Monterey Exploration Ltd.
TSX : MXL

Monterey Exploration Ltd.

March 23, 2009 18:15 ET

Monterey Exploration Ltd. Announces Financial And Operating Results for the Three Months And Year Ended December 31, 2008 & Annual Information Form Filing

CALGARY, ALBERTA--(Marketwire - March 23, 2009) - Monterey Exploration Ltd. ("Monterey" or the "Corporation") (TSX:MXL) is pleased to provide its financial and operating results for the three months and year ended December 31, 2008.

Monterey also announces that it has filed its audited financial statements for the year ended December 31, 2008, the related management's discussion and analysis and it annual information form which includes Monterey's statement of reserves data and other oil and gas information for the year ended December 31, 2008 as mandated by National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities ("NI 51-101").

Monterey's audited financial statements for the year ended December 31, 2008, management's discussion and analysis for the three months and year ended December 31, 2008 and annual information form are available on SEDAR at www.sedar.com and on Monterey's website at www.montereyexploration.com.

2008 HIGHLIGHTS

- Average daily production for the fourth quarter of 2,130 barrels of oil equivalent per day ("boe/d"), a 38 percent increase compared with 1,540 boe/d during the comparative quarter in 2007.

- Fourth quarter funds flow from operations(2) of $3.7 million which is approximately 43 percent higher than the $2.6 million generated in the fourth quarter of 2007; and generated $15.0 million in funds flow for the year ended December 31, 2008 which is 27 percent more than the $11.9 million generated in the year ended December 31, 2007.

- Proved plus probable reserves increased to 10.0 million barrels of oil equivalent ("mmboe") as at December 31, 2008, a 43 percent increase over the 7.0 mmboe at December 31, 2007.

- Proved plus probable additions of 3.7 mmboe replaced 480 percent of the Corporation's 2008 production.

- Finding and development costs of $12.55 per boe for proved plus probable reserves excluding the change in future development capital ("FDC") and $22.84 per boe including the change in FDC.

- Finding, development and acquisition costs for proved plus probable reserves excluding the change in FDC of $17.98 per boe and $24.88 per boe including the change in FDC.

- Average Finding, development and acquisition costs for the past three years for proved plus probable reserves including the change in FDC of $19.95 per boe. This equates to a recycle ratio of 1.4 based on the average field netback over the same period.

- Monterey's net asset value as at December 31, 2008 increased to $4.84 per common share (basic) based on the Corporation's future net revenues discounted at 10 percent, before income taxes.

- Incurred $33.9 million in exploration and development capital expenditures during 2008. Activities included: validation of the Corporation's application of horizontal multi-stage fracture technology on the Cadomin resource at Brassey, accelerate the recovery of the Corporation's Baldonnel gas holdings at Laprise, further develop the Corporation's Gething resource in the Squirrel area utilizing horizontal multi-stage fracture technology and acquisition of an additional 5 sections of crown land on the play fairway, jointly develop a deep basin Cardium play at Smoky, Alberta and acquired a 5 section 100 percent working interest parcel of undeveloped crown land in the heart of the Groundbirch Montney fairway.

- Completed the earning of undeveloped lands under the terms of the Cadomin farm-in agreement at Brassey in Northeast British Columbia ("NEBC").

- Completed the corporate acquisition of Upper Lake Oil and Gas Ltd. on August 29, 2008 which added approximately 660 boe/d of average daily production, 1.3 mmboe of proved plus probable reserves, a complementary inventory of 27,509 acres (16,759 net) of undeveloped land and approximately $35.3 million in tax pools.

- Commenced trading on the Toronto Stock Exchange on September 4, 2008 under the symbol "MXL".

- Increased the Corporation's credit facility to $45 million during the third quarter.

SUBSEQUENT EVENTS

- Entered into an agreement to earn a 75 percent working interest in 10 (7.5 net) sections of contiguous land directly offsetting Monterey's existing Groundbirch landholdings. A test well was drilled and cased fulfilling Monterey's earning requirements.

- Completed the disposition of 1.4 net sections of undeveloped non-core Montney lands and one non-producing well at Dawson on January 29, 2009 for net proceeds of $6 million. The net proceeds reduced the Corporation's net debt on February 1, 2009 to approximately $31.8 million.

- The Corporation's credit facility (the "Existing Facility") has been reviewed and renewed at $45 million (the "New Facility") with the next scheduled review to be completed on or before May 31, 2010.



FINANCIAL & OPERATING SUMMARIES

Financial
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Three Months Ended Year Ended
December 31, December 31,

2008 2007 2008 2007
Production Revenue(1)
(000's) $ 8,965 $ 6,366 $ 33,289 $ 25,536

Funds Flow from
Operations(2) :
(000's) $ 3,694 $ 2,588 $ 15,004 $ 11,852
Per share(3) :
Basic and diluted $ 0.11 $ 0.11 $ 0.54 $ 0.50

Net Earnings /
(Loss):
(000's) $ (2,110) $ (1,101) $ 903 $ 806
Per share:
Basic and diluted ($0.06) ($0.04) $ 0.03 $ 0.03

Capital
Expenditures(4)
(000's) $ 10,969 $ 3,615 $ 31,844 $ 36,017

Ending Net Debt (5)
(000's)
$ 37,924 $ 15,142 $ 37,924 $ 15,142

Share Data:
Outstanding:
Common 32,902,500 19,993,066 32,902,500 19,993,066
Non-voting common - 5,061,096 - 5,061,096
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Total basic 32,902,500 25,054,162 32,902,500 25,054,162
Stock options 3,135,666 2,295,666 3,135,666 2,295,666
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Total fully diluted 36,038,166 27,349,828 36,038,166 27,349,828
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Weighted average
shares
outstanding:
Basic 32,902,500 24,527,532 27,735,885 23,713,491
Diluted 32,904,058 24,683,965 27,736,277 23,878,617
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Operations
-----------

Three Months Ended Year Ended
December 31, December 31,
2008 2007 2008 2007
Average Daily Production:
Light oil and NGL (bbl/d) 453 212 292 246
Natural gas (mcf/d) 10,058 7,969 8,062 7,410
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Oil equivalent (boe/d) 2,130 1,540 1,636 1,481
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Unit of Production Summary::
Average prices:
Light oil and NGL ($/bbl) 51.78 80.32 78.90 67.47
Natural gas(1) ($/mcf) 7.35 6.54 8.39 7.18
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Oil equivalent(1) ($/boe) 45.75 44.95 55.60 47.25
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Funds flow from Operations(2) Summary
($/boe)
Revenue(1) 45.75 44.95 55.60 47.25
Royalties (7.98) (7.59) (10.08) (7.61)
Operating expenses (14.61) (13.60) (13.56) (11.74)
Transportation expenses (1.78) (1.69) (1.73) (1.77)
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Operating income(6) 21.38 22.07 30.23 26.13
Unrealized (gain) on financial
instruments 1.08 1.29 - -
General & administrative(7) (2.21) (3.50) (3.47) (3.22)
Interest expense (1.40) (1.59) (1.70) (0.98)
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Funds flow from operations(2) ($/boe) 18.85 18.27 25.06 21.93
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Drilling
---------

Three Months Ended Year Ended
December 31, December 31,
2008 2007 2008 2007
Gross Wells:
Natural gas 1 - 11 13
Oil - - - -
Dry & abandoned - - 2 5
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Total 1 - 13 18
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Net Wells:
Natural gas 1.0 - 6.9 8.2
Oil - - - -
Dry & abandoned - - 1.3 4.5
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Total 1.0 - 8.2 12.7
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Landholdings
-------------
as at
December 31,
2008 2007
Gross Acres:
Developed 129,113 111,080
Undeveloped 146,873 107,648
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Total 275,986 218,729
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Net Acres:
Developed 71,108 56,174
Undeveloped 93,561 68,050
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Total 164,668 124,225
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OIL AND GAS RESERVES

The Corporation's oil and gas reserves were evaluated for the year ended December 31, 2008, by GLJ Petroleum Consultants Ltd. ("GLJ"), independent reserves evaluators, in accordance with National Instrument 51-101 - Standards of Disclosure for Oil and Gas Activities ("NI 51-101"). The proved plus probable company interest reserves were 10.0 million barrels of oil equivalent as at December 31, 2008.

The following table provides summary information presented in GLJ's report effective December 31, 2008 and is based on GLJ's pricing forecast summary as of January 1, 2009. Detailed reserve information will be presented in the Statement of Reserves Data and Other Oil and Gas Information section of Monterey's Annual Information Form anticipated to be filed on SEDAR prior to March 31, 2009:



Light/medium Natural gas Barrels of oil
oil liquids Natural gas equivalent
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Comp. Comp. Comp. Comp. Comp. Comp. Comp. Comp.
Gross Net Gross Net Gross Net Gross Net
(mbbl) (mbbl) (mbbl) (mbbl) (mmcf) (mmcf) (mboe) (mboe)
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Proved:
Producing 308 273 330 257 17,829 15,040 3,609 3,037
Non-Producing 37 34 92 63 3,832 3,083 768 610
Undeveloped - - 39 31 7,960 6,758 1,365 1,157
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Total Proved 345 307 461 350 29,621 24,881 5,743 4,804
Probable 93 83 313 232 23,350 20,108 4,297 3,666
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Total Proved plus
Probable 437 390 774 582 52,971 44,990 10,040 8,470
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Notes on Reserves data:
(a) "Comp. Gross" refers to working interest reserves before deduction of
royalty burdens payable.
(b) "Comp. Net" refers to working interest reserves after deduction of
royalty burdens payable.
(c) Oil equivalent amounts have been calculated using a conversion rate of
six thousand cubic feet of natural gas per barrel of oil (6 mcf: 1 bbl).
(d) Columns may not add due to rounding.


