Arsenal Energy Inc.
TSX : AEI

Arsenal Energy Inc.

August 25, 2005 08:00 ET

Arsenal Announces Second Quarter 2005 Operating And Financial Results

CALGARY, ALBERTA--(CCNMatthews - Aug. 25, 2005) - Arsenal Energy Inc. ("Arsenal or the Company") (TSX:AEI) is pleased to announce the results of operations for the three and six month periods ended June 30, 2005, and announce the reappointment of a Director to its Audit Committee.

SECOND QUARTER CORPORATE HIGHLIGHTS

- Production averaged a record 1,165 barrels of oil equivalent per day

- Record cashflow of $0.03/share

- Acquisition of 350 boe/d from a private vendor for $6.8 million

- Development of a 28.0 well (12.0 net) drilling program on the lands acquired June 29, 2005. The program was initiated in June 2005 and will continue through October 2005



SELECTED FINANCIAL AND OPERATIONAL INFORMATION

Three Months Ended Six Months Ended
FINANCIAL June 30 June 30
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2005 2004 2005 2004
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Funds from operations(1) 871,288 (35,215) 1,357,861 6,639

Per unit - basic 0.03 (0.00) 0.06 0.00
Per unit - diluted 0.03 (0.00) 0.05 0.00

Bank debt 12,668,469 - 12,668,469 -
Operating costs per boe 16.39 6.62 14.55 7.85
Operating netbacks
per boe 14.30 32.04 15.10 33.13

Market

Shares outstanding
End of period 28,015,244 11,591,875 28,015,244 11,591,875
Weighted average
- basic 26,601,305 11,396,541 23,531,894 11,375,898
Weighted average
- diluted 27,817,126 12,506,417 24,747,715 12,485,774

Shares trading

High 1.69 0.90 1.92 0.95
Low 1.00 0.58 0.88 0.60
Close 1.40 0.65 1.40 0.65

Average daily volume 51,600 15,500 51,100 14,200
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OPERATIONS
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Daily production
(average)

Crude oil (bbl) 1,022 37 890 43
NGLs (bbl) 43 1 37 1
Natural gas (mcf) 597 6 414 6
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Total (boe)(2) 1,165 39 996 45

Realized commodity
prices ($Cdn.)

Total crude oil (bbl) 41.19 47.17 38.67 44.09
NGLs (bbl) 40.78 42.45 38.53 32.48
Natural gas (mcf) 7.19 6.76 7.46 6.49
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Average (boe)(2) 41.35 46.56 38.59 41.94

Reference pricing

WTI (U.S.$/bbl) 53.17 38.29 51.51 36.72
AECO gas ($Cdn./mcf) 6.99 6.45 6.67 6.36
Foreign Exchange
($U.S./$Cdn.) 1.24 1.36 1.24 1.34
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(1) This release 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.

OPERATIONS IN REVIEW

NORTH DAKOTA

Optimization initiatives undertaken during the fourth quarter of 2004 produced superb results for the Company during 2005 as operations costs decreased by approximately $8.00 per barrel of oil equivalent over the prior year. Production for the quarter remained consistent at approximately 400 barrels of oil equivalent per day.

WESTERN SASKATCHEWAN

Second quarter production in Western Saskatchewan was severely restricted due to an early spring breakup and persistent wet weather throughout the period. Road bans throughout the quarter limited rig and truck access, restricting the Company's ability to ship oil and complete workovers. Approximately 300 boe/d was shut in for the quarter due to these issues, 100 boe/d of which was recovered during the period. Operating costs on these properties increased over the first quarter, as unanticipated rig costs were incurred to bring the shut in properties back online.

Arsenal currently has approximately 200 boe/d of production shut in at Lloydminster and Maidstone. We are making every effort to attempt to resolve the shut in production issues, however management cautions that a portion of this production may be lost due to water and sand encroachment in the reservoirs.

ALBERTA

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.

Arsenal participated in one well in December 2004 in the Edson area, targeting natural gas. The well encountered hydrocarbons, however water and reservoir pressure did not support merchantable reserves, and the well was subsequently abandoned.

