Monterey Exploration Ltd.
TSX : MXL

Monterey Exploration Ltd.

March 22, 2010 18:42 ET

Monterey Exploration Ltd. Announces Financial and Operating Results for the Three Months and Year Ended December 31, 2009 & Annual Information Form Filing

CALGARY, ALBERTA--(Marketwire - March 22, 2010) - Monterey Exploration Ltd. ("Monterey" or the "Corporation") (TSX:MXL) is pleased to provide its financial and operating results for the three months and year ended December 31, 2009.

Monterey also announces that it has filed its audited financial statements for the year ended December 31, 2009, the related management's discussion and analysis and its annual information form which includes Monterey's statement of reserves data and other oil and gas information for the year ended December 31, 2009 as mandated by National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities ("NI 51-101").

Monterey's audited financial statements for the year ended December 31, 2009, the related management's discussion and analysis and the Corporation's annual information form are available on SEDAR at www.sedar.com and on Monterey's website at www.montereyexploration.com.

2009 HIGHLIGHTS

- Proved plus probable reserves increased to 14.6 million barrels of oil equivalent ("mmboe") as at December 31, 2009, a 45 percent increase over the 10 mmboe at December 31, 2008. A press release issued by the Corporation on January 19, 2010 contains additional information on Monterey's reserves for the year ended December 31, 2009.

- Average finding, development and acquisition costs including change in future development capital for proved reserve additions of $15.06 per barrel of oil equivalent ("boe") and $8.81 per boe for proved plus probable.

- Proved plus probable reserve additions of 4.6 mmboe replaced 575 percent of the Corporation's 2009 production.

- Successfully completed the Corporation's first 100 percent working interest Montney Groundbirch horizontal well at 4-30 -80-21 W6M ("4-30"). After 48 hours of continuous flow testing, the 4-30 well had a measured natural gas rate of approximately 9 million cubic feet per day ("mmcf/d"). Monterey also drilled and cased a second 100 percent working interest Montney Groundbirch horizontal well at 2-21-80-21 W6M ("2-21") in mid January 2010.

- Achieved average daily production for the fourth quarter of 1,907 barrels of oil equivalent per day ("boe/d"), and 2,192 boe/d for the full year in line with full year production guidance of 2,200 boe/d.

- Monterey generated quarterly funds flow from operations of $2.2 million versus $3.7 million of funds flow from operations generated in the fourth quarter of 2008. The 2009 fourth quarter funds flow from operations figures are lower than those of 2008 due to the combination of a 21 percent decrease in the average sales price received per boe and a 10 percent reduction in production volumes.

- Received all required regulatory approval to construct and commission a 100 percent working interest 28 million cubic feet per day ("mmcf/d") natural gas processing facility at Groundbirch.

- Completed the issuance of 8.1 million common shares for gross cash proceeds of approximately $16.1 million in October 2009. Also, in February 2010, Monterey completed the issuance of approximately 4.8 million common shares for gross cash proceeds of $20.0 million. Monterey's estimated net debt after closing of the financing on February 19, 2010 was approximately $9 million on a $45 million credit facility.

- Disposed of non-core properties for total cash proceeds of approximately $8.8 million. The dispositions consisted of 3.0 net sections of undeveloped non-core lands in the Town area of northeast British Columbia ("NEBC") and 1.4 net sections of undeveloped non-core lands and one non-producing well at Dawson. All proceeds were applied to development activities at Groundbirch.

- During the months of December 2009 and January 2010, the Corporation entered into three forward financial swap contracts, combined the contracts fix the average natural gas price to be $5.42 per gigajoule ("GJ") on 2,000 GJ per day from February 1, 2010 until June 30, 2010 and 1,000 GJ per day from July 1, 2010 until October 31, 2010.

2010 DEVELOPMENTS

- Initiated the construction of the 28 mmcf/d processing facility at Groundbirch. Clearing and preparation of the road access and plant site has begun with construction activities scheduled for the second half of 2010.

- Drilled and cased the Corporation's second and third horizontal Montney development wells at 2-21-80-21 W6M (100 percent working interest) and 13-27-80-21 W6M (75 percent working interest) and drilled and cased a step out vertical stratigraphic Montney test at 16-31-80-21 W6M on the Western extent of the Corporation's landholdings at Groundbirch.

- Engaged GLJ Petroleum Consultants ("GLJ") to prepare an updated resource evaluation effective February 28, 2010 of all 15 (13.0 net) sections of Montney landholdings in the Groundbirch area of NEBC. Based on drilling results to date including the vertical test well at 16-31-80-21 W6M, GLJ has estimated that there exists a best estimate of 1.7 trillion cubic feet ("tcf") of Discovered Petroleum Initially-In-Place ("DPIIP") net to the Corporation.



FINANCIAL & OPERATING SUMMARIES

Financial
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Three Months Ended Year Ended
December 31, December 31,
2009 2008 2009 2008
Production Revenue(1) (000's) $ 6,358 $ 8,965 $ 24,510 $ 33,287

Funds Flow from Operations(2):
(000's) $ 2,201 $ 3,694 $ 6,545 $ 15,004
Per share(3) :
Basic $ 0.05 $ 0.11 $ 0.19 $ 0.54
Diluted $ 0.05 $ 0.11 $ 0.18 $ 0.54

Net Earnings (Loss):
(000's) $ (2,265) $ (2,110) $ (16,733) $ 903
Per share:
Basic and diluted $ (0.06) $ (0.06) $ (0.48) $ 0.03

Capital Expenditures(4)
(000's) $ 9,958 $ 10,969 $ 8,168 $ 31,844

Ending Net Debt (5) (000's) $ 24,997 $ 37,924 $ 24,997 $ 37,924

Share Data:
Basic common shares
outstanding 41,002,500 32,902,500 41,002,500 32,902,500
Stock options 3,968,166 3,135,666 3,968,166 3,135,666
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Total fully diluted 44,970,666 36,038,166 44,970,666 36,038,166
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Weighted average shares
outstanding:
Basic 40,914,457 32,902,500 34,921,952 27,735,885
Diluted 42,726,800 32,904,058 36,762,557 27,736,277
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Operations
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Three Months Ended Year Ended
December 31, December 31,
2009 2008 2009 2008
Average Daily Production:
Natural gas (mcf/d) 8,751 10,058 10,430 8,062
Light oil and NGL (bbl/d) 449 453 454 292
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Oil equivalent (boe/d) 1,907 2,130 2,192 1,636
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Unit of Production Summary:
Average prices:
Light oil and NGL ($/bbl) 57.95 51.78 48.21 78.90
Natural gas(1) ($/mcf) 4.93 7.35 4.34 8.39
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Oil equivalent(1) ($/boe) 36.23 45.75 30.63 55.60
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Funds flow from Operations(2)
Summary ($/boe)
Revenue(1) 36.23 45.75 30.63 55.60
Royalties (3.01) (7.98) (4.32) (10.08)
Operating expenses (13.32) (14.61) (11.85) (13.56)
Transportation expenses (1.58) (1.78) (1.57) (1.73)
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Operating income(6) 18.32 21.38 12.89 30.23
Unrealized (gain) on financial
instruments (0.18) 1.08 (0.04) -
General & administrative(7) (4.17) (2.21) (3.38) (3.47)
Interest expense (1.42) (1.40) (1.29) (1.70)
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Funds flow from operations(2)
($/boe) 12.55 18.85 8.18 25.06
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Drilling
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Three Months Ended Year Ended
December 31, December 31,
2009 2008 2009 2008
Gross Wells:
Natural gas 2 1 3 11
Oil - - - -
Dry & abandoned - - - 2
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Total 2 1 3 13
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Net Wells:
Natural gas 2.0 1.0 3.0 6.9
Oil - - - -
Dry & abandoned - - - 1.3
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Total 2.0 1.0 3.0 8.2
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Landholdings as at
December 31,
2009 2008
Gross Acres:
Developed 121,359 129,113
Undeveloped 129,680 146,873
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Total 251,039 275,986
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Net Acres:
Developed 66,140 71,108
Undeveloped 81,168 93,561
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Total 147,308 164,668
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2010 FIRST QUARTER OPERATIONAL UPDATE

Monterey has had a very operationally intensive first quarter with several key operations continuing in the field. The second Montney horizontal development well located at 2-21-80-21 W6M ("2-21") on the Western land block in the Groundbirch area of NEBC was drilled and cased in the second week of January. The third horizontal development well at 13-27-80-21 W6M ('13-27") also on the Western block was drilled and cased in the first week of March. The 16-31-80-21 W6M ("16-31") vertical stratigraphic test well was drilled and cased at the end of February to evaluate the Montney formation on the Western edge of the Corporation's lands and the information obtained from the Montney formation was utilized in the current GLJ resource evaluation.

The completion operations related to the two cased horizontal wells at 13-27 and 2-21 have been delayed to the end of the first quarter. The delays were due to the unusually warm weather in early March accelerating the early onset of spring break up coupled with limited access to high rate fracture stimulation equipment due to extremely high industry demand.

The Corporation has now secured the required equipment and personnel to concurrently complete both horizontal wells and with more seasonal temperatures returning in the second half of March, fracture operations commenced simultaneously at 13-27 and 2-21 on March 20th. The horizontal sections are being fracture stimulated utilizing limited entry slick water multi-stage fracture technology.

Completion operations at 16-31 were started in mid March on the first of several zones of interest in the wellbore. Flow testing and additional completion operations are scheduled to continue until access to the location is no longer attainable.

The drilling rig that drilled the 13-27 horizontal well has been moved back to the Eastern land block and due to poor access conditions and construction delays in early March has been racked until the next drilling pad can be constructed. Crews are currently building a five well drilling pad that will be utilized to drill the fourth and fifth horizontal development wells on one of the sections adjacent to the 9 mmcf/d well test at 4-30 which results were announced on November 22, 2009. If the construction of this drilling pad can be completed prior to break up, the rig is scheduled to move and commence drilling operations on the fourth horizontal development well. Otherwise, the rig will remain racked and should start drilling operations in early June once summer access is available. The drilling of these additional 2 wells is anticipated to complete the initial five well development phase for the start up of the processing facility.

Construction crews are also working on the road access and gas plant site and plan to have all the necessary surface construction and preparation completed by the end of March.

GROUNDBIRCH MONTNEY RESOURCE EVALUATION

Monterey engaged GLJ to prepare an updated independent evaluation effective February 28, 2010 of the DPIIP as defined in the Canadian Oil and Gas Evaluation Handbook ("COGE Handbook") on 15 (13.0 net) sections of Montney landholdings in the Groundbirch area of NEBC. Based on the drilling results to date, GLJ has estimated that there exists a best estimate of 1.9 tcf (1.7 tcf net) of DPIIP on Monterey's landholdings. This report represents an increase of 500 billion cubic feet (400 net) from the previous report of 1.4 (1.3 tcf net) dated December 31, 2009. The total Montney proved reserves assigned to the Groundbirch project area of 17.3 billion cubic feet of natural gas equivalent ("BCFGE") and total proved plus probable reserves of 38.5 BCFGE as at December 31, 2009 represents 1.1% and 2.4% respectively of the current DPIIP and only reflect reserves associated to the first horizontal well drilled at 4-30.

It should be noted that given the early stages of development, the best estimate of DPIIP may change significantly in the future with further exploration and development activity and the amount of contingent resources, as defined in the COGE Handbook, has yet to be determined. Additional drilling, testing and development are required to confirm commercial economic development. The resource estimates provided herein are estimates only and the actual resources may be greater or less than the estimates provided herein. Other than the resources which have been booked as reserves as described above, a recovery factor for the remaining resources has not been estimated by GLJ and a recovery project cannot be defined for these volumes of DPIIP at this time. There is no certainty that it will be commercially viable to produce any portion of the natural gas currently classified as DPIIP except to the extent identified as proved or probable reserves.

OUTLOOK

The Corporation is maintaining its previous 2010 first half capital expenditure guidance of $15 million and first half production guidance of 1,600 - 1,700 boe/d. First quarter capital expenditures are estimated at approximately $10 - $11 million if all scheduled operations at Groundbirch can be completed prior to spring break up.

The weak forward commodity strip price for natural gas continues to apply significant downward economic pressure on the Canadian natural gas industry. In order for natural gas entities to compete and survive in this lower price environment, they will need to explore for and develop repeatable scalable plays that can generate above average recycle ratios with natural gas prices below $5.00 per mcf. Management believes that the Montney project at Groundbirch in NEBC has the potential to generate one of the higher recycle ratios in the Western Canadian gas basin and as a result, Monterey will continue to aggressively evaluate and develop this project through the remainder of 2010 and beyond. Exclusive of the Groundbirch project the Corporation also has an inventory of more than $75 million in additional development projects.

Management is very encouraged with the drilling and completion results to date at Groundbirch and will continue to update shareholders as additional results are obtained.

Notes:

(1) Includes gain or loss on financial instruments from commodity price hedging activities.

(2) Funds flow is not defined by Canadian generally accepted accounting principles ("GAAP") and thus is referred to as a non-GAAP measure; other entities may calculate funds flow differently than Monterey. Funds flow is based on cash provided by operating activities before changes in non-cash working capital and asset retirement expenditures.

(3) Funds flow per share is not defined by Canadian GAAP and thus is referred to as a non-GAAP measure. Funds flow per share is calculated by dividing funds flow by the weighted average number of shares outstanding during the period consistent with the calculation of net income per share.

(4) Capital expenditures is not defined by Canadian GAAP and thus is referred to as a non-GAAP measure. Capital expenditures is the cost of recorded property and equipment additions net of cash disposition proceed less non-cash additions (including long lived asset retirement, capitalized stock-based compensation expense and future income tax liability adjustments for non-taxed based additions) and the recorded costs of business combinations.

(5) Net debt is equal to total bank indebtedness plus capital lease obligations and less working capital (excluding financial instrument assets or liabilities).

(6) Operating income is not defined by GAAP and thus is referred to as a non-GAAP measure; other entities may calculate operating income differently than Monterey. Operating income is calculated by deducting the sum of royalty, operating and transportation expenses from production revenue and gains or losses from financial instruments.

(7) Excludes capitalized general & administrative expenditures and stock-based compensation expense.

BOE Disclosure

Disclosure provided herein in respect of barrels of oil equivalent (boe) may be misleading, particularly if used in isolation. A boe conversion ratio of 6 mcf: 1 bbl is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.

BCFGE Disclosure

Disclosure provided herein in respect of billion cubic feet of natural gas equivalent (Bcfge) may be misleading, particularly if used in isolation. A Bcfge conversion ratio of 1 million bbl: 6 billion cubic feet is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.

Forward Looking Statements & Advisories

This press release contains forward-looking statements, including but not limited to statements concerning the timing of construction of and the capacity of new processing facilities, the timing and outcome of drilling and completion activities with respect to spring break-up and otherwise, the identification of drilling and facility locations, the discovery and potential of the Corporation's natural gas project at Groundbirch, the amount and on-stream timing of new production, the performance characteristics of production from Monterey's developed oil and gas properties, the access to and availability of production facilities, anticipated market prices received by Monterey for its production, expectations regarding the ability to continually add to reserves through exploration and development activities, the amount capital expenditures in the project inventory excluding capital expenditures at Groundbirch, Monterey's continued access to existing credit facilities, future operating and financial results and expectations regarding exploration, development and operating costs. Additionally, the use of any of the words "guidance", "initial", "scheduled, "will", "prior to", "estimate", "anticipate", "believe", "potential", "should", "unaudited", "forecast", "future", "continue", "may", "expect", "project" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, certain of which are beyond the Corporation's control, including the impact of general economic conditions; volatility in market prices for crude oil and natural gas; industry conditions; volatility of commodity prices; currency fluctuation; imprecision of reserve estimates; liabilities inherent in crude oil and natural gas operations; environmental risks; incorrect assessments of the value of acquisitions and exploration and development programs; competition from other producers; the lack of availability of qualified personnel or management; changes in income tax laws or changes in tax laws and incentive programs relating to the oil and gas industry; hazards such as fire, explosion, blowouts, cratering, and spills, each of which could result in substantial damage to wells, production facilities, other property and the environment or in personal injury; stock market volatility; and ability to access sufficient capital from internal and external sources. As a consequence, Monterey's actual results may differ materially from those expressed in, or implied by, the forward-looking statements. Although Monterey believes that the expectations reflected in such forward-looking statements or information are reasonable, undue reliance should not be placed on forward-looking statements as the Corporation can give no assurance that such expectations will prove to be correct.

Actual results may differ materially from those expressed or implied in any forward-looking statements made by, or on behalf of, Monterey. In addition to other factors and assumptions which may be identified in this press release and other documents filed by the Corporation, assumptions have been made regarding, among other things: the impact of increasing competition; the general stability of the economic and political environment in which Monterey operates; the ability of the Corporation to obtain qualified staff, equipment and services in a timely and cost efficient manner; drilling results; the ability of the operator of the projects which the Corporation has an interest in to operate the field in a safe, efficient and effective manner; Monterey's ability to obtain financing on acceptable terms; field production rates and decline rates; the ability to replace and expand oil and natural gas reserves through acquisition, development or exploration; the timing and costs of pipeline, storage and facility construction and expansion; the ability of the Corporation to secure adequate product transportation; future oil and natural gas prices; currency, exchange and interest rates; the regulatory framework regarding royalties, taxes and environmental matters in the jurisdictions in which the Corporation operates; and Monterey's ability to successfully market its oil and natural gas products. Readers are cautioned that the foregoing list of factors is not exhaustive. Forward-looking statements contained in this press release are made as at the date of this press and Monterey disclaims any intent or obligation to update publicly or to revise any of the included forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by applicable securities laws.

However, in the event that subsequent events are reasonably likely to cause actual results to differ materially from material forward-looking statements or information previously disclosed by Monterey for a period that is not yet complete, Monterey will provide disclosure on such events and the anticipated impact of such events.

Discovered Petroleum Initially in Place

This press release contains references to estimates of gas classified as DPIIP in the Corporation's Groundbirch area in NEBC which are not, and should not be confused with oil and gas reserves. "Discovered Petroleum Initially in Place" is defined in the COGE Handbook as the quantity of hydrocarbons that are estimated, as of a given date, to be contained in known accumulations. DPIIP is divided into recoverable and unrecoverable portions, with the estimated future recoverable portion classified as reserves and contingent resources. There is no certainty that it will be commercially viable to produce any portion of this DPIIP except to the extent identified as proved or probable reserves. Resources do not constitute, and should not be confused with, reserves.

There are a number of assumptions associated with the development of the Corporation's lands at Groundbirch relating to performance from new and existing wells, future drilling programs, the lack of infrastructure, well density per section, recovery factors and development necessarily involves known and unknown risks and uncertainties, including those risks identified in this press release. Significant positive and negative factors include: (i) net gas pay could be thicker or thinner than that established by the wells drilled to date; (ii) porosity and water saturation could be higher or lower than that estimated to date; and (iii) the reserves for the 04-30 well and offset drilling locations are based on type curves derived from analogous wells; given the limited data in the immediate vicinity of the Corporation's lands, it is possible that the Montney formation could perform better or worse than the analogous wells.

