Masters Energy Inc.
TSX : MSY

Masters Energy Inc.

August 02, 2006 17:39 ET

Masters Energy Inc. Reports Second Quarter 2006 Interim Results

CALGARY, ALBERTA--(CCNMatthews - Aug. 2, 2006) - Masters Energy Inc. (TSX:MSY) ("Masters" or the "Company") is pleased to report financial and operating results for the three and six months periods ended June 30, 2006. Several significant accomplishments were achieved during the period;

- Increased daily production 22 percent to 1,427 boe per day from the first half of 2005.

- Funds generated by operations in the second quarter 2006 increased 40 percent to $3.6 million from $2.5 million in the first quarter of 2006 and year to date increased 28 percent compared to the same period of 2005.

- Issued flow-through shares for total proceeds of $6.1 million.

- Drilled 18 wells resulting in 10 natural gas discoveries.

- Shot 105 square kilometers of 3-D seismic and in excess of 100 kilometers of 2-D seismic.



HIGHLIGHTS

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
------------------------------------------------------------------------
(Unaudited)
Financial ($ thousands, except
per share amounts)
Gross revenue 6,545 4,836 12,333 8,846
Funds generated by operations 3,553 2,699 6,095 4,768
Per share - basic 0.23 0.19 0.41 0.33
- diluted 0.22 0.18 0.39 0.32
Net earnings 800 643 1,017 1,200
Per share - basic 0.05 0.04 0.07 0.08
- diluted 0.05 0.04 0.06 0.08
Capital expenditures 4,487 10,358 12,843 13,466
Working capital (deficiency) (1,496) 323 (1,496) 323
Long-term debt 18,584 13,137 18,584 13,137

Operations
Production
Crude oil (bbls/d) 781 715 797 697
NGL (bbls/d) 13 11 11 9
Natural gas (mcf/d) 3,543 3,025 3,714 2,798
Total production (boe/d at 6:1) 1,384 1,236 1,427 1,172

Average sales price
Crude oil ($/bbl) 59.65 41.64 49.59 39.95
NGL ($/bbl) 61.62 49.56 59.71 48.26
Natural gas ($/mcf) 5.91 7.34 6.69 7.11


President's Message to the Shareholders

Throughout the first half of 2006, Masters continued to exploit its large undeveloped land base and build its prospect inventory. Masters invested $12.8 million in the exploration and development program with a relatively high allocation of funds to land and seismic. Masters shot 105 square kilometers of 3-D and in excess of 100 kilometers of 2-D seismic that will provide the foundation for the Company's future exploration and development program. Drilling activity was focused on natural gas prospects resulting in 10 natural gas discoveries. To date only one natural gas discovery has been tied-in. The remaining discoveries will be tied-in over the remainder of 2006 and into early 2007.

Activity in the second quarter was focused on expanding the Company's inventory of high impact exploration prospects and continuing with the drilling program in the North Peace River Arch. During the second quarter of 2006, Masters drilled two high impact exploration plays outside of our core areas. Both have been cased and currently require further evaluation. In the North Peace River Arch core area, a multi-well drilling program started in May with 15 - 20 wells to be drilled by the end of the year. In April 2006, Masters closed a $6.1 million bought deal financing through the issue of one million common shares on a "flow-through" basis. The proceeds are being allocated to Masters' exploration program.

Production for the first six months of 2006 averaged 1,427 boe per day, an increase of 22 percent over the 2005 first half. In the North Peace River Arch area, approximately 150 boe per day of production, tied-in at the end of the first quarter, has been shut-in for most of the second quarter due to restricted access caused by spring break up and wet surface conditions. Work is underway to provide year round production of the shut-in wells. Currently, total corporate production is approximately 1,300 boe per day (approximately 60 percent crude oil production), with approximately 600 boe per day behind-pipe. We anticipate the majority of behind-pipe volumes to be onstream by year end.

Due to the temporary shut-in of natural gas production and the delays of getting new production onstream in the North Peace River Arch area, the Company is adjusting guidance for 2006. The capital program will remain at $21 million, however the average production in the year is estimated to be 1,500 - 1,600 boe per day with an exit volume of 1,800 - 2,000 boe per day at year end. Guidance for 2007 will be provided later in the year.

Commodity prices were volatile during the second quarter. The 2006 average WTI crude oil price increased from $63.34(US) per barrel in the first quarter to $70.51(US) per barrel in the second quarter and the quality differential for medium gravity type crude decreased from approximately $30.00 per barrel to $18.00 per barrel. The net effect of these two changes resulted in the Company receiving an average crude price of $59.65 per barrel, an increase of 50 percent over the first quarter of 2006. Natural gas prices during the second quarter decreased 20 percent from the first quarter to $5.91 per mcf.

Outlook

The strategy for the remainder of 2006 and 2007 is to:

- pursue the drilling opportunities in the North Peace River Arch area that have been identified through the extensive seismic program;

- place the shut-in and behind-pipe natural gas volumes onstream;

- continue to pursue several high impact exploration plays outside of our core areas; and

- continue to pursue acquisitions that are a strategic fit.

At current commodity prices and forecasted production volumes Masters is expected to have ample resources to finance the remainder of the 2006 capital program. The Company has been challenged by delays and operational issues which has prevented placing more natural gas production onstream. We believe that many of the pertinent issues have been resolved and expect production volumes to be increasing in the near future.

Masters is poised for significant growth to the end of 2006 and into 2007. Growth is expected to come from placing existing shut-in reserves onstream, and successful drilling in the North Peace River Arch area and the high impact exploration prospects.



On behalf of the Board of Directors,

Geoff C. Merritt
President and Chief Executive Officer
August 2, 2006


MANAGEMENT'S DISCUSSION AND ANALYSIS

ADVISORIES

Management's discussion and analysis ("MD&A") of Masters Energy Inc. ("Masters or the Company"), provided as of August 2, 2006, should be read in conjunction with the unaudited financial statements presented for the three and six months ended June 30, 2006 and 2005 and the audited financial statements for the year ended December 31, 2005.