COMMODITY PRICING

Heavy oil pricing was significantly impacted by disruptions in the western Canadian synthetic crude oil and heavy crude markets during the first quarter of 2005. The heavy oil price differential has returned to historical averages of 30% of WTI, however diluent costs remain high. We anticipate that the differential will follow historical seasonality and widen during the fall and winter months, however it is unlikely the differential will be as large as it was during 2004 and early 2005.

Light sweet crude oil continues to set record highs with increasing demand from Asia, limited refining capacity, and stagnant global production. It is anticipated in the market that WTI will remain above $50 U.S. for the remainder of the year, and potentially could increase further if 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.

EGYPT

On August 11, 2005 we completed the acquisition of Quadra Resources Corp. ("Quadra"). This acquisition illustrates our intention to differentiate Arsenal from other junior exploration companies. Quadra's principle asset is the 7.5 million acre Nuqra concession in Egypt. The lands in the concession are located in South Eastern Egypt near the city of Luxor on the east bank of the Nile River and are situated in the heart of the Komombo Basin. The Komombo Basin is a rift basin analogous to the Gulf of Suez Basin in Egypt and the Muglad Basin in Sudan, both of which have major proven oil reserves in the order of 5 to 10 billion barrels of original oil in place. The concession is accompanied by 3,000 km of 2D seismic, covering less than twenty percent of the acquired acreage. Quadra has identified 13 seismically defined exploratory leads from existing technical data. Well data from the concession confirms the existence of Cretaceous and Jurassic sandstone formations which may hold the potential for discovery of significant accumulations of oil reserves.

The operator of the Nuqra concession, TransGlobe Energy Corporation ("TransGlobe") is currently reprocessing the acquired seismic data on the concession, and intends to shoot an additional 800 km of seismic in the fourth quarter of 2005. The first exploratory wells are anticipated to be drilled in the late second or early third quarter of 2006.

Our management team has long held that the Western Canadian Sedimentary basin is mature, and the majority of significant reservoirs have been discovered. Valuations on many junior exploration companies in Canada have increased to the point where investors are pricing in a measure of growth that is not sustainable in a mature basin. We believe that Northern Africa, and Egypt in particular offer shareholders with an opportunity for both rapid and considerable growth, as these unexplored basins are developed for the first time.

REAPPOINTMENT OF AUDIT COMMITTEE DIRECTOR

Arsenal reports that Mr. Gregory Belzberg has been reappointed to the audit committee of the Company. Mr. Belzberg is an independent director of Arsenal.

OUTLOOK

Arsenal will continue to pursue acquisitions both in Canada and internationally while generating value through the drill bit on our lands in Canada. Our management team will work with the operator on the Nuqra concession in Egypt to develop and implement the drilling program as quickly as possible.

Arsenal is currently producing 1,700 barrels of oil equivalent per day, and target exiting the year in excess of 2,000 barrels of oil equivalent per day. If the shut in production issues can be resolved, the Company should achieve this mark with the new drilling that will be undertaken during the remainder of the year.

RESULTS OF OPERATIONS

PRODUCTION AND MARKETING

Production volumes for the three and six month periods ended June 30, 2005 increased to 1,165 boe/d and 996 boe/d, which represents a 2,888% and 2,113% increase respectively, over the same periods in 2004. The increase in volumes is attributable to the integration of corporate and property acquisitions and new wells drilled in the first and second quarters.

For the three month period ending June 30, 2005, crude oil production increased 2,663%, attributable to the acquisition of properties in North Dakota and Lloydminster, and the completion of the six well drilling program at Lloydminster. Natural gas production increased 9,848% and related natural gas liquids increased 4,247% over the year from properties acquired at Saskatchewan and North Dakota.

Second quarter production in Saskatchewan was severely restricted due to an early spring breakup and persistent wet weather throughout the period. Road bans throughout the quarter limited rig and truck access, restricting the Company's ability to ship oil and complete workovers. Approximately 300 boe/d was shut in for the period due to these issues.