Non-GAAP Measures

Within this press release, references are made to terms commonly used in the oil and gas industry. Management uses funds flow from operations, operating income and capital expenditures to analyze operating performance. These measures do not have standardized meanings prescribed by GAAP, and may not be comparable to similar measures presented by other companies. For this press release the measures used are: (i) Funds flow from operations is determined by using cash flow from operations before changes in non-cash operating working capital and asset retirement expenditures; (ii) Operating income is calculated by deducting royalties, operating costs and transportation costs from sales revenues and hedging gains / (losses); (iii) Net capital expenditures is the cost of recorded property and equipment additions net of cash disposition proceed less non-cash additions (including long lived asset retirement, capitalized stock-based compensation expense and future income tax liability adjustments for non-taxed based additions) and the recorded costs of business combinations; (iv) Finding and development costs is equal to the cost of recorded property and equipment additions less the additions for long lived asset retirement, office furniture and equipment, property acquisitions and business combinations grossed up for the recorded proceeds of property dispositions for the period; (v) Finding, development and acquisition costs is equal to finding and development costs as described in note (iv) above plus the recorded additions for property acquisitions less the recorded proceeds of property dispositions for the period; (vi) Funds flow per basic and funds flow per diluted share is calculated by dividing funds flow as described earlier, by the total number of respective weighted average basic and diluted common shares outstanding during the period; (vii) Net debt is equal to total bank indebtedness plus capital lease obligations less/(plus) non-cash working capital/(deficit); and (viii) fully diluted share figures are calculated by adding the number of common shares underlying the outstanding stock options to the number of common shares outstanding (i.e. basic outstanding common shares) at the respective date. For additional information concerning Monterey's use of non-GAAP measures and reconciliations to the applicable GAAP measures, please see Monterey's management's discussion and analysis for the year ended December 31, 2009 available at www.sedar.com.

MANAGEMENT'S DISCUSSION AND ANALYSIS

This Management's Discussion and Analysis ("MD&A") should be read in conjunction with Monterey's audited Financial Statements for the year ended December 31, 2009 and the Annual Information Form for the year ended December 31, 2009. The Financial Statements have been prepared in Canadian dollars and in accordance with Canadian generally accepted accounting principles ("GAAP").

This MD&A contains forward-looking statements, non-GAAP measures, and disclosures of barrels of oil equivalent volumes. Readers are referred to the advisories concerning forward-looking statements, non-GAAP measures, and barrels of oil equivalent conversions contained under the heading "Forward Looking Statements & Advisories".

Additional information regarding Monterey Exploration Ltd. such as the audited Financial Statements, Annual Information Form and other disclosure documents can be found on SEDAR at www.sedar.com or on the Corporation's website www.montereyexploration.com.

This MD&A is dated March 18, 2010.

Monterey Exploration Ltd. ("Monterey" or the "Corporation") is continued under the Business Corporations Act (Alberta) and is engaged in the acquisition, exploration, development and production of natural gas, natural gas liquids and crude oil in the Western Canadian Sedimentary Basin.

Please note that certain tables presented in this MD&A may not add due to rounding.

FREQUENTLY USED TERMS

In this document certain terms are used frequently. For instance, Monterey Exploration Ltd. is commonly referred to as either "Monterey" or the "Corporation" and barrels of oil equivalent are regularly noted with the term "boe". The Corporation's farm-in commitment in the Brassey area is denoted as the "Brassey Farm-in".



Term or abbreviation
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"boe" Barrel(s) of oil equivalent
"mcf" Thousand cubic feet
"bbl" Barrel
"GJ" Gigajoule
"LIBOR" London Interbank Offered Rate
"m" preceding a volumetric
measure 1,000 units of the volumetric measure
"mm" preceding a volumetric
measure 1,000,000 units of the volumetric measure
"NGL" Natural gas liquids
"NEBC" Northeast British Columbia
"Upper Lake" Upper Lake Oil and Gas Ltd.


ACCOUNTING PRONOUNCEMENTS AND ACCOUNTING POLICY CHANGES

During the first quarter of 2009, Monterey adopted CICA handbook section 3064, Goodwill and Intangible Assets. The handbook section applies to goodwill subsequent to initial recognition and establishes standards for the recognition, measurement and disclosure of goodwill and intangible assets. Adoption of the new disclosure requirement did not have an impact on the Corporation's financial statements or disclosure in the notes to the financial statements.

The Corporation will be obligated to convert its financial statements and changeover to international financial reporting standards ("IFRS") for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011. Management has taken steps to educate its staff and reviewed its accounting systems to determine the differences between Canadian GAAP and IFRS. An implementation plan for the changeover from Canadian GAAP to IFRS has been prepared that calls for the determination of cash generating units, adjustments to the accounting system and allocation of Canadian GAAP balances to the cash generating units during the fourth quarter of 2009. Upon the completion of the December 31, 2009 Canadian GAAP financial statements the adjustments to convert the December 31, 2009 Canadian GAAP balance sheet to be IFRS compliant are to be calculated. In addition, Monterey intends to prepare IFRS compliant financial statements, excluding the notes to the financial statements for each fiscal quarter, which will allow the Corporation to have comparative information readily available for financial reporting when IFRS is adopted on January 1, 2011. As discussed below, the application of IFRS accounting policies is likely to have a material impact on Monterey's financial statements.

Management has identified differences between Canadian GAAP and IFRS with respect to Monterey's financial statements and notes thereto for the following: accounting for property, plant & equipment ("PP&E"), asset retirement obligations, and share-based payments. The most significant impact upon adoption of IFRS will be to the Corporation's recorded PP&E balance resulting from changes in calculating depletion, depreciation and accretion expense, impairment testing and the recording of exploration and evaluation costs.

In July 2009, the International Accounting Standards Board ("IASB") approved amendments and released additional exemptions to IFRS 1 - Additional Exemptions for First-time Adopters ("IFRS 1"). IFRS 1 permits first-time adopters engaged in the business of oil and gas exploration, development and production using the full cost accounting method to allocate their oil and gas asset balance as determined under full cost accounting to the IFRS categories of exploration and evaluation assets and development and producing properties as at the date of transition, January 1, 2010 rather than to retroactively restate the balance from the date of inception. The allocation of Monterey's PP&E balance under full cost accounting to individual, smaller, IFRS cash generating units will be based on the Corporation's reserve values at the date of transition, and will further be subject to tests for impairment.

The determination of depletion, depreciation and accretion expense for PP&E assets under IFRS also permits the inclusion of proved and probable reserves, whereas under Canadian GAAP, only proved reserves are used in to calculate depletion, depreciation and accretion expense for PP&E assets.

Following the transition from full cost accounting under Canadian GAAP to IFRS, impairment of the Corporation's PP&E assets must be calculated at the cash generating unit level, whereas Monterey assesses for impairment in relation to the net book value of the Corporation's total PP&E asset balance under Canadian GAAP.

Management will be updating its information technology ("IT") systems to ensure compliance with IFRS reporting requirements in 2010, and has completed the review of changes to third-party IT software updates which have been designed to facilitate compliance with IFRS.

In association with the adoption of IFRS, Management will modify the Corporation's internal controls over financial reporting. One such modification will consist of additional internal controls to accurately determine the classification of costs incurred from exploration activities, and whether they should be reclassified to PP&E or charged against income. Potential changes to the internal control environment will be evaluated for the implementation of new IT systems and software as well.

INTERNAL CONTROLS REPORTING

Disclosure Controls and Procedures

The Chief Executive Officer and the Chief Financial Officer, together with other members of Management, have designed Monterey's disclosure controls and procedures to provide reasonable assurance that material information relating to the Corporation is disclosed in a timely manner and free from material misstatement.

In March 2009, subsequent to Monterey filing the Annual Information Form ("AIF") for the year ended December 31, 2008 it was determined that certain reserve information contained in the AIF was inconsistent with the form requirements. Upon discovery of the errors the AIF was corrected and a revised AIF filed. As a result of this event the Chief Executive Officer and Chief Financial Officer took action to ensure that the individuals connected with the errors were fully educated as to the data required to be disclosed in the AIF. In addition, in circumstances where data associated with an independent external party is disclosed in any public document that the document will not be considered complete and released until a written consent permitting disclosure of the data from the independent external party is received.

As at December 31, 2009, an evaluation of the effectiveness of Monterey's disclosure controls and procedures was conducted in accordance with Multilateral Instrument 52-109, Certification of Disclosure in Issuers' Annual Financial and Interim Filings. Based on that evaluation, the Chief executive Officer and the Chief Financial Officer concluded that the design and operation of Monterey's disclosure controls and procedures were effective as at December 31, 2009.

Internal Controls over Financial Reporting

Also in accordance with National Instrument 52-109, the Chief Executive Officer and Chief Financial Officer of Monterey are responsible for establishing and maintaining adequate internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Canadian generally accepted accounting principles. The Chief Executive Officer and Chief Financial Officer directed the assessment of the design and operating effectiveness of Monterey's internal controls over financial reporting as at December 31, 2009 and based on that assessment determined that the Corporation's internal control over financial reporting was, in all material respects, appropriately designed and operated effectively.

During the year ended December 31, 2009, there have been no material changes in the design or operation of the Corporation's disclosure controls and procedures or in internal controls over financial reporting.

It should be noted that due to inherent limitations that a control system, including the Corporation's disclosure controls and procedures and internal controls over financial reporting, no matter how well conceived or operated may not prevent or detect misstatements, errors or fraud and can only provide reasonable assurance that the objectives of the control system are met.

SIGNIFICANT EVENTS

During the fourth quarter of 2009, the following items had a significant impact on either the current or future operations of the Corporation:

- Successfully completed the Corporation's first Montney Groundbirch horizontally drilled, multi-stage fracture completion well at 4-30 -80-21 W6M ("4-30"). After 48 hours of continuous flow testing, the 4-30 well had a measured natural gas rate of approximately 9 mmcf/day. Monterey also drilled and cased a second Montney Groundbirch horizontal well at 2-21-80-21 W6M ("2-21").

- Received all required regulatory approval to construct and commission a 100 percent working interest 28 mmcf/d feet per day natural gas processing facility at Groundbirch.

- Completed the issuance of 8.1 million common shares for gross cash proceeds of approximately $16.1 million in October 2009. Also, in February 2010, Monterey completed the issuance of approximately 4.8 million common shares for gross cash proceeds of $20.0 million.

- Average daily production for the fourth quarter of 1,907 barrels of oil equivalent per day ("boe/d"), which is, due to natural production declines, a 10 percent decrease compared with 2,130 boe/d produced during the comparative quarter in 2008.

- Monterey generated quarterly funds flow from operations of $2.2 million, versus $3.7 million of funds flow from operations generated in the fourth quarter of 2008. Fourth quarter funds flow from operations per diluted share was $0.05 for 2009 and $0.11 for 2008. The 2009 fourth quarter funds flow from operations figures are lower than those of 2008 due to the combination of a 21 percent decrease in the average sales price received per boe and 10 percent reduction in production volumes.

- Entered into a financial swap contract on a total of 2,000 gigajoules per day ("GJ/d") for the term from November 1, 2009 to December 31, 2009 at an average price of $5.32/mcf and realized a total gain of approximately $0.1 million. During the months of December 2009 and January 2010, the Corporation entered into three forward financial swap contracts, combined the contracts fix the average natural gas price to be $5.68/mcf on 2,000 GJ per day from February 1, 2010 until June 30, 2010 and 1,000 GJ per day from July 1, 2010 until October 31, 2010.

In addition to significant events of the fourth quarter, the following items which took place during the first nine months of 2009 had a significant impact on either the current or future operations of the Corporation:

- Disposed of non-core properties for total cash proceeds of approximately $8.8 million. The dispositions consisted of 3.0 net sections of undeveloped non-core lands in the Town area of NEBC for total net proceeds of $2.7 million and 1.4 net sections of undeveloped non-core lands and one non-producing well at Dawson for net proceeds of $6.1 million.

- Renewed the Corporation's credit facility, whereby total funds available under the credit facility remain unchanged at $45 million.



SUMMARY OF FINANCIAL AND OPERATING RESULTS

Three months Three months Three months
In $000's unless referring to ended ended ended
volumetric measures or Dec 31, 2009 Sept 30, 2009 Dec 31, 2008
otherwise noted (unaudited) (unaudited) (unaudited)
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 8,751 9,918 10,058
Oil and NGLs (bbl/d) 449 436 453
----------------------------------------------------------------------------
Oil equivalent (boe/d) 1,907 2,089 2,130
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) (1) $ 4.93 $ 3.17 $ 7.35
Oil and NGLs ($/bbl) $ 57.95 $ 49.82 $ 51.78
----------------------------------------------------------------------------
Oil equivalent ($/boe) (1) $ 36.23 $ 25.71 $ 45.75
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 6,358 $ 4,941 $ 8,965
Operating income $ 3,215 $ 1,818 $ 4,191
Funds flow from operations $ 2,201 $ 880 $ 3,694
Net earnings (loss) $ (2,265) $ (4,809) $ (2,110)
Total capital expenditures (2) $ 9,958 $ (1,076) $ 10,900

Per Share:
Funds flow from operations
per share:
Basic $ 0.05 $ 0.03 $ 0.11
Diluted $ 0.05 $ 0.03 $ 0.11

Net earnings (loss) per share:
Basic and diluted $ (0.06) $ (0.15) $ (0.06)

Financial Position:
Net debt (surplus) $ 24,997 $ 32,204 $ 37,924
Total assets $ 136,441 $ 123,789 $ 147,119
Total long-term liabilities $ 4,646 $ 4,610 $ 4,516
Shareholders' equity $ 98,096 $ 84,976 $ 99,063

Share data:
Outstanding:
Common shares 41,002,500 32,902,500 32,902,500
Non-voting shares - - -
----------------------------------------------------------------------------
Total outstanding 41,002,500 32,902,500 32,902,500
Stock options 3,968,166 3,135,666 3,135,666
----------------------------------------------------------------------------
Total diluted shares
outstanding 44,970,666 36,038,166 36,038,166
----------------------------------------------------------------------------
Weighted average:
Basic 40,914,457 32,902,500 32,902,500
Diluted 42,726,800 33,191,051 32,904,058
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Year Year Year
In $000's unless referring to ended ended ended
volumetric measures or Dec 31, 2009 Dec 31, 2008 Dec 31, 2007
otherwise noted (audited) (audited) (audited)
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 10,430 8,062 7,410
Oil and NGLs (bbl/d) 454 292 246
----------------------------------------------------------------------------
Oil equivalent (boe/d) 2,192 1,636 1,481
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) (1) $ 4.34 $ 8.39 $ 7.18
Oil and NGLs ($/bbl) $ 48.21 $ 78.90 $ 67.47
----------------------------------------------------------------------------
Oil equivalent ($/boe) (1) $ 30.63 $ 55.60 $ 47.25
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 24,510 $ 33,289 $ 25,536
Operating income $ 10,313 $ 18,099 $ 14,121
Funds flow from operations $ 6,545 $ 15,004 $ 11,852
Net earnings (loss) $ (16,733) $ 903 $ 806
Total capital expenditures (2) $ 8,168 $ 66,581 $ 36,017

Per Share:
Funds flow from operations
per share:
Basic $ 0.19 $ 0.54 $ 0.50
Diluted $ 0.18 $ 0.54 $ 0.50

Net earnings (loss) per share:
Basic and diluted $ (0.48) $ 0.03 $ 0.03

Financial Position:
Net debt (surplus) $ 24,997 $ 37,924 $ 15,142
Total assets $ 136,441 $ 147,119 $ 90,978
Total long-term liabilities $ 4,646 $ 4,516 $ 2,366
Shareholders' equity $ 98,096 $ 99,063 $ 69,908

Share data:
Outstanding:
Common shares 41,002,500 32,902,500 19,993,066
Non-voting shares - - 5,061,096
----------------------------------------------------------------------------
Total outstanding 41,002,500 32,902,500 25,054,162
Stock options 3,968,166 3,135,666 2,295,666
----------------------------------------------------------------------------
Total diluted shares
outstanding 44,970,666 36,038,166 27,349,828
----------------------------------------------------------------------------
Weighted average:
Basic 34,921,952 27,735,885 23,713,491
Diluted 36,762,557 27,736,277 23,878,617
----------------------------------------------------------------------------
----------------------------------------------------------------------------

(1) Includes processing, marketing income and gains (losses) on financial
instruments.
(2) Net of disposition proceeds.


FOURTH QUARTER 2009 VERSUS THIRD QUARTER 2009

Three months Three months
ended Dec 31, ended Sept 30, Percentage
2009 2009 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (mcf/d) 8,751 9,918 (12)
Oil and NGLs (bbl/d) 449 436 3
----------------------------------------------------------------------------
Oil equivalent (boe/d) 1,907 2,089 (9)
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) 4.78 3.17 51
Natural gas including financial
instruments ($/mcf) 4.93 3.17 56
Oil and NGLs ($/bbl) 57.95 49.82 16
----------------------------------------------------------------------------
Oil equivalent ($/boe) 35.56 25.71 38
Oil equivalent including
financial instruments ($/boe) 36.23 25.71 41
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the three months ended December 31, 2009, Monterey's average daily production was 1,907 boe/d, which is nine percent lower than the 2,089 boe/d average daily production for the third quarter of 2009. The decrease over the previous quarter primarily consists of natural decline on Monterey's producing properties, nominally offset by a nominal increase in liquids volumes.

Realized Prices

During the fourth quarter the Corporation entered into a financial commodity price risk management contract. Under the terms of the contract, Monterey agreed to market 2,000 gigajoules of natural gas per day at a price of $5.07 per gigajoule for the period from November 1, 2009 to December 31, 2009, ultimately realizing a gain of approximately $86,000.

Including the impact of financial instruments, Monterey's average realized natural gas price during the fourth quarter of 2009 was $4.93 per mcf, an increase of 56 percent relative to the Corporation's average realized natural gas price per mcf of $3.17 during the third quarter of 2009. Monterey's average realized liquids price for the fourth quarter of 2009 increased by 16 percent when compared to the third quarter.

The increase in Monterey's average sales prices during the fourth quarter is consistent with increased seasonal demand following the commencement of the North American winter heating season.

The 16 percent increase in Monterey's average liquids price received over the third quarter of 2009 was consistent with the change in the market.

To reduce the impact on production revenue from fluctuations in the North American natural gas prices Monterey was a party to the following forward commodity price contracts as at and subsequent to December 31, 2009:




Contract Unrealized
Volume Prices Gain
Term Instrument (GJ per day) ($ per GJ) $000's
----------------------------------------------------------------------------
February 1 - March 31, 2010 Fixed Price 2,000 5.40 $15
----------------------------------------------------------------------------
April 1 - June 30, 2010 Fixed Price 1,000 5.42 $17
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Entered into subsequent to December 31, 2009:
----------------------------------------------
April 1 - October 31, 2010 Fixed Price 1,000 5.425 -
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Royalties

During the fourth quarter, the Corporation had an average royalty cost per boe of $3.01. In comparison to the third quarter, the Corporation had an average royalty cost per boe of $4.18. The decrease in royalty costs per boe over the third quarter of 2009 despite higher realized oil and gas prices was due to re-filing previous year's gas cost allowance credits on properties obtained in the 2008 acquisition of Upper Lake Oil and Gas Ltd. The average royalty rate decreased to eight percent in the fourth quarter, down from 16 percent in the third quarter due to the aforementioned gas cost allowance credits.

Operating Costs

Relative to the third quarter of 2009, operating costs per boe increased to $13.32 from $10.78 per boe. The primary reason for the unfavorable variance during the fourth quarter of 2009 was due to the commencement of winter operating conditions which historically result in higher overall operating costs associated with the mechanical equipment repairs and thawing of frozen hydrates in wellheads and pipelines.