Basis of Presentation - The financial data presented below has been prepared in accordance with Canadian generally accepted accounting principles ("GAAP"). The reporting and the measurement currency is the Canadian dollar.

Non-GAAP Measures - The MD&A contains the terms 'funds generated by operations' and 'funds generated by operations per share', which should not be considered an alternative to, or more meaningful than net earnings or cash flow from operating activities as determined in accordance with GAAP as an indicator of the Company's performance. Masters' determination of funds generated by operations and funds generated by operations per share may not be comparable to that reported by other companies. Management uses funds generated by operations to analyze operating performance and leverage and considers funds generated by operations to be a key measure as it demonstrates the Company's ability to generate cash necessary to fund future capital investments and to repay debt. The reconciliation between net earnings and funds generated by operations can be found in the statements of cash flows in the financial statements. The Company presents funds generated by operations per share, which is prohibited under GAAP. Per share amounts are calculated using weighted average shares outstanding consistent with the calculation of earnings per share.

BOE Presentation - Masters bases calculations of barrels of oil equivalent ("boe") on a conversion rate of six thousand cubic feet ("mcf") of natural gas to one barrel ("bbl") of crude oil. The boe unit may be misleading, particularly if used in isolation. A boe conversion ratio of six mcf equals one 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.

Forward-Looking Information - This MD&A contains forward-looking or outlook information with regard to Masters within the meaning of applicable securities laws. Forward-looking statements may include estimates, plans, expectation, forecasts, guidance or other statements that are not statements of fact. Masters believes the expectations reflected in such forward-looking statements are reasonable. However, no assurance can be given that such expectations will prove to be correct. These statements are subject to certain risks and uncertainties and may be based on assumptions that could cause actual results to differ materially from those anticipated or implied in the forward-looking statements. These risks include but are not limited to: crude oil and natural gas price volatility, exchange rate and interest rate fluctuations, availability of services and supplies, market competition, uncertainties in the estimates of reserves, the timing of development expenditures, production levels and the timing of achieving such levels, Masters' ability to replace and expand oil and natural gas reserves, the sources and adequacy of funding for capital investments, the Company's future growth prospects and current and expected financial requirements, the cost of future reclamation and site restoration, Masters' ability to enter into or renew leases and to secure adequate product transportation, changes in environmental and other regulations and general economic conditions. These statements speak only as of the date of this MD&A and Masters does not undertake an obligation to update our forward-looking statements except as required by law.



PRODUCTION

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
--------------------------------------
Total Production
Crude oil (bbl) 71,106 65,091 144,319 126,097
Natural gas liquids ("NGL") (bbl) 1,148 1,014 1,925 1,585
Natural gas (mcf) 322,381 277,992 672,271 506,428
Total (boe) 125,984 112,437 258,289 212,087
Daily Production
Crude oil (bbl/d) 781 715 797 697
NGL (bbl/d) 13 11 11 9
Natural gas (mcf/d) 3,543 3,055 3,714 2,798
Total (boe/d) 1,384 1,236 1,427 1,172


Production volumes for the second quarter ended June 30, 2006 averaged 1,384 boe/d, an increase of 12 percent in comparison with the second quarter of 2005. Oil and NGL production for the second quarter of 2006 increased nine percent to 781 bbl/d from 715 bbl/d in the same period in 2005. Natural gas production for the second quarter ended June 30, 2006 increased 16 percent to 3.5 mmcf per day from 3.1 mmcf per day for the three months ended June 30, 2005. Year to date equivalent production for the first six months of 2006 was 1,427 boe/d, an increase of 22 percent in comparison to the same period for 2005. Production increased during 2006 as a result of successful wells being drilled and tied-in and the acquisition of producing properties in the Peace River Arch area during 2005.



PRICES

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
--------------------------------------
Crude oil ($/bbl) 59.65 41.64 49.59 39.95
--------------------------------------
--------------------------------------
NGL ($/bbl) 61.62 49.56 59.71 48.26
--------------------------------------
--------------------------------------
Natural gas ($/mcf) 5.91 7.34 6.69 7.11
--------------------------------------
--------------------------------------


West Texas Intermediate ("WTI") is the benchmark for North American oil prices and is the crude type against which NYMEX futures contracts are priced. Canadian crude oil prices are based on refiners' postings at hubs such as Edmonton and Hardisty, Alberta. The basis for Canadian postings is the WTI price at Cushing, Oklahoma minus a transportation differential, adjusted for the US/Canadian currency exchange rate and for relative quality and regional market conditions.

During the second quarter of 2006, North America continued to see historically high price levels for WTI crude oil primarily due to concerns over supply. As a result, the average price for a barrel of WTI crude during the period increased over $17.29(US) to $70.51(US) from the second quarter of 2005. The average price for a barrel of WTI crude during the first six months of 2006 increased $15.40(US) to $66.95(US) from the first half of 2005. The Canadian dollar strengthened relative to the US dollar during the course of the year. The average currency exchange rate for $1.00 Canadian increased from $0.810(US) in the first half of 2005 to $0.879(US) in the similar period of 2006. As a result, this lowered the effective price received for delivery of crude expressed in Canadian dollars. The quality price differential postings on medium type crudes also experienced a positive effect during the second quarter of 2006. The average differential between Edmonton light sweet crude postings and Hardisty Bow River medium crude was approximately $18.15 per bbl in the second quarter of 2006 versus $24.57 per bbl in the second quarter of 2005. The Company's crude oil field price for the second quarter of 2006 increased 43 percent to $59.65 per bbl from the average price received in the second quarter of 2005. The narrowing differential has positively impacted Masters' oil revenues and cash flow, as the majority of the Company's crude oil production is medium gravity crude.

The Company's crude oil field price during the first six months of 2006 was $49.59 per bbl versus $74.16 per bbl for light sweet postings at Edmonton, Alberta. The average differential for the 2006 period was approximately the same as 2005. For the first half of 2006 the crude field price increased 24 percent to $49.59 per bbl from the average price received during the comparable period in 2005.