Arsenal is currently producing approximately 1,700 boe/d, with approximately 200 boe/d shut in. The Company is making every effort to attempt to resolve the shut in production issues, however management cautions that a portion of this production may be lost due to water and sand encroachment in the reservoir.



Three Months ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Crude oil (bbl/d) 1,022 37 2,663 890 43 1,970
NGL (bbl/d) 43 1 4,247 37 1 1,100
Natural gas (mcf/d) 597 6 9,848 414 6 1,267
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Total (boe/d) 1,165 39 2,888 996 45 2,113
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Production split
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Oil & NGLs 91% 97% (6) 93% 98% (5)
Natural Gas 9% 2% 327 7% 2% 212
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COMMODITY PRICES

Commodity price realizations during the three month and six month period ending June 30, 2005 decreased 11% and 8% respectively, over the same periods in 2004. 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. The decrease is also reflective of the asset portfolio of Arsenal at June 30, 2005, with approximately 60% 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 June 30 Six Months Ended June 30
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Prices - Before
Derivatives 2005 2004 % Change 2005 2004 % Change
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Total crude oil
(bbl) 41.19 47.17 (13) 38.67 44.09 (12)
NGLs (bbl) 40.78 42.45 (4) 38.53 32.48 19
Natural gas (mcf) 7.19 6.76 6 7.46 6.49 15
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Total (boe) 41.35 $ 46.56 (11) 38.59 41.94 (8)
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Reference Pricing
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WTI ($U.S./bbl) 53.17 38.29 39 51.51 36.72 40
AECO gas
($Cdn./mcf) 6.99 6.45 8 6.67 6.36 5
NYMEX gas
($U.S./mmbtu) 6.85 5.97 15 6.58 5.83 13
Foreign exchange
($U.S./$Cdn.) 1.24 1.36 (9) 1.24 1.34 (8)
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OIL AND GAS REVENUE

Net oil and gas revenue for the three month and six month period ending June 30, 2005 was 2,394% and 1,605% respectively higher than the comparable periods in 2004, reflecting increased petroleum and natural gas production resulting from the corporate and property acquisitions. Revenues per boe for the three month and six month period ending June 30, 2005 decreased 17% and 23% respectively, over the same period in 2004 reflecting the impact of heavy oil price realizations.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Crude oil
sales 3,768,420 162,351 2,221 6,295,479 392,554 1,504
NGL sales 158,829 345 45,937 314,566 766 40,966
Natural gas
sales 384,448 1,477 25,929 493,113 2,468 19,880
Other 93,951 - - 187,564 - -
Loss on
forward
contracts (311,725) - - (542,941) - -
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Gross oil and
gas revenue 4,093,923 164,173 2,394 6,747,781 395,788 1,605

Per boe 38.19 45.76 (17) 37.43 48.59 (23)
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ROYALTIES

During the three and six month period ending June 30, 2005, royalties as a percentage of gross oil and gas revenue increased 25% and 31% respectively, over the same periods in 2004 due to higher freehold royalties on the properties acquired in North Dakota and Canada during the year.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Royalties 803,083 25,464 3,054 1,402,759 62,037 2,161
% of gross oil
and gas revenue 20 16 25 21 16 31
Per boe 7.49 7.10 6 7.78 7.62 2
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OPERATING COSTS

Operating expenses per boe for the three month and six month period ended June 30, 2005 increased 148% and 85% respectively, over the same periods in 2004. Operating costs per boe have increased by approximately $5.00 since the first quarter of 2005. The increase is attributable to increased rig costs incurred to revive production that was shut in during the period as a result of the unseasonably warm and wet weather experienced in Saskatchewan during the second quarter. Arsenal completed numerous optimization initiatives in North Dakota and Lloydminster during the first two quarters of 2005, and notes that operating costs have declined from the fourth quarter of 2004, when they averaged $19.31/boe. Arsenal expects operating costs to continue to trend lower as the remaining shut in wells are brought back online and additional optimization initiatives are completed during the third quarter.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Operating
expense 1,757,315 23,749 7,300 2,622,212 63,947 4,001
Per boe 16.39 6.62 148 14.55 7.85 85
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PRODUCT NETBACKS

Netbacks for the three and six month period ending June 30, 2005 decreased 55% and 54% over the comparative periods reflecting the impact of heavy oil price realizations and higher royalty rates during 2005. Net revenue increases during the second quarter were offset by higher operating expenses which resulted in a reduction to netbacks compared to the first quarter.



