Arsenal Energy Inc.
TSX : AEI
FRANKFURT : A1E

Arsenal Energy Inc.

March 27, 2006 18:00 ET

Arsenal Announces 2005 Operating and Financial Results

CALGARY, ALBERTA--(CCNMatthews - March 27, 2006) -

This news release is not for distribution in the United States.

Arsenal Energy Inc. ("Arsenal or the Company") (TSX:AEI) (FRANKFURT:A1E) is pleased to announce the results of operations for the three and twelve month periods ended December 31, 2005. Arsenal has filed the detailed Management's Discussion and Analysis ("MD&A") and audited Financial Statements at www.sedar.com.

2005 CORPORATE HIGHLIGHTS

- Record funds from operations of $0.15 per share during 2005.

- Generation of exceptional shareholder returns. At the time of printing our share price was 65% greater than it was at the beginning of 2005.

- Proved and probable reserves increased 30 percent to 3.8 mmboe from 2.9 mmboe in 2004.

- The corporate acquisition of IC Energy Inc., which closed March 31, 2005.

- The acquisition of 350 barrels of oil equivalent in west central Saskatchewan and east central Alberta which closed on June 29, 2005. After a successful drilling program these assets were producing approximately 450 barrels of oil equivalent at December 31, 2005.

- The corporate acquisition of Quadra Resources Corp., which closed on August 11, 2005. The principal asset of Quadra at acquisition was the 7.5 million acre Nuqra concession in Egypt.

- The execution of a successful four well drilling program in northern Alberta. We achieved 50% success in exploratory drilling at Evi, Mitsue and Lubicon targeting high quality crude oil.



SELECTED FINANCIAL AND OPERATIONAL INFORMATION

------------------------------------------------------------------------
Three Months Ended Twelve Months Ended
FINANCIAL December 31 December 31
------------------------------------------------------------------------
2005 2004 2005 2004
------------------------------------------------------------------------
Financial
Funds from operations(1) 1,048,820 92,492 4,242,029 287,764
Per unit - basic 0.03 0.00 0.15 0.02
Per unit - diluted 0.03 0.00 0.14 0.02
Bank debt 2,496,195 3,743,852 2,496,195 3,743,852
Operating costs per boe 17.54 19.31 15.14 17.60
Operating netbacks
per boe 16.16 15.05 16.13 18.26
Market
Shares outstanding
End of period 42,231,244 18,989,706 42,231,244 18,989,706
Weighted average
- basic 33,705,825 14,759,445 28,586,521 11,837,622
Weighted average
- diluted 34,407,996 15,603,505 29,288,692 12,681,693
Shares trading
High 1.98 1.00 1.98 1.00
Low 1.21 0.59 0.88 0.59
Close 1.70 0.85 1.70 0.85
Average daily volume 99,000 19,000 67,000 13,200
------------------------------------------------------------------------
------------------------------------------------------------------------

OPERATIONS
------------------------------------------------------------------------
Daily production (average)
Crude oil (bbl) 1,340 369 1,140 152
NGLs (bbl) 32 32 35 11
Natural gas (mcf) 609 245 500 82
------------------------------------------------------------------------
Total (boe)(2) 1,473 442 1,257 177
Realized commodity prices
($Cdn.)
Total crude oil (bbl) 45.19 49.62 51.33 49.83
NGLs (bbl) 68.99 49.54 49.25 47.01
Natural gas (mcf) 8.40 7.77 7.28 7.52
------------------------------------------------------------------------
Average (boe)(2) 43.98 45.68 44.02 46.36
Reference pricing
WTI (U.S.$/bbl) 60.07 48.28 56.57 41.40
AECO gas ($Cdn./mcf) 11.08 7.08 8.31 6.79
Foreign Exchange
($U.S./$Cdn.) 1.17 1.22 1.21 1.33
------------------------------------------------------------------------
------------------------------------------------------------------------


(1) Funds from operations before change in non-cash working capital is not a recognized measure under Canadian generally accepted accounting principles. Management uses funds from operations before change in non-cash working capital to analyze performance and considers it a key measure as it demonstrates the Company's ability to generate the cash necessary to fund future capital investments and to repay debt. Funds from operations before change in non-cash working capital has been defined by the Company as net earnings (loss) plus the addback of non-cash items (depletion, depreciation and accretion, stock-based compensation, future income taxes and unrealized foreign exchange) and excludes the change in non-cash working capital related to operating activities. Arsenal's determination of funds from operations before change in non-cash working capital may not be comparable to that reported by other companies. Arsenal also presents funds from operations before change in non-cash working capital per share whereby amounts per share are calculated using weighted average shares outstanding consistent with the calculation of earnings per share.

(2) The term barrels of oil equivalent ("boe") may be misleading, particularly if used in isolation. A boe conversion ratio of six thousand cubic feet per barrel (6mcf/bbl) of natural gas to barrels of oil equivalence is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. All boe conversions in the report are derived from converting gas to oil in the ratio mix of six thousand cubic feet of gas to one barrel of oil.

OPERATIONS IN REVIEW

2005 was another strong year for oil and gas producers in Canada. Record commodity prices, and new drilling and optimization technologies combined to generate above average returns for most producers. For Arsenal it was a year in which the foundation was laid for future growth and the generation of shareholder value. Starting with the IC Energy acquisition and continuing with the Saskatchewan property and Quadra acquisitions, we were able to achieve record production and cashflow for the year.

NORTH DAKOTA

Production has remained stable throughout the year at 365 barrels of oil equivalent per day. During 2006 we intend to initiate a waterflood over certain properties to enhance production and reduced operating costs, and are currently reviewing both 3D and 2D seismic to identify drilling locations for second quarter of 2006.

LLOYDMINISTER

Production at Lloydminster was continually impacted by both wet weather and access to service rigs during 2005. We completed an 8.0 (net) well drilling program on these lands during the fourth quarter of 2005 with an 88 percent success rate. We continue to actively pursue service rigs to regain our shut-in production here and are reviewing alternative opportunities including contracting a service rig for an extended period of time to mitigate this risk during 2006.

ALBERTA

We drilled the first wells on our farm-in lands at Evi, Mitsue and Lubicon, achieving a 50 percent drill success rate. These wells target the Granite Wash and Gilwood formations, and produce high quality, light sweet oil. We intend to actively drill on these lands during 2006, however we have been unsuccessful in securing a drilling rig as record activity levels has severely restricted supply. As spring break-up approaches, we are confident that we will be able to secure a rig for an extended period and begin our drilling program. The majority of our lands are located in areas with year round access, which enables us to drill as soon as road bans are lifted after spring breakup.

EGYPT

During the first quarter of 2006, Arsenal along with its working interest partners are currently completing an 800 kilometer 2D seismic program. The seismic acquisition program is anticipated to be completed in the second quarter and the first two exploration wells are scheduled to be drilled in the fourth quarter of 2006. A field geological survey is also underway to investigate surface outcrops and oil seeps in the Nuqra area.

COMMODITY PRICING

Light sweet crude oil continues to test historical highs with increasing demand from Asia and stagnant global production. It is anticipated in the market that WTI will remain above $55 US for the remainder of the year, and potentially could increase as supply concerns continue to dominate the market.

In the first quarter of 2006, natural gas remained well above historical averages for the past year, however it has recently weakened as inventories rose as the result of unseasonably warm weather, particularly in the north eastern United States.

Heavy oil pricing was significantly impacted by disruptions in the western Canadian synthetic crude oil and heavy crude market at the beginning of 2005. Due to maintenance and equipment failures industry bitumen upgraders were off production in January of 2006 and bitumen streams normally moved into the synthetic market were diverted into the heavy crude oil market. This reduced the amount of upgrading capacity and increased the amount of heavy crude oil on the markets, significantly increasing the price differentials for heavy oil. The heavy oil differential widened uncharacteristically fast during the third quarter of 2005, reflecting decreased demand from an unseasonably wet spring and summer which shortened the summer paving season.