US natural gas prices are typically referenced off NYMEX at Henry Hub, Louisiana while Canadian prices are referenced at Nova Inventory Transfer ("NIT") or the AECO Hub. Most of Masters' natural gas is sold to the spot market according to the AECO reference price. Masters did not enter into any fixed or hedged type gas sales contracts during 2005 or 2006. The average natural gas price received during the second quarter of 2006 was $5.91 per mcf, a decrease of 19 percent from the price received in the same period of 2005 and a decrease of 20 percent compared to $7.41 per mcf received in the first quarter of 2006. The average natural gas price received for the first half of 2006 was $6.69 per mcf, a decrease of six percent from the average price received in the first six months of 2005.



REVENUES

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands, except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Crude oil revenue 4,242 2,710 7,157 5,037
NGL revenue 71 50 115 76
Natural gas revenue 1,904 2,041 4,497 3,062
--------------------------------------
Total petroleum and natural gas
revenue 6,217 4,801 11,769 8,715
Royalty and other revenue 328 35 564 131
--------------------------------------
Total revenue 6,545 4,836 12,333 8,846
--------------------------------------
--------------------------------------
Total petroleum and natural gas
revenue per boe ($) 49.34 42.71 45.57 41.09
--------------------------------------
--------------------------------------
Total revenue per boe ($) 51.95 43.01 47.75 41.71
--------------------------------------
--------------------------------------


Petroleum and natural gas revenues for the second quarter of 2006 increased 29 percent to $6.2 million from the similar period in 2005 as crude and NGL prices remained strong and production volumes continued to grow. The petroleum and natural gas revenue for the first half of 2006 was $11.8 million, an increase of 35 percent over the same period of 2005.

Royalty and other income for the second quarter of 2006 increased by 837 percent to $0.3 million as a result of royalty interests acquired with the Peace River Arch acquisition as well as higher commodity prices received during the second quarter of 2006. The royalty and other revenue for the first half of 2006 was $0.6 million, an increase of 330 percent.



ROYALTIES

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands, except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Crown 1,239 881 2,403 1,530
Alberta Royalty Tax Credit ("ARTC") (125) (132) (250) (229)
--------------------------------------
Crown, net of ARTC 1,114 749 2,153 1,301
Freehold and gross overriding 193 151 361 306
--------------------------------------
Net royalties 1,307 900 2,514 1,607
--------------------------------------
--------------------------------------
Per boe ($) 10.38 8.00 9.74 7.58
--------------------------------------
--------------------------------------
Average royalty rate -- net (%)(1) 21.0 18.8 21.4 18.4
--------------------------------------
--------------------------------------
(1) A percentage of total petroleum and natural gas revenue


For the three months ended June 30, 2006, royalties, net of Alberta royalty tax credit, totaled $1.3 million for an average royalty rate relative to oil and gas revenues of 21.0 percent. The increase in the net average royalty rate is due to the increase in natural gas production which has a higher crown royalty rate. On a boe basis, royalties for the period were $10.38 per boe. For the similar period in 2005 the net royalty rate averaged 18.8 percent of oil and gas revenues or $8.00 per boe.

For the six months ended June 30, 2006 royalties totaled $2.5 million for an average royalty rate of 21.4 percent or $9.74 per boe. For the comparable period in 2005 the royalty rate averaged 18.4 percent or $7.58 per boe.

Forecasted royalty rates for the balance of 2006, before ARTC, are anticipated to be consistent with the 2006 second quarter rates. The Company anticipates maximizing its ARTC claim on Crown royalties during 2006.



OPERATING EXPENSES

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Total operating expenses 1,070 894 2,295 1,697
--------------------------------------
--------------------------------------
Per boe ($) 8.49 7.96 8.89 8.00
--------------------------------------
--------------------------------------


Operating expenses for the three months ended June 30, 2006 was $1.1 million, an increase of 20 percent compared to $0.9 million during the same period in 2005, primarily as a result of higher production. On a boe basis, the 2006 second quarter operating expenses increased seven percent, to an average cost of $8.49 per boe produced, from $7.96 per boe in the same period in 2005 as a result of higher processing and water hauling fees for the increased natural gas production.

Operating expenses of $8.89 per boe in the first half of 2006 have increased 11 percent compared to the average boe operating expense for the similar period in 2005.

Operating expenses per boe for the balance of 2006 are anticipated to remain consistent with the year to date results.



Netback Analysis

Three Months Ended Six Months Ended
June 30, June 30,
($ per boe) 2006 2005 2006 2005
------------------------------------------------------------------------
Oil and gas revenues 49.34 42.71 45.57 41.09
Royalty and other revenue 2.61 0.30 2.18 0.62
--------------------------------------
51.95 43.01 47.75 41.71
Royalties, net of ARTC (10.38) (8.00) (9.74) (7.58)
Operating expenses (8.49) (7.96) (8.89) (8.00)
--------------------------------------
Operating netback 33.08 27.05 29.12 26.13
--------------------------------------
--------------------------------------


Operating income netback of $33.08 per boe for the second quarter of 2006 increased 22 percent in comparison with the similar period in 2005. For the six months ended June 30, 2006 the operating income netback was $29.12 per boe, an increase of 11 percent in comparison to the same period in 2005.



GENERAL and ADMINISTRATIVE

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands, except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Gross general and administrative 526 421 1,446 1,019
Operating recoveries (27) (28) (56) (50)
Capitalized expenses (170) (144) (473) (357)
--------------------------------------
General and administrative expense,
before stock-based compensation 329 249 917 612
Stock-based compensation expense 214 57 270 114
--------------------------------------
Total general and administrative
expense 543 306 1,187 726
--------------------------------------
--------------------------------------
General and administrative expense,
before stock-based compensation,
per boe ($) 2.61 2.22 3.55 3.16
--------------------------------------
--------------------------------------
Total general and administrative
expense per boe ($) 4.31 2.72 4.60 3.41
--------------------------------------
--------------------------------------


During the second quarter of 2006, net general and administrative costs before stock-based compensation increased over the second quarter 2005 as a result of an overall salary increase awarded to employees and higher than anticipated professional advisory fees paid in the period. The increase in the year to date 2006 general administrative costs compared to the first half of 2005 is due to the awarding of short term incentive bonuses in addition to the other increases noted for the second quarter period.

