and agreements, and other financial reports. The annual information form will be of particular interest for current and potential shareholders as it discusses a variety of subject matter including the nature of the business, description of our operations, general and recent business developments, risk factors, reserves data and other oil and gas information. March 22, 2011 Advantage Oil & Gas Ltd. - 33 Ma anagement’s Responsibi lity for Finan ncial Stateme ents Consolidated C Financial St tatements The con con prin info e Management nsolidated finan nsolidated finan nciples and util ormation conta t of Advantage ncial statement ncial statement lize the best es ained throughou e Oil & Gas L s together with ts have been p stimates and ca ut the annual re Ltd. (the “Corp h all operationa repared by Ma areful judgmen eport is consiste poration”) is r al and other fin anagement in a nts of Managem ent with that pr responsible for nancial inform accordance wit ment, where ap rovided in the c r the preparatio mation contained th Canadian ge ppropriate. Ope consolidated fin on and presen d in the annua enerally accepte erational and o nancial stateme ntation of the al report. The ed accounting other financial nts. Ma are fina tha anagement has d accurately and ancial results w t the Corporati developed and d reliably recor within acceptabl ion’s assets are maintains a sys rded, that the le limits of mat properly safegu stem of interna consolidated f teriality, that al uarded. al controls desig financial statem ll other operatio gned to provid ments accuratel onal and finan de reasonable as ly report the C ncial informatio ssurance that al Corporation’s o n presented is ll transactions operating and accurate, and The fulf Ma mat Ma the e Audit Comm fills its financia anagement, the tters and vario anagement and se consolidated mittee, comprise al reporting an external audito ous aspects of the external au d financial state d of non-mana nd internal con ors, and the int f financial repo uditors, and rec ments. agement directo ntrol responsibi ternal auditors orting. The A commended app ors, acts on beh ilities. The Aud to discuss inte udit Committe proval to the B half of the Boar dit Committee ernal controls o ee reviewed th Board of Direct rd of Directors is responsible over financial r he consolidated tors. The Board s to ensure that e for meeting r reporting proce d financial sta d of Directors t Management regularly with esses, auditing atements with has approved Pric of t loss acc cewaterhouseC the Corporation s, comprehensi cordance with C Coopers LLP, an n, has audited t ive loss and d Canadian genera n independent the consolidate deficit and cash ally accepted au firm of Charte d balance sheet h flows for the uditing standard ered Accountan ts as at Decemb e years then e ds and have unl nts, appointed b ber 31, 2010 an ended. The ex limited and unr by the shareho nd 2009 and the xternal auditor restricted access olders as the ex e consolidated s conducted th s to the Audit C xternal auditor statements of heir audits in Committee. An CE Ma dy J. Mah EO arch 22, 2011 Kelly I. Drader K Pr resident and CF FO Ma anagement’s Report on In nternal Cont rol over Fina ancial Repor The con as a the Com as o Bec syst pre inad Pric aud fina opi e Management ntrol over finan amended. Unde effectiveness o mmittee of Spo of December 3 cause of inhere tems determine esentation. Furt dequate becaus cewaterhouseC dit and provide ancial reporting inion. of Advantage ncial reporting f er the supervisi of our internal onsoring Organ 1, 2010, our int ent limitations, ed to be effect ther, projection se of changes in Coopers LLP, th an independen g as at Decem Oil & Gas Ltd for the Corpora ion of our Chi control over f nizations of the ternal control o internal contr tive can provid s of any evalua n conditions, or he Corporation nt opinion on b ber 31, 2010, a d. (the “Corpor ation as such te ef Executive O financial report e Treadway Com over financial re ol over financi de only reasona ation of effectiv r that the degree n’s independent both the conso as stated in th ration”) is respo erm is defined i Officer and Chie ting based on t mmission (“CO eporting was eff ial reporting m able assurance veness to future e of compliance t firm of Chart olidated financia eir Auditor’s R rting onsible for esta in Rule 13a-15 ef Financial Of the Internal Co OSO”). Based o ffective. may not preven with respect t e periods are su e with the polic tered Accounta al statements a Report. Pricewa ablishing and m (f) of the Secur fficer, we have ontrol-Integrate on our assessm maintaining ade rities Exchange conducted an ed Framework ment, we have co quate internal e Act of 1934, evaluation of issued by the oncluded that nt or detect mi to the financial ubject to the ris cies or procedu ants, was appoi and the Corpor aterhouseCoop isstatements an l statement pre sk that controls ures may deterio inted by the sh ration’s internal pers LLP has p nd even those eparation and s may become orate. hareholders to l control over provided such An CE Ma dy J. Mah EO arch 22, 2011 Kelly I. Drader K Pr resident and CF FO Advantage e Oil & Gas Ltd d. - 34 March 22, 2011 Independent Auditor’s Report To the Shareholders of Advantage Oil & Gas Ltd. PricewaterhouseCoopers LLP Chartered Accountants 111 5 Avenue SW, Suite 3100 Calgary, Alberta Canada T2P 5L3 Telephone +1 403 509 7500 Facsimile +1 403 781 1825 www.pwc.com/ca We have completed integrated audits of Advantage Oil & Gas Ltd.’s 2010 and 2009 consolidated financial statements and its internal control over financial reporting as at December 31, 2010. Our opinions, based on our audits, are presented below. Report on the consolidated financial statements We have audited the accompanying consolidated financial statements of Advantage Oil & Gas Ltd., which comprise the consolidated balance sheets as at December 31, 2010 and 2009 and the consolidated statements of loss, comprehensive loss and deficit and cash flows for the years then ended, and the related notes including a summary of significant accounting policies. Management’s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with Canadian generally accepted accounting principles and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. Canadian generally accepted auditing standards require that we comply with ethical requirements. An audit involves performing procedures to obtain audit evidence, on a test basis, about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the company’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances. An audit also includes evaluating the appropriateness of accounting principles and policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion on the consolidated financial statements. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Advantage Oil & Gas Ltd. as at December 31, 2010 and 2009 and the results of its operations and cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Advantage Oil & Gas Ltd. - 35 Report on in nternal contr rol over finan ncial reportin ng We have also based on crit Organization o audited Adv teria establish ns of the Trea vantage Oil & hed in Interna dway Commi & Gas Ltd.’s in al Control - Int ssion (COSO nternal contro tegrated Fram O). ol over financi mework, issue al reporting a ed by the Com as at Decemb mmittee of Sp er 31, 2010 ponsoring Managemen Managemen of the effectiv on Internal C nt’s responsi t is responsib veness of inte Control over F ibility for inte ble for maintai ernal control o inancial Repo ernal control ining effective over financial orting. l over financ e internal con reporting, inc g cial reporting ncial reporting ntrol over finan accompanyin cluded in the g and for its a ng Manageme assessment ent’s Report Auditor’s re Our respons audit. We co Public Comp the audit to o maintained in sponsibility ibility is to exp nducted our a pany Accounti obtain reason n all material press an opin audit of intern ing Oversight able assuran respects. nion on the co nal control ove t Board (Unite ce about whe ompany’s inte er financial re ed States). Th ether effective ernal control o eporting in acc hose standard e internal cont over financial cordance with ds require tha trol over finan reporting bas h the standard at we plan and ncial reporting sed on our ds of the d perform g was An audit of in financial repo operating eff we consider nternal contro orting, assess fectiveness of necessary in ol over financi sing the risk th f internal cont the circumsta al reporting in hat a materia trol based on ances. ncludes obtain l weakness e the assessed ning an unde exists, testing d risk, and pe rstanding of i and evaluatin erforming such nternal contro ng the design h other proce ol over n and edures as We believe th financial repo hat our audit orting. provides a re easonable bas sis for our aud dit opinion on n the company y’s internal co ontrol over Definition of A company’s regarding the accordance w includes thos accurately an assurance th with generall only in accor assurance re company’s a f internal con s internal cont e reliability of with generally se policies an nd fairly reflec hat transaction y accepted a rdance with au egarding prev ssets that cou ntrol over fin trol over finan financial repo y accepted ac nd procedures ct the transac ns are record ccounting prin uthorizations vention or time uld have a ma nancial repor ncial reporting orting and the ccounting prin s that (i) perta ctions and dis ed as necess nciples, and t of managem ely detection aterial effect o rting g is a process e preparation nciples. A com ain to the main positions of th sary to permit that receipts a ent and direc of unauthoriz on the financ s designed to of financial st mpany’s intern ntenance of r he assets of t t preparation o and expenditu ctors of the co zed acquisition ial statements provide reaso tatements for nal control ov records that, i the company; of financial st ures of the co ompany; and n, use, or dis s. ance onable assura poses in r external pur eporting ver financial re e detail, n reasonable reasonable ; (ii) provide r accordance tatements in a being made ompany are b (iii) provide re easonable e position of the mitations ts inherent lim nts. Also, proje y become inad rocedures ma mitations, inte rnal control o ections of any y evaluation o ause of chang dequate beca . ay deteriorate over financial of effectivenes ges in conditio reporting may ss to future p ons or that the y not prevent periods are su e degree of c t or detect ubject to the ri ompliance wi isk that ith the n, Advantage orting as at D ssued by CO e Oil & Gas Lt ecember 31, SO. td. maintained 2010 based o d, in all mater on criteria est rial respects, tablished in In effective inter nternal Contro ver rnal control ov d ol - Integrated Inherent lim Because of it misstatemen controls may policies or