Arsenal Energy Inc.
TSX VENTURE : AEI

Arsenal Energy Inc.

May 30, 2005 21:00 ET

Arsenal Announces First Quarter 2005 Operating and Financial Results

CALGARY, ALBERTA--(CCNMatthews - May 30, 2005) - Arsenal Energy Inc. (TSX VENTURE:AEI) ("Arsenal or the Company") is pleased to announce the results of operations for the three month period ending March 31, 2005.

FIRST QUARTER CORPORATE HIGHLIGHTS

- Production averaged 828 barrels of oil equivalent per day.

- Forecast price P+P+P at 10% NPV: $1.60/share, $1.44/share fully diluted (adjusted for debt) at March 31, 2005.

- Constant price P+P+P at 10% NPV: $2.47/share, $2.20/share fully diluted (adjusted for debt) at March 31, 2005.

- Record cashflow of $0.02/share for the period ended March 31, 2005.

- Optimization initiatives undertaken during the fourth quarter reduced operation costs from $19.31 per barrel of oil equivalent at December 31, 2004 to $11.36 barrels of oil equivalent at March 31, 2005.

- Assembling of a land inventory in Alberta and Saskatchewan. In Alberta our targets include natural gas and light sweet crude. In Saskatchewan our targets are low risk developmental heavy crude.

OVERVIEW

Drilling, recompletions, and other optimization activities grew Arsenal's production to record highs, as the Company spent the first quarter focused on internally generated opportunities to create value for shareholders. At March 31, 2005 we acquired IC Energy Inc., a privately held company at Maidstone, Saskatchewan for total consideration of $10.0 million.

On May 17, 2005 we announced the acquisition of approximately 350 barrels of oil per day from a private vendor, subject to certain conditions. The acquisition is anticipated to close June 30, 2005. The acquired properties are located in the Buzzard, Lashburn, Marsden and Rush Lake areas of western Saskatchewan. The acquisition will also include properties at Wildmere in eastern Alberta. All areas are complementary to Arsenal's operations at Lloydminster and Maidstone in western Saskatchewan.

OPERATIONS IN REVIEW

NORTH DAKOTA

Optimization initiatives undertaken during the fourth quarter of 2004 produced superb results for the Company during the first quarter of 2005 as operations costs decreased by approximately $8.00 per barrel of oil equivalent. Production for the quarter remained consistent at approximately 400 barrels of oil equivalent per day. We intend to further optimize these properties in the second quarter of 2005, and anticipate production increases of approximately 50 barrels of oil equivalent per day and additional cost savings once those initiatives are completed.

LLOYDMINISTER

These properties were initially acquired through the Nahanni acquisition in December 2004. After a six well drilling program during December 2004 and January 2005, production from the Lloydminister area was approximately 600 barrels of oil equivalent per day. We have identified an additional 10 locations on our existing lands, which will be undertaken during 2005 and 2006.

MAIDSTONE

These properties were acquired on March 31, 2005 through acquisition of IC Energy Inc. At the date of acquisition production from these properties was approximately 775 barrels of oil equivalent per day. These properties are in close proximity to the Lloydminister lands, enabling us to exploit certain operating efficiencies between both areas.

ALBERTA

We continued to acquire land and enter into farm-in agreements on lands throughout Alberta. One well was drilled at Edson during December 2004 and January 2005 which continued to be evaluated and tested by the operator during the first quarter of 2005. One additional well is anticipated to be drilled at Edson this summer and, with the operator, Arsenal acquired an additional five sections of land in the area during the first quarter.

We signed farm-in agreements for a three well program at Evi South and Malmo, with an option for additional locations at Kaybob and Evi. Drilling on these lands is scheduled to begin in August of 2005 and continue through the remainder of the year.

COMMODITY PRICING

Heavy oil pricing was significantly impacted by disruptions in the western Canadian synthetic crude oil and heavy crude markets. Due to maintenance and equipment failures industry bitumen upgraders were off production in December 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. Diluent costs increased to reflect the great demand requirements. The heavy oil price differential has reduced to near historical averages, however diluent costs remain high. As the summer season approaches and heavy oil demand peaks, we expect to see a full recovery of the heavy oil market, as differentials return to the historical average of 30 percent of WTI.

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 $40 U.S. for the remainder of the year, and potentially could increase from current record highs if Asian demand increases or there is a supply shock.