Estimated Future Net Revenues:

The estimated future net revenues associated with Monterey's reserves effective December 31, 2008, and based on the GLJ's pricing forecast summary as of January 1, 2009 are summarized in the following table:



Discounted at
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0% 5% 8% 10% 15% 20%
($MM) ($MM) ($MM) ($MM) ($MM) ($MM)
Proved:
Producing 110,888 89,201 79,945 74,835 64,711 57,221
Non-Producing 22,163 17,657 15,686 14,584 12,376 10,724
Undeveloped 30,426 17,740 13,173 10,833 6,537 3,634
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Total Proved 163,478 124,598 108,804 100,252 83,624 71,579
Probable 121,657 72,894 56,519 48,360 33,853 24,456
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Total Proved plus
Probable 285,134 197,492 165,323 148,612 117,477 96,035
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Notes on Future Net Revenues:
(a) Future net revenue values are stated before deducting income taxes and
future estimated site restoration costs and is reduced for estimated
future abandonment costs and estimated capital for future development
associated with the reserves.
(b) It should not be assumed that the undiscounted and discounted future net
revenues estimated by GLJ represent the fair market value of the
reserves.
(c) Columns may not add due to rounding.


Finding, Development and Acquisition Costs

The following table summarizes each of the finding and development ("F&D") cost and finding, development and acquisition ("FD&A") cost information for the year compared with prior periods based on NI 51-101 methodology:



Three
2008 2007 2006 Year
Finding & Development Costs:

F&D costs excluding FDC ($ millions) $ 33.9 $ 29.0 $ 30.4 $ 93.4

Proved F&D:
F&D costs including change in FDC
($ millions) $ 42.1 $ 39.5 $ 35.1 $ 116.7
Change in proved reserves (mboe) 1,479 1,395 1,210 4,084
F&D cost excluding FDC ($/boe) $ 22.93 $ 20.81 $ 25.16 $ 22.87
F&D cost including FDC ($/boe) $ 28.46 $ 28.30 $ 29.03 $ 28.57

Proved plus Probable F&D:
F&D including change in FDC ($
millions) $ 61.7 $ 50.4 $ 42.8 $ 154.9
Change in proved plus probable
reserves (mboe) 2,702 2,194 2,260 7,156
F&D cost excluding FDC ($/boe) $ 12.55 $ 13.23 $ 13.47 $ 13.05
F&D cost including FDC ($/boe) $ 22.84 $ 22.96 $ 18.96 $ 21.65

Finding, Development & Acquisition
Costs:

FD&A costs excluding FDC ($ millions) $ 66.6 $ 36.5 $ 66.9 $ 170.0

Proved FD&A:
FD&A including change in FDC ($
millions) $ 75.3 $ 47.0 $ 71.6 $ 193.9
Change in proved reserves (mboe) 2,049 1,661 3,630 7,340
FD&A cost excluding FDC ($/boe) $ 32.52 $ 21.98 $ 18.42 $ 23.16
FD&A cost including FDC ($/boe) $ 36.75 $ 28.29 $ 19.71 $ 26.41

Proved plus Probable FD&A:
FD&A including change in FDC
($ millions) $ 92.2 $ 60.9 $ 79.3 $ 232.4
Change in proved plus probable
reserves (mboe) 3,707 2,488 5,451 11,646
FD&A cost excluding FDC ($/boe) $ 17.98 $ 14.67 $ 12.27 $ 14.60
FD&A cost including FDC ($/boe) $ 24.88 $ 24.46 $ 14.54 $ 19.95


Notes to Finding, Development and Acquisition costs information
(a) The aggregate of the exploration and development costs incurred in the
most recent financial year and the change during that year in estimated
future development costs generally will not reflect total finding and
development costs related to reserve additions for that year.
(b) Finding and development costs are calculated in accordance with NI
51-101 as exploration and development costs incurred in the year along
with the change in estimated future development costs related to the
applicable reserves, divided by the applicable reserve additions.
(c) Monterey also calculates finding, development and acquisition costs
which incorporate both the costs and associated reserve additions
related to acquisitions net of any dispositions during the year. Since
acquisitions can have a significant impact on Monterey's annual reserve
replacement costs, the Corporation believes that FD&A costs provide a
more meaningful portrayal of Monterey's cost structure.



Net Asset Value & Net Asset Value per Share
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as at
December 31,
Net Asset Value ($000's): 2008 2007
Future net revenues(a) :
Proved reserves $ 100,252 $ 63,052
Probable reserves 48,360 24,550
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148,612 87,602
Undeveloped land value(b) 47,708 12,400
Seismic(c) 750 750
Net debt (37,924) (15,142)
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Net Asset Value $ 159,146 $ 85,610
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Net Asset Value per Share ($/share):
Basic(d) $ 4.84 $ 3.42
Fully diluted(e) $ 4.59 $ 3.35


Notes on Net Asset & Net Asset Value per Share information
(a) Future net revenue values are stated before deducting income taxes and
future estimated site restoration costs and is reduced for estimated
future abandonment costs and estimated capital for future development
associated with the reserves, discounted by 10% to calculate the present
value, all as determined by GLJ Petroleum Consultants.
(b) Value as at December 31, 2008 as calculated by independent land
evaluator; value as at December 31, 2007 internal estimate calculated by
multiplying the net undeveloped land acreage by approximately $133 per
acre.
(c) Internal estimate of the value of proprietary seismic data.
(d) Based on total basic common shares outstanding of 32,902,500 shares as
at December 31, 2008 and 25,054,162 shares as at December 31, 2007.
(e) Calculated by adding the proceeds from stock option exercises of
$6,356,000 as at December 31, 2008 and $5,915,000 as at December 31,
2007 to the respective net asset value, divided by the fully diluted
share figure calculated by adding 3,135,666 as at December 31, 2008 and
2,295,666 shares as at December 31, 2007 both figures being the number
of shares underlying stock options outstanding to the basic number of
common shares outstanding for the respective date.


2009 FIRST QUARTER OPERATIONAL UPDATE

Monterey's first quarter capital program has been directed towards the completion of tie-in operations on four wells that were drilled and completed in 2008 and the 100 percent working interest stratigraphic Montney test well that was drilled at Groundbirch.

At Ferrybank in West Central Alberta, the 100 percent working interest exploratory well that was drilled and completed in November 2008 was tied-in to an existing Monterey operated processing facility in mid-January and is producing at a stable production rate of 1.2 mmcf/d.

At Smoky in West Central Alberta, three (0.75 net) Cardium wells were tied-in to existing infrastructure in late January and are producing at stable rates to a third party operated facility. The total net production on the project based on the Corporation's 25 percent working interest is approximately 125 boe/d.

With all of Monterey's 2008 capital program completed and on stream, the Corporation averaged approximately 2,350 boe/d for the first 2 months of 2009 and is currently producing at approximately 2,400 boe/d based on field production estimates for the first two weeks of March.

Major Project Updates

Brassey Cadomin project

The Corporation has completed the earning of undeveloped lands under the terms of the Cadomin farm-in agreement at Brassey in NEBC following the tie-in of two successful 100 percent working interest horizontal wells completed during the fourth quarter of 2008. The first three month average combined production rate of 3 mmcf/d for the two wells contributes favorably to Corporation's assessment of the potential of the Cadomin formation on the Monterey lands.

The project area consists of 21.5 gross (11.8 net) contiguous sections of development acreage located in the main Cadomin resource fairway. Current net production is approximately 500 boe/d. Monterey has an inventory of over 30 horizontal locations based on a two well per section development program and the next 4 locations have been licensed for future development.

Groundbirch Montney project

Monterey entered into a transaction with an industry partner in NEBC in January that has significantly enhanced the Corporation's undeveloped Montney land holdings at Groundbirch.

The Corporation committed to and has completed the drill and case of a 2,800 meter Montney test well on Monterey's existing 100 percent working interest lands at Groundbirch. The test well has converted a 10 (7.5 net) section license of contiguous land directly offsetting Monterey's existing land holdings to a five year lease. The resulting project area consists of 15 gross (12.5 net) sections of concentrated Monterey controlled and operated land holdings situated in the heart of the Montney fairway.

