Fairquest Energy Limited
TSX : FQE

Fairquest Energy Limited

August 08, 2005 23:02 ET

Fairquest Energy Limited- Second Quarter Interim Report and News Release for the Period Ended June 30, 2005

CALGARY, ALBERTA--(CCNMatthews - Aug. 8, 2005) - Fairquest Energy Limited (TSX:FQE)

FAIRQUEST REPORTS RESULTS FOR ITS FIRST MONTH OF OPERATIONS



HIGHLIGHTS
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For the period from June 1 to 30, 2005
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Financial ($ thousands, except per share amounts)
Petroleum and natural gas revenue 1,460
Funds generated from operations 739
Per share - basic $ 0.03
Per share - diluted $ 0.03
Net income 119
Per share - basic $ 0.01
Per share - diluted $ -
Exploration and development expenditures 752
Acquisitions, net of dispositions 40,955
Total assets 71,041
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Operations (units as noted)
Production
Natural gas (Mcf per day) 5,514
Natural gas liquids (bbls per day) 115
Total (BOE per day) 1,034
Average sales price
Natural gas ($ per Mcf) 7.43
Natural gas liquids ($ per bbl) 67.01
Netback per BOE ($ per BOE)
Petroleum and natural gas sales 47.07
Royalties (10.25)
Transportation (1.29)
Operating expenses (8.04)
Operating netback 27.49
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MESSAGE TO SHAREHOLDERS

Fairquest Energy Limited ("Fairquest" or the "Company") is pleased to present the results of its operations for the month of June, 2005. Fairquest commenced commercial operations on June 1, 2005 pursuant to a Plan of Arrangement under which Fairborne Energy Ltd. ("Fairborne") reorganized its affairs and created Fairborne Energy Trust, owning approximately 90% of Fairborne's oil and gas properties, and Fairquest which owns the balance of Fairborne's oil and gas properties and certain undeveloped lands. Fairquest is a junior oil and gas company whose primary focus will be on exploration of an extensive inventory of prospects.

Fairquest's initial properties produce approximately 1,000 BOE per day, net to Fairquest, the majority of which is natural gas and associated natural gas liquids. Fairquest acquired 68,000 net acres of prospective undeveloped lands and entered into farm-in agreements whereby Fairquest received an option to farm-in on 83,000 net acres of Fairborne lands, retained by Fairborne Energy Trust. This land inventory, with extensive drill ready prospects, provides Fairquest with a rich portfolio of exploration and development opportunities. In conjunction with the Plan of Arrangement, Fairborne and Fairquest entered into a Technical Services Agreement which provides for the shared services required to manage Fairquest's activities and govern the allocation of general and administrative expenses between the entities.

To allow Fairquest to aggressively pursue its opportunity base, Fairquest entered into an agreement, in early June, 2005, with a syndicate of underwriters to issue, on a "bought deal" private placement basis, 4,000,000 common shares at a price of $6.65 per share for gross proceeds of $26.6 million. This issue closed on June 28, 2005. Fairquest's capital budget for the remainder of 2005 and early 2006 is between $35 and $40 million.

OPERATIONS:

Fairquest's production for the month of June averaged 1,034 BOE per day consisting of 5.5 Mmcf per day of natural gas and 115 barrels per day of natural gas liquids. Strong prices resulted in funds generated for the month of $739,000. It is expected that production levels should reach between 1,500 and 2,000 BOE per day by the end of 2005.

Fairquest's initial capital budget has been set at between $35 and $40 million for the drilling of 25-30 (12 to 15 net) wells, an additional 6 recompletions of existing wells, various facility and pipeline projects, and includes approximately $4.5 million allocated to new undeveloped land and seismic.

Since June 1, 2005 Fairquest has been active in its four core areas of operations.

West Central Alberta - West Pembina/Columbia Harlech:

The West Pembina/Columbia Harlech area accounts for 60 percent of the Company's current production. Since early June the Company has drilled and cased three deep (ranging from 3225m to 3600m) tests, successfully recompleted a well that is now producing natural gas, and is drilling a 4000m Nisku test. The three recently cased wells will be completed in August and Fairquest's average working interest is 43 percent. The Company plans to drill an additional six to eight wells in this area over the next five to six months.

Deep Basin - Wild River/Marsh

The Deep Basin area accounts for 16 percent of the Company's current production but comprises over 50 percent of the Company's undeveloped lands. A well was recently spudded at Marsh with a planned target depth of 4100 meters and will test multiple Cretaceous gas targets. Two additional wells will be drilled in the next 5 months in this area. The Company's average interest in these wells is 50 percent. At Wild River Fairquest recently completed a gas well and plans to spud two 4000 meter exploration tests in the fall of 2005.

Central Alberta - Westerose/Pigeon Lake

For the balance of 2005 the Company has a six well program planned for this area in partnership with Fairborne Energy Trust. To date, three of these wells have been drilled and cased, one has been completed as a gas well and is awaiting tie-in and two remain to be completed. The Company has varying interests in these areas ranging from 10 percent to 50 percent.

Peace River Arch

The Rycroft Area on the Peace River Arch accounts for 16 percent of Fairquest's current production. The Company plans to drill three wells in this area in 2005. The first well (34 percent interest) is a 2100 meter Triassic test that recently spudded.