RESULTS OF OPERATIONS

DRILLING ACTIVITY

Arsenal participated in 7.0 gross wells (4.50 net) during the fourth quarter in Northern Alberta and Lloydminster. During the year Arsenal drilled 20.0 (12.08 gross) wells. 5.0 wells (2.5 net) were drilled in Northern Alberta and 15.0 (9.58 net) were drilled at Lloydminster.



Three Months Ended Twelve Months Ended
December 31 December 31
------------------------------------------------------------------------
2005 2004 2005 2004
Drilling Activity Gross Net Gross Net Gross Net Gross Net
------------------------------------------------------------------------
Oil 5.0 3.30 2.0 1.0 17.0 9.88 10.0 3.375
Gas 0.0 0.0 0.0 0.0 0.0 0.0 2.0 1.400
Dry and abandoned 2.0 1.2 0.0 0.0 3.0 2.2 0.0 0.0
------------------------------------------------------------------------
Total 7.0 4.50 2.0 1.0 20.0 12.08 12.0 4.775
------------------------------------------------------------------------
------------------------------------------------------------------------


RESULTS OF OPERATIONS

PRODUCTION AND MARKETING

Production volumes for the year ended December 31, 2005 increased to 1,257 boe/d, which represents a 612% increase over 2004. Production volumes for the three month period ended December 31, 2005 averaged 1,473 boe/d, a 233% increase over the same period in 2004. The increase in volumes over comparable periods is attributable to corporate and property acquisitions completed during they year. At September 30, 2005, the Company anticipated fourth quarter production of 1,800 boe/d. The eight well drilling program was not started until December of 2005, which negatively impacted the average production rate. Inability to obtain a service rig also impacted production during the quarter as wells which were shut-in took longer than anticipated to get back onstream.

Crude oil production increased 650% for the year ended December 31, 2005, attributable to the acquisition of IC Energy on March 31, 2005 and new drilling completed at Maidstone and in northern Alberta. Natural gas production increased 1,267% and related natural gas liquids increased 1,100% over the prior year due to natural gas and NGL production acquired through the acquisition of IC Energy.

Crude oil is sold under 30-day evergreen contracts while natural gas production is sold in the spot market. Arsenal continues to be an oil weighted producer, however with the corporate acquisition of Tiverton Petroleums which closed March 13, 2006 will add approximately 2,600 mcf/d of natural gas production and approximately 215 boe/d of light sweet and medium crude oil production.

Drilling and service rig availability continues to be a restrictive factor on the Company's production. As spring break up approaches Arsenal expects that several drilling rigs will be available and the Company will be able to commence drilling on its northern Alberta lands which have year round access. Drilling at Tower Creek is slated to begin during March and continue through June, reflecting the 5,100 meter depth of the play.



Three Months Ended Twelve Months Ended
December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Crude oil
(bbl/d) 1,340 369 263 1,140 152 650
NGL (bbl/d) 32 32 (1) 35 11 1,100
Natural gas
(mcf/d) 609 245 148 500 82 1,267
------------------------------------------------------------------------
Total (boe/d) 1,473 442 233 1,257 177 612
------------------------------------------------------------------------
------------------------------------------------------------------------
Production split
------------------------------------------------------------------------
Oil & NGLs 93% 91% 3 93% 92% 1
Natural Gas 7% 2% 244 7% 8% (14)
------------------------------------------------------------------------
------------------------------------------------------------------------


COMMODITY PRICES

Commodity price realizations decreased 5% and 14% respectively over comparable periods in 2004. Fourth quarter crude oil prices before realized derivatives losses decreased 18% compared to the same quarter in 2004, attributable to the increased production from Arsenal's heavy oil properties at Lloydminster. The impact of favourable crude oil prices was partly offset by a 9% decline in the value of the US dollar relative to the Canadian dollar during the year. Fourth quarter natural gas prices increased 8% over the same period in 2004, while the benchmark AECO and NYMEX prices increased 56% and 87% respectively over the same period.

Arsenal anticipates continued high commodity prices as supply issues continue to dominate the market.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
Prices - Before % %
Derivatives 2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Total crude oil
(bbl) 45.19 55.21 (18) 51.33 49.83 3
NGLs (bbl) 68.99 49.54 39 49.25 47.01 5
Natural gas
(mcf) 8.40 7.77 8 7.28 7.52 (3)
------------------------------------------------------------------------
Total (boe) 43.98 51.27 (14) 44.02 46.36 (5)
------------------------------------------------------------------------
------------------------------------------------------------------------


Reference Pricing
------------------------------------------------------------------------
WTI ($U.S./bbl) 60.07 48.28 24 56.57 41.40 37
AECO gas
($Cdn./mcf) 11.08 7.08 56 8.31 6.79 22
NYMEX gas
($U.S./mmbtu) 12.85 6.87 87 9.06 6.09 49
Foreign exchange
($Cdn./$U.S.) 1.17 1.22 (4) 1.21 1.33 (9)
------------------------------------------------------------------------
------------------------------------------------------------------------


OIL AND GAS REVENUE

Net oil and gas revenue for the fourth quarter of 2005 was 220% higher than the comparable period in 2004, reflecting increased crude oil production resulting from corporate and property acquisitions combined with higher commodity prices. Net oil and gas revenue for the twelve months ended December 31, 2005 was 513% higher in 2005 when compared to the prior period.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Crude oil
sales 5,451,047 1,669,198 227 17,684,874 2,775,998 537
NGL sales 196,127 146,137 34 614,493 197,021 212
Natural gas
sales 454,044 175,144 159 1,316,093 226,122 482
Other 214,146 90,687 - 409,533 162,388 -
Loss on
forward
contracts (294,188) (198,674) - (1,287,328) (262,583) -
------------------------------------------------------------------------
Gross oil and
gas revenue 6,021,176 1,882,492 220 18,737,666 3,098,946 505

Per boe 44.42 46.31 (4) 40.71 47.93 (15)
------------------------------------------------------------------------
------------------------------------------------------------------------


ROYALTIES

During the fourth quarter, royalties as a percentage of gross oil and gas revenue decreased 4% over the prior year reflecting a royalty holiday granted on one new well drilled at Evi. Royalties as a percentage of gross oil and gas revenue were consistent at 22% for the 12 months ending December 31, 2005 and 2004.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Royalties 1,452,733 485,960 199 4,344,657 732,630 493
% of gross
oil and gas
revenue 24 23 (4) 23 22 -
Per boe 10.72 11.96 (10) 9.44 11.33 (17)
------------------------------------------------------------------------
------------------------------------------------------------------------


OPERATING COSTS

Operating expenses per boe for the three and twelve months ended December 31, 2005 decreased 9% and 14%, respectively, over the prior periods. The decrease is due to lower field optimization costs in 2005 compared to 2004. Arsenal plans to continue with field optimization initiatives in Canada and North Dakota, and expects costs to trend lower during 2006. Operating costs continue to be higher than management estimates as services costs have increased significantly over 2005, reflecting heightened activity in the industry.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Operating
expense 2,377,754 784,873 203 6,968,397 1,141,164 511
Per boe 17.54 19.31 (9) 15.14 17.65 (14)
------------------------------------------------------------------------
------------------------------------------------------------------------


PRODUCT NETBACKS

Netbacks for both the three month period ended December 31, 2005 increased 15% over 2004 reflecting the impact of the light sweet production from Evi and Mitsue. Netbacks for the twelve months ended December 31, 2005 decreased 10% over the comparable period reflecting the impact of heavy oil production.