Transportation Costs

Transportation costs during the fourth quarter of 2009 increased nominally in relation to the third quarter. On a per boe basis, the unit transportation cost for the fourth quarter of $1.58 per boe is 22 percent higher than transportation costs recorded in the third quarter of 2009 of $1.29 per boe. Higher pipeline tariff costs during the fourth quarter accounted for the increase in both total and per boe transportation costs.

Operating Income

During the fourth quarter of 2009, Monterey's average realized operating income per boe increased to $18.32, an increase of approximately 94 percent relative to operating income per boe of $9.46 during the third quarter of 2009. The increase is primarily attributable to higher commodity prices, partially offset by incremental operating expenditures associated with the Corporation's commencement of winter operations during the fourth quarter.



Change due to:
----------------
Three Three
months months
ended ended
Dec 31, Price/ Sept 30,
($000's) 2009 Cost Volume 2009
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 3,848 1,252 (347) $ 2,943
Oil and NGLs sales 2,392 335 59 1,998
Gain / (loss) from financial
instruments 118 118 - -
----------------------------------------------------------------------------
6,358 1,705 (288) 4,941

Royalties 529 (204) (70) 803
Operating costs 2,337 445 (180) 2,072
Transportation costs 277 51 (22) 248
----------------------------------------------------------------------------

Operating income $ 3,215 1,413 (16) $ 1,818
----------------------------------------------------------------------------
$/boe $ 18.32 $ 9.46
----------------------------------------------------------------------------


Depletion, Depreciation and Accretion ("DD&A")
-----------------------------------------------
Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2009 2009
----------------------------------------------------------------------------
Oil and gas properties $ 4,127 $ 5,409
Office equipment 17 17
Asset retirement accretion 174 179
----------------------------------------------------------------------------
$ 4,318 $ 5,605
----------------------------------------------------------------------------
$/boe $ 24.61 $ 28.18
----------------------------------------------------------------------------


DD&A expense for the fourth quarter of 2009 decreased by approximately $1.3 million over the previous quarter. The decrease in DD&A expense per boe reflects the Corporation's improvement in efficiency of adding proved reserves as a result of exploration and development of the Montney resource at Groundbirch in NEBC. The reduction in DD&A expense relative to the third quarter is due to the combination of the lower DD&A rate and production volumes.

General & Administrative ("G&A")

Total general and administrative costs for the fourth quarter of 2009 were higher than costs incurred during the third quarter of 2009. The increase in fourth quarter G&A reflects the hiring of new employees, payment of the 2009 bonus and stock-based compensation expense associated with options granted during the fourth quarter.



Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2009 2009
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 732 $ 627
Stock-based compensation 180 84
----------------------------------------------------------------------------
Total expensed G&A $ 912 $ 711
----------------------------------------------------------------------------
$/boe $ 5.21 $ 3.71
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 266 $ 236
Stock-based compensation 82 45
----------------------------------------------------------------------------
Total capitalized G&A $ 348 $ 281
----------------------------------------------------------------------------
$/boe $ 1.98 $ 1.46
----------------------------------------------------------------------------

Total G&A costs $ 1,260 $ 992
----------------------------------------------------------------------------
$/boe $ 7.19 $ 5.17
----------------------------------------------------------------------------


The capitalized general and administrative costs include both general and administrative cash expenditures and non-cash stock-based compensation associated with exploration and development activities. The table below provides additional disclosure of the components of capitalized general and administrative costs.



Three months Three months
ended Dec 31, ended Sept 30,
(in $000's) 2009 2009
----------------------------------------------------------------------------
Salaries and employment costs $ 216 $ 183
Office rent 48 51
Other general and administrative costs 2 2
----------------------------------------------------------------------------
Capitalized cash general and administrative costs $ 266 $ 236
----------------------------------------------------------------------------
Capitalized stock-based compensation 82 45
----------------------------------------------------------------------------
Capitalized non-cash costs $ 82 $ 45
----------------------------------------------------------------------------

Total capitalized general and administrative costs $ 348 $ 281
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest
Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2009 2009
----------------------------------------------------------------------------
Interest expense $ 258 $ 317
Interest income (8) (6)
----------------------------------------------------------------------------
Net interest expense / (income) $ 250 $ 311
----------------------------------------------------------------------------
$/boe $ 1.42 $ 1.62
----------------------------------------------------------------------------


The 20 percent decrease in the fourth quarter net interest expense and 12 percent decrease net interest expense per boe, relative to the third quarter is the result of the reduction in average bank debt during the fourth quarter following the closing of the October 1, 2009 share issuance.



FUNDS FLOW FROM OPERATIONS

Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2009 2009
----------------------------------------------------------------------------
Operating income $ 3,215 $ 1,818
Unrealized gain on financial instruments (32) -
General and administrative expenses (1) (732) (627)
Net interest expense (250) (311)
----------------------------------------------------------------------------
Funds flow from operations $ 2,201 $ 880
----------------------------------------------------------------------------

Operating income per boe $ 18.32 $ 9.46
Unrealized gain on financial instruments (0.18) -
General and administrative expenses (1) (4.17) (3.26)
Interest expense (1.42) (1.62)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 12.55 $ 4.58
----------------------------------------------------------------------------
(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.


Monterey's funds flow from operations for the fourth quarter of 2009 increased by approximately $1.3 million in comparison to the third quarter of 2009 as a result higher commodity prices being partially offset by the combination of natural production decline and higher operating costs due to commencement of winter operations.

Fourth quarter unit funds flow from operations of $12.55 per boe was 174 percent higher than the $4.58 per boe recorded in the third quarter due to higher oil and gas prices.



FOURTH QUARTER 2009 VERSUS FOURTH QUARTER 2008

Three months ended
Dec 31, Dec 31, Percentage
2009 2008 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (Mcf/d) 8,751 10,058 (13)
Oil and NGLs (Bbl/d) 449 453 (1)
----------------------------------------------------------------------------
Oil equivalent (Boe/d) 1,907 2,130 (10)
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/Mcf) 4.78 7.35 (35)
Natural gas including financial
instruments ($/Mcf) 4.93 7.35 (33)
Oil and NGLs ($/Bbl) 57.95 51.78 12
----------------------------------------------------------------------------
Oil equivalent ($/Boe) 35.56 45.75 (22)
Oil equivalent including financial
instruments ($/Boe) 36.23 45.75 (21)
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the three months ended December 31, 2009, Monterey's average daily production was 1,907 boe per day, a decrease of 223 boe per day or 10 percent compared to the average daily production for the fourth quarter of 2008. The decrease in production relative to the fourth quarter of 2008 represents natural decline on the Corporation's producing properties.

Realized Prices

Monterey's average natural gas price including financial instruments during the fourth quarter of 2009 was $4.93 per mcf, a significant decrease of 33 percent in relation to the average natural gas price during the comparative quarter in 2008. During 2009, North American natural storage inventories were high, relative to historical norms, and industrial demand was reduced as a result of weaker economic conditions. The commencement of the 2009 winter heating season helped firm natural gas prices over the third quarter of 2009; however, the 2009 heating demand impact on sales prices was insufficient to lift the fourth quarter average natural gas price received by Monterey to the level recorded in the comparative fourth quarter of 2008.

Monterey's average realized liquids price increased by 12 percent in comparison to the fourth quarter of 2008, as the stabilization and recovery of world liquids prices and underlying demand has taken place faster than the recovery of natural gas prices in North America.

Royalties

Monterey's average royalty rate in the fourth quarter of 2009 was eight percent, as compared to the average royalty rate of 17 percent during the comparative quarter of 2008. On a per boe basis royalties decreased from $7.98 during the fourth quarter of 2008 to $3.01 in the current quarter. The decrease in royalty costs per boe over the fourth quarter of 2008 was due to the combination of lower average realized natural gas prices as well as re-filing previous year's gas cost allowance credits on properties obtained in the 2008 acquisition of Upper Lake Oil and Gas Ltd.

Operating Costs

Relative to the fourth quarter of 2008, operating costs per boe decreased by $1.29 or nine percent from $14.61 to $13.32 during the current quarter. The 2009 decrease is largely explained by cost control and optimization activities completed at Monterey's Harmattan area.

Transportation Costs

Transportation costs of $1.58 per boe for the fourth quarter of 2009 decreased by 11 percent from costs incurred of $1.78 per boe during the fourth quarter of 2008. The decrease is the result of the expiry of Monterey's firm service transportation agreements in late 2008; the cost of the firm service transportation rendered a higher average transportation cost per boe.

Operating Income

On a per boe basis Monterey's average operating income for the fourth quarter of 2009 decreased by $3.06 per boe to $18.32, predominately due to the decrease in the prices received for the Corporation's natural gas volumes relative to the comparative quarter of 2008.



Three Three
months Change due to: months
ended ------------------- ended
Dec 31, Price/ Dec 31,
($000's) 2009 Cost Volume 2008
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 3,848 (2,073) (884) $ 6,805
Oil and NGLs sales 2,392 255 (23) 2,160
Gain / (loss) from financial
instruments 118 118 - -
----------------------------------------------------------------------------
6,358 (1,700) (907) 8,965

Royalties 529 (872) (162) 1,563
Operating costs 2,337 (227) (299) 2,863
Transportation costs 277 (35) (36) 348
----------------------------------------------------------------------------

Operating income $ 3,215 (566) (410) $ 4,191
----------------------------------------------------------------------------
$/boe $ 18.32 $ 21.38
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Depletion, Depreciation and Accretion Expense
----------------------------------------------

Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Oil and gas properties $ 4,127 $ 5,274
Office equipment 17 32
Asset retirement accretion 174 125
----------------------------------------------------------------------------
$ 4,318 $ 5,431
----------------------------------------------------------------------------
$/boe $ 24.61 $ 27.72
----------------------------------------------------------------------------


In comparison to the three months ended December 31, 2008, the DD&A provision in 2009 decreased 20 percent due to the combination of the 11 percent decrease in the unit DD&A expense per boe and a 10 percent decrease in production volumes from natural production declines. The DD&A expense per boe decreased by $3.11 as proved reserves added from 2009 exploration and development activities on the Montney resource in the Groundbirch area of NEBC had a significantly lower average cost relative to Monterey's 2008 proved reserve base.

General & Administrative

Total General and Administrative expense for the fourth quarter of 2009 was nearly $0.3 million higher than total G&A expense for the same quarter during 2008. The average cost per boe for fourth quarter 2009 total G&A expenses increased 80 percent to $5.21 per boe reflecting incremental costs associated with the hiring of new employees, higher stock-based compensation expense in respect of options granted during the current quarter and a lower production base.

Total capitalized G&A decreased by approximately $0.1 million, or $0.21 per boe as compared to the fourth quarter of 2008. The decrease is the result of lower capitalized salaries and employment costs in respect of exploration activities.

The net impact of the increase in fourth quarter 2009 total expensed G&A and offset by the decrease in total capitalized G&A led to the 2009 fourth quarter total G&A being 26 percent higher than the amount recorded in 2008. The following table summarizes the G&A costs recorded for each of the fourth quarters of 2009 and 2008.



Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 732 $ 433
Stock-based compensation 180 136
----------------------------------------------------------------------------
Total expensed G&A $ 912 $ 569
----------------------------------------------------------------------------
$/boe $ 5.21 $ 2.90
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 266 $ 344
Stock-based compensation 82 85
----------------------------------------------------------------------------
Total capitalized G&A $ 348 $ 429
----------------------------------------------------------------------------
$/boe $ 1.98 $ 2.19
----------------------------------------------------------------------------

Total G&A costs $ 1,260 $ 998
----------------------------------------------------------------------------
$/boe $ 7.19 $ 5.09
----------------------------------------------------------------------------


The capitalized general and administrative costs include both general and administrative cash expenditures and non-cash stock-based compensation associated with exploration and development activities. The table below provides additional disclosure of the components of capitalized general and administrative costs.



Three months Three months
ended Dec 31, ended Dec 31,
(in $000's) 2009 2008
----------------------------------------------------------------------------
Salaries and employment costs $ 216 $ 294
Office rent 48 48
Other general and administrative costs 2 2
----------------------------------------------------------------------------
Capitalized cash general and administrative costs $ 266 $ 344
----------------------------------------------------------------------------
Capitalized stock-based compensation 82 85
----------------------------------------------------------------------------
Capitalized non-cash costs $ 82 $ 85
----------------------------------------------------------------------------

Total capitalized general and administrative costs $ 348 $ 429
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest
---------

Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Interest expense $ 258 $ 276
Interest income (8) -
----------------------------------------------------------------------------
Net interest expense / (income) $ 250 $ 276
----------------------------------------------------------------------------
$/boe $ 1.42 $ 1.40
----------------------------------------------------------------------------


Net interest expense for the fourth quarter of 2009 was lower than net interest expenses during the comparative quarter of 2008 due to a decrease in the amount of Monterey's bank debt. Despite the reduction in total net interest expense in the current quarter, the decrease in Monterey's production volumes from the fourth quarter of 2008 from natural declines led to a nominal increase in the Corporation's net interest expense per boe relative to the fourth quarter of 2008.



FUNDS FLOW FROM OPERATIONS

Three months ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------

Operating income $ 3,215 $ 4,191
Unrealized (gain) loss on financial instruments (32) 212
General and administrative expenses (1) (732) (433)
Interest expense (250) (276)
----------------------------------------------------------------------------
Funds flow from operations $ 2,201 $ 3,694
----------------------------------------------------------------------------

Operating income per boe $ 18.32 $ 21.38
Unrealized (gain) loss on financial instruments (0.18) 1.08
General and administrative expenses (1) (4.17) (2.21)
Interest expense (1.42) (1.40)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 12.55 $ 18.85
----------------------------------------------------------------------------
(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.


The Corporation's funds flow from operations for the current quarter of $2.2 million was 40 percent lower than the $3.7 million reported during same quarter of 2008. The decrease was due to the combination of the 35 percent reduction in the average natural gas price and the 10 percent natural decline in production volumes from natural decline.

On a per boe basis, funds flow from operations was 33 percent lower during the fourth quarter of 2009, again, primarily from lower natural gas prices.



YEAR ENDED DEC 31, 2009 VERSUS YEAR ENDED DEC 31, 2008

Year ended
Dec 31, Dec 31, Percentage
2009 2008 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (Mcf/d) 10,430 8,062 29
Oil and NGLs (Bbl/d) 454 292 55
----------------------------------------------------------------------------
Oil equivalent (Boe/d) 2,192 1,636 34
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/Mcf) 4.31 8.61 (50)
Natural gas including financial
instruments ($/Mcf) 4.34 8.39 (48)
Oil and NGLs ($/Bbl) 48.21 78.90 (39)
----------------------------------------------------------------------------
Oil equivalent ($/Boe) 30.49 56.71 (46)
Oil equivalent including financial
instruments ($/Boe) 30.63 55.60 (45)
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the year ended December 31, 2009, Monterey's average daily production was 2,192 boe/d, 556 boe/d or 34 percent higher than the average daily production for 2008 of 1,636 boe/d. Increased sales volumes relative to 2008 primarily resulted from the impact of a full year's production resulting from the September 2008 acquisition of Upper Lake combined with new production added during the first quarter 2009 at Ferrybank.

Realized Prices

Monterey's average realized natural gas price including financial instruments during the year ended 2009 was $4.34 per mcf, a decrease of 48 percent in relation to the average realized natural gas price during the comparative period in 2008 of $8.39 per mcf. Natural gas prices were at their lowest levels during 2009 in comparison to recent years. In 2009, lingering economic uncertainty from the world financial crisis which began in September 2008 accompanied by record levels of natural gas in North American storage led to soft natural gas prices during 2009, particularly during the summer months.

In 2008 the Corporation's natural gas hedge was outstanding for a longer period of time, and was at a price below market resulting in a loss from natural gas hedging activity (financial instruments) of nearly $0.7 million whereas, the Corporation's fixed price volumes in 2009 resulted in a nominal gain during 2009 of $0.1 million. Details of the contracts entered into during 2008, 2009 and subsequent to the end of 2009 are noted in the table below:



Contract
Volume Prices
Term Instrument (GJ per day) ($ per GJ)
----------------------------------------------------------------------------
2008 Hedge Contract:
--------------------
--------------------
April 1, 2008 - October 31, 2008 Fixed Price 4,000 7.63
----------------------------------------------------------------------------
2009 Hedge Contracts:
---------------------
---------------------
November 1, 2009 - December 31, 2009 Fixed Price 2,000 5.07
February 1, 2010 - March 31, 2010 Fixed Price 2,000 5.40
April 1, 2010 - June 30, 2010 Fixed Price 1,000 5.42
----------------------------------------------------------------------------
Entered into subsequent to 2009:
---------------------------------
---------------------------------
April 1, 2010 - October 31, 2010 Fixed Price 1,000 5.425
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Monterey's average realized liquids price decreased by 39 percent, in comparison to 2008 from weak global economic conditions that led to reduced demand.

The 45 percent decrease in Monterey's 2009 average realized sales price per boe over 2008 was the result of weaker demand for oil and natural gas associated with prolonged worldwide economic instability.

Royalties

Monterey's average royalty rate for the year ended December 31, 2009 was 14 percent, a four percent decrease compared to the 18 percent average royalty rate during the year ended 2008. The decrease in Monterey's average royalty rate is primarily the result of lower average sales prices relative to 2008. On a per boe basis, the Corporation's royalty cost per boe was $4.32 in 2009 versus $10.08 during 2008.

Operating Costs

Relative to the year ended December 31, 2008, operating costs per boe decreased by 13 percent or $1.71 per boe from $13.56 in 2008 to $11.85 in 2009. The decrease is primarily attributed to optimization and cost saving measures undertaken at Monterey's core property areas, specifically at Harmattan and winter access only areas such as Red Eye. The $1.4 million increase in 2009 total operating costs over 2008 was entirely due to higher production volumes.

Transportation Costs

Transportation costs for the year ended December 31, 2009 averaged $1.57 per boe, down from $1.73 per boe during 2008. The absence of higher cost per unit fixed rate transportation agreements in 2009 was the primary reason for the favorable variance.

Operating Income

On a per boe basis Monterey's average operating income for the year ended December 31, 2009 decreased by $17.34 per boe to $12.89. The $7.8 million decrease in operating income is primarily the net result of lower commodity prices, which led production revenue to fall about 62 percent, partially offset by the impact of increased sales volumes.



Year Change due to: Year
ended ------------------- ended
Dec 31, Price/ Dec 31,
($000's) 2009 Cost Volume 2008
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 16,405 (16,481) 7,370 $ 25,516
Oil and NGLs sales 7,987 (5,084) 4,637 8,434
Gain / (loss) from financial
instruments 118 780 - (662)
----------------------------------------------------------------------------
24,510 (20,785) 12,007 33,289

Royalties 3,461 (4,609) 2,033 6,037
Operating costs 9,483 (1,368) 2,732 8,119
Transportation costs 1,253 (128) 348 1,033
----------------------------------------------------------------------------

Operating income $ 10,313 (14,680) 6,894 $ 18,099
----------------------------------------------------------------------------
$/boe $ 12.89 $ 30.23
----------------------------------------------------------------------------
----------------------------------------------------------------------------
(1) May not add due to rounding


Depletion, Depreciation and Accretion Expense
----------------------------------------------
Year Year
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Oil and gas properties $ 22,086 $ 14,926
Office equipment 69 58
Asset retirement accretion 727 364
----------------------------------------------------------------------------
$ 22,882 $ 15,348
----------------------------------------------------------------------------
$/boe $ 28.60 $ 25.64
----------------------------------------------------------------------------


The 2009 DD&A provision of $22.9 million is 49 percent more than the $15.3 million recorded in 2008. The increase in the 2009 provision can largely be explained by the growth in production volumes in 2009. In comparison to the year ended December 31, 2008, DD&A unit cost per boe increased 12 percent or $2.96 to $28.60 per boe. Significant proved reserve additions were recognized in the fourth quarter of 2009 as a result of exploration and development of the Corporation's Montney asset in the Groundbirch area of northeast British Columbia. With continued operational success at Groundbirch, Monterey anticipates that DD&A expense per boe should be lower in 2010.