Outlook

The future of the oil and gas industry in Western Canada looks promising as commodity prices maintain historically high levels. Richard A. Walls, President and CEO says "As a new company, Fairquest is in an enviable position of starting with a large inventory of exploration and development projects that have been accumulated over the last several years and access to sufficient capital to proceed with a large capital program to develop these projects. The management and staff of Fairquest look forward to reporting on future progress as Fairquest continues its search for new oil and gas reserves".

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") was prepared at, and is dated, August 8, 2005. This MD&A is provided by the management of Fairquest Energy Limited ("Fairquest" or the "Company") to review second quarter 2005 activities. This MD&A should be read in conjunction with the unaudited interim financial statements including notes for the period from commencement of operations on June 1 to June 30, 2005. Additional information relating to Fairquest, is available on SEDAR at www.sedar.com.

NATURE OF BUSINESS: Fairquest was incorporated on March 7, 2005 and commenced commercial operations on June 1, 2005 under a Plan of Arrangement involving Fairborne Energy Limited, Fairborne Energy Trust ("Fairborne"), Fairquest and security holders of Fairborne Energy Ltd. ("Plan of Arrangement"). Pursuant to the Plan of Arrangement, Fairquest acquired certain petroleum and natural gas properties of Fairborne.

Fairquest maintains its head office in Calgary and is engaged in the business of exploring for, developing, acquiring and producing crude oil and natural gas in Western Canada. Fairquest follows a strategy of balancing risk and reward by focusing on opportunities by geographic area and prospect type. Within these select areas, Fairquest develops a portfolio of exploration and development prospects in conjunction with an active acquisition strategy.

FORWARD LOOKING STATEMENTS: This MD&A contains forward-looking statements. Forward-looking statements are based on current expectations that involve a number of risks and uncertainties which could cause events or results to differ materially from those reflected in the MD&A. Forward-looking statements are based on the estimates and opinions of Fairquest's management at the time the statements were made. Fairquest assumes no obligation to update forward-looking statements should circumstances or management's estimates change.

NON-GAAP TERMS: This document contains the terms "funds generated from operations" and "netbacks" which are non-GAAP terms. The Company uses these measures to help evaluate its performance. The Company considers corporate netbacks a key measure as it demonstrates its profitability relative to current commodity prices. The Company considers funds generated from operations a key measure as it demonstrates Fairquest's ability to generate funds necessary to repay debt and to fund future growth through capital investment. Funds generated from operations should not be considered as an alternative to, or more meaningful than, cash flow from operating activities as determined in accordance with Canadian GAAP as an indicator of Fairquest's performance. Fairquest's determination of funds generated from operations may not be comparable to that reported by other companies. The reconciliation between net income and funds generated from operations can be found in the statement of cash flows in the financial statements. Fairquest also presents funds generated from operations per share whereby per share amounts are calculated using weighted average shares outstanding consistent with the calculation of income per share.

BOE CONVERSIONS: Barrel of oil equivalent ("BOE") amounts may be misleading, particularly if used in isolation. A BOE conversion ratio has been calculated using a conversion rate of six thousand cubic feet of natural gas to one barrel and is based on an energy equivalent conversion method application at the burner tip and does not necessarily represent an economic value equivalency at the wellhead.

PLAN OF ARRANGEMENT

Fairquest Energy Limited (the "Company" or "Fairquest") was incorporated on March 7, 2005 and commenced commercial operations on June 1, 2005 under a Plan of Arrangement involving Fairborne Energy Ltd., Fairborne Energy Trust ("Fairborne"), Fairquest and security holders of Fairborne Energy Ltd. ("Plan of Arrangement"). Pursuant to the Plan of Arrangement, Fairquest acquired certain petroleum and natural gas properties of Fairborne Energy Ltd.. The assets and liabilities transferred to Fairquest were accounted for on a continuity of interest basis and recorded at their carrying value.

RELATIONSHIP WITH FAIRBORNE ENERGY TRUST

As a result of the Plan of Arrangement, Fairquest and Fairborne have joint interests in certain properties and undeveloped land. In addition, the companies have entered into farm-in agreements whereby Fairquest received an option to farm-in on 83,000 net acres of Fairborne exploratory lands.

In conjunction with the Plan of Arrangement, Fairborne and Fairquest entered into a Technical Services Agreement which provides for the shared services required to manage Fairquest's activities and govern the allocation of general and administrative expenses between the entities. Under the Technical Services Agreement, Fairquest is charged a technical services fee by Fairborne, on a cost recovery basis, in respect of the management, development, exploitation, operations and marketing activities on the basis of relative production and capital expenditures. In addition, under the Technical Services Agreement, Fairborne markets Fairquest's natural gas, crude oil and natural gas liquids. For the period June 1 to June 30, 2005 the technical services fee was $39,000. The Technical Services Agreement has no set termination date and will continue until terminated by either party with six months prior written notice to the other party or on some other date as may be mutually agreed. The Company has issued Performance Shares and options to the employees of Fairborne as service providers to Fairquest.



