CVR Energy Annual Report 2010

Plain-text annual report

2 0 1 0 A N N U A L R E P O R T MOMENTUM AN INTERNATIONAL ENERGY PRODUCER ON THE RISE Calvalley Petroleum Inc. (“the Company”) has established a strong record of reserves growth from its initial Exploration and Production Project, at Block 9 in the Masila Basin of the Republic of Yemen. The Project is based on a Production Sharing Agreement (“PSA”) which was signed with the Government of Yemen. Since initiating commercial production in 2006, the Company has had consistently positive cash ﬂows without the requirement for any debt ﬁnancing which has provided a growth momentum that continues to carry Calvalley forward as a corporation. Calvalley’s ongoing Block 9 exploration success has led to the successive development of the Hiswah, Al Roidhat, Auqban and, most recently, Ras Nowmah Fields. During 2010, the Company completed appraisal activities at Ras Nowmah which led to the acquisition of 340 kilometers of 2D seismic data. Interpretation of that data has produced two additional prospects for the Company’s rich exploration asset inventory. The development of these ﬁelds has enabled the Company to continue investing in future growth activities. Since 2006, Calvalley has exported its production via truck transport through the Safer Petroleum export transit facility at Block 18, to the Red Sea port of Ras Isa. However, completion of the Company’s new Bock 51 Truck Ofﬂoading Facility (“TOF”) will allow Calvalley to access the higher value export market afforded by the Masila Export Pipeline System (“MEPS”) to the Arabian Gulf port of Ash Shihr at Mukalla, Yemen. The near-term commissioning of the TOF will further enable the Company to pursue mid and long-term growth and to enhance shareholder value. Yemen Ethiopia Chairman and Chief Executive Ofﬁcer’s Letter Selected Highlights 04 06 08 17 18 Management’s Discussion and Analysis Exploration and Operations Review Operations Statistical Review Independent Auditor’s Report 40 Management’s Report 41 42 45 IBC Corporate Information Consolidated Financial Statements Notes to the Consolidated Financial Statements Note: All currency references are in United States dollars unless otherwise indicated. During 2010, Calvalley successfully achieved a number of key accomplishments which are setting the stage for signiﬁcant growth potential: 1) Construction completion of the TOF at Block 51, which will be commissioned in the second quarter of 2011, will allow the Company to produce and sell a blend of all Block 9 crude oil production at the high value Masila Blend price. 2010 HAS BEEN A MILESTONE YEAR IN BUILDING A PLATFORM FOR GROWTH 2) The Ras Nowmah-2 appraisal well conﬁrmed the quality and highly productive nature of the ﬁeld by producing 30˚ API crude oil at a stabilized rate of 3,000 bbls/day with only a 9.5% pressure drawdown and no formation water present. 3) Due to both the discovery success at Ras Nowmah and to the successful implementation of the pressure maintenance program at the Hiswah Field, the Company’s reserves grew at impressive rates. Proved plus Probable (“2P”) reserves increased to 31.8 mmbbls at December 31, 2010 compared to 26.5 mmbbls at December 31, 2009 representing a 20% increase. 2010 Annual Report 1 CALVALLEY IS POSITIONED Since initiating commercial production in 2006, Calvalley has established a strong foundation for growth with effective long-range planning which prioritized exploration success, focused on signiﬁcant reserves additions and established key scalable infrastructure. This enabled the Company to maintain limited but stable production which has funded all capital activities without the need for debt ﬁnancing. CATALYSTS Exploration Success Key Infrastructure – Truck Ofﬂoading Facility Production Growth 2 Calvalley Petroleum Inc. FOR GROWTH As Calvalley begins operation of the TOF, it is initiating an active program of development and appraisal drilling that will unlock the full production and reserves potential of Block 9 in the Masila Basin. And, with the Company having established an improved export outlet via the Masila Export Pipeline System, the TOF will enable the Company to market its blend of crude oil production at an improved price, equivalent to the traditional 26˚ API Masila Blend. Combined with the recent exploration success at Ras Nowmah, the acquisition and analysis of 340 kilometers of 2D seismic data has yielded two additional exploration prospects for a total of six. Additionally, the 31.8 mmbbls of 2P reserves, as veriﬁed in Calvalley’s Reserves Report as at December 31, 2010, has conﬁrmed the Company’s position for continued production growth which will translate into increased shareholder value. 2010 Annual Report 3 SELECTED HIGHLIGHTS Years ended December 31, Sales revenues, net of royalties ($000s) Funds ﬂow from operations ($000s) Cash ﬂow from operating activities ($000s) Net income ($000s) Shares outstanding (millions) at December 31 Weighted average shares outstanding (millions) Per common share (basic) Funds ﬂow ($/share) Cash ﬂow ($/share) Net income ($/share) Production (bbls/share) Proved + probable reserves (bbls/share) Cash and GICs ($000s) Total assets at year-end ($000s) Long-term debt Oil production (bopd) Exploration and development spending ($000s) Year-end proved + probable reserves (mbbls) Reserve replacement ratio (proved + probable) Wells drilled (number) Realized oil price ($/bbl) Dated Brent oil price ($/bbl) 2010 $ 39,494 21,915 21,592 10,941 97.7 97.9 0.22 0.22 0.11 0.008 0.32 73,020 190,710 – 2,256 21,077 31,824 740% 7 85.44 86.48 2009 $ 31,354 13,600 13,971 2,951 98.2 98.9 0.14 0.14 0.03 0.008 0.27 70,426 172,991 – 2,160 11,803 26,540 343% 3 57.08 61.67 Note: All currency references are in United States dollars unless otherwise indicated. change % 26.0 61.1 54.5 370.8 (0.5) (1.0) 57.1 57.1 366.7 – 18.5 3.7 10.2 – 4.4 78.6 19.9 215.7 233.3 49.7 40.2 4 Calvalley Petroleum Inc. Reserves (mmboe) 2006 24.527 17.734 8.933 2007 23.385 16.468 8.065 2008 35.418 24.623 11.476 2009 39.499 26.54 11.907 2010 47.304 31.824 15.573 Proved Probable Possible Over the past ﬁve years, Calvalley has demonstrated a strong and consistent record of reserves growth. During 2010, the Company realized for year-over-year growth of 31% for proved reserves, 20% proved plus probable reserves, and 21% for proved plus probable plus possible reserves. Over the past ﬁve years, 1P reserves have increased by 174%, 2P reserves have increased by 179%, and 3P increased reserves have by 194%. Finding and Development Costs Three-year average ($/boe) 5.70 Proved 2.55 Proved plus Probable 2.16 Proved plus Probable plus Possible The Company has efﬁciently realized its strong reserves growth. Attractive and three-year development costs of $5.70/bbl for 1P reserves, $2.55/bbl for 2P reserves, and $2.16/bbl for 3P reserves. average ﬁnding Working Capital ($ mm) Reserves Replacement Ratio Three Year Average (%) 2006 72,352 2007 75,059 2008 75,775 2009 70,705 2010 69,683 The Company has consistently funded the majority of exploration and development activities through operating cash ﬂows. As a result, Calvalley has maintained strong working capital ranging between $69.7 million and $75.8 million over the past ﬁve years. 2008 408% 2009 730% 2010 1093% through While continuing to fund its capital the development program production and sale of crude oil from Block 9, the Company has maintained strong reserve three-year average replacement ratios of 408% for proved reserves, 730% for proved plus probable reserves, and 1,093% for proved plus probable plus possible reserves. $0 Debt Calvalley continues to execute its growth strategies while incurring no debt. 2010 Annual Report 5 CHAIRMAN AND CHIEF EXECUTIVE OFFICER’S LETTER I am pleased to report to you the Company’s ﬁnancial and operating results for the 2010 ﬁscal year. Our strong team of experienced personnel in both Yemen and in Calgary has contributed to continued efficient reserve growth along with the establishment of key infrastructure projects and ongoing enhancement of exploration potential. These important developments clear the way for signiﬁcant near-term production growth which will lead to enhanced shareholder value. The Company continued its strong record of consistent reserve growth during 2010. Proved plus probable reserves rose to 31.8 mmbbls at December 31, 2010, representing a 20% increase over the 26.5 mmbbls reported at December 31, 2009. An equally important component of our achievements in exploring for and successfully appraising and developing new discoveries is the efﬁciency with which we have realized success. Finding & Development to (“F&D”) costs $3.22/bbl for proved (“1P”) reserves, $0.64/bbl for proved plus probable (“2P”) reserves, and $0.80/bbl for proved plus probable and possible (“3P”) reserves. In addition to cost containment in the short-term, we have demonstrated industry-leading exploration cost efﬁciency over the longer term. On a three-year average basis, our F&D costs were $5.70/bbl for 1P reserves, $2.55/bbl for 2P reserves, and $2.16/bbl for 3P reserves. for 2010 amounted Our exploration success resulted in part from the successful appraisal well at Ras Nowmah-2 which ﬂowed at a stabilized rate of 3,000 bbls/day of 30˚ API crude oil with no formation water and with only a 9.5% pressure drawdown during production tests. We have also made signiﬁcant progress in implementing our pressure maintenance program at the Hiswah Field. 6 Calvalley Petroleum Inc. During the ﬁrst quarter of 2011, the Company also completed drilling of the Qarn Qaymah-3 (“QQ-3”) appraisal well which is currently undergoing a pressure build-up in preparation for full ﬁeld assessment. The Company has also focused signiﬁcant energy and resources to relieve transportation and marketing bottlenecks by constructing a new TOF at Block 51. As Calvalley nears completion of the TOF, the Company begins an active program of development and appraisal drilling that will unlock the full potentiality of Block 9 in the Masila Basin. And with the Company having established an improved export outlet, via the Masila Export Pipeline System, the TOF will enable the Company to market its blend of better than 26˚ API crude at a price equivalent the traditional Masila Blend. to in Ethiopia, With regard to Calvalley’s project the Metema and surface geological work at Gimbi Blocks was completed and fully evaluated. Based on the surface geological work, Calvalley undertook the acquisition of aeromagnetic survey data over a region covering an area of approximately 26,000 square kilometers. The Company is currently interpreting and mapping the coverage area based on the results of this aeromagnetic survey. Looking to the future, your management will continue to focus on its strategy of continued exploration success along with a marked increase in production from the Block 9 project in Yemen. I would like to thank the Calvalley team and the Board of Directors for their outstanding efforts and achievements during 2010 and their continuing efforts to maximize shareholder value. Sincerely, Edmund Shimoon Chairman and Chief Executive Ofﬁcer March 31, 2011 2010 Annual Report 7 EXPLORATION AND OPERATIONS REVIEW Yemen Strategies Execution and Outlook (cid:85)(cid:202) (cid:10)(cid:156)(cid:152)(cid:204)(cid:136)(cid:152)(cid:213)(cid:105)(cid:202)(cid:204)(cid:156)(cid:202)(cid:105)(cid:221)(cid:171)(cid:62)(cid:152)(cid:96)(cid:202)(cid:204)(cid:133)(cid:105)(cid:202)(cid:136)(cid:152)(cid:118)(cid:192)(cid:62)(cid:195)(cid:204)(cid:192)(cid:213)(cid:86)(cid:204)(cid:213)(cid:192)(cid:105)(cid:202) and production capacity to markedly increase production of all crude reserves on Block 9 (cid:85)(cid:202) (cid:44)(cid:105)(cid:62)(cid:143)(cid:136)(cid:226)(cid:105)(cid:202)(cid:171)(cid:192)(cid:156)(cid:96)(cid:213)(cid:86)(cid:204)(cid:136)(cid:156)(cid:152)(cid:202)(cid:125)(cid:192)(cid:156)(cid:220)(cid:204)(cid:133) (cid:85)(cid:202) (cid:42)(cid:213)(cid:192)(cid:195)(cid:213)(cid:105)(cid:202)(cid:105)(cid:221)(cid:171)(cid:143)(cid:156)(cid:192)(cid:62)(cid:204)(cid:136)(cid:156)(cid:152)(cid:202)(cid:62)(cid:86)(cid:204)(cid:136)(cid:219)(cid:136)(cid:204)(cid:136)(cid:105)(cid:195)(cid:202)(cid:156)(cid:152)(cid:202) Block 9 to increase the Company’s reserve base (cid:85)(cid:202) (cid:19)(cid:213)(cid:152)(cid:96)(cid:202)(cid:9)(cid:143)(cid:156)(cid:86)(cid:142)(cid:202)(cid:153)(cid:202)(cid:156)(cid:171)(cid:105)(cid:192)(cid:62)(cid:204)(cid:136)(cid:152)(cid:125)(cid:93)(cid:202)(cid:105)(cid:221)(cid:171)(cid:143)(cid:156)(cid:192)(cid:62)(cid:204)(cid:136)(cid:156)(cid:152)(cid:202) and development activities through internally-generated cash ﬂows (cid:85)(cid:202) (cid:10)(cid:156)(cid:147)(cid:147)(cid:136)(cid:195)(cid:195)(cid:136)(cid:156)(cid:152)(cid:202)(cid:204)(cid:133)(cid:105)(cid:202)(cid:47)(cid:192)(cid:213)(cid:86)(cid:142)(cid:202)(cid:34)(cid:118)(cid:121)(cid:156)(cid:62)(cid:96)(cid:136)(cid:152)(cid:125)(cid:202) Facility at Block 51 and expand production and deliveries of oil reserves from the Hiswah, Al-Roidhat, and Ras Nowmah Fields (cid:85)(cid:202) (cid:10)(cid:156)(cid:152)(cid:204)(cid:136)(cid:152)(cid:213)(cid:105)(cid:202)(cid:171)(cid:192)(cid:105)(cid:195)(cid:195)(cid:213)(cid:192)(cid:105)(cid:202)(cid:147)(cid:62)(cid:136)(cid:152)(cid:204)(cid:105)(cid:152)(cid:62)(cid:152)(cid:86)(cid:105)(cid:202) program at the Hiswah Field (cid:85)(cid:202) (cid:42)(cid:213)(cid:192)(cid:195)(cid:213)(cid:105)(cid:202)(cid:105)(cid:221)(cid:171)(cid:143)(cid:156)(cid:192)(cid:62)(cid:204)(cid:156)(cid:192)(cid:222)(cid:202)(cid:171)(cid:192)(cid:156)(cid:125)(cid:192)(cid:62)(cid:147)(cid:202)(cid:62)(cid:204)(cid:202) Block 9 Ethiopia Strategies (cid:85)(cid:202) (cid:22)(cid:152)(cid:204)(cid:105)(cid:192)(cid:171)(cid:192)(cid:105)(cid:204)(cid:202)(cid:62)(cid:152)(cid:96)(cid:202)(cid:147)(cid:62)(cid:171)(cid:202)(cid:204)(cid:133)(cid:105)(cid:202)(cid:86)(cid:156)(cid:219)(cid:105)(cid:192)(cid:62)(cid:125)(cid:105)(cid:202) area based on the results of the aeromagnetic survey completed during 2010 (cid:85)(cid:202) (cid:42)(cid:213)(cid:192)(cid:195)(cid:213)(cid:105)(cid:202)(cid:118)(cid:213)(cid:192)(cid:204)(cid:133)(cid:105)(cid:192)(cid:202)(cid:105)(cid:221)(cid:171)(cid:143)(cid:156)(cid:192)(cid:62)(cid:204)(cid:136)(cid:156)(cid:152)(cid:202)(cid:62)(cid:86)(cid:204)(cid:136)(cid:219)(cid:136)(cid:204)(cid:136)(cid:105)(cid:195)(cid:202) as warranted by the Company’s geological and geophysical team Execution and Outlook (cid:85)(cid:202) (cid:12)(cid:105)(cid:171)(cid:105)(cid:152)(cid:96)(cid:136)(cid:152)(cid:125)(cid:202)(cid:156)(cid:152)(cid:202)(cid:204)(cid:133)(cid:105)(cid:202)(cid:192)(cid:105)(cid:195)(cid:213)(cid:143)(cid:204)(cid:195)(cid:202)(cid:156)(cid:118)(cid:202)(cid:204)(cid:133)(cid:105)(cid:202) aeromagnetic survey, the Company may pursue additional acquisition of technical data with the objective of identifying leads and prospects 8 Calvalley Petroleum Inc. Turkey Azerbaijan Armenia Turkmenistan Syria Iraq Iran Jordan Kuwait Libya Egypt United Arab Emirates Saudi Arabia Oman Chad Sudan Red Sea YEMEN BLOCK 9 Sana’a Central African Republic METEMA GIMBI Adis Ababa ETHIOPIA Somalia Congo Uganda Kenya Indian Ocean Demographic Republic of Congo Ruanda Burundi United Republic of Tanzania Angola Zambia Zimbabwe Mozambique 2010 Annual Report 9 EXPLORATION AND OPERATIONS REVIEW Yemen Block 9 Stratigraphic Column for Block 9 SAYUN - MASILA BASIN E N E G O E L A P S U O E C A T E R C Umm Er Radhuma Fm Wadi ZONE OF INTEREST FIELD DISCOVERY Mukalla Fm HARSHIYAT SAND RAS NOOR 0m 500m 1,000m 1,500m Harshiyat Fm QISHN CLASTICS SAND AL ROIDHAT, HISWAH, RAS NOWMAH 2,000m Aptian Unconformity SAAR DOLOMITE AL HEDBA, RAS NOWMAH 2,500m Qishn Carbs Valanginian Unconformity SAAR/NAIFA LIMESTONE HISWAH C I S S A R U J 3,000m 3,500m Precambrian 4,000m Saar Fm Naifa Fm Madbi Fm Shuqra Fm Kohlan Fm Basement SHUQRA LIMESTONE AUQBAN GRANITE WASH/KOHLAN SAND QARN QAYMAH, AUQBAN FRACTURED BASEMENT QARN QAYMAH Block 9 occupies the western part of the Sayun-Masila Basin. The Sayun-Masila Basin is an important extensional basin initiated in the middle Jurassic. Prior to the rifting event, the Arabian craton was exposed and sandstones of the Kohlan Formation were deposited in a dominantly ﬂuvial environment. Subsidence in the early to middle Jurassic resulted in a regional marine transgression, during which time the Kohlan sandstones were re-worked and carbonate deposition of the Shuqra Formation was initiated. The basal Kohlan sandstones and overlying Shuqra carbonates both contain reservoir quality rock and are sealed by tight carbonates and shales. Both reservoirs are oil-charged at Auqban and the Kohlan is one of the primary reservoirs at Qarn Qaymah. Onset of rifting began in Oxfordian-Kimmeridgian time. The Jurassic rifting event was responsible for the creation of restricted marine embayments where the Madbi Formation source-rock shale was deposited. Continued extensional rift tectonics and basin subsidence resulted in the dramatic thickening of sediments within the rift basins. Both grabens and half-grabens are developed within the faults are often viewed as Sayun-Masila Basin. Basin-margin growth-faults and lap pre-existing basement horst blocks. the basinal sediments appear to on The rifting phase was followed in the Cretaceous by structural sagging. Development of the sag basin was the result of both continued subsidence and differential compaction. These processes resulted in the draping of sediments over pre-existing basement horst blocks. The structural draping results in positive structural closures that are the primary targets for oil exploration in Block 9. Composite Seismic Line 06CV-45 to CY9-91-W9 AUQBAN-2 AUQBAN-1 QUARN QAYMAH -1 QUARN QAYMAH -2 Qishn Saar Naifa Madbi Shuqra Basement M 0 0 5 2500 M 10 Calvalley Petroleum Inc. Block 9 Gas cap Oil pool The Sayun-Masila Basin has attractive source-reservoir-seal combinations. Oil that has been generated from the Madbi source rock is responsible for charging all reservoirs in Block 9. Oil migrating out of the source-rock basins can charge prospective reservoirs both laterally and vertically via faults. AUQBAN HISWAH QARN QAYMAH RAS NOWMAH AL ROIDHAT Concessions Saudi Arabia Yemen S2 2 57 9 71 53 32 51 10 2 OMV 9 CALVALLEY 10 TOTAL 32 DNO 51 CDN NEXEN 53 DOVE ENERGY 71 SINOPEC S2 OMV 2010 Annual Report 11 EXPLORATION AND OPERATIONS REVIEW Yemen Block 9 Al Roidhat Development of Al Roidhat continued during 2010. Calvalley worked over the four wells which had previously been completed and tested and three additional wells. Extended completed production to better tests were conducted understand the sustainable production capability of the wells and the ﬁeld. Currently six wells are fully equipped and ready to commence production as soon as the TOF is completed at Block 51. Production from these wells will be accumulated at the ﬁeld storage tanks from which oil will be transported by tanker truck to the CPF for blending with lighter oil produced by other ﬁelds. The wells are ready to produce. Yemen Block 9 Hiswah During 2010, Calvalley successfully completed the drilling of ﬁve horizontal producers at Hiswah. The ﬁrst three wells were placed on production at an initial ﬂow rate of approximately 250-400 bbls/day with no water. The remaining two wells are currently shut-in awaiting delivery of downhole pumps (ESPs). The wells produced at rates better than modelled production rates as a result of our improved reservoir modeling and completion techniques. The successful development of these wells resulted in an upward revision of recoverable reserves in both Proved and Proved plus Probable categories from the ﬁeld by the independent reserve engineers. The Company is also continuing its pressure maintenance and production optimization program for the Hiswah Field. The pressure maintenance program at Hiswah involves the reinjection of produced gas to reduce ﬂaring and increase oil recoveries. During 2010, Calvalley commenced Hiswah water injection at 6,500 bbls/day with a single horizontal well, H-26, which has been performing better than expected. The Company also commissioned a second water injector (H-25) which is also performing better than expected. The Company will continue to monitor long-term performance of water injection as a means of pressure maintenance to optimize the ongoing development of the ﬁeld and to extend the life of plateau production. Up to ﬁve more water injectors are included in the 2011 drilling program. The Company plans to drill two of these wells in the ﬁrst half of 2011. Management expects a total water injection volume greater than 25,000 bbls/day by the end of 2011. With the recent installation of gas compression facilities, the Company is currently injecting more than 2 mmcf/day of produced gas into the Hiswah Field. An additional injection well is currently being tied-in in an attempt to increase gas injection up to the compression facility’s capacity of approximately 5 mmcf/day. The pressure maintenance scheme is expected to reduce the natural ﬁeld production decline and to improve the recovery percentage. 