General & Administrative

Total expensed G&A costs in 2009 of almost $3.1 million were approximately $0.6 million higher than in 2008. The increase largely reflects the incremental costs associated with being a public entity and higher office rent costs. During the previous year, Monterey became a public entity in September; therefore, only a portion of these incremental costs impacted total expensed G&A costs during 2008. On a per boe basis, total expensed G&A costs decreased $0.28 or seven percent as a result of higher sales volumes in 2009.

Total capitalized G&A costs decreased nominally in comparison to 2008; however, higher sales volumes in 2009 enabled the Corporation to reduce the capitalized G&A cost per boe by 29 percent to $1.52.

The net impact of the increase in total expensed G&A and nominal decrease in total capitalized G&A led to a $0.6 million increase in total G&A costs, despite a $0.90 or 14 percent reduction in total G&A costs per boe.

The following table provides a breakdown of General & Administrative expenses.



Year Year
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 2,702 $ 2,075
Stock-based compensation 428 435
----------------------------------------------------------------------------
Total expensed G&A $ 3,130 $ 2,510
----------------------------------------------------------------------------
$/boe $ 3.91 $ 4.19
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 998 $ 1,021
Stock-based compensation 216 258
----------------------------------------------------------------------------
Total capitalized G&A $ 1,214 $ 1,279
----------------------------------------------------------------------------
$/boe $ 1.52 $ 2.14
----------------------------------------------------------------------------

Total G&A costs $ 4,344 $ 3,789
----------------------------------------------------------------------------
$/boe $ 5.43 $ 6.33
----------------------------------------------------------------------------


The capitalized general and administrative costs include both general and administrative cash expenditures and non-cash stock-based compensation associated with exploration and development activities. The table below provides additional disclosure of the components of capitalized general and administrative costs.



Year Year
ended Dec 31, ended Dec 31,
(in $000's) 2009 2008
----------------------------------------------------------------------------
Salaries and employment costs $ 794 $ 865
Office rent 195 128
Other general and administrative costs 9 28
----------------------------------------------------------------------------
Capitalized cash general and administrative costs $ 998 $ 1,021
----------------------------------------------------------------------------
Capitalized stock-based compensation 216 258
----------------------------------------------------------------------------
Capitalized non-cash costs $ 216 $ 258
----------------------------------------------------------------------------

Total capitalized general and administrative
costs $ 1,214 $ 1,279
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest
---------
Year Year
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------
Interest expense $ 1,101 $ 1,034
Interest income (67) (15)
----------------------------------------------------------------------------
Net interest expense $ 1,034 $ 1,019
----------------------------------------------------------------------------
$/boe $ 1.29 $ 1.70
----------------------------------------------------------------------------


Net interest expense for the year ended December 31, 2009 nominally exceeded net interest expense during the 2008, on a per boe basis Monterey's net interest expense of $1.29 per boe in 2009 decreased by $0.41 relative to 2008. The nominal increase in net interest expense primarily results from higher average outstanding bank debt in 2009, while the decrease in net interest expense per boe represents higher total sales volumes in the current year as compared to 2008.



FUNDS FLOW FROM OPERATIONS

Year ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2009 2008
----------------------------------------------------------------------------

Operating income $ 10,313 $ 18,099
Unrealized gain on financial instruments (32) -
General and administrative expenses (1) (2,702) (2,075)
Net interest expense (1,034) (1,019)
----------------------------------------------------------------------------
Funds flow from operations (3) $ 6,545 $ 15,004
----------------------------------------------------------------------------

Operating income per boe $ 12.89 $ 30.23
Unrealized gain on financial instruments (0.04) -
General and administrative expenses (1) (3.38) (3.47)
Interest expense (1.29) (1.70)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 8.18 $ 25.06
----------------------------------------------------------------------------
(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.
(3) May not add due to rounding.


Relative to 2008, Monterey's funds flow from operations for 2009 decreased by 56 percent and by 67 percent on a per boe basis, primarily due to the impact of lower average sales prices partially offset by the increase in production over the previous year.

INCOME TAXES

During the three months and year ended December 31, 2009 Monterey did not pay any cash income taxes and does not anticipate the payment of any cash income taxes in the foreseeable future. At December 31, 2009 Monterey has tax pools totaling approximately $194.3 million available to be utilized against future taxable income. The tax pools include approximately $45.0 million in non-capital losses to reduce future taxable income, $69.8 million in Canadian exploration and development expenses, $45.2 million in oil and gas property expenses, $32.6 million in tangible expenses and $1.7 million of share issue costs.

In accordance with GAAP the financial statements do not reflect the full value of benefit of the tax pools. In order to recognize the value of the pools in the financial statements, the Corporation has to demonstrate that it may generate consistent, future annual profitability to utilize such pools.

Based upon the application of the December 31, 2009 income tax pools against future net funds flow from operations that will be generated from estimated proved developed producing reserves, approximately $16.0 million, $28.3 million and $0.7 million of the non-capital losses may expire unutilized at the end of 2010, 2011, and 2012 respectively. Nonetheless, Management anticipates that increased funds flow from operations resulting from future successful exploration and development activities and acquisitions will reduce this risk of non-capital losses expiring unutilized.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2009 the Corporation had total capitalization of more than $123 million consisting of $25 million in net debt and approximately $98 million in equity. Monterey increases shareholder value primarily by growing its oil and natural gas reserves in a cost effective manner. The Corporation's operations and exploration and development programs are financed by a combination of funds flow from operations resulting from the production and sale of oil and gas reserves, utilization of working capital, bank borrowings or other debt, dispositions of non-core oil and gas properties and if necessary equity financing.



Capitalization Dec 31, 2009 Dec 31, 2008
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Net current deficiency $ 2,393 $ 2,593
Bank indebtedness 22,559 35,286
Long term obligations under capital lease - 45
Share capital 108,066 92,944
Contributed surplus 4,322 3,678
Retained earnings (deficit) (14,292) 2,441
----------------------------------------------------------------------------
Total Capitalization $ 123,048 $ 136,987
----------------------------------------------------------------------------
----------------------------------------------------------------------------


In 2009 Monterey's capital expenditures were primarily directed to the exploration and development of its natural gas resource project in the Groundbirch area of northeast British Columbia and bank indebtedness was reduced in response to the challenging economic environment. Funds flow from operations, dispositions of non-core oil and gas properties and an infusion of equity capital financed the capital spending and reduction in bank indebtedness.

In 2010 Monterey anticipates that capital spending will continue to be mainly directed to the exploration and development of the natural gas resource projects in the Brassey and Groundbirch areas of northeast British Columbia. The funding for the capital spending will be financed by a combination of funds flow from operations, bank borrowing or other funding arrangements, non-core property dispositions or issuances of equity. The impact on funds flow from operations resulting from growth in production as a result of the 2009 exploration and development program will be realized in late 2010 or early 2011 when the recently added Groundbirch reserves are placed on-stream. As a result the Corporation completed an equity offering in February 2010 that provided Monterey with sufficient funding to continue its exploration and development program while maintaining prudent levels of bank debt. Management reviews its net debt to equity ratio and net debt to forward cash flow and compares the ratios to accepted prudent financial ratios, against the ratios of similar sized publicly listed entities operating in the upstream oil and gas exploration and development industry and the anticipated business environment, opportunities and operations of the Corporation. If any of Monterey's ratios do not meet Management's expectations then action such as an equity financing, disposition of oil or gas properties, or reduction of capital expenditure programs would be undertaken to ensure the Corporation is able to settle its obligations when due and to carry on conducting business.

Net current deficiency

As at December 31, 2009 Monterey had a net current deficiency of $2.4 million, which is nominally lower that the net current deficiency as at December 31, 2008. Despite a 33 percent reduction in the Corporation's fourth quarter 2009 average natural gas price relative to the comparative quarter during 2008, and a more active winter drilling program in the current period, the issuance of common shares on October 1, 2009 enabled the Corporation to reduce bank indebtedness and prevent the net current deficiency from increasing.

Bank indebtedness

The Corporation has access to a demand revolving credit facility (the "Facility") of $45 million and a derivatives facility with a Canadian banking institution (the "Lender"). The forms, costs and terms of borrowing under the Facility are fully disclosed in Note 6 to the December 31, 2009 audited financial statements.

During 2009, Monterey made drawings against the Facility in the form of prime based loans and guaranteed rate term notes with maturities of up to 365 days from issue. As at December 31, 2009, Monterey had bank indebtedness of approximately $22.6 million (2008 - $35.3 million) in guaranteed rate notes having terms to maturity of less than one year.

Management reviews its net debt to equity ratio and net debt to forward cash flow and compares the ratios to accepted prudent financial ratios, against the ratios of similar sized publicly listed entities operating in the upstream oil and gas exploration and development industry and the anticipated business environment, opportunities and operations of the Corporation. If any of Monterey's ratios do not meet Management's expectations then action such as a reduction in the capital expenditure program, disposition of oil or gas properties or an equity financing would be undertaken to ensure the Corporation is able to settle it obligations when due and to carry on conducting its oil and gas operations.

The Lender reviews the Facility at least annually. The next annual review is scheduled to be completed prior to June 1, 2010. In 2009, Monterey's proved and proved plus probable oil and natural gas reserves increased 18 percent, after accounting for 2009 production; however the before income taxes estimated future net revenues (discounted at 10 percent) decreased by nearly 34 percent for proved reserves and 19 percent for total proved plus probable reserves from December 31, 2008. The decrease in the discounted value of the reserves is due to the application of lower forecast natural gas prices and the inclusion estimated future development capital to place the Groundbirch reserves on production. Management anticipates that the reduction in the estimated future value of the proved reserves may lead to a reduction in the Lender's calculated borrowing base at the next annual review of the Facility. As a result, Management has already taken or is implementing action to ensure that the amount and timing of the 2010 capital spending will not exceed the Corporation's financial resources.

Share Capital

During the fourth quarter of 2009, 8,100,000 common shares were issued for total cash proceeds of approximately $16.1 million. Of this total, 2,650,000 common shares were issued on a flow-through basis, which will require the Corporation to incur $6,042,000 in exploration expenditures by December 31, 2010. As at December 31, 2009 Monterey had incurred approximately $3,750,000 in exploration expenditures, leaving $2,292,000 to be incurred prior to the end of 2010.

In February 2010 Monterey completed an equity financing providing approximately $18.8 million, net of the underwriters' fee and issue costs, by issuing 4,762,000 common shares at a price of $4.20 per share. The net proceeds from this financing will be utilized to assist with the financing of Monterey's 2010 exploration and development of the Groundbirch area natural gas resource project located in NEBC.

At March 18, 2010, Monterey had 45,764,500 voting common shares outstanding, and has granted stock options providing rights to holders to acquire up to 3,968,666 common shares.

Contributed Surplus

The Corporation's contributed surplus is equal to the fair value of stock options accrued over the vesting period of the stock options. The fair value of the stock options is estimated at the date the options are granted using the Black-Scholes option pricing model. When shares are issued as a result of the exercise of stock options the fair value of the stock option reflected in contributed surplus is credited to share capital and the contributed surplus balance reduced.



CAPITAL EXPENDITURES

Three Months ended Year ended
Dec 31, Dec 31, Dec 31, Dec 31,
2009 2008 2009 2008
----------------------------------------------------------------------------
Land and retention $ 33 $ 1,181 $ 200 $ 6,452
Geological and geophysical 256 78 468 840
Drilling and completions 9,044 6,426 13,569 19,390
Production equipment and facilities 359 2,967 1,687 5,145
Capitalized G&A 266 344 998 1,021
----------------------------------------------------------------------------

Exploration and development
expenditures $ 9,958 $ 10,996 $ 16,922 $ 32,848
Property acquisitions - 100 - 377
Office furniture, equipment and
software - 188 - 201
----------------------------------------------------------------------------

Capital expenditures before
dispositions $ 9,958 $ 11,284 $ 16,922 $ 33,426
Property dispositions - (315) (8,754) (1,582)
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Capital expenditures $ 9,958 $ 10,969 $ 8,168 $ 31,844
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Monterey's total capital spending during the fourth quarter of 2009 was approximately $10.0 million. Exploration and development activities during the quarter included $3.5 million for the drilling of a horizontal well (1.0 net) in the Groundbirch area, and $5.3 million drilling and completing a horizontal well (1.0 net) at Groundbirch. Micro-seismic studies were commissioned on the completed horizontal well, which accounts for the approximate $0.3 million of geological and geophysical expenditures during the fourth quarter of 2009.

The capital expenditures incurred in 2009 activities were primarily directed to the exploration and development of the Corporation's Groundbirch Montney gas project. In addition to the fourth quarter activities discussed above, during the first quarter Monterey drilled a stratigraphic test well in the Groundbirch area. The stratigraphic test confirmed the extent and quality of the Montney formation existing on the lands held by Monterey. As a result of a pooling arrangement with a competitor the stratigraphic test also resulted in Monterey earning a 75 percent working interest in an additional 10 sections of Montney prospective undeveloped land held by the competitor. During the fourth quarter, Monterey received regulatory approval to proceed with a 28 mmcf per day natural gas processing facility at Groundbirch, more than $0.3 million of the 2009 production equipping and facilities spending can be attributed to the pre-engineering work required to secure regulatory approval for this processing facility.

During 2009, Monterey disposed of non-core properties for total cash proceeds of approximately $8.8 million. The dispositions consisted of 3.0 net sections of undeveloped non-core lands in the Town area of NEBC for total net proceeds of $2.7 million and 1.4 net sections of undeveloped non-core Montney lands and one non-producing well at Dawson for net proceeds of $6.1 million.

In comparison to the fourth quarter of 2009, Monterey's total capital spending during the fourth quarter of 2008 was approximately $11.0 million. Exploration and development activities during the quarter included the drilling of 1.0 net well in the Ferrybank area, the re-entry and tie-in of a vertical well at Brassey, and the completion and tie-in of the Corporation's first horizontally drilled Cadomin well at Brassey, which was drilled during the third quarter of 2008.

Exploration and development expenditures during the first nine months of 2008 were focused on building the Corporation's project inventory through the acquisition of undeveloped crown lands, participation in the drilling and tie-in of three wells in the Corporation's new Smoky project area located in Alberta, and two wells in NEBC at Squirrel and Nig. Nearly all of the undeveloped lands acquired during the first quarter were located in British Columbia targeting the tight gas Montney formation. Second quarter activities were primarily directed to the completion of a horizontal well, using multi-stage fracturing techniques, and the drilling of an unsuccessful well, both wells were located in the Squirrel area of NEBC.



COMMITMENTS

As at December 31, 2009 Monterey has the following contractual obligations:

Recognized
in financial Less than 1 - 3 4 - 5 After 5
($000's) statements 1 Year years years years Total
----------------------------------------------------------------------------
Credit Facility Yes $ 22,559 - - - $ 22,559
Stamping fees Yes 212 - - - 212
Stamping fees No 46 - - - 46
Exploration
expenditures No 2,292 2,292
Asset retirement(1) Yes - 264 418 7,443 8,125
Operating leases No 354 1,062 295 - 1,711
----------------------------------------------------------------------------
Total $ 25,463 $ 1,326 $ 713 $ 7,443 $ 34,945
----------------------------------------------------------------------------

(1) Asset retirement costs shown are undiscounted.


The $22.6 million credit facility obligation classified as needing to be repaid in less than one year is the Corporation's current bank debt as at December 31, 2009. Management anticipates that upon review by the bank in 2010, the Facility will be renewed and that bank debt will continue to be outstanding and not actually be repaid until a later time.

The stamping fees are in respect of guaranteed notes issued under the prior credit facility; when the existing Facility was negotiated Monterey agreed to pay an increase in the stamping fee upon maturity of each guaranteed note. In the table above a portion of the stamping fee obligation has been accrued as interest expense and is reflected in the financial statements while the portion yet to be accrued is not reflected in the financial statements as at December 31, 2009.

The exploration expenditures are in respect of Monterey's flow-through share offering on October 1, 2009 whereby the Corporation has a commitment to incur approximately $6,042,000 in Canadian exploration expenditures by December 31, 2010. As at December 31, 2009 Monterey had incurred approximately $3,750,000 of Canadian exploration expenditures leaving $2,292,000 to be incurred prior to the end of 2010.

The asset retirement obligation is in respect of the costs to decommission oil and gas properties, the amount in the table above differs from the asset retirement obligations reflected in the December 31, 2009 financial statements due to the fact that the $8.1 million in the above table contains the anticipated cash payments while the financial statements reflect a discounted figure.

Monterey is committed to future payments under an operating lease for head office space and parking facilities totaling approximately $1.7 million until October 30, 2014. Of this total, Monterey is committed to payments of $354,000 for each of the years from 2010 to 2013, and $295,000 in 2014.

RELATED PARTY TRANSACTIONS

Legal Services

A director of Monterey is a partner at a law firm that provides legal services to the Corporation. During the year ended December 31, 2009, the Corporation incurred approximately $139,000 in legal services and disbursements associated with this related party (2008 - $210,000). At December 31, 2009 the Corporation did not have an outstanding payable with this related party (2008 - $10,000).

Corporate Shareholder

During the year ended December 31, 2009, the Corporation had transactions totaling approximately $186,000 (2008 - $479,000) with an entity that holds approximately 20% of the outstanding common shares of Monterey. The transactions primarily consisted of Monterey's participation in the joint exploration, development and production of petroleum and natural gas properties. All transactions were completed on an arm's length basis consistent with normal industry terms. The value of the transactions between Monterey and the related party were recorded at the carrying amount, which approximated their fair value. At December 31, 2009, Monterey's records include $8,000 (2008 - $6,000) in accounts receivable and $5,000 in accounts payable (2008 - $26,000) with this shareholder.

Corporate Management and Directors

Certain directors of Monterey are also the directors or management of other entities that participate in joint operations with the Corporation. Transactions with these related parties are on terms that are consistent with parties dealing at arm's length. For the year ended December 31, 2009, the aggregate value of transactions entered into between Monterey and these entities was approximately $2,842,000 (2008 - $5,804,000). At December 31, 2009 Monterey's records include outstanding payables owed to the related parties of $1,271,000 (2008 - $53,000) and accounts receivables due to Monterey of approximately $75,000 (2008 - $206,000).

SUBSEQUENT EVENTS

Forward Commodity Price Contract

In January 2010, Monterey entered into a forward financial commodity price contract on 1,000 gigajoules ("GJ") per day of natural gas at a price of $5.425 per GJ, for the period from April 1, 2010 until October 31, 2010.