QUARTERLY FINANCIAL INFORMATION

The following is a summary of selected financial information for the
second quarter of 2005:

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Period from
June 1 to 30, 2005
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Financial ($ thousands, except per share amounts)
Petroleum and natural gas sales, before royalties 1,460
Funds generated from operations 739
Per share - basic $ 0.03
Per share - diluted $ 0.03
Net Income 119
Per share - basic $ 0.01
Per share - diluted $ -
Total assets 71,041
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------------------------------------------------------------------------
Operations (units as noted)
Average production
Natural gas (Mcf per day) 5,514
Natural gas liquids (bbls per day) 115
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Total (BOE per day) 1,034
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SECOND QUARTER 2005 RESULTS

Production and Prices

Fairquest recorded natural gas production of 5,514 Mcf per day and 115 bbls per day of associated natural gas liquids during the month of June 2005. All of the Company's production was from properties acquired from Fairborne Energy Ltd. pursuant to the Plan of Arrangement. June 2005 production was impacted by a facility turnaround at Fairquest 's Wild River property which reduced production for several days at the beginning of the month.

Based on current production levels and exploration activities planned, Fairquest expects production to increase over the next six months with an expected year end 2005 production level of between 1,500 and 2,000 BOE per day.

Fairquest realized a natural gas price of $7.43 per Mcf and an average price of $67.01 for associated natural gas liquids in the month of June 2005. Fairquest does not currently utilize any hedging or fixed sales contracts on its production.

Petroleum and Natural Gas Revenue

Fairquest recorded total revenue of $1.5 million for the period June 1 to June 30, 2005.



------------------------------------------------------------------------
Period from
($ thousands, except per unit amounts) June 1 to 30, 2005
------------------------------------------------------------------------
Revenues
Natural gas 1,229
Natural gas liquids 231
Other income 5
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Total 1,465
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Prices
Natural gas ($ per Mcf) 7.43
Natural gas liquids ($ per bbl) 67.01
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Total ($ per BOE) 47.07
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Royalties

Fairquest recorded royalty expense of $318,000 for the period June 1 to June 30, 2005 for an effective royalty rate of 21.8%. The Company expects royalties to range between 22% and 24% for the remainder of 2005.

Transportation costs

The majority of Fairquest's transportation costs are transportation and fuel costs associated with usage of the TransCanada natural gas pipeline. The Company expects transportation costs to be between $0.20 and $0.25 per Mcf for the remainder of 2005.

Operating Expenses

Fairquest recorded $249,000 or $8.04 per BOE in operating costs for the month of June 2005. All of Fairquest's properties are currently operated by Fairborne. The Company expects BOE operating costs to remain around $8.00 for the remainder of 2005.



Operating Netbacks
------------------------------------------------------------------------
Period from
($/BOE) June 1 to 30, 2005
------------------------------------------------------------------------
Revenue 47.07
Royalties (10.25)
Transportation costs (1.29)
Operating costs (8.04)
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Operating netback 27.49
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General and Administrative ("G&A") Expenses

Fairquest recorded $152,000 for G&A expenses during the period June 1 to June 30, 2005. G&A expenses included $39,000 payable to Fairborne under the Technical Services Arrangement and $38,000 of non-cash compensation expense for the stock options issued by Fairquest during the month of June.

Depletion, Depreciation and Accretion

Depletion and depreciation expense for the period June 1 to June 30, 2005 was $475,000 or $15.30 per BOE. Fairquest's depletion rate reflects the carrying value of properties transferred from Fairborne pursuant to the Plan of Arrangement.

The Company estimates its total undiscounted future liability for asset retirement obligations to be approximately $3.0 million, the present value of which is $762,000 at June 30, 2005. Accretion of asset retirement obligations in the month of June 2005 was $5,000 ($0.17 per BOE).

Taxes

Fairquest's effective tax rate, including the effect of non-deductible stock based compensation, for the month of June 2005 was 47.3%, the majority of which was future income taxes. Fairquest recorded a tax asset on the transfer of properties from Fairborne under the Plan of Arrangement. The tax asset was due to future tax deductions based on fair market values which are in excess of the carrying values used to record the acquisition in Fairquest's records. Based on available tax pools, expected capital expenditures and forecast net income for 2005, the Company does not anticipate paying cash income taxes other than capital taxes in 2005.



Funds Generated from Operations and Net Income
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Period from
($ thousands) June 1 to 30, 2005
------------------------------------------------------------------------
Funds generated from operations 739
Per share - basic $ 0.03
Per share - diluted $ 0.03
Net Income 119
Per share - basic $ 0.01
Per share - diluted $ -
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------------------------------------------------------------------------

Unit Analysis
------------------------------------------------------------------------
Period from June 1 to 30, 2005
($ thousands, except per unit amounts) ($thousands) ($ per BOE)
------------------------------------------------------------------------
Production revenue 1,460 47.07
Royalties 318 10.25
Transportation costs 40 1.29
Operating expenses 249 8.04
General & administrative (1) 114 3.68
Interest (income) (5) (0.17)
Capital taxes 5 0.16
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Funds generated from operations 739 23.82
Compensation expense 38 1.22
Depletion, depreciation and accretion 480 15.47
Future income taxes 102 3.29
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Net Income 119 3.84
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(1) net of compensation expense (non-cash)


LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Equivalents

At June 30, 2005, Fairquest had $25.3 million in cash and term deposits with maturities of less than three months. The majority of the balance is attributable to the private placement of $26.6 million which closed on June 28, 2005. The Company plans to utilize its cash balances, together with funds generated from operations to fund capital expenditures over the remainder of 2005.

Capital Expenditures

Fairquest's exploration and development expenditures for the month of June 2005 totalled $752,000.