12 Calvalley Petroleum Inc. EXPLORATION AND OPERATIONS REVIEW Yemen Block 9 Qarn Qaymah Drilling of the Qarn Qaymah-3 appraisal well was completed on March 8, 2011 to a total depth of 4,460 meters, including an openhole section of approximately 1,000 meters in the Fractured Granitic Basement (“FGB”). The wellbore image logs and electrical logs indicate that the openhole section encountered a number of fractured sections in the FGB. On March 9, 2011, Calvalley began testing of QQ-3. The well is currently undergoing pressure build up. Due to the complicated nature of the FGB reservoirs, the testing program is usually a lengthy process and is expected to be completed in the second quarter of 2011. Calvalley has retained the services of two reputable reservoir consulting ﬁrms in Calgary to analyze the wellbore image logs and electrical logs in order to better deﬁne and model the reservoir. Yemen Block 9 Ras Nowmah of 57 meters The Company successfully drilled the Ras Nowmah-2 appraisal well in record time with a total gross hydrocarbon column including 41 meters in the Qishn and 16 meters in the Saar Formations. The initial test results have signiﬁcant implications for the future exploration and development of Block 9. The ﬁrst implication is lighter oil – contrary to previous belief that Qishn structures in Block 9 contain only heavy oil, the Ras Nowmah discovery has proven that the Block 9 Qishn structures are similar to those in the Masila block. The success of Ras Nowmah has added a new and exciting exploration dimension to Calvalley’s already rich portfolio of prospect inventory. As a result, both of the near- term and long-term exploration programs are expected to expand signiﬁcantly. Ras Nowmah is situated along a prospective fairway where Calvalley has already identiﬁed several other Qishn structures based on new seismic interpretation. The success of Ras Nowmah-2 has reduced the geological risk of exploration drilling on these structures. Calvalley has recently commenced drilling of the Ras Nowmah East-1 (“RNE-1”) exploration well. The well is targeting both Qishn and Saar Formations similar to those of the Ras Nowmah wells. The well is expected to reach total depth by mid-April 2011, at which time the drilling rig will be mobilized to the Ras Nowmah Field to drill two successive development wells (RN-4 and RN-5). 2010 Annual Report 13 EXPLORATION AND OPERATIONS REVIEW Oil Transportation and Marketing A critical component of Calvalley’s future success is the ability to market different qualities of crude without delivery restrictions which limit production to reservoirs containing light, sweet crude. During 2010, Calvalley management focused on negotiating transportation agreements which would allow the Company to commence production from all existing and future discoveries on Block 9. Calvalley Block 9 Block 14 Block 18 Block 4 Gas pipeline Oil pipeline Calvalley key block These efforts were rewarded in February 2010 with the execution of agreements which will enable Calvalley to activate shut-in Al Roidhat wells and transport blended crude of 26˚ API or higher from Block 9 through the Masila System. Immediate production growth is expected to be realized upon completion of the TOF which is pictured above. 14 Calvalley Petroleum Inc. EXPLORATION AND OPERATIONS REVIEW Exploration Upside: Yemen Calvalley has successfully completed a 340 kilometer 2D seismic program over the Plateau area which covers the Ras Nowmah discovery and nearby structures such as Sueda, East Ras Nowmah, North Ras Nowmah, South Ras Nowmah, Al Hedba, Al Gadaﬁr and Malik. The ﬁnal processing of the 2D seismic indicates that good quality data have been than acquired. The ﬁnal expected prospectivity over the coverage area. To date, two additional prospects have been identiﬁed for a total of six in the Qishn Formation. interpretation suggests better Ethiopia: Exploration Ethiopia represents an opportunity for Calvalley to diversify its operations outside Yemen. Surface geological work at the Metema and Gimbi Blocks in Ethiopia has been completed and fully evaluated. Based on the surface geological work, Calvalley has completed the acquisition of aeromagnetic survey data over a region covering an area of approximately 26,000 square kilometers. The Company is currently interpreting and mapping the coverage area based on the results of this aeromagnetic survey. 2010 Annual Report 15 EXPLORATION AND OPERATIONS REVIEW Yemen – Pools, Prospects and Leads AL HORG Q, Sc AL AKABA Q, Sc MASVAN Q EL ALDWI Q. Sc, S/N K, B NORTH QARN QAYMAH RUBEYA NW WADI EL AFAR Q. Sc, S/N, K, B Sq, K, B QARN QAYMAH RUBEYA K,B K, B WADI EL BAN – EL GARB Q. Sc, S/N, K, B MAHBUD LM GOREID Sc, LM, K, B AUQBAN N. DAYSAH Q. Sc SOUTH QARN QAYMAH K, B N. HISWAH S/N HISWAH S/N MALIK PLATEAU Q. B MALIK EL GADAFIR Q. Sc SAGHIRA S/N TAHIA Q, Sc EL GADAFIR Q, Sc RAS NOWMAH NORTH Q, Sd SUEDA Q, Sd RAS NOWMAH RAS NOWMAH EAST Q, Sd RAS NOWMAH SOUTH Q, Sd AL ROIDHAT Q AL KHOWEIT Q. Sc, K, B DAHBIL Q, Sc, K, B AL HEDBA PLATEAU AL HEDBA SOLEYL Q. Sc, LM, K, B BAFARAG Q. Sd AL FURAG Q, Sd Gas pool Oil pool Sd Saar dolomite S/N Saar/Naifa carbonates Prospect/lead LM Lower Madbi build ups H Harshiyat and debris fan Q Qishn clastics GW Granite Wash Sc Saar clastics K B Kohlan Basement RASNAFOOD H, Q SHAMEH/SHARKIA/DARIN H, Q RAS NOOR 16 Calvalley Petroleum Inc. OPERATIONS STATISTICAL REVIEW Drilling Activity The Company drilled one exploration well, two appraisal wells and ﬁve development wells during 2010. As a result of the production testing activity at Ras Nowmah and ﬁeld optimization work at the Hiswah Field, the Company’s proved and probable reserves increased to 31.8 million bbls at December 31, 2010, representing a 20% increase (23% including reserves produced in 2010) over the 26.5 million bbls at December 31, 2009. Production Oil and NGL Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 2010 2010 2010 2010 2009 2009 2009 2009 (Block 9 gross boe/day) 4,334 4,512 4,606 4,597 4,404 4,184 4,164 4,532 Oil and NGL (Calvalley working interest boe/day) 2,167 2,256 2,303 2,299 2,202 2,092 2,082 2,266 Production rates during 2010 were generally stable. While four development wells were drilled at Hiswah, the production increase has been offset by the fact that as of year-end, twelve producing wells remained shut-in due to delays in delivery of production equipment. Reserves and NPV Proved Developed producing Developed non-producing Undeveloped Total Proved Probable Total Proved + Probable Possible Total Proved + Probable + Possible * Based on McDaniel forecast prices (Jan 2011 Forecast) Reserves NPV (10% After Tax) NPV (8% After Tax) Gross (WI) (MMbbls) Net (after royalty & tax) (MMbbls) ($ million) ($ million) 3.8 4.7 10.9 15.7 16.3 31.8 15.8 47.6 2.3 2.6 4.9 7.5 6.9 14.4 6.0 20.3 75.7 89.1 125.3 214.4 180.2 394.7 165.0 559.7 78.5 92.3 135.5 227.8 199.6 427.3 188.2 615.5 2010 Annual Report 17 ManageMent’s Discussion anD analysis References to “Calvalley” or the “Company” refer to Calvalley Petroleum Inc. and its share of consolidated subsidiaries and joint ventures unless the context indicates otherwise. All currency references are to United States dollars unless otherwise specifically indicated. References to “C$” are to Canadian dollars. The purpose of this Management’s Discussion and Analysis (MD&A) is to provide readers the ability to view Calvalley in much the same way as Company management. The following combination of historical and prospective information and financial and business analyses, together with the consolidated financial statements, are intended to impart useful knowledge to investors and other readers. This MD&A should be read in conjunction with the Company’s unaudited consolidated financial statements and related notes for the year ended December 31, 2010. Additional information relating to the Company, including the Company’s Annual Information Form, is available on SEDAR at www.sedar.com or on the Company’s website at www.calvalleypetroleum.com. References in text or tables throughout this document to “2010”, “2009”, and “2008” refer to the years ended December 31, 2010, 2009 and 2008, respectively. References in text or tables labelled “Q4”, “Q3”, “Q2” and “Q1” refer to the periods ended December 31, September 30, June 30 and March 31, respectively, of the year indicated. This MD&A contains information current to March 22, 2010. non-gaaP MeasuRes Funds Flow From operations Funds flow from operations is a measure not recognized under Canadian generally accepted accounting principles (GAAP) that represents funds generated from operating activities before changes in non-cash working capital. Funds flow from operations should not be considered an alternative to, or more meaningful than, cash flow from operating activities. Management believes that funds flow from operations is a useful supplemental measure to analyze the Company’s ability to generate cash flow to fund capital investment and working capital requirements. Funds flow from operations may not be comparable to similar measures used by other companies. eBitDa and operating income Earnings before interest, taxes, depreciation and amortization (EBITDA) and operating income are non-GAAP measures. The Company calculates EBITDA as revenue net of royalties, operating expenses, taxes, and general and administrative expenses. The Company calculates operating income by deducting depletion, depreciation and amortization expense from EBITDA. Management believes that EBITDA and operating income are useful supplemental measures to analyze operating performance and to provide an indication of the results generated by the Company’s principal business activities prior to the consideration of other income and expenses. EBITDA and operating income may not be comparable to similar measures used by other companies. netback Netback is a non-GAAP measure that represents oil and natural gas revenue net of royalties, operating expenses and current taxes. Management believes that netback is a useful supplemental measure to analyze operating performance and provides an indication of the results generated by the Company’s principal business activities prior to the consideration of other income and expenses. Netback may not be comparable to similar measures used by other companies. Finding and Development costs Finding and development costs refers to all current year capital expenditures excluding property acquisitions, property dispositions and corporate office expenditures and including changes in future development capital on a proved and proved plus probable basis (as applicable). “Finding and development costs per barrel of oil equivalent” (“F&D $/boe”) is calculated by dividing finding and development costs by the current year’s reserve extensions, discoveries and revisions on a proved or proved plus probable reserve basis (as applicable). 18 Calvalley Petroleum Inc. selecteD QuaRteRly inFoRMation 2010 ($000s unless otherwise noted) Full year Q4 Q3 Q2 Q1 Full Year Q4 2009 Q3 Q2 Q1 Avg. production volume – Calvalley share (bopd) Average sales volume (bopd) Average realized price ($/bbl) Oil sales Oil sales, net (1) Cash flow from operating activities Funds flow from operations (1) Funds flow from operations per share ($/share) (1) Basic and diluted Net income (loss) Net income (loss) per share ($/share) Basic and diluted Working Capital Total assets Long-term debt 2,256 2,186 80.03 2,167 2,804 85.44 63,867 22,042 39,494 13,681 21,592 11,863 21,915 7,976 2,256 2,839 76.10 19,877 12,328 1,150 6,744 2,303 973 84.70 7,499 4,564 3,457 1,926 2,299 2,115 75.91 2,160 2,440 57.08 2,202 2,081 73.83 2,092 2,020 67.74 14,449 50,839 14,136 12,591 8,921 5,122 5,269 31,354 13,971 13,600 8,742 9,271 4,652 7,766 3,587 4,453 2,082 3,695 51.30 17,252 10,686 3,325 4,644 2,266 1,967 38.75 6,860 4,160 (962) (149) 0.22 10,941 0.08 4,987 0.07 2,744 0.02 485 0.05 2,725 0.14 2,951 0.05 2,109 0.04 2,122 0.05 765 0.00 (2,045) 0.11 0.05 0.03 0.01 0.03 0.03 0.02 0.02 0.01 (0.02) 69,683 69,683 73,293 72,650 72,182 70,705 70,705 71,278 72,059 72,599 190,710 190,710 176,970 172,390 172,378 172,991 172,991 165,178 164,193 165,683 – – – – – – – – – – (1) Revenue net of royalties and government share of profit oil (2) See “Non-GAAP Measures”. See “Operating Activities” in “Consolidated Cash Flow” section for reconciliation between Funds flow from operations and Cash provided by (used in) operations. oVeRall PeRFoRMance Net income for the year ended December 31, 2010 was $10.9 million versus $3.0 million for 2009. Working capital at December 31, 2010 decreased to 69.7 million from $70.7 million at December 31, 2009. Funds flow from operations for the year ended December 31, 2010 improved to $21.9 million from $13.6 million for the year ended December 31, 2009. During the year ended December 31, 2010, the Company’s ability to generate positive funds flow from operations enabled it to finance its capital program and to buy back 718,662 shares at a cost of $2.2 million representing an average cost of C$3.13/share. The Company continues to generate cash flow from its operations at Block 9 in the Republic of Yemen. 2010 Annual Report 19 Business enViRonMent Calvalley produces high quality crude oil sold at world prices. As such, the Company’s financial results are significantly influenced by fluctuations in commodity prices. The following table shows selected market benchmark prices as well as the Company’s realized selling price of oil for the five most recent quarters: Dated Brent average oil price ($/bbl) Calvalley realized price ($/bbl) Premium/(discount) to Dated Brent 2010 Q4 2010 Q3 2010 Q2 2010 Q1 2009 Q4 86.48 85.44 76.86 76.10 (1.04) (0.76) 78.24 84.70 6.46 76.37 75.91 (0.45) 74.53 73.83 (0.70) The price of Dated Brent oil averaged $86.48/bbl in Q4 2010, an increase of 16% from the Q4 2009 price of $74.53/bbl. The price of Dated Brent oil reached a record high of $144.23/bbl. However, financial market instability and a worldwide recession resulted in a steep decline in the price of Dated Brent oil from August to December 2008. During 2009 and into 2010, the price of oil recovered some of this decline. The price of Dated Brent oil at December 31, 2010 was $92.55/bbl. outlooK As Calvalley nears completion of the Truck Offloading Facilities (“TOF”) at Block 51, the Company is entering an active phase of the development and appraisal drilling program to unlock the production and reserves potential of Block 9. As well, with the Company having established an improved export outlet, via the Masila Export Pipeline System (“MEPS”), the TOF will enable the Company to market its blend of better than 26˚ API crude at a price equivalent to the traditional Masila Blend. At the field level, Calvalley has positioned itself to gradually increase its production of blended crude to 10,000 bopd (5,000 bopd net). In that regard, the Company continues to add new development wells at its Hiswah and Ras Nowmah fields in preparation for the production increase. As well, the shut-in Al Roidhat wells are set to begin production which will be trucked for storage at the CPF until the TOF is commissioned. During Q4 2010, Calvalley successfully drilled a development well at the Al Roidhat field encountering 22 meters (72 feet) of net oil pay with average porosity of 23.5%. The well is now completed and is currently being production tested. Drilling of the Qarn Qaymah-3 (“QQ-3”) appraisal well was completed on March 8, 2011 to a total depth of 4,460 meters including an openhole section of approximately 1,000 meters in the Fractured Granitic Basement (“FGB”). The wellbore image logs and electrical logs indicate that the openhole section encountered a number of fractured sections in the FGB. On March 9, 2011, Calvalley began testing of QQ-3. The well is currently undergoing pressure build up. Calvalley has retained services of two reputable reservoir consulting firms in Calgary to analyze the well bore image logs and electrical logs in order to better define the reservoir. Calvalley has recently commenced drilling of the Ras Nowmah East-1 (“RNE-1”) exploration well. The well is targeting both Qishn and Saar Formation similar to those of the Ras Nowmah wells. The well is expected to reach total depth by mid-April 2011, at which time the drilling rig will be mobilized to the Ras Nowmah Field to drill two successive development wells (RN-4 and RN-5). 