Natural gas has remained well above historical averages for the past year, and is expected to continue to remain above those averages in the short term, as infrastructure constraints continue to restrict supply.

OUTLOOK

Our corporate mandate remains unchanged. We will continue to seek acquisitions that are accretive, while also generating value through the drill bit. We will further optimize and exploit our acquired production in Saskatchewan and North Dakota, to achieve maximum return on our invested capital.

As we enter the second quarter, we have developed an eighteen well drilling program at Lloydminister and Maidstone which is scheduled to begin during the second quarter, and with IC Energy production will exceed 1,700 barrels of oil equivalent. Shrinking heavy oil differentials combined with increased production and reduced operations costs ensure that further record production and cashflows will be realized in upcoming periods.



HIGHLIGHTS

------------------------------------------------------------------------
FINANCIAL Three Months Ended March 31
------------------------------------------------------------------------
2005 2004
------------------------------------------------------------------------
Funds from operations(1) 486,573 29,135
Per unit - basic 0.02 -
Per unit - diluted 0.02 -
Bank debt 7,601,583 -
Operating costs per boe 11.36 11.58
Operating netbacks per boe 15.62 23.75
Market
Shares outstanding
End of period 26,407,303 11,265,836
Weighted average - basic 20,134,963 11,265,836
Weighted average - diluted 21,454,309 12,240,178
Shares trading
High 1.92 0.95
Low 0.88 0.60
Close 1.48 0.70
Average daily volume 49,700 13,600
------------------------------------------------------------------------
------------------------------------------------------------------------

OPERATIONS
------------------------------------------------------------------------
Daily production (average)
Crude oil (bbl) 758 58
NGLs (bbl) 31 1
Natural gas (mcf) 231 6
------------------------------------------------------------------------
Total (boe)(2) 828 60
Realized commodity prices ($Cdn.)
Total crude oil (bbl) 38.67 44.09
NGLs (bbl) 38.53 32.48
Natural gas (mcf) 7.46 6.49
------------------------------------------------------------------------
Average (boe)(2) 38.59 41.94
Reference pricing
WTI (U.S.$/bbl) 49.84 35.15
AECO gas ($Cdn./mcf) 6.63 6.61
Foreign Exchange ($U.S./$Cdn.) 1.23 1.32
------------------------------------------------------------------------

(1) Management's Discussion and Analysis contains the term funds from
operations, funds from operations per share, and operating netbacks,
which should not be considered to be an alternative to, or more
meaningful than net income as determined in accordance with Canadian
generally accepted accounting principles as an indicator of the
Company's performance. The company presents funds from operations per
share whereby per share amounts are calculated 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.


MANAGEMENT'S DISCUSSION AND ANALYSIS

This Management's Discussion and Analysis ("MD&A") for Arsenal Energy Inc. ("Arsenal" or the "Company") should be read in conjunction with the unaudited interim consolidated financial statements for the three months ended March 31, 2005 and 2004 and with the audited consolidated financial statements and MD&A for the year ended December 31, 2004. The consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles ("Canadian GAAP") and are presented in Canadian currency except where indicated as being in another currency. Arsenal is an oil and gas issuer and disclosures pertaining to oil and gas activities are presented in accordance with National Instrument 51-101 ("NI 51-101"). For additional disclosures as required under NI 51-101 please refer to http://www.sedar.com. This MD&A is dated May 20, 2005.

RESULTS OF OPERATIONS

PRODUCTION AND MARKETING

Production volumes for the three month period ended March 31, 2005 increased to 828 boe/d, which represents a 1,279% increase over 2004. The increase in volumes is attributable to the integration of corporate and property acquisitions and a successful drilling program completed in January.

Crude oil production increased 1,207%, attributable to the acquisition of properties in North Dakota and Lloydminister, and the completion of the six well drilling program at Lloydminister. Natural gas production increased 1,100% and related natural gas liquids increased 1,267% over the year from properties acquired at Saskatchewan and North Dakota.

Arsenal continues to be an oil weighted producer, however the Company is committed to increasing its natural gas production through the continued development of the Edson natural gas play with its joint venture partners.