Common Share Issuance

In February 2010, Monterey completed the issuance of 4,762,000 common shares at a price of $4.20 per common share on a bought deal basis, for total gross proceeds of $20.0 million, or approximately $18.8 million in net proceeds after taking into account share issue costs of $1.2 million. Approximately $10.6 million of the net proceeds received by the Corporation was initially applied to reduce bank indebtedness, thereby freeing up borrowing capacity which will redrawn and applied to fund Monterey's ongoing capital expenditure program.

As part of the February 2010 common share issuance, the related party disclosed in Note 13b) to the December 31, 2009 audited financial statements purchased 952,500 common shares of Monterey, accounting for approximately $4.0 million of the $20.0 million in gross proceeds.

Alberta Royalty Regime Changes

On March 11, 2010 the Government of Alberta announced changes to Alberta's royalty system. The changes are intended to increase Alberta's competitiveness in the upstream oil and natural gas sectors; specifically, the maximum royalty rates for conventional oil and natural gas production will be decreased effective for the production month of January 2011 and certain temporary incentive programs currently on place will be made permanent. The majority of the Corporation's production and planned exploration and development activities are located in the province of British Columbia; as such the March 11, 2010 changes announced by the Government of Alberta are likely to only have a nominal impact on Monterey's current and planned operations and the estimated net present value of the Corporation's reserves.

OUTLOOK

The Corporation is maintaining its previous 2010 first half capital expenditure guidance of $15 million and first half production guidance of 1,600 - 1,700 boe/d. The solid production performance of the underlying asset base and a deep inventory of development projects in excess of $75 million exclusive of the Groundbirch asset has allowed the company to continue to focus all of its forward capital spending in 2010 on the Groundbirch gas project. First quarter capital expenditures are estimated at approximately $10 - $11 million if all scheduled operations can be completed prior to spring break up.

The weak forward commodity strip price for natural gas continues to apply significant downward economic pressure on the Canadian natural gas industry. In order for natural gas entities to compete and survive in this lower price environment, they will need to explore for and develop repeatable scalable plays that can generate above average recycle ratios with natural gas prices below $5.00 per mcf. Management believes that the Montney project at Groundbirch in NEBC has the potential to generate one of the higher recycle ratios in the Western Canadian gas basin and as a result, Monterey will continue to aggressively evaluate and develop this project through the remainder of 2010 and beyond. Management is very encouraged with the drilling and completion results to date at Groundbirch and will continue to update shareholders as additional results are obtained.

SENSITIVITY ANALYSIS

Monterey's financial performance is impacted by changes in production and the business environment. The table below indicates key variables influencing the Corporation's financial performance, Monterey's assumptions and the estimated impact on funds flow from operations over the January 1, 2010 to June 30, 2010 period as a result of a change in each key variable.

Variable



Impact on
Funds flow from
Monterey operations
Variable Assumption Variance ($000's)
----------------------------------------------------------------------------
Natural gas production 7.5 -- 8.5 mmcf/d 1.0 mmcf/d 520
Natural gas prices $5.20 mcf $1.00/mcf 1,260
WTI oil price $79.90US $1.00US 40
Foreign exchange rate $1.05Cdn : $1.00US $0.01Cdn 95
Bank prime lending rate 2.25% 1.00% 55


QUARTERLY SUMMARY INFORMATION

----------------------------------------------------------------------------
----------------------------------------------------------------------------
(in thousands, except for Three Months Ended (unaudited)
commodity prices, per share ----------------------------------------
amounts, or unless otherwise Dec. 31, Sept. 30, Jun. 30, Mar. 31,
noted) 2009 2009 2009 2009
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 8,751 9,918 11,151 11,939
Light oil and NGL (bbl/d) 449 436 470 461
----------------------------------------------------------------------------
Oil equivalent (boe/d) 1,907 2,089 2,329 2,451
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf)(1) $ 4.93 $ 3.17 $ 3.60 $ 5.59
Light oil and NGL ($/bbl) $ 57.95 $ 49.82 $ 44.81 $ 37.84
----------------------------------------------------------------------------
Oil equivalent ($/boe)(1) $ 36.23 $ 25.71 $ 26.42 $ 34.52
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 6,358 $ 4,941 $ 5,597 $ 7,614
Operating income (1) $ 3,215 $ 1,818 $ 1,842 $ 3,438
Funds flow from operations $ 2,201 $ 880 $ 844 $ 2,620
Net earnings / (loss) $ (2,265) $ (4,809) $ (5,485) $ (4,174)
Total capital expenditures $ 9,958 $ (1,076) $ 1,104 $ (1,818)
Net current surplus / (deficit) (2) $ (2,438) $ (2,122) $ (1,067) $ (2,820)
Bank debt $ 22,559 $ 30,082 $ 33,085 $ 31,052
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Per share:
Funds flow from operations (3):
Basic $ 0.05 $ 0.03 $ 0.03 $ 0.08
Diluted $ 0.05 $ 0.03 $ 0.03 $ 0.08
Earnings / (loss):
Basic and diluted $ (0.06) $ (0.15) $ (0.17) $ (0.13)
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Share data:
Outstanding common shares 41,003 32,903 32,903 32,903
----------------------------------------------------------------------------

Stock options 3,968 3,136 3,136 3,136
----------------------------------------------------------------------------

Total diluted shares outstanding 44,971 36,039 36,039 36,039
----------------------------------------------------------------------------
Weighted average:
Basic 40,914 32,903 32,903 32,903
Diluted 42,727 33,191 33,136 32,933
----------------------------------------------------------------------------
----------------------------------------------------------------------------



----------------------------------------------------------------------------
----------------------------------------------------------------------------
(in thousands, except for Three Months Ended (unaudited)
commodity prices, per share ----------------------------------------
amounts, or unless otherwise Dec. 31, Sept. 30, Jun. 30, Mar. 31,
noted) 2008 2008 2008 2008
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 10,058 8,400 6,598 7,168
Light oil and NGL (bbl/d) 453 292 181 241
----------------------------------------------------------------------------
Oil equivalent (boe/d) 2,130 1,691 1,280 1,435
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) (1) $ 7.35 $ 10.24 $ 9.03 $ 7.09
Light oil and NGL ($/bbl) $ 51.78 $ 101.08 $ 105.92 $ 83.07
----------------------------------------------------------------------------
Oil equivalent ($/boe) (1) $ 45.75 $ 68.45 $ 62.03 $ 49.34
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 8,965 $ 10,652 $ 7,227 $ 6,444
Operating income (1) $ 4,191 $ 6,445 $ 4,163 $ 3,301
Funds flow from operations $ 3,694 $ 3,345 $ 4,417 $ 3,547
Net earnings / (loss) $ (2,110) $ 1,301 $ 601 $ 1,111
Total capital expenditures $ 10,900 $ 40,930 $ 2,167 $ 12,586
Net current surplus / (deficit) (2) $ (2,593) $ (7,752) $ (3,961) $ (5,874)
Bank debt $ 35,286 $ 22,606 $ 18,038 $ 18,227
----------------------------------------------------------------------------

Per share:
Funds flow from operations (3):
Basic $ 0.11 $ 0.12 $ 0.18 $ 0.14
Diluted $ 0.11 $ 0.12 $ 0.17 $ 0.14
Earnings / (loss):
Basic and diluted $ (0.06) $ 0.05 $ 0.02 $ 0.04
----------------------------------------------------------------------------

Share data:
Outstanding common shares 32,903 32,903 25,107 25,107
----------------------------------------------------------------------------

Stock options 3,136 2,771 2,151 2,151
----------------------------------------------------------------------------

Total diluted shares outstanding 36,039 35,674 27,258 27,258
----------------------------------------------------------------------------
Weighted average:
Basic 32,903 27,818 25,107 25,058
Diluted 32,904 27,818 25,329 25,255
----------------------------------------------------------------------------
----------------------------------------------------------------------------

(1) Includes gains and losses from financial instruments
(2) net current deficiency plus capital lease obligation
(3) See Non-GAAP measures


CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of the financial statements in accordance with GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, if any, at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. In determining estimates required to prepare the Corporation's financial statements, management uses available information it considers to be reasonable under the circumstances. Readers are cautioned that actual results could differ from these estimates.

Other critical accounting estimates that affect Monterey's financial statements include:

Full Cost Accounting

Monterey follows the full cost method of accounting, whereby all costs associated with the exploration and development of oil and natural gas reserves are capitalized in cost centers on a country-by-country basis. Such costs include lease acquisition costs, geological and geophysical costs, carrying charges of non-producing properties, costs of drilling both productive and non-productive wells, the cost of petroleum and natural gas production equipment and overhead charges directly related to exploration and development activities. Gains or losses are not recognized upon the disposition of oil and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the rate of depletion by 20% or more.

Depletion and Depreciation

Costs capitalized under the full cost method of accounting, together with estimated future capital costs associated with proved reserves, are depreciated and depleted using the unit-of production method which is based on gross production and estimated proved oil and natural gas reserves as determined by independent reserve evaluators. The cost of unproven properties is excluded from the depreciation and depletion base. These unproven properties are assessed periodically to ascertain if impairment has occurred. When proved reserves are assigned or the property is considered impaired the costs of the property or the amount of the impairment is added to the costs subject to depletion. For purposes of the depletion and depreciation calculations, oil and natural gas reserves are converted to a common unit of measure on the basis of their relative energy content, being six thousand cubic feet of natural gas to one barrel of oil equivalent. Depreciation of office furniture and equipment is provided for over its useful lives using the declining balance method at a rate of 25%.

Ceiling Test

Oil and natural gas properties and equipment are evaluated at least annually at year-end to determine whether the carrying amount in a cost centre is recoverable and does not exceed the fair market value of the properties in the cost centre. The carrying amounts are assessed to be recoverable when the sum of the undiscounted funds flows expected from the properties and the cost of major development projects exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted funds flows expected from the production of proved plus probable reserves, the lower of cost and market of unproved properties and the cost of major development projects of the cost centre. The funds flows are estimated using expected future product prices and costs and are discounted using a risk-free interest rate.

Asset Retirement Obligations

Estimated costs associated with Monterey's asset retirement obligations are subject to uncertainty associated with the method, timing, and extent of future retirement activities. At December 31, 2009, Management's estimate of Monterey's total inflation adjusted, undiscounted, asset retirement liabilities was approximately $8.1 million.

Purchase Price Allocations

The cost of corporate and asset acquisitions are allocated to the acquired assets and liabilities based on their fair value at the time of acquisition. Management use assumptions and estimates in determining the fair values of assets acquired and liabilities assumed, which are inherently subjective. Purchase price allocations affect the Corporation's reported assets, liabilities and future net earnings.

Income Taxes

All tax filings are subject to subsequent government audit and potential reassessments. Accordingly, final income tax liabilities as assessed by the government may differ materially from amounts estimated and recorded by Monterey.

Financial Instruments

The determination of fair value of financial instruments often relies on the use of estimates and judgment based on the best quality of information that is available at the time. The ultimate value of consideration received or paid for the settlement of financial instruments in future periods may materially differ from those estimated fair values at the end of each reporting period.

Stock-based Compensation

Stock-based Compensation expense is determined with the use of estimates and information available at the date of an option's grant. The ultimate settlement of the underlying stock option through an option exercise or the expiry of the option depends on the value of the Corporation's future share price, and the number of option forfeitures at the maturity of an option grant.

NON-GAAP MEASURES

Within this MD&A, references are made to terms commonly used in the oil and gas industry. Management uses funds flow from operations, operating income, capital expenditures and net debt to analyze operating performance. These measures do not have standardized meanings prescribed by GAAP, and may not be comparable to similar measures presented by other companies. For this MD&A the measures used are: (i) Funds flow from operations; (ii) Operating income; (iii) Capital expenditures; (iv) Total capital expenditures; (v) Funds flow from operations per basic and funds flow from operations per diluted share is calculated by dividing funds flow from operations as described earlier, by the total number of respective weighted average basic and diluted common shares outstanding during the period; (vi) Net debt; (vii) Net current surplus (deficiency); and (viii) Estimated forward cash flow being funds flow from operations for a particular month adjusted for one time or extraordinary items which is then annualized. This non-GAAP measure provides a quick and reasonably accurate estimate, under current business conditions, of the funds flow from operations for the next twelve months.

The following tables reconcile the non-GAAP measures used in this Management Discussion and Analysis to the most directly comparable measure calculated in accordance with GAAP:



Funds flow from operations
---------------------------

Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2009 2008 2009 2008
----------------------------------------------------------------------------
Cash flow provided by operating
activities $ 2,327 $ 677 $ 6,999 $ 11,477
Changes in non-cash working capital (284) 2,844 (1,026) 3,085
Asset retirement expenditures 158 173 572 442
----------------------------------------------------------------------------
Funds flow from operations $ 2,201 $ 3,694 $ 6,545 $ 15,004
----------------------------------------------------------------------------


Funds flow from operations is an important measure to Management and investors because it provides a better indication of Monterey's internal funds generated from ongoing operations, versus cash flow provided by (used in) operating activities. Cash flow from (used in) operating activities takes into account the net change in non-cash working capital items and asset retirement expenditures which are not considered part of normal operations, may be infrequent and vary significantly from one period to the next.



Operating income
-----------------

Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2009 2008 2009 2008
----------------------------------------------------------------------------
Net earnings (loss) $ (2,265) $ (2,110) $(16,733) $ 903
Add: Future income tax expense
(recovery) - 26 - (1,682)
Add: Depreciation, depletion
and accretion 4,318 5,431 22,882 15,348
Add: Net interest expense 250 275 1,034 1,020
Add: General and administrative 912 569 3,130 2,510
----------------------------------------------------------------------------
Operating income $ 3,215 $ 4,191 $ 10,313 $18,099
----------------------------------------------------------------------------


Management views operating income as an important measure of the Corporation's viability and contribution from the operation of its core business and is reflective of Monterey's gross margin.



Capital expenditures & Total capital expenditures
--------------------------------------------------

Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2009 2008 2009 2008
----------------------------------------------------------------------------
Cash flow used in investing
activities $ 4,507 $ 15,574 $ 3,842 $ 32,816
Business combination transaction
costs - 140 - (649)
Change in non-cash working capital 5,451 (4,745) 4,326 (323)
----------------------------------------------------------------------------
Capital expenditures $ 9,958 $ 10,969 $ 8,168 $ 31,844
Upper Lake business combination - (69) - 36,347
Long lived asset retirement - - - (1,610)
----------------------------------------------------------------------------
Total capital expenditures $ 9,958 $ 10,900 $ 8,168 $ 66,581
----------------------------------------------------------------------------


Capital expenditures measure the net cash resources directed to exploring for and developing of oil and gas reserves along with the investment in office furniture and equipment to support Monterey's business activities. While total capital expenditures also reflect the cost of property and equipment, excluding the associated long lived asset retirement cost. These measures are each considered by Management to be better measures than capital additions recorded under GAAP to determine the Corporation's success and efficiency in growing its reserves and reserve value. Capital expenditures indicate the investment customarily incurred in the exploration and development activities and is readily comparable to other periods; while total capital expenditure also encompasses the incremental costs incurred to increase Monterey's oil and natural gas reserves via business combination. The capital additions under GAAP include non-cash adjustments that impair Management's and the reader's of this MD&A abilities to accurately assess Monterey's performance in respect of growing oil and natural gas reserves.



Net debt
---------

As at Dec 31, As at Dec 31,
($000's) 2009 2008
----------------------------------------------------------------------------
Bank indebtedness $ 22,559 $ 35,286
Less: Current assets (8,734) (5,661)
Add: Accounts payable and accrued liabilities 11,095 8,075
Add: Obligation under capital lease 45 224
Add: Commodity price risk management contracts 32 -
----------------------------------------------------------------------------
Net debt $ 24,997 $ 37,924
----------------------------------------------------------------------------


Net debt is an important measure as it provides a measure of the net obligations that can be reasonably expected to be settled with the Corporation's assets in the near term. Total liabilities under GAAP, also include asset retirement obligations as well as liabilities arising from financial instruments for which the timing of settlement with the Corporation's existing and future assets involve greater use of estimation and as a result the timing and amount expended to satisfy the obligation may be subject to significant variation.



Net current deficiency
-----------------------

As at Dec 31, As at Dec 31,
($000's) 2009 2008
----------------------------------------------------------------------------
Current liabilities $ 33,699 $ 43,540
Less: Current assets (8,734) (5,661)
----------------------------------------------------------------------------
Working capital deficit 24,965 37,879
Add: Commodity price risk management contracts 32 -
Less: Current portion of bank indebtedness (22,559) (35,286)
----------------------------------------------------------------------------
Net current deficiency $ 2,438 $ 2,593
----------------------------------------------------------------------------


Net current deficiency is a key measure for the Corporation as it gives a measure of net working capital excluding unrealized financial instrument assets and liabilities. Unrealized commodity price risk management contract assets and liabilities for Monterey primarily consist of the estimated future settlement value of forward financial contracts and the underlying sales volumes and are not necessarily indicative of the net cash inflows or outflows at the settlement date of the financial instruments.

RISKS & UNCERTAINTIES

Some of the risks that Monterey is exposed to which impact Management's ability to execute the Corporation's business plan include but are not limited to:

- Exploration, development and production activities

Monterey's success depends upon its ability to find, secure rights, acquire, develop and commercially produce oil and natural gas reserves. Risks associated with the exploration, finding and development and production of oil and gas reserves is impacted by: attracting, hiring and retaining knowledgeable and experienced staff; competition for prospective land for exploration and development activities; geological and operational risks; application of changing or new technologies, imprecision of reserve estimates and valuation; timely receipt of required regulatory approvals; ability to secure or obtain equipment, services and supplies when needed; weather; field operating risks; and existence and ability to access production infrastructure to deliver production to market.

Management attempts to manage and overcome these risks by careful addition of staff, early identification and evaluation of opportunities; careful planning of operations and development of contingency plans; developing continuing relationships with reliable suppliers of services, equipment and supplies; and carrying appropriate levels of insurance.

- Risks relating to Monterey's Groundbirch natural gas project

Monterey's exploration and development activities in 2009 were primarily directed to the natural gas project located in the Groundbirch area of northeast British Columbia. Management intends that the majority of the Corporation's capital spending in 2010 will be directed to Groundbirch and other similar unconventional natural gas opportunities.

Drilling, completion and the operation of wells in tight gas plays presents certain challenges that differ from conventional oil and gas operations. Generally, such wells are more susceptible to mechanical problems associated with drilling and completion such as casing collapse and the loss of equipment in the wellbore. In addition, the fracturing of prospective formations may be more extensive and complicated than fracturing the geological formations in Monterey's other areas of operation and generally requires greater volumes of water than conventional gas wells. As a result, the drilling and completion of wells in the tight gas plays tend to be more costly than drilling and completion of wells in other areas in which Monterey carries on operations.

Monterey has and will continue to mitigate these concerns by applying the internal experience and knowledge derived from activities to date and using service providers with proven technical knowledge, appropriate equipment and experienced personnel. Through its budgeting process Management will ensure that it has the financial capability to meet the costs associated with carrying out unconventional drilling and completion activities prior to start of an operation.