------------------------------------------------------------------------
Period from
($ thousands) June 1 to 30, 2005
------------------------------------------------------------------------
Exploration and development
Land and lease acquisitions 24
Drilling, completions and workovers 591
Well equipment and facilities 137
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752
Property acquisitions 40,955
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Total 41,707
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During the month of June 2005, the Company commenced the drilling of one (0.5 net) gas well which was completed in July.

The acquisition of properties from Fairborne on June 1, 2005 was treated as a continuity of interests with the petroleum and natural gas assets recorded as at their carrying value of $41 million.

Bank Indebtedness

At June 30, 2005 the Company has available $16 million of demand operating credit facilities from a syndicate of Canadian chartered banks based on the bank's valuation of the Company's petroleum and natural gas properties. The facilities are secured by a first ranking floating charge on all real property of the Company and a general security agreement.

Share Capital

The Company is authorized to issue an unlimited number of common shares, an unlimited number of preferred shares issuable in series and 1,000,000 Performance Shares.

On June 1, 2005, prior to completion of the Plan of Arrangement, Fairquest completed an initial private placement of 4,740,000 units at a price of $2.11 per unit and 1,000,000 Performance Shares at a price of $0.01 per share for total gross proceeds of $10 million. Each unit included one common share and one warrant to acquire a common share at a price of $3.17 per share. All of the common shares, warrants and Performance shares issued under the initial private placement are subject to 3 year vesting periods and/or contractual hold periods and contain provisions which require holders to remain as Fairquest service providers.

On June 1, 2005, pursuant to the Plan of Arrangement, 17,308,830 common shares were issued to the former shareholders of Fairborne Energy Ltd. On June 28, 2005, the Company issued 4,000,000 common shares at a price of $6.65 per share for gross proceeds of $26.6 million.

The following table provides a summary of outstanding common shares and other equity instruments as at the dates indicated:



------------------------------------------------------------------------
August 8, June 30,
2005 2005
------------------------------------------------------------------------
Common shares 26,048,831 26,048,831
Warrants 4,740,000 4,740,000
Performance shares 1,000,000 1,000,000
Stock options 1,054,400 1,054,400
Weighted average common shares
Basic n/a 22,449,000
Diluted n/a 25,824,000
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------------------------------------------------------------------------


Commitments

Pursuant to the Technical Services Agreement entered into between Fairquest and Fairborne in conjunction with the Plan of Arrangement, Fairquest is committed to shared services to mange its activities on a cost recovery basis with Fairborne. Fairquest has also committed to drill 25 wells on Fairborne lands over the two year term of the farm-in agreement with Fairborne.


BUSINESS ENVIRONMENT AND RISK

The business risks the Company is exposed to are those inherent in the oil and gas industry as well as those governed by the individual nature of Fairquest's operations. Geological and engineering risks, the uncertainty of discovering commercial quantities of new reserves, commodity prices, interest rate and foreign exchange risks, competition and government regulations - all of these govern the businesses and influence the controls and management at the Company. Fairquest manages these risks by:

- attracting and retaining a team of highly qualified and motivated professionals who have a vested interest in the success of the Company;

- operating properties in order to identify and capitalize on opportunities;

- employing risk management instruments to minimize exposure to fluctuation in commodity prices, interest rate and foreign exchange rates;

- maintaining a strong financial position; and

- maintaining strict environmental, safety and health practices.

CRITICAL ACCOUNTING ESTIMATES

Depletion and depreciation expense

The Company uses the full cost method of accounting for exploration and development activities whereby all costs associated with these activities are capitalized, whether successful or not. The aggregate of capitalized costs, including future development costs, net of certain costs related to unproved properties is subject to amortization as depletion and depreciation expense. Depletion and depreciation expense is calculated on a unit-of-production based on estimated proved reserves.

The costs of acquiring and evaluating unproved properties are initially excluded from depletion calculations. These properties are assessed periodically to ascertain whether impairment has occurred. When proved reserves are assigned or the property is considered to be impaired, the cost of the property or the amount of impairment is added to the costs subject to depletion.

Full cost accounting ceiling test

The carrying value of petroleum and natural gas properties and equipment is reviewed at least annually for impairment. Any impairment would be included as additional depletion and depreciation in the period which it occurred. The carrying value is based on estimates of proved reserves, production rates, commodity prices, future capital costs, royalty rates and other assumptions. By their nature, these estimates are subject to measurement uncertainty and the effect on the financial statements of changes in such estimates in future periods could be significant.

Asset Retirement Obligation ("ARO")

The Company estimates the fair value of ARO in the period in which it is incurred and records an ARO liability with a corresponding increase in the carrying amount of the related asset. The capitalized amount is depleted on the unit-of-production method based on estimated proved reserves. The liability amount is increased each reporting period due to the passage of time based on an estimated risk-free interest rate, and the amount of accretion is expensed to income in the period.

Income Taxes

The Company follows the liability method of accounting for income taxes. The determination of the Company's income and other tax liabilities requires interpretation of laws and regulations, which are revised periodically. All tax filings are subject to audit and could be reassessed after a considerable period of time. Future tax assets and liabilities are booked at substantively enacted future income tax rates which include changes over a period of time. The rate used by the Company is based on estimated future net revenues, estimated future depletion rates and other assumptions. Accordingly, the actual income tax liability may differ significantly from the amounts estimated and can impact the current and future income tax expense recorded in future periods.