With the full impact of the production acquired through the acquisition of IC Energy Inc. ("IC Energy"), Arsenal expects corporate production to exceed 1,700 boe/d effective April 1, 2005. With the full impact of the asset purchase expected to close on June 30, 2005, Arsenal expects production to exceed 2,050 boe/d.



Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Crude oil (bbl/d) 758 58 1,207
NGL (bbl/d) 31 1 1,100
Natural gas (mcf/d) 231 6 1,267
------------------------------------------------------------------------
Total (boe/d) 828 60 1,279
------------------------------------------------------------------------
------------------------------------------------------------------------
Production split
------------------------------------------------------------------------
Oil & NGLs 95% 98% (3)
Natural Gas 5% 2% 179
------------------------------------------------------------------------
------------------------------------------------------------------------


COMMODITY PRICES

Commodity price realizations during the first quarter decreased 12% over the same period in 2004. The impact of favourable crude oil prices was partly offset by a 7% decline in the value of the US dollar relative to the Canadian dollar during the year. The decrease is also reflective of the asset portfolio of Arsenal at March 31, 2005, with approximately 40% of its oil production comprised of lower gravity heavy crude oil.

Natural gas produced in North Dakota is high heat, and has historically achieved a price in excess of the NYMEX Henry Hub reference price.

Arsenal anticipates continued high commodity prices as supply issues continue to impact natural gas, while ongoing tensions in the Middle East continues to put upward pressure on the WTI reference price.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
Prices - Before Derivatives 2005 2004 % Change
------------------------------------------------------------------------
Total crude oil (bbl) 38.67 44.09 (12)
NGLs (bbl) 38.53 32.48 19
Natural gas (mcf) 7.46 6.49 15
------------------------------------------------------------------------
Total (boe) 38.59 41.94 (8)
------------------------------------------------------------------------
------------------------------------------------------------------------

Reference Pricing
------------------------------------------------------------------------
WTI ($U.S./bbl) 49.84 35.15 42
AECO gas ($Cdn./mcf) 6.63 6.61 0
NYMEX gas ($U.S./mmbtu) 6.53 6.14 6
Foreign exchange ($U.S./$Cdn.) 1.23 1.32 (7)
------------------------------------------------------------------------
------------------------------------------------------------------------


OIL AND GAS REVENUE

Net oil and gas revenue for the first quarter of 2005 was 1,007% higher than the comparable period in 2004, reflecting increased crude oil production resulting from the corporate and property acquisitions. Revenues per boe decreased 17% over the same period in 2004 reflecting the impact of heavy oil price realizations.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Crude oil sales 2,527,059 228,381 1,007
NGL sales 155,737 766 20,231
Natural gas sales 108,665 2,468 4,303
Other 93,613 - -
Loss on forward contracts (231,216) - -
------------------------------------------------------------------------
Gross oil and gas revenue 2,653,858 231,615 1,046

Per boe 34.86 41.96 (17)
------------------------------------------------------------------------
------------------------------------------------------------------------


ROYALTIES

During the first quarter, royalties as a percentage of gross oil and gas revenue increased 19% over the same period in 2004 due to higher freehold royalties on the properties acquired in North Dakota.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Freehold royalties 599,676 36,573 1,540
% of gross oil and gas revenue 21 16 31
Per boe 7.88 6.63 19
------------------------------------------------------------------------
------------------------------------------------------------------------


OPERATING COSTS

Operating expenses per boe for the three months ended March 31, 2005 decreased 2%, over the same period in 2004. Arsenal completed numerous optimization initiatives in North Dakota and Lloydminister during 2004, and notes that operating costs have declined substantially from the fourth quarter of 2004, when they averaged $19.31/boe. Arsenal expects operating costs to continue to trend lower as the initiatives are completed in the second quarter of 2005.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Operating expense 864,897 63,947 1,253
Per boe 11.36 11.58 (2)
------------------------------------------------------------------------
------------------------------------------------------------------------


PRODUCT NETBACKS(1)

Netbacks for the three month period ending March 31, 2005 decreased over the comparative period reflecting the impact of heavy oil price realizations and higher royalty rates during 2005.