pr Opinion In our opinion financial repo Framework is Chartered A Accountants Advantage e Oil & Gas Ltd d. - 36 Consolidated Balance Sheets (thousands of dollars) Assets Current assets Accounts receivable Prepaid expenses and deposits Derivative asset (note 11) Derivative asset (note 11) Fixed assets (note 3) Liabilities Current liabilities Accounts payable and accrued liabilities Current portion of capital lease obligations (note 4) Current portion of convertible debentures (note 5) Derivative liability (note 11) Future income taxes (note 8) Derivative liability (note 11) Capital lease obligations Bank indebtedness (note 6) Convertible debentures (note 5) Asset retirement obligations (note 7) Future income taxes (note 8) Other liability (note 9) Shareholders' Equity Share capital (note 10) Convertible debentures equity component (note 5) Contributed surplus (note 10) Deficit Commitments (note 13) Subsequent events (note 14) see accompanying Notes to Consolidated Financial Statements On behalf of the Board of Directors of Advantage Oil & Gas Ltd: December 31, 2010 December 31, 2009 $ $ 42,276 6,488 25,157 73,921 - 1,768,650 1,842,571 54,531 9,936 30,829 95,296 323 1,831,622 1,927,241 $ $ $ 112,457 759 61,570 2,367 5,876 183,029 177 - 288,852 72,811 58,281 29,399 1,835 634,384 2,199,491 15,896 17,754 (1,024,954) 1,208,187 1,842,571 $ $ 111,901 1,375 69,553 12,755 4,704 200,288 1,165 759 247,784 130,658 68,555 38,796 3,431 691,436 2,190,409 18,867 7,275 (980,746) 1,235,805 1,927,241 $ __________________ Paul G. Haggis, Director ______________ Andy J. Mah, Director Advantage Oil & Gas Ltd. - 37 Consolidated Statements of Loss, Comprehensive Loss and Deficit (thousands of dollars, except for per share amounts) Revenue Petroleum and natural gas Realized gain on derivatives (note 11) Unrealized gain (loss) on derivatives (note 11) Royalties Expenses Operating General and administrative Management internalization (note 10) Interest Interest and accretion on convertible debentures Depletion, depreciation and accretion Loss before taxes Future income tax reduction (note 8) Income and capital taxes (note 8) Net loss and comprehensive loss Deficit, beginning of year Distributions declared Deficit, end of year Net loss per share (note 10) Basic and diluted see accompanying Notes to Consolidated Financial Statements Year ended December 31, 2010 Year ended December 31, 2009 $ 319,368 45,133 5,381 (44,640) 325,242 93,875 37,578 - 13,545 15,583 215,780 376,361 (51,119) (8,225) 1,314 (6,911) (44,208) (980,746) - (1,024,954) $ $ 343,005 86,487 (23,738) (49,010) 356,744 119,022 39,335 1,724 19,752 16,030 256,882 452,745 (96,001) (10,855) 1,280 (9,575) (86,426) (877,054) (17,266) (980,746) $ $ (0.27) $ (0.56) Advantage Oil & Gas Ltd. - 38 Consolidated Statements of Cash Flows (thousands of dollars) Operating Activities Net loss Add (deduct) items not requiring cash: Unrealized loss (gain) on derivatives Equity-based compensation (note 10) Non-cash general and administrative (note 9) Management internalization Accretion on other liability (note 9) Accretion on convertible debentures Depletion, depreciation and accretion Future income tax reduction Expenditures on asset retirement (note 7) Changes in non-cash working capital Cash provided by operating activities Financing Activities Convertible debenture maturities (note 5) Increase (decrease) in bank indebtedness Reduction of capital lease obligations Units issued, less costs (note 10) Convertible debentures issued, less costs (note 5) Distributions to Unitholders Changes in non-cash working capital Cash used in financing activities Investing Activities Expenditures on fixed assets Property dispositions (note 3) Changes in non-cash working capital Cash provided by (used in) investing activities Net change in cash Cash, beginning of year Cash, end of year Supplementary Cash Flow Information Interest paid Taxes paid see accompanying Notes to Consolidated Financial Statements Year ended December 31, 2010 Year ended December 31, 2009 $ (44,208) $ (86,426) (5,381) 13,415 (538) - 199 4,097 215,780 (8,225) (6,275) 33,630 202,494 (69,927) 41,068 (1,375) - - - (310) (30,544) (223,308) 69,676 (18,318) (171,950) - - $ - $ $ 21,533 1,200 23,738 6,392 3,781 1,724 85 2,354 256,882 (10,855) (5,437) (21,349) 170,889 (82,107) (336,933) (2,299) 96,770 82,515 (23,481) 500 (265,035) (169,066) 245,150 18,062 94,146 - - $ - $ $ 31,335 1,410 Advantage Oil & Gas Ltd. - 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2010 and 2009 All tabular amounts in thousands except as otherwise indicated. 1. Business and Structure of Advantage Oil & Gas Ltd. Advantage Oil & Gas Ltd. (“Advantage” or the “Corporation”) is an intermediate oil and natural gas exploration and production corporation with properties located in Western Canada. Advantage was created on July 9, 2009, through the completion of a plan of arrangement pursuant to an information circular dated June 5, 2009. Advantage Energy Income Fund (the “Fund”) was dissolved and converted into the corporation, Advantage Oil and Gas Ltd., with each Trust Unit converted into one Common Share. 2. Summary of Significant Accounting Policies The Management of the Corporation prepares its consolidated financial statements in accordance with Canadian generally accepted accounting principles (“Canadian GAAP”) and all amounts are stated in Canadian dollars. The preparation of consolidated financial statements requires Management to make estimates and assumptions that affect the reported amount of assets, liabilities and equity and disclosures of contingencies at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the periods. The following significant accounting policies are presented to assist the reader in evaluating these consolidated financial statements and, together with the notes, should be considered an integral part of the consolidated financial statements. (a) Consolidation and joint operations These consolidated financial statements include the accounts of the Corporation and all subsidiaries. All intercompany balances and transactions have been eliminated. The Corporation conducts exploration and production activities jointly with other participants. The accounts of the Corporation reflect its proportionate interest in such joint operations. (b) Fixed assets (i) Petroleum and natural gas properties The Corporation follows the “full cost” method of accounting in accordance with the guideline issued by the Canadian Institute of Chartered Accountants (“CICA”) whereby all costs associated with the acquisition of and the exploration for and development of petroleum and natural gas reserves, whether productive or unproductive, are capitalized in a Canadian cost centre and charged to income as set out below. Such costs include lease acquisition, drilling and completion, production facilities, asset retirement costs, geological and geophysical costs and overhead expenses related to exploration and development activities, net of any government incentive programs. Gains or losses are not recognized upon disposition of petroleum and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the rate of depletion and depreciation of 20% or more. Depletion of petroleum and natural gas properties and depreciation of lease, well equipment and production facilities is provided on accumulated costs using the “unit-of-production” method based on estimated proved petroleum and natural gas reserves, before royalties, as determined by independent engineers. For purposes of the depletion and depreciation calculation, proved petroleum and natural gas reserves are converted to a common unit-of-measure on the basis of one barrel of oil or liquids being equal to six thousand cubic feet of natural gas. The depletion and depreciation cost base includes total capitalized costs, less costs of unproved properties, plus an estimate of future development costs of proved undeveloped reserves. Costs of acquiring and evaluating unproved properties are excluded from depletion calculations until it is determined whether or not proved reserves are attributable to the properties or impairment occurs. Petroleum and natural gas properties are evaluated in each reporting period to determine that the carrying amount in a cost centre is recoverable and does not exceed the fair value of the properties in the cost centre (the “ceiling test”). The carrying amounts are assessed to be recoverable when the sum of the undiscounted net cash flows expected from the production of Advantage Oil & Gas Ltd. - 40 (i) Petroleum and natural gas properties (continued) proved reserves, the lower of cost and market of unproved properties and the cost of major development projects exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted net cash flows expected from the production of proved and probable reserves, the lower of cost and market of unproved properties and the cost of major development projects of the cost centre. The net cash flows are estimated using expected future product prices and costs and are discounted using a risk-free interest rate. (ii) Furniture and equipment The Corporation records furniture and equipment at cost and provides depreciation on the declining balance method at a rate of 20% per annum which is designed to amortize the cost of the assets over their estimated useful lives. The Corporation records leasehold improvements at cost and provides depreciation on the straight-line method over the term of the lease. (c) Distributions Distributions previously declared by the Fund were reported on an accrual basis. (d) Financial instruments The Corporation’s financial instruments consist of financial assets, financial liabilities, and non-financial derivatives. All financial instruments are initially recognized at fair value on the balance sheet. Measurement of financial instruments subsequent to the initial recognition, as well as resulting gains and losses, is based on how each financial instrument was initially classified. The Corporation has classified each identified financial instrument into the following categories: held for trading, loans and receivables, held to maturity investments, available for sale financial assets, and other financial liabilities. Held for trading financial instruments are measured at fair value with gains and losses recognized in earnings immediately. Available for sale financial assets are measured at fair value with gains and losses, other than impairment losses, recognized in other comprehensive income and transferred to earnings when the asset is derecognized. Loans and receivables, held to maturity investments and other financial liabilities are recognized at amortized cost using the effective interest method and impairment losses are recorded in earnings when incurred. With all new financial instruments, an election is available that allows entities