Drilling and completion data(8) from the two vertical test wells drilled by a competitor in February of 2008 immediately offsetting Monterey's acreage are no longer under confidential status and have been released to a public data base. The first well to the northeast of Monterey's landholdings was drilled 100 meters into the Montney formation and exhibited over 90 meters of continuous upper Montney porosity ranging from 4 to 7 percent. The second well to the southwest of Monterey's landholdings was drilled through the entire Montney interval and exhibited approximately 140 meters of continuous upper and middle porosity from 4 to 7 percent. Both vertical wells were completed in different sections of the Montney package with test rates of 1.1 mmcf/d and 0.4 mmcf/d respectively. The formation appears to be significantly overpressured with calculated reservoir pressures in excess of 34,000 kilopascals. Monterey's vertical test well drilled at 3-25 penetrated the entire Montney section and encountered over 150 meters of continuous upper and middle Montney with porosity ranging from 4 to 7 percent. The 3-25 and the two offset wells represent one of the thickest packages of continuous porosity seen anywhere within the Montney fairway in NEBC.

Based on these results, Monterey is proceeding with the survey and licensing of the first 2 horizontal test/development locations. The first well will be located adjacent to the 3-25 vertical test and the second well will be located on the 10 section contiguous land block directly to the West. These wells are expected to be licensed for second half 2009 operations.

OUTLOOK

The Corporation is maintaining its previous 2009 capital expenditure guidance of $10 million with $4-5 million being allocated to the first half of the year. With this first half capital program, production is expected to decline modestly from the current levels of approximately 2,400 boe/d. Monterey's production for the first six months of 2009 is forecast to average 2,200 boe/d, which is slightly higher than the 2,130 boe/d recorded in the fourth quarter of 2008.

During this time of continued uncertainty in the credit and equity markets as well as extreme volatility in the commodity prices of both oil and natural gas, the Corporation will continue to conserve capital and preserve balance sheet strength to maintain financial flexibility while moving forward the key projects that have the potential of adding significant future value to the entity. Monterey has a high quality producing asset base and a deep inventory of drill ready natural gas prospects and will continue to execute its business plan in a manner focused on adding value to Monterey's current and future shareholders.

Notes:

(1) Includes gain or loss on financial instruments from commodity price hedging activities.

(2) Funds flow is not defined by Canadian generally accepted accounting principles ("GAAP") and thus is referred to as a non-GAAP measure; other entities may calculate funds flow differently than Monterey. Funds flow is based on cash provided by operating activities before changes in non-cash working capital and asset retirement expenditures.

(3) Funds flow per share is not defined by Canadian GAAP and thus is referred to as a non-GAAP measure. Funds flow per share is calculated by dividing funds flow by the weighted average number of shares outstanding during the period consistent with the calculation of net income per share.

(4) Capital expenditures is not defined by Canadian GAAP and thus is referred to as a non-GAAP measure. Capital expenditures is the cost of recorded property and equipment additions net of cash disposition proceed less non-cash additions (including long lived asset retirement, capitalized stock-based compensation expense and future income tax liability adjustments for non-taxed based additions) and the recorded costs of business combinations.

(5) Net debt is equal to total bank indebtedness plus capital lease obligations and less working capital (excluding financial instrument assets or liabilities).

(6) Operating income is not defined by GAAP and thus is referred to as a non-GAAP measure; other entities may calculate operating income differently than Monterey. Operating income is calculated by deducting the sum of royalty, operating and transportation expenses from production revenue and gains or losses from financial instruments.

(7) Excludes capitalized general & administrative expenditures and stock-based compensation expense.

(8) The noted drilling and completion data may constitute "analogous information". Such information was released in February 2009 by the British Columbia provincial government regulatory agency. The well data relates to exploratory wells drilled into the Montney formation and in geographical proximity to prospective Montney exploratory lands held by Monterey. Monterey believes the information is relevant as it helps to define the reservoir characteristics in which Monterey may have an interest. The Corporation is unable to confirm that the analogous information was prepared by a qualified reserves evaluator or auditor or in accordance with the COGE Handbook and therefore, the reader is cautioned that the data relied upon by Monterey may be in error and/or may not be analogous to Monterey's land holdings.

Forward Looking Statements & Advisories

This press release contains forward-looking statements, including but not limited to, statements concerning the amount and on-stream timing of new production, the performance characteristics of production from Monterey's developed oil and gas properties, approval and timing of applications and requests made to regulatory authorities, the access to and availability of production facilities, the timing of construction and start-up of new production facilities, certain expected actions to be performed and completed by industry partners, anticipated market prices received by Monterey for its production, the amount of future net revenues from the sale of crude oil and natural gas reserves, expectations regarding the ability to continually add to reserves through acquisitions exploration and development activities, projections and costs and expenses, crude oil and natural gas production levels, Monterey's continued access to existing credit facilities, future operating and financial results, expectations regarding operating costs, anticipated interest and foreign exchange rates, supply and demand for crude oil and natural gas, average royalty rates, availability of tax pools and amount of general and administrative expenses. Additionally, the use of any of the words "anticipate", "continue", "estimate", "expect", "forecast", "future", "may", "will", "project", "should", "believe" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, certain of which are beyond the Corporation's control, including the impact of general economic conditions; volatility in market prices for crude oil and natural gas; industry conditions; volatility of commodity prices; currency fluctuation; imprecision of reserve estimates; liabilities inherent in crude oil and natural gas operations; environmental risks; incorrect assessments of the value of acquisitions and exploration and development programs; competition from other producers; the lack of availability of qualified personnel or management; changes in income tax laws or changes in tax laws and incentive programs relating to the oil and gas industry; hazards such as fire, explosion, blowouts, cratering, and spills, each of which could result in substantial damage to wells, production facilities, other property and the environment or in personal injury; stock market volatility; and ability to access sufficient capital from internal and external sources.
As a consequence, Monterey's actual results may differ materially from those expressed in, or implied by, the forward-looking statements. Although Monterey believes that the expectations reflected in such forward-looking statements or information are reasonable, undue reliance should not be placed on forward-looking statements as the Corporation can give no assurance that such expectations will prove to be correct. Actual results may differ materially from those expressed or implied in any forward-looking statements made by, or on behalf of, Monterey. In addition to other factors and assumptions which may be identified in this press release and other documents filed by the Corporation, assumptions have been made regarding, among other things: the impact of increasing competition; the general stability of the economic and political environment in which Monterey operates; the ability of the Corporation to obtain qualified staff, equipment and services in a timely and cost efficient manner; drilling results; the ability of the operator of the projects which the Corporation has an interest in to operate the field in a safe, efficient and effective manner; Monterey's ability to obtain financing on acceptable terms; field production rates and decline rates; the ability to replace and expand oil and natural gas reserves through acquisition, development or exploration; the timing and costs of pipeline, storage and facility construction and expansion; the ability of the Corporation to secure adequate product transportation; future oil and natural gas prices; currency, exchange and interest rates; the regulatory framework regarding royalties, taxes and environmental matters in the jurisdictions in which the Corporation operates; and Monterey's ability to successfully market its oil and natural gas products. Readers are cautioned that the foregoing list of factors is not exhaustive. Forward-looking statements contained in this press release are made as at the date of this press and Monterey disclaims any intent or obligation to update publicly or to revise any of the included forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by applicable securities laws.

However, in the event that subsequent events are reasonably likely to cause actual results to differ materially from material forward-looking statements or information previously disclosed by Monterey for a period that is not yet complete, Monterey will provide disclosure on such events and the anticipated impact of such events.

BOE Disclosure

Disclosure provided herein in respect of barrels of oil equivalent (boe) may be misleading, particularly if used in isolation. A boe conversion ratio of 6 Mcf: 1 Boe is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.

Non-GAAP Measures

Within this press release, references are made to terms commonly used in the oil and gas industry. Management uses funds flow from operations, operating income and capital expenditures to analyze operating performance. These measures do not have standardized meanings prescribed by GAAP, and may not be comparable to similar measures presented by other companies. For this press release the measures used are: (i) Funds flow from operations is determined by using cash flow from operations before changes in non-cash operating working capital and asset retirement expenditures; (ii) Operating income is calculated by deducting royalties, operating costs and transportation costs from sales revenues and hedging gains / (losses); (iii) Net capital expenditures is the cost of recorded property and equipment additions net of cash disposition proceed less non-cash additions (including long lived asset retirement, capitalized stock-based compensation expense and future income tax liability adjustments for non-taxed based additions) and the recorded costs of business combinations; (iv) Finding and development costs is equal to the cost of recorded property and equipment additions less the additions for long lived asset retirement, office furniture and equipment, property acquisitions and business combinations grossed up for the recorded proceeds of property dispositions for the period; (v) Finding, development and acquisition costs is equal to finding and development costs as described in note (iv) above plus the recorded additions for property acquisitions less the recorded proceeds of property dispositions for the period; (vi) Funds flow per basic and funds flow per diluted share is calculated by dividing funds flow as described earlier, by the total number of respective weighted average basic and diluted common shares outstanding during the period; (vii) Net debt is equal to total bank indebtedness plus capital lease obligations less/(plus) non-cash working capital/(deficit); and (viii) fully diluted share figures are calculated by adding the number of common shares underlying the outstanding stock options to the number of common shares outstanding (i.e. basic outstanding common shares) at the respective date. For additional information concerning Monterey's use of non-GAAP measures and reconciliations to the applicable GAAP measures, please see Monterey's management's discussion and analysis for the year ended December 31, 2008 available at www.sedar.com.