Three Months Ended Twelve Months Ended
($Cdn. per boe) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Net revenue
after
derivatives 44.42 46.31 (4) 40.71 47.93 (15)
Royalties (10.72) (11.96) (10) (9.44) (11.33) (17)
Operating
expense (17.54) (19.31) (9) (15.14) (17.65) (14)
------------------------------------------------------------------------
Operating
netback 16.16 15.05 7 16.13 18.95 (15)
------------------------------------------------------------------------
------------------------------------------------------------------------


GENERAL AND ADMINISTRATIVE

General and administrative costs per boe decreased 56% and 66% during both the three and twelve month periods ended December 31, 2005 over the respective periods in 2004. The decrease is attributable to significantly higher production with consistent staffing levels over the prior year. Arsenal expects general and administrative costs per boe to continue to trend lower as production continues to increase with the acquisition of Tiverton.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
General and
administrative 609,310 362,995 68 2,235,660 881,918 153
General and
administrative
per boe 4.49 8.93 (50) 4.86 13.64 (64)
------------------------------------------------------------------------
------------------------------------------------------------------------


FINANCE CHARGES

Finance charges were 220% and 349% higher over the three and twelve month period ended December 31, 2004. The increase is attributable to the higher average draw on the Company's credit facility during the current year. Finance charges per boe were 4% and 37% lower than comparable periods reflecting higher production levels in 2005.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Finance
charges 120,625 37,655 220 423,197 94,266 349
Per boe 0.89 0.93 (4) 0.92 1.46 (37)
------------------------------------------------------------------------
------------------------------------------------------------------------


DEPLETION, DEPRECIATION, AND ACCRETION

Depletion, depreciation and accretion ("DD&A") per boe increased 126% and 20%, respectively, for the three and twelve months ended December 31, 2005 compared to the same periods in 2004. The increase is attributable to the significantly increased asset base and production levels over the prior year.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Depletion,
depreciation
and
accretion 1,723,002 228,910 653 4,324,855 507,458 752
Per boe 12.71 5.63 126 9.40 7.85 20
------------------------------------------------------------------------
------------------------------------------------------------------------


STOCK BASED COMPENSATION

Compensation expense per boe increased 23% and 87% respectively over comparable periods in 2005. The increase is due to new option grants completed during 2005 and the vesting of options granted in 2004.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Compensation
expense 344,322 84,193 309 1,119,466 84,193 1,230
Per boe 2.54 2.07 23 2.43 1.30 87
------------------------------------------------------------------------
------------------------------------------------------------------------


TAXES

During the twelve month period ended December 31, 2005, Arsenal accrued $342,090 of current taxes on its US streamed income. In Canada, Arsenal does not expect to pay any cash taxes in 2006 based on existing tax pools, planned capital expenditures and the most recent forecast of 2006 taxable income. Although current tax horizons depend on product prices, production levels, and the nature, magnitude and timing of capital spending, the Company currently believes that no cash income tax will be payable for three years.

Future income taxes are recorded to the extent that the carrying value of the assets of Arsenal are different from the tax basis, and if Company has incurred a net loss during the year. Future income taxes are recorded on corporate acquisitions to the extent the book value of assets acquired exceeds the tax basis.

Future income tax recoveries are booked to the extent that the Company satisfies the "more likely than not" test, in that the future tax asset is "more likely than not" to be realized in future periods.

During the fourth quarter of 2005, Arsenal reduced future income taxes by $148,873 compared to a future tax reduction of $228,093 in 2004. A future income tax balance of $7,509,044 is recorded as a liability as at December 31, 2005 (2004 - 1,443,129).

With the closing of Tiverton corporate acquisition on March 13, 2005, Arsenal inherits approximately $23.0 million in tax pools, subject to successor rules as defined by the Canada Revenue Agency.



Three Months Ended Twelve Months Ended
($Cdn.) December 31 December 31
------------------------------------------------------------------------
% %
2005 2004 Change 2005 2004 Change
------------------------------------------------------------------------
Current income
taxes 342,090 - 100 342,090 - 100
Future income
taxes
(reduction) (148,873) (228,093) (35) 79,768 (216,174) (137)
------------------------------------------------------------------------
193,217 (228,093) (185) 421,858 (216,174) (295)

Taxes per boe 1.43 (5.61) (125) 0.92 (3.34) (127)
------------------------------------------------------------------------
------------------------------------------------------------------------


SUMMARY OF ANNUAL RESULTS

Year Ended December 31
------------------------------------
Restated
2005 2004 2003
------------------------------------------------------------------------
Total revenue 18,737,666 3,098,946 984,587
Net income (loss) (1,100,424) (126,509) 104,599
Per share - basic and diluted (0.04) (0.01) 0.02
Funds from operations 4,242,029 287,764 103,143
Per share - basic and diluted 0.15 0.02 0.02
Total assets 54,157,383 16,690,703 2,889,856
Total debt 2,496,195 3,743,852 -
------------------------------------------------------------------------
------------------------------------------------------------------------


Total revenue has increased commensurate with production growth over the past three years. Higher price realizations are offset by higher royalty rates and operating costs reflecting the impact of heavy oil and higher royalties in North Dakota.

Net income per share has decreased due to higher DD&A rates resulting from a larger property, plant and equipment base, additional stock-based compensation expense and higher absolute general and administrative costs when compared to prior periods. Funds from operations per share has increased significantly over prior years reflecting higher production levels and commodity prices.

Total assets have increased commensurate with corporate and property acquisitions completed over the past three years along with internal development activities. Debt has remained consistent over the past year, reflecting equity raised during the fourth quarter of 2005.

SUMMARY OF QUARTERLY RESULTS

The following table highlights the Company's performance for the most recent eight quarters that comprise the 2005 and 2003 fiscal years. Total revenue is primarily impacted by commodity prices, production volumes and royalties. Net income and net income per share are primarily impacted by operating, general and administrative costs DD&A and future income taxes. Per share values for the fourth quarter of 2005 are also impacted by the significant increase in shares outstanding, reflecting equity issues during the period.

Funds from operations primarily impacted by commodity prices, production, operating costs and royalties. Per share values for the fourth quarter are also impacted by the significant increase in shares outstanding, reflecting equity issues during the period.



($Cdn.) 2005
------------------------------------------------------------------------
Q4 Q3 Q2 Q1
------------------------------------------------------------------------
Total net revenue 4,568,443 4,479,544 3,290,840 2,054,182
Net income (loss) (586,319) (200,436) (157,408) (156,261)
Per share - basic (0.04) (0.01) (0.01) (0.01)
Per share - diluted (0.04) (0.01) (0.01) (0.01)

Funds from operations 1,048,820 1,835,348 871,288 486,573
Per share - basic 0.03 0.06 0.03 0.02
Per share - diluted 0.03 0.06 0.03 0.02
Total assets 54,157,383 48,955,973 38,308,547 30,978,254
Total bank debt 2,496,195 12,443,478 12,668,469 7,601,583
Shares outstanding 42,231,244 33,400,567 28,015,244 26,407,303
------------------------------------------------------------------------
------------------------------------------------------------------------

($Cdn.) 2004
------------------------------------------------------------------------
Q4 Q3 Q2 Q1
------------------------------------------------------------------------
Total net revenue 1,802,339 716,186 138,709 195,042
Net income (loss) 45,846 (50,832) (77,265) (44,258)
Per share - basic 0.00 (0.01) (0.01) (0.01)
Per share - diluted 0.00 (0.01) (0.01) (0.01)

Funds from operations 92,492 119,608 (35,215) 29,135
Per share - basic 0.01 0.01 (0.01) 0.01
Per share - diluted 0.01 0.01 (0.01) 0.01
Total assets 16,690,703 9,777,944 3,364,353 3,169,054
Total bank debt 3,743,852 3,700,000 - -
Shares outstanding 18,989,706 13,588,667 11,591,875 11,591,875
------------------------------------------------------------------------
------------------------------------------------------------------------