($Cdn.
per boe) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Net revenue after
derivatives 38.19 45.76 (17) 37.43 48.59 (23)
Royalties (7.49) (7.10) 6 (7.78) (7.62) 2
Operating expense (16.39) (6.62) 148 (14.55) (7.85) 85
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Operating netback 14.30 32.04 (55) 15.10 33.13 (54)
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GENERAL, ADMINISTRATIVE AND COMPENSATION EXPENSES

General and administrative costs per boe for the three and six month periods ending June 30, 2005 decreased by 88% and 80% respectively over the same periods in 2004. 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 expense of $321,955 was accrued during the second quarter reflecting grants made during the period and amortization of compensation expense incurred for options which vested during the period.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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General and
administrative 514,955 148,745 246 1,122,758 252,135 345
Compensation
expense 321,955 - 100 407,196 - 100
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836,910 148,745 463 1,529,954 252,135 507

General and
administrative
per boe 4.80 41.46 (88) 6.23 30.96 (80)
Compensation
expense per boe 3.00 - 100 2.26 - 100
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FINANCE CHARGES

Finance charges for the three and six month period ending June 30, 2005 increased 100% over to the comparative periods as the Company drew on its credit facility to fund both drilling and acquisition activities during the first and second quarters of 2005, but had not drawn on its facility during the first and second quarters of 2004.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Finance charges 127,455 - 100 192,185 - 100
Per boe 1.19 - 100 1.07 - 100
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DEPLETION, DEPRECIATION, AND ACCRETION

Depletion, depreciation and accretion ("DD&A") per boe decreased 27% for the six month period ended June 30, 2005 over the same period in 2004. The decrease is attributable to the significantly increased reserve base over the prior year.



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Depletion,
depreciation
and accretion 647,364 43,480 1,389 1,160,987 71,963 1,513
Per boe 6.04 12.12 (50) 6.44 8.84 (27)
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TAXES

During the first six months of 2005, Arsenal accrued future income expenses totalling $80,905 compared to future tax expenses of $1,430 during the same period in 2004. A future income tax balance of $5,676,686 is recorded as a liability as at June 30, 2005 (June 30, 2004 - $579,848).



($Cdn.) Three Months Ended June 30 Six Months Ended June 30
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2005 2004 % Change 2005 2004 % Change
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Provison for
future taxes 44,291 - 100 80,905 1,430 5,558
Per boe 0.41 - 100 0.45 0.18 156
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SUMMARY OF QUARTERLY RESULTS

The following table highlights the Company's performance for the most recent eight quarters that comprise first two quarters of 2005, four quarters of 2004 and the third and fourth quarters of 2003. 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
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Q2 Q1 Q4 Q3 Q2 Q1
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Total net
revenue 3,290,840 2,054,182 1,802,339 894,574 181,270 220,763
Net income
(loss) (157,408) (156,261) 45,846 (38,913) (77,695) (55,747)

Per share
- basic (0.01) (0.01) - (0.01) (0.01) (0.01)
Per share
- diluted (0.01) (0.01) - (0.01) (0.01) (0.01)

Funds from
operations 871,288 486,573 92,492 119,608 46,529 29,135

Per share
- basic 0.03 0.02 0.01 0.01 (0.01) 0.01
Per share
- diluted 0.03 0.02 0.01 0.01 (0.01) 0.01

Total
assets 38,308,547 16,690,703 3,364,353
30,978,254 9,777,944 3,169,054
Total
bank
debt 12,668,469 3,743,852 -
7,601,583 3,700,000 -
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($Cdn.) 2003
---------------------------------------------------------------------
Q4 Q3
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Total net revenue 286,736 174,180
Net income (loss) 56,633 (2,146)