($Cdn. per boe) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Net revenue after derivatives 34.86 41.96 (17)
Royalties (7.88) (6.63) 19
Operating expense (11.36) (11.58) (2)
------------------------------------------------------------------------
Operating netback 15.62 23.75 (34)
------------------------------------------------------------------------
------------------------------------------------------------------------


GENERAL AND ADMINISTRATIVE

General and administrative costs per boe decreased by 51% during the three month period ending March 31, 2005. Costs on a per boe basis decreased over the prior period reflecting increases in production during the year. Arsenal anticipates general and administrative costs to increase in absolute terms but decrease on a per barrel basis as the Company continues to grow production. Stock-based compensation charges of $85,241 are included in general and administrative costs.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
General and administrative 693,044 101,960 580
Per boe 9.10 18.47 (51)
------------------------------------------------------------------------
------------------------------------------------------------------------


FINANCE CHARGES

Finance charges for the three month period ending March 31, 2005 increased $64,730 compared to $nil in the comparative period as the Company drew on its credit facility to fund both drilling and acquisition activities during the first quarter of 2005, but had not drawn on its facility during the comparative period.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Finance charges 64,730 - 100
Per boe 0.85 - 100
------------------------------------------------------------------------
------------------------------------------------------------------------


DEPLETION, DEPRECIATION, AND ACCRETION

Depletion, depreciation and accretion ("DD&A") per boe decreased 51% for the three months ended March 31, 2005 compared to the same period in 2004. The decrease is attributable to the significantly increased reserve and asset base over the prior year.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Depletion, depreciation
and accretion 513,623 71,963 614
Per boe 6.75 13.04 (48)
------------------------------------------------------------------------
------------------------------------------------------------------------


STOCK-BASED COMPENSATION EXPENSE

Stock-based compensation expense increased $85,241 compared to $nil in the comparative period in 2004. During the first quarter of 2004, Arsenal did not grant any options and as such no compensation expense was accrued. This expense is included in general and administrative costs at March 31, 2005.



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Compensation expense 85,241 - 100
Per boe 1.12 - 100
------------------------------------------------------------------------
------------------------------------------------------------------------


TAXES

During the first quarter of 2005, Arsenal accrued future income taxes totalling $36,614 compared to $1,430 during the same period in 2004. A future income tax balance of $5,632,396 is recorded as a liability as at March 31, 2005 (March 31, 2004 - 456,215).



($Cdn.) Three Months Ended March 31
------------------------------------------------------------------------
2005 2004 % Change
------------------------------------------------------------------------
Provison for future taxes 36,614 1,430 2,460
Per boe 0.48 0.26 86
------------------------------------------------------------------------
------------------------------------------------------------------------


SUMMARY OF QUARTERLY RESULTS

The following table highlights the Company's performance for the most recent eight quarters that comprise first quarter of 2005 and the 2004 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.



($Cdn.) 2005 2004
------------------------------------------------------------------------
Q1 Q4 Q3 Q2 Q1
------------------------------------------------------------------------
Total revenue 2,054,182 1,802,339 894,574 181,270 220,763
Net income (loss) (156,261) 45,846 (38,913) (77,695) (55,747)
Per share - basic (0.01) - (0.01) (0.01) (0.01)
Per share - diluted (0.01) - (0.01) (0.01) (0.01)
Funds from
Operations(1) 486,573 92,492 119,608 46,529 29,135
Per share - basic 0.02 0.01 0.01 (0.01) 0.01
Per share - diluted 0.02 0.01 0.01 (0.01) 0.01
Total assets 30,978,254 16,690,703 9,777,944 3,364,353 3,169,054
Total bank debt 7,601,583 3,743,852 3,700,000 - -
------------------------------------------------------------------------
------------------------------------------------------------------------




($Cdn.) 2003
----------------------------------------------------
Q4 Q3 Q2
----------------------------------------------------
Total revenue 286,736 174,180 132,048
Net income (loss) 56,633 (2,146) (39,624)
Per share - basic 0.01 (0.01) (0.01)
Per share - diluted 0.01 (0.01) (0.01)
Funds from
Operations(1) (77,159) 37,990 (12,823)
Per share - basic (0.01) 0.01 (0.01)
Per share - diluted (0.01) 0.01 (0.01)
Total assets 2,889,856 2,059,738 1,741,488
Total bank debt - 700,000 710,000
----------------------------------------------------
----------------------------------------------------


LIQUIDITY

At March 31, 2005, the Company had a debt adjusted working capital deficit of approximately $1.2 million, compared to a working capital deficiency of $1.5 million at December 31, 2004. The working capital deficit is due to a combination of drilling activity during the first quarter, optimization costs for the North Dakota properties, and the acquisition of IC Energy.