INTERIM BALANCE SHEET (Unaudited)
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($ thousands) June 30, 2005
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Assets
Current assets
Cash and cash equivalents $ 25,289
Accounts receivable 1,474
------------------------------------------------------------------------
26,763
Capital assets (Note 3) 41,989
Future income taxes (Note 6) 2,289
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$ 71,041
------------------------------------------------------------------------
------------------------------------------------------------------------
Liabilities
Current liabilities
Accounts payable and accrued liabilities $ 1,618
Asset retirement obligation (Note 5) 762

Shareholders' Equity
Capital stock and warrants (Note 7) 68,504
Contributed surplus (Note 7) 38
Retained earnings 119
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68,661
------------------------------------------------------------------------
$ 71,041
------------------------------------------------------------------------
------------------------------------------------------------------------
See accompanying notes to the interim financial statements


INTERIM STATEMENT OF OPERATIONS AND RETAINED EARNINGS (Unaudited)

For the period from commencement of operations
on June 1 to June 30, 2005
------------------------------------------------------------------------
($ thousands) 2005
------------------------------------------------------------------------
Revenue
Petroleum and natural gas $ 1,460
Royalties (318)
Transportation (40)
Interest 5
------------------------------------------------------------------------
1,107
Expenses
Operating 249
General and administrative 152
Depletion, depreciation and accretion 480
------------------------------------------------------------------------
881
------------------------------------------------------------------------
Income before taxes 226
Taxes (Note 6)
Future 102
Capital 5
------------------------------------------------------------------------
107
------------------------------------------------------------------------
Net income 119
Retained earnings, beginning of period -
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Retained earnings, end of period $ 119
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------------------------------------------------------------------------

Net income per share (Note 7)
Basic $ 0.01
Diluted $ -
------------------------------------------------------------------------
------------------------------------------------------------------------
See accompanying notes to the interim financial statements


INTERIM STATEMENT OF CASH FLOWS (Unaudited)

For the period from commencement of operations on
June 1 to June 30, 2005
------------------------------------------------------------------------
($ thousands) 2005
------------------------------------------------------------------------
Cash provided by (used in):
Operating activities
Net income $ 119
Items not involving cash
Depletion, depreciation and accretion 480
Compensation expense 38
Future income taxes 102
------------------------------------------------------------------------
739
Change in non-cash working capital (672)
------------------------------------------------------------------------
67
------------------------------------------------------------------------
Financing activities
Issuance of common shares, warrants and
performance shares, net of costs 35,158
Repayment of bank debt (10,000)
------------------------------------------------------------------------
25,158
------------------------------------------------------------------------
Investing activities
Capital expenditures (752)
Change in non-cash working capital 816
------------------------------------------------------------------------
64
------------------------------------------------------------------------
Change in cash and cash equivalents 25,289
Cash and cash equivalents, beginning of period -
------------------------------------------------------------------------
Cash and cash equivalents, end of period $25,289
------------------------------------------------------------------------
------------------------------------------------------------------------
See accompanying notes to the interim financial statements


NOTES TO THE INTERIM FINANCIAL STATEMENTS

For the period from commencement of operations on June 1 to June 30, 2005 (unaudited)

(tabular amounts are stated in thousands of dollars except per share amount)

NATURE OF OPERATIONS:

Fairquest Energy Limited (the "Company" or "Fairquest") was incorporated on March 7, 2005 and commenced commercial operations on June 1, 2005 under a Plan of Arrangement involving Fairborne Energy Ltd., Fairborne Energy Trust ("Fairborne"), Fairquest and security holders of Fairborne Energy Ltd. ("Plan of Arrangement"). Pursuant to the Plan of Arrangement, Fairquest acquired certain petroleum and natural gas properties of Fairborne. The assets and liabilities transferred to Fairquest were accounted for on a continuity of interest basis and recorded at their carrying value.

RELATIONSHIP WITH FAIRBORNE ENERGY TRUST

As a result of the Plan of Arrangement, Fairquest and Fairborne have joint interests in certain properties and undeveloped land. In addition, the companies have entered into farm-in agreements whereby Fairquest received an option to farm-in on 83,000 net acres of Fairborne exploratory lands.

In conjunction with the Plan of Arrangement, Fairborne and Fairquest entered into a Technical Services Agreement which provides for the shared services required to manage Fairquest's activities and govern the allocation of general and administrative expenses between the entities.Under the Technical Services Agreement, Fairquest is charged a technical services fee by Fairborne, on a cost recovery basis, in respect of the management, development, exploitation, operations and marketing activities on the basis of relative production and capital expenditures. In addition, under the Technical Services Agreement, Fairborne markets Fairquest's natural gas, crude oil and natural gas liquids. For the period June 1 to June 30, 2005 the technical services fee was $39,000. The Technical Services Agreement has no set termination date and will continue until terminated by either party with one year prior written notice to the other party or on some other date as may be mutually agreed. As contemplated in the Plan of Arrangement, the Company has issued Performance Shares to the employees of Fairborne as service providers to Fairquest.

As at June 30, 2005, accounts payable included $72,500 due to Fairborne, which includes joint venture amounts including capital expenditures.