Per share - basic 0.01 (0.01)
Per share - diluted 0.01 (0.01)

Funds from operations (77,159) 37,990

Per share - basic (0.01) 0.01
Per share - diluted (0.01) 0.01
Total assets 2,889,856 2,059,738
Total bank debt - 700,000
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LIQUIDITY

At June 30, 2005, the Company had a working capital surplus of approximately $0.1 million, compared to a working capital deficiency of approximately $1.5 million at December 31, 2004. The change in working capital since year end is attributable to revenue increases and the private placement which completed its first close June 29, 2005. At June 30, 2005 the Company has $1.4 million available on its credit facility in addition to the working capital surplus.

CAPITAL RESOURCES

Revolving Demand Loan

At June 30, 2005, Arsenal had a revolving demand loan for $14.2 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 June 30, 2005, the interest rate was bank prime plus 0.75% (December 31, 2004 - bank prime plus 1.0%).

Private Placement

On June 29, 2005, Arsenal completed the first close of a private placement comprised of three tranches. The first tranche is for 800,000 shares at a price of 1.25 per share. The second tranche is for 100,000 shares at a price of $1.50 per share. The third tranche is comprised of flow-through common shares at a price of $1.72 per share. At June 30, 2005, $1.6 million was raised through these placements.

CAPITAL EXPENDITURES

Capital expenditures for the period ended June 30, 2005 totalled $19.5 million. $10.0 million was spent for the acquisition of IC Energy which closed March 31, 2005. An additional $6.9 million was spent on the property acquisition which closed June 29, 2005. Land costs relate to undeveloped lands acquired in northwestern Alberta and at Maidstone, Saskatchewan. Drilling and facility costs were incurred at Edson and Lloydminster.



($ Cdn.) Total
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Corporate and property acquisitions 16,941,054
Land 346,804
Seismic 207,708
Drilling and completions 1,093,183
Production facilities 879,807
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Total capital expenditures 19,468,556
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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 June 30, 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 and second quarters of 2005 in order to establish high-quality drilling prospects. The Company also entered into a three well farm-in agreement on lands in north western Alberta. These lands target high quality light sweet crude oil and deep natural gas. If successful, the Company has option to farm into an additional six wells in the same area.

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 corporate acquisitions and the recent property acquisition is the existence of a high quality drilling inventory. Drilling on the IC Energy and property acquisition lands commenced in June 2005.

Arsenal intends to utilize the cashflow generated in North America to develop the Nuqra concession in Egypt. The Company will continue to pursue international opportunities that will achieve superior returns to shareholders with minimum risk.

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
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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
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CONSOLIDATED BALANCE SHEETS

June 30, 2005 December 31, 2004
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Unaudited Audited

ASSETS
Current assets
Cash - 217,063
Accounts receivable 1,827,244 582,762
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1,827,244 799,825
Reclamation bonds 215,145 210,960
Property, plant and equipment 33,600,960 15,679,918
Goodwill (note 3) 2,665,198 -
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38,308,547 16,690,703
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LIABILITIES
Current liabilities
Accounts payable and accrued
liabilities 1,729,738 2,265,903
Revolving demand loan (note 4) 12,668,469 3,743,852
Current portion of deferred
revenue 352,650 352,650
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14,750,857 6,362,405
Deferred revenue 148,223 198,229
Future income taxes 5,676,686 1,443,129
Asset retirement obligation (note 5) 1,064,342 780,889
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21,640,108 8,784,652
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SHAREHOLDERS' EQUITY
Shareholders' equity (note 6) 16,794,912 7,458,134
Warrants (note 7) 414,048 988,760
Contributed surplus (note 8) 458,174 144,183
Deficit (998,695) (685,026)
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16,668,439 7,906,051
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38,308,547 16,690,703
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Segmented information (note 10)
Subsequent events (note 11)


CONSOLIDATED STATEMENTS OF OPERATIONS AND DEFICIT
(UNAUDITED)