The working capital deficiency is mitigated through the increase of the revolving demand loan which is anticipated to be increased to $12.8 million by the Company's lenders on June 3, 2005. Cashflows generated from both the acquired and existing production will also mitigate the deficiency.

CAPITAL RESOURCES

Revolving demand loan

At March 31, 2005, Arsenal had a revolving demand loan for $8.6 million (December 31, 2004 - $4.0 million) with a Canadian financial institution. The facility may be drawn down or repaid at any time and there are no scheduled repayment terms. The debt is secured by a demand debenture containing a first fixed charge on all crude oil and natural gas assets of Arsenal. At March 31, 2005, the interest rate was bank prime plus 0.75% (December 31, 2004 - bank prime plus 1.0%).

On May 10, 2005, the Company's applied to its lending institution to increase the total credit available under the demand operating loan to $12.8 million, bearing interest at the bank prime rate plus 0.75%. The increase is anticipated to be granted June 3, 2005.

Exercise of stock options and warrants

During March 2005, holders of the Company's share purchase warrants and stock options had exercised an aggregate of 4,307,603 warrants and options for total proceeds of $3,103,116. At March 31, 2005 there are approximately 3.0 million warrants outstanding, exercisable into one common share for one dollar per share. Approximately 0.5 million of these warrants expire during August 2005, with the remainder expiring during December 2005.

CAPITAL EXPENDITURES

Capital expenditures for the period ended March 31, 2005 totalled $11.5million. $10.0 million was spent for the acquisition of IC Energy which closed March 31, 2005. Land costs relate to undeveloped lands acquired in northwestern Alberta and at Maidstone, Saskatchewan. Drilling and facility costs were incurred at Edson and Lloydminister.



($ Cdn.) Total
------------------------------------------------------------------------
Corporate and property acquisitions 10,000,000
Land 346,804
Seismic 60,640
Drilling and completions 762,860
Production facilities 376,228
------------------------------------------------------------------------
Total capital expenditures 11,546,532
------------------------------------------------------------------------
------------------------------------------------------------------------


COMMITTMENTS AND CONTINGENCIES

Arsenal has contractual obligations in the normal course of operations including purchase of assets and services, operating agreements, transportation commitments and sales commitments. These obligations are of a recurring and consistent nature and impact cash flow in an ongoing manner. There have been no changes to Arsenal's operating lease commitments from those disclosed in the Company's December 31, 2004 Annual Report.

RISK MANAGEMENT

Business risks affecting Arsenal are unchanged from those disclosed in the December 31, 2004 Annual Report.

SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES

The interim consolidated financial statements dated March 31, 2005 have been prepared following the same accounting policies and methods of computation as the consolidated financial statements for the fiscal year ended December 31, 2004, with the addition of the policy outlined below.

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. In accordance with CICA Handbook Section 3062, "Goodwill and Other Intangibles", 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 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.

FINANCIAL REPORTING UPDATE

COMPREHENSIVE INCOME

The CICA has issued Section 1530 "Comprehensive Income" which establishes standards for reporting and display of comprehensive income. This Section is effective for annual and interim periods beginning on or after October 1, 2006 with early adoption permitted for fiscal year ending on or after December 31, 2004. Arsenal has assessed that this guideline is unlikely to have a material effect on the financial statements and does not anticipate adopting the standard until October 2006.

OUTLOOK

STRATEGY

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 2004 and throughout the first quarter of 2005 in order to establish high-quality drilling prospects. The Company also entered into a four well farm-in agreement on lands in north western Alberta. These lands target high quality light sweet crude oil and deep natural gas.

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 Nahanni and IC Energy acquisitions is the existence of a high quality drilling inventory which Arsenal intends to quickly develop starting June 2005. Arsenal believes that over the long term, outlook for both crude oil and natural gas pricing remains strong.