1. SIGNIFICANT ACCOUNTING POLICIES

a) Basis of presentation

The financial statements of the Company have been prepared by management in accordance with Canadian generally accepted accounting principles.

b) Petroleum and natural gas operations

The Company follows the full cost method of accounting for petroleum and natural gas properties and facilities whereby all costs associated with the exploration for and development of petroleum and natural gas reserves are capitalized. Such costs include land acquisition costs, geological and geophysical costs, lease rental costs on nonproducing properties, costs of both productive and unproductive drilling and production equipment. Gains or losses are not recognized upon disposition of petroleum and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the depletion rate of 20% or more.

The accumulated costs, less the costs of unproved properties, are depleted and depreciated using the unit-of-production method based on total proved reserves before royalties as determined by independent evaluators. Natural gas reserves and production are converted into equivalent barrels of oil based upon the estimated relative energy content.

The costs of acquiring and evaluating unproved properties, are initially excluded from depletion calculations. These properties are assessed periodically to ascertain whether impairment has occurred. When proved reserves are assigned or the property is considered to be impaired, the cost of the property or the amount of impairment is added to the costs subject to depletion.

The Company places a limit on the carrying value of petroleum and natural gas properties and equipment, which may be depleted against revenues of future periods (the "ceiling test"). The carrying value is assessed to be recoverable when the sum of the undiscounted cash flows expected from the production of proved reserves, the lower of cost and market of unproved properties and the cost of major development projects exceeds the carrying value. When the carrying value is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying value of assets exceeds the sum of the discounted cash flows expected from the production of proved and probable reserves, the lower of cost and market of unproved properties and the cost of major development projects. The cash flows are estimated using expected future product prices and costs and are discounted using a risk-free interest rate.

c) Asset retirement obligations ("ARO")

The Company recognizes the fair value of ARO in the period in which it is incurred when a reasonable estimate of the fair value can be made. The fair value of the estimated ARO is recorded as a liability, with a corresponding increase in the carrying amount of the related asset. The capitalized amount is depleted on the unit-of-production method based on proved reserves. The liability amount is increased each reporting period due to the passage of time and the amount of accretion is expensed to income in the period. Actual costs incurred upon the settlement of the ARO are charged against the ARO.

d) Interest in joint ventures

Substantially all of the Company's oil and gas exploration and development activities are conducted jointly with others and, accordingly, the financial statements reflect only the Company's proportionate interest in such activities.

e) Stock-Based Compensation

The Company has a stock based compensation plan, which is described in Note 7. Compensation expense associated with the stock based compensation plan is recognized in income over the vesting period of the plan with a corresponding increase in contributed surplus. Compensation expense is based on the fair value of the stock based compensation at the date of the grant using a Black-Scholes option pricing model.

Any consideration received upon exercise of the stock based compensation together with the amount of non-cash compensation expense recognized in contributed surplus is recorded as an increase in capital stock.

f) Income Taxes

The Company uses the liability method of accounting for future income taxes. Under the liability method, future income tax assets and liabilities are determined based on "temporary differences" (differences between the accounting basis and the tax basis of the assets and liabilities), and are measured using the currently enacted, or substantively enacted tax rates and laws expected to apply when these differences reverse. A valuation allowance is recorded against any future income tax assets if it is more likely than not that the asset will not be realized.

g) Cash and cash equivalents

The Company considers cash and short term deposits with original maturities of three months or less as cash and cash equivalents.

h) Measurement uncertainty

The preparation of financial statements in conformity with Canadian generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and revenue and expenses for the period then ended. Actual results could differ from those estimates.

The amounts recorded for depletion and depreciation and the provision for asset retirement obligations are based on estimates. The ceiling test calculation is based on estimates of proved and probable reserves, production rates, petroleum and natural gas prices, future costs and relevant assumptions. By their nature, these estimates are subject to measurement uncertainty and may impact the consolidated financial statements of future periods.

i) Per Share Information

Basic per share amounts are calculated using the weighted average number of shares outstanding during the year. Diluted per share amounts are calculated based on the treasury-stock method, which assumes that any proceeds obtained on the exercise of in the money options and warrants would be used to purchase common shares at the average market price during the period. The weighted average number of shares outstanding is then adjusted by the net change.

j) Revenue Recognition

Revenue from the sale of oil and natural gas is recognized when the product is delivered. Revenue from processing and other miscellaneous sources is recognized upon completion of the relevant service.

2. TRANSFER OF ASSETS AND COMMENCEMENT OF COMMERCIAL OPERATIONS

Under the Plan of Arrangement, Fairborne transferred to Fairquest certain producing petroleum and natural gas properties, undeveloped lands and a portion of its bank debt. The assets and liabilities transferred to Fairquest were accounted for on a continuity of interest basis and recorded at their carrying value as follows:



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Net assets received:
Petroleum and natural gas properties and equipment $ 41,712
Future income taxes 1,890
Bank debt assumed (10,000)
Asset retirement obligations (757)
Deficit 3,766
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Common shares issued (17,308,830 shares) 36,611
Reduction of stated capital (3,766)
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Common shares $ 32,845
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Pursuant to the Plan of Arrangement, the deficit was eliminated by an
equal reduction to the stated share capital of common shares.