Currently, the Corporation has no production from the Groundbirch lands and there is no natural gas processing facility located near the Groundbirch lands. While Monterey has received regulatory approval and intends to proceed with the construction of a natural gas processing facility to enable future production from Groundbirch, there can be no assurance that a natural gas processing facility will be completed in accordance with Management's timing expectations or at all, or that the Corporation will have the necessary capital to complete the construction of a natural gas processing facility. In the event that a natural gas processing facility is successfully completed and the amount of natural gas produced by Monterey exceeds the capacity of the various gathering and transportation pipelines, it may be necessary for Monterey to expand the natural gas processing facility and install additional pipelines and gathering systems. As a result of the current economic climate, the development of natural gas facilities, pipeline projects or gathering systems may not occur for lack of financing. In such event, Monterey may have to defer development of or shut in its wells awaiting a pipeline connection or capacity and/or sell natural gas production at significantly lower prices than it would otherwise realize which may adversely affect Monterey's results of operations.

Management has already taken steps to mitigate this risk by obtaining regulatory approval to build a gas processing facility, consulted with marketing consultants and the owners of transportation pipelines and has already completed the planning, design and ordering of equipment and the plant site is currently being prepared. In terms of financing, Monterey is investigating arrangements with third parties, such as midstream entities or the Corporation may defer desired future drilling and completion activities to ensure that there are sufficient funds available from existing sources to finance the construction and commissioning of the facility.

- Global economic uncertainty

During the later portion of 2008 and into 2009 market conditions and events led to significant disruptions of international credit markets and the overall deterioration of worldwide economic conditions leading to increased volatility in markets (including financial and product markets), reduced liquidity, widening of corporate spreads, increased credit losses and tightening of credit conditions which led to a recession throughout the globe. Governments throughout the world intervened to prevent the collapse of banks, insurers and financial institutions. In 2009 the financial conditions showed improvement and economies throughout the globe appeared to be emerging from the recession; however uncertainty continues with concerns of the viability of European banks and the need for financial institutions in China to increase reserve limits in respect of lending. These conditions have negatively impacted Monterey due to volatility in oil and gas commodity prices, currency exchange, interest rates, access to and the amount of debt and equity financing available.

Management continues to attempt to mitigate the impacts of the global economic conditions and uncertain credit markets by taking action to manage the amount and timing of the capital program to ensure that the Corporation can satisfy obligations and liabilities from readily available funds, fix the cost of debt by utilizing guaranteed notes as the form of borrowing and strategically access financing from the equity markets.

- Capital requirements

Monterey's core business requires sufficient funds for the future acquisition, exploration, development and production of oil and natural gas reserves. Economic conditions can cause significant volatility of commodity prices meaning that internal generation of funds or reasonable return of investment is uncertain. In addition, global economic uncertainty can result in a reduction in the access to, timing, amount and cost of debt thus making the Corporation's ability to conduct or complete exploration and development activities more difficult.

Management ensures that projects are adequately evaluated to estimate viability under challenging economic conditions. In addition development of capital spending plans are carefully prepared and are subject to ongoing review to ensure that sufficient financial resources are available and that projects will earn a positive return on investment. Management manages its balance sheet, remains apprised of developments in the equity markets and changes in the current and forecasted commodity prices to maintain financial flexibility so that the business plans can be carried out.

- Commodity prices, markets and marketing

The marketability and price of oil and natural gas that may be acquired or discovered by Monterey is and will continue to be affected by numerous factors beyond its control. The Corporation's ability to market its oil and natural gas may depend upon its ability to acquire space on pipelines that deliver natural gas to commercial markets. Monterey may also be affected by deliverability uncertainties related to the proximity of its reserves to pipelines and processing and storage facilities and operational problems affecting such pipelines and facilities as well as extensive government regulation relating to price, taxes, royalties, land tenure, allowable production, the export of oil and natural gas and many other aspects of the oil and natural gas business.

The prices of oil and natural gas may be volatile and subject to fluctuation. Any material decline in prices could result in a reduction of the Corporation's net production revenue. The economics of producing from some wells may change as a result of lower prices, which could result in reduced production of oil or gas and a reduction in the volumes of Monterey's oil and natural gas reserves. The Corporation might also elect not to produce from certain wells at lower prices. All of these factors could result in a material decrease in Monterey's expected net production revenue and a reduction in its oil and gas acquisition, development and exploration activities. Prices for oil and gas are subject to large fluctuations in response to relatively minor changes in the supply of and demand for oil and gas, market uncertainty and a variety of additional factors beyond the control of the Corporation. Any substantial and extended decline in the price of oil and gas would have an adverse effect on Monterey's carrying value of its reserves, borrowing capacity, revenues, profitability and cash flows from operations and may have a material adverse effect on the Corporation's business, financial condition, results of operations and prospects.

Management attempts to mitigate the risks associated with volatile commodity prices through the use of hedging to ensure that revenues will be sufficient to assist with the financing of ongoing operations and exploration and development activities. Management has arrangements with marketing consultants to assist with reducing marketing risks to make sure that arrangements for the sale of the Corporation's production are made with creditworthy purchasers, that the sale of production is diversified amongst a portfolio of purchasers and geographical sales points and that access and availability of pipelines and facilities is monitored to ensure that production can cost effectively be delivered to sales points.

- Operational matters

The operation of oil and gas wells involves a number of operating and natural hazards that may result in blowouts, environmental damage and other unexpected or dangerous conditions resulting in damage to Monterey and possible liability to third parties. The costs arising from damages associated with damage or liability resulting from operational matters may materially impact Monterey.

To mitigate these risks Management employs experienced and knowledgeable employees and consultants. Monterey applies best practices employed by entities of its size including preparation of procedure policies and manuals that are documented and distributed to field staff and service providers along with test checking to ensure that policies and procedures are followed. The Corporation also maintains liability well control in amounts consistent with industry standards. Monterey also purchases business interruption and boiler and machinery insurance for selected facilities. The Corporation may become liable for damages arising from operational matters which are not insurable or that Monterey has elected not to obtain insurance due to high insurance costs, an assessment that the risk is low or limited or other reasons.

- Project Risks

Monterey manages a variety of small and large projects in the conduct of its business. Project delays may delay expected revenues from operations. Significant project cost over-runs could make a project uneconomic. The Corporation's ability to execute projects and market oil and natural gas depends upon numerous factors beyond Monterey's control, including:

- the availability of processing capacity;

- the availability and proximity of pipeline capacity;

- the availability of storage capacity;

- the supply of and demand for oil and natural gas;

- the availability of alternative fuel sources;

- the effects of inclement weather;

- the availability and access to field services and related equipment;

- unexpected cost increases;

- accidental events;

- currency fluctuations;

- changes in regulations;

- the availability and productivity of skilled labour; and

- the regulation of the oil and natural gas industry by various levels of government and governmental agencies.

Because of these factors, the Corporation may be unable to execute projects on time, on budget or at all, and may not be able to effectively market the oil and natural gas that it produces. Management attempts to mitigate project risks by hiring experienced and knowledgeable employees, consultants and service providers. In addition careful ongoing budgeting and planning minimizes the impacts of changing prices, costs and other factors such as weather.

- Operational Dependence

Other companies operate some of the assets in which the Corporation has an interest. As a result, the Corporation has limited ability to exercise influence over the operation of those assets or their associated costs, which could adversely affect the Corporation's financial performance. The Corporation's return on assets operated by others therefore depends upon a number of factors that may be outside of the Corporation's control, including the timing and amount of capital expenditures, the operator's expertise and financial resources, the approval of other participants, the selection of technology and risk management practices.

Monterey mitigates the impact from the risks of operational dependence with written agreements, ongoing communication and collaboration with working interest and third party operators.

- Third party credit risk

Monterey may be exposed to third party credit risk through its contractual arrangements with joint venture partners, purchasers of production and other parties. During challenging economic periods the Corporation may have slower accessibility to funds needed to finance the ongoing business or meet obligations due to the increase in the amount of time required to collect or the lack of collectability of accounts receivables.

Management mitigates this risk by entering into joint ventures or sell production to a diverse portfolio of entities that have sufficient capital resources and an established record of paying obligations when due. The Corporation monitors the amount and aging of accounts receivable to improve collectability and when necessary issues cash calls to collect payment in advance from a partner for the partner's share of a project.

- Competition

The petroleum industry is competitive in all its phases. Monterey competes with numerous other organizations in the search for, and the acquisition of, oil and natural gas properties and in the marketing of oil and natural gas. The Corporation's competitors include oil and natural gas companies that have substantially greater financial resources, staff and facilities than those of Monterey. The Corporation's ability to increase its reserves in the future will depend not only on its ability to explore and develop its present properties, but also on its ability to select and acquire other suitable producing properties or prospects for exploratory drilling. Competitive factors in the distribution and marketing of oil and natural gas include price and methods and reliability of delivery and storage. Competition may also be presented by alternate fuel sources.

Management attempts to deal with competitive risks through careful selection of areas in which it operates, partnering with competitors and identification and securing of opportunities prior to industry competitors.

- Climate change

The determination of the impact of climate change is currently unknown and cannot be reasonably estimated. Physical access to opportunities and timing to conduct operations could change or become more costly. Potential new laws or regulatory requirements to control greenhouse gases or other emissions may increase the cost and the method of conducting exploration, development, production and processing oil and gas. Lastly new taxes, tariffs, penalties or costs to acquire offsetting credits as a result of finding, developing, producing, transporting and selling oil and gas may also impair the commercial viability of Monterey's activities or the oil and gas industry overall.

Management continues to monitor developments in this evolving area. Methods to be used to mitigate the risks associated with climate change include: education to understand the changes physical changes to the environment and new and changes to laws or regulatory requirements, and careful planning to determine cost effective means to perform Monterey's exploration, development and production activities and ensure compliance with laws and regulations.

- Environmental

All phases of the oil and natural gas business present environmental risks and hazards and are subject to environmental regulation pursuant to a variety of federal, provincial and local laws and regulations. Environmental legislation provides for, among other things, restrictions and prohibitions on spills, releases or emissions of various substances produced in association with oil and natural gas operations. The legislation also requires that wells and facility sites be operated, maintained, abandoned and reclaimed to the satisfaction of applicable regulatory authorities. Compliance with such legislation can require significant expenditures and a breach of applicable environmental legislation may result in the imposition of fines and penalties, some of which may be material. Environmental legislation is evolving in a manner expected to result in stricter standards and enforcement, larger fines and liability and potentially increased capital expenditures and operating costs. The discharge of oil, natural gas or other pollutants into the air, soil or water may give rise to liabilities to governments and third parties and may require the Corporation to incur costs to remedy such discharge. Although the Corporation believes that it will be in material compliance with current applicable environmental regulations no assurance can be given that environmental laws will not result in a curtailment of production or a material increase in the costs of production, development or exploration activities or otherwise have a material adverse effect on the Corporation's business, financial condition, results of operations and prospects.

The risk associated with environmental matters is reduced by the experience and knowledge of employees, consultants and service providers engaged by Monterey. Management maintains appropriate liability insurance to minimize the financial impact of environmental risks; however there are limits to the protection provided by insurance and there may be environmental matters that are not insurable or that Management has elected not to insure due to the cost of insurance premiums or other reasons. The Corporation's board of directors has a subcommittee that provides oversight of Monterey's environmental practices and matters.

- Changes in laws and regulations

The Corporation's economic viability and its ability to carry out its business plan may be impacted by changes in laws and regulations by governments and regulatory authorities. Monterey currently operates in the provinces of Alberta and British Columbia and is subject to a number of local authorities in each province. Imposition, implementation, or changes to laws and regulations, including royalties and incentive programs may have a material impact on the Corporation's business, financial condition and operations.

Management intends to comply with all enacted laws and regulations. When unfair, undesirable or unworkable changes or the introduction of new laws and regulations is contemplated or announced by the appropriate authority Monterey will individually and participate with other members of industry, to have modifications made to the laws or regulations.

- Geo-political risks

The marketability and price of oil and natural gas that may be acquired or discovered by the Corporation is and will continue to be affected by political events throughout the world that cause disruptions in the supply of oil. Conflicts, or conversely peaceful developments, arising in the Middle-East, and other areas of the world, have a significant impact on the price of oil and natural gas. Any particular event could result in a material decline in prices and therefore result in a reduction of the Corporation's net production revenue.

In addition, the Corporation's oil and natural gas properties, wells and facilities could be subject to a terrorist attack. If any of the Corporation's properties, wells or facilities are the subject of terrorist attack it may have a material adverse effect on the Corporation's business, financial condition, results of operations and prospects. The Corporation will not have insurance to protect against the risk from terrorism.

Management will employ hedging to minimize the impact of volatility of oil and gas commodity prices. The Corporation also employs security measures such as locked gates and visits by field staff to discourage terrorist actions that may be taken against Monterey's assets.

FORWARD LOOKING STATEMENTS & ADVISORIES

Certain information regarding Monterey set forth in this MD&A, including but not limited to Management's expectations regarding the timing and quantitative impact of its IFRS change over plans, expectations regarding its financial capabilities, continued availability of debt financing, expectations regarding tax pool expiries, the ability and timing associated with incurring sufficient Canadian exploration expenditures to fulfill flow-through expenditure requirements, expectations concerning future funds flow from operations, expectations regarding the timing and ultimate costs required to settle existing commitments, future exploration and development activities, planned capital expenditures, treatment under royalty regimes, plans regarding the development of the Corporation's project inventory and expectations relating to production levels and forecast production may constitute forward-looking statements under applicable securities laws and regulations involve substantial known and unknown risks and uncertainties. The use of any of the words "anticipate", "continue", "estimate", "expect", "may", "will", "project", "should", "believe", "if" and similar expressions are intended to identify forward-looking statements. Such statements represent Monterey's internal projections, estimates or beliefs concerning, among other things, an outlook on the estimated amounts, timing and allocation of capital expenditures, the future cost efficiency of adding new reserves, commodity prices, anticipated future debt and repayment time frame, revenues or other expectations, beliefs, plans, objectives, assumptions, intentions or statements about future events or performance. These statements are only predictions and actual events or results may differ materially. In addition, statements relating to "reserves" or "resources" are deemed to be forward looking statements, as they involve the implied assessment, based on certain estimates and assumptions, that the resources and reserves described can be profitably produced in the future. Although Monterey believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievement since such expectations are inherently subject to significant business, economic, competitive, political and social uncertainties and contingencies. Many factors could cause Monterey's actual results to differ materially from those expressed or implied in any forward-looking statements made by, or on behalf of, Monterey.

The forward-looking statements included in this MD&A also include, but are not limited to, statements with respect to the size of, and future net revenues from, crude oil and natural gas reserves; the focus of capital expenditures; expectations regarding the ability to raise capital and to continually add to reserves through acquisitions and development; projections of market prices and costs; the performance characteristics of Monterey's crude oil and natural gas properties; crude oil and natural gas production levels; Monterey's future operating and financial results; expectations regarding Monterey's capital expenditure programs; supply and demand for crude oil and natural gas; average royalty rates; development drilling; amount of general and administrative expenses; treatment under governmental regulatory regimes and tax laws; the risk of non-capital losses expiring unutilized; and expectations regarding operating costs.

These forward-looking statements are subject to numerous risks and uncertainties, certain of which are beyond the Corporation's control, including the impact of general economic conditions; volatility in market prices for crude oil and natural gas; industry conditions; volatility of commodity prices; currency fluctuation; imprecision of reserve estimates; liabilities inherent in crude oil and natural gas operations; environmental risks; incorrect assessments of the value of acquisitions and exploration and development programs; competition from other producers; the lack of availability of qualified personnel or management; changes in income tax laws or changes in tax laws and incentive programs relating to the oil and gas industry; hazards such as fire, explosion, blowouts, cratering, and spills, each of which could result in substantial damage to wells, production facilities, other property and the environment or in personal injury; stock market volatility; and ability to access sufficient capital from internal and external sources.

With respect to forward-looking statements contained in this MD&A, Monterey has made assumptions regarding: the success of exploration and development activities, the impact of increasing competition; the general stability of the economic and political environment in which Monterey operates; the ability of the Corporation to obtain qualified staff, equipment and services in a timely and cost efficient manner; drilling results; the ability of the operator of the projects which the Corporation has an interest in to operate the field in a safe, efficient and effective manner; Monterey's ability to obtain financing on acceptable terms; field production rates and decline rates; the ability to replace and expand oil and natural gas reserves through acquisition, development or exploration; the timing and costs of pipeline, storage and facility construction and expansion; the ability of the Corporation to secure adequate product transportation; future oil and natural gas prices; currency, exchange and interest rates; the regulatory framework regarding royalties, taxes and environmental matters in the jurisdictions in which the Corporation operates; and Monterey's ability to successfully market its oil and natural gas products.

Management has included the above summary of assumptions and risks related to forward-looking information provided in this MD&A in order to provide readers with a more complete perspective on Monterey's future operations and such information may not be appropriate for other purposes. Monterey's actual results, performance or achievement could differ materially from those expressed in, or implied by, these forward-looking statements and, accordingly, no assurance can be given that any of the events anticipated by the forward-looking statements will transpire or occur, or if any of them do so, what benefits that Monterey will derive there from. Readers are cautioned that the foregoing lists of factors are not exhaustive. These forward-looking statements are made as of the date of this MD&A and Monterey disclaims any intent or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or results or otherwise, other than as required by applicable securities laws.

However, in the event that subsequent events are reasonably likely to cause actual results to differ materially from material forward-looking statements or information previously disclosed by Monterey for a period that is not yet complete, Monterey will provide disclosure on such events and the anticipated impact of such events.

The reporting and measurement currency is the Canadian dollar. For the purpose of calculating unit costs, natural gas is converted to a barrel of oil equivalent ("boe"), which may be misleading if used in isolation. A boe conversion ratio of six thousand cubic feet of natural gas equal to one barrel of oil equivalent is used by Monterey and is based on an energy equivalency method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.

Financial Statements

For the years ended December 31, 2009 and 2008

MANAGEMENT'S REPORT

The accompanying financial statements of Monterey Exploration Ltd. ("Monterey" or the "Corporation") have been prepared by Management in accordance with Canadian generally accepted accounting principles.

Management is responsible for the integrity of the financial information. Internal control systems are designed and maintained to provide reasonable assurance that assets are safeguarded from loss or unauthorized use and to produce reliable accounting records for financial reporting purposes.

Management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses for the period. These estimates and assumptions are based on Management's best information and judgment and, in the near term are not expected to materially change the recorded amounts of assets, liabilities, revenues and expenses. The financial statements have been prepared using policies and procedures established by Management and outlined in the notes to the accompanying financial statements and reflect fairly the Corporation's financial condition and results of operations.

KPMG LLP was appointed by Monterey's shareholders' to perform an audit of Monterey's December 31, 2009 financial statements so as to express an opinion on the financial statements. Their examination included such tests and procedures, as they considered necessary, to provide reasonable assurance that the financial statements are presented fairly in accordance with Canadian generally accepted accounting principles.

The Board of Directors is responsible for ensuring that Management fulfills its responsibilities for financial reporting and internal control. The Board exercises this responsibility though the Audit Committee of the Board of Directors, with assistance from the Reserve Committee regarding the annual independent evaluation of Monterey's petroleum and natural gas reserves. The Audit Committee meets regularly with Management and the independent auditors to ensure that Management's responsibilities are properly discharged, to review the financial statements and recommend that the financial statements be presented to the Board of Directors for approval. The Audit Committee also considers the independence of the external auditors, reviews the services provided and the fees charged by the external auditors. The external auditors have access to the Audit Committee without the presence of Management.