SENSITIVITIES

The following table provides estimates for 2005 of the sensitivity of the Company's 2005 net income and cash flow to changes in commodity prices and the U.S./Cdn. Dollar exchange rate:



Variable Change Cash Flow
------------------------------------------------------------------------
Crude oil price $U.S. 1/bbl $ 350,000
Natural gas price $Cdn. 0.10/mcf $ 50,000
$U.S./$Cdn. exchange rate 0.01 $ 50,000
Interest rate 1.00% $ 60,000
Crude oil production 100 bbl/d $ 750,000
Natural gas production 100 mcf/d $ 125,000
------------------------------------------------------------------------
------------------------------------------------------------------------



CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2005 2004
------------------------------------------------------------------------
Unaudited Audited
ASSETS
Current assets
Cash - 217,063
Accounts receivable 1,202,706 582,762
------------------------------------------------------------------------
1,202,706 799,825
Reclamation bonds 213,149 210,960
Property, plant and equipment 26,897,201 15,679,918
Goodwill (note 3) 2,665,198 -
------------------------------------------------------------------------
30,978,254 16,690,703
------------------------------------------------------------------------
------------------------------------------------------------------------

LIABILITIES
Current liabilities
Accounts payable and accrued liabilities 2,442,624 2,265,903
Revolving demand loan (note 4) 7,601,583 3,743,852
Current portion of deferred revenue 352,650 352,650
------------------------------------------------------------------------
10,396,857 6,362,405
Deferred revenue 168,050 198,229
Future income taxes 5,632,396 1,443,129
Asset retirement obligation (note 5) 885,701 780,889
------------------------------------------------------------------------
17,083,004 8,784,652
------------------------------------------------------------------------

SHAREHOLDERS' EQUITY
Shareholders' equity (note 6) 14,104,745 7,458,134
Warrants (note 7) 495,573 988,760
Contributed surplus (note 8) 136,219 144,183
Deficit (841,287) (685,026)
------------------------------------------------------------------------
13,895,250 7,906,051
------------------------------------------------------------------------
30,978,254 16,690,703
------------------------------------------------------------------------
------------------------------------------------------------------------

Segmented information (note 10)
Subsequent events (note 11)


CONSOLIDATED STATEMENTS OF OPERATIONS AND DEFICIT
(UNAUDITED)

For the three months ended March 31, 2005 March 31, 2004
------------------------------------------------------------------------

REVENUE
Oil and gas 2,653,858 231,615
Royalties expense,
net of Alberta Royalty Tax Credit (599,676) (36,573)
------------------------------------------------------------------------
2,054,182 195,042
------------------------------------------------------------------------

EXPENSES
Operating 864,897 63,947
General and administrative 693,044 101,960
Finance charges 64,730 -
Depletion, depreciation and accretion 513,623 71,963
Foreign exchange 37,535 -
------------------------------------------------------------------------
2,173,829 237,870
------------------------------------------------------------------------

Loss before future income taxes (119,647) (42,828)
Provision for future income taxes 36,614 1,430
------------------------------------------------------------------------
Net income (156,261) (44,258)
Deficit - beginning of period (685,026) (159,523)
------------------------------------------------------------------------
Deficit - end of period (841,287) (203,781)
------------------------------------------------------------------------
------------------------------------------------------------------------

Loss per share - basic and diluted $ (0.01) $ (0.00)

Segmented information (note 10)


CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)

For the three months ended March 31, 2005 March 31, 2004
------------------------------------------------------------------------

Cash flows from operating activities
Net income (loss) (156,261) (44,258)
Items not affecting cash
Depletion, depreciation and accretion 513,623 71,963
Future income tax provision 36,614 1,430
Stock-based compensation expense (note 8) 85,241 -
Deferred revenue (30,179) -
Foreign exchange 37,535 -
------------------------------------------------------------------------
Funds from operations 486,573 29,135
Net change in non-cash working
capital items (note 9) (485,797) (450,104)
------------------------------------------------------------------------
Net cash provided by (used in)
operating activities 776 (420,969)
------------------------------------------------------------------------

Cash flows from investing activities
Corporate acquisitions (note 3) (5,500,000) -
Additions to property, plant and equipment (1,546,532) (478,114)
Changes in non-cash working capital
- investing items 42,574 -
------------------------------------------------------------------------
Net cash provided by (used in)
investing activities (7,003,958) (478,114)
------------------------------------------------------------------------

Cash flows from financing activities
Issue of shares for cash - 675,000
Issue of shares for cash upon exercise
of stock options 193,784 -
Issue of shares for cash upon
exercise of warrants 2,909,332 -
Share issue costs (174,728) (7,775)
Revolving demand loan 3,857,731 -
------------------------------------------------------------------------
Net cash provided by (used in)
financing activities 6,786,119 667,225
------------------------------------------------------------------------