3. CAPITAL ASSETS


---------------------------------------------------------------------
June 30, 2005
---------------------------------------------------------------------
Petroleum and natural gas properties and equipment $ 42,464
Accumulated depletion and depreciation (475)
---------------------------------------------------------------------
$ 41,989
---------------------------------------------------------------------
---------------------------------------------------------------------


As at June 30, 2005, costs of acquiring unproved properties in the amount of $9.0 million were excluded from the depletion calculation. Included in the Company's petroleum and natural gas properties and equipment balance is $0.8 million relating to asset retirement obligation, net of accumulated depletion.

4. BANK INDEBTEDNESS

At June 30, 2005 the Company has available $16 million of demand operating credit facilities from a syndicate of Canadian chartered banks based on the bank's valuation of the Company's petroleum and natural gas properties. The facilities bear interest at the bank's prime rate, banker's acceptance rates or LIBOR rates plus margins ranging from 0.0% to 1.4% depending on financial statement ratios and the nature of the advance. The facilities are secured by a first ranking floating charge on all real property of the Company and a general security agreement.

5. ASSET RETIREMENT OBLIGATIONS

The Company's asset retirement obligations result from net ownership interests in petroleum and natural gas assets including well site, gathering systems and processing facilities. The Company estimated the total undiscounted amount required to settle its asset retirement obligations to be approximately $3.1 million which is scheduled to be incurred between 2018 and 2020. The majority of the costs are scheduled to be incurred in 2018. A credit-adjusted risk-free interest rate of 8.5 percent and an inflation rate of 1.5 percent was used to calculate the fair value of the asset retirement obligations.

A reconciliation of the asset retirement obligations is provided below:



---------------------------------------------------------------------
Period from
commencement
of operation
on June 1 to
June 30, 2005
---------------------------------------------------------------------
Transfer of assets through Plan of Arrangement (Note 2) $ 757
Accretion expense 5
---------------------------------------------------------------------
Balance, June 30, 2005 $ 762
---------------------------------------------------------------------
---------------------------------------------------------------------

6. FUTURE INCOME TAXES

The provision for income taxes in the financial statements differs
from the result, which would have been obtained in applying the
combined federal and provincial tax rate to the Company's earnings
before income taxes. The difference results from the following items:


---------------------------------------------------------------------
Period from
commencement
of operation
on June 1 to
June 30, 2005
---------------------------------------------------------------------
Earnings before taxes $ 226
Combined federal and provincial tax rate 37.6%
---------------------------------------------------------------------
Computed "expected" income tax expense 85
Increase (decrease) in income taxes resulting from:
Non-deductible Crown charges 71
Non-deductible stock based compensation 14
Resource allowance (59)
Other (9)
---------------------------------------------------------------------
Future income taxes 102
Capital taxes 5
---------------------------------------------------------------------
Total taxes $ 107
---------------------------------------------------------------------
---------------------------------------------------------------------

The components of the future income tax asset at June 30, 2005 is as
follows:

---------------------------------------------------------------------
Petroleum and natural gas properties and equipment $ 1,543
Asset retirement obligations 253
Share issue costs 493
---------------------------------------------------------------------
Future income tax asset $ 2,289
---------------------------------------------------------------------
---------------------------------------------------------------------


7. CAPITAL STOCK

a) Authorized

(i) Unlimited number of common shares; and
(ii) 1,000,000 Performance Shares.


b) Issued and Outstanding

---------------------------------------------------------------------
Period from commencement
of operation on
June 1 to June 30, 2005
Number
of Shares Amount
---------------------------------------------------------------------
COMMON SHARES

Issued on incorporation 1 $ -
Issued pursuant to private placement 4,740,000 8,928
Issued pursuant to Plan of Arrangement (Note 2) 17,308,830 32,845
Issued for cash 4,000,000 26,600
Share issue costs - (1,453)
Future tax benefit of issue costs - 501
---------------------------------------------------------------------
Balance, June 30, 2005 26,048,831 $67,421
---------------------------------------------------------------------
---------------------------------------------------------------------
WARRANTS

Issued pursuant to private placement 4,740,000 $ 1,073
---------------------------------------------------------------------
Balance, June 30, 2005 4,740,000 $ 1,073
---------------------------------------------------------------------
---------------------------------------------------------------------
PERFORMANCE SHARES

Issued pursuant to private placement 1,000,000 $ 10
---------------------------------------------------------------------
Balance, June 30, 2005 1,000,000 $ 10
---------------------------------------------------------------------
---------------------------------------------------------------------


On June 1, 2005, prior to completion of the Plan of Arrangement, Fairquest completed a private placement of 4,740,000 units at a price of $2.11 per unit and 1,000,000 Performance Shares at a price of $0.01 per share for total gross proceeds of $10 million. Each unit included one common share and one warrant to acquire a common share at a price of $3.17 per share. The common shares are subject to a contractual hold period and will be released as to one-third of the aggregate number held on each of June 1, 2006, 2007 and 2008. Any holder that ceases to be a Fairquest service provider will not be entitled to any further releases.

The warrants are exercisable as to one-third on each of June 1, 2006, 2007 and 2008 and expire June 1, 2010. The weighted average fair value of warrants was determined using the Black-Scholes valuation model with the following weighted average assumptions: risk free rate of 4 percent, expected volatility of 30 percent and an expected life of 3 years. In the event that a subscriber voluntarily ceases to be a Fairquest service provider or is terminated with cause, such person shall lose all unvested warrants.