20 Calvalley Petroleum Inc. We have successfully completed a 2D seismic program of 340 km over the Plateau area which covers the Ras Nowmah discovery and nearby prospects such as Sueda, Ras Nowmah East, Al Hedba, Al Gadafir, and the Malik Plateau. The recent mapping and interpretation of the seismic program data indicates a better than expected prospectivity of the coverage area. Two new prospects over the Plateau have also been identified. With regard to Block 9 infrastructure developments, Calvalley has recently commenced technical work associated with an inter-field pipeline connecting the Al Roidhat and Ras Nowmah fields to the Hiswah CPF. During 2010, Calvalley commenced Hiswah water injection at 6,500 barrels a day with a single horizontal well, H-26, which has been performing better than expected. The Company also commissioned a second water injector (H-25) and is monitoring the well performance. Up to five more water injectors are included in the 2011 drilling program. Two of these wells will be drilled in the first half of 2011. We expect a total water injection volume greater than 25,000 bbl/d by the end of 2011. As well, with the recent installation of gas compression facilities, we are currently injecting more than 2 MMcf/d of produced gas into the Hiswah Field. An additional injection well is currently being tied-in in an attempt to increase gas injection up to the compression facility’s capacity of approximately 5MMcf/d. The pressure maintenance scheme is expected to reduce the natural field production decline and to improve the recovery percentage. Surface geological work at the Metema and Gimbi Blocks in Ethiopia has been completed and fully evaluated. Based on the surface geological work, Calvalley has completed the acquisition of aeromagnetic survey data over a region covering an area of approximately 26,000 square km. The company is currently interpreting and mapping the coverage area based on the results of this aeromagnetic survey. eXPloRation anD DeVeloPMent PRogRaM Block 9 – Republic of yemen Joint Operating Agreement (JOA) Substantially all of Calvalley’s operations and assets are related to its 50% working interest in the Block 9 Production Sharing Agreement (PSA) with the Government of Yemen. Calvalley is the operator of the Block 9 Joint Venture (JV) pursuant to the JOA among Calvalley, HoodOil Ltd. (“HoodOil”), Reliance Industries Limited (“Reliance”) and a subsidiary of the Yemen Oil and Gas General Corporation (“Yemen Co.”), an entity owned by the Government of Yemen. Yemen Co.’s interest under the JOA consists of a 15% overriding royalty on the JV’s allocation of profit oil under the PSA. Production Sharing Agreement Oil and natural gas production from Block 9 is allocated between the JV and agencies of the Government of Yemen pursuant to the terms of the PSA. The Government of Yemen receives a 10% royalty in kind from all Block 9 production, after which the remaining oil production is shared between the JV and the Government of Yemen. The JV is first allocated up to 45% of gross production to recover capital and operating costs incurred in order to operate Block 9. To the extent that recoverable costs exceed 45% of the 2010 Annual Report 21 fair value of gross production, any excess costs are carried forward for recovery against future production. After deducting cost oil, the remaining profit oil is allocated between the Government of Yemen and the JV as follows: • 39.23% of total profit oil to the JV (before deducting 35% income tax on JV’s share of profit oil and after deducting 15% override to Yemen Co.); and • 60.77% to the Government of Yemen (including Yemen Co.’s override and before including income tax on JV’s share of profit oil). Provided that total recoverable costs do not exceed 45% of gross production, the JV may recover operating costs during the year in which they are incurred and may deduct 50% of capital costs incurred during the year of expenditure and 50% during the following year. As at December 31, 2010, the Company’s share of capital costs to be carried forward for recovery against future production was approximately $51.4 million. Until these costs have been recovered, together with future operating and capital costs that become eligible for recovery during that time period, the Company’s net oil production will equal 31.33% of gross oil production (22.5% from cost oil and 8.83% from profit oil). Following full recovery of past operating costs, the Company’s net oil production will range between 17.65% and 31.33% of gross oil production, which will vary depending upon prevailing crude oil selling prices and the capital and operating costs incurred by the JV. The Company’s share of profit oil is subject to 35% income tax to the Government of Yemen which is paid by the Government of Yemen out of its share of profit oil. ethiopia Production Sharing Contract In 2008, Calvalley entered into its first Production Sharing Contract with the Ethiopian Government for the exploration, development and production of petroleum substances in the Gimbi and Metema blocks under a single contract covering a total area of over 46,470 km2 (11.5 million acres). Calvalley has a 100% operated working interest in both blocks for an exploration period of eight years, consisting of an initial period of four years followed by two subsequent option periods consisting of two years each. The option period will be activated at the discretion of Calvalley. Furthermore, subject to hydrocarbon discovery during the total eight year period, the PSC provides for an additional 25 year development period with a 10-year optional extension. The PSC gives Calvalley the rights to explore, develop, and produce hydrocarbons including oil, condensate, natural gas, and associated liquids. Total initial work obligations under the PSC, to be incurred during the initial 4-year exploration program amount to approximately $8.5 million and consist of the acquisition and processing of 400 km of 2D seismic and the drilling of one exploration well. As at December 31, 2010, the Company has incurred $1.2 million in exploration expenditures in fulfillment of these obligations. Key PeRFoRMance inDicatoRs Calvalley uses key financial indicators to help assess its business performance and manage its operations. These financial indicators measure business growth (revenue and capital expenditures), cash generation (EBITDA and funds flow from operations) and profitability (operating income and net income). These key financial indicators are discussed in more detail in the following sections. Production and sales information Block 9 oil production (bopd) Company working interest share (bopd) 22 Calvalley Petroleum Inc. Year Total 4,512 2,256 Q4 4,334 2,167 2010 Q3 4,512 2,256 Q2 4,606 2,303 Q1 4,597 2,299 2009 Year Total 4,320 2,160 Q4 4,404 2,202 Production Substantially all of Calvalley’s crude oil production in 2010 and 2009 came from the Hiswah oil field, which produces high-quality, lighter crude oil that is sold at prices comparable to the Dated Brent crude oil reference price. All of the Company’s crude oil production was trucked more than 250 kilometers to the Safer Exploration and Production Operations Co. processing facility on Block 18, where the crude oil was processed and shipped via pipeline to the Ras Isa marine terminal facility for export. During the year ended December 2010, the Company’s working interest oil production averaged 2,256 barrels of oil per day (bopd) (2009 – 2,160 bopd). Production rates during the year ended December 2010 improved in comparison to rates during the year ended December 2009. During the fourth quarter of 2010, the Company conducted a detailed review of its Hiswah field development plan and material requirements. Delays in receiving delivery of certain materials had resulted in the shutting in of 12 producing wells and 2 new development wells. As a result of the review, the Company has selected a new supplier with superior downhole production equipment that will result in long-term optimization of production rates. The Company ordered 23 electric submersible pumps, 4 of which have been delivered to Block 9. This will allow the Company to bring all shut-in wells into production in 2011. During 2010 the Company finalized transportation agreements which will provide for the Company’s use of export facilities at Block 51 and Block 14. Once shipments to Block 51 commence, the Company will begin production from the Al Roidhat and Ras Nowmah fields. Finding and Development costs (F&D costs) The following table summarizes finding and development costs for 2010, 2009, and 2008. Reserve Additions (000 boe) Proved Probable F&D Costs – Proved ($000) Change in future development costs Capital expenditures (1) Total F&D costs – proved F&D Costs – Proved Plus Probable ($000) Change in future development costs Capital expenditures (1) Total F&D costs – proved Finding and Development Costs Per Barrel ($/boe) Proved (F&D costs/reserve additions) Proved plus probable (F&D costs/reserve additions) Three Years 2010 2009 2008 9,947 17,795 4,492 6,111 1,219 2,704 4,236 8,980 (794) (3,963) 57,455 56,661 18,406 14,443 11,110 13,456 24,566 (7,941) 25,593 17,652 (12,148) (14,467) 25,850 (23,531) 57,455 45,307 18,406 3,939 13,456 39,306 25,593 2,062 5.70 2.55 3.22 0.64 20.15 14.53 4.17 0.23 (1) Capital expenditures exclude capitalized general and administrative expenditures (2010 – $2.0 million; 2009 – $1.2 million; 2008 – $2.4 million) as well as expenditures associated with the Company’s activities in Ethiopia (2010 – $0.6 million; 2009 – $0.3 million; 2008 – $0.3 million). (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. (3) BOEs may be misleading, particularly if used in isolation. A BOE conversion ratio of 6 Mcf: 1bbl is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency. Note however, that the Company reserves are comprised of in excess of 98% oil. 2010 Annual Report 23 selected operating information The following table sets forth key indicators for the periods indicated: 2010 2009 ($000) Oil sales Royalties (including government share of profit oil) Operating expenses Current taxes Netback (2) Management fees Facility usage fee (1) Taxes EBITDA (2) Depletion, depreciation and amortization Operating income (loss) (2) Net income (loss) Capital expenditures Funds flow from operations (2) Year Total Q4 Q3 Q2 Q1 63,867 22,042 19,877 7,499 14,449 Year Total (1) 50,839 (24,373) (10,157) (3,940) 25,397 466 – (8,361) (3,588) (1,362) 8,731 146 – (7,549) (3,487) (1,229) 7,612 125 – (2,935) (1,194) (463) 2,907 94 – 3,940 25,454 1,362 9,212 1,229 7,876 463 2,295 (5,528) (19,485) (1,888) (10,313) (886) (3,143) 6,147 17,898 101 – 886 389 (1,025) (4,413) 3,143 6,071 15,992 Q4 14,136 (5,394) (2,321) (880) 5,541 107 – (1,095) 880 5,433 (9,437) (2,690) (3,235) (1,178) (2,334) (9,850) (2,433) 16,017 10,941 21,077 21,915 6,522 4,987 10,302 7,976 4,641 2,744 4,734 6,744 1,150 1,117 485 2,842 1,926 3,457 3,737 2,725 3,199 5,269 5,122 6,142 2,951 11,803 13,600 13,971 3,000 2,109 4,813 4,652 9,271 General and administrative expenses (4,349) (1,027) (1,090) (1,169) (1,063) Cash flow (deficiency) from operating activities 21,592 11,863 (1) For the purpose of calculating netback, operating expenses for the year total of 2009 were adjusted to exclude the portion of the facility usage fee (FUF) which relates to deliveries of crude oil prior to January 1, 2009 in the amount of $1,025. See discussion on operating expenses for further details. (2) See “Non-GAAP Measures”. Netbacks are calculated on barrels sold as sales revenue less government royalties, taxes and operating expenses and are recognized when the underlying oil is sold. Government royalties and taxes taken in kind are attributed value at the price received by Calvalley for its production as follows: netbacks ($/bbl) Oil sales Royalties (including government share of profit oil) Operating expenses Current taxes Netback (2) 2010 2009 Year Total 80.03 (30.59) (12.73) (4.94) 31.77 Q4 Q3 Q2 Q1 85.44 76.10 84.70 75.91 (32.43) (13.91) (5.28) 33.82 (28.96) (13.35) (4.70) 29.09 (33.25) (13.49) (5.23) 32.73 (29.09) (9.92) (4.69) 32.21 Year Total (1) 57.08 (21.92) (11.58) (3.53) 20.05 Q4 73.83 (28.28) (12.12) (4.56) 28.87 (1) For the purpose of calculating netback, operating expenses for the first quarter and year total of 2009 were adjusted to exclude the portion of the FUF which relates to deliveries of crude oil prior to January 1, 2009 in the amount of $5.79/bbl. See “Operating Expenses”. (2) See “Non-GAAP Measures”. 24 Calvalley Petroleum Inc. Netbacks for the quarter ended December 2010 were $33.82/bbl compared to $28.87/bbl for the quarter ended December 2009. Netbacks for the year ended December 31, 2010 were $31.77/bbl in comparison to $20.05/bbl for the comparable period in 2009. Fluctuations in netbacks are primarily attributable to changes in the prevailing price of crude oil. Netbacks are also impacted by fluctuations in operating costs as discussed below. Revenue During the fourth quarter of 2010, Calvalley recorded oil revenue of $22.0 million as compared to $14.1 million for the three months ended December 31, 2009. The significant increase in revenue is attributable to a 34.8% increase in sales volume and a 15.7% increase in selling price. The Company recognized revenue on the sale of 258,004 barrels during the quarter ended December 31, 2010 compared with 191,456 barrels during the three-month period ended December 31, 2009. The average selling price realized during three months ended December 31, 2010 was $85.44/bbl in comparison to $73.83/bbl during the fourth quarter of 2009. The increase in sales volume is attributable to the timing of lifts and is not directly correlated with production, which was 398,717 bbls in 2010 versus 405,160 bbls in 2009. For the year ended December 31, 2010 oil revenues totalled $63.9 million compared to $50.8 million for the year ended December 31, 2009. The directional variance for the twelve-month period is attributable to the same factors as for the three-month period. The decrease in sales volume from 890,636 barrels during the year ended December 31, 2009 to 798,066 barrels during the year ended December 31, 2010 accounted for a 10.4% decline in revenue. The decrease was offset by a 40.2% increase in the average selling price which improved from $57.08/bbl in 2009 to $80.03/bbl in 2010. other Revenue Other revenue amounted to $0.3 million for the quarter ended December 31, 2010 (2009 – $0.2 million) and $0.9 million for the year ended December 31, 2010 (2009 – $1.2 million). Interest revenue resulted from maintaining significant cash reserves and guaranteed investment certificates (GICs) throughout the period. Interest income has declined from 2009 due to reduced interest rates throughout the year. Interest rates on interest-bearing deposits declined throughout 2008 and 2009, and have remained depressed during 2010 as central banks attempt to stimulate their economies by reducing borrowing rates. operating expenses Operating expenses during the fourth quarter of 2010 were $3.6 million ($13.91/bbl) as compared to $2.3 million (12.12/bbl) in the year ended December 31, 2009. Operating expenses for the year ended December 31, 2010 were $10.2 million ($12.73/bbl) compared to $11.3 million ($11.58/bbl) for the year ended December 31, 2009. Total operating expenses were higher in the quarter ended December 31, 2010 than during the comparable period during 2009 as a result a $0.3 million charge ($1.01/bbl) taken by the Company in respect of processing fees associated with the sulphur content of certain oil deliveries. Total operating expenses were higher for the year ended December 31, 2010 in comparison to the year ended December 31, 2009 as a result a $0.6 million charge ($0.75/bbl) taken by the Company in respect the processing fee issue noted above. In addition, the Company conducted certain non-recurring maintenance projects. During the first quarter of 2009, the Government of Yemen charged Calvalley $1.1 million for facilities usage. All producers of crude oil in Yemen are subject to the FUF. The charge was applied retroactively from the commencement of production at Block 9. The portion of the charge related to deliveries that occurred prior to January 1, 2009 amounted to $1.0 million and has been excluded from operating expenses for the purpose of this MD&A to maintain comparability of operating expenses. The balance of the charge in the amount of $81,000 ($0.40/bbl) related to oil that was delivered to the government facility during the first quarter of 2009. The FUF is recoverable from the Company’s share of cost oil in accordance with the terms of the PSA. Operating expenses include $5.47 (2009 – $5.06) per gross barrel for trucking costs, third-party processing costs, and tariffs for use of pipeline and marine terminal facilities. The increase in costs relates to the sulphur processing fees discussed above. 