Change in cash during the period (217,063) (231,858)
Cash - Beginning of period 217,063 743,580
------------------------------------------------------------------------
Cash - End of period - 511,722
------------------------------------------------------------------------
------------------------------------------------------------------------

Supplemental information (note 9)
Segmented information (note 10)


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. SIGNIFICANT ACCOUNTING POLICIES

The interim consolidated financial statements of Arsenal Energy Inc. ("Arsenal" or the "Company") have been prepared by management in accordance with accounting principles generally accepted in Canada. The interim consolidated financial statements have been prepared following the same accounting policies and methods of computation as the consolidated financial statements for the fiscal year ended December 31, 2004, with the addition of the policy outlined in note 2. The disclosures provided below are incremental to those included with the annual consolidated financial statements. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto in Arsenal's annual report for the year ended December 31, 2004.

2. 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 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.

3. BUSINESS ACQUISITON

Effective March 31, 2005 Arsenal acquired all of the issued and outstanding shares of IC Energy Inc. ("IC Energy"). The purchase method of accounting was used for this business combination and the allocation of the purchase price and consideration for the acquisition is as follows:



------------------------------------------------------------------------
Net assets acquired at assigned values:
------------------------------------------------------------------------
Property, plant and equipment 10,243,000
Goodwill 2,665,198
Asset retirement obligation (123,713)
Future income taxes (2,784,485)
------------------------------------------------------------------------
Net assets acquired 10,000,000
------------------------------------------------------------------------
------------------------------------------------------------------------

Financed by:
------------------------------------------------------------------------
Shares issued 4,500,000
Cash 5,500,000
------------------------------------------------------------------------
Purchase price 10,000,000
------------------------------------------------------------------------
------------------------------------------------------------------------


4. REVOLVING DEMAND LOAN

At March 31, 2005, The Company has available a demand operating loan in the amount of $8.6 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 is in breach of a bank covenant relating to its working capital ratio. Management has informed the bank of the situation and the bank has issued a letter to the Company stating that the bank will review the financial statements in order to determine future covenant requirements.

On May 10, 2005, the Company's applied to its lending institution to increase the total credit available under the demand operating loan to $12.8 million, bearing interest at the bank prime rate plus 0.75%. The increase is anticipated to be granted June 3, 2005.

5. ASSET RETIREMENT OBLIGATIONS

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


Three Months Ended Year Ended
March 31, 2005 December 31, 2004
------------------------------------------------------------------------
Asset retirement obligation
- beginning of period 780,889 106,582
Liabilities acquired 123,713 609,300
Liabilities incurred - 58,891
Adjustment (32,045) -
Accretion expense 13,144 6,116
------------------------------------------------------------------------
Asset retirement obligation
- end of period 885,701 780,889
------------------------------------------------------------------------
------------------------------------------------------------------------


6. SHAREHOLDERS' EQUITY

The following table presents the reconciliation of the beginning and ending shareholders equity and number of common shares outstanding:



Three Months Ended Year Ended
March 31, 2005 December 31, 2004
------------------------------------------------------------------------
Shares Amount Shares Amount
------------------------------------------------------------------------
Balance
- beginning of period 18,989,706 7,458,134 8,740,836 2,163,533
Corporate acquisition 3,000,000 4,500,000 2,850,000 1,300,375
Issued for cash - - 7,298,870 4,270,532
Cost of shares issued - (174,728) - (493,306)
Tax effect of flow-through shares - (1,445,169)
Tax effect of share issue costs - 77,000 - 197,000
Issued on exercise of options 904,277 193,784 100,000 20,000
Issued on exercise
of warrants 3,513,320 2,909,332 - -
Allocated from contributed
surplus - 93,205 - -
Allocated from warrants - 493,187 - -
------------------------------------------------------------------------
Balance - end of period 26,407,303 14,104,745 18,989,706 7,458,134
------------------------------------------------------------------------
------------------------------------------------------------------------


The per share calculations for the period ended March 31, 2005 was based on weighted average shares outstanding of 20,134,963 (March 31, 2004 - 11,265,836). In computing net income per share - diluted, 1,319,346 (March 31, 2004 - 974,342) were added to the weighted average number of shares outstanding for the quarter, reflecting the dilutive effect of stock options and share purchase warrants.