MANAGEMENT'S DISCUSSION AND ANALYSIS

This Management's Discussion and Analysis ("MD&A") should be read in conjunction with Monterey's audited Financial Statements for the year ended December 31, 2008 and the Annual Information Form for the year ended December 31, 2008. The Financial Statements have been prepared in Canadian dollars and in accordance with Canadian generally accepted accounting principles ("GAAP").

This MD&A contains forward-looking statements, non-GAAP measures, and disclosures of barrels of oil equivalent volumes. Readers are referred to the advisories concerning forward-looking statements, non-GAAP measures, and barrels of oil equivalent conversions contained under the heading "Forward Looking Statements & Advisories".

Additional information regarding Monterey Exploration Ltd. such as the audited Financial Statements, Annual Information Form and other disclosure documents can be found on SEDAR at www.sedar.com or on the Corporation's website www.montereyexploration.com.

This MD&A is dated March 19, 2009.

Monterey Exploration Ltd. ("Monterey" or the "Corporation") is continued under the Business Corporations Act (Alberta) and is engaged in the acquisition, exploration, development and production of natural gas, natural gas liquids and crude oil in the Western Canadian Sedimentary Basin.

FORWARD LOOKING STATEMENTS & ADVISORIES

Certain information regarding Monterey set forth in this MD&A, including but not limited to Management's expectations regarding the timing of its IFRS change over plans, expectations regarding its financial capabilities, continued availability of debt financing, expectations regarding tax pool expiries, expectations concerning future funds flow from operations, future exploration and development activities, planned capital expenditures, treatment under royalty regimes, plans regarding the development of the Corporation's project inventory and expectations relating to production levels and forecast production may constitute forward-looking statements under applicable securities laws and regulations involve substantial known and unknown risks and uncertainties. The use of any of the words "anticipate", "continue", "estimate", "expect", "may", "will", "project", "should", "believe" and similar expressions are intended to identify forward-looking statements. Such statements represent Monterey's internal projections, estimates or beliefs concerning, among other things, an outlook on the estimated amounts and timing of capital expenditures, anticipated future debt, revenues or other expectations, beliefs, plans, objectives, assumptions, intentions or statements about future events or performance. These statements are only predictions and actual events or results may differ materially. In addition, statements relating to "reserves" or "resources" are deemed to be forward looking statements, as they involve the implied assessment, based on certain estimates and assumptions, that the resources and reserves described can be profitably produced in the future. Although Monterey believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievement since such expectations are inherently subject to significant business, economic, competitive, political and social uncertainties and contingencies. Many factors could cause Monterey's actual results to differ materially from those expressed or implied in any forward-looking statements made by, or on behalf of, Monterey.

The forward-looking statements included in this MD&A also include, but are not limited to, statements with respect to the size of, and future net revenues from, crude oil and natural gas reserves; the focus of capital expenditures; expectations regarding the ability to raise capital and to continually add to reserves through acquisitions and development; projections of market prices and costs; the performance characteristics of Monterey's crude oil and natural gas properties; crude oil and natural gas production levels; Monterey's future operating and financial results; expectations regarding Monterey's capital expenditure programs; supply and demand for crude oil and natural gas; average royalty rates; development drilling; amount of general and administrative expenses; treatment under governmental regulatory regimes and tax laws; the risk of non-capital losses expiring unutilized; and expectations regarding operating costs.

These forward-looking statements are subject to numerous risks and uncertainties, certain of which are beyond the Corporation's control, including the impact of general economic conditions; volatility in market prices for crude oil and natural gas; industry conditions; volatility of commodity prices; currency fluctuation; imprecision of reserve estimates; liabilities inherent in crude oil and natural gas operations; environmental risks; incorrect assessments of the value of acquisitions and exploration and development programs; competition from other producers; the lack of availability of qualified personnel or management; changes in income tax laws or changes in tax laws and incentive programs relating to the oil and gas industry; hazards such as fire, explosion, blowouts, cratering, and spills, each of which could result in substantial damage to wells, production facilities, other property and the environment or in personal injury; stock market volatility; and ability to access sufficient capital from internal and external sources.

With respect to forward-looking statements contained in this MD&A, Monterey has made assumptions regarding: the success of exploration and development activities, the impact of increasing competition; the general stability of the economic and political environment in which Monterey operates; the ability of the Corporation to obtain qualified staff, equipment and services in a timely and cost efficient manner; drilling results; the ability of the operator of the projects which the Corporation has an interest in to operate the field in a safe, efficient and effective manner; Monterey's ability to obtain financing on acceptable terms; field production rates and decline rates; the ability to replace and expand oil and natural gas reserves through acquisition, development or exploration; the timing and costs of pipeline, storage and facility construction and expansion; the ability of the Corporation to secure adequate product transportation; future oil and natural gas prices; currency, exchange and interest rates; the regulatory framework regarding royalties, taxes and environmental matters in the jurisdictions in which the Corporation operates; and Monterey's ability to successfully market its oil and natural gas products.

Management has included the above summary of assumptions and risks related to forward-looking information provided in this MD&A in order to provide readers with a more complete perspective on Monterey's future operations and such information may not be appropriate for other purposes. Monterey's actual results, performance or achievement 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 Monterey will derive there from. Readers are cautioned that the foregoing lists of factors are not exhaustive. These forward-looking statements are made as of the date of this MD&A and Monterey disclaims any intent or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or results or otherwise, other than as required by applicable securities laws.

However, in the event that subsequent events are reasonably likely to cause actual results to differ materially from material forward-looking statements or information previously disclosed by Monterey for a period that is not yet complete, Monterey will provide disclosure on such events and the anticipated impact of such events.

The reporting and measurement currency is the Canadian dollar. For the purpose of calculating unit costs, natural gas is converted to a barrel of oil equivalent ("boe"), which may be misleading if used in isolation. A boe conversion ratio of six thousand cubic feet of natural gas equal to one barrel of oil equivalent is used by Monterey and is based on an energy equivalency method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.

Please note that certain tables presented in this MD&A may not add due to rounding.

NON-GAAP MEASURES

Within this MD&A, references are made to terms commonly used in the oil and gas industry. Management uses funds flow from operations, operating income, capital expenditures and net debt to analyze operating performance. These measures do not have standardized meanings prescribed by GAAP, and may not be comparable to similar measures presented by other companies. For this MD&A the measures used are: (i) Funds flow from operations; (ii) Operating income; (iii) Capital expenditures; (iv) Total capital expenditures; (v) Funds flow from operations per basic and funds flow from operations per diluted share; (vi) Net debt; (vii) Net current surplus (deficiency); and (viii) Estimated forward cash flow being funds flow from operations for a particular month adjusted for one time or extraordinary items which is then annualized. The non-GAAP measure identified as estimated forward cash flow provides a reasonably accurate estimate, based on current operations and business conditions, of the funds flow from operations for the next twelve months.

The following tables reconcile the non-GAAP measures used in this Management Discussion and Analysis to the most directly comparable measure calculated in accordance with GAAP:



Funds flow from operations
Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2008 2007 2008 2007
----------------------------------------------------------------------------
Cash flow provided by (used in)
operating activities $ 677 $ 3,880 $ 11,477 $ 12,427
Changes in non-cash working
capital 2,844 (1,275) 3,085 (674)
Asset retirement expenditures 173 16 442 99
----------------------------------------------------------------------------
Funds flow from operations $ 3,694 $ 2,588 $ 15,004 $ 11,852
----------------------------------------------------------------------------


Funds flow from operations is an important measure to Management and investors because it provides a better indication of Monterey's internal funds generated from ongoing operations, versus cash flow provided by (used in) operating activities. Cash flow from (used in) operating activities takes into account the net change in non-cash working capital items and asset retirement expenditures which are not considered part of normal operations, may be infrequent and vary significantly from one period to the next.



Operating income
Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2008 2007 2008 2007
----------------------------------------------------------------------------
Net earnings (loss) $ (2,110) $ (1,101) $ 903 $ 806
Add: Future income tax expense
(recovery) 26 93 (1,682) (1,311)
Add: Depreciation, depletion and
accretion 5,431 3,230 15,348 11,662
Add: Net interest expense 275 225 1,020 530
Add: General and administrative 569 679 2,510 2,435
----------------------------------------------------------------------------
Operating income $ 4,191 $ 3,126 $ 18,099 $ 14,122
----------------------------------------------------------------------------

Management views operating income as an important measure of the
Corporation's viability and contribution from the operation of its core
business and is reflective of Monterey's gross margin.