The Audit Committee of the Board of Directors reviewed the audited financial statements of Monterey Exploration Ltd. as at December 31, 2009 as compiled by Management. The Board of Directors on the recommendation of the Audit Committee has approved these financial statements.



(signed) "Patrick D. Manuel" (signed) "David M. Fisher"
Patrick D. Manuel David M. Fisher
President & Chief Executive Officer Vice President, Finance & Chief
Financial Officer

March 18, 2010


AUDITORS' REPORT TO THE SHAREHOLDERS

We have audited the balance sheets of Monterey Exploration Ltd. as at December 31, 2009 and December 31, 2008 and the statements of earnings (loss) and retained earnings (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.

In our opinion, these financial statements present fairly, in all material respects, the financial position of the Corporation as at December 31, 2009 and December 31, 2008 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles.



(signed) "KPMG LLP"
Chartered Accountants

Calgary, Canada
March 18, 2010


MONTEREY EXPLORATION LTD.
Balance Sheets
($000's)

December 31, December 31,
2009 2008
----------------------------------------------------------------------------
Assets
Current assets:
Cash and cash equivalents $ 5,373 $ -
Accounts receivable 2,795 4,980
Prepaid expenses and deposits 534 681
Commodity price risk management contracts 32 -
----------------------------------------------------------------------------
8,734 5,661

Property and equipment (Note 4) 127,707 141,458
----------------------------------------------------------------------------

$ 136,441 $ 147,119
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Liabilities and Shareholders' Equity
Current liabilities:
Bank indebtedness (Note 6) $ 22,559 $ 35,286
Accounts payable and accrued liabilities 11,095 8,075
Obligation under capital lease 45 179
----------------------------------------------------------------------------

33,699 43,540

Obligation under capital lease - 45
Asset retirement obligations (Note 7) 4,646 4,471

Shareholders' equity:
Share capital (Note 8) 108,066 92,944
Contributed surplus (Note 8) 4,322 3,678
Retained earnings (deficit) (14,292) 2,441
----------------------------------------------------------------------------

98,096 99,063
----------------------------------------------------------------------------
Commitments (Notes 8 and 12)
Subsequent events (Note 14)
$ 136,441 $ 147,119
----------------------------------------------------------------------------
----------------------------------------------------------------------------

See accompanying notes to the financial statements

Approved on behalf of the Board:

(signed) "Chris G. Webster" (signed) "William V. Bradley"
Chris G. Webster, Director William V. Bradley, Director


Monterey Exploration Ltd.
Statements of Earnings (Loss) and Retained Earnings (Deficit)
For the year ended
($000's)

December 31, December 31,
2009 2008
----------------------------------------------------------------------------
Revenues:
Production $ 24,392 $ 33,949
Royalties (3,461) (6,037)
Gain (loss) on financial instruments 118 (662)
Interest 67 15
----------------------------------------------------------------------------

21,116 27,265
----------------------------------------------------------------------------
Expenses:
Operating 9,483 8,119
Transportation costs 1,253 1,033
General and administrative 3,130 2,510
Interest 1,101 1,034
Depreciation, depletion and accretion 22,882 15,348
----------------------------------------------------------------------------

37,849 28,044
----------------------------------------------------------------------------
Loss before income taxes: (16,733) (779)
Future income tax reduction (Note 10) - 1,682
----------------------------------------------------------------------------
Net earnings (loss) (16,733) 903
Retained earnings, beginning of year 2,441 1,538
----------------------------------------------------------------------------
Retained earnings (deficit), end of year $ (14,292) $ 2,441
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Net earnings (loss) per share (Note 8)
Basic and diluted $ (0.48) $ 0.03
----------------------------------------------------------------------------

See accompanying notes to the financial statements


MONTEREY EXPLORATION LTD.
Statements of Cash Flows
For the year ended
($000's)

December 31, December 31,
2009 2008
----------------------------------------------------------------------------

Cash provided by (used in):

Operating activities:
Net earnings (loss) $ (16,733) $ 903
Items not requiring cash from operations:
Unrealized gain on financial instruments (32) -
Stock-based compensation 428 435
Depreciation, depletion and accretion 22,882 15,348
Future income tax reduction - (1,682)
Asset retirement expenditures (Note 7) (572) (442)
Change in non-cash working capital items
(Note 11) 1,026 (3,085)
----------------------------------------------------------------------------

6,999 11,477
----------------------------------------------------------------------------

Financing activities:
Increase (repayments) in bank indebtedness (12,727) 21,661
Share issue costs (1,003) (395)
Issue of common shares 16,125 123
Obligation under capital lease repayments (179) (57)
----------------------------------------------------------------------------

2,216 21,332
----------------------------------------------------------------------------

Investing activities:
Property and equipment additions (16,922) (33,049)
Oil and natural gas property acquisitions - (377)
Oil and natural gas property dispositions 8,754 1,582
Upper Lake Oil & Gas Ltd. transaction costs - (649)
Change in non-cash working capital items (Note 11) 4,326 (323)
----------------------------------------------------------------------------

(3,842) (32,816)
----------------------------------------------------------------------------

Change in cash and cash equivalents 5,373 (7)
Cash and cash equivalents, beginning of year - 7
----------------------------------------------------------------------------

Cash and cash equivalents, end of year $ 5,373 $ -
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Supplemental cash flow disclosure (Note 11)

See accompanying notes to the financial statements


MONTEREY EXPLORATION LTD.
Notes to the Financial Statements
For the years ended December 31, 2009 and 2008


1. NATURE OF OPERATIONS

Monterey Exploration Ltd. (the "Corporation" or "Monterey") is incorporated under the Business Corporations Act (Alberta) and is engaged in the acquisition, exploration, development and production of natural gas, natural gas liquids and crude oil in the Western Canadian Sedimentary Basin.

2. SIGNIFICANT ACCOUNTING POLICIES

a) Basis of presentation

Management has prepared the financial statements in accordance with Canadian generally accepted accounting principles and all amounts are stated in Canadian dollars, except where otherwise indicated.

b) Measurement uncertainty

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. Actual amounts could differ from those estimates.

The amounts recorded for stock-based compensation, depletion, depreciation and accretion, the provision for asset retirement obligations and determining whether the carrying value of oil and natural gas interests is impaired are based upon estimates of proved oil and natural gas reserves, production rates, commodity prices, future costs and other relevant assumptions. Future income tax expense (reduction) is calculated using income tax rates based on the estimated timing of reversal of temporary differences between accounting and tax values of certain assets and liabilities and involves forecasting the amount of the future income tax asset that will be realized. By their nature, these estimates are subject to measurement uncertainty, and the impact on the financial statements of future periods could be material.

c) Cash and cash equivalents

Cash and cash equivalents are composed of cash and short-term investments with original maturities of less than three months.

d) Joint operations accounting

A portion of Monterey's exploration, development and production activities are conducted jointly with others and accordingly the financial statements reflect only the Corporation's proportionate working interest in such activities.

e) Oil and natural gas properties and equipment

i) Capitalized costs:

Monterey follows the full cost method of accounting, whereby all costs associated with the exploration and development of oil and natural gas reserves are capitalized in cost centers on a country-by-country basis. Such costs include lease acquisition costs, geological and geophysical costs, carrying charges of non-producing properties, costs of drilling both productive and non-productive wells, the cost of petroleum and natural gas production equipment and overhead charges directly related to exploration and development activities. Gains or losses are not recognized upon the disposition of oil and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the rate of depletion and depreciation by 20% or more.

ii) Depletion and depreciation:

Costs capitalized under the full cost method of accounting, together with estimated future capital costs associated with proved reserves, are depreciated and depleted using the unit-of production method which is based on gross production and estimated proved oil and natural gas reserves as determined by independent reserve evaluators. When proved reserves are assigned or the property is considered impaired the costs of the property or the amount of the impairment is added to the costs subject to depletion. For purposes of the depletion and depreciation calculations, oil and natural gas reserves are converted to a common unit of measure on the basis of their relative energy content, being six thousand cubic feet of natural gas to one barrel of oil equivalent. The cost of unproven properties is excluded from the depreciation and depletion base. These unproven properties are assessed periodically to ascertain if impairment has occurred.

Depreciation of office furniture and equipment is provided for over the estimated useful lives of the assets using the declining balance method at a rate of 25%.

iii) Ceiling Test:

Oil and natural gas properties and equipment are evaluated at least annually at year-end to determine whether the carrying amount in a cost centre is recoverable and does not exceed the fair market value of the properties in the cost centre. The carrying amounts are assessed to be recoverable when the sum of the undiscounted cash flows expected from the properties and the lower of cost and market of unproved properties exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted cash flows expected from the production of proved plus probable reserves, and the lower of cost and market of unproved properties of the cost centre. The cash flows are estimated using expected future product prices and costs and are discounted using a risk free interest rate.

f) Asset retirement obligations

The Corporation records a liability for the fair value of legal obligations associated with the abandonment of oil and gas properties in the period in which they are incurred, normally when the asset is purchased or developed. Upon recognition of the liability there is a corresponding increase in the carrying amount of the related asset known as the asset retirement cost which is depleted on a unit-of production basis over the life of the reserves. The liability is adjusted each reporting period to reflect the passage of time, with accretion charged to earnings, and for revisions to the estimated future cash flows. Actual costs incurred upon the settlement of the obligations are charged against the liability.

g) Flow-through shares

The Corporation will finance a portion of its exploration and development activities through the issuance of flow-through common shares. Under the terms of the flow-through share agreements, the resource expenditures deductions for income tax purposes are renounced to subscribers in accordance with the appropriate income tax legislation. A future income tax liability is recorded and share capital is reduced by the estimated tax benefits transferred to the flow-through common share subscribers at the time the qualifying expenditures are renounced to such subscribers.

h) Revenue recognition

Revenue for the sale of oil and natural gas production of the Corporation is recognized based on volumes delivered to customers at contractual delivery points and rates, whereby title passes from the Corporation to its customers and collection of funds is reasonably assured.

i) Stock-based compensation

The Corporation has an equity incentive plan that is described in Note 7c). The Corporation accounts for its stock-based compensation plan using the fair value method. Under the fair value method, the fair value of stock options is charged to earnings over the vesting period with a corresponding increase in contributed surplus. The fair value of options granted is estimated at the date of grant using the Black-Scholes evaluation model. Upon the exercise of the stock option, consideration paid by the option holder together with the amount previously recognized in contributed surplus, is credited to share capital.

j) Income taxes

Monterey follows the asset and liability method of accounting for income taxes. Under this method, income tax liabilities and assets are recognized for the estimated income tax consequences attributable to differences between the amounts reported in the financial statements of Monterey and its respective tax base using substantively enacted future income tax rates. The effective change in income tax rates on future income tax liabilities and assets is recognized in income in the period in which the change occurs. Temporary differences arising on acquisitions result in future income tax assets and liabilities. Future income tax assets are recognized to the extent that realization of such assets is more likely than not.

k) Per share amounts

Basic per share amounts are calculated using the weighted average number of common shares outstanding. The treasury stock method is used to determine the dilutive effect of stock options and other dilutive instruments. This method assumes that the proceeds from the exercise of "in-the-money" stock options plus the unamortized stock-based compensation are used to repurchase the Corporation's shares at the weighted average market price during the period.

l) Financial instruments

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument to another entity. Upon initial recognition, all financial instruments, including all derivatives, are recognized on the balance sheet at fair value. Subsequent measurement is then based on the financial instruments being classified into one of five categories: held for trading, held to maturity, loans and receivables, available for sale, and other financial liabilities. "Held for trading" financial assets and financial liabilities are measured at fair value with changes in fair value recognized in earnings (loss). Financial assets classified as being "Available for sale" are measured at fair value, with changes in fair value recognized in other comprehensive income (loss). "Held to maturity" financial assets and "loans and receivables" and "other financial liabilities" are measured at amortized cost.

The Corporation may enter into certain financial derivative or physical delivery sales contracts in order to reduce its exposure to market risks from fluctuations in commodity prices. These instruments are not used for trading or speculative purposes. The Corporation will not designate its financial derivative contracts as effective accounting hedges. As a result, all financial derivative contracts will be classified as held for trading and will be recorded on the balance sheet at fair value, with changes in the fair value recognized in petroleum and natural gas revenue. Settlements of financial derivative contracts will be recognized in petroleum and natural gas revenue at the time each transaction under contract is settled.

From time to time, Monterey may enter into physical delivery sales contracts, for the purpose of receipt or delivery of oil or natural gas. Settlements of physical sale contracts will be recognized in petroleum and natural gas sales at the time of the settlement and there will be no recognition of fair value on the balance sheet.

m) Changes in accounting policies

On January 1, 2009, Monterey adopted Section 3064 "Goodwill and Other Intangible Assets" issued by the CICA. Under the new accounting standard, criteria for the recognition, measurement and disclosure of Goodwill and Other Intangible Assets are clarified. Adoption of the new accounting standard did not result in changes to Monterey's financial statements or note disclosures.

On January 1, 2011, the Corporation will be required to adopt International Financial Reporting Standards ("IFRS") and prepare its financial statements under this new set of standards, thereby replacing the preparation of Monterey's financial statements using Canadian generally accepted accounting principles.

3. FINANCIAL INSTRUMENTS

At December 31, 2009, Monterey's financial instruments include cash and cash equivalents, accounts receivable, commodity price risk management contracts, accounts payable and accrued liabilities, bank indebtedness and obligation under capital lease. The Corporation's financial instruments have been classified accordingly: i) held for trading - cash and cash equivalents and commodity price risk management contracts, and ii) loans and receivables - accounts receivable, and iii) other liabilities - accounts payable and accrued liabilities, bank indebtedness and obligation under capital lease.



As at December 31, 2009 Monterey is a party to the following commodity
price risk management contracts:

Volume Unrealized
(GJ per Price Gain in
Sales Point Contract Type Term day) ($ per GJ) $000's
----------------------------------------------------------------------------
February 2010 -
AECO C Financial - swap - March 2010 2,000 5.40 $15
April 2010 -
AECO C Financial - swap June 2010 1,000 5.42 $17


The Corporation's derivative financial instruments are initially recorded at their fair value, and are subsequently marked to market, while Monterey's loans and receivables are recorded at their amortized cost.

Monterey has exposure to market risk, credit risk, and liquidity risk. A discussion of how the Corporation is exposed and manages each type of risk is noted below:

a) Market risk

(i) Commodity price risk:

The Corporation is primarily exposed to market risk in the form of commodity price volatility. Monterey's objective for commodity price risk management is to ensure that sufficient protection exists to enable the Corporation to meet budgeted capital expenditures in the event of downward movements in commodity prices. The Corporation's Board of Directors ("Board") has authorized Management to enter into forward financial and physical risk management contracts on Monterey's production. Management may, subject to approval by the Corporation's Board, commit up to 50 percent of Monterey's annualized, production before royalties as reported in the most recently completed calendar quarter to a forward risk management contract. In addition, the term of any commodity contract cannot exceed a period of two years.

In addition to the commodity price risk management contracts noted in the table above, during the fourth quarter of 2009, the Corporation entered into a fixed price derivative contract on 2,000 GJs of natural gas per day at a price of $5.07 per GJ for the period from November 1, 2009 to December 31, 2009. Monterey realized a gain on this contract of approximately $86,000.

(ii) Interest rate risk:

Monterey's capital and operating expenditures are funded by any combination of the following: bank indebtedness, working capital, cash flow from operations and the issuance of equity. To the extent that expenditures are funded by incurring additional bank indebtedness, the Corporation has a contractual obligation to repay those funds borrowed plus interest on those borrowings. Changes in Canadian interest rates result in variation in the interest expense on funds borrowed by the Corporation.

Monterey's Board manages the Corporation's exposure to interest rate risk by restricting budgeted expenditures, and in turn controlling the amount of bank indebtedness that Monterey may incur. The Corporation may also minimize its exposure to interest rate risk by issuing equity or selling assets to reduce bank indebtedness or by fixing the interest rate on short-term borrowings through the issue of guaranteed notes.

At December 31, 2009, Monterey had total bank indebtedness of approximately $22.6 million. Assuming that the Corporation maintained its existing bank indebtedness for one year, a 1.00% change in Canadian interest rates would result in a variance of approximately $0.2 million in Monterey's average annualized interest expense.

b) Credit risk

A substantial majority of Monterey's petroleum and natural gas production is marketed under standard industry terms, with a pre-arranged monthly settlement day for payment of revenues from Monterey's purchasers of its sales volumes. As a result, the Corporation is exposed to credit risk as a financial loss would result if Monterey's customers or joint venture partners failed to meet their contractual obligations to reimburse the Corporation for its accounts receivables. At December 31, 2009, approximately $0.2 million, or 6% of the Corporation's accounts receivables were outstanding for over 90 days, with a significant majority of receivables outstanding for less than 30 days.

Monterey's accounts receivable are with established customers and joint operating partners in the petroleum and natural gas industry and are subject to normal industry credit risks.

Monterey's policy is to manage its credit risk by transacting with customers and entities that have good established credit ratings, and by diversifying its sales with a large group of customers.

The Corporation may further mitigate its credit risk by withholding production from joint venture partners in the event of non-payment. At December 31, 2009, Monterey did not have a provision for doubtful accounts as the majority of its receivables have been outstanding for less than 30 days, and the Corporation has a favorable collection history.

c) Liquidity risk

Liquidity risk is the risk that Monterey cannot meet its financial obligations as they come due. During times of extreme downward volatility in commodity prices, the Corporation manages this risk by maintaining net debt (bank debt plus capital lease obligation and non-cash working capital deficit or less non-cash working capital surplus) below the total amount of borrowings available under the Corporation's credit facility. The Corporation may reduce its net debt through the issuance of equity, the disposal of assets or by reducing anticipated capital expenditures to an amount less than cash flow generated from operations.

During 2009, in order to control the Corporation's exposure to liquidity risk, Monterey has actively taken steps to manage its bank indebtedness, including: year-to-date dispositions of non-core undeveloped oil and gas properties for approximate net cash proceeds of $8.8 million; renewed its credit facility of $45.0 million until May 2010; completed an equity issuance for net cash proceeds of $15.1 million; and entered into forward commodity price contracts to secure the price received on sales volumes in the near term from commodity price volatility.



4. PROPERTY AND EQUIPMENT

Accumulated
depletion and
($000's) Cost depreciation Net book value
----------------------------------------------------------------------------

Oil and natural gas
properties $ 183,522 $ 56,021 $ 127,501
Office furniture and
equipment 387 181 206
----------------------------------------------------------------------------

December 31, 2009 $ 183,909 $ 56,202 $ 127,707
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Accumulated
depletion and
($000's) Cost depreciation Net book value
----------------------------------------------------------------------------
Oil and natural gas
properties $ 175,118 $ 33,935 $ 141,183
Office furniture and
equipment 387 112 275
----------------------------------------------------------------------------

December 31, 2008 $ 175,505 $ 34,047 $ 141,458
----------------------------------------------------------------------------
----------------------------------------------------------------------------


During the year ended December 31, 2009, Monterey capitalized, to the cost of oil and natural gas properties, approximately $1,214,000 of general and administrative expenses that were directly related to exploration and development activities (2008 - $1,279,000). This amount includes approximately $216,000 (2008 - $258,000) of non-cash stock-based compensation expenses.

Undeveloped property costs of $8,503,000 were excluded from the depletion and depreciation calculation of oil and natural gas properties at December 31, 2009 (2008 - $9,718,000). Future costs of $47,155,000 to develop proved undeveloped reserves have been included in the depletion and depreciation calculation of oil and natural gas properties at December 31, 2009 (2008 - $24,042,000).