2010 Annual Report 25 general and administrative expenses (g&a) G&A, net of $0.7 million that was capitalized into resource development costs, totalled $1.0 million for the quarter ended December 31, 2010 as compared to $1.1 million for the quarter ended December 31, 2009. For the year ended December 31, 2010 G&A costs were $4.3 million compared to $4.4 million during the year ended December 31, 2009. G&A costs directly associated with Block 9 operations become recoverable costs and will be recovered from revenue associated with cost oil under the terms of the PSA. eBitDa During 2010, the Company generated EBITDA of $25.5 million compared with $16.0 million during 2009. For the fourth quarter EBITDA was $9.2 million compared to $5.4 million for the corresponding period in 2009. The fluctuation in EBITDA is primarily attributable to changes in the prevailing price of crude oil. The FUF referred to above in the discussion on operating expenses was a significant contributor to the decrease in EBITDA recognized for the twelve and three months ended December 31, 2009. EBITDA is also impacted by the timing of lifts by the purchaser of the Company’s crude oil. Depletion, Depreciation and amortization (DD&a) expenses DD&A ($000) DD&A ($/bbl) Year Total 9,437 11.82 Q4 2,690 10.43 2010 Q3 3,235 12.39 Q2 1,178 13.31 Q1 2,334 12.26 2009 Year Total 9,850 11.06 Q4 2,433 12.71 Calvalley recorded DD&A expenses of $2.7 million for the quarter ended December 31, 2010 as compared to $2.4 million for the fourth quarter of 2009. For the year ended December 31, 2010, DD&A expenses of $9.4 million were recorded in comparison to $9.9 million for the year ended December 31, 2009. The changes in the 2010 versus 2009 annual DD&A rates per barrel are primarily related to adjustments as reflected in the Company’s December 31, 2010 reserve report. The DD&A provision is also impacted by the build up of inventory at each period end. operating income During the fourth quarter of 2010, the Company generated operating income of $6.5 million compared with $3.0 million during the three months ended December 31, 2009. During the year ended December 31, 2010 the Company generated operating income of $16.0 million in comparison with $6.1 million for the corresponding period during 2009. Operating income was impacted by the same factors as those affecting netbacks and EBITDA. income taxes Current income tax expense amounted to $1.4 million (2009 – $0.9 million) for the fourth quarter of 2010 and 3.9 million (2009 – $3.1 million) for the year ended December 31, 2010. The charge represents income taxes incurred and paid under the laws of Yemen pursuant to the PSA. The income tax is calculated as 35% of the Company’s profit oil revenue in Yemen, and is paid by the Government of Yemen out of its share of profit oil. 26 Calvalley Petroleum Inc. consoliDateD casH FloW operating activities ($000) Funds flow from operations Change in non-cash working capital Year Total 21,915 (323) Q4 7,976 3,887 Cash provided by (used in) operations 21,592 11,863 2010 Q3 6,744 (5,594) 1,150 Q2 1,926 1,531 3,457 2009 Q1 Year Total 5,269 13,600 (147) 371 5,122 13,971 Q4 4,652 3,369 8,021 As at December 31, 2010, the Company held cash and cash equivalents of $19.5 million compared with $20.0 million at the end of 2009. Additionally, the Company held GICs with an initial term greater than 90 days in the amount of $53.4 million (December 31, 2009 – $50.4 million). The Company invests its cash reserves in GICs issued by an Alberta credit union in which deposits are guaranteed by the Province of Alberta. Funds flow from operations of $8.0 million during the fourth quarter of 2010 was sufficient to fund the majority of additions to property, plant and equipment in the amount of $10.3 million. During the fourth quarter of 2009, funds flow from operations of $4.7 million. Funds flow from operations was 21.9 million during the year ended December 31, 2010 compared to 13.6 million for the year ended December 31, 2009. investing activities ($000) Year Total Q4 Additions to property, plant and equipment (21,077) (10,302) 2010 Q3 (4,734) (2,538) Q2 Q1 2009 Year Total Q4 (2,842) (3,199) (11,803) (4,811) Change in non-cash working capital Net investment in GICs 3,843 (3,064) 6,731 (69) (281) 6,960 (168) 4,327 1,286 (8,509) (7,637) Cash provided by (used in) investing activities (20,298) (3,739) (2,945) (1,625) (11,989) (12,480) 5,608 (6,359) (5,562) During 2010, the Company made capital expenditures of $21.1 million compared with $11.8 million during 2009. The Company invested in the construction of additional facilities for water and gas injection, and the blending of crude oil. The Company also continues to invest resources to construct the truck offloading facility at Block 51 in anticipation of delivering oil to this location in accordance with the terms of the agreements described in detail in the Outlook section of this MD&A. Expenditures were incurred to prepare and complete the Al Roidhat wells for production, to drill development wells in the Hiswah area, and to drill exploration and appraisal wells in the Ras Nomah and Salmin areas. Finally, the Company conducted a seismic acquisition program during the fourth quarter of 2010. The Company’s funding of expenditures on behalf of its partners exceeded payments received from the Company’s partners in the amount of $1.7 million during 2010. Capital expenditures related to the shortfall amounted to $2.7 million. The Company also invested in GICs during the year ended December 31, 2010. Financing activities ($000) Issuance of common shares Common share repurchase Year Total 393 (2,189) (1,796) Q4 183 (720) (537) 2010 Q3 41 (626) (585) 2009 Q1 114 (843) (729) Year Total 776 (3,342) (2,566) Q4 19 (521) (502) Q2 55 – 55 2010 Annual Report 27 During 2010 the Company repurchased 718,662 Class A Common Voting Shares on the open market pursuant to its normal course issuer bids at a cost of $2.2 million representing an average cost of $3.04/share (C$3.13/share). Proceeds from the issuance of Class A Common Voting Shares during the year were related solely to the exercise of stock options and totalled $0.4 million. consoliDateD Financial Position Assets ($000) As at period-end Cash and cash equivalents GICs Accounts receivable Due from joint venture partners Oil inventory Prepaid expenses Property and equipment Total assets 2010 2009 Q4 19,573 53,447 4,611 Q3 11,937 53,279 3,910 10,825 12,052 120 371 1,804 608 Q2 14,316 57,606 33 5,825 2,947 549 Q1 12,437 58,892 3,007 6,607 428 201 Q4 20,043 50,383 2,821 9,112 225 341 Q3 17,997 44,024 2,707 12,143 266 373 101,763 190,710 93,380 91,114 90,806 90,066 87,668 176,970 172,390 172,378 172,991 165,178 As at December 31, 2010, the Company’s total assets were $190.8 million, an increase of $17.7 million from December 31, 2009. Cash and cash equivalents amounted to $19.6 million compared with $20.0 million at the beginning of the year. The decrease was offset by an increase of $3.1 million in GICs. Accounts receivable increased by $1.8 million to $4.6 million as at December 31, 2010. The amount due from JV partners increased from $9.1 million at the beginning of the year to $10.8 million as at December 31, 2010. Oil inventory decreased from $0.2 million at December 31, 2009 to $0.1 million at December 31, 2010. Oil inventory results from the timing of lifts and relates to oil production in storage at the end of a period, valued at the average cost of production. At December 31, 2010, the Company’s oil inventory net of royalties and taxes amounted to 2,562 bbls compared to 5,805 bbls at December 31, 2009. Property and equipment increased to $101.8 million as at December, 2010. The movement in property and equipment resulted from capital expenditures of $21.1 million, which was offset by DD&A expense of $9.4 million less $0.1 million in net adjustments to depletion related to oil in inventory. Liabilities and Shareholders’ Equity ($000) As at period-end Q4 Q3 Q2 Q1 Q4 Q3 Accounts payable and accrued liabilities 19,264 10,297 8,626 9,390 12,220 6,232 Share capital 116,140 116,079 116,227 116,143 116,387 116,622 2010 2009 Accounts payable and accrued liabilities increased to $19.3 million as at December 31, 2010, from $12.2 million as at December 31, 2009. The primary reason for this decrease is the increased capital spending related to heightened exploration and development activity during the last two months of 2010 and the timing of payments made to suppliers and contractors. Share capital decreased to $116.1 million as at December 31, 2010 from $116.4 million as at the end of 2009 as a result of the repurchase of common shares through the Company’s normal course issuer bids. The decrease was partially offset by the issuance of Class “A” Common Voting Shares from the exercise of stock options during the period. 28 Calvalley Petroleum Inc. liQuiDity anD caPital ResouRces Calvalley’s principal source of liquidity has been funds flow from operations. Calvalley manages its liquidity risk by regularly monitoring its cash flows from operating activities and holding adequate amounts of cash and cash equivalents. The Company does not invest its funds in speculative securities. The 2010 budget is expected to be funded from cash flow from operations and existing cash resources. Should the prevailing Dated Brent Crude price decline to lower than budgeted, Calvalley has sufficient flexibility in its capital budget to adjust capital expenditures to enable the capital program to be funded through internally generated cash flow. Fluctuations in commodity prices, product demand, foreign exchange rates and interest rates, as well as various other risks relating to factors beyond the control of Calvalley may impact capital resources. Calvalley has no outstanding bank debt or other interest-bearing indebtedness as at December 31, 2010. The Company has not arranged any undrawn operating lines of credit with any financial institution as the Company intends to fund its near-term capital expenditure programs from available cash on hand, funds flow from operations and, if required, from the issuance of additional share capital. As at December 31, 2010, the Company’s total assets were $190.7 million, an increase of $17.7 million from December 31, 2009. Cash and cash equivalents amounted to $19.6 million compared with $20.0 million at the beginning of the year. Cash equivalents are invested with high-quality financial institutions with terms to maturity of less than three months. Additionally, the Company held GICs with an initial term greater than 90 days. Total cash and cash equivalents plus GICs increased from $70.4 million at December 31, 2009 to $73.0 million at December 31, 2010. Interest rates on interest-bearing deposits have remained depressed over the past year as central banks attempt to stimulate their economies by reducing borrowing rates. Most of Calvalley’s funds are deposited at a credit union where deposits are guaranteed by the Government of Alberta. As at December 31, 2010 the Company’s working capital decreased to $69.7 million as compared to $70.7 million as at December 31, 2009. At December 31, 2010 the Company had Canadian tax pools of approximately $34.2 million, of which $16.8 million were non-capital losses, $7.1 million were Canadian resource tax pools, $10.3 million were undepreciated capital cost allowance and $Nil were deferred financing costs. No provision has been made to record these pools as an asset because the Company is not likely to take advantage of them due to the insignificance of its Canadian operations and assets. The Company has no long-term contractual obligations in Canada other than an operating lease for office space of approximately $0.2 million in each of 2011, 2012, and 2013. Its long-term commitments regarding its Yemen property include its 50% proportionate share of government allowances and bonuses payable under the terms of the PSA of $450,000 per year, plus its 50% proportionate share of certain other bonus payments of $2 million, $3 million and $4 million when and if sustainable production exceeds 25,000, 75,000 and 100,000 bopd day, respectively. During 2008, Calvalley entered into its first Production Sharing Contract (PSC) with the government of the Federal Democratic Republic of Ethiopia. Pursuant to the PSC, the Company has entered into certain commitments to spend approximately $8.5 million during the first four years of its work program. Calvalley had no off-balance-sheet arrangements as at December 31, 2010 or December 31, 2009. 2010 Annual Report 29 econoMic sensitiVities The following table shows the estimated after-tax effect that changes to crude oil prices, gross crude oil production, operating costs and interest rates would have had on Calvalley’s net income for the year ended December 31, 2010, had these changes occurred on January 1, 2010. These calculations are based on business conditions, production and sales volumes existing for the current period. The 1,000 bopd increase assumes the increase is to gross field production and Calvalley’s entitlement is calculated according to the provisions of the PSA and JOA. Average realized price Crude oil production Increase in operating expenses Interest rate Change (+) $10.00/bbl 1,000 bopd $1.00/bbl 1% Net Income Impact ($ millions) Net Income Impact ($ per basic share) 4.5 3.6 (0.8) 0.7 0.05 0.04 (0.01) 0.01 The impact of the above changes may be compounded or offset by changes to other business conditions. In addition, the table does not reflect any inter-relationships between the above factors. Changes in the foreign exchange rates have not been considered in this analysis as they do not have a significant impact on Calvalley’s operations. RelateD-PaRty tRansactions On June 10, 2009 the Company advanced $113,000 to a member of the Board of Directors. The advance was provided to provide funds for the exercise of options and was included in accounts receivable, was non-interest-bearing, repayable within 90 days, and secured by shares of the Company. The advance was repaid in full during August 2009. RisK FactoRs Calvalley is exposed to a number of risks inherent in exploring for, developing and producing oil and natural gas. This section describes the risks and other matters that would be most likely to influence an investor’s decision to purchase securities of Calvalley. Calvalley manages a number of risks in its business in order to achieve an acceptable level of risk without hindering the ability to maximize returns. Management has adopted procedures to identify and manage significant operational and financial risks. commodity Risk Calvalley’s principal business is the production and sale of crude oil. Revenues, earnings and cash flows from the sale of crude oil are sensitive to change in market prices, over which the Company has little or no control. The Company has the ability to address its price-related exposures through the limited use of options, future and forward contracts, but generally does not enter into such arrangements. currency Fluctuations Calvalley undertakes transactions in currencies other than the United States dollar. The Company’s primary foreign exchange risk is to changes in the value of the Canadian dollar relative to the United States dollar. Fluctuations in exchange rates between the United States dollar and other currencies will give rise to foreign currency exposure, either favourable or unfavourable, which may have material effects on the Company’s operations and financial condition. The Company has the ability to address its currency-related exposures through the use of foreign exchange contracts. It generally does not enter into such hedging arrangements but maintains a portion of its currency in Canadian dollars to meet its Canadian dollar requirements. 30 Calvalley Petroleum Inc. interest Rates The Company has no interest-bearing debt. The Company invests surplus cash balances in short-term investments with recognized Canadian financial institutions. Fluctuations in interest rates, either favourable or unfavourable, may have material effects on the Company’s interest income on short-term cash investments. credit Risk and concentration of sales Risk In January 2007, the Company entered into a long-term crude oil marketing agreement under which the Company sells all of its crude oil production to a single purchaser for a period of 18 months. The purchaser is a subsidiary of Reliance Industries Limited, India’s largest business enterprise, which is a party to the JOA for Yemen Block 9. The purchaser’s obligations under the crude oil marketing agreement are guaranteed by Reliance, which has been assigned credit ratings of Baa2 Stable Outlook by Moody’s and BBB Stable Outlook by S&P (above Sovereign Rating). The contract was formally extended in April 2009 and remains in effect. Credit risk also relates to the risk that joint venture partners may not fulfill their contractual obligations for financial contributions towards exploration, development, appraisal and production operations. During the initial agreement negotiations and ratification, these risks are considered and incorporated into the terms of the applicable contracts. Furthermore, cash calls can be made in advance of incurring costs to help ensure costs are recovered. However, it is possible that the interest of Calvalley and its JV partners are not aligned, resulting in project delays, additional costs or disagreements, which could adversely affect business results. insurable Risk Calvalley employs risk management practices to reduce and mitigate operational risks and other hazard risks and exposures, although it is impossible to completely protect its operations from all such risks. The Company places types and an amount of insurance that it considers consistent with industry practice to the extent coverage is available and cost effective. Such coverage includes third-party liability insurance and property and business interruption insurance. The Company may become liable for damages arising from unforeseen events which it cannot insure against or chooses to self-insure. Costs incurred to repair such uninsured damage or to pay associated liabilities may have a material effect on the financial condition of the Company. legal contingencies The Company has been named in a claim filed in the Commercial Court of Yemen by a Saudi Arabian company. The claimant alleges that, pursuant to an agency agreement entered into in 1996, it is entitled to a percentage of the net profit attributable to the Company. Over the past several years this issue has been before the Commercial Court of Yemen, the Yemeni Court of Appeal and the Supreme Court of Yemen on a number of procedural issues and has now been sent back to the Supreme Court of Yemen for reassessment. Interim judgments have been issued and both parties appealed an initial ruling which limited the plaintiff’s entitlement to an interest on the net profit from profit oil production prior to February, 2008. Calvalley has cross-appealed on a number of matters of substance and procedure. The Company’s legal advisors in Sana’a and Calgary are pursuing the appeal jointly. The outcome of the action in the Supreme Court of Yemen is undeterminable at this time and the Company is exploring both judicial, and extra judicial, resolution. No amounts have been accrued in the consolidated financial statements for the periods ended December 31, 2010 as the ultimate resolution is uncertain. The Company will record any amounts due, if any, once the outcome of the contingency is likely and reasonably estimated. Between 2004 and 2007, the Company billed its Block 9 joint venture partners (JV Partners) for fees in accordance with the terms of the PSA which governs the joint venture operating activities on Block 9. The JV Partners contend that certain of these fees are not billable under the terms of the Joint Operating Agreement (JOA) between the Company and the JV Partners. Pending resolution of this matter, the Company has not charged the JV Partners for the fees in question during 2008 and 2009. The 2010 Annual Report 31 Company and its JV Partners have now agreed to enter into a binding expert determination in London, England to interpret the terms of the JOA and to obtain a ruling on whether the fees in question are billable. While management is not able to determine the likelihood of a positive or negative outcome, the maximum liability to the Company related to fees charged from 2004 to 2007 is $1.0 million. Conversely, should the fees be deemed billable, the Company would recover fees which have not previously been recorded in the accounts in the amount of $926,997. In the normal course of operations, the Company may be subject to litigation and claims. In the opinion of management, other