The Performance Shares were issued for cash and recorded at $0.01 per share. The Performance Shares are convertible into the percentage of a common share equal to the weighted average trading price of the common shares for the five trading days prior to such conversion (the "Fairquest Price"), less $2.11, if positive, divided by the Fairquest Price. The Performance Shares become convertible into common shares as to one-third on each of June 1, 2006, 2007 and 2008 and will be automatically converted if not previously converted on June 1, 2010. If the holder ceases to be a Fairquest service provider before the Performance Shares become convertible, Fairquest may, subject to applicable law, redeem each Performance Share at a redemption price of $0.01 per share. If the Fairquest Price less $2.11 is not positive on the conversion date, Fairquest will, subject to applicable law, redeem each Performance Shares at a redemption price of $0.01 per share. The weighted average fair value of the Performance Shares was determined using the Black-Scholes valuation model with the resulting value recorded as compensation cost over the vesting term of the shares (Note 7(e)).

On June 1, 2005, pursuant to the Plan of Arrangement, 17,308,830 common shares were issued to the former shareholders of Fairborne Energy Ltd.

On June 28, 2005, the Company issued 4,000,000 common shares at a price of $6.65 per share for gross proceeds of $26.6 million.

c) Per Share Amounts

The following table summarizes the weighted average common shares used in calculating net income per share:



---------------------------------------------------------------------
Period from commencement
of operation on
June 1 to June 30, 2005
---------------------------------------------------------------------
Basic 22,449,000
Diluted 25,824,000
---------------------------------------------------------------------
---------------------------------------------------------------------


The reconciling item between the basic and diluted average common shares are outstanding stock options, Performance shares and warrants. Excluded from weighted average common shares are 1,054,400 stock options which are out-of-themoney based on the average trading price for the period.

d) Stock Options

There are 1,054,400 stock options outstanding at June 30, 2005 with an exercise price of $7.18 per share. Options vest evenly over a three year period and expire five years from the date of grant. The outstanding options expire on June 13, 2010.



e) Contributed Surplus

---------------------------------------------------------------------
Period from commencement
of operation on
June 1 to June 30, 2005
---------------------------------------------------------------------
Balance, beginning of period $ -
Stock based compensation expense
Stock options 8
Performance shares 30
---------------------------------------------------------------------
Balance, June 30, 2005 $ 38
---------------------------------------------------------------------
---------------------------------------------------------------------


The weighted average fair value of stock options granted during the period from June 1 to June 30, 2005 was $1.83 per option and the weighted average fair value of Performance shares granted during the same period was $0.48 per share using the Black-Scholes option pricing model with the following weighted average assumptions: risk free rate of 4 percent, expected volatility of 30 percent and an expected life of 3 years.

8. FINANCIAL INSTRUMENTS

a) Credit Risk:

A significant portion of the Company's accounts receivable is from an oil and gas marketing agent and is subject to normal industry credit risks.

b) Fair value of financial instruments:

The carrying value of the Company's financial instruments approximate their fair value due to their short maturity.

READER ADVISORY: Certain information set forth in this document, including managements' assessment of the future plans and operations of Fairquest Energy Limited ('Fairquest'), contains forward looking statements. By their nature, forward-looking statements are subject to numerous risks and uncertainties, some of which are beyond these parties' control, including the impact of general economic conditions, industry conditions, volatility of commodity prices, currency fluctuations, imprecision of reserve estimates, environmental risks, competition from other industry participants, the lack of availability of qualified personnel or management, stock market volatility and ability to access sufficient capital from internal and external sources. Readers are cautioned that the assumptions used in the preparation of such information, although considered reasonable at the time of preparation, may prove to be imprecise and, as such, undue reliance should not be placed on forward looking statements. The actual results, performance or achievement of Fairquest could differ materially from those expressed in, or implied by, these forward-looking statements and, accordingly, no assurance can be given that any of the events anticipated by the forward looking statements will transpire or occur, or if any of them do so, what benefits that Fairquest will derive therefrom. Fairquest disclaims any intention or obligation to update or revise any forward-looking statements,whether as a result of new information, future events or otherwise, BOE disclosure may be misleading, particularly if used in isolation. A BOE conversion ratio of 6 Mcf to 1 Bbl is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Fairquest Energy Limited is a growth oriented, junior gas exploration, development and production company operating exclusively in western Canada. Fairquest's common shares are publicly traded on the Toronto Stock Exchange under the trading symbol "FQE".



FAIRQUEST ENERGY LIMITED
3400, 450 - First Street S.W.
Calgary, Alberta T2P 5H1
Telephone (403) 290-7750
Fax (403) 290-3216

Email: info@fairquestenergy.com
Website: www.fairquestenergy.com

DIRECTORS

Richard A. Walls
Robert A. Maitland
Donald J. Nelson
Gary F. Aitken
Brian A. Felesky
David M. Fitzpatrick

OFFICERS

Richard A. Walls
Robert A. Maitland

STOCK EXCHANGE LISTING

The Toronto Stock Exchange
Trading Symbol: FQE


Contact Information

  • Fairquest Energy Limited
    Richard A. Walls
    President, and Chief Executive Officer
    (403) 290-7750
    or
    Fairquest Energy Limited
    Robert A. Maitland
    Vice President, Finance and Chief Financial Officer
    (403) 290-7750
    (403) 290-3216 (FAX)
    Email: info@fairquestenergy.com
    Website: www.fairquestenergy.com