to classify any financial instrument as held for trading. Only those financial assets and liabilities that must be classified as held for trading are classified as such by the Corporation. Derivative instruments executed by the Corporation to manage market risk associated with volatile commodity prices are classified as held for trading and recorded on the balance sheet at fair value as derivative assets and liabilities. Gains and losses on these instruments are recorded as unrealized gains and losses on derivatives in the consolidated statement of loss, comprehensive loss and deficit in the period they occur and as realized gains and losses on derivatives when the contracts are settled. Since unrealized gains and losses on derivatives are non-cash items, there is no impact on cash provided by operating activities as a result of their recognition. Transaction costs are frequently attributed to the acquisition or issue of a financial asset or liability. Such costs incurred on held for trading financial instruments are expensed immediately. For other financial instruments, an entity can adopt an accounting policy of either expensing transaction costs as they occur or adding such transaction costs to the fair value of the financial instrument. The Corporation has chosen a policy of adding transaction costs to the fair value initially recognized for financial assets and liabilities that are not classified as held for trading. (e) Comprehensive income Comprehensive income consists of net income and other comprehensive income (“OCI”) with amounts included in OCI shown net of tax. Accumulated other comprehensive income is comprised of the cumulative amounts of OCI. To date, the Corporation does not have any adjustments in OCI and therefore comprehensive loss is currently equal to net loss. (f) Convertible debentures The Corporation’s convertible debentures are financial liabilities consisting of a liability with an embedded conversion feature. As such, the debentures are segregated between liabilities and equity based on the residual value method, where the liability is first measured using a discount rate without the conversion feature and the remaining amount is allocated to equity. Therefore, the debenture liabilities are presented at less than their eventual maturity values. The liability and equity components are further reduced for issuance costs initially incurred. The discount of the liability component as compared to maturity value is accreted by the “effective interest” method over the debenture term and expensed accordingly. As debentures are converted to shares, an appropriate portion of the liability and equity components are transferred to share capital. Advantage Oil & Gas Ltd. - 41  (g) Asset retirement obligations The Corporation records the future cost associated with removal, site restoration and asset retirement costs. The fair value of the liability for the Corporation’s asset retirement obligations is recorded in the period in which it is incurred, discounted to its present value using the Corporation’s credit adjusted risk-free interest rate and the corresponding amount recognized by increasing the carrying amount of fixed assets. The asset recorded is depleted on a “unit-of-production” basis over the life of the reserves consistent with the Corporation’s depletion and depreciation policy for petroleum and natural gas properties. The liability amount is increased each reporting period due to the passage of time and the amount of accretion is charged to income in the period. Revisions to the estimated timing of cash flows or to the original estimated undiscounted cost could also result in an increase or decrease to the obligation. Actual costs incurred upon settlement of the retirement obligations are charged against the obligation to the extent of the liability recorded. (h) Income taxes The Corporation follows the “liability” method of accounting for future income taxes. Under this method future income tax assets and liabilities are determined based on differences between the carrying value of an asset or liability and its tax basis using substantively enacted tax rates and laws expected to apply when the differences reverse. The effect a change in income tax rates has on future tax assets and liabilities is recognized in net income in the period in which the change is substantively enacted. (i) Equity-based compensation Advantage accounts for compensation expense based on the “fair value” of rights granted under its equity-based compensation plans. Prior to converting to a corporation, the Fund had Trust Units held in escrow relating to management internalization (note 10) and a Restricted Trust Unit Plan. Subsequent to converting to a corporation, Advantage has a Restricted Share Performance Incentive Plan (note 10). The escrowed Trust Units relating to the management internalization vested equally over three years, the period during which employees were required to provide service to receive the Trust Units. Therefore, the management internalization consideration was being deferred and amortized into income as management internalization expense over the specific vesting periods during which employee services were provided, including an estimate of future Trust Unit forfeitures. Advantage’s Restricted Share Performance Incentive Plan (“RSPIP” or the “Plan”), authorizes the Board of Directors to grant restricted shares to service providers of the Corporation, including directors, officers, employees, and consultants. The restricted share grants generally vest one-third immediately on grant date, with the remaining two-thirds vesting evenly on the following two yearly anniversary dates. Compensation cost related to the Plan is recognized as compensation expense within general and administrative expense over the service period and incorporates the share grant price, the estimated number of restricted shares to vest, and certain management estimates. As compensation expense is recognized, contributed surplus is recorded until the restricted shares vest at which time the appropriate shares are then issued to the services providers and the contributed surplus is transferred to share capital. The Plan replaced the previous Restricted Trust Unit (“RTU”) plan that was in place prior to the conversion to a corporation and for which the accounting was the same. (j) Revenue recognition Revenue associated with the sale of petroleum, natural gas and natural gas liquids is recognized when the title and risks pass to the purchaser, normally at the pipeline delivery point for natural gas and at the wellhead for crude oil. (k) Per share amounts Net loss per share is calculated using the weighted average number of shares outstanding during the year. Diluted net loss per share is calculated using the “if-converted” method to determine the dilutive effect of convertible debentures and the “treasury stock” method for equity-based compensation. (l) Measurement uncertainty The amounts recorded for depletion and depreciation of fixed assets, the provision for asset retirement obligation costs and related accretion expense, impairment calculations for fixed assets, derivative fair value calculations, future income tax provisions, fair values initially assigned to convertible debentures liability and equity components, as well as fair values assigned to any identifiable assets and liabilities in business combinations are based on estimates. These estimates are significant and include proved and probable reserves, future production rates, future petroleum and natural gas prices, future costs, future interest rates, future tax rates, fair value assessments, and other relevant assumptions. By their nature, these estimates are subject to measurement uncertainty and the effect on the consolidated financial statements of changes in such estimates in future years could be material. Advantage Oil & Gas Ltd. - 42 (m) Recent accounting pronouncements issued but not implemented (i) International Financial Reporting Standards (“IFRS”) Effective January 1, 2011, Advantage will adopt IFRS. (n) Comparative figures Certain comparative figures have been reclassified to conform to the current year presentation. 3. Fixed Assets December 31, 2010 Petroleum and natural gas properties Furniture and equipment December 31, 2009 Petroleum and natural gas properties Furniture and equipment Cost 3,366,697 12,188 3,378,885 $ $ Cost 3,218,785 11,785 3,230,570 $ $ Accumulated Depletion and Depreciation $ $ 1,600,839 9,396 1,610,235 Accumulated Depletion and Depreciation $ $ 1,390,784 8,164 1,398,948 $ Net Book Value 1,765,858 2,792 1,768,650 $ $ Net Book Value 1,828,001 3,621 1,831,622 $ In May and June 2010, Advantage closed two asset dispositions for net cash proceeds of $66.5 million, and other minor dispositions of $3.2 million (December 31, 2009 - $245.2 million). As these dispositions did not result in a change of more than 20% in the rate of depletion and depreciation, no gain or loss was recognized. During the year ended December 31, 2010, Advantage capitalized general and administrative expenditures directly related to exploration and development activities of $9.6 million (December 31, 2009 - $10.2 million). Costs of $30.7 million (December 31, 2009 - $38.2 million) for unproved properties have been excluded from the calculation of depletion expense, and future development costs of $1.2 billion (December 31, 2009 - $845.3 million) have been included in costs subject to depletion. The Corporation performed a ceiling test calculation at December 31, 2010 to assess the recoverable value of fixed assets. Based on the calculation, there has been no impairment of the Corporation’s petroleum and natural gas properties. The carrying amounts are recoverable as compared to the sum of the undiscounted net cash flows expected from the production of proved reserves based on the following benchmark prices: Year 2011 2012 2013 2014 2015 2016 Approximate escalation rate after 2016 WTI Crude Oil ($US/bbl) Exchange Rate ($US/$Cdn) AECO Gas ($Cdn/mmbtu) $ 88.40 $ 89.14 $ 88.77 $ 88.88 $ 90.22 $ 91.57 1.5% $ 0.932 $ 0.932 $ 0.932 $ 0.932 $ 0.932 $ 0.932 - $4.04 $4.66 $4.99 $6.58 $6.69 $6.80 1.5% Benchmark prices are adjusted for a variety of factors, such as quality differentials, to determine the expected price to be realized by the Corporation when performing the ceiling test calculation. Advantage Oil & Gas Ltd. - 43 4. Capital Lease Obligations The Corporation has capital leases on a variety of fixed assets. Future minimum lease payments at December 31, 2010 consist of the following: 2011 Less amounts representing interest Current portion $ 779 (20) 759 (759) $ - Fixed assets subject to capital leases are depreciated on a “unit-of-production” basis over the life of the reserves consistent with the Corporation’s depletion and depreciation policy for petroleum and natural gas properties and is included in depletion, depreciation and accretion expense. 