Capital expenditures & Total capital expenditures

Three Three
months months Year Year
ended ended ended ended
Dec 31, Dec 31, Dec 31, Dec 31,
($000's) 2008 2007 2008 2007
----------------------------------------------------------------------------
Cash flow used in investing
activities $ 15,574 $ 7,874 $ 32,816 $ 38,449
Business combination
transaction costs 140 - (649) -
Change in non-cash working capital (4,745) (4,259) (323) (2,432)
----------------------------------------------------------------------------
Capital expenditures $ 10,969 $ 3,615 $31,844 $ 36,017
Upper Lake business combination (69) - 36,347 -
Long lived asset retirement - - (1,610) -
----------------------------------------------------------------------------
Total capital expenditures $ 10,900 $ 3,615 $66,581 $ 36,017
----------------------------------------------------------------------------


Capital expenditures measure the net cash resources directed to exploring for and developing of oil and gas reserves along with the investment in office furniture and equipment to support Monterey's business activities. While total capital expenditures also reflect the cost of property and equipment, excluding the associated long lived asset retirement cost. These measures are each considered by Management to be better measures than capital additions recorded under GAAP to determine the Corporation's success and efficiency in growing its reserves and reserve value. Capital expenditures indicate the investment customarily incurred in the exploration and development activities and is readily comparable to other periods; while total capital expenditure also encompasses the incremental costs incurred to increase reserve via business combination. The capital additions under GAAP include non-cash adjustments that impair Management's and the reader's of this MD&A abilities to accurately assess Monterey's performance in respect of growing reserves.



Net debt
As at As at
Dec 31, Dec 31,
($000's) 2008 2007
----------------------------------------------------------------------------
Bank indebtedness $ 35,286 $ 13,625
Less: Current assets (5,661) (3,562)
Add: Accounts payable and accrued liabilities 8,075 5,079
Add: Obligation under capital lease 224 -
----------------------------------------------------------------------------
Net debt $ 37,924 $ 15,142
----------------------------------------------------------------------------


Net debt is an important measure as it provides a measure of the net obligations that can be reasonably expected to be settled with the Corporation's assets in the near term. Total liabilities under GAAP, also include asset retirement obligations as well as liabilities arising from financial instruments for which the timing of settlement with the Corporation's existing and future assets involve greater use of estimation and as a result the timing and amount expended to satisfy the obligation may be subject to significant variation.



Net current deficiency
As at As at
Dec 31, Dec 31,
($000's) 2008 2007
----------------------------------------------------------------------------
Current liabilities $ 43,540 $ 18,704
Less: Current assets (5,661) (3,562)
----------------------------------------------------------------------------
Working capital deficit 37,879 15,142
Less: Current portion of bank indebtedness (35,286) (13,625)
Less: Current portion of obligation under
capital lease (179) -
----------------------------------------------------------------------------
Net current deficiency $ 2,414 $ 1,517
----------------------------------------------------------------------------


Net current deficiency is a key measure for the Corporation as it gives a measure of net working capital excluding unrealized financial instrument assets and liabilities. Unrealized financial instrument assets and liabilities for Monterey primarily consist of the estimated future settlement value of forward financial contracts and the underlying sales volumes and are not necessarily indicative of the net cash inflows or outflows at the settlement date of the financial instruments.

FREQUENTLY USED TERMS

In this document certain terms are used frequently. For instance, Monterey Exploration Ltd. is commonly referred to as either "Monterey" or the "Corporation" and barrels of oil equivalent are regularly noted with the term "boe". The Corporation's farm-in commitment in the Brassey area is denoted as the "Brassey Farm-in".



Term or abbreviation
----------------------------------------------------------------------------
"boe" Barrel(s) of oil equivalent
"mcf" Thousand cubic feet
"bbl" Barrel
"GJ" Gigajoule
"LIBOR" London Interbank Offered Rate
"m" preceding a volumetric measure 1,000 units of the volumetric measure
"mm" preceding a volumetric measure 1,000,000 units of the volumetric
measure
"NGL" Natural gas liquids
"NEBC" Northeast British Columbia
"Upper Lake" Upper Lake Oil and Gas Ltd.


CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of the financial statements in accordance with GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, if any, at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. In determining estimates required to prepare the Corporation's financial statements, management uses available information it considers to be reasonable under the circumstances. Readers are cautioned that actual results could differ from these estimates.

Other critical accounting estimates that affect Monterey's financial statements include:

Full Cost Accounting

Monterey follows the full cost method of accounting, whereby all costs associated with the exploration and development of oil and natural gas reserves are capitalized in cost centers on a country-by-country basis. Such costs include lease acquisition costs, geological and geophysical costs, carrying charges of non-producing properties, costs of drilling both productive and non-productive wells, the cost of petroleum and natural gas production equipment and overhead charges directly related to exploration and development activities. Gains or losses are not recognized upon the disposition of oil and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the rate of depletion by 20% or more.

Depletion and Depreciation

Costs capitalized under the full cost method of accounting, together with estimated future capital costs associated with proved reserves, are depreciated and depleted using the unit-of production method which is based on gross production and estimated proved oil and natural gas reserves as determined by independent reserve evaluators. The cost of unproven properties is excluded from the depreciation and depletion base. These unproven properties are assessed periodically to ascertain if impairment has occurred. When proved reserves are assigned or the property is considered impaired the costs of the property or the amount of the impairment is added to the costs subject to depletion. For purposes of the depletion and depreciation calculations, oil and natural gas reserves are converted to a common unit of measure on the basis of their relative energy content, being six thousand cubic feet of natural gas to one barrel of oil equivalent. Depreciation of office furniture and equipment is provided for over its useful lives using the declining balance method at a rate of 25%.

Ceiling Test

Oil and natural gas properties and equipment are evaluated at least annually at year-end to determine whether the carrying amount in a cost centre is recoverable and does not exceed the fair market value of the properties in the cost centre. The carrying amounts are assessed to be recoverable when the sum of the undiscounted funds flows expected from the properties and the cost of major development projects exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted funds flows expected from the production of proved plus probable reserves, the lower of cost and market of unproved properties and the cost of major development projects of the cost centre. The funds flows are estimated using expected future product prices and costs and are discounted using a risk-free interest rate.

Asset Retirement Obligations

Estimated costs associated with Monterey's asset retirement obligations are subject to uncertainty associated with the method, timing, and extent of future retirement activities. At December 31, 2008, Management's estimate of Monterey's total inflation adjusted, undiscounted, asset retirement liabilities was approximately $8.2 million.

Purchase Price Allocations

The cost of corporate and asset acquisitions are allocated to the acquired assets and liabilities based on their fair value at the time of acquisition. Management use assumptions and estimates in determining the fair values of assets acquired and liabilities assumed, which are inherently subjective. Purchase price allocations affect the Corporation's reported assets, liabilities and future net earnings.

Income Taxes

All tax filings are subject to subsequent government audit and potential reassessments. Accordingly, final income tax liabilities as assessed by the government may differ materially from amounts estimated and recorded by Monterey.

Financial Instruments

The determination of fair value of financial instruments often relies on the use of estimates and judgment based on the best quality of information that is available at the time. The ultimate value of consideration received or paid for the settlement of financial instruments in future periods may materially differ from those estimated fair values at the end of each reporting period.

Stock-based Compensation

Stock-based Compensation expense is determined with the use of estimates and information available at the date of an option's grant. The ultimate settlement of the underlying stock option through an option exercise or the expiry of the option depends on the value of the Corporation's future share price, and the number of option forfeitures at the maturity of an option grant.

ACCOUNTING PRONOUNCEMENTS AND ACCOUNTING POLICY CHANGES

During the second quarter of 2008, the accounting standards board ("AcSB") has confirmed the date of changeover to international financial reporting standards ("IFRS") will be for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011. Management has taken steps to educate its staff and reviewed its accounting systems to determine the differences between Canadian GAAP and IFRS. An implementation plan for the changeover from Canadian GAAP to IFRS will be prepared later in 2009. Changes in accounting policies are likely going to have a material impact on Monterey's financial statements; however Management is not able to quantify the impacts at this time.

CICA handbook section 3064, Goodwill and Intangible Assets, will be in effect for fiscal years beginning on or after January 1, 2009. The handbook section applies to goodwill subsequent to initial recognition and establishes standards for the recognition, measurement and disclosure of goodwill and intangible assets. At this time, the new disclosure requirement is not expected to have an impact on the Corporation's financial statements.

On or before January 1, 2011, Monterey will be required to adopt Section 1582 "Business Combinations". Adoption of the section intends to enhance the relevance, reliability and comparability of information reporting entities provide in financial statements about business combinations and their effects. The section establishes criteria for the recognition and measurement of identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree, and goodwill (if any) acquired in the business combination or a gain from a bargain purchase. Lastly, the section also specifies disclosure requirements concerning business combinations.

During the year ended December 31, 2008 Monterey adopted CICA handbook sections 1535 - Capital Disclosures, Section 3031 - Inventories and Sections 3862 and 3863 - Financial Instruments Presentation and Disclosure.

Section 1535 - Capital Disclosures requires entities to disclose information that enables users of Monterey's financial statements to evaluate the Corporation's objectives, policies and processes for managing its capital. The standard did not have an impact on the classification or measurement of Monterey's financial statements.