LIQUIDITY

Three Twelve
Months Ended Months Ended
December 31, December 31,
($Cdn.) 2005 2005
------------------------------------------------------------------------
Sources
Funds from operations 1,048,820 4,242,029
Issue of shares - net 11,130,428 12,849,372
Issue of warrants 1,582,144 6,133,159
Exercise of stock options 13,550 207,334
Change in non-cash working capital -
operating items 2,454,073 786,775
Change in non-cash working capital -
investing items (1,257,006) (688,265)
------------------------------------------------------------------------
Total sources of cash 14,972,008 23,530,404

Uses
Corporate acquisitions 5,941,054 (5,500,000)
Plant, property and equipment additions (10,965,780) (16,999,809)
Cash on hand - 217,062
------------------------------------------------------------------------
Total uses of cash (5,024,725) (22,282,747)

Decrease in bank debt 9,947,283 1,247,657
------------------------------------------------------------------------
------------------------------------------------------------------------


Bank Debt plus Working Capital Deficit

At December 31, 2005, the Company had $2.5 million outstanding on its credit facility and a working capital deficit of $1.2 million, for total debt plus working capital deficit of $4.2 million, compared to total debt plus working capital of $5.4 million at December 31, 2004. The Company's anticipated funds from operations before change in non-cash working capital is expected to be sufficient to meet the current working capital deficit. The capital intensive nature of the industry will generally result in the Company having a working capital deficit, however, the Company will maintain total debt plus working capital deficit below the Company's credit facility. At December 31, 2005, the Company had a credit facility of $14.2 million.

Share Capital

The following table outlines the common share issues, warrant and option exercises during the year:



Common shares
------------------------------------------------------------------------
Opening 18,989,706
Issued to acquire IC Energy 3,000,000
Issued to acquire Quadra 4,088,292
Issued for cash 8,760,496
Issued on exercise of options 972,025
Issued on exercise of warrants 6,745,725
------------------------------------------------------------------------
Closing 42,556,244
------------------------------------------------------------------------
------------------------------------------------------------------------


CAPITAL EXPENDITURES

Capital expenditures for the year ended December 31, 2005 totalled $35.3 million. Corporate, land and property acquisitions relate to IC Energy, Quadra and the property acquisition which closed June 30, 2005. Seismic expenditures were incurred at Kaybob, Evi and Malmo. Drilling and completion expenditures relate to wells at Evi, Lubicon and Mitsue in Alberta, and Tangleflags and Maidstone in Saskatchewan.



($ Cdn.) Total
------------------------------------------------------------------------
Corporate, property and land acquisitions 22,217,797
Seismic 386,251
Drilling and completions 8,672,104
Production facilities 1,867,684
------------------------------------------------------------------------
Total capital expenditures 33,143,835
------------------------------------------------------------------------
------------------------------------------------------------------------


OUTLOOK

STRATEGY

Arsenal's domestic production and cashflow has increased significantly over 2004. The Company anticipates continued growth domestically both through the drill-bit and accretive acquisitions like Tiverton.

The Company remains committed to utilizing a portion of cashflows earned domestically to fund high impact international opportunities like the Nuqra concession in Egypt. The Company continues to search for other international opportunities with the following profile:

- Experienced and established international operator

- Considerable land acreage

- Pre-existing seismic or geological data establishing existence of source and reservoir rock.

Egypt

The 800 km seismic evaluation program is currently being completed on schedule, and the reprocessing of 3,100 km of seismic acquired over the concession has confirmed thirteen leads ranging in size between 9.0 million original barrels in place and more than 100.0 million original barrels in place. The first two wells are scheduled to be drilled in the fourth quarter of 2006.

North America

Arsenal emphasises a full-cycle approach to its business and plans to continue with internal development opportunities as a means to enhancing its production base and creating value for shareholders. Consistent with its full-cycle approach, Arsenal actively added to its undeveloped land position through crown land sales during 2005 and in early 2006 in order to establish high-quality drilling prospects. The Company also obtained seismic options over considerable acreage in northern Alberta to further expand our core areas there.

The Company will continue to pursue acquisitions that will be accretive on a per share basis to cash flow, production, reserves and net asset value. One of the key components of the Tiverton acquisition is the existence of a high quality drilling inventory which Arsenal intends to quickly develop during 2006. Arsenal believes that over the long term, outlook for both crude oil and natural gas pricing remains strong.



2006 CAPITAL BUDGET

($Cdn.)
------------------------------------------------------------------------
Drilling
Western Alberta 10,500,000
Central Saskatchewan 6,000,000
North Dakota 2,750,000
Egypt 6,000,000
Optimization
North Dakota 750,000
Central Saskatchewan 1,000,000
------------------------------------------------------------------------
Total Capital 27,000,000
------------------------------------------------------------------------
------------------------------------------------------------------------


Arsenal will fund its 2005 capital program through cash flow and its credit facility. The Company has a $6.5 million flow-through obligation which will be satisfied through exploratory drilling in Western Alberta and Central Saskatchewan during 2006.

2006 PRODUCTION VOLUMES

The production forecast for 2006 will be principally impacted by weather, timing of new production and economic activity and are derived based on management's assumptions utilized for 2006 planning purposes. Assumptions include certain levels and profiles of capital expenditures, operating costs, projected sales volumes, interest rates, foreign currency exchange rates, and other assumptions that impact operations. These assumptions can vary significantly from actual events and may result in material variances from the expected results.

This forecast includes the impact of the Tiverton Petroleums acquisition which closed March 13, 2006.



Minimum Maximum 2005 Actual
------------------------------------------------------------------------
Light Oil and NGLs (bbl/d) 650 1,600 400
Heavy Oil (bbl/d) 1,100 2,000 774
Natural gas (mcf/d) 2,700 3,000 500
------------------------------------------------------------------------
Total (boe/d) 2,200 4,100 1,257
------------------------------------------------------------------------
------------------------------------------------------------------------
Production split
------------------------------------------------------------------------
Light Oil & NGLs 30% 39% 32%
Heavy Oil 50% 49% 62%
Natural Gas 20% 12% 7%
------------------------------------------------------------------------
------------------------------------------------------------------------


CONSOLIDATED BALANCE SHEETS

As at December 31 2005 2004
------------------------------------------------------------------------
ASSETS
Current assets
Cash - 217,063
Accounts receivable 4,583,927 582,762
------------------------------------------------------------------------
4,583,927 799,825
Reclamation bonds (note 7) 203,291 210,960
Property, plant and
equipment (note 6) 44,578,604 15,679,918
Goodwill (note 4) 4,791,561 -
------------------------------------------------------------------------
54,157,383 16,690,703
------------------------------------------------------------------------
------------------------------------------------------------------------

LIABILITIES
Current liabilities
Accounts payable and
accrued liabilities 6,365,577 2,265,903
Revolving demand loan (note 9) 2,496,195 3,743,852
Current portion of
deferred revenue (note 8) 287,533 352,650
------------------------------------------------------------------------
9,149,305 6,362,405
Deferred revenue (note 8) - 198,229
Future income taxes (note 10) 7,509,044 1,443,129
Asset retirement
obligations (note 11) 1,295,500 780,889
------------------------------------------------------------------------
17,953,849 8,784,652
------------------------------------------------------------------------

SHAREHOLDERS' EQUITY
Shareholders' equity (note 12) 36,514,809 7,458,134
Warrants (note 13) 303,731 988,760
Contributed surplus (note 14) 1,170,444 144,183
Deficit (1,785,450) (685,026)
------------------------------------------------------------------------
36,203,534 7,906,051
------------------------------------------------------------------------
54,157,383 16,690,703
------------------------------------------------------------------------
------------------------------------------------------------------------

Segmented information (note 16)
Commitments and contingencies (note 17)
Subsequent events (note 18)

See accompanying notes to the financial statements.