5. Convertible Debentures The convertible unsecured subordinated debentures pay interest semi-annually and are convertible at the option of the holder into shares of Advantage at the applicable conversion price per share plus accrued and unpaid interest. The details of the convertible debentures including fair market values initially assigned and issuance costs are as follows: 7.75% 8.00% 5.00% Trading symbol Issue date Maturity date Conversion price Liability component Equity component Gross proceeds Issuance costs Net proceeds AAV.DBD AAV.DBG Sep. 15, 2004 Nov. 13, 2006 Dec. 31, 2009 Jan. 30, 2015 Dec. 1, 2011 Dec. 31, 2011 20.33 $ $ AAV.DBH $ 21.00 8.60 $ 47,444 2,556 $ 14,884 26,561 $ 73,019 13,231 50,000 (2,190) 41,445 - 86,250 (3,735) $ 47,810 $ 41,445 $ 82,515 The convertible debentures are redeemable prior to their maturity dates, at the option of the Corporation, upon providing appropriate advance notification as per the debenture indentures. The redemption prices for the various debentures, plus accrued and unpaid interest, is dependent on the redemption periods and are as follows: Convertible Debenture Redemption Periods 7.75% 8.00% 5.00% After December 1, 2009 and before December 1, 2011 After December 31, 2010 and before December 31, 2011 After January 31, 2013 and on or before January 30, 2015 Provided that Current Market Price exceeds 125% of Conversion Price Redemption Price $ $ $ 1,000 1,025 1,000 Advantage Oil & Gas Ltd. - 44 5. Convertible Debentures (continued) The balance of debentures outstanding at December 31, 2010 and changes in the liability and equity components during the years ended December 31, 2010 and 2009 are as follows: Trading symbol Debentures outstanding Liability component: 8.25% AVN.DBB $ - 8.75% AVN.DBF $ - 7.50% AAV.DBC $ - 6.50% AAV.DBE $ - Balance at December 31, 2008 Accretion of discount Matured Balance at December 31, 2009 Accretion of discount Matured Balance at December 31, 2010 $ 4,859 8 (4,867) - $ - - $ - $ 29,687 152 (29,839) - $ - - $ - $ 51,579 689 (52,268) - $ - - $ - $ $ 68,807 746 - 69,553 374 (69,927) $ - Equity component: Balance at December 31, 2008 Expired Balance at December 31, 2009 Expired Balance at December 31, 2010 Trading symbol Debentures outstanding Liability component: Balance at December 31, 2008 Issued Accretion of discount Matured Balance at December 31, 2009 Accretion of discount Matured Balance at December 31, 2010 Equity component: Balance at December 31, 2008 Issued Expired Balance at December 31, 2009 Expired Balance at December 31, 2010 $ 248 (248) - $ - $ - $ 852 (852) - $ - $ - $ 2,248 (2,248) - $ - $ - $ $ 2,971 - 2,971 (2,971) $ - 7.75% AAV.DBD 46,766 $ 8.00% AAV.DBG 15,528 $ 5.00% AAV.DBH 86,250 $ Total $ 148,544 $ $ 44,964 - 610 - 45,574 619 - 46,193 2,286 - - 2,286 - 2,286 $ $ $ $ $ $ $ $ $ $ 15,078 - 149 - 15,227 150 - 15,377 798 - - 798 - 798 - $ 69,857 - - 69,857 2,954 - 72,811 $ $ - $ 12,812 - 12,812 - 12,812 $ $ $ $ 214,974 69,857 2,354 (86,974) 200,211 4,097 (69,927) 134,381 $ $ 9,403 12,812 (3,348) 18,867 (2,971) 15,896 $ $ Advantage Oil & Gas Ltd. - 45 5. Convertible Debentures (continued) The principal amount of 8.25% convertible debentures matured on February 1, 2009 and were settled by issuing 946,887 Trust Units. The 8.75% convertible debentures matured and were settled with $29.8 million in cash on June 30, 2009. The 7.50% convertible debentures matured and were settled with $52.3 million in cash on September 30, 2009. The principal amount of 6.50% convertible debentures matured and were settled with $69.9 million in cash on June 30, 2010. On December 31, 2009, 5.00% convertible debentures were issued for net proceeds of $82.5 million. The debentures have a face value of $1,000 per debenture, mature on January 30, 2015 and are convertible into shares of the Corporation at the option of the holder at a conversion price of $8.60. The debentures pay interest semi-annually in arrears on January 31 and July 31 of each year, commencing on July 31, 2010. The debentures will not be redeemable by the Corporation prior to January 31, 2013. On and after January 31, 2013 and prior to January 30, 2015, the debentures may be redeemed by the Corporation in whole or in part from time to time at the option of the Corporation at a redemption price equal to their principal amount plus accrued and unpaid interest, provided that the Current Market Price is at least 125% of the Conversion Price. In the event that a holder of debentures exercises their conversion right following a notice of redemption by the Corporation, such holder shall be entitled to receive accrued and unpaid interest, in addition to the applicable number of shares to be received on conversion. During the years ended December 31, 2010 and 2009, there were no convertible debenture conversions. 6. Bank Indebtedness Revolving credit facility Discount on Bankers Acceptances and other fees Balance, end of year December 31, 2010 $ 290,657 (1,805) 288,852 $ December 31, 2009 $ 250,262 (2,478) 247,784 $ Advantage’s credit facilities of $525 million is comprised of a $20 million extendible revolving operating loan facility from one financial institution and a $505 million extendible revolving loan facility from a syndicate of financial institutions (the "Credit Facilities"). Amounts borrowed under the Credit Facilities bear interest at a floating rate based on the applicable Canadian prime rate, US base rate, LIBOR rate or bankers' acceptance rate plus between 1.25% and 3.75% depending on the type of borrowing and the Corporation’s debt to cash flow ratio. The Credit Facilities are collateralized by a $1 billion floating charge demand debenture covering all assets of the Corporation. The amounts available to Advantage from time to time under the Credit Facilities are based upon the borrowing base determined semi-annually by the lenders. The revolving period for the Credit Facilities will end in June 2011 unless extended at the option of the syndicate for a further 364 day period. If the Credit Facilities are not extended, they will convert to non-revolving term facilities due 365 days after the last day of the revolving period. The credit facilities prohibit the Corporation from entering into any derivative contract where the term of such contract exceeds three years. Further, the aggregate of such contracts cannot hedge greater than 60% of total estimated petroleum and natural gas production over two years and 50% over the third year. The Credit Facilities contain standard commercial covenants for credit facilities of this nature. The only financial covenant is a requirement for Advantage to maintain a minimum cash flow to interest expense ratio of 3.5:1, determined on a rolling four-quarter basis. This covenant was met at December 31, 2010 and 2009. Breach of any covenant will result in an event of default in which case Advantage has 20 days to remedy such default. If the default is not remedied or waived, and if required by the lenders, the administrative agent of the lenders has the option to declare all obligations under the credit facilities to be immediately due and payable without further demand, presentation, protest, days of grace, or notice of any kind. Interest payments under the debentures are subordinated to the repayment of any amounts owing under the credit facilities and are not permitted if the Corporation is in default of such credit facilities or if the amount of outstanding indebtedness under such facilities exceeds the then existing current borrowing base. For the year ended December 31, 2010, the average effective interest rate on the outstanding amounts under the facility was 5.0% (December 31, 2009 – 4.9%). Advantage also has issued letters of credit totaling $2.9 million at December 31, 2010 (December 31, 2009 – $1.3 million). Advantage Oil & Gas Ltd. - 46 7. Asset Retirement Obligations The Corporation’s asset retirement obligations result from net ownership interests in petroleum and natural gas properties including well sites, gathering systems and processing facilities. The Corporation estimates the total undiscounted amount of cash flows required to settle its asset retirement obligations is approximately $320 million which will be incurred between 2011 and 2070. A credit-adjusted risk-free rate of 7% and an inflation factor of 2% were used to calculate the fair value of the asset retirement obligations. A reconciliation of the asset retirement obligations is provided below: Balance, beginning of year Accretion expense Liabilities incurred Change in estimates Property dispositions Liabilities settled Balance, end of year 8. Income Taxes Year ended December 31, 2010 68,555 $ 4,493 1,370 4,107 (13,969) (6,275) 58,281 $ Year ended December 31, 2009 73,852 $ 5,297 699 16,419 (22,275) (5,437) 68,555 $ The provision for income taxes varies from the amount that would be computed by applying the combined Canadian federal and provincial income tax rates for the following reasons: Loss before taxes Canadian combined federal and provincial income tax rates Expected income tax recovery at statutory rates Increase (decrease) in income taxes resulting from: Amounts included in trust income Conversion to a corporation Management internalization Change in estimated pool balances Equity-based compensation Difference between current and expected tax rates Other Future income tax reduction Income and capital taxes Year ended December 31, 2010 Year ended December 31, 2009 $ (51,119) 28.17% (14,400) $ (96,001) 29.20% (28,032) - - - - 4,674 696 805 (8,225) 1,314 (6,911) $ (5,042) 22,637 503 (4,682) 2,393 - 1,368 (10,855) 1,280 (9,575) $ Advantage Oil & Gas Ltd. - 47 8. Income Taxes (continued) The components of the future income tax liability are as follows: December 31, 2010 December 31, 2009 Fixed assets in excess of tax basis Asset retirement obligations Non-capital tax loss carry forward Net derivative assets Other Future income tax liability Current future income tax liability Long-term future income tax liability $ $ 211,355 (14,828) (159,358) 6,034 (7,928) 35,275 5,876 29,399 35,275 $ $ $ $ $ $ 193,821 (17,418) (127,941) 4,867 (9,829) 43,500 4,704 38,796 43,500 Advantage has a federal non-capital loss carry forward balance of approximately $633 million (December 31, 2009 - $508 million). These losses expire between 2023 and 2030. The estimated tax pools in place at December 31, 2010 are as follows: December 31, 2010 Estimated Tax Pools ($ millions) Undepreciated Capital Cost Canadian Oil and Gas Property Expenses Canadian Development Expenses Canadian Exploration Expenses Non-capital losses Other $ 413 138 331 44 633 11 1,570 $ 9. Other Liability In August 2009, Advantage vacated an office location as the space was no longer required. Advantage