Section 3031 - Inventories requires the measurement of inventories at the lower of cost and net realizable value with additional guidance on the determination of cost, including allocation of overheads and other costs to inventory. Monterey's adoption of the standard in 2008 did not result in an impact to the valuation of the Corporation's inventory as at January 1, 2008 or to Monterey's reported earnings for the current or prior periods.

Section 3862 and 3863 - Financial Instruments Presentation and Disclosure require an entity to provide greater emphasis on disclosures about the nature and extent of risk arising from financial instruments and how Monterey manages those identified risks. The standard did not have an impact on the classification or measurement of Monterey's financial statements.

INTERNAL CONTROLS REPORTING

Disclosure Controls and Procedures

The Chief Executive Officer and the Chief Financial Officer, together with other members of Management, have designed Monterey's disclosure controls and procedures to provide reasonable assurance that material information relating to the Corporation is disclosed in a timely manner and free from material misstatement. As at December 31, 2008, an evaluation of the effectiveness of Monterey's disclosure controls and procedures was conducted in accordance with Multilateral Instrument 52-109, Certification of Disclosure in Issuers' Annual Financial and Interim Filings, based on that evaluation, the Chief executive Officer and the Chief Financial Officer concluded that the design and operation of Monterey's disclosure controls and procedures were effective as at December 31, 2008.

Internal Controls over Financial Reporting

Also in accordance with Multilateral Instrument 52-109, the Chief Executive Officer and Chief Financial Officer of Monterey are responsible for establishing and maintaining adequate internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Canadian generally accepted accounting principles. The Chief Executive Officer and Chief Financial Officer directed the assessment of the design and operating effectiveness of Monterey's internal controls over financial reporting as at December 31, 2008 and based on that assessment determined that the Corporation's internal control over financial reporting was, in all material respects, appropriately designed and operated effectively.

During the year ended December 31, 2008, there have been no material changes in the design or operation of the Corporation's disclosure controls and procedures or in internal controls over financial reporting.

It should be noted that due to inherent limitations that a control system, including the Corporation's disclosure controls and procedures and internal controls over financial reporting, no matter how well conceived or operated may not prevent or detect misstatements, errors or fraud and can only provide reasonable assurance that the objectives of the control system are met.

RISKS & UNCERTAINTIES

Some of the risks that Monterey is exposed to which impact Management's ability to execute the Corporation's business plan include but are not limited to:

- Exploration, development and production activities

Monterey's success depends upon its ability to find, secure rights, acquire, develop and commercially produce oil and natural gas reserves. Risks associated with the exploration, finding and development and production of oil and gas reserves is impacted by: attracting, hiring and retaining knowledgeable and experienced staff; competition for prospective land for exploration and development activities; geological and operational risks; application of changing or new technologies, imprecision of reserve estimates and valuation; timely receipt of required regulatory approvals; ability to secure or obtain equipment, services and supplies when needed; weather; field operating risks; and existence and ability to access production infrastructure to deliver production to market.

Management attempts to manage and overcome these risks by careful addition of staff, early identification and evaluation of opportunities; careful planning of operations and development of contingency plans; developing continuing relationships with reliable suppliers of services, equipment and supplies; and carrying appropriate levels of insurance.

- Global financial crisis

During 2008 market conditions and events led to significant disruptions of international credit markets and the overall deterioration of worldwide economic conditions leading to increased volatility in markets (including financial and product markets), reduced liquidity, widening of corporate spreads, increased credit losses and tightening of credit conditions. Governments throughout the world have been required to intervene in preventing the collapse of banks, insurers and financial institutions. These conditions have impacted Monterey due to volatility of commodity prices, currency exchange, interest rates, access to and amount of debt and equity financing available, and the Corporation's valuations (stock market trading price and net asset value) have been negatively impacted.

Management has attempted to mitigate the impacts of the global recession and uncertain credit markets by taking action to dispose of a non-core property to reduce debt, reduced the size of the capital expenditure program roughly equal to funds flow from operations, fixed the cost of debt through the issue of guaranteed notes and entered into a new credit facility to determine the amount of bank debt that Monterey can access through to May 2010.

- Capital requirements

The Corporation's core business requires sufficient funds for the future acquisition, exploration, development and production of oil and natural gas reserves. Economic conditions, such as the current worldwide recession can cause significant volatility of commodity prices meaning that internal generation of funds or reasonable return of investment is uncertain. In addition the global credit crisis can result in a reduction in the access to, timing, amount and cost of debt thus making Monterey's ability to conduct or complete exploration and development activities more difficult.

Management ensures that projects are adequately evaluated to estimate viability under challenging economic conditions. In addition development of capital spending plans are carefully prepared and are subject to ongoing review to ensure that sufficient financial resources are available and that projects will earn a positive return on investment. Management manages its balance sheet, remains apprised of developments in the equity markets and changes in the current and forecasted commodity prices to maintain financial flexibility so that the business plans can be carried out.

- Third party credit risk

Monterey may be exposed to third party credit risk through its contractual arrangements with joint venture partners, purchasers of production and other parties. During challenging economic periods the Corporation may have slower accessibility to funds needed to finance the ongoing business or meet obligations due to the increase in the amount of time required to collect or the lack of collectability of accounts receivables.

Management mitigates this risk by entering into joint ventures or sell production to a diverse portfolio of entities that have sufficient capital resources and an established record of paying obligations when due. The Corporation monitors the amount and aging of accounts receivable to improve collectability and when necessary issues cash calls to collect payment in advance from a partner for its share of a project.

- Climate change

The determination of the impact of climate change is currently unknown and cannot be reasonably estimated. Physical access to opportunities and timing to conduct operations could change or become more costly. Potential new laws or regulatory requirements to control greenhouse gases or other emissions may increase the cost and the method of conducting exploration, development, production and processing oil and gas. Lastly new taxes, tariffs, penalties or costs to acquire offsetting credits as a result of finding, developing, producing, transporting and selling oil and gas may also impair the commercial viability of Monterey's activities or the oil and gas industry overall.

Management continues to monitor developments in this evolving area. Methods to be used to mitigate the risks associated with climate change include: education to understand the changes physical changes to the environment and new and changes to laws or regulatory requirements, and careful planning to determine cost effective means to perform Monterey's exploration, development and production activities and ensure compliance with laws and regulations.

- Changes in laws and regulations

On October 25, 2007 the Government of Alberta released the New Royalty Framework ("NRF") outlining revisions to its crown royalty program that will take effect on January 1, 2009. In April 2008, the Government of Alberta announced a new program to support exploration and development of deep oil and gas reserves that would be uneconomic under the NRF. The incentives associated with the new program applies to oil exploration wells and natural gas wells having depths greater than 2,000 meters and 2,500 meters, respectively. Furthermore, on November 19, 2008 the Government of Alberta introduced a five-year transitional royalty program to promote new drilling. Companies that drill new conventional oil or natural gas wells between the depths of 1,000 and 3,500 meters, will be granted a one-time option per well to adopt the new transitional rates or those outlined in the NRF. The transitional royalty rates for conventional oil will range from 10 percent to 39 percent, and transitional royalty rates for conventional gas will range from five percent to 30 percent. These transitional rates have lower maximum royalty rates in comparison to royalty rates under the NRF which range from zero to 50 percent on oil production and five percent to 50 percent for natural gas production.

On March 3, 2009, the Government of Alberta announced a three-point incentive program to stimulate new and continued economic activity in Alberta which included a drilling royalty credit for new conventional oil and natural gas wells and a new royalty incentive program. Under the drilling royalty credit program a $200 per meter royalty credit will be available on new conventional oil and gas wells drilled between April 1, 2009 and March 31, 2010. The new well incentive program will apply to wells beginning production of conventional oil and natural gas between April 1, 2009 and March 31, 2010 and provides for a maximum 5% royalty rate for the first 12 months of production, up to a maximum of 50,000 barrels of oil or 500 mmcf of natural gas.

The majority of Monterey's production is from properties located in the province of British Columbia; as such this change will have a nominal impact on the Monterey's current operations and the estimated net present value of its reserves. Approximately 20% of the Corporation's production is from wells located in the province of Alberta; furthermore Monterey's Alberta production is from low productivity and shallow depth wells. The Corporation's ability to attract investment capital for future investment in Alberta may be impacted by the negative effect the NRF will have on the economics of capital projects located in the province of Alberta.

In February 2009 the Government of British Columbia announced changes to the Deep Royalty Program under which royalty credits can be earned as a result of the vertical depth or the length of the horizontal leg of new drills. Royalties earned by the drilling of a well are applied against the crown royalties on production from the well. The changes announced have favorably adjusted the factor applied to calculating the royalty earned as a result of the length of the horizontal well. These changes will improve the economic viability of future horizontal wells to be drilled by Monterey in the Brassey and Groundbirch areas of NEBC.