CONSOLIDATED STATEMENTS OF OPERATIONS AND DEFICIT

For the year ended December 31 2005 2004
------------------------------------------------------------------------

REVENUE
Oil and gas 18,737,666 3,098,946
Royalties (net of Alberta
Royalty Tax Credit) (4,344,657) (732,630)
------------------------------------------------------------------------
14,393,009 2,366,316
------------------------------------------------------------------------

EXPENSES
Operating 6,968,397 1,141,164
General and administrative 2,235,660 881,918
Finance charges 423,197 94,266
Depletion, depreciation
and accretion 4,324,855 507,458
Stock-based compensation
expense 1,119,466 84,193
------------------------------------------------------------------------
15,071,575 2,708,999
------------------------------------------------------------------------

Loss before income taxes (678,566) (342,683)
------------------------------------------------------------------------
Income taxes (note 10)
Current income taxes 342,090 -
Future income taxes (reduction) 79,768 (216,174)
------------------------------------------------------------------------
Income taxes 421,858 (216,174)
------------------------------------------------------------------------
Net loss (1,100,424) (126,509)
Deficit - beginning of year (685,026) (159,523)
Acquisition adjustment (note 4) - (398,994)
------------------------------------------------------------------------
Deficit - end of year (1,785,450) (685,026)
------------------------------------------------------------------------
------------------------------------------------------------------------

Loss per share - basic and diluted $ (0.04) $ (0.01)

Segmented information (note 16)

See accompanying notes to the financial statements.


CONSOLIDATED STATEMENTS OF CASH FLOWS

For the year ended December 31 2005 2004
------------------------------------------------------------------------

Cash flows from operating activities
Net loss (1,100,424) (126,509)
Items not affecting cash
Depletion, depreciation
and accretion 4,324,855 507,458
Future income taxes (note 10) 79,768 (216,174)
Stock-based compensation
expense (note 14) 1,119,466 84,193
Deferred revenue (263,346) -
Unrealized foreign exchange 81,709 38,796
------------------------------------------------------------------------
4,242,028 287,764
Net change in non-cash working
capital items (note 15) 786,775 131,421
------------------------------------------------------------------------
Net cash provided by operating
activities 5,028,803 419,185
------------------------------------------------------------------------

Cash flows from investing activities
Corporate acquisitions (note 4) (5,500,000) (2,118,879)
Additions to property,
plant and equipment (16,999,809) (9,017,185)
Changes in non-cash working capital
- investing items (note 15) (688,265) 1,109,645
------------------------------------------------------------------------
Net cash used in investing
activities (23,188,074) (10,026,419)
------------------------------------------------------------------------

Cash flows from financing activities
Issue of shares for cash 13,573,157 4,270,532
Issue of shares upon exercise
of warrants 6,133,159 988,760
Issue of shares for cash upon
exercise of stock options 207,334 20,000
Share issue costs (723,785) (493,306)
Deferred revenue - 550,879
Proceeds from revolving
demand loan 12,443,478 3,743,852
Repayment of revolving
demand loan (13,691,135) -
------------------------------------------------------------------------
Net cash provided by financing
activities 17,942,208 9,080,717
------------------------------------------------------------------------

Change in cash during the year (217,063) (526,517)
Cash - Beginning of year 217,063 743,580
------------------------------------------------------------------------
Cash - End of year - 217,063
------------------------------------------------------------------------
------------------------------------------------------------------------

Supplemental information (note 15)
Segmented information (note 16)

See accompanying notes to the financial statements.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005 and 2004


1. ORGANIZATION AND BASIS OF PRESENTATION

Arsenal Energy Inc. ("Arsenal")

Arsenal Capital Inc. is incorporated under the laws of the province of Alberta. The principal business of the Company is the exploration for, exploitation, development and production of oil and natural gas reserves in Canada, the United States and Egypt. Each country in which Arsenal conducts business has been treated as an identifiable reporting segment, refer to note 16 for additional disclosures.

2. SIGNIFICANT ACCOUNTING POLICIES

Consolidation

These consolidated financial statements include the accounts of Arsenal and its wholly owned subsidiaries from the date of acquisition (note 4). These accounts are referred to collectively as "Arsenal" or "the Company". Investments and unincorporated joint ventures are accounted for using the proportionate consolidation method, whereby the Company's proportionate share of revenues, expenses, assets and liabilities are included in the accounts.

Revenue recognition

Revenue associated with the sale of crude oil, natural gas, and natural gas liquids owned by the Company are recognized when title passes from the Company to its customers.

Property, plant and equipment

Arsenal uses the full cost accounting method for oil and gas exploration, development and production activities. The cost of acquiring oil and natural gas properties as well as subsequent development costs are capitalized and accumulated in a cost center. Maintenance and repairs are charged against income, and renewals and enhancements, which extend the economic life of the property, plant and equipment, are capitalized. Gains and losses are not recognized upon disposition of oil and natural gas properties unless such a disposition would alter the rate of depletion by at least 20%. All other equipment is carried at the lesser of depreciated cost and fair value.

Ceiling test

A ceiling test is performed at least annually to assess the carrying value of oil and gas assets. A cost center is defined on a country by country basis, and is tested for recoverability using undiscounted future cash flows from proved reserves and forward indexed commodity prices, adjusted for contractual obligations and product quality differentials. A cost center is written down to its fair value when its carrying value, less the cost of unproved properties, is in excess of the related undiscounted cash flows. Fair value is estimated using accepted present value techniques that incorporate risk and uncertainty when determining expected future cash flows. Unproved properties are excluded from the ceiling test calculation and subject to a separate impairment test.

Depletion, depreciation and accretion

In accordance with the full cost accounting method, all crude oil and natural gas acquisition, exploration, and development costs, including asset retirement costs, are accumulated in a cost center. The aggregate of net capitalized costs and estimated future development costs, less the cost of unproved properties and estimated salvage value, is amortized using the unit-of-production method based on current period production and estimated proved oil and gas. All other equipment is depreciated over the estimated useful life of the respective assets.

Oil and gas reserves

The estimation of reserves is a subjective process. Forecasts are based on engineering data, projected future rates of production, estimated commodity prices, and consider the timing of future expenditures. Arsenal expects reserve estimates to be revised based on the results of future drilling activity, testing, production levels, and economics of recovery based on cash flow forecasts.

Income taxes

Arsenal uses the assets and liability method of accounting for income taxes and records future income taxes for the effect of any difference between the accounting and income tax basis of an asset or liability, using the substantively enacted income tax rates. Accumulated future income tax balances are adjusted to reflect changes in income tax rates that are substantively enacted during the period with the adjustment recognized in net income. Future tax assets are recorded only to the extent it is more likely than not that these assets will be realized. The determination of Arsenal's income and other tax liabilities are subject to audit and potential reassessment after the lapse of considerable time. Accordingly, actual income tax liabilities or recoveries may differ from estimates.

Goodwill

Goodwill is the residual amount that results when the purchase price of an acquired business exceeds the fair value of the net identifiable assets and liabilities of the acquired business. Net identifiable liabilities acquired include an estimate of future income taxes. Goodwill is tested at least annually for impairment. Impairment is charged to net income in the period in which it occurs.

The test for impairment is the comparison of the book value of net assets (assets less liabilities) to the fair value of the business unit, being the Company. If the fair value of the Company is less than its book value, the impairment loss is measured by allocating the fair value of the Company to the identifiable assets and liabilities at their fair values. The excess of the Company's fair value over the identifiable net assets is the implied fair value of goodwill. If this amount is less than the book value of goodwill, the difference is the impairment amount.

Per share calculations

Basic per share amounts are calculated using the weighted average number of shares outstanding during the year. Weighted average number of shares is determined by relating the portion of time within the reporting period that common shares have been outstanding to the total time in that period.