is obligated to make lease payments for the remainder of the life of the lease, which terminates in November 2012. As a result, the full fair value of future scheduled lease payments was recognized as general and administrative expense in 2009 with a corresponding liability. Fair value was determined on a present value basis, using a credit-adjusted risk free rate of 7%. In November 2010, Advantage subleased a portion of the space to a subtenant, and accordingly recognized a reduction in the liability and a corresponding recovery of general and administrative expense. A reconciliation of the other liability is as follows: Year ended Year ended Balance, beginning of year Office lease liability incurred Accretion expense Reduction of liability by subleasing space Liability settled Balance, end of year December 31, 2010 December 31, 2009 $ 3,431 - 199 (538) (1,257) 1,835 $ - 3,781 85 - (435) 3,431 $ $ Advantage Oil & Gas Ltd. - 48 10. Shareholders’ Equity (a) Share capital (i) Authorized The Corporation is authorized to issue an unlimited number of shares without nominal or par value. (ii) Issued Balance at July 9, 2009 Issued on conversion to a corporation Issued pursuant to Restricted Share Performance Incentive Plan Balance at December 31, 2009 Issued pursuant to Restricted Share Performance Incentive Plan Balance at December 31, 2010 Number of Shares - 162,197,790 547,738 162,745,528 1,346,481 164,092,009 Amount - $ 2,186,802 3,607 2,190,409 9,082 2,199,491 $ $ On July 9, 2009, the Fund successfully completed the plan of arrangement pursuant to an information circular dated June 5, 2009. The Fund was dissolved and converted into the Corporation, with each Trust Unit converted into one Common Share. (b) Unit capital Balance at December 31, 2008 Distribution reinvestment plan Issued on maturity of debentures Issued pursuant to Restricted Trust Unit Plan Management internalization forfeitures Issued, less costs net of future taxes Purchased from dissenting Unitholders Cancelled on conversion to a corporation Balance at July 9, 2009 Number of Units 142,824,854 1,263,158 946,887 171,093 (7,862) 17,000,000 (340) (162,197,790) - Amount $ 2,077,760 5,211 4,867 939 (159) 98,185 (1) (2,186,802) - Concurrent with the acquisition of Ketch Resources Trust on June 23, 2006, the Fund internalized the external management contract structure and eliminated all related fees for total original consideration of 1,933,208 Trust Units initially valued at $39.1 million. These Trust Units were subject to escrow provisions over a three-year period, vesting one-third each year beginning in 2007. The management internalization consideration was deferred and amortized into income as management internalization expense over the specific vesting periods during which employee services were provided. For the year ended December 31, 2009, a total of 7,862 Trust Units issued for the management internalization were forfeited and $1.7 million was recognized as management internalization expense. At December 31, 2010 and 2009, all Trust Units in respect of management internalization were issued and none remained held in escrow. Prior to converting to a corporation on July 9, 2009, 1,263,158 Trust Units were issued under the Premium Distribution(TM), Distribution Reinvestment and Optional Trust Unit Purchase Plan, generating $5.2 million reinvested in the Fund during the year ended December 31, 2009. The Premium Distribution(TM), Distribution Reinvestment and Optional Trust Unit Purchase Plan was discontinued on March 18, 2009, concurrent with the discontinuation of cash distributions. The principal amount of 8.25% convertible debentures matured on February 1, 2009 and were settled by issuing 946,887 Trust Units. On July 7, 2009, the Fund closed a bought deal financing with 17 million Trust Units issued at $6.00 each, for gross proceeds of $102 million, less $3.8 million related to $5.2 million of issuance costs net $1.4 million of related future taxes. Advantage Oil & Gas Ltd. - 49 10. Shareholders’ Equity (continued) (c) Contributed surplus The changes in contributed surplus during the years ended December 31, 2010 and 2009 are as follows: Balance, beginning of year Equity-based compensation Expiration of convertible debentures equity component (note 5) Balance, end of year The components of contributed surplus are as follows: Expired convertible debentures equity component Equity-based compensation Balance, end of year (d) Equity-based compensation Year ended December 31, 2010 $ 7,275 7,508 2,971 17,754 $ December 31, 2010 $ 6,606 11,148 17,754 $ Year ended December 31, 2009 287 $ 3,640 3,348 7,275 $ December 31, 2009 $ 3,635 3,640 7,275 $ Advantage has a Restricted Share Performance Incentive Plan (“RSPIP” or the “Plan”) as approved by the shareholders on July 9, 2009, concurrent with the conversion to a corporation. The Plan authorizes the Board of Directors to grant restricted shares to service providers of the Corporation, including directors, officers, employees, and consultants. The number of restricted shares granted is based on the Corporation’s share price return for a twelve-month period and compared to the performance of a peer group approved by the Board of Directors. The share price return is calculated at the end of each and every quarter and is primarily based on the twelve-month change in the share price. If the share price return for a twelve-month period is positive, a restricted share grant will be calculated based on the return. If the share price return for a twelve-month period is negative, but the return is still within the top two-thirds of the approved peer group performance, the Board of Directors may grant a discretionary restricted share award. The restricted share grants generally vest one-third immediately on grant date, with the remaining two-thirds vesting evenly on the following two yearly anniversary dates. The holders of restricted shares may elect to receive cash upon vesting in lieu of the number of shares to be issued, subject to consent of the Corporation. However, it is the intent to settle unvested amounts with shares. The Plan replaced the previous Restricted Trust Unit (“RTU”) plan that was in place prior to the conversion to a corporation and outstanding grants under the RTU are now subject to the RSPIP. In conjunction with the corporate conversion, a transitional award of restricted shares to service providers was approved by shareholders valued at $5.80 per share or $8.4 million and to be issued in shares. The restricted shares were granted on September 2, 2009 with the first one-quarter of the grant vesting immediately and the remaining three-quarters of the grant that will vest over the subsequent three anniversary dates. Total equity-based compensation recorded in general and administrative expenses during the year ended December 31, 2010 was $16.1 million, including a non-cash amount of $13.4 million (December 31, 2009 - $8.1 million, including a non-cash amount of $6.4 million). During the year ended December 31, 2010, 1,346,481 shares were issued in satisfaction of grants vesting under the RSPIP. For the year ended December 31, 2009, 547,738 shares were issued subsequent to the corporate conversion in satisfaction of grants vesting under the RSPIP, and prior to the corporate conversion, 171,093 Trust Units were issued in satisfaction of grants vesting under the previous RTU plan. Advantage Oil & Gas Ltd. - 50 10. Shareholders’ Equity (continued) The details of restricted shares granted and outstanding at December 31, 2010 are as follows: Date Granted January 15, 2009 September 2, 2009 October 15, 2009 January 12, 2010 April 12, 2010 July 12, 2010 Total Restricted Shares Granted Restricted Shares Vested Restricted Shares Forfeited 691,178 1,453,609 1,153,314 779,013 979,915 788,092 5,845,121 487,427 741,842 775,367 269,544 332,973 262,689 2,869,842 22,268 9,172 6,299 4,623 5,975 1,074 49,411 Restricted Shares Outstanding 181,483 702,595 371,648 504,846 640,967 524,329 2,925,868 Weighted average fair value at grant date $5.49 $5.80 $7.51 $7.27 $6.97 $6.53 $6.59 In January 2011, an RSPIP grant was made to service providers valued at $6.95 per share or $0.5 million and is to be issued in shares. No compensation expense was included in general and administrative expense as this grant occurred after December 31, 2010. (e) Net loss per share The calculations of basic and diluted net loss per share are derived from both net loss and weighted average shares outstanding, calculated as follows: Net loss Basic and diluted Weighted average shares outstanding Basic and diluted Year ended December 31, 2010 Year ended December 31, 2009 $ (44,208) $ (86,426) 163,467,225 153,139,829 The calculation of diluted net loss per share excludes all series of convertible debentures for the years ended December 31, 2010 and 2009 as the impact would be anti-dilutive. Total weighted average shares issuable in exchange for the convertible debentures and excluded from the diluted net loss per share calculation for the year ended December 31, 2010 was 14,401,412 shares (December 31, 2009 – 8,165,575 shares). As at December 31, 2010, the total convertible debentures outstanding were immediately convertible to 13,019,819 shares (December 31, 2009 – 15,821,382 shares). Restricted shares granted have been excluded from the calculation of diluted net loss per share for the years ended December 31, 2010 and 2009, as the impact would have been anti-dilutive. Total weighted average shares issuable in exchange for the restricted shares and excluded from the diluted net loss per share calculation for the year ended December 31, 2010 was 1,094,135 (December 31, 2009 – 331,281). Management internalization escrowed Trust Units have been excluded from the calculations of diluted net loss per share for the year ended December 31, 2009 as the impact would be anti-dilutive. Total weighted average Trust Units issuable in exchange for the management internalization escrowed Trust Units and excluded from the diluted net loss per share calculation for the year ended December 31, 2009 was 207,018. Advantage Oil & Gas Ltd. - 51 11. Financial Instruments Financial instruments of the Corporation include accounts receivable, deposits, accounts payable and accrued liabilities, bank indebtedness, convertible debentures, other liabilities and derivative assets and liabilities. Accounts receivable and deposits are classified as loans and receivables and measured at amortized cost. Accounts payable and accrued liabilities, bank indebtedness and other liabilities are all classified as other liabilities and similarly measured at amortized cost. As at December 31, 2010, there were no significant differences between the carrying amounts reported on the balance sheet and the estimated fair values of these financial instruments due to the