SIGNIFICANT EVENTS

During the fourth quarter of 2008, the following items had a significant impact on either the current or future operations of the Corporation:

- Completed the earning of undeveloped lands under the terms of the farm-in agreement at Brassey in NEBC, following the successful tie-in of Monterey's first horizontally drilled, multi-stage fracture completed well, and re-entry and tie-in of an existing wellbore both targeting the Cadomin resource at Brassey. Both successful operations have been producing natural gas at a combined total stabilized average daily production rate of approximately 3.0 million cubic feet per day ("mmcf/d").

- Average daily production for the fourth quarter of 2,130 barrels of oil equivalent per day ("boe/d"), a 38 percent increase compared with 1,540 boe/d during the comparative quarter in 2007.

- Generated quarterly funds flow from operations of $3.7 million, versus $2.6 million of funds flow from operations generated in the fourth quarter of 2007. Fourth quarter funds flow from operations per diluted share was $0.11 for both 2008 and 2007.

In addition to significant events during the fourth quarter, the following items which took place during the first nine months of 2008 had a significant impact on either the current or future operations of the Corporation:

- Incurred net, cash capital expenditures of $32.5 million during 2008, to validate the application of horizontally drilled wells completed using multi-stage fracture technology on the Cadomin resource at Brassey, accelerate the recovery of the Corporation's Baldonnel gas holdings at Laprise, further develop the Squirrel area's Gething resource, jointly develop a new area for Monterey, at Smoky, Alberta with a arm's-length party and amassed a contiguous 5 net section parcel of undeveloped land in the heart of the Groundbirch Montney fairway.

- Completed the corporate acquisition of Upper Lake Oil and Gas Ltd. on August 29, 2008 by issuing 7,795,704 common shares of Monterey, adding approximately 663 boe/d of average daily production, 1.3 mmboe of proved plus probable reserves, a complementary inventory of 27,509 acres (16,759 net) of undeveloped land and approximately $35.3 million in tax pools.

- Commenced trading on the Toronto Stock Exchange (the "Exchange") on September 4, 2008 under the symbol "MXL".

- Increased the Corporation's credit facility to $45 million during the third quarter.

- Disposed of non-core properties producing approximately 20 boe/d for total cash proceeds of close to $1.6 million.

ACQUISTION OF UPPER LAKE OIL AND GAS LTD.

On July 3, 2008 Monterey announced that it had entered into an agreement to acquire Upper Lake Oil and Gas Ltd. ("Upper Lake") under a plan of arrangement. On August 29, 2008 the Corporation completed the acquisition by issuing 7,795,704 Monterey common shares and assumed $4.5 million of Upper Lake net debt and asset retirement obligations totaling $1.6 million. The table below summarizes the value of the oil and gas properties acquired, obligations assumed, value of Monterey common shares issued and the costs associated with the acquisition.



($000's)
----------------------------------------------------------------------------
Issue of Monterey common shares $ 29,513
Transaction costs 649
Assumption of Upper Lake obligations:
Net debt $ 4,575
Asset retirement obligation 1,610 6,185
----------------------------------------------------------------------------

Oil and natural gas properties acquired $ 36,347
----------------------------------------------------------------------------
----------------------------------------------------------------------------


As a result of the completion of the business combination on August 29, 2008 Monterey added the following:

- 663 boe per day of production comprised of 2.7 mmcf per day of natural gas and 211 bbls per day of oil and natural gas liquids, the majority of which is located in close proximity to Monterey's existing production in the Ferrybank area of Alberta;

- Undeveloped land of 27,509 (16,759 - net) acres most of which compliments Monterey's existing undeveloped landholdings in NEBC for exploration of the Montney formation; and

- $35.3 million in tax pools available to offset future net revenues from oil and gas properties acquired. The tax pools balance is made up of $28.6 million in intangible pools and $6.7 million in tangible undepreciated capital costs.



SUMMARY OF FINANCIAL AND OPERATING RESULTS

In $000's unless referring to Three months Three months Three months
volumetric measures or ended ended ended
otherwise noted (unaudited) Dec 31, 2008 Sept 30, 2008 Dec 31, 2007
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 10,058 8,400 7,969
Oil and NGLs (bbl/d) 453 292 212
----------------------------------------------------------------------------
Oil equivalent (boe/d) 2,130 1,691 1,540
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) (1) $ 7.35 $ 10.24 $ 6.54
Oil and NGLs ($/bbl) $ 51.78 $ 101.08 $ 80.32
----------------------------------------------------------------------------
Oil equivalent ($/boe) (1) $ 45.75 $ 68.45 $ 44.95
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 8,965 $ 10,652 $ 6,366
Operating income $ 4,191 $ 6,445 $ 3,126
Funds flow from operations $ 3,694 $ 3,345 $ 2,588
Net earnings (loss) $ (2,110) $ 1,301 $ (1,101)
Total capital expenditures $ 10,900 $ 40,930 $ 3,615

Per Share:
Funds flow from operations
per share:
Basic $ 0.11 $ 0.12 $ 0.11
Diluted $ 0.11 $ 0.12 $ 0.11

Net earnings per share:
Basic and diluted $ (0.06) $ 0.05 $ (0.04)

Financial Position:
Net debt (surplus) $ 37,924 $ 30,358 $ 15,142
Total assets $ 147,119 $ 140,482 $ 90,978
Total long-term liabilities $ 4,516 $ 4,122 $ 2,366
Shareholders' equity $ 99,063 $ 101,111 $ 69,908

Share data:
Outstanding:
Common shares 32,902,500 32,902,500 19,993,066
Non-voting shares - - 5,061,096
----------------------------------------------------------------------------
Total outstanding 32,902,500 32,902,500 25,054,162
Stock options 3,135,666 2,770,666 2,295,666
Equalization warrants - - -
----------------------------------------------------------------------------
Total diluted shares
outstanding 36,038,166 35,673,166 27,349,828
----------------------------------------------------------------------------

Weighted average:
Basic 32,902,500 27,818,345 24,527,532
Diluted 32,904,058 27,818,345 24,683,965
----------------------------------------------------------------------------
----------------------------------------------------------------------------


In $000's unless referring to Year Year Year
volumetric measures or ended ended ended
otherwise noted (unaudited) Dec 31, 2008 Dec 31, 2007 Dec 31, 2006
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Average sales volumes:
Natural gas (mcf/d) 8,062 7,410 5,527
Oil and NGLs (bbl/d) 292 246 245
----------------------------------------------------------------------------
Oil equivalent (boe/d) 1,636 1,481 1,166
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/mcf) (1) $ 8.39 $ 7.18 $ 7.01
Oil and NGLs ($/bbl) $ 78.90 $ 67.47 $ 64.19
----------------------------------------------------------------------------
Oil equivalent ($/boe) (1) $ 55.60 $ 47.25 $ 46.88
----------------------------------------------------------------------------

Financial:
Production revenue (1) $ 33,289 $ 25,536 $ 19,357
Operating income $ 18,099 $ 14,121 $ 11,036
Funds flow from operations $ 15,004 $ 11,852 $ 9,996
Net earnings (loss) $ 903 $ 806 $ 732
Total capital expenditures $ 66,581 $ 36,017 $ 65,878

Per Share:
Funds flow from operations
per share:
Basic $ 0.54 $ 0.50 $ 0.46
Diluted $ 0.54 $ 0.50 $ 0.36

Net earnings per share:
Basic and diluted $ 0.03 $ 0.03 $ 0.03

Financial Position:
Net debt (surplus) $ 37,924 $ 15,142 $ (3,914)
Total assets $ 147,119 $ 90,978 $ 75,006
Total long-term liabilities $ 4,516 $ 2,366 $ 2,244
Shareholders' equity $ 99,063 $ 69,908 $ 64,347

Share data:
Outstanding:
Common shares 32,902,500 19,993,066 18,378,066
Non-voting shares - 5,061,096 5,061,096
----------------------------------------------------------------------------
Total outstanding 32,902,500 25,054,162 23,439,162
Stock options 3,135,666 2,295,666 1,555,000
Equalization warrants - - 5,265,547
----------------------------------------------------------------------------
Total diluted shares
outstanding 36,038,166 27,349,828 30,259,709
----------------------------------------------------------------------------
Weighted average:
Basic 27,735,885 23,713,491 21,940,702
Diluted 27,736,277 23,878,617 27,418,642
----------------------------------------------------------------------------
----------------------------------------------------------------------------
(1) Includes processing, marketing income and gains / losses on financial
instruments.