than as disclosed above, no such litigation or claim, individually or in aggregate, would result in a liability that would have a significant adverse effect on the financial position or results of operations of the Company. concentration of Producing assets Substantially all of Calvalley’s production is generated from highly productive individual wells in Yemen. The production and sale of crude oil in Yemen involves the use of central production facilities, oil pipelines, and export terminals, either operated by the Company or by third parties. As significant production is generated from each of these assets, any single event causing an interruption to any one of these operations could result in the loss of production and reserves as a result. exploration, Development and Production Risks Acquiring, developing and exploring for oil and natural gas involves many risks which include but are not limited to encountering unexpected formations or pressures, premature declines of reservoirs, blow-outs, well bore collapse, equipment failures and other accidents, craterings and sour gas releases, uncontrollable flows of oil, natural gas or well fluids, and environmental risks. In many oil and natural gas producing countries, oil and natural gas properties, together with related production and transportation infrastructure, can be situated in remote areas. In addition to the operational risks described above, oil and natural gas properties in some of these countries may be vulnerable to premeditated acts of violence which have the potential to cause significant damage to oil and natural gas operations and injury or death to personnel. The Company relies on the Government of Yemen’s support in providing appropriate security for crude oil operations in Block 9. Calvalley may not be fully insured against all of these risks. Losses resulting from the occurrence of these risks could have a material impact on the Company’s financial results. Reserve additions Calvalley’s future crude oil reserves and production, and therefore its operating cash flows and results of operations, are highly dependent upon the Company’s success in exploiting its current reserve base and acquiring or discovering additional reserves. Without reserve additions through exploration, development or acquisitions, the Company’s reserves and production will decline over time as reserves are produced. The business of exploring for, developing or acquiring reserves is capital-intensive. To the extent cash flows from operations are insufficient and external sources of capital become limited or unavailable, Calvalley’s ability to make the necessary capital investments to maintain and expand its oil production and reserves will be impaired. environment, Health, safety and Regulatory approvals Environmental, health and safety laws and regulations are continually evolving. Compliance with such laws and regulations can require significant expenditures which may materially affect the Company’s financial condition or results of operations. Expansion of existing operations and the development of new operating sites generally require approval of regulatory authorities. If such approvals are delayed or not achieved, the Company’s ability to meet project schedule or cost objectives or to operate at expanded or existing levels could be materially impacted. Workplace health and safety risks for workers arise from the inherent nature of the Company’s operations and the jurisdictions within which it operates. 32 Calvalley Petroleum Inc. Political Risks Beyond the risk inherent in the oil and gas industry, the Company is subject to additional risks resulting from the current unrest in the Middle East. These risks can involve matters arising out of the evolving laws and policies, the imposition of special taxes or similar charges, oil export or pipeline restrictions, foreign currency controls, the unenforceability of contractual rights, restrictions on the use of expatriates in the operations and other matters. There can be no assurance that agreements entered into with various parties are enforceable or binding in accordance with the Company’s understanding of their terms or that if breached, the Company would be able obtain favourable remedies. The Company bears the risk that political change could occur and that such change could have a further impact on the Company’s operations. competition There is strong competition relating to all aspects of the oil and natural gas industry. Calvalley actively competes for skilled industry personnel who are in high demand, particularly at its Canadian headquarters, with a substantial number of other oil and natural gas companies, many of which have significantly greater financial and other resources. changes in legislation There can be no assurance that laws and regulations relating to the oil and natural gas industry will not be changed in a manner which would adversely affect the operations of the Company. Under the PSA, the Company is not obligated to comply with regulatory changes that are inconsistent with the provisions of the PSA. Further, the PSA stipulates that the interests, rights and obligations of the Government of Yemen and the Company shall be solely governed by the provisions of the PSA unless altered or amended by mutual agreement. In particular, the PSA requires that the Government of Yemen pay profit taxes on the Company’s behalf, out of the Government of Yemen’s share of profit oil. MeasuReMent unceRtainty The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and revenue and expenses during the reporting period. Actual results, including petroleum and natural gas sales, royalties and operating expenses, can differ from these estimates. In particular, amounts recorded for depreciation and depletion and amounts used for ceiling test calculations are based on estimates of petroleum and natural gas reserves and future costs required to develop those reserves. The Company’s reserve estimates are evaluated annually by an independent engineering firm. By their nature, these estimates of reserves and the related future cash flows are subject to measurement uncertainty and the impact on the consolidated financial statements of future periods could be material. Computations of provisions and estimates for income taxes involve management making judgments with respect to interpretation of tax regulations and related legislation which is continually changing. In addition, there are tax matters that have not yet been confirmed by taxation authorities. While management believes the provision for income taxes is adequate, these amounts are subject to measurement uncertainty. Adjustments required, if any, to these provisions will be reflected in the period when it is determined that adjustments are warranted. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which were fully tradable with no vesting restrictions. This option valuation model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options and warrants have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the calculated fair value, such value is subject to measurement uncertainty. 2010 Annual Report 33 Amounts recorded as due from joint venture partners are based on the Company’s interpretation of underlying agreements and may be subject to joint approval. The Company has recorded balances due based on costs incurred and its interpretation of allowable expenditures. Any adjustments required as a result of joint venture audits are recorded in the period of settlement with joint venture partners. aDDitional inFoRMation As at December 31, 2010, the Company had 97,714,280 common shares outstanding. Additionally, there were 4,801,668 options outstanding which were issued pursuant to the Company’s stock option plan. As at March 22, 2011, the Company had 97,554,679 common shares outstanding. Additionally, there were 4,764,341 options outstanding which were issued pursuant to the Company’s stock option plan. DisclosuRe contRols anD PRoceDuRes Disclosure Controls and Procedures (“DC&P”) are designed to provide reasonable assurance that information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in applicable securities legislation, and include controls and procedures designed to ensure that information required to be disclosed is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. As at December 31, 2010, an evaluation of the design of the Company’s DC&P was carried out under the supervision of, and with the participation of management including its certifying officers. Based on that evaluation, the Company’s certifying officers concluded that the design of the Company’s DC&P was effective as at December 31, 2010 and would provide reasonable assurance that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities during the period in which the annual filings were prepared, and that information required to be disclosed by the Company would be recorded, processed, summarized and reported within the time periods specified under applicable securities legislation. inteRnal contRols oVeR Financial RePoRting Internal Controls over Financial Reporting (“ICFR”) are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with Canadian GAAP. ICFR can only provide reasonable assurance and may not prevent or detect misstatements. Projections of an evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate. As at December 31, 2010, an evaluation of the design of the Company’s ICFR was carried out under the supervision of, and with the participation of management including its certifying officers. Based on that evaluation, the Company’s certifying officers concluded that the design of the Company’s ICFR was effective as at December 31, 2010 and would provide reasonable assurance that material weaknesses in ICFR would be made known to them, and reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. 34 Calvalley Petroleum Inc. eFFect oF FutuRe cHanges in accounting Policies international Financial Reporting standards (iFRs) In February 2008, the CICA’s Accounting Standards Board confirmed that all Canadian publicly accountable enterprises will be required to adopt IFRS for interim and annual reporting purposes for fiscal years beginning on or after January 1, 2011. Calvalley is continually assessing the impact of the convergence of Canadian GAAP with IFRS on the Company’s results of operations, financial position and disclosures. Under the direction and oversight of the Board of Directors and Audit Committee, the Company has assembled a project team to manage the transition and to ensure successful implementation within the required timeframe. The Company recognizes that the changeover to IFRS has complex implications on a combination of accounting, financial reporting, and information technology and business systems. Consequently, senior management has engaged external consultants to conduct a business impact study, to assist in the development a project plan, and to provide assistance in considering various accounting policy decisions which will be required throughout the transition period. Company personnel involved with the transition project have also received appropriate training and education. The overall IFRS transition project consists of five phases: (i) Scope; (ii) Plan; (iii) Design and Build; (iv) Implement; (v) Review. The Scope phase, which consisted of identifying the significant differences between Canadian GAAP and IFRS, has been completed. The Company concluded that the following key issues will have the most significant impact on Calvalley’s results of operations, financial position and disclosures: IFRS 1 – First-time adoption of International Financial Reporting Standards; IFRS 6 – Exploration and Evaluation of Mineral Resources; International Accounting Standard (IAS) 16 – Property, Plant and Equipment; and IAS 36 – Impairment of Assets. The Company has also completed the Plan phase. During this phase, the Company gathered information and financial data to assess the potential impacts of the differences identified during the Scope phase. Management established the resources that are required to complete the transition to IFRS, assembled an IFRS transition project team, and established internal milestones and timelines. The Company is currently adhering to the timelines established in its transition project plan. The Company continues to progress through the Design and Build phase of the transition project. The IFRS project team’s development of recommendations for IFRS policy decisions is ongoing, based on appropriately documented consideration of the following factors: • Impact on financial and key performance indicators; • Impact on information technology and systems; • Impact on the internal control and disclosure control frameworks; • Transition and maintenance costs; • Impact on communications with key stakeholders; and • Other general business impacts. 2010 Annual Report 35 Accounting Policies The IFRS project team conducted a preliminary detailed analysis of all IFRSs identified during the Scope phase and has identified the impact of the available policy alternatives to the Company’s financial reports. A draft IFRS transition date consolidated balance sheet has been reviewed and approved by management and by the Audit Committee. Management has reviewed the available policy alternatives and has presented recommendations to the Audit Committee. IFRS 1 provides the framework for the first-time adoption of IFRS and specifies that, in general, an entity shall apply the principles under IFRS retrospectively. Adjustments that arise on retrospective conversion to IFRS from other GAAP are recognized directly in retained earnings. However, certain optional exemptions and mandatory exceptions to retrospective application are provided for under IFRS 1. Anticipated impacts to the Company of applying certain IFRS 1 exemptions and other relevant accounting differences between Canadian GAAP and IFRS on the consolidated financial statements of the Company are as follows: Financial Statement Item Implications of IFRS Expected Impact on Calvalley Property, plant and equipment (PP&E) The Company plans to use the IFRS 1 deemed cost exemption for the opening IFRS carrying value of oil and gas assets, and management has assessed that all oil and gas assets in Yemen and Canada are technically feasible and commercially viable as at January 1, 2010. As a result, exploration costs incurred in Ethiopia will be reclassified from PP&E to intangible E&E assets, and Yemen PP&E costs will be classified as D&P PP&E in the opening IFRS balance sheet. The Company conducted IAS 36 impairment tests on its PP&E as at January 1, 2010. None of the Company’s assets were found to be impaired at the date of transition. Going forward under IFRS, the one-step impairment test approach could trigger more frequent impairment losses, and the reversal of impairments could result in greater volatility in net income and carrying values of assets. The existing Canadian GAAP oil and gas full cost pool must be segregated into exploration and evaluation (E&E) assets and development and producing (D&P) PP&E. Per IFRS 6, assets are to be reclassified from E&E assets to D&P PP&E once technical feasibility and commercial viability have been achieved. Using the IFRS 1 deemed cost exemption the carrying value of the assets in the full cost pool under Canadian GAAP is deemed to be the opening carrying value under IFRS, subject to an impairment test. Canadian GAAP requires a two-step approach to impairment testing. Asset carrying values are first compared to undiscounted cash flows to determine whether impairment exists. If an impairment is indicated, the magnitude of the impairment is measured by comparing the carrying value to the fair value of discounted cash flows. IAS 36 uses a one-step approach for testing and measuring impairment. Asset carrying values are compared to the higher of fair value less costs to sell and value in use (which uses discounted future cash flows). IFRS also requires reversal of impairment losses when circumstances for previous impairment have changed, however Canadian GAAP prohibits reversal. 