The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only dilutive instruments where the market price exceeds the exercise price impact the diluted calculations.

Measurement uncertainty

The timely preparation of financial statements in conformity with Canadian generally accepted accounting principles requires that management make estimates and assumptions and use judgment regarding assets, liabilities, revenues, and expenses. Such estimates primarily relate to unsettled transactions and events as of the date of the financial statements. Accordingly, actual results may differ from estimated amounts as future confirming events occur.

Amounts recorded for depreciation, depletion, and amortization, asset retirement costs and obligations, and amounts used for ceiling test and impairment calculations are based on estimates of oil and natural gas reserves and future costs required to develop those reserves. By their nature, these estimates are subject to measurement uncertainty, and the impact on the financial statements of future periods could be material.

Foreign currency translation

The Company translates foreign currency denominated transactions and the financial statements of integrated foreign operations using the temporal method. Monetary assets and liabilities are translated at year-end rates. Non-monetary assets and liabilities are translated at rates in effect on the dates of the transactions. Income and expenses are translated at average rates in effect during the year with the exception of amortization, which is translated at historic rates. Exchange gains and losses on translation of monetary assets and liabilities are reflected in income immediately.

Flow-through shares

Flow-through shares are issued at a fixed price and the proceeds are used to fund qualifying exploration and development expenditures within a defined period. The qualifying expenditure deductions funded by flow-through arrangements are renounced to investors in accordance with Canadian tax legislation. To recognize the foregone tax benefits of flow-through shares, share capital is reduced and a future income tax liability is recorded for the estimated future tax cost of the renounced expenditures, when the expenditures are renounced.

3. CHANGES IN ACCOUNTING POLICIES

Asset retirement obligations

Effective January 1, 2004, Arsenal retroactively adopted new Canadian accounting standards for asset retirement obligations. The standard requires that the fair value of an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made.

The present value of the asset retirement obligation is recognized as a liability with the corresponding asset retirement cost capitalized as part of property, plant and equipment. The asset retirement obligation will increase over time due to accretion and the asset retirement cost will be depreciated on a basis consistent with depreciation and depletion. Arsenal previously used the unit-of-production method to match estimated future retirement costs with the revenues generated over the life of the petroleum and natural gas properties based on total estimated proved reserves and an estimated future liability.

As a result of adopting the new standard January 1, 2004, property, plant and equipment increased $90,307 and retained earnings decreased $20,734.

There was no impact on the Company's cash flow as a result of adopting this new standard. See Note 11 for additional information on the asset retirement obligation.

Derivative instruments and hedging relationships

Effective January 1, 2004, Arsenal adopted new Canadian accounting standards for hedging relationships and accounting for trading, speculative or non trading derivative financial instruments. In accordance with the new guideline, all unrealized derivative instruments that either do not qualify as a hedge, or are not designated as a hedge, are recorded as a derivative asset or a derivative liability on the consolidated balance sheet with any changes in fair value during the period recognized in income. Prior to January 1, 2004, Arsenal recognized gains and losses on derivative contracts at the time of settlement.

The Company did not enter into any contractual relationships that qualify for hedge accounting during 2004. The Company has received a prepayment on the forward contract it has entered into at August 31, 2004, and as such no derivative gain or loss has been recognized.

4. ACQUISITIONS

On August 11, 2005 Arsenal acquired all of the issued and outstanding securities of Quadra Resources Corp. ("Quadra"). On March 31, 2005 Arsenal acquired all of the issued and outstanding shares of IC Energy Inc. ("IC Energy").

On December 15, 2004 Arsenal acquired all of the issued and outstanding shares of Nahanni Oil and Gas Ltd. ("Nahanni"). On March 24, 2004 Arsenal acquired all of the issued and outstanding shares of Orange Exploration Inc. ("Orange"). The purchase method of accounting was used for each business combination and the allocation of the purchase price and consideration for each acquisition is as follows:



Quadra IC Energy Nahanni Orange
2005 2005 2004 2004
------------------------------------------------------------------------
Net assets acquired at
assigned values:
------------------------------------------------------------------------
Working capital
deficiency (145,650) - (234,988) -
Property, plant
and equipment - 10,243,000 4,965,504 325,080
Undeveloped land 4,785,794 - - -
Seismic 720,000 - - -
Goodwill 2,126,363 2,665,198 - -
Debt assumed - - (193,851) -
Asset retirement
obligation - (123,713) (88,123) -
Future income taxes (2,003,493) (2,784,485) (1,579,663) (92,880)
------------------------------------------------------------------------
Net assets acquired 5,483,014 10,000,000 2,868,879 232,200
------------------------------------------------------------------------
------------------------------------------------------------------------

Financed by:
------------------------------------------------------------------------
Shares issued (note 12) 5,233,014 4,500,000 750,000 550,375
Warrants issued - - - 80,819
Cash - 5,500,000 2,118,879 -
Acquisition adjustment - - - (398,994)
Acquisition costs 250,000 - - -
------------------------------------------------------------------------
Purchase price 5,483,014 10,000,000 2,868,879 232,200
------------------------------------------------------------------------
------------------------------------------------------------------------


5. RELATED PARTY TRANSACTIONS

Subscription receivable

The Company issued shares to an officer and director on a subscription receivable basis, the proceeds of which will be recognized on a cash basis. At December 31, 2005, $325,000 is owed by the officer and director. The shares have not been recognized as issued for accounting purposes.

Acquisition of Orange Exploration Inc.

On March 24, 2004 the Company acquired 100% of the issued and outstanding shares of Orange Exploration Inc. ("Orange"). This transaction was a related party transaction in that both companies had common ownership and control. The acquisition was accounted for as a purchase based on the fair value of the consideration paid which was equal to $631,194. The asset was recorded in property, plant and equipment at the carrying value of Orange of $232,200, the difference between the fair value of the consideration given and the carrying value of $398,994 was recorded as a reduction of retained earnings. The fair value of the share purchase warrants granted was calculated using the following assumptions: zero dividend yield; expected volatility of 80%; risk free rate of 4%: and an expected life of 1 year. This resulted in fair a value of $0.07 per warrant.



6. PROPERTY, PLANT AND EQUIPMENT

2005 2004
------------------------------------------------------------------------
Property, plant, and equipment 49,648,267 16,504,432
Accumulated depletion, depreciation,
and amortization (5,069,663) (824,514)
------------------------------------------------------------------------
44,578,604 15,679,918
------------------------------------------------------------------------
------------------------------------------------------------------------


In Canada and the United States, all costs of unproved properties, net of any associated revenues, have been capitalized and depleted during 2005 and 2004. Future development costs totalling $637,600 (2004 - $453,000) were included in the full cost pool for depletion. In Egypt, costs of unproved properties totalling $5,505,794 have been excluded from depletion as drilling and production activities have not commenced.

Included in property, plant, and equipment are asset retirement costs of $1,020,118 (2004 - $752,743). The prices used in the ceiling test evaluation of Arsenal's natural gas, crude oil, and natural gas liquids reserves at December 31, 2005 were as follows:



Foreign Hardisty
WTI Oil Exchange Heavy Oil NYMEX Gas AECO Gas
Year ($U.S./bbl) ($Cdn./$U.S.) ($Cdn./bbl) ($U.S./mcf) ($Cdn./mcf)
------------------------------------------------------------------------
2006 60.00 1.17 44.60 11.50 11.25
2007 61.20 1.17 46.00 10.20 10.25
2008 62.45 1.17 47.50 8.85 8.65
2009 61.60 1.17 46.50 8.50 8.25
2010 59.55 1.17 44.10 8.65 8.45
2011 - 2025 63.63 1.17 48.89 10.18 10.30
Remainder (1) 2.00%
------------------------------------------------------------------------
------------------------------------------------------------------------
(1) Percentage change represents the annual change each year from 2010
to the end of the reserve life.