General and administrative expenses per boe for the remainder of 2006 are anticipated to be similar to 2005. Based on forecasted production and capital spending, 2006 staff levels are anticipated to be similar to 2005.



INTEREST EXPENSE

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Total interest expense 246 87 450 133
--------------------------------------
--------------------------------------
Per boe ($) 1.95 0.77 1.74 0.63
--------------------------------------
--------------------------------------


Interest expense for the three months ended June 30, 2006 was $0.2 million, an increase of 183 percent compared to the same period in 2005, due to higher average debt levels and an increase in interest rates. On a boe basis, the 2006 second quarter interest expense increased 153 percent to an average cost of $1.95 per boe produced from $0.77 per boe in the same period in 2005. For the year to date period to June 30, 2006, interest expense increased 238 percent to $0.5 million in comparison to the similar period in 2005.



DEPLETION, DEPRECIATION and ACCRETION

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Depletion 2,418 1,479 4,799 2,655
Depreciation 3 2 5 4
Accretion on asset retirement
obligations 31 31 61 56
--------------------------------------
Total depletion, depreciation and
accretion expense 2,452 1,512 4,865 2,715
--------------------------------------
--------------------------------------
Depletion, depreciation and
accretion expense per boe ($) 19.46 13.44 18.83 12.80
--------------------------------------
--------------------------------------


For the second quarter of 2006, depletion, depreciation and accretion expense increased 62 percent to $2.5 million from $1.5 million for the same period in 2005. The increase is due to higher production in 2006 and increased seismic and equipment spending over the two most recent quarters. On a boe basis, depletion, depreciation and accretion expense for the second quarter ended June 30, 2006 increased 45 percent to $19.46 from $13.44 in the same period in 2005.

For the six months ended June 30, 2006, depletion, depreciation and accretion expense increased 79 percent to $4.9 million from $2.7 million for the same period in 2005. For the first six months of 2006, the depletion, depreciation and accretion expense per boe increased 47 percent to $18.83 per boe.

At June 30, 2006, the ceiling test calculation indicated that the estimated undiscounted future cash flows from proven reserves exceeded the carrying values of producing petroleum and natural gas properties and therefore a ceiling test adjustment was not required.



INCOME TAXES

Three Months Ended Six Months Ended
June 30, June 30,
($ thousands, except as indicated) 2006 2005 2006 2005
------------------------------------------------------------------------
Future income taxes 128 494 5 768
Capital taxes (1) - - -
-----------------------------------
Total income taxes 127 494 5 768
-----------------------------------
-----------------------------------
Effective tax rate (%) 13.7 43.4 - 39.0
-----------------------------------
-----------------------------------


The future income tax expense provision for the three months ended June 30, 2006 decreased to $0.1 million from a future tax expense of $0.5 million in the same period in 2005. For the six months ended June 30, 2006, future income taxes decreased to $5,000 from $0.8 million in the comparable period in 2005. The decrease in 2006 future tax expense is due to lower earnings before taxes and a reduction in the federal and provincial income rates that have been substantially enacted during the second quarter of 2006.

As at June 30, 2006, the Company has approximately $54.1 million in tax pools to shelter taxable income in the future years.

NET EARNINGS and FUNDS GENERATED BY OPERATIONS

Net earnings increased to $0.8 million for the three months ended June 30, 2006 compared to $0.6 million during the same period in 2005. The increase was mainly due to lower future income tax expense as a result of lower federal and provincial tax rates enacted during the second quarter of 2006. Net earnings per basic and diluted share for the quarter was $0.05 compared to $0.04 per basic and diluted share during the same quarter in 2005.

For the six months ended June 30, 2006, net earnings decreased 15 percent to $1.0 million compared to $1.2 million during the comparable period in 2005. The decrease was a result of higher depletion rates per boe received over the same period in 2005, offset in part by lower future income tax expenses. Net earnings per basic and diluted share for the six month period was $0.07 and $0.06, respectively, compared to $0.08 per basic and diluted share during the same period in 2005.

Funds generated by operations increased 32 percent to $3.6 million for the three months ended June 30, 2006 compared to $2.7 million during the same period in 2005. For the first half of 2006, funds generated by operations increased 28 percent to $6.1 million compared to $4.8 million during the first six months of 2005. The increase is primarily due to higher production and crude oil prices.

CAPITAL EXPENDITURES

During the first half of 2006, the Company spent approximately $12.8 million in exploration and development capital expenditures compared to $5.9 million spent in the same period of 2005. In June 2005 the Company acquired properties in the North Peace River Arch area of Alberta for $7.6 million. For the six months ended June 30, 2006, the Company drilled 18 wells (7.6 net) with a success rate of 56 percent, added over 9,300 net undeveloped acres and shot 105 square kilometers of 3-D and over 100 kilometers of 2-D seismic data.



Three Months Ended Six Months Ended
June 30, June 30,
($ thousands) 2006 2005 2006 2005
------------------------------------------------------------------------
Land 411 351 1,216 639
Geological and geophysical 679 106 2,540 323
Drilling and completions 2,291 1,907 5,225 4,041
Equipping and facilities 1,106 442 3,862 905
Other - - - 6
-----------------------------------

Total exploration and development
capital 4,487 2,806 12,843 5,914

Producing property acquisitions - 7,552 - 7,552
-----------------------------------
4,487 10,358 12,843 13,466
-----------------------------------
-----------------------------------


Drilling Results

During the second quarter of 2006, the Company drilled eight wells resulting in six natural gas wells for a success rate of 75 percent. For the first half of 2006, the Company drilled 18 wells resulting in 10 natural gas wells and eight dry and abandoned wells for an overall success rate of 56 percent.