The Corporation has performed the ceiling test as at December 31, 2009 to assess the recoverable value of the property and equipment. The crude oil and natural gas future prices are based on the January 1, 2010 commodity price forecast of Monterey's independent reserve evaluators as outlined in the following table. Based on these assumptions, the undiscounted value of the future net revenues from the Corporation's estimated proved reserves exceeded the carrying value of property and equipment as at December 31, 2009.



----------------------------------------------------------------------------
WTI Edmonton Monterey's AECO Monterey's Exchange
Oil Price Oil Price Oil Price Gas Price Gas Price Rate
Year ($US/bbl) ($Cdn/bbl) ($Cdn/bbl) ($Cdn/mmbtu) ($Cdn/mcf) ($US/$Cdn)
----------------------------------------------------------------------------
2010 80.00 83.26 75.66 5.96 5.72 0.95
2011 83.00 86.42 79.45 6.79 6.51 0.95
2012 86.00 89.58 83.20 6.89 6.65 0.95
2013 89.00 92.74 86.65 6.95 6.71 0.95
2014 92.00 95.90 90.11 7.05 6.83 0.95
2015 93.84 97.84 92.04 7.16 6.93 0.95
2016 95.72 99.81 94.02 7.42 7.21 0.95
2017 97.64 101.83 96.04 7.95 7.78 0.95
2018 99.59 103.88 98.09 8.52 8.39 0.95
2019 101.58 105.98 100.19 8.69 8.57 0.95
2020+ +2.00% escalation per year 0.95
----------------------------------------------------------------------------


5. ACQUISITION OF UPPER LAKE OIL & GAS LTD. ("UPPER LAKE")

On August 29, 2008, Monterey acquired all of the common shares of Upper Lake, a Canadian publicly traded oil and gas exploration corporation active in the Western Canadian Sedimentary Basin, through the issuance of 7,795,704 common shares at a total fair value of approximately $29,513,000 ($30,162,000 including transaction costs).

The acquisition was accounted for using the purchase method, with results of operations included from the date of acquisition. The allocation to assets and liabilities is as follows:



($000's)
----------------------------------------------------------------------------
Purchase consideration:
Issue of common shares $ 29,513
Transaction costs 649
----------------------------------------------------------------------------

Total purchase consideration $ 30,162
----------------------------------------------------------------------------
----------------------------------------------------------------------------


($000's)
----------------------------------------------------------------------------
Net assets acquired:
Oil and natural gas properties $ 36,347
Working capital deficit (1,826)
Bank indebtedness (2,469)
Obligation under capital lease (280)
Asset retirement obligations (1,610)
----------------------------------------------------------------------------

Net assets acquired $ 30,162
----------------------------------------------------------------------------
----------------------------------------------------------------------------


6. BANK INDEBTEDNESS, BANK DEBT & DERIVATIVES FACILITY

The Corporation has access to a demand revolving credit facility (the "Facility") of $45 million and a derivatives facility with a Canadian banking institution (the "Lender"). The Facility permits Canadian and U.S. dollar borrowings to finance the Corporation's operations.

During 2009, Monterey made drawings against the Facility in the form of prime based loans and guaranteed rate term notes with maturities of up to 365 days from issue. As at December 31, 2009, Monterey had bank indebtedness of approximately $22.6 million (2008 - $35.3 million). In addition, the Corporation has issued approximately $149,000 in letters of credit/guarantee under the Facility.

Under the Facility, Monterey has the ability to borrow from the Lender up to $45 million in the form of: (i) revolving prime based and US prime based borrowing in multiples of $25,000; (ii) issue of guaranteed notes and LIBOR borrowing subject to minimum borrowings of $1 million and additional amounts in multiples of $0.1 million having terms to maturity from 15 to 365 days from the date of issue; and (iii) letters of credit/guarantee, to a cumulative maximum of $12.5 million, for a period of up to one year. The Facility permits Monterey's access to a derivates facility, whereby the Corporation may enter into U.S. foreign exchange forward contracts or interest and commodity derivatives contracts with the Lender. Covenants on Monterey's derivatives facility limit the commodity derivatives contracts entered into by the Corporation to a maximum of 60% of Monterey's annualized before royalties production as reported in the most recently completed calendar quarter and that the term of any commodity contract will not exceed a period of two years.

Under the Facility interest rates on: (i) Canadian and US dollar prime based borrowing will be at the applicable Lender's prime lending rate plus 1.25%; (ii) on the issue of guaranteed notes or LIBOR borrowing Monterey will pay the base rate plus a stamping fee of 2.5% per annum; and a fee equal to 1.25% per annum, payable at issue, on letters of credit/guarantee. Monterey borrowings in excess of $40.5 million will incur interest at an additional 1% per annum. Monterey also pays a monthly stand-by fee on the average unused portion of the Facility at a rate of 0.35% per annum.

The Lender has the right to demand repayment or to terminate all or a portion of the amount of the borrowings availability under the Facility at any time without notice. Monterey has the right to draw against the Facility, repay amounts borrowed or convert the type of borrowings subject to providing same day notice for borrowings less than $5.0 million and one business day notice for borrowings of $5.0 million or more.

The Facility is guaranteed by a Monterey general security agreement providing a floating charge on all the Corporation's lands and a security interest over all present and subsequently acquired personal property. Under the terms of the Facility, Monterey is obligated to meet certain covenants including providing certain financial and engineering information in a timely manner; however, Monterey is not required to meet any specific numerical financial covenants, such as a debt to equity ratio or minimum working capital or liquidity amounts. The next review of the Facility will be completed prior to June 2010.

Upon maturity of certain borrowings in the form of guaranteed notes in March 2010, the Corporation will pay the Lender $0.3 million in respect of stamping fee adjustments.

7. ASSET RETIREMENT OBLIGATIONS

Monterey's asset retirement obligation results from net ownership interests in oil and natural gas properties including well sites, gathering systems, compression and processing facilities. The Corporation estimates that at December 31, 2009 the total undiscounted amount of cash flows required to settle its asset retirement obligations is approximately $8.1 million (inflation adjusted). The timing for settlement of these obligations is based on the economic lives of the underlying assets. The majority of the costs associated with the asset retirement obligations are anticipated to be incurred between the next 15 to 20 years. Monterey used a credit-adjusted risk-free rate of 8.75% and an inflation rate of 2% to calculate the fair value of the asset retirement obligations.



The changes in the asset retirement obligation for the year ended December
31, 2009, is as follows:

Year ended Year ended
($000's) December 31, 2009 December 31, 2008
----------------------------------------------------------------------------

Balance, beginning of year $ 4,471 $ 2,366

Liabilities incurred and acquired 29 1,729
Liabilities disposed (9) (23)
Accretion expense 727 364
Liabilities settled (572) (442)
Revisions - 477
----------------------------------------------------------------------------

Balance, end of year $ 4,646 $ 4,471
----------------------------------------------------------------------------
----------------------------------------------------------------------------


8. SHARE CAPITAL

a) Authorized

Monterey is authorized to issue an unlimited number of common shares and unlimited number of non-voting common shares.



b) Issued

Common shares Number ($000's)
----------------------------------------------------------------------------
Voting common shares, December 31, 2007 19,993,066 57,190
Non-voting common shares, December 31, 2007 5,061,096 8,003
----------------------------------------------------------------------------

Voting and non-voting common shares,
December 31, 2007 25,054,162 65,193
----------------------------------------------------------------------------
February 29, 2008 flow-through share
renouncement - (1,710)
Exercise of stock options 52,634 123
Exercise of stock options, from contributed
surplus - 109
Issued to acquire Upper Lake (Note 4) 7,795,704 29,513
Issue costs, net of income tax benefit
of $111,000 - (284)
----------------------------------------------------------------------------

Voting common shares, December 31, 2008 32,902,500 92,944
----------------------------------------------------------------------------
October 1, 2009 share issuance 8,100,000 16,125
Issue costs - (1,003)
----------------------------------------------------------------------------

Share capital, December 31, 2009 41,002,500 $ 108,066
----------------------------------------------------------------------------
----------------------------------------------------------------------------


(i) Common shares

During the fourth quarter of 2009, 8,100,000 common shares were issued for total cash proceeds of approximately $16.1 million. Of this total, 2,650,000 common shares were issued on a flow-through basis, which will require the Corporation to incur $6,042,000 in exploration expenditures by December 31, 2010. As at December 31, 2009 Monterey had incurred approximately $3,750,000 in exploration expenditures, leaving $2,292,000 to be incurred prior to the end of 2010.

(ii) Common shares held in escrow

On January 12, 2009, 5,061,096 Common Shares previously held in escrow by directors, management, employees and consultants (the "Service Providers") of the Corporation, were released from escrow upon expiry of the escrow agreement.

(iii) Reorganization of non-voting common shares

During the second quarter of 2008, the shareholders of Monterey voted in favor of reorganizing the Corporation's capital structure. Under the reorganization, Monterey's outstanding non-voting shares were exchanged on a one-to-one basis for common shares of the Corporation, thus eliminating the non-voting shares of Monterey from the Corporation's share capital.

c) Stock options

Monterey has established a stock option plan whereby employees, management, directors and consultants may be granted options to purchase common shares. Options granted vest in equal amounts annually over a three-year period and expire five years from the date of grant. The stock options outstanding may not exceed 10% of the outstanding common shares.



The following table provides a summary of the outstanding stock options as
at December 31, 2009:

Weighted average
exercise price
Number ($ per share)
----------------------------------------------------------------------------

Outstanding, December 31, 2007 2,295,666 $2.58
----------------------------------------------------------------------------
Options exercised (52,634) (2.33)
Options forfeited (262,366) (2.58)
Options issued 1,155,000 1.33
----------------------------------------------------------------------------

Outstanding, December 31, 2008 3,135,666 2.12
----------------------------------------------------------------------------
Options issued 832,500 3.71
----------------------------------------------------------------------------

Outstanding, December 31, 2009 3,968,166 $2.45
----------------------------------------------------------------------------



The following table summarizes the stock options outstanding and
exercisable under the stock option plan at December 31, 2009:

Options outstanding Options exercisable
----------------------------------------------------------------------------
Number Weighted Number
outstanding average Weighted exercisable Weighted
Range of at remaining average at average
Exercise December 31, contractual exercise December 31, exercise
prices 2009 life price 2009 price
----------------------------------------------------------------------------

$0.55 535,000 4.0 $0.55 178,333 $0.55
$2.00 - $2.90 2,569,666 2.2 $2.39 1,885,336 $2.42
$3.49 - $4.40 863,500 4.5 $3.81 80,667 $3.49
----------------------------------------------------------------------------

----------------------------------------------------------------------------
3,968,166 2.9 $2.45 2,144,336 $2.40
----------------------------------------------------------------------------
----------------------------------------------------------------------------


d) Stock-based compensation

The Corporation uses the fair value based method for the determination of the stock-based compensation costs. The fair value of each option granted was estimated on the date of grant using the Black-Scholes option pricing model.

During the year ended December 31, 2009, 832,500 (2008 - 1,155,000) stock options were granted to directors and employees of the Corporation. In the pricing model used to determine the value of the option grants during 2009, the following average assumptions were used: risk free interest rate used for options granted was 2.4% (2008 - 2.7%), volatility of 102.0% (2008 - 66.0%), an expected life of 5.0 years and no dividends (2008 - 5.0 years and no dividends). The average fair value of the options issued in 2009 was determined to be $2.80 per option (2008 - $0.65).

e) Contributed surplus



The following table reconciles the contributed surplus at December 31,
2009:

($000's)
----------------------------------------------------------------------------
Balance, December 31, 2008 $ 3,678
Stock-based compensation recognized during 2009 644
----------------------------------------------------------------------------
Balance, December 31, 2009 $ 4,322
----------------------------------------------------------------------------
----------------------------------------------------------------------------


f) Per share amounts

For the year ended December 31, 2009 there were 34,921,952 basic and 36,762,557 diluted weighted average shares outstanding. For the year ended December 31, 2008 there were 27,735,885 basic and 27,736,277 diluted weighted average shares outstanding.

9. CAPITAL DISCLOSURES

Monterey's objectives for managing its capital consist of:



a. Providing an adequate level of return to shareholders of the
Corporation, relative to the risk of Monterey's assets.

b. Preserving a strong balance sheet with sufficient capital from
shareholders to develop existing and prospective assets.


Monterey's main objective is to build a profitable growing energy corporation. As such, the Corporation's primary capital management objective is to promote investor, lender and stakeholder confidence that Monterey is able to meet its obligations and will continue to carry on its business.

Monterey manages its capital structure by issuing new equity or debt, adjusting planned capital spending, or through the sale of assets to reduce debt. Processes primarily utilized to effectively manage capital include ongoing calculation of certain key financial benchmarks such as total liabilities to equity ratio, that net debt (as described under Liquidity risk in Note 3c) is less than funding available under the Facility and net debt to forward cash flow (also described under Liquidity risk in Note 3c) ratio, and comparing the Corporation's benchmarks figures against: (i) accepted prudent financial management benchmarks; (ii) the benchmark figures of similar sized publicly listed entities operating in the Canadian upstream oil and gas industry; and (iii) the anticipated business environment, opportunities and the operations of the Corporation. In addition to the key financial ratios Monterey will also periodically review other measures such as net asset value, funds flow from operations per share and debt adjusted funds flow from operations per share to provide additional indications that the Corporation's capital structure supports investor, lender and stakeholder confidence.

As at December 31, 2009, Monterey's benchmark figures of total debt to equity ratio was 0.39 and the net debt of $25 million was less than the $45 million in funding available under the Facility, and both of these measures meet the Corporation's management control limits. However Monterey's net debt to forward cash flow ratio exceeded the control limit of 2.5. The Corporation has taken and will continue to take various actions, when Monterey deems to be prudent, to reduce the Corporation's net debt.

Actions taken during 2009 by Monterey's management to reduce net debt and meet the capital management objectives include: disposition of non-core oil and gas properties for net proceeds of $8.8 million, renewal of the Facility to eliminate the risks in respect of the cost and the amount of bank debt borrowing available to the Corporation, completion of an equity issue providing $15.1 million in net proceeds and the forward sale of production.

10. INCOME TAXES

The provision for income tax differs from the result that would be obtained by applying the applicable statutory federal and provincial income tax rates to net earnings (loss) before income taxes. This difference results from the following items for the year ended December 31, 2009 and December 31, 2008:



($000's) 2009 2008
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Loss before income taxes $ (16,733) $ (779)

Combined federal and provincial statutory tax rate 29.29% 30.24%
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Expected income tax recovery $ (4,901) $ (235)

Increase (decrease) resulting from the tax effect of:
Stock-based compensation expense 125 131
Effect of change in income tax rate 415 879
Expiry of non-capital losses 2,031 -
Change in valuation allowance 2,325 (2,460)
Other 5 3
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Income tax reduction $ - $ (1,682)
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The components of the Corporation's future income tax assets and
liabilities, as at December 31, 2009 and December 31, 2008 are as follows:

($000's) 2009 2008
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Future income tax assets:
Share issue costs $ 445 $ 416
Non-capital losses 12,257 15,966
Asset retirement obligation 1,165 1,148
Valuation allowance (19,005) (16,471)
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(5,138) 1,059

Future income tax liability:
Property and equipment 5,138 (1,059)
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Net future income tax asset $ - $ -
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At December 31, 2009, subject to confirmation by income tax authorities, Monterey has approximately $194,277,000 of income tax deductions, including non-capital losses of approximately $44,969,000, available for application against future taxable income. The full benefit of which has not been included in these financial statements.



The Corporation's non-capital losses, if not utilized, expire as follows:

($000's)
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2010 $ 15,986
2011 28,318
2012 665
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Non-capital losses available $ 44,969
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11. SUPPLEMENTAL CASH FLOW INFORMATION

a) Increase (decrease) in non-cash working capital items:

Year Year
ended ended
($000's) Dec 31, 2009 Dec 31, 2008
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Change in non-cash working capital:
Accounts receivable $ 2,185 $ 3,451
Prepaid expenses and deposits 147 355
Accounts payable and accrued liabilities 3,020 (7,214)
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$ 5,352 $ (3,408)
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Changes in non-cash working capital related to:
Operating activities $ 1,026 $ (3,085)
Investing activities 4,326 (323)
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$ 5,352 $ (3,408)
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b) Supplementary cash flow information:

Year Year
ended ended
($000's) Dec 31, 2009 Dec 31, 2008
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Cash interest paid $ 725 $ 962
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12. COMMITMENT

Office lease

Monterey is committed to future payments under an operating lease for head office space and parking facilities totaling approximately $1.7 million until October 30, 2014. Of this total, Monterey is committed to $354,000 for each of the years from 2010 to 2013, and $295,000 in 2014.

13. RELATED PARTY TRANSACTIONS

a) Legal services

A director of Monterey is a partner at a law firm that provides legal services to the Corporation. During the year ended December 31, 2009, the Corporation incurred approximately $139,000 in legal services and disbursements associated with this related party (2008 - $210,000). At December 31, 2009 the Corporation did not have an outstanding payable with this related party (2008 - $10,000).

b) Transactions with shareholder

During the year ended December 31, 2009, the Corporation had transactions totaling approximately $186,000 (2008 - $479,000) with an entity that holds approximately 20% of the outstanding common shares of Monterey. The transactions primarily consisted of Monterey's participation in the joint exploration, development and production of petroleum and natural gas properties. All transactions were completed on an arm's length basis consistent with normal industry terms. The value of the transactions between Monterey and the related party were recorded at the carrying amount, which approximated their fair value. At December 31, 2009, Monterey's records include $8,000 (2008 - $6,000) in accounts receivable and $5,000 in accounts payable (2008 - $26,000) with this shareholder.

c) Common management and directors

Certain directors of Monterey are also the directors or management of other entities that participate in joint operations with the Corporation. Transactions with these related parties are on terms that are consistent with parties dealing at arm's length. For the year ended December 31, 2009, the aggregate value of transactions entered into between Monterey and these entities was approximately $2,842,000 (2008 - $5,804,000). At December 31, 2009 Monterey's records include outstanding payables owed to the related parties of $1,271,000 (2008 - $53,000) and accounts receivables due to Monterey of approximately $75,000 (2008 - $206,000).

14. SUBSEQUENT EVENTS

a) Forward commodity price contract

In January 2010, Monterey entered into a forward financial commodity price contract on 1,000 gigajoules ("GJ") per day of natural gas at a price of $5.425 per GJ, for the period from April 1, 2010 until October 31, 2010.

b) Common share issuance

In February 2010, Monterey completed the issuance of 4,762,000 common shares at a price of $4.20 per common share on a bought deal basis, for total gross proceeds of $20.0 million, or approximately $18.8 million in net proceeds after taking into account share issue costs of $1.2 million.

As part of the February 2010 common share issuance, the related party disclosed in Note 13b) purchased 952,500 common shares of Monterey, accounting for approximately $4.0 million of the $20.0 million in gross proceeds.

Contact Information

  • Monterey Exploration Ltd.
    Patrick Manuel
    President and Chief Executive Officer
    (403) 691-7725
    or
    Monterey Exploration Ltd.
    David Fisher
    Vice President, Finance & Chief Financial Officer
    (403) 691-7725
    www.montereyexploration.com