During the year, Arsenal capitalized general and administrative expenses of $167,500 (2004 - $88,000).

7. RECLAMATION BONDS

At December 31, 2005 the Company had $203,291 (2004 - $210,960) on deposit with the United States Federal and State governments for future site reclamation activities. These funds will be returned when the Company abandons and reclaims well sites in the United States.

8. RISK MANAGEMENT AND FINANCIAL INSTRUMENTS

Commodity price risk management

The Company entered into a crude oil sale contract during the period fixing the price of future production of 180 barrels per day at $46.93 per barrel. The Company received a prepayment on the contract equal to an incremental $5.59 per barrel which will be recognized as revenue based on deliveries over the life of the contract. This forward contract expires in September of 2006.

Fair value of financial instruments

The Company's exposure under its financial instruments is limited to financial assets and liabilities, all of which are included in these financial statements. The fair values of financial assets and liabilities that are included in the balance sheet approximate their carrying amounts.

Credit risk

A substantial portion of the Company's accounts receivable are with customers and joint venture partners in the oil and gas industry and are subject to normal industry credit risks. Purchasers of the Company's natural gas, crude oil and natural gas liquids are subject to an internal credit review to minimize the risk of non-payment.

Foreign currency exchange risk

The Company is exposed to foreign currency fluctuations as crude oil and natural gas prices received are referenced to U.S. dollar denominated prices.

Interest rate risk

The Company is exposed to interest rate risk to the extent that bank debt is at a floating rate of interest.

9. REVOLVING DEMAND LOAN

At December 31, 2005, The Company has available a demand operating loan in the amount of $14.2 million (December 31, 2004 - $4.0 million) bearing interest at the bank prime rate plus 0.75% per annum and is secured by a fixed and floating charge debenture providing a fixed charge over certain petroleum and natural gas interests and a floating charge over all Canadian and U.S. assets.

At March 31, 2005, the Company was in breach of a bank covenant relating to its working capital ratio. Arsenal obtained a waiver letter from its lending institution in respect of this breach.

10. INCOME TAXES

The tax provision differs from the amount computed by applying the combined Canadian federal and provincial income tax statutory rates to income before income taxes as follows:



2005 2004
------------------------------------------------------------------------
Loss before income taxes (678,566) (342,683)
Statutory tax rate 38.89% 41.37%
------------------------------------------------------------------------
Expected tax provision (recovery) (263,894) (141,768)
Adjustments:
Non-deductible crown royalties 531,672 11,280
Resource allowance (354,877) (13,780)
Stock-based compensation 435,373 30,000
Higher income tax rates in other jurisdictions
and other rate adjustments 85,674 (60,900)
Other (12,091) (41,006)
------------------------------------------------------------------------
Income taxes (recovery) 421,858 (216,174)
------------------------------------------------------------------------
Future tax liability comprised of:
Property, plant and equipment 8,312,970 2,353,334
Non-capital losses - (458,983)
Share issue costs (332,753) (167,212)
Asset retirement obligations (471,173) (284,010)
------------------------------------------------------------------------
Future income taxes 7,509,044 1,443,129
------------------------------------------------------------------------
------------------------------------------------------------------------


11. ASSET RETIREMENT OBLIGATIONS

The following table presents the reconciliation of the beginning and ending aggregate carrying amount of the obligation associated with the retirement of oil and gas properties:



Year Ended Year Ended
December 31, 2005 December 31, 2004
------------------------------------------------------------------------
Asset retirement obligation
- beginning of year 780,889 106,582
Liabilities acquired 334,119 609,300
Liabilities incurred 114,808 58,891
Foreign exchange (14,022) -
Accretion expense 79,706 6,116
------------------------------------------------------------------------
Asset retirement obligation - end of year 1,295,500 780,889
------------------------------------------------------------------------
------------------------------------------------------------------------


The total undiscounted amount of estimated cash flows required to settle the obligation is $6,839,195 (2004 - $1,119,750), which has been discounted using a credit-adjusted risk free rate of 8.0% (2004 - 8.0%) and an inflation factor of 1.5%. The majority of these obligations will be incurred between 2014 and 2025, however certain obligations are not anticipated to be incurred until 2035.



12. SHAREHOLDERS' EQUITY

Authorized

i) Unlimited number of common shares

ii) Unlimited number of non-voting preferred shares, issuable in series

Year Ended Year Ended
December 31, 2005 December 31, 2004
------------------------------------------------------------------------
Shares Amount($) Shares Amount($)
------------------------------------------------------------------------
Balance - beginning of year 18,989,706 7,458,134 8,740,836 2,163,533
Issued to acquire IC Energy 3,000,000 4,500,000 - -
Issued to acquire Quadra 4,088,292 5,483,014 - -
Issued to acquire Nahanni - - 1,000,000 750,000
Issued to acquire Orange - - 1,850,000 550,375
Issued for cash 8,760,496 13,573,157 7,298,870 4,270,532
Cost of shares issued - (723,785) - (493,306)
Tax effect of flow-through
shares - (1,445,169) - -
Tax effect of share issue
costs - 247,000 - 197,000
Issued on exercise of
options 972,025 207,334 100,000 20,000
Issued on exercise of
warrants 6,745,725 6,133,159 - -
Allocated from contributed
surplus - 93,205 - -
Allocated from warrants - 988,760 - -
------------------------------------------------------------------------
Shares issued 42,556,244 36,514,809 18,989,706 7,458,134
Shares held in escrow
(note 5) (325,000) - - -
------------------------------------------------------------------------
Balance - end of year 42,231,244 36,514,809 18,989,706 7,458,134
------------------------------------------------------------------------
------------------------------------------------------------------------


Per share amounts

The per unit calculations for the year ended December 31, 2005 were based on weighted average shares outstanding of 28,586,521 (2004 - 11,838,661). In computing net income per share - diluted, 702,171 (2004 - 843,032) shares were added to the weighted average number of shares outstanding for the year, reflecting the dilutive effect of options and warrants.

Flow through shares

During November and December of 2005 the Company issued 3,279,544 flow-through shares for gross proceeds of $5,739,202. Future tax adjustments relating to the flow-through shares will be recorded as the qualifying expenditures are renounced during 2006.
In June 2005 the Company issued 435,101 flow-through shares for gross proceeds of $748,374. Future tax adjustments relating to the flow-through shares will be recorded as the qualifying expenditures are renounced during 2006.

In December 2004 the Company issued 4,400,000 flow-through shares for gross proceeds of $3,300,000. Future tax adjustments relating to the flow-through shares will be recorded as the qualifying expenditures are renounced during 2005.

In March 2004 the Company issued 675,000 flow-through shares for gross proceeds of $675,000. Future tax adjustments relating to the flow-through shares will be recorded as the qualifying expenditures are renounced during 2005.

13. WARRANTS

During 2005, Arsenal issued warrants through a private placement equity issue. During 2004, the Company issued share purchase warrants in conjunction with the Orange acquisition and through a private placement equity issue. The fair value of each warrant is estimated on the date of issuance using the Black-Scholes option pricing model with the following weighted average assumptions:



2005 2004
------------------------------------------------------------------------
Risk free rate 4% 4%
Expected life 1-2 years 1-2 years
Expected volatility 46%-80% 80%-110%
Expected dividend nil nil
------------------------------------------------------------------------
------------------------------------------------------------------------


Year Ended Year Ended
December 31, 2005 December 31, 2004
------------------------------------------------------------------------
Warrants Amount($) Warrants Amount($)
------------------------------------------------------------------------
Balance - beginning of year 6,588,664 988,760 - -
Issued on acquisition of
Orange (note 5) - - 1,200,000 80,820
Private placement 2,031,100 303,731 5,388,664 907,940
Agents' warrants (1) 157,061 -
Allocated to common equity
upon exercise of warrants (6,745,725) (988,760) - -
------------------------------------------------------------------------
Balance - end of year 2,031,100 303,731 6,588,664 988,760
------------------------------------------------------------------------
------------------------------------------------------------------------
(1) During 2005 the Company's underwriters and agents exercised their
right to an additional 157,061 warrants pursuant to their respective
agency agreements. These warrants were exercised during 2005.