Three Months Ended Six Months Ended Six Months Ended
June 30, 2006 June 30, 2006 June 30, 2005
(wells) Gross Net Gross Net Gross Net
------------------------------------------------------------------------

Oil - - - - 3 3.0
Natural Gas 6 2.8 10 4.2 7 4.8
Dry 2 0.8 8 3.4 1 1.0
----------------------------------------------------
Total 8 3.6 18 7.6 11 8.8
----------------------------------------------------
----------------------------------------------------
Success rate (%) 75 78 56 55 91 89
----------------------------------------------------
----------------------------------------------------


CONTRACTUAL OBLIGATIONS

On April 18, 2006, the Company completed the issuance of 1,000,000 flow-through common shares for total proceeds of $6.1 million. The proceeds from the share issuance are to be spent on qualified exploration expenditures prior to December 31, 2007. As at June 30, 2006, approximately $4.4 million of exploration expenditure obligations remained outstanding.

There are no commodity hedge contracts outstanding as at June 30, 2006.

LIQUIDITY and CAPITAL RESOURCES

The Company's total capitalization at June 30, 2006 was $84.6 million with the market value of common shares representing 70 percent of total capitalization. Net debt represented 24 percent and asset retirement obligations and future income taxes accounted for six percent.



Total Market Capitalization
($ thousands except as indicated) 2006 %
------------------------------------------------------------------------
Common shares outstanding (thousands) 15,570
Share price, June 30, 2006 ($ per share) 3.80
--------------------
Total market capitalization 59,166 70
--------------------
Working capital deficiency 1,496
Bank debt 18,584
--------------------
Net debt 20,080 24
--------------------
Asset retirement obligation 3,541 4
Future income taxes 1,870 2
--------------------
Total capitalization 84,657 100
--------------------
--------------------
Net debt to total capitalization 24%
--------------------
--------------------


At June 30, 2006, the Company had borrowed approximately $18.6 million and had a working capital deficit of $1.5 million, totaling $20.1 million of total net debt. The net debt amount represents approximately 1.4 times the annualized second quarter 2006 funds generated by operations.

The Company has a bank revolving term facility to $22.0 million to fund future activities. The facility is a borrowing base facility that is determined by the Company's latest reserve assessment, results of operations, current and forecasted commodity prices and the prevailing market conditions. The facility is reviewed semi-annually with the next date being October 31, 2006. As at June 30, 2006, the Company had drawn $18.6 million of the revolving term facility and the amount is recorded as a long-term liability.

The Company's future investing activities, which consist primarily of capital expenditures on oil and gas activities, will be funded with working capital, funds generated by operations, bank debt and the net proceeds from the issue of flow-through shares completed April 18, 2006.

As at June 30, 2006, the issued and outstanding common shares of the Company were 15,569,979, options outstanding were 1,451,000 and there were performance warrants outstanding of 885,000.

SELECTED QUARTERLY INFORMATION

The financial data presented below has been prepared in accordance with Canadian generally accepted accounting principles. The reporting and measurement currency is the Canadian dollar.



2006
------------------------------------------------------------------------
Operations Q2 Q1
------------------------------------------------------------------------
Production
Oil (bbl/d) 781 813
NGL (bbl/d) 13 9
Natural gas (mcf/d) 3,543 3,888
Total (boe/d) 1,384 1,470
Pricing
Oil, before hedging ($/bbl) 59.65 39.82
Hedging costs - -
------------------------------------------------------------------------
Oil, after hedging ($/bbl) 59.65 39.82
NGL ($/bbl) 61.62 56.87
Natural gas ($/mcf) 5.91 7.41
Total ($/boe) 49.34 41.97
Financial
($ thousands, except as indicated)
Total revenue 6,545 5,788
Funds generated by operations 3,553 2,542
Net earnings (loss) 800 217
Per share - basic 0.05 0.02
Per share - diluted 0.05 0.01
Capital spending
Exploration and development 4,487 8,355
Acquisitions/ (dispositions) - -
Total assets 66,533 64,228
Working capital (deficiency) (1,496) (7,477)
Long-term debt 18,584 17,442
Shareholders' equity 38,940 32,064
Common Shares
Weighted average common shares
outstanding (thousands)
- basic 15,356 14,523
- diluted 16,052 15,433
Trading Activity
Volume (thousands)
- total 804 1,757
- daily 13 27
Price ($ per share)
- high 5.39 6.75
- low 3.56 4.25
- closing 3.80 4.89


2005 2004
------------------------------------------------------------------------
Operations Q4 Q3 Q2 Q1 Q4 Q3
------------------------------------------------------------------------
Production
Oil (bbl/d) 707 688 715 678 588 597
NGL (bbl/d) 10 15 11 6 13 5
Natural gas (mcf/d) 3,619 3,872 3,055 2,538 2,406 1,980
Total (boe/d) 1,320 1,349 1,236 1,107 1,002 932
Pricing
Oil, before hedging
($/bbl) 42.50 56.92 41.64 38.14 36.91 42.40
Hedging costs - - - - (0.01) (4.25)
------------------------------------------------------------------------
Oil, after hedging
($/bbl) 42.50 56.92 41.64 38.14 36.90 38.15
NGL ($/bbl) 60.85 59.56 49.56 46.12 50.72 40.20
Natural gas ($/mcf) 11.29 9.09 7.34 6.83 6.62 6.24
Total ($/boe) 54.18 55.84 42.71 39.28 38.09 37.90
Financial
($ thousands, except as
indicated)
Total revenue 6,908 7,175 4,836 4,010 3,679 3,319
Funds generated by
operations 2,915 4,476 2,699 2,069 1,676 1,513
Net earnings (loss) 630 1,781 643 557 (124) 79
Per share - basic 0.04 0.12 0.04 0.04 (0.01) 0.01
Per share - diluted 0.04 0.12 0.04 0.04 (0.01) 0.01
Capital spending
Exploration and
development 11,570 2,805 2,806 3,108 3,240 2,531
Acquisitions/ - - -
(dispositions) 31 (339) 7,552
Total assets 60,016 51,142 48,130 38,830 37,291 35,518
Working capital
(deficiency) (5,013) 1,381 323 (5,155) (4,116) (2,551)
Long-term debt 14,093 11,911 13,137 - - -
Shareholders' equity 31,791 31,033 28,884 28,184 27,570 27,639
Common Shares
Weighted average common
shares outstanding (thousands)
- basic 14,491 14,462 14,364 14,364 14,364 14,364
- diluted 15,482 15,146 14,931 14,801 14,614 14,553
Trading Activity
Volume (thousands)
- total 2,351 2,467 3,096 4,149 2,858 910
- daily 38 39 48 67 45 14
Price ($ per share)
- high 6.95 4.70 3.80 4.20 2.85 2.77
- low 4.60 3.62 3.05 2.31 2.30 2.25
- closing 6.47 4.55 3.64 3.40 2.60 2.70