Three Months Ended June 30 Six Months Ended June 30
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2005 2004 2005 2004
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REVENUE
Oil and gas 4,093,923 164,173 6,747,781 395,788
Royalties expense (803,083) (25,464) (1,402,759) (62,037)
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3,290,840 138,709 5,345,022 333,751
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EXPENSES
Operating 1,757,315 23,749 2,622,212 87,696
General and
administrative 836,910 148,745 1,529,954 252,135
Finance charges 127,455 - 192,185 -
Depletion,
depreciation and
accretion 647,364 43,480 1,160,987 115,443
Foreign exchange 34,913 - 72,448 -
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3,403,957 215,974 5,577,786 455,274
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Loss before future
income taxes (113,117) (77,265) (232,764) (121,523)
Provision for future
income taxes 44,291 - 80,905 -
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Net loss (157,408) (77,265) (313,669) (121,523)
Deficit - beginning
of period (841,287) (203,781) (685,026) (159,523)
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Deficit - end of
period (998,695) (281,046) (998,695) (281,046)
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Income (loss) per
share - basic
and diluted $ (0.01) $ 0.01 $ (0.01) $ (0.01)

Segmented information (note 10)


CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)

Three Months Ended June 30 Six Months Ended June 30
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2005 2004 2005 2004
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Cash flows from
operating activities
Net income (loss) (157,408) (77,265) (313,669) (121,523)
Items not affecting
cash
Depletion,
depreciation and
accretion 647,364 43,480 1,160,987 115,443
Future income tax
provision 44,291 (1,430) 80,905 -
Stock-based
compensation
expense (note 8) 321,955 - 407,196 12,719
Deferred revenue (19,827) - (50,006) -
Foreign exchange 34,913 - 72,448 -
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Funds from operations 871,288 (35,215) 1,357,861 6,639
Net change in
non-cash working
capital items
(note 9) (1,363,332) (9,140) (1,849,129) (709,244)
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Net cash provided
by (used in)
operating
activities (492,044) (44,355) (491,268) (702,605)
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Cash flows from
investing activities
Corporate acquisitions
(note 3) (5,941,054) - (11,441,054) -
Additions to
property, plant
and equipment (1,268,337) (297,318) (2,814,870) (538,151)
Changes in
non-cash working
capital
- investing items 25,908 - 68,482 -
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Net cash provided
by (used in)
investing
activities (7,183,483) (297,318) (14,187,442) (538,151)
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Cash flows from
financing activities
Issue of shares
for cash 1,672,510 - 1,672,510 675,000
Issue of shares for
cash upon exercise
of stock options - - 193,784 (24,896)
Issue of shares for
cash upon exercise
of warrants 946,418 - 3,855,750 -
Share issue costs (10,287) (17,121) (185,014) -
Revolving demand
loan 5,066,886 - 8,924,617 -
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Net cash provided
by (used in)
financing
activities 7,675,527 (17,121) 14,461,647 650,104
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Change in cash
during the period - (358,794) (217,063) (590,652)
Cash - Beginning
of period - 511,722 217,063 743,580
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Cash - End of period - 152,928 - 152,928
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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"), a private Canadian company. 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
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Financed by:
---------------------------------------------------------------------
Shares issued 4,500,000
Cash 5,500,000
---------------------------------------------------------------------
Purchase price 10,000,000
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4. REVOLVING DEMAND LOAN

At June 30, 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.

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:



Six Months Ended Year Ended
June 30, 2005 December 31, 2004
---------------------------------------------------------------------
Asset retirement obligation
- beginning of period 780,889 106,582
Liabilities acquired 242,159 609,300
Liabilities incurred - 58,891
Foreign exchange (2,010) -
Accretion expense 43,304 6,116
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Asset retirement obligation
- end of period 1,064,342 780,889
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---------------------------------------------------------------------

6. SHAREHOLDERS' EQUITY

Six Months Ended Year Ended
June 30, 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 1,174,712 1,672,510 7,298,870 4,270,532
Cost of shares issued - (185,014) - (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 3,946,549 3,855,750 - -
Allocated from
contributed surplus - 93,205 - -
Allocated from warrants - 574,712 - -
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Balance - end of period 28,015,244 16,794,912 18,989,706 7,458,134
---------------------------------------------------------------------
---------------------------------------------------------------------