7. WARRANTS

When share purchase warrants are exercised, the consideration paid is recorded to the shareholders' equity account along with an allocation for the deemed value of the warrants previously recognized in the warrants account. The following table reconciles the movement in the warrant account balance:



Three Months Ended Year Ended
March 31, 2005 December 31, 2004
------------------------------------------------------------------------
Balance - beginning of period 988,760 -
Warrants issued on acquisition of
Orange Exploration - 80,820
Private placement - 907,940
Reclassification to common shares on
exercise of warrants (493,187) -
------------------------------------------------------------------------
Balance - end of period 495,573 988,760
------------------------------------------------------------------------
------------------------------------------------------------------------


8. STOCK OPTIONS

A summary of the changes in the options outstanding under the Option Plan is as follows:



Three Months
Ended Year Ended
March 31, December 31,
2005 2004
Weighted Weighted
Average Average
Options Price ($) Options Price ($)
------------------------------------------------------------------------
Balance
- beginning of period 2,505,000 0.40 1,150,000 0.21
Granted 290,000 0.98 1,455,000 0.58
Exercised (904,277) 0.23 (100,000) 0.20
Cancelled (185,723) 0.59 - -
------------------------------------------------------------------------
Balance - end of period 1,705,000 0.40 2,505,000 0.40
------------------------------------------------------------------------
Exercisable - end of period 736,661 0.47 1,125,833 0.26
------------------------------------------------------------------------
------------------------------------------------------------------------


The Company incurred non-cash compensation expense of $85,241 during the quarter (2004 - nil) related to vested options issued under the Option Plan with a corresponding increase to contributed surplus. When options are exercised by employees, contractors and directors of the Company, the consideration paid is recorded to the shareholders' equity account along with related non-cash compensation expense previously recognized in contributed surplus. The following table reconciles the movement in the contributed surplus balance:


Three Months Ended Year Ended
March 31, 2005 December 31, 2004
------------------------------------------------------------------------
Balance - beginning of period 144,183 59,990
Issuance of stock options 85,241 84,193
Reclassification to common shares on
exercise of options (93,205)
------------------------------------------------------------------------
Balance - end of period 136,219 144,183
------------------------------------------------------------------------
------------------------------------------------------------------------


9. SUPPLEMENTAL CASH FLOW INFORMATION

Three Months Ended Three Months Ended
March 31, 2005 March 31, 2004
------------------------------------------------------------------------
Change in non-cash working capital items
Operating accounts receivable (619,944) (87,775)
Operating accounts payable 134,147 (362,329)
Capital accounts payable 42,574 -
------------------------------------------------------------------------
(443,223) (450,104)
------------------------------------------------------------------------
------------------------------------------------------------------------

Interest paid 42,751 nil
------------------------------------------------------------------------
------------------------------------------------------------------------


10. SEGMENTED INFORMATION

A significant portion of the Company's assets and revenues are earned in the United States, 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 in both geographical regions. There are no comparative figures as Arsenal acquired the United States properties August 31, 2004.



$ Cdn. Canada U.S. Total
------------------------------------------------------------------------
Oil and gas revenue 985,340 1,601,232 2,586,572
Net income before tax 7,070 233,079 240,149
Operating income 456,480 732,805 1,189,285
Assets 24,521,453 6,456,801 30,978,254
Capital expenditures 1,546,532 - 1,546,532
------------------------------------------------------------------------
------------------------------------------------------------------------


11. SUBSEQUENT EVENTS

Property acquisition

On May 17, 2005, the Company entered into an agreement to purchase oil and gas properties from a private vendor for a total purchase price of $6.8 million. The acquisition is scheduled to close June 30, 2005.

Application for increase to credit facility limit

On May 10, 2005, the Company's applied to its lending institution to increase the total credit available under the demand operating loan to $12.8 million, bearing interest at the bank prime rate plus 0.75%. The increase is anticipated to be granted June 3, 2005.

Granting of stock options

On April 25, 2005 Arsenal granted 1.325 million stock options to employees, directors and officers with an exercise price of $1.21.

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

The TSX Venture Exchange does not accept responsibility for the adequacy or accuracy of this release.

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