36 Calvalley Petroleum Inc. Financial Statement Item Implications of IFRS Expected Impact on Calvalley Contributed surplus – stock-based compensation Where the Company recorded stock-based compensation expense on a straight-line basis and forfeitures as they occurred under Canadian GAAP, IFRS 2 Share-based Payment requires expense recognition over the individual vesting periods of graded vesting awards and an estimation of forfeiture rates. Using the IFRS 1 share- based payment transactions exemption, IFRS 2 is retrospectively applied only to stock options issued after November 7, 2002, that had not vested as at January 1, 2010. Accumulated other comprehensive income – cumulative translation differences Applying the IFRS 1 cumulative translation differences exemption resets previously recognized translation differences relating to investments in foreign operations to zero. IAS 21 The Effects of Changes in Foreign Exchange Rates requires the Company to formally assess the functional currency of each entity in the consolidated group. Some variances in functional currency criteria exist between IFRS and Canadian GAAP. The Company plans to apply the IFRS 1 share-based payment transactions exemption. The opening IFRS balance sheet will reflect an increase to contributed surplus and a corresponding decrease to retained earnings for additional stock-based compensation expense. Going forward under IFRS, stock-based compensation expense will be concentrated in the earlier years of an issue of graded vesting options. The Company plans to elect the IFRS 1 cumulative translation differences exemption. Accumulated other comprehensive income as at January 1, 2010 will consequently be decreased with a corresponding increase to retained earnings. Consistent with its assessment under Canadian GAAP, the Company determined that the US dollar is the functional currency of each entity within the consolidated group. Accounting for the Company’s foreign currency transactions and balances under IFRS will remain consistent with Canadian GAAP. While management and the Audit Committee have made preliminary decisions and approvals regarding some of the Company’s IFRS accounting policies, the areas impacted by IFRS discussed above should not be regarded as a comprehensive list of changes that will result from the transition to IFRS. The Company’s selected IFRS policies have not been finalized and remain subject to review by the Company’s external auditors. As the Company proceeds with the Implementation and Review stages, management may find it necessary to refine its policy choices in order to accommodate developments to industry best practices and to provide more useful information in the financial statements. Further, the International Accounting Standards Board has ongoing projects that could affect IFRS prior to conversion in 2011 as well as the Company’s financial statements in future years. DC&P and ICFR Implementation of the necessary changes to entity level, information technology, financial reporting, disclosure, and business process controls will be executed as policy choices are finalized. Where significant changes are identified, these changes will be mapped and tested to ensure that no material deficiencies exist as a result of the Company’s conversion to IFRS. 2010 Annual Report 37 Business Activities In conjunction with policy development, the Company continues to assess whether the transition to IFRS will have an impact on business activities. Management does not anticipate that IFRS will significantly affect the Company’s contractual agreements, as the Company has no debt covenants, and the Yemen PSA and Ethiopian PSC stipulate particular accounting and reporting requirements. Management has not identified any instances where IFRS would have major implications on existing contractual arrangements or on other business activities. Information Technology and Data Systems In respect of information technology systems implications, management has communicated with software suppliers to confirm that systems in place are sufficient to enable the IFRS transition. Management is in the process of developing a strategy for implementing IFRS-compliant financial reporting processes during 2010 using the existing accounting software suite and financial reporting infrastructure. Plans are also under development in preparation for the Q1 2011 transition to IFRS, which will require the loading of IFRS financial information into the current accounting and reporting systems. noRMal couRse issueR BiDs On April 21, 2009, the Company made the necessary filings, and received the necessary approvals, to make a normal course issuer bid through the facilities of the Toronto Stock Exchange (TSX) commencing April 23, 2009 and ending April 22, 2010. A copy of the notice filed with the Toronto Stock Exchange can be obtained by any shareholder of the Company, without charge, by contacting the Company. A total of 4,948,029 Class A Common Shares (the “Common Shares”) were authorized to be acquired under the bid, representing 5% of the 98,960,580 Common Shares outstanding as of April 15, 2009. Calvalley was to acquire Common Shares under the bid at the market price at the time of purchase, and all Common Shares acquired were to be cancelled. Unless Calvalley utilized a Block Purchase Exemption as permitted by the TSX, purchases were subject to a daily purchase restriction equal to 25% of the average daily trading volume of the Common Shares over the preceding six calendar months, or a maximum of 28,824 Common Shares per trading day. In the opinion of Calvalley’s Board of Directors, Calvalley’s Common Shares were, from time to time, undervalued by the market, and the cost of acquiring the shares is an expense prudently incurred by Calvalley to increase shareholder value. A total of 1,657,688 shares were acquired under the bid at an average cost of C$1.93/share. On September 14, 2010, the Company made the necessary filings, and received the necessary approvals, to make a normal course issuer bid through the facilities of the Toronto Stock Exchange (TSX) commencing September 16, 2010 and ending September 15, 2011. A copy of the notice filed with the Toronto Stock Exchange can be obtained by any shareholder of the Company, without charge, by contacting the Company. A total of 7,841,792 Class A Common Shares (the “Common Shares”) were authorized to be acquired under the bid, representing 10% of the public float of Common Shares of the Company. Calvalley may acquire Common Shares under the bid at the market price at the time of purchase, and all Common Shares acquired are to be cancelled. Unless Calvalley utilizes a Block Purchase Exemption as permitted by the TSX, purchases are subject to a daily purchase restriction equal to 25% of the average daily trading volume of the Common Shares over the preceding six calendar months, or a maximum of 32,134 Common Shares per trading day. In the opinion of Calvalley’s Board of Directors, Calvalley’s Common Shares are, from time to time, undervalued by the market, and the cost of acquiring the shares is an expense prudently incurred by Calvalley to increase shareholder value. As of March 22, 2011, a total of 563,804 shares have been acquired under the bid at an average cost of C$4.17/share. 38 Calvalley Petroleum Inc. coMPaRaBility WitH PRioR PeRioDs Revenue may fluctuate from period to period due to the timing of shipments of oil from the Ras Isa Oil Terminal. Revenue is recognized only when oil is loaded onto a tanker. Oil in storage at period-end is recorded as inventory at the average cost of production and depletion and in situations where the take-or-pay provisions of the crude marketing agreement take effect, any receivable related to those provisions is recorded in the accounts as deferred revenue. At December 31, 2010, the Company had no take-or-pay revenue and oil inventory was $0.1 million. In April 2009, the Government of Yemen charged Calvalley $1.1 million for facilities usage. All producers of crude oil in Yemen are subject to the Facility Usage Fee (FUF). The charge was applied retroactively from the commencement of production at Block 9 and was accrued in the first quarter 2009 financial statements. The portion of the charge related to deliveries that occurred prior to January 1, 2009 amounted to $1.0 million. The balance of the charge in the amount of $81,000 ($0.40/bbl) related to oil that was delivered to the government facility during Q1 2009. The Company will continue to incur the $0.40/bbl FUF in future periods. The FUF is recoverable from the Company’s share of cost oil in accordance with the terms of the Production Sharing Agreement. FoRWaRD-looKing stateMents This MD&A contains certain forward-looking statements. Some of the statements contained herein including, without limitation, financial and business prospects and financial outlooks of the Company may be forward-looking statements which reflect management’s expectations regarding future plans and intentions, growth, results of operations, performance and business prospects and opportunities. Words such as “may”, “will”, “should”, “could”, “anticipate”, “believe”, “expect”, “intend”, “plan”, “potential”, “continue”, and similar expressions have been used to identify these forward-looking statements. These statements reflect management’s current beliefs and are based on information currently available to management. Forward-looking statements involve significant risk and uncertainties. A number of factors could cause actual results to differ materially from the results discussed in the forward-looking statements including, but not limited to, changes in general economic, political and market conditions and other risk factors. Although the forward-looking statements contained herein are based upon what management believes to be reasonable assumptions, management cannot assure that actual results will be consistent with these forward-looking statements. Investors should not place undue reliance on forward-looking statements. These forward-looking statements are made as of the date hereof. Forward-looking statements and other information contained herein concerning the oil and natural gas industry and Calvalley’s general expectations concerning this industry are based on estimates prepared by management using data from publicly available industry sources as well as from reserve reports, market research and industry analysis and on assumptions based on data and knowledge of this industry which Calvalley believes to be reasonable. However, this data is inherently imprecise, although generally indicative of relative market positions, market shares and performance characteristics. While Calvalley is not aware of any misstatements regarding any industry data presented herein, the industry involves risks and uncertainties and is subject to change based on various factors. See “Risk Factors.” Calvalley does not undertake any obligation to update publicly or revise any forward-looking statements contained in this or in any other document filed with Canadian securities regulatory authorities, whether as a result of new information, future events or otherwise, except as required by applicable securities laws. 2010 Annual Report 39 ManageMent’s RePoRt The consolidated financial statements of Calvalley Petroleum Inc. were prepared by management within acceptable limits of materiality and are in accordance with Canadian generally accepted accounting principles. Management is responsible for ensuring that the financial and operating information presented in the Company’s 2010 annual report is consistent with that shown in the consolidated financial statements. The consolidated financial statements have been prepared by management in accordance with the accounting principles as described in the notes to the consolidated financial statements. Timely release of financial information sometimes necessitates the use of estimates when transactions affecting the current accounting period cannot be finalized until future periods. When necessary, such estimates are based on informed judgments made by management. Management has designed and maintains an appropriate system of internal controls to provide reasonable assurance that all assets are safeguarded and financial records properly maintained to facilitate the preparation of consolidated financial statements for reporting purposes. Deloitte & Touche LLP, an independent firm of Chartered Accountants appointed by the shareholders, have conducted an examination of the corporate and accounting records in order to express their opinion on the consolidated financial statements. The Audit Committee, consisting of three independent directors, has met with representatives of Deloitte & Touche LLP and management in order to determine if management has fulfilled its responsibilities in the preparation of the consolidated financial statements. The Board of Directors has approved the consolidated financial statements. Edmund Shimoon Chairman and CEO March 22, 2011 Zacharie J. Magnan Acting Chief Financial Officer 40 Calvalley Petroleum Inc. inDePenDent auDitoR’s RePoRt to the shareholders of calvalley Petroleum inc.: We have audited the accompanying consolidated financial statements of Calvalley Petroleum Inc., which comprise the consolidated balance sheets as at December 31, 2010, and 2009, and the consolidated statements of operations and retained earnings and cash flows for the years then ended, and a summary of significant accounting policies and other explanatory information. 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. Those standards require that we comply with ethical requirements and plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence 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 entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting 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. opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Calvalley Petroleum Inc. as at December 31, 2010 and 2009, and its results from operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Calgary, Alberta March 22, 2011 Deloitte & Touche LLP Chartered Accountants 2010 Annual Report 41 2010 $ 19,573 53,447 4,611 120 10,825 371 88,947 101,763 190,710 19,264 19,264 116,140 8,462 3,963 42,881 171,446 190,710 2009 $ 20,043 50,383 2,821 225 9,112 341 82,925 90,066 172,991 12,220 12,220 116,387 7,146 3,963 33,275 160,771 172,991 consoliDateD Balance sHeets (Expressed in thousands of United States Dollars) As at December 31 ASSETS Current Cash and cash equivalents (note 4) Guaranteed investment certificates (note 5) Accounts receivable Oil inventory (note 6) Due from joint venture partners (note 7) Prepaid expenses Property, Plant and Equipment (note 8) LIABILITIES AND SHAREHOLDERS’ EQUITY Current Accounts payable and accrued liabilities Commitments (note 17) Contingencies (note 18) Shareholders’ Equity Share capital (note 9) Contributed surplus (note 10) Accumulated other comprehensive income (note 2) Retained earnings See accompanying notes On behalf of the Board: Edmund Shimoon Gary Robertson 42 Calvalley Petroleum Inc. consoliDateD stateMents oF oPeRations anD RetaineD eaRnings (Expressed in thousands of United States Dollars) For the years ended December 31 REVENUE Oil sales Royalties Management fees Interest and other EXPENSES Operating General and administrative, net of recoveries Stock-based compensation Depletion, depreciation and amortization Income Before Other Items Foreign exchange gain (loss) Income Before Income Tax Income tax (note 12) Net Income and Comprehensive Income Retained earnings, beginning of year Common share repurchases (note 9) Retained Earnings, End of Year Earnings Per Share (note 15) Basic Diluted See accompanying notes 2010 $ 63,867 (24,373) 39,494 466 400 40,360 10,157 4,349 1,530 9,437 25,473 14,887 (6) 14,881 3,940 10,941 33,275 (1,335) 42,881 $ 0.11 $ 0.11 2009 $ 50,839 (19,485) 31,354 389 798 32,541 11,338 4,413 928 9,850 26,529 6,012 82 6,094 3,143 2,951 30,480 (156) 33,275 $ 0.03 $ 0.03 2010 Annual Report 43 consoliDateD stateMents oF casH FloWs (Expressed in thousands of United States Dollars) For the years ended December 31 OPERATING ACTIVITIES Net income for the year Add (deduct) items not affecting cash: Stock-based compensation Depletion, depreciation and amortization Unrealized foreign exchange gain (loss) Change in non-cash working capital (note 13) INVESTING ACTIVITIES Additions to property, plant and equipment Investment in guaranteed investment certificates Redemption of guaranteed investment certificates Change in non-cash working capital (note 13) FINANCING ACTIVITIES Issuance of common shares (note 9) Common share repurchases (note 9) Foreign exchange gain on cash and cash equivalents held in foreign currencies Decrease in cash and cash equivalents Cash and cash equivalents, beginning of year (note 4) Cash and Cash Equivalents, End of Year See accompanying notes – non-cash transactions (note 7) 2010 $ 10,941 1,530 9,437 7 21,915 (323) 21,592 (21,077) (224,090) 221,026 3,843 (20,298) 393 (2,189) (1,796) 32 (470) 20,043 19,573 2009 $ 2,951 928 9,850 (129) 13,600 371 13,971 (11,803) (148,576) 140,939 6,960 (12,480) 776 (3,342) (2,566) 129 (946) 20,989 20,043 44 Calvalley Petroleum Inc. notes to tHe consoliDateD Financial stateMents (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 1. Description of Business Calvalley Petroleum Inc. (the “Company” or “Calvalley”) was incorporated on July 1, 1996 under the Canada Business Corporations Act and is engaged in the exploration, development and production of crude oil and natural gas. The Company’s activities are carried out in Yemen, Ethiopia, and Canada. 2. summary of significant accounting Policies These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (GAAP). In these consolidated financial statements, all dollar amounts are expressed in United States dollars, unless otherwise indicated. All references to US$ or $ are to United States dollars and references to C$ are to Canadian dollars. consolidation The consolidated financial statements include the financial statements of the Company and its wholly owned subsidiaries. Inter-company accounts and balances are eliminated on consolidation. accumulated other comprehensive income Effective December 31, 2005, management changed the reporting currency of the Company from Canadian dollars (C$) to United States dollars ($), as this currency is more appropriate for the Company’s investors and other users of the financial statements. The Company followed the recommendations of the Emerging Issues Committee (EIC) of the Canadian Institute of Chartered Accountants (CICA), set out in EIC-130, “Translation Method when the Reporting Currency Differs from the Measurement Currency or there is a Change in the Reporting Currency.” Financial statements for all periods were translated from Canadian dollars to US dollars using the current rate method. Using this method, all consolidated assets and liabilities were translated using the exchange rate at the balance sheet dates, while shareholders’ equity was translated using the historical rates of exchange in effect on the dates of the corresponding transactions. The consolidated statements of operations and deficit and consolidated statements of cash flows were translated using the prevailing average exchange rates for the periods. The resulting exchange difference due to this translation of $3,963 was included in shareholders’ equity as accumulated other comprehensive income. Joint interests Substantially all of the Company’s exploration and development activities are conducted jointly with other parties. These financial statements reflect only the Company’s proportionate interest in such activities. Foreign currency The activities of the Canadian parent have been translated into United States dollars using the temporal method. Under this method, monetary assets and liabilities are translated at exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are translated at rates in effect on the dates the assets were acquired or liabilities were incurred. Revenue and expenses are translated at the rates of exchange prevailing at the date of the transaction. Foreign exchange gains and losses are included in net income in the period in which they arise. Foreign-currency-denominated transactions are recorded at the rates of exchange prevailing at the date of the transaction. 2010 Annual Report 45 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 Measurement uncertainty The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and revenue and expenses during the reporting period. Actual results, including petroleum and natural gas sales, royalties and operating expenses, can differ from these estimates. In particular, amounts recorded for depreciation and depletion and amounts used for ceiling test calculations are based on estimates of petroleum and natural gas reserves and future costs required to develop those reserves. The Company’s reserve estimates are evaluated annually by an independent engineering firm. By their nature, these estimates of reserves and the related future cash flows are subject to measurement uncertainty and the impact on the consolidated financial statements of future periods could be material. Computations of provisions and estimates for income taxes involve management making judgments with respect to interpretation of tax regulations and related legislation which is continually changing. In addition, there are tax matters that have not yet been confirmed by taxation authorities. While management believes the provision for income taxes is adequate, these amounts are subject to measurement uncertainty. Adjustments required, if any, to these provisions will be reflected in the period when it is determined that adjustments are warranted. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which were fully tradable with no vesting restrictions. This option valuation model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options and warrants have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the calculated fair value, such value is subject to measurement uncertainty. Amounts recorded as due from joint venture partners are based on the Company’s interpretation of underlying agreements and may be subject to joint approval. The Company has recorded balances due from its joint venture partners based on costs incurred and its interpretation of allowable expenditures. Any adjustments required as a result of joint venture audits are recorded in the period of settlement with joint venture partners. Revenue Recognition Revenues associated with the sale of the Company’s crude oil are recognized when the title passes from the Company to its customer. Pursuant to the crude oil sales agreement, the Block 9 joint venture is entitled to invoice the buyer in any month that the crude oil available for sale but not purchased by the buyer exceeds 200,000 barrels (commonly referred to as a “take or pay” feature). The price used in such a take or pay invoice is the price that would apply had a crude oil transfer occurred in that particular month and is based on the average of the Dated Brent benchmark price for the applicable month. Due to the revenue recognition accounting policy stated above, take or pay invoice amounts are not recorded as sales revenue. Rather, such amounts are reported as deferred revenue in the current liabilities section of the balance sheet. These amounts are recognized as revenue in the period in which the underlying crude oil is sold. In Yemen, the government receives crude oil production as payment of the Company‘s profit taxes on the profit oil share of production. The Company recognizes this amount as revenue with a corresponding income tax expense when the oil is sold. Management fees are based on amounts expended and are recognized in the period when the underlying expenditure is incurred. cash and cash equivalents Cash and cash equivalents include short-term deposits with maturity terms of three months or less at the date of investment. 46 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 Financial instruments All financial instruments are initially recognized at fair value on the consolidated balance sheet. The Company has classified each financial instrument into one of the following categories: held-for-trading (assets and liabilities), loans and receivables, financial assets available-for-sale, financial assets held-to-maturity, and other financial liabilities. Subsequent measurement of financial instruments is based on their classification. Financial assets and liabilities held-for-trading are subsequently measured at fair value with changes in those fair values recognized in net earnings. Financial assets available-for-sale are subsequently measured at fair value with changes in fair value recognized in other comprehensive income, net of tax. Financial assets held-to-maturity, loans and receivables, and other financial liabilities are subsequently measured at amortized cost using the effective interest method. Cash and cash equivalents are classified as held-for-trading. Accounts receivable and amounts due from joint venture partners are classified as loans and receivables. Accounts payable and accrued liabilities are designated as other financial liabilities. The Company does not have any hedges or derivative instruments, including embedded derivatives. oil inventory Oil inventory represents the volume of crude oil in storage, which is valued at the aggregate of average production costs and depletion costs per barrel. Inventory is stated at the lower of cost and net realizable value. Property, Plant and equipment The Company follows the full cost method of accounting for oil and natural gas operations whereby all costs relating to the acquisition of, exploration for and development of petroleum and natural gas properties are capitalized in cost centres on a country-by-country basis. Such costs include lease acquisition costs, geological and geophysical expenditures, lease rentals, costs of drilling and equipping productive and non-productive wells and certain overhead expenditures related to exploration and development activities. Overhead expenditures relating to petroleum and natural gas cost centres in the pre-production stage of development are capitalized. Proceeds from the disposal of properties are applied as a reduction of the cost of the remaining assets except where such a disposal would alter the depletion and depreciation rate by more than 20 percent, in which case a gain or loss would be recognized. The Company tests the impairment of producing cost centres using undiscounted future net revenue from proved reserves at expected future product prices and production costs. Impairment is recognized when the carrying amount is greater than the undiscounted future net revenues, at which time assets are written down to the fair value of proved and probable reserves plus the cost of unproved properties, net of impairment allowances. Fair value is determined using expected future product prices and production costs, and amounts are discounted using an adjusted interest rate. The recoverability of new undeveloped cost centres is assessed annually based on results of geological and geophysical assessments, drilling activity and planned operations. Depletion and Depreciation Capitalized costs of properties, including a provision for future costs to develop proved reserves, are amortized through depletion and depreciation charges using the unit of production method based on estimated proved crude oil and natural gas reserves in that cost centre. For purposes of these calculations, production of crude oil, natural gas liquids, natural gas, and proved reserves before royalties is converted to a common unit of measure on the basis of each commodity’s approximate relative energy content. Costs of acquiring and evaluating unproved properties are excluded from costs subject to depletion until it is determined whether proved reserves are attributable to the properties or impairment occurs. 2010 Annual Report 47 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 Other capital assets are depreciated using the declining balance method based on the estimated service lives of the assets, which vary from three to five years. income taxes The Company follows the liability method of accounting for income taxes. Under this method, future tax liabilities and assets are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Future tax liabilities and assets are measured using enacted or substantively enacted tax rates. The effect on future tax liabilities and assets of a change in tax rates is recognized in income in the period that the change occurs. Future income tax assets are evaluated and if realization is not considered “more likely than not”, a valuation allowance is provided. The Company’s contractual arrangements in Yemen stipulate that income taxes are paid by the respective government out of its share of production sharing oil. Such amounts are included in income tax expense at the statutory rate in effect at the time of production. earnings Per share Basic earnings per share is calculated based on net earnings or loss for the year divided by the weighted average number of shares outstanding during the year. The Company follows the treasury stock method in calculating diluted earnings per share. Under this method, the diluted weighted average number of shares is calculated assuming the proceeds from the exercise of options and warrants are used to purchase common shares at the average market price for the year. stock-Based compensation The fair value of options and warrants granted is estimated at the date of the grant using the Black-Scholes valuation model. Stock-based compensation is recognized over the vesting period of the options granted. Stock-based compensation expense is recorded with a corresponding increase recorded to contributed surplus. Upon the exercise of the options and warrants, consideration paid by employees, consultants or directors together with the amount previously recognized in contributed surplus is recorded as an increase to share capital. The Company does not incorporate an estimated forfeiture rate for stock options that will not vest. Forfeitures are accounted for as they occur. 3. changes in accounting Policies new accounting standards International Financial Reporting Standards (IFRS) In February 2008, the Accounting Standards Board confirmed that all Canadian publicly accountable enterprises will be required to adopt IFRS for interim and annual reporting purposes for fiscal years beginning on or after January 1, 2011. Calvalley is currently assessing the impact of the convergence of Canadian GAAP with IFRS on the Company’s results of operations, financial position and disclosures. The significant impact to Calvalley’s results of operations, financial position and disclosures will be on property, plant and equipment, as it relates to the Company’s policy of full-cost accounting for its exploration assets and the continued ability to utilize this policy, how these assets are ultimately depreciated, and how impairment is ultimately determined and measured. Other areas of potential impact include stock-based compensation. 4. cash and cash equivalents Cash and cash equivalents at December 31, 2010 include various short-term deposits of $13,403 (December 31, 2009 – $16,664), bearing interest at 0.18% (December 31, 2009 – 0.20% to 0.28%) and maturing from January 20-23, 2011, and $6,170 (December 31, 2009 – $3,379) of cash. 48 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 5. guaranteed investment certificates Guaranteed investment certificates (GICs) with original maturities in excess of 90 days at December 31, 2010 are as follows: Maturity October 7, 2011 November 12, 2011 Face Value $ $ 47,692 5,656 Interest Rate 0.85% 0.60% The GICs are carried at cost plus interest, which approximates fair value and can be redeemed at any time without penalty. 6. oil inventory Inventory sold is expensed through production and depletion expenses in the period when it is sold. During 2010, $225 (2009 – $2,995) was expensed with respect to oil which was sold. 7. Due from Joint Venture Partners Amounts due from joint venture partners are comprised primarily of amounts due for operating costs and capital expenditures. The balances are due under normal trade terms. During 2010, there were no adjustments to the amounts due from joint venture partners. During 2009, the Company assumed and recorded as additions to property, plant and equipment certain costs previously billed to its joint venture partners in the amount of $3,221. 8. Property, Plant and equipment December 31, 2010 Yemen: Oil and natural gas properties Ethiopia: Oil and natural gas properties Canada: Oil and natural gas properties Other capital assets Accumulated Depletion and Depreciation Cost $ $ Net Book Value $ 146,358 45,984 100,374 1,206 – 1,206 129 335 464 90 191 281 39 144 183 148,028 46,265 101,763 2010 Annual Report 49 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 December 31, 2009 Yemen: Oil and natural gas properties Ethiopia: Oil and natural gas properties Canada: Oil and natural gas properties Other capital assets ceiling test Accumulated Depletion and Depreciation Cost Net Book Value 125,889 36,653 89,236 639 130 294 424 – 80 153 233 639 50 141 191 126,952 36,886 90,066 The Company performed a ceiling test as at December 31, 2010 to assess the recoverable value of its property, plant and equipment. The crude oil future prices are based on December 31, 2010 commodity prices forecast by independent reserve engineers adjusted for differentials specific to the Company’s reserves. The following table summarizes the benchmark prices used in the ceiling test calculation. Based on these assumptions, the value of future net revenues from the Company’s reserves exceeded the carrying value of property, plant and equipment at December 31, 2010. Year 2011 2012 2013 2014 2015 2016 Thereafter yemen Dated Brent Adjusted Crude Oil Price US$/bbl 85.00 87.20 89.50 92.30 95.20 98.30 2% The Company has a 50% working interest in the Malik Block 9 Joint Venture in Yemen. The Company’s right to produce crude oil under the Production Sharing Agreement (PSA) continues to 2025, with a provision for a five-year extension. The ownership of all assets, tangible and intangible, remains with the Yemen authority. During the year, the Company capitalized overhead costs relating to oil and natural gas exploration and development activities of $1,995 (2009 – $1,242). ethiopia During 2008, the Company signed a Production Sharing Contract (PSC) with the government of the Federal Democratic Republic of Ethiopia on the Metema and Gimbi Blocks covering a total area of 11.5 million acres. Costs incurred during 2010 and 2009 related to initial exploration efforts. Costs incurred during 2008 were related to the signing of the PSC. Properties in Ethiopia are unproved and the costs incurred of $1,206 (December 31, 2009 – $639) have been excluded from costs subject to depletion and depreciation. 50 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 9. sHaRe caPital (a.) common shares Authorized: Unlimited number of Class A Common Voting Shares. Issued: Year Ended December 31, 2010 Class A Common Voting Shares Shares outstanding, beginning of year Issued on the exercise of options (i) Contributed surplus reclassified on exercise of options (i) Repurchased and cancelled (ii) Balance, end of year Number Amount ($) 98,217,984 214,958 – (718,662) 97,714,280 116,387 393 214 (854) 116,140 (i) During 2010, the Company issued 214,958 Class A shares upon the exercise of options for proceeds of $393. An amount of $214 related to stock-based compensation expensed in prior periods was reclassified from contributed surplus to share capital in connection with options exercised. (ii) During 2010, the Company repurchased 718,662 of its common shares pursuant to its Normal Course Issuer Bid at a cost of $2,189. The cost to repurchase common shares at prices in excess of their average book value has been charged to retained earnings. Year ended December 31, 2009 Class A Common Voting Shares Shares outstanding, beginning of year Issued on the exercise of options (i) Contributed surplus reclassified on exercise of options (i) Repurchased and cancelled (ii) Balance, end of year Number Amount ($) 100,265,602 563,300 – (2,610,918) 98,217,984 118,243 776 452 (3,084) 116,387 (i) The Company issued 563,300 Class A Common Voting Shares upon the exercise of options for proceeds of $776. An amount of $452 related to stock-based compensation expensed in prior years was reclassified from contributed surplus to share capital in connection with options exercised in 2009. (ii) The Company repurchased 2,610,918 of its common shares pursuant to its Normal Course Issuer Bid at a cost of $3,342. The cost to repurchase common shares at prices in excess of their average book value has been charged to retained earnings and contributed surplus. The cost to repurchase shares at prices below their average book value has been credited to contributed surplus. 2010 Annual Report 51 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 (b.) stock options The Company’s restated stock option plan, as approved effective May 11, 2010, provides for the issue of stock options to directors, officers, employees and consultants. Vesting terms are determined by the Board of Directors as they are granted and currently include periods ranging from immediately to evenly over three or five years. The options’ maximum term is five years (10 years for options granted prior to October 1, 2001). At December 31, 2010 a total of 9,771,428 (December 31, 2009 – 9,821,798) shares were reserved for issue under this plan. Options which are forfeited are available for reissue. The following is a continuity of stock options outstanding: Price C$ Opening balance Granted Forfeited/expired Exercised Ending balance Year ended December 31, 2010 Year ended December 31, 2009 Options (000s) Weighted Average Exercise Price C$ 4,095 1,310 (388) (215) 4,802 3.53 3.57 3.67 1.77 3.60 Options (000s) 4,358 945 (645) (563) 4,095 Weighted Average Exercise Price C$ 3.66 1.76 3.52 1.58 3.53 Stock options outstanding at December 31, 2010 were as follows: Number of Options (000s) Granted Exercisable Weighted average Exercise price – C$ 680 50 75 160 1,420 357 570 200 1,290 4,802 680 50 75 160 1,246 235 290 67 300 3,103 4.13 0.90 6.86 7.61 4.32 1.61 1.65 2.22 3.57 Year of expiry 2011 2011 2011 2012 2013 2013 2014 2014 2015 During 2010, stock-based compensation costs of $1,530 (2009 – $928) were expensed and credited to contributed surplus. The fair value of the options granted during 2010 was C$2,745 (2009 – C$910) or C$2.10 per option (2009 – C$0.96 per option) using the Black-Scholes option pricing model with the following assumptions: Risk-free interest rate Expected hold period to exercise Volatility in the price of the Company’s shares Dividend yield 2010 2009 2.29 to 2.59% 1.6 to 2.5% 5 years 66 to 67% Nil 5 years 70 – 71% Nil 52 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 10. contributed surplus Year ended December 31 Opening balance Stock-based compensation Stock-based compensation associated with exercised options Shares repurchased and cancelled Closing balance 11. capital Disclosure The Company defines and computes its capital employed as follows: December 31 Shareholders’ equity Long-term debt Cash and cash equivalents GICs Total capital 2010 $ 7,146 1,530 (214) – 8,462 2010 $ 171,446 – (19,573) (53,447) 98,426 2009 $ 6,772 928 (452) (102) 7,146 2009 $ 160,771 – (20,043) (50,383) 90,345 The Company’s objectives in managing capital are to safeguard the Company’s ability to continue as a going concern, so that it can continue to provide returns for shareholders and benefits for other stakeholders. The Company sets the amount of capital in proportion to risk. The Company manages the capital structure and makes adjustments to it in the light of changes in economic conditions and the risk characteristics of the underlying assets. In order to maintain or adjust the capital structure, the Company may adjust the amount of dividends paid to shareholders, return capital to shareholders, issue or repurchase shares, incur debt or sell assets to reduce debt. The Company currently has no requirement for debt financing and has not required debt financing over the last two completed fiscal years. The objectives and strategy for utilizing capital are monitored to provide the appropriate capital structure for the risk profile of corporate objectives. The Company has no debt and therefore has no financial covenants. 