The per share calculations for the six month period ended June 30, 2005 was based on weighted average shares outstanding of 23,531,894 (June 30, 2004 - 11,375,898). The per share calculations for the three month period ended June 30, 2005 was based on weighted average shares outstanding of 26,601,305 (June 30, 2004 - 11,396,541). In computing net income per share - diluted, 1,215,821 shares (June 30, 2004 - 1,109,876) were added to the weighted average number of shares outstanding for both the three and six month periods, 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:



Six Months Ended Year Ended
June 30, 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 (574,712) -
---------------------------------------------------------------------
Balance - end of period 414,048 988,760
---------------------------------------------------------------------
---------------------------------------------------------------------


8. STOCK OPTIONS

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



Six Months
Ended Year Ended
June 30, 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 1,655,000 1.17 1,455,000 0.58
Exercised (904,277) 0.23 (100,000) 0.20
Cancelled (435,723) 0.59 - -
---------------------------------------------------------------------
Balance - end of period 2,820,000 0.90 2,505,000 0.40
---------------------------------------------------------------------
Exercisable - end of
period 1,098,335 0.66 1,125,833 0.26
---------------------------------------------------------------------
---------------------------------------------------------------------


The Company incurred non-cash compensation expense of $407,196 for the six month period ending June 30, 2005 (2004 - nil) related to vested options issued under the Option Plan with a corresponding increase to contributed surplus. The Company incurred non-cash compensation expense of $321,955 for the three month period ending June 30, 2005 (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:




Six Months Ended Year Ended
June 30, December 31,
2005 2004
---------------------------------------------------------------------
Balance - beginning of period 144,183 59,990
Issuance of stock options 407,196 84,193
Reclassification to common shares on
exercise of options (93,205) -
---------------------------------------------------------------------
Balance - end of period 458,174 144,183
---------------------------------------------------------------------
---------------------------------------------------------------------

9. SUPPLEMENTAL CASH FLOW INFORMATION

Three Three Six Six
Months Months Months Months
Ended Ended Ended Ended
June June June June
30, 2005 30, 2004 30, 2005 30, 2004
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Change in non-cash working
capital items
Operating accounts
receivable (693,020) (36,457) (1,312,964) (66,579)
Operating accounts payable (670,312) 27,317 (536,165) (642,665)
Capital accounts payable 25,908 - 68,482 -
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(1,337,424) (9,140) (1,780,647) (709,244)
---------------------------------------------------------------------
---------------------------------------------------------------------
Interest paid 105,476 - 170,026 -
---------------------------------------------------------------------
---------------------------------------------------------------------


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 3,212,548 3,535,233 6,747,781
Net income before tax (944,631) 630,962 (313,669)
Operating income 1,243,003 1,479,807 2,722,810
Assets 31,880,325 6,428,222 38,308,547
Capital expenditures 14,255,924 - 14,255,924
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---------------------------------------------------------------------


11. SUBSEQUENT EVENTS

Acquisition of Quadra Resources Corp.

On June 20, 2005, Arsenal entered into an agreement which was completed by way of Plan of Arrangement ("the Arrangement") and closed on August 11, 2005.

Under the terms of the Arrangement, Quadra shareholders will receive 0.025 of an Arsenal common share for each one (1) Quadra share; Quadra warrantholders will receive 0.025 of an Arsenal purchase warrant for each one (1) Quadra purchase warrant, with the exercise price adjusted to reflect the exchange ratio and Quadra broker warrantholders will receive 0.025 of an Arsenal broker warrant for each one (1) Quadra broker warrant, with the exercise price adjusted to reflect the exchange ratio.

Arsenal issued 4.07 million shares at a deemed price of $1.28 per share to Quadra shareholders for gross proceeds of $5.2 million plus assumption of net working capital. After giving effect to the Arrangement, Arsenal has an additional 1,013,570 share purchase warrants with a strike price ranging between $5.20 and $7.80 per share purchase warrant.

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 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.

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

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