short terms to maturity and the floating interest rate on the bank indebtedness. The Corporation has convertible debenture obligations outstanding, of which the liability component has been classified as other liabilities and measured at amortized cost. The convertible debentures have different fixed terms and interest rates (note 5) resulting in fair values that will vary over time as market conditions change. As at December 31, 2010, the estimated fair value of the total outstanding convertible debenture obligation was $153.2 million (December 31, 2009 - $207.9 million). The fair value of the convertible debentures was determined by a Level 2 valuation model, based on discounted cash flows assuming no future conversions and continuation of current interest and principal payments as well as taking into consideration the current public trading activity of such debentures. The Corporation applied discount rates of between 5% and 7% considering current available market information, assumed credit adjustments, and various terms to maturity. Advantage has an established strategy to manage the risk associated with changes in commodity prices by entering into derivatives, which are recorded at fair value as derivative assets and liabilities with gains and losses recognized through earnings. As the fair value of the contracts varies with commodity prices, they give rise to financial assets and liabilities. The fair values of the derivatives are determined by a Level 2 valuation model, where pricing inputs other than quoted prices in an active market are used. These pricing inputs include quoted forward prices for commodities, foreign exchange rates, volatility and risk-free rate discounting, all of which can be observed or corroborated in the marketplace. The actual gains and losses realized on eventual cash settlement can vary materially due to subsequent fluctuations in commodity prices and foreign exchange rates as compared to the valuation assumptions. Credit Risk Accounts receivable, deposits, and derivative assets are subject to credit risk exposure and the total carrying value of $70.4 million (December 31, 2009 - $92.0 million) reflects Management’s assessment of the associated maximum exposure to such credit risk. Advantage mitigates such credit risk by closely monitoring significant counterparties and dealing with a broad selection of partners that diversify risk within the sector. The Corporation’s deposits are primarily due from the Alberta Provincial government and are viewed by Management as having minimal associated credit risk. To the extent that Advantage enters derivatives to manage commodity price risk, it may be subject to credit risk associated with counterparties with which it contracts. Credit risk is mitigated by entering into contracts with only stable, creditworthy parties and through frequent reviews of exposures to individual entities. In addition, the Corporation only enters into derivative contracts with major banks and international energy firms to further mitigate associated credit risk. Substantially all of the Corporation’s accounts receivable are due from customers and joint operation partners concentrated in the Canadian oil and gas industry. As such, accounts receivable have been subject to normal industry credit risks. As at December 31, 2010, $2.3 million or 5.4% of accounts receivable have been outstanding for 90 days or more (December 31, 2009 - $6.9 million or 12.6% of accounts receivable). The Corporation believes that the entire balance is collectible, and in some instances the Corporation has the ability to mitigate risk through withholding production or offsetting payables with the same parties. Management has provided for an allowance for doubtful accounts of $0.2 million at December 31, 2010 (December 31, 2009 – $0.5 million). Advantage Oil & Gas Ltd. - 52 11. Financial Instruments (continued) Liquidity Risk The Corporation is subject to liquidity risk attributed from accounts payable and accrued liabilities, bank indebtedness, convertible debentures, other liabilities, and derivative liabilities. Accounts payable and accrued liabilities, and derivative liabilities are primarily due within one year of the balance sheet date and Advantage does not anticipate any problems in satisfying the obligations from cash provided by operating activities and the existing credit facility. The Corporation’s bank indebtedness is subject to a $525 million credit facility agreement (note 6) and does not have specific maturity dates. Under the terms of the agreement, the facility is reviewed annually, with the next review scheduled in June 2011. The credit facility constitutes a revolving facility for a 364 day term which is extendible annually for a further 364 day revolving period at the option of the syndicate. If not extended, the revolving credit facility is converted to a one year term facility with the principal payable at the end of such one year term. Management fully expects that the facility will be extended at each annual review. Although the credit facility is a source of liquidity risk, the facility also mitigates liquidity risk by enabling Advantage to manage interim cash flow fluctuations. The terms of the credit facility are such that it provides Advantage adequate flexibility to evaluate and assess liquidity issues if and when they arise. Additionally, the Corporation regularly monitors liquidity related to obligations by evaluating forecasted cash flows, optimal debt levels, capital spending activity, working capital requirements, and other potential cash expenditures. This continual financial assessment process further enables the Corporation to mitigate liquidity risk. Advantage has several series of convertible debentures outstanding that mature in 2011 and 2015 (note 5). Interest payments are made semi-annually with excess cash provided by operating activities. As the debentures become due, the Corporation can satisfy the obligations in cash or issue shares at a price determined in the applicable debenture indentures. This settlement alternative allows the Corporation to adequately manage liquidity, plan available cash resources and implement an optimal capital structure. To the extent that Advantage enters derivatives to manage commodity price risk, it may be subject to liquidity risk as derivative liabilities become due. While the Corporation has elected not to follow hedge accounting, derivative instruments are not entered for speculative purposes and Management closely monitors existing commodity risk exposures. As such, liquidity risk is mitigated since any losses actually realized are subsidized by increased cash flows realized from the higher commodity price environment. The timing of cash outflows relating to financial liabilities as at December 31, 2010 are as follows: Accounts payable and accrued liabilities Capital lease obligations Derivative liabilities Bank indebtedness - principal - interest - principal - interest Convertible debentures Other liability $ Less than one year 112,457 779 2,367 - 13,717 62,294 9,179 - 200,793 $ One to three years $ - - 177 290,657 6,577 - 8,625 1,966 308,002 $ Four to five years $ - - - - - 86,250 6,469 - 92,719 $ Thereafter $ - - - - - - - - $ - $ Total 112,457 779 2,544 290,657 20,294 148,544 24,273 1,966 601,514 $ Interest on bank indebtedness was calculated assuming conversion of the revolving credit facility to a one-year term facility. Advantage Oil & Gas Ltd. - 53 11. Financial Instruments (continued) The timing of cash outflows relating to financial liabilities as at December 31, 2009 are as follows: Accounts payable and accrued liabilities Capital lease obligations Derivative liabilities Bank indebtedness - principal - interest - principal - interest Convertible debentures Other liability $ Less than one year 111,901 1,459 12,755 - 12,008 69,927 9,679 - 217,729 $ One to three years $ - 779 1,165 250,262 6,004 62,294 13,492 3,803 337,799 $ Four to five years - $ - - - - - 8,625 - 8,625 $ Thereafter - $ - - - - 86,250 2,156 - 88,406 $ $ Total 111,901 2,238 13,920 250,262 18,012 218,471 33,952 3,803 652,559 $ Interest on bank indebtedness was calculated assuming conversion of the revolving credit facility to a one-year term facility. Interest Rate Risk The Corporation is exposed to interest rate risk to the extent that bank indebtedness is at a floating rate of interest and the Corporation’s maximum exposure to interest rate risk is based on the effective interest rate and the current carrying value of the bank indebtedness. The Corporation monitors the interest rate markets to ensure that appropriate steps can be taken if interest rate volatility compromises the Corporation’s cash flows. A 1% increase in interest rates for the year ended December 31, 2010 could have increased net loss for the year by approximately $1.9 million (December 31, 2009 - $3.4 million). Price and Currency Risk Advantage’s derivative assets and liabilities are subject to both price and currency risks as their fair values are based on assumptions including forward commodity prices and foreign exchange rates. The Corporation enters derivative financial instruments to manage commodity price risk exposure relative to actual commodity production and does not utilize derivative instruments for speculative purposes. Changes in the price assumptions can have a significant effect on the fair value of the derivative assets and liabilities and thereby impact net loss. It is estimated that a 10% increase in the forward natural gas prices used to calculate the fair value of the natural gas derivatives at December 31, 2010 could increase net loss for the year ended December 31, 2010 by approximately $2.7 million (December 31, 2009 - $7.1 million). As well, an increase of 10% in the forward crude oil prices used to calculate the fair value of the crude oil derivatives at December 31, 2010 could increase net loss for the year ended December 31, 2010 by $4.0 million (December 31, 2009 - $4.7 million). A similar magnitude increase in the forward currency rate assumption underlying the derivatives fair value does not materially increase net loss. As at December 31, 2010 the Corporation had the following derivatives in place: Description of Derivative Term Volume Average Price Natural gas - AECO Fixed price Fixed price Fixed price Fixed price Crude oil – WTI Fixed price Fixed price April 2010 to January 2011 January 2011 to December 2011 January 2011 to December 2011 January 2011 to December 2011 18,956 mcf/d 9,478 mcf/d 9,478 mcf/d 9,478 mcf/d Cdn$7.25/mcf Cdn$6.24/mcf Cdn$6.24/mcf Cdn$6.26/mcf April 2010 to January 2011 January 2011 to December 2011 2,000 bbls/d 1,500 bbls/d Cdn$69.50/bbl Cdn $91.05/bbl As at December 31, 2010, the fair value of the derivatives outstanding resulted in an asset of approximately $25.2 million (December 31, 2009 – $31.1 