Factors that caused variations over the quarters -

- The Company completed four acquisitions since its initial financing in the fourth quarter of 2003 which have impacted production growth:

-- The acquisition of the Little Bow property in Southern Alberta on December 22, 2003 added approximately 450 boe per day consisting of approximately 90 percent crude oil production. Proved and probable reserves acquired were approximately 1.4 million boe with an estimated reserve life index of 8.6 years.

-- The acquisition of Terraquest Energy Corporation on February 26, 2004 added production of approximately 400 boe per day consisting of approximately 60 percent natural gas. Proved and probable reserves acquired were approximately 1.1 million boe with an estimated reserve life index of 7.9 years based on the production at the time of acquisition.

-- The two acquisitions of producing properties in the Peace River Arch area of Northwest Alberta on June 3, 2005 and September 12, 2005 added approximately 160 boe per day consisting primarily of natural gas production. Proved and probable reserves acquired were approximately 0.5 million boe with an estimated reserve life index of 7.0 years.

- Production growth, other than the acquisitions, is a result of Masters' exploration, development and exploitation activities. Timing of production is subject to timing of drilling and facility construction.

- Growth in revenue and funds generated by operations is the combination of increased production and strong commodity prices. Oil prices for medium grade quality crude experienced a large drop in the latter portion of the fourth quarter 2004 due to wider than historical quality differentials. This impacted the prices received by Masters since that time as a majority of the crude production is of medium quality.

- The net earnings are impacted by depletion, depreciation and accretion and future income taxes. The Company estimates its reserves every quarter based on its acquisition and drilling activities. The annual reserves are determined by independent qualified reservoir evaluators, the results of which can affect fourth quarter reserve additions. Future income taxes have been impacted with the enacted changes to the federal and provincial income tax rates for the oil and gas industry.

- The development of future drilling prospects and seasonal field conditions influence capital spending. Funds generated by operations and bank debt primarily funded capital spending.



Masters Energy Inc.
Balance Sheets
------------------------------------------------------------------------
($ thousands)

(unaudited)

As at June As at December
30, 2006 31, 2005
Assets

Current assets
Accounts receivable $ 1,794 $ 3,608
Prepaid expenses and deposits 308 190
---------- ----------

2,102 3,798

Property and equipment (note 2) 64,431 56,218
---------- ----------

$ 66,533 $ 60,016
---------- ----------
---------- ----------

Liabilities

Current liabilities
Accounts payable and accrued liabilities $ 3,598 $ 8,811
---------- ----------


Long-term bank debt (note 3) 18,584 14,093

Asset retirement obligations (note 4) 3,541 3,316

Future income taxes (note 8) 1,870 2,005
---------- ----------

27,593 28,225
---------- ----------

Shareholders' Equity

Share capital (note 5) 33,403 27,469
Contributed surplus (note 6) 591 393
Retained earnings 4,946 3,929
---------- ----------

38,940 31,791
---------- ----------

$ 66,533 $ 60,016
---------- ----------
---------- ----------

See accompanying notes to the financial statements.

Approved on behalf of the Board,

William R. Stedman, Director Douglas H. Mitchell, Director


Masters Energy Inc.
Statements of Earnings and Retained Earnings
($ thousands except share and per share amounts, unaudited)

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
------------------------------------------------------------------------

Revenue
Petroleum and
natural gas $ 6,217 $ 4,801 $ 11,769 $ 8,715
Royalty and other
revenue 328 35 564 131
---------- ---------- ---------- ----------
6,545 4,836 12,333 8,846

Royalties, net of
Alberta Royalty Tax
Credit (1,307) (900) (2,514) (1,607)
---------- ---------- ---------- ----------
5,238 3,936 9,819 7,239
---------- ---------- ---------- ----------

Expenses
Operating 1,070 894 2,295 1,697
General and
administrative 543 306 1,187 726
Interest - long-term debt 246 43 450 43
- short-term debt - 44 - 90
Depletion, depreciation
and accretion 2,452 1,512 4,865 2,715
---------- ---------- ---------- ----------
4,311 2,799 8,797 5,271
---------- ---------- ---------- ----------

Earnings before taxes 927 1,137 1,022 1,968

Taxes

Capital (1) - - -

Future (note 8) 128 494 5 768
---------- ---------- ---------- ----------

127 494 5 768
---------- ---------- ---------- ----------

Net earnings 800 643 1,017 1,200

Retained earnings,
beginning of period 4,146 875 3,929 318
---------- ---------- ---------- ----------

Retained earnings,
end of period $ 4,946 $ 1,518 $ 4,946 $ 1,518
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------

Earnings per share
(note 7)
Basic $ 0.05 $ 0.04 $ 0.07 $ 0.08
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------

Diluted $ 0.05 $ 0.04 $ 0.06 $ 0.08
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------

Weighted average
number of shares
outstanding

Basic 15,355,767 14,363,647 14,941,839 14,363,647
----------- ---------- ---------- -----------
----------- ---------- ---------- -----------

Diluted 16,051,752 14,931,360 15,742,143 14,866,257
----------- ---------- ---------- -----------
----------- ---------- ---------- -----------

See accompanying notes to the financial statements.