2010 Annual Report 53 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 12. income taxes The provision for income taxes differs from the calculated tax obtained by applying the combined statutory Canadian federal and provincial tax rate to the loss before income taxes as follows: Applicable tax rate Provision for income taxes computed at the Canadian statutory rate Increase (decrease) in taxes resulting from: Non-deductible stock-based compensation Change in valuation allowance net of foreign exchange Difference in foreign jurisdiction tax rate Recognition of cost recovery pool Other Income tax expense 2010 $ 28.0% 4,167 428 339 1,308 (2,025) (277) 3,940 2009 $ 29.0% 1,767 269 (431) 928 537 73 3,143 The Company has non-capital losses of $16,774 available to carry forward for deduction against future years’ Canadian taxable income. These losses, the benefit of which has not been recognized in these financial statements, expire in the following years: 2014 2015 2026 2027 2028 2030 The significant components of the Company’s Canadian future income tax assets are as follows: Differences between tax bases and reported amounts of depreciable assets and resource properties Non-capital loss carry-forwards Share issue costs Total future tax assets Less: valuation allowance Future income taxes 2010 $ 4,308 4,194 – 8,502 (8,502) – $ 943 937 2,745 4,356 3,840 3,953 16,774 2009 $ 4,092 3,372 316 7,780 (7,780) – 54 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 13. supplemental cash Flow information Changes in non-cash working capital: Accounts receivable Due from joint venture partners Oil inventory Prepaid expenses Accounts payable and accrued liabilities Deferred revenue Changes in non-cash working capital: Operating activities Investing activities 2010 $ (1,790) (1,713) 48 (30) 7,005 – 3,520 (323) 3,843 3,520 2009 $ 472 6,086 1,561 (60) 2,527 (3,255) 7,331 371 6,960 7,331 During the year ended December 31, 2010, the Company incurred cash outlays of $Nil for interest (2009 – $Nil) and $Nil for taxes (2009 – $Nil). Yemen income taxes in the amount of $3,940 (2009 – $3,143) were remitted to the government through its allocation of oil under the PSA. 14. geographical information The Company has defined its continuing operations as oil and natural gas operations. The majority of the Company’s oil and natural gas operations are located in Yemen with lesser operations in Ethiopia and Canada. Revenue for each segment is as follows: Year ended December 31 Yemen Ethiopia Canada Total 2010 $ 64,173 – 560 64,733 2009 $ 51,086 – 940 52,026 2010 Annual Report 55 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 15. Per share amounts In calculating basic and diluted earnings per share, the following weighted average numbers of shares were used: Weighted average number of shares outstanding Dilutive effect of stock options Weighted average number of diluted shares outstanding 2010 97,947 597 98,544 2009 98,926 201 99,127 A total of 3,525,000 (2009 – 2,915,000) options were not in the money and were excluded from the dilutive calculation. 16. Financial instruments and Risk Management carrying Values and estimated Fair Values of Financial assets and liabilities The Company has classified its cash and cash equivalents and GICs as assets held for trading which are measured at fair value with changes being recognized in net income. Accounts receivable and amounts due from joint venture partners are classified as loans and receivables, which are measured at amortized cost. Accounts payable and accrued liabilities are classified as other financial liabilities and are measured at amortized cost. The carrying value and fair value of financial assets and liabilities are summarized as follows: Classification Financial assets held for trading Loans and receivables Accounts payable and accrued liabilities credit Risk Carrying Value ($) Fair Value ($) 73,020 15,436 19,264 73,020 15,436 19,264 The majority of the accounts receivable are in respect of oil and natural gas operations and are due from the Company’s joint venture partners or its customer for oil sales. Management believes the risk is mitigated by the size and reputation of the companies to which the Company extends credit. The Company has not experienced any material credit loss in the collection of accounts receivable to date. The Company is under contract to sell its production to one purchaser. The selling price is based on the quoted Dated Brent price on the date of shipment adjusted for the official selling price differential posted by the Government of Yemen. At December 31, 2010, $4,530 (2009 – $2,771) was receivable under the contract. Payment is secured by a guarantee issued by the purchaser’s parent company. The Company funds capital and operating costs and bills joint venture partners their share of those costs. In the event that a joint venture partner was incapable of fulfilling its obligation to pay its share of the costs, the Company could, under the terms of the joint operating agreement, recover the costs from the joint venture partner’s share of proceeds from crude oil sales. 56 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 Trade and other receivables from continuing operations are analyzed in the table below. With respect to the trade and other receivables that are neither impaired nor past due, there are no indications as of the reporting date that the debtors will not meet their payment obligations. Trade and other receivables at December 31, 2010 Neither impaired nor past due Impaired (net of valuation allowance) Not impaired and past due in the following period: Within 30 days 31-60 days 61-90 days Over 90 days interest Rate Risk $ 13,562 – $ 1,874 – – – The Company has exposure to interest rate risk as it relates to investments in GICs. Interest rate risk relates to the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The Company incurs interest rate risk on its cash and cash equivalents, and GICs. All cash balances are current and available immediately. The Company does not hedge its exposure to interest rate risk. A 100-basis-point increase in interest rates during 2010 would have increased net income by approximately $682 ($0.01/share). liquidity Risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they become due. Liquidity describes a company’s ability to access cash. Companies operating in the upstream oil and natural gas industry require sufficient cash in order to fund capital programs necessary to maintain and increase production and proved reserves, to acquire strategic oil and natural gas assets, and to repay debt. The Company actively monitors its cash requirements to ensure it has sufficient available funds to meet current and foreseeable financial requirements at a reasonable cost. The Company prepares annual capital expenditure budgets, which are regularly monitored and updated as considered necessary. The Company also utilizes authorizations for expenditures to further manage capital expenditures. The Company’s obligations coming due in the next 12 months are accounts payable and accrued liabilities of $19,264. In addition, the Company has commitments under existing agreements as described in note 17. Given the Company’s working capital position, management assesses liquidity risk as being low. In determining the fair value of financial instruments, the Company maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs reflect market-driven or market-based information obtained from independent sources, while unobservable inputs reflect the Company’s estimate about market data. Based on the observability of significant inputs used, the Company classifies its fair value measurements in accordance with a three-level hierarchy. This hierarchy is based on the quality and reliability of the information used to determine fair value, as follows: Level 1: Valuations are based on quoted prices in active markets for identical assets or liabilities. Since the valuations are based on quoted prices that are readily available in an active market, they are not subject to significant measurement uncertainty. Level 2: Valuations are based on observable inputs other than quoted prices. Level 3: Valuations are based on at least one unobservable input that is supported by little or no market activity and is significant to the fair value measurement. 2010 Annual Report 57 notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 In assigning financial instruments to the appropriate levels, the Company performs detailed analysis. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. The level within which the fair value measurement is categorized is based on the lowest-level input that is significant to the fair value measurement in its entirety. The Company’s fair value measurement of held for trading financial assets was conducted using Level 1 of the hierarchy. commodity Price Risk Management While the Company is exposed to business risk associated with fluctuations in the price of crude oil, the Company does not hold financial instruments whose fair values are susceptible to variability resulting from changes in the price of crude oil. Foreign exchange Risk The Company holds substantially all of its cash and cash equivalents and GICs at one financial institution in Canada. The Company invests its cash reserves in GICs issued by an Alberta credit union which deposits are guaranteed by the Province of Alberta. Approximately $1,363 of the $19,573 in cash and cash equivalents is held in Canadian-dollar-denominated accounts. As such, the Company is exposed to foreign currency risk. The impact to net income of a 10% change in the foreign exchange rates between the Canadian and United States dollars at December 31, 2010 would have been approximately $104 ($0.00/share). 17. commitments The Company is committed to operating leases for office space with payments due and to its proportionate share of various allowances and bonus payments to the Government of Yemen. 2011 2012 2013 2014 2015 $ 513 $ 492 $ 410 $ 225 $ 225 In addition to the payments indicated above, the Company is obligated to pay to the Government of Yemen its 50% proportionate share of a $2,000, a $3,000 and a $4,000 bonus payment when sustainable production exceeds 25,000, 75,000 and 100,000 barrels of oil per day, respectively. The Company is also committed to pay a royalty of $1.25 per barrel of oil produced from the Yemen properties to an arm’s- length party until its commitment to pay these royalties has been satisfied. The total commitment outstanding at December 31, 2010 under this obligation is approximately $2,217 (December 31, 2009 – $2,777). As part of the Production Sharing Contract with the Government of Ethiopia, the Company has entered into certain commitments to spend approximately $8.5 million during the first four years of its work program. The Company has incurred approximately $1,206 in respect of this commitment. 58 Calvalley Petroleum Inc. notes to the consolidated Financial statements (Financial figures expressed in thousands of United States Dollars) December 31, 2010 and 2009 18. contingencies The Company has been named in a claim filed in the Commercial Court of Yemen by a Saudi Arabian company. The claimant alleges that, pursuant to an agency agreement entered into in 1996, it is entitled to a percentage of the net profit attributable to the Company. Over the past several years this issue has been before the Commercial Court of Yemen, the Yemeni Court of Appeal and the Supreme Court of Yemen on a number of procedural issues and has now been sent back to the Supreme Court of Yemen for reassessment. Interim judgments have been issued and both parties appealed an initial ruling which limited the plaintiff’s entitlement to an interest on the net profit from profit oil production prior to February, 2008. Calvalley has cross-appealed on a number of matters of substance and procedure. The Company’s legal advisors in Sana’a and Calgary are pursuing the appeal jointly. The outcome of the action in the Supreme Court of Yemen is undeterminable at this time and the Company is exploring both judicial, and extra judicial, resolution. No amounts have been accrued in the consolidated financial statements for the periods ended December 31, 2010 as the ultimate resolution is uncertain. The Company will record any amounts due, if any, once the outcome of the contingency is likely and reasonably estimated. Between 2004 and 2007, the Company billed its Block 9 joint venture partners (JV Partners) for fees in accordance with the terms of the PSA which governs the joint venture operating activities on Block 9. The JV Partners contend that certain of these fees are not billable under the terms of the Joint Operating Agreement (JOA) between the Company and the JV Partners. Pending resolution of this matter, the Company has not charged the JV Partners for the fees in question during 2008 and 2009. The Company and its JV Partners have now agreed to enter into a binding expert determination in London, England to interpret the terms of the JOA and to obtain a ruling on whether the fees in question are billable. While management is not able to determine the likelihood of a positive or negative outcome, the maximum liability to the Company related to fees charged from 2004 to 2007 is $1,012. Conversely, should the fees be deemed billable, the Company would recover fees which have not previously been recorded in the accounts in the amount of $927. In the normal course of operations, the Company may be subject to litigation and claims. In the opinion of management, other than as disclosed above, no such litigation or claim, individually or in aggregate, would result in a liability that would have a significant adverse effect on the financial position or results of operations of the Company. 19. Related Party transactions On June 10, 2009, the Company advanced $113 to a member of its Board of Directors. The advance was included in accounts receivable, was non-interest-bearing, repayable within 90 days, and was secured by shares of the Company. The advance was repaid in full during August 2009. 2010 Annual Report 59 abbreviations Bbls barrels of oil Mbbls thousand barrels Bopd barrels of oil per day Km kilometre Km2 square kilometre Mmcf million cubic feet Mmcf/d million cubic feet per day Forward-Looking Statements This Annual Report contains certain forward-looking statements. Some of the statements contained herein including, without limitation, financial and business prospects and financial outlooks of the Company, may be forward-looking statements which reflect management’s expectations regarding future plans and intentions, growth, results of operations, performance and business prospects and opportunities. Words such as “may”, “will”, “should”, “could”, “anticipate”, “believe”, “expect”, “intend”, “plan”, “potential”, “continue”, and similar expressions have been used to identify these forward-looking statements. These statements reflect management’s current beliefs and are based on information currently available to management. Forward-looking statements involve significant risk and uncertainties. A number of factors could cause actual results to differ materially from the results discussed in the forward-looking statements including, but not limited to, changes in general economic, political and market conditions and other risk factors. Although the forward-looking statements contained herein are based upon what management believes to be reasonable assumptions, management cannot assure that actual results will be consistent with these forward-looking statements. Investors should not place undue reliance on forward-looking statements. These forward-looking statements are made as of the date hereof. Forward-looking statements and other information contained herein concerning the oil and natural gas industry and Calvalley’s general expectations concerning this industry are based on estimates prepared by management using data from publicly available industry sources as well as from reserve reports, market research and industry analysis and on assumptions based on data and knowledge of this industry which Calvalley believes to be reasonable. However, this data is inherently imprecise, although generally indicative of relative market positions, market shares and performance characteristics. While Calvalley is not aware of any misstatements regarding any industry data presented herein, the industry involves risks and uncertainties and is subject to change based on various factors. See “Risk Factors.” Calvalley does not undertake any obligation to update publicly or revise any forward- looking statements contained in this or in any other document filed with Canadian securities regulatory authorities, whether as a result of new information, future events or otherwise, except as required by applicable securities laws. 60 Calvalley Petroleum Inc. CORPORATE INFORMATION STOCK LISTING Toronto Stock Exchange CVI.A BANKERS Scotiabank First Calgary Savings & Credit Union Ltd. LEGAL COUNSEL Macleod Dixon LLP Auditors Deloitte & Touche LLP TRANSFER AGENT Computershare Trust Company of Canada CORPORATE OFFICE Suite 700, 600 - 6th Avenue S.W. Calgary, Alberta T2P 0S5 Ofﬁce: +1 (403) 297-0490 +1 (403) 297-0499 Fax: Sana’a Ofﬁce P.O. Box 7090 Hadda Area, Sana’a Republic of Yemen Ofﬁce: +9671 41 5555 +9671 42 3580 Fax: www.calvalleypetroleum.com DIRECTORS Edmund M. Shimoon Calgary, Alberta Gary Robertson (1) Montreal, Quebec Kenneth M. Stephenson (1) (2) Calgary, Alberta Memet Kont (2) Calgary, Alberta Thomas H. Skupa (1) (2) Calgary, Alberta Thomas E. Valentine Calgary, Alberta (1) Member of Audit Committee (2) Member of Reserves Committee OFFICERS Edmund M. Shimoon Chairman and Chief Executive Ofﬁcer Memet Kont President and Chief Operating Ofﬁcer Zacharie J. Magnan Vice President, Finance and Acting Chief Financial Ofﬁcer Thomas E. Valentine Corporate Secretary a d a n a C n i d e t n i r P m o c . e g d e n . i l r e m w w w . c n I e g d E n i l r e M y b d e c u d o r p d n a d e n g s e D i CALVALLEY PETROLEUM INC. Calgary Ofﬁce: Suite 700, 600 - 6th Avenue S.W. Calgary, Alberta T2P 0S5 Ofﬁce: Fax: (403) 297-0490 (403) 297-0499 CALVALLEY PETROLEUM (CYPRUS) LTD. Yemen Ofﬁce: P.O. Box 7090 Hadda Area, Sana’a Republic of Yemen Ofﬁce: +9671 41 5555 +9671 42 3580 Fax: www.calvalleypetroleum.com

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