14. STOCK OPTIONS

Arsenal has established an Option Plan (the "Plan") for employees, consultants and independent directors. Pursuant to the Plan arrangement, employees, directors and long-term consultants may be granted options to purchase shares. The exercise price for each option granted was not less than the market price of the shares on the grant date and the contractual term of each option is not to exceed five years. Options granted before October 29, 2004 vested immediately; options granted after October 29, 2004 vest over 18 months.



Year Ended Year Ended
December December
31, 2005 31, 2004
Weighted Weighted
Average Average
Options Price($) Options Price($)
------------------------------------------------------------------------
Balance - beginning of period 2,505,000 0.40 1,150,000 0.21
Granted 2,495,000 1.24 1,455,000 0.58
Exercised (972,025) 0.23 (100,000) 0.20
Cancelled (435,723) 0.59 - -
------------------------------------------------------------------------
Balance - end of period 3,592,252 0.99 2,505,000 0.40
------------------------------------------------------------------------
Exercisable - end of period 1,977,259 0.90 1,125,833 0.26
------------------------------------------------------------------------
------------------------------------------------------------------------

------------------------------------------------------------------------
Weighted average contractual
life (years) 3.60 3.93
------------------------------------------------------------------------
------------------------------------------------------------------------


Stock-based compensation expense

The fair value of each option granted is estimated at the date of grant using the Black-Scholes option-pricing model with weighted average assumptions for grants as follows:



2005 2004
------------------------------------------------------------------------
Risk free rate 4% 4%
Expected life 5 years 5 years
Expected volatility 80% 180%
Expected dividend nil nil
Expected forfeitures nil nil
------------------------------------------------------------------------
------------------------------------------------------------------------


Year Ended Year Ended
December 31, 2005 December 31, 2004
------------------------------------------------------------------------
Balance - beginning of period 144,183 59,990
Issuance of stock options 1,119,466 84,193
Reclassification to common shares
on exercise of options (93,205) -
------------------------------------------------------------------------
Balance - end of period 1,170,444 144,183
------------------------------------------------------------------------
------------------------------------------------------------------------


15. SUPPLEMENTAL CASH FLOW INFORMATION

Year Ended Year Ended
December 31, 2005 December 31, 2004
------------------------------------------------------------------------
Change in non-cash working capital items
Operating accounts receivable (3,312,900) (1,598,968)
Operating accounts payable 4,099,675 1,730,389
------------------------------------------------------------------------
Amounts relating to operating activities 786,775 131,421
Amounts relating to investing activities (688,265) 1,109,645
------------------------------------------------------------------------
98,510 1,241,066
------------------------------------------------------------------------
------------------------------------------------------------------------

Interest paid 392,691 61,818
------------------------------------------------------------------------
------------------------------------------------------------------------


16. SEGMENTED INFORMATION

A significant portion of the Company's assets and revenues are earned in the United States and Egypt, and are monitored as an identifiable reporting segment by management. The remaining assets and associated revenues are earned in Canada by Arsenal Energy Inc. Business risks and economic indicators are similar across all geographical regions.



2005
($ Cdn.) Canada U.S. Egypt Total
------------------------------------------------------------------------
Oil and gas revenue 11,089,939 7,647,727 - 18,737,666
Net income (loss)
before tax (1,191,691) 905,996 (145,650) (431,345)
Operating income 4,465,121 3,132,712 - 7,597,833
Plant, property and
equipment 34,522,710 4,695,750 5,360,144 44,578,604
Capital expenditures
(including acquisitions) 22,401,656 98,153 - 22,499,809
------------------------------------------------------------------------
------------------------------------------------------------------------

2004
($ Cdn.) Canada U.S. Egypt Total
------------------------------------------------------------------------
Oil and gas revenue 927,268 2,171,678 - 3,098,946
Net income (loss)
before tax (754,492) 411,809 - (342,683)
Operating income 514,313 710,839 - 1,225,152
Plant, property and
equipment 10,195,320 6,495,383 - 15,679,918
Capital expenditures
(including acquisitions) 7,372,608 5,492,399 - 12,865,007
------------------------------------------------------------------------
------------------------------------------------------------------------


17. COMMITMENTS AND CONTINGENCIES

Egyptian Concession

With the corporate acquisition of Quadra Resources Corp. which closed on August 11, 2005, Arsenal has acquired the Nuqra Concession in Egypt. The Concession Agreement signed with the Egyptian government requires gross expenditures of USD$11.0 million over an eight year period on seismic evaluation, exploratory drilling and developmental drilling. After completing a farm out agreement with a Canadian public company, Arsenal is responsible for incurring approximately USD$2.0 million of expenditures to maintain the Concession.

Flow-through shares

The Company has a $6.5 million flow-through obligation which will be satisfied through exploratory drilling and seismic shooting in Western Alberta and Central Saskatchewan during 2006. During 2005 the Company's obligation relating to flow-through shares was $4.0 million which was satisfied through exploratory drilling and seismic activities during the year ended December 31, 2005.

Office Lease

The Company leases its office premises through an arrangement deemed to be an operating lease for accounting purposes. As such, Arsenal is not required to record its lease obligation as a liability nor does it record its leased premises as an asset. The estimated operating lease commitments relating to leased office premises for the next five years are as follows:



($Cdn.)
------------------------------------------------------------------------
2006 120,000
2007 120,000
2008 120,000
2009 120,000
2010 70,000
------------------------------------------------------------------------
------------------------------------------------------------------------


18. SUBSEQUENT EVENTS

Acquisition of Tiverton Petroleums

On March 14, 2005, the Company completed the corporate acquisition of Tiverton Petroleums Ltd. ("Tiverton"), a Canadian public corporation trading on the TSX Exchange. The acquisition was completed by way of Plan of Arrangement ("the Amended Plan").

Under the amended Plan Tiverton security holders received 0.23 shares of Arsenal for each Tiverton security held, which resulted in approximately 23.4 million shares of Arsenal issued at closing valued at approximately $32.8 million. In addition to share consideration, Arsenal assumed approximately $3.4 million in bank debt, convertible debentures with a face value of $3.5 million and negative working capital of $0.6 million.

Tower Creek

On February 8, 2006 the Company entered into an agreement to drill and complete a well at Tower Creek in Alberta. Arsenal has committed to expend 20% of the estimated $17.5 million required to drill and complete the test well in order to earn a 14% working interest following completion. Expenditures incurred for the drilling and completion of this well will qualify as exploratory drilling and will satisfy a portion of the Company's 2006 flow-through obligation as described in note 17.

Certain statements in this material may be "forward-looking statements" including outlook on oil and gas prices, estimates of future production, estimated completion dates of acquisitions and construction and development projects, business plans for drilling and exploration, estimated amount and timing of capital expenditures and anticipated future debt levels and royalty rates. Information concerning reserves contained in this material may also be deemed forward-looking statements as such estimates involve the implied assessment that the resources described can be profitably produced in the future. These statements are based on current expectations, estimates and projections that involve a number of risks and uncertainties, which could cause actual results to differ from those anticipated by Arsenal.

The term barrels of oil equivalent ("boe") may be misleading, particularly if used in isolation. A boe conversion ratio of six thousand cubic feet per barrel (6mcf/bbl) of natural gas to barrels of oil equivalence is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. All boe conversions in the report are derived from converting gas to oil in the ratio mix of six thousand cubic feet of gas to one barrel of oil.


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