million) and a liability of approximately $2.5 million (December 31, 2009 – $13.9 million). For the year ended December 31, 2010, $5.4 million was recognized in net loss as an unrealized derivative gain (December 31, 2009 - $23.7 million unrealized derivative loss) and $45.1 million was recognized in net loss as a realized derivative gain (December 31, 2009 – $86.5 million realized derivative gain). Advantage Oil & Gas Ltd. - 54 12. Capital Management The Corporation manages its capital with the following objectives: • To ensure sufficient financial flexibility to achieve the ongoing business objectives including replacement of production, funding of future growth opportunities, and pursuit of accretive acquisitions; and • To maximize shareholder return through enhancing the share value. Advantage monitors its capital structure and makes adjustments according to market conditions in an effort to meet its objectives given the current outlook of the business and industry in general. The capital structure of the Corporation is composed of working capital (excluding derivative assets and liabilities), bank indebtedness, convertible debentures, capital lease obligations and shareholders’ equity. Advantage may manage its capital structure by issuing new shares, repurchasing outstanding shares, obtaining additional financing either through bank indebtedness or convertible debenture issuances, refinancing current debt, issuing other financial or equity-based instruments, declaring a dividend, implementing a dividend reinvestment plan, adjusting capital spending, or disposing of assets. The capital structure is reviewed by Management and the Board of Directors on an ongoing basis. Advantage’s capital structure is as follows: December 31, 2010 December 31, 2009 Bank indebtedness (long-term) Working capital deficit (1) Net debt Shares outstanding, representing shareholders' equity Shares closing market price ($/share) Market capitalization (2) Convertible debentures maturity value (current and long-term) Capital lease obligations (long-term) Total capitalization $ $ 290,657 64,452 355,109 164,092,009 6.76 1,109,262 148,544 - 1,612,915 $ $ $ $ $ 250,262 48,809 299,071 162,745,528 6.90 1,122,944 218,471 759 1,641,245 $ $ $ (1) Working capital deficit includes accounts receivable, prepaid expenses and deposits, accounts payable and accrued liabilities, and the current portion of capital lease obligations. (2) Market capitalization is a non-GAAP measure The Corporation’s bank indebtedness is governed by a $525 million credit facility agreement (note 6) that contains standard commercial covenants for facilities of this nature. The only financial covenant is a requirement for Advantage to maintain a minimum cash flow to interest expense ratio of 3.5:1, determined on a rolling four quarter basis. This covenant was met at December 31, 2010 and 2009. As well, the borrowing base for the Corporation’s credit facilities is determined through utilizing Advantage’s regular reserve estimates. The banking syndicate thoroughly evaluates the reserve estimates based upon their own commodity price expectations to determine the amount of the borrowing base. Revision or changes in the reserve estimates and commodity prices can have either a positive or a negative impact on the borrowing base of the Corporation. Management of the Corporation’s capital structure is facilitated through its financial and operational forecasting processes. The forecast of the Corporation’s future cash flows is based on estimates of production, commodity prices, forecast capital and operating expenditures, and other investing and financing activities. The forecast is regularly updated based on new commodity prices and other changes, which the Corporation views as critical in the current environment. Selected forecast information is frequently provided to the Board of Directors. The Corporation’s capital management objectives, policies and processes have remained unchanged during the year ended December 31, 2010. Advantage Oil & Gas Ltd. - 55 13. Commitments Advantage has several lease commitments relating to office buildings and transportation. The estimated remaining annual minimum operating lease payments are as follows, of which $1.8 million is recognized in other liabilities: 2011 2012 2013 2014 2015 $ 11,756 11,791 10,576 8,723 2,108 44,954 $ 14. Subsequent Events On March 7, 2011, Advantage announced that Longview Oil Corp. (“Longview”), a wholly-owned subsidiary of the Corporation, filed a preliminary prospectus on March 4, 2011 for an initial public offering (the “Offering”), which is targeted to raise gross proceeds of $150 million prior to an over-allotment option. The closing of the Offering is expected to occur in April, 2011. Concurrent with closing of the Offering, Longview will purchase certain oil-weighted assets from Advantage (the “Transaction”), with consideration comprised of the net proceeds of the Offering, an equity ownership interest of approximately 68% (approximately 63% if the over-allotment option is exercised in full) of the common shares of Longview and proceeds of $100 million to be drawn from an independent Longview credit facility. Advantage plans to use the cash proceeds from the Transaction to reduce outstanding bank indebtedness. The Transaction is conditional upon customary industry conditions including the approval of the Board of Directors of Advantage. 15. Reconciliation of Financial Statements to United States Generally Accepted Accounting Principles The consolidated financial statements of Advantage have been prepared in accordance with accounting principles generally accepted in Canada. Canadian GAAP, in most respects, conforms to generally accepted accounting principles in the United States (“US GAAP”). Significant differences in accounting principles between Canadian GAAP and US GAAP, as they apply to Advantage, are as described below. (a) Equity-based compensation Advantage accounts for compensation expense based on the fair value of the equity awards on the grant date and the initial fair value is not subsequently remeasured. Prior to converting to a corporation, the Fund’s equity-based compensation consisted of a Restricted Trust Unit Plan and Trust Units held in escrow subject to service requirement provisions. Advantage’s current equity- based compensation consists of a Restricted Share Performance Incentive Plan. The initial fair value is expensed over the vesting period of the grants. Under US GAAP, the Corporation adopted ASC 718 “Stock compensation” on January 1, 2006 using the modified prospective approach and applies the fair value method of accounting for all equity-based compensation granted after January 1, 2006. Prior to converting to a corporation, a US GAAP difference existed as grants of Trust Unit compensation were considered liability awards for US GAAP and equity awards for Canadian GAAP. Under US GAAP, the fair value of a liability award is measured at the grant date and is subsequently remeasured at each reporting period. When the Trust Unit grants vested, the amount recorded as a liability was recognized as temporary equity. Upon conversion to a corporation, all equity-based compensation are now considered equity awards under both US and Canadian GAAP. Accordingly, there is no US GAAP difference with respect to equity-based compensation awards granted subsequent to conversion to a corporation. (b) Convertible debentures and issuance costs The Corporation applies CICA 3863 “Financial Instruments – Presentation” in accounting for convertible debentures which results in their classification as liabilities. The convertible debentures also have an embedded conversion feature which must be segregated between liabilities and equity, based on the residual value method, where the liability is first measured using a discount rate without the conversion feature and the remaining amount is allocated to equity. Therefore, the debenture liabilities are presented at less than their eventual maturity values. The liability and equity components are further reduced for issuance costs initially incurred. The discount of the liability component, net of issuance costs, as compared to maturity value is accreted by the effective interest method over the debenture term. As debentures are converted to shares, an appropriate portion of the liability and equity components are transferred to share capital. Interest and accretion expense on the convertible debentures are shown on the Consolidated Statements of Loss. Advantage Oil & Gas Ltd. - 56 Under US GAAP, convertible debentures issued after the corporate conversion are shown as a liability. The embedded conversion feature is not accounted for separately as a component of equity. Given that the convertible debentures are carried at maturity value, it is not necessary to accrete the balance over the term of the debentures which results in an expense reduction as compared to Canadian GAAP. For the year ended December 31, 2009, the Corporation implemented retrospectively changes prescribed by ASC 470 “Debt” which became effective for years beginning after December 15, 2008. As a result, for all convertible debentures that existed prior to the corporate conversion, the instruments were divided into a liability and an equity component, similar to Canadian GAAP treatment, and opening Shareholders’ Equity was increased $3.5 million. Additionally, under US GAAP, issuance costs related to liabilities are generally shown as a deferred charge rather than netted from the carrying value and are amortized to interest expense over the term of the liability. (c) Depletion and depreciation For Canadian GAAP, depletion of petroleum and natural gas properties and depreciation of lease and well equipment is provided on accumulated costs using the unit-of-production method based on estimated proved petroleum and natural gas reserves, before royalties, based on forecast prices and costs. US GAAP provides for a similar accounting methodology except that estimated proved petroleum and natural gas reserves are net of royalties and based on the first-day-of-month average prices for the prior twelve months (“constant prices”). Therefore, depletion and depreciation under US GAAP will be different since changes to royalty rates will impact both proved reserves and production and differences between constant prices as compared to forecast prices will impact proved reserve volumes. Additionally, differences in depletion and depreciation will result in divergence of net book value for Canadian GAAP and US GAAP from year-to-year and impact future depletion and depreciation expense as well as the net book value utilized for future impairment calculations. (d) Impairment of Petroleum and Natural Gas Properties Under Canadian GAAP, petroleum and natural gas properties are evaluated each reporting