Masters Energy Inc.
Statements of Cash Flows
($ thousands, unaudited)

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
------------------------------------------------------------------------
------------------------------------------------------------------------
Cash provided by (used for):

Operating activities
Net earnings $ 800 $ 643 $ 1,017 $ 1,200
Add non-cash items
Depletion, depreciation
and accretion 2,452 1,512 4,865 2,715
Future income tax expense 128 494 5 768
Stock-based compensation
expense 214 57 270 114
Settlement of performance
warrants (52) - (52) -
Settlement of asset
retirement costs 11 (7) (10) (29)
----------- ----------- ----------- ------------
3,553 2,699 6,095 4,768
Changes in non-cash working
capital (2,430) (346) (3,962) (1,865)
----------- ----------- ----------- ------------
1,123 2,353 2,133 2,903
----------- ----------- ----------- ------------
Financing activities
Long-term bank debt 1,142 9,713 4,491 9,713
Proceeds on flow-through
share issue 6,100 - 6,100 -
Proceeds on exercise of
options 99 - 99 -
Share issuance fees (425) - (425) -
Changes in non-cash
working capital - (1,683) - -
----------- ----------- ----------- ------------
6,916 8,030 10,265 9,713
----------- ----------- ----------- ------------
Investing activities
Exploration and
development (4,487) (2,806) (12,843) (5,914)
Producing property
acquisition - (7,552) - (7,552)
----------- ----------- ----------- ------------
(4,487) (10,358) (12,843) (13,466)
Changes in non-cash
working capital (3,552) (25) 445 850
----------- ----------- ----------- ------------
(8,039) (10,383) (12,398) (12,616)
----------- ----------- ----------- ------------
Change in cash and cash
equivalents - - - -
Cash and cash equivalents,
beginning of period - - - -
----------- ----------- ----------- ------------
Cash and cash equivalents,
end of period $ - $ - $ - $ -
----------- ----------- ----------- ------------
----------- ----------- ----------- ------------

Supplemental Cash Flow Information
Interest paid $ 246 $ 87 $ 450 $ 133
Capital taxes paid $ 2 $ - $ 2 $ -
------------------------------------------------------------------------

See accompanying notes to the financial statements.

Masters Energy Inc.
Notes to the Financial Statements
(Unaudited)


1. Accounting Policies

The interim financial statements of Masters Energy Inc. ("the Company") have been prepared following the same accounting policies and methods of computation as the financial statements of the Company for the year ended December 31, 2005. The disclosures provided below are incremental to those included with the annual financial statements. These interim financial statements should be read in conjunction with the financial statements and notes disclosed in the Company's annual report for the year ended December 31, 2005.

The Company is engaged in the exploration, development and production of petroleum and natural gas in Western Canada. The financial statements are stated in Canadian dollars and have been prepared in accordance with Canadian generally accepted accounting principles.



2. Property and equipment

($ thousands) Accumulated
Depletion
and Net Book
As at June 30, 2006 Cost Depreciation Value
------------------- --------- ------------ ----------

Petroleum and natural gas
properties and well equipment $ 80,010 $ 15,619 $ 64,391
Office equipment 73 33 40
--------- ------------ ----------
$ 80,083 $ 15,652 $ 64,431
--------- ------------ ----------
--------- ------------ ----------

As at December 31, 2005
-----------------------

Petroleum and natural gas
properties and well equipment $ 66,992 $ 10,820 $ 56,172
Office equipment 73 27 46
--------- ------------ ----------

$ 67,065 $ 10,847 $ 56,218
--------- ------------ ----------
--------- ------------ ----------


The value of undeveloped lands excluded from costs subject to depletion was $8.5 million at June 30, 2006 ($8.7 million - December 31, 2005).

During the six months ended June 30, 2006, $0.5 million ($0.4 million - June 30, 2005) of general and administrative costs were capitalized.

3. Bank debt

The Company has access to a revolving term credit facility with a Canadian chartered bank to a maximum of $22.0 million. The credit facility may be drawn with advances or bankers' acceptances or repaid. Direct advances bear interest at the bank's prime lending rate and the bankers' acceptances bear interest at the applicable bankers' acceptance rate plus a stamping fee.

The Company has available a $2.5(US) million demand swap facility, to assist in financing the contingent exposure of settlement for financial commodity swaps. The facility bears interest at a US base rate per annum on amounts drawn.

The revolving term credit facility is available for a period of 364 days until April 30, 2007. Up to 60 days prior to April 30, 2007 the Company may request an extension of the revolving facility for a period of another 364 days, subject to the bank's approval. If the Company does not request the extension or the bank does not agree to the extension, the credit facility principal borrowed will be repaid in full with a single payment 366 days subsequent to April 30, 2007. The repayment terms of the lending facility are such that it is recognized as a long-term liability.

As of June 30, 2006, $18.6 million ($14.1 million - December 31, 2005) has been drawn against the revolving term credit facility.

Security pledged for the facilities consists of a general assignment of book debts, a $40.0 million demand debenture, secured by a first floating charge over all the assets of the Company. The Company is not in breach of any covenants under its credit facility.



4. Asset retirement obligation

The following table summarizes changes in the asset retirement
obligation for the periods ended as indicated:

Six Months Year Ended
Ended June December 31,
($ thousands) 30, 2006 2005
------------------------------------------------------------------------
------------------------------------------------------------------------

Asset retirement obligation, beginning
of period $ 3,316 $ 3,044
Adjustments - (256)
Liabilities acquired - 305
Liabilities incurred 174 390
Asset retirement expenditures (10) (281)
Accretion expense 61 114
--------- ----------

Asset retirement obligation, end of period $ 3,541 $ 3,316
--------- ----------
--------- ----------


The total estimated, undiscounted cash flows required to settle the obligations, before considering salvage, is $4.8 million as at June 30, 2006 ($4.6 million - December 31, 2005) which has been discounted using a weighted average credit-adjusted risk-free interest rate of 5.9 percent. The Company expects these obligations to be settled in approximately 1 to 14 years.