period to determine that the carrying amount is recoverable and does not exceed the fair value of the properties in the cost centre (the “ceiling test”). The carrying amounts are assessed to be recoverable when the sum of the undiscounted net cash flows expected from the production of proved reserves, the lower of cost and market of unproved properties and the cost of major development projects exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted net cash flows expected from the production of proved and probable reserves, the lower of cost and market of unproved properties and the cost of major development projects of the cost centre. The cash flows are estimated using expected future product prices and costs and are discounted using a risk-free interest rate. For Canadian GAAP purposes, Advantage has not recognized an impairment loss since inception. Under US GAAP, the carrying amounts of petroleum and natural gas properties, net of deferred income taxes, shall not exceed an amount equal to the sum of the present value of estimated net future after-tax cash flows of proved reserves at constant prices and costs computed using a discount factor of ten percent plus the lower of cost or estimated fair value of unproved properties. Any excess is charged to expense as an impairment loss through depletion, depreciation and accretion expense. Under US GAAP, Advantage recognized impairment losses of $49.5 million in 2001 ($28.3 million net of tax), $535.4 million in 2006 ($477.8 million net of tax), $1,047.5 million in 2008 ($770.8 million net of tax), and $303.9 million in 2009 ($227.4 million net of tax). Impairment losses decrease net book value of petroleum and natural gas properties which reduces depletion and depreciation expense subsequently recorded as well as future potential impairment calculations. (e) Income tax The future income tax accounting standard under Canadian GAAP is substantially similar to the deferred income tax approach as required by US GAAP. Pursuant to Canadian GAAP, substantively enacted tax rates are used to calculate future income tax, whereas US GAAP applies enacted tax rates. However, there were no tax rate differences for the years ended December 31, 2010 and 2009. The differences between Canadian GAAP and US GAAP relate to future income tax impacts on other GAAP differences. Under Canadian GAAP as at December 31, 2010, the Corporation’s carrying value of its net assets exceeded its tax bases and resulted in a future income tax liability. Adjustments under US GAAP result in a large future income tax recovery and a future income tax asset, as the impairment significantly lowered the Corporation’s fixed assets carrying value under US GAAP. Advantage Oil & Gas Ltd. - 57 (f) Goodwill Under Canadian and US GAAP, the Corporation is required to test the carrying amount of goodwill at each balance sheet reporting date and the methodologies are substantially the same. However, the carrying value of the reporting unit (the Corporation) under US GAAP is much lower due to the impairments to fixed assets required under US GAAP (note 15(d)). For the year ended December 31, 2008, goodwill was determined to be fully impaired, and was therefore written down to Nil under Canadian GAAP. However, under US GAAP, the fair value of the reporting unit (the Corporation) was in excess of its carrying values and no impairment of goodwill was recorded for the year ended December 31, 2008. For the years ended December 31, 2010 and 2009, the fair value of the reporting unit continued to be in excess of carrying values as determined under US GAAP and no impairment of goodwill was recorded. (g) Shareholders’ equity Since converting to a corporation on July 9, 2009, Shareholders’ Equity of Advantage consists primarily of shares. For both Canadian and US GAAP, the shares are considered permanent equity and presented as a component of Shareholders’ equity. Prior to conversion to a corporation, the Trust Units of the Fund were redeemable at any time on demand by the holders, which was required for the Fund to retain its Canadian mutual fund trust status. The holders were entitled to receive a price per Trust Unit equal to the lesser of: (i) 85% of the simple average of the closing market prices of the Trust Units, on the principal market on which the Trust Units were quoted for trading, during the 10 trading-day period commencing immediately after the date on which the Trust Units were surrendered for redemption; and (ii) the closing market price on the principal market on which the Trust Units were quoted for trading on the redemption date. For Canadian GAAP purposes, the Trust Units were considered permanent equity and were presented as a component of Unitholders’ equity. Under US GAAP, it is required that equity with a redemption feature be presented as temporary equity between the liability and equity sections of the balance sheet. Therefore, prior to the corporate conversion temporary equity was shown at an amount equal to the redemption value based on the terms of the Trust Units and all components of Unitholders’ equity related to Trust Units was eliminated. Changes in the redemption value from year-to-year was charged to deficit. For the year ended December 31, 2009, shareholders’ equity was increased by $130.8 million corresponding to changes in the Trust Units redemption value from January 1, 2009 to July 8, 2009. On July 9, 2009, the entire recorded value of temporary equity of $660.1 million was transferred to permanent equity concurrent with the corporate conversion. A continuity schedule of significant equity accounts for each reporting period is required disclosure under US GAAP. The following table is a continuity of shareholders’ equity, the Corporation’s only significant equity account: Shareholders' Equity (thousands of Canadian dollars) Year ended December 31, 2010 Year ended December 31, 2009 $ $ 115,469 - 115,469 65,050 - - - 9,082 7,508 197,109 $ $ (451,946) 3,494 (448,452) (216,595) (17,266) 130,751 660,145 3,607 3,279 115,469 $ $ Balance, beginning of year (previously reported) Effect on opening Shareholders' Equity of implementation of ASC 470 - note 15(b) Balance, beginning of year (restated) Net income (loss) and comprehensive income (loss) Distributions declared Change in redemption value of temporary equity Temporary equity transferred to share capital Shares issued pursuant to Restricted Share Performance Incentive Plan Equity-based compensation Balance, end of year Advantage Oil & Gas Ltd. - 58 (h) Balance Sheet Disclosure US GAAP requires disclosure of certain line items for balances that would be aggregated in the Canadian GAAP financials. The following are the additional line items to be disclosed for accounts receivable and accounts payable: (thousands of Canadian dollars) Accounts receivable Trade receivables Other receivables Total accounts receivable Accounts payable and accrued liabilities Accounts payable Accrued liabilities Other payables Total accounts payable and accrued liabilities December 31, 2010 December 31, 2009 42,276 - 42,276 $ $ $ 42,340 70,117 - 112,457 $ $ $ 54,531 - 54,531 17,202 94,699 - 111,901 $ $ (i) Statements of cash flow The differences between Canadian GAAP and US GAAP have not resulted in any significant variances concerning the statements of cash flows as reported. The application of US GAAP would have the following effect on net income (loss) as reported: Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) (thousands of Canadian dollars) Net loss - Canadian GAAP, as reported US GAAP Adjustments: General and administrative - note 15 (a) Management internalization - note 15 (a) Interest and accretion on convertible debentures - note 15 (b) Depletion, depreciation and accretion - notes 15 (c) and (d) Future income tax - note 15 (e) Net income (loss) and comprehensive income (loss) - US GAAP Year ended December 31, 2010 $ (44,208) Year ended December 31, 2009 $ (86,426) - - 2,191 143,043 (35,976) 65,050 $ 358 1,026 - (153,711) 22,158 (216,595) $ The application of US GAAP would have the following effect on the balance sheets as reported: Consolidated Balance Sheets (thousands of Canadian dollars) Assets Deferred charge - note 15 (b) Fixed assets, net - notes 15 (c) and (d) Future income taxes - note 15 (e) Goodwill - note 15 (f) Liabilities and Shareholders' Equity Current portion of convertible debentures - note 15 (b) Bank indebtedness - note 15 (b) Convertible debentures - note 15 (b) Future income taxes - note 15 (e) Shareholders' equity - note 15 (g) December 31, 2010 US GAAP Canadian GAAP December 31, 2009 US GAAP Canadian GAAP $ - 1,768,650 - - $ 3,851 270,727 347,642 120,271 $ - 1,831,622 - - $ 5,310 190,656 374,221 120,271 61,570 61,847 69,553 69,553 288,852 72,811 29,399 1,208,187 289,454 86,250 - 197,109 247,784 130,658 38,796 1,235,805 248,808 147,602 - 115,469 Advantage Oil & Gas Ltd. - 59 Corporate Information Directors Stephen E. Balog (1)(2) Kelly I. Drader Paul G. Haggis(1) John A. Howard (2)(3) Andy J. Mah Ronald A. McIntosh (1)(2) Sheila H. O’Brien (2)(3) Carol D. Pennycook (1)(3) Steven Sharpe (1) Member of Audit Committee (2) Member of Reserve Evaluation Committee (3) Member of Human Resources, Compensation & Corporate Governance Committee Officers Andy J. Mah, CEO Kelly I. Drader, President and CFO Patrick J. Cairns, Senior Vice President Craig Blackwood, Vice President, Finance Weldon M. Kary, Vice President, Geosciences and Land Neil Bokenfohr, Vice President, Exploitation Corporate Secretary Jay P. Reid, Partner Burnet, Duckworth and Palmer LLP Auditors PricewaterhouseCoopers LLP Bankers The Bank of Nova Scotia National Bank of Canada Bank of Montreal Royal Bank of Canada Canadian Imperial Bank of Commerce Union Bank, Canada Branch Alberta Treasury Branches HSBC Bank Canada BNP Paribas (Canada) Independent Reserve Evaluators Sproule Associates Limited Legal Counsel Burnet, Duckworth and Palmer LLP Transfer Agent Computershare Trust Company of Canada Abbreviations - barrels bbls - barrels per day bbls/d - barrels of oil equivalent (6 mcf = 1 bbl) boe - barrels of oil equivalent per day boe/d - thousand cubic feet mcf - thousand cubic feet per day mcf/d mmcf - million cubic feet mmcf/d - million cubic feet per day - billion cubic feet bcf - trillion cubic feet tcf - gigajoules gj - natural gas liquids NGLs - West Texas Intermediate WTI Corporate Office 700, 400 – 3 Avenue SW Calgary, Alberta T2P 4H2 (403) 718-8000 Contact Us Toll free: 1-866-393-0393 Email: ir@advantageog.com Visit our website at www.advantageog.com Toronto Stock Exchange Trading Symbols Shares: AAV 7.75% Convertible Debentures: AAV.DBD 8.00% Convertible Debentures: AAV.DBG 5.00% Convertible Debentures: AAV.DBH New York Stock Exchange Trading Symbol Shares: AAV Advantage Oil & Gas Ltd. - 60 

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