5. Share Capital

(a) Authorized

Unlimited number of voting common shares without nominal or par value.
Unlimited number of preferred shares issuable in series, with rights and privileges to be determined at the time of issuance by the Board of Directors.



(b) Common shares issued
($ thousands, except number of shares) Number Amount
------------------------------------------------------------------------

Balance, December 31, 2005 14,523,313 $ 27,469
Issue of flow-through shares 1,000,000 6,100
Exercise of stock options 46,666 99
Transfer from contributed surplus from
exercise of options - 20
Share issue costs
(net of future taxes of $140,000) - (285)
--------- ----------
Balance, June 30, 2006 15,569,979 $ 33,403
--------- ----------
--------- ----------


On April 18, 2006 the Company issued, through a private placement, 1,000,000 common shares on a "flow-through" basis at a price of $6.10 per share for net proceeds (after share issue costs of $425,000) of $5,675,000. The Company is obligated to incur $6.1 million of qualifying expenditures prior to December 31, 2007. As at June 30, 2006, the remaining obligation was approximately $4.4 million.

6. Stock-based Compensation

(a) Stock options

The following table sets forth reconciliation of the stock option plan activity for the six months ended June 30, 2006:



Weighted
average
Number exercise
of options price
------------------------------------------------------------------------

Balance, December 31, 2005 1,127,000 $2.28
Granted 404,000 4.62
Cancelled (33,334) 2.09
Exercised (46,666) 2.12
--------- ----------
Balance, June 30, 2006 1,451,000 $2.94
--------- ----------
--------- ----------


On May 3, 2006 at the annual and special meeting of the shareholders of the Company, the shareholders approved the amendment of the stock option plan, whereby, the maximum number of common shares reserved for the granting of stock options is limited to 10 percent of the issued and outstanding common shares of the Company. Previously, the maximum number of options reserved for future stock option grants was fixed at 1,435,042 common shares.

The fair value of the options and performance warrants granted during the period was estimated on the date of the grant using the Black-Scholes option pricing model with weighted average assumptions and resulting value for the grant as follows:



Options and Risk-free
warrants Expected interest Total fair
Grant date granted volatility rate value
------------------------------------------------------------------------
(%) (%) ($ thousands)
April 10, 2006 150,000 42 3.7 266
May 11, 2006 319,000 44 4.0 578


(b) Performance warrants

Performance warrant plan activity for the six months ended June 30, 2006
is as follows:

Number of Weighted
performance average price
warrants per warrant
------------------------------------------------------------------------

Balance, December 31, 2005 870,000 $3.55
Granted 65,000 4.58
Settled (50,000) 3.66
----------
Balance, June 30, 2006 885,000 $3.62
----------
----------


(c) Contributed surplus

The Company's contributed surplus activity for the six months ended June
30, 2006 is as follows:


($ thousands)
------------------------------------------------------------------------

Balance, December 31, 2005 $ 393
Stock-based compensation expense 270
Exercise of options (20)
Settlement of performance warrants (52)
--------
Balance, June 30, 2006 $ 591
--------
--------


7. Per share amounts

Per share amounts have been calculated using the basic weighted average number of common shares outstanding of 15,355,767 and 14,941,839 during the three and six months periods ended June 30, 2006 (14,363,647 - three and six months periods ended June 30, 2005). For the three month period ended June 30, 2006, a total of 695,985 (567,713 - 2005) were added to the total to take into account the dilutive effect of the options and warrants for the period. A total of 800,304 common shares were added to take into account the dilutive effect during the six month period ended June 30, 2006 (502,610 - 2005).

8. Future income taxes

(a) The provision for income tax expense differs from that which would be expected from applying the combined effective Canadian federal and provincial income tax rate of 34.5% (37.62% - 2005) to earnings before income taxes. The difference results from the following:



Three Months Ended Six Months Ended
June 30, June 30,
($ thousands) 2006 2005 2006 2005
------------------------------------------------------------------------
Expected income tax expense $ 319 $ 428 $ 353 $ 741

Increase (decrease) resulting from:
Non-deductible crown payments 128 260 264 378
Resource allowance (119) (214) (217) (339)
Impact in effective tax rate applied (301) 42 (301) 20
Stock based compensation expense 73 23 93 43
Increase in ACRI (36) - (84) -
Other 64 (45) (103) (75)
------ ------ ------ -------
Total future tax expense $ 128 $ 494 $ 5 $ 768
------ ------ ------ -------
------ ------ ------ -------


(b) The components of the future income tax liability are as follows:

As at
As at June December 31,
($ thousands) 30, 2006 2005
------------------------------------------------------------------------
Carrying value of property and equipment
in excess of available tax deductions $ 3,388 $ 3,582
Asset retirement obligation (1,027) (1,076)
Share issuance costs (320) (286)
Attributed Canadian Royalty Income (171) (215)
--------- ---------
$ 1,870 $ 2,005
--------- ---------
--------- ---------


Masters Energy Inc. is an Alberta based corporation engaged in the business of acquiring or exploring for and developing oil and natural gas reserves in western Canada. Masters' common shares are listed on the Toronto Stock Exchange under the trading symbol "MSY".

ADVISORY

The Toronto Stock Exchange has neither approved nor disapproved of the information contained herein. Certain information regarding the Company, including management's assessment of future plans and operations, may constitute forward-looking statements under applicable securities law and necessarily involve risks associated with oil and gas exploration, production, marketing and transportation such as loss of market, volatility of prices, currency fluctuations, impression of reserve estimates, environmental risks, competition from other producers and ability to access sufficient capital from internal and external sources: as a consequence, actual results may differ materially from those anticipated. The Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results could differ from those contemplated by the forward-looking statements.

Contact Information

  • Masters Energy Inc.
    Geoff Merritt
    President and CEO
    (403) 290-1785
    or
    Masters Energy Inc.
    Randall Boyd
    Chief Financial Officer
    (403) 290-1785
    Website: www.mastersenergy.com