FOURTH QUARTER 2008 VERSUS THIRD QUARTER 2008

Three months Three months
ended Dec 31, ended Sept 30, Percentage
2008 2008 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (mcf/d) 10,058 8,400 20
Oil and NGLs (bbl/d) 453 292 55
----------------------------------------------------------------------------
Oil equivalent (boe/d) 2,130 1,691 26
----------------------------------------------------------------------------


Average sales prices:
Natural gas ($/mcf) 7.35 7.94 (7)
Natural gas including
financial instruments ($/mcf) 7.35 10.24 (28)
Oil and NGLs ($/bbl) 51.78 101.08 (49)
----------------------------------------------------------------------------
Oil equivalent ($/boe) 45.75 57.06 (20)
Oil equivalent including
financial instruments ($/boe) 45.75 68.45 (33)
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the three months ended December 31, 2008, Monterey's average daily production was 2,130 boe/d, which is 26 percent higher than the 1,691 boe/d average daily production for the third quarter of 2008. The increase over the previous quarter consists of the inclusion of sales volumes associated with the acquisition of Upper Lake for the entire fourth quarter, as well new sales volumes added from successful drilling and tie in activities during the fourth quarter at the Corporation's Brassey and Laprise areas. The increase in sales volumes over the third quarter was negatively impacted by the loss of an average 100 boe per day for the fourth quarter due to a labor strike at a third party-operated processing facility in December. In addition to the labor strike, cold weather during the month of December further reduced sales volumes for the quarter due to mechanical equipment failures and freezing of hydrates in wells and gathering systems causing temporary production outages.

Realized Prices

Including the impact of financial instruments, Monterey's average realized natural gas price during the fourth quarter of 2008 was $7.35 per mcf, a decrease of 28 percent relative to the Corporation's average realized natural gas price per mcf of $10.24 during the third quarter of 2008. Monterey's average realized liquids price for the fourth quarter of 2008 decreased by 49 percent when compared to the third quarter.

The decrease in Monterey's average sales prices during the fourth quarter followed the collapse in world crude prices and weakened natural gas pricing as demand for both oil and natural gas have softened as a result of a worldwide economic recession combined with excess supply.

Royalties

During the fourth quarter, the Corporation had an average royalty cost per boe of $7.98. In comparison to the third quarter, the Corporation had an average royalty cost per boe of $12.10. The decrease in royalty costs per boe over the third quarter of 2008 was due to lower average realized commodity prices during the fourth quarter. The average royalty rate decreased to 17.4% in the fourth quarter from 21.2% in the third quarter due to receipt of marginal crown royalty rate relief on low productivity NEBC wells drilled in 2007.

Operating Costs

Relative to the third quarter of 2008, operating costs per boe increased to $14.61 from $13.16 per boe. The primary reason for the unfavorable variance during the fourth quarter of 2008 was due to the commencement of winter operating conditions which historically result in higher overall operating costs associated with the construction of ice roads, mechanical equipment repairs and thawing of frozen hydrates. Operating costs per boe were further impacted by a labor strike at a third party-operated facility which resulted in lower sales volumes to offset the Corporation's fixed operating expenditures during the quarter. Monterey completed workover activities at its Harmattan area which also contributed to the increase in operating costs over the third quarter of 2008.

Transportation Costs

Transportation costs during the fourth quarter of 2008 increased in relation to the third quarter of 2008 due to higher sales. However, effective November 1, 2008 the last of the firm service contracts for natural gas transportation attached to the NEBC oil and gas properties in January 2006 expired, thus eliminating Monterey's obligation to absorb the cost of unutilized pipeline capacity. On a per boe basis, the unit transportation cost for the fourth quarter of $1.78 per boe is about the same as that recorded in the third quarter of 2008.

Operating Income

During the fourth quarter of 2008, Monterey's average realized operating income per boe decreased to $21.38, a decrease of approximately 48 percent relative to the third quarter of 2008. The decrease is primarily attributable to lower commodity prices, accompanied by incremental operating expenditures associated with the Corporation's winter operations during the fourth quarter.



Change due to:
----------------------
Three Three
months months
ended ended
Dec 31, Sept 30,
($000's) 2008 Price/Cost Volume 2008
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 6,805 (581) 1,217 $ 6,169
Oil and NGLs sales 2,160 (2,056) 1,505 2,711
Gain / (loss) from financial
instruments - (1,772) - 1,772
----------------------------------------------------------------------------
8,965 (4,409) 2,722 10,652

Royalties 1,563 (807) 488 1,882
Operating costs 2,863 285 530 2,048
Transportation costs 348 - 71 277
----------------------------------------------------------------------------

Operating income $ 4,191 (3,887) 1,633 $ 6,445
----------------------------------------------------------------------------
$/boe $ 21.38 $ 41.41
----------------------------------------------------------------------------


Depletion, Depreciation and Accretion ("DD&A")
----------------------------------------------

Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2008 2008
----------------------------------------------------------------------------
Oil and gas properties $ 5,274 $ 4,004
Office equipment 32 17
Asset retirement accretion 125 79
----------------------------------------------------------------------------
$ 5,431 $ 4,100
----------------------------------------------------------------------------
$/boe $ 27.72 $ 26.35
----------------------------------------------------------------------------


DD&A expense for the fourth quarter of 2008 increased by approximately $1.3 million over the previous quarter. The increase in total DD&A expense was a result of higher production volumes following the acquisition of Upper Lake on August 29, 2008. The increase in DD&A per boe reflects the higher cost of proved reserves acquired in the Upper Lake transaction relative to Monterey's existing base of total proved reserves.

General & Administrative ("G&A")

Total general and administrative costs for the fourth quarter of 2008 were lower than costs incurred during the third quarter of 2008. The decrease in fourth quarter G&A reflects a reduction in the 2008 annual bonus, partially offset by higher office rent inherited through the acquisition of Upper Lake. On a per boe basis, G&A expenses decreased by $1.53 due to the benefit of increased economies of scale associated with the increase in production volumes realized without increasing general and administrative costs.



Three Months Three Months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2008 2008
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 433 $ 657
Stock-based compensation 136 100
----------------------------------------------------------------------------
Total expensed G&A $ 569 $ 757
----------------------------------------------------------------------------
$/boe $ 2.90 $ 4.87
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 344 $ 214
Stock-based compensation and income tax
adjustment 85 58
----------------------------------------------------------------------------
Total capitalized G&A $ 429 $ 272
----------------------------------------------------------------------------
$/boe $ 2.19 $ 1.75
----------------------------------------------------------------------------

Total G&A costs $ 998 $ 1,029
----------------------------------------------------------------------------
$/boe $ 5.09 $ 6.62
----------------------------------------------------------------------------


The capitalized general and administrative costs include both general and administrative cash expenditures and non-cash stock-based compensation associated with exploration and development activities. The table below provides additional disclosure of the components of capitalized general and administrative costs.



Three Months Three Months
ended Dec 31, ended Sept 30,
(in $000's) 2008 2008
----------------------------------------------------------------------------
Salaries and employment costs $ 294 $ 182
Office rent 48 30
Other general and administrative costs 2 2
----------------------------------------------------------------------------
Capitalized cash general and administrative
costs $ 344 $ 214
----------------------------------------------------------------------------
Capitalized stock-based compensation 59 39
Stock-based compensation income tax adjustment 26 19
----------------------------------------------------------------------------
Capitalized non-cash costs $ 85 $ 58
----------------------------------------------------------------------------

Total capitalized general and administrative
costs $ 429 $ 272
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest

Three Months Three Months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2008 2008
----------------------------------------------------------------------------
Interest expense $ 276 $ 247
Interest income - -
----------------------------------------------------------------------------
Net interest expense / (income) $ 276 $ 247
----------------------------------------------------------------------------
$/boe $ 1.40 $ 1.59
----------------------------------------------------------------------------


The 12 percent increase in the fourth quarter interest expense, relative to the third quarter is the net result of increased bank debt offset by falling interest rates. The decrease in interest expense per boe from $1.59 during the third quarter of 2008 is mainly due to incremental production volumes from the acquisition of Upper Lake and the tie in of new production from the Brassey and Laprise areas.



FUNDS FLOW FROM OPERATIONS

Three months Three months
ended Dec 31, ended Sept 30,
(in $000's except per boe amounts) 2008 2008
----------------------------------------------------------------------------
Operating income $ 4,191 $ 6,445
Unrealized (gain) / loss on financial
instruments 212 (2,196)
General and administrative expenses (1) (433) (657)
Interest expense (276) (247)
----------------------------------------------------------------------------
Funds flow from operations $ 3,694 $ 3,345
----------------------------------------------------------------------------

Operating income per boe $ 21.38 $ 41.41
Unrealized (gain) / loss on financial
instruments 1.08 (14.12)
General and administrative expenses (1) (2.21) (4.20)
Interest expense (1.40) (1.59)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 18.85 $ 21.50
----------------------------------------------------------------------------

(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.


Monterey's funds flow from operations for the fourth quarter of 2008 increased by approximately $0.3 million in comparison to the third quarter of 2008 as a result higher sales volumes being partially offset by lower commodity prices.

Fourth quarter unit funds flow from operations of $18.85 per boe was about 12 percent less than the $21.50 per boe recorded in the third quarter. Increased production resulting from the Upper Lake acquisition and placing on-stream new production from successful exploration and development activities in the Brassey and Laprise areas of NEBC, had a positive impact reducing the unit costs of interest and general and administrative expenses; however falling product prices and the increase in operating costs more than offset the positive changes.



FOURTH QUARTER 2008 VERSUS FOURTH QUARTER 2007

Three months ended
Dec 31, Dec 31, Percentage
2008 2007 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (Mcf/d) 10,058 7,969 26
Oil and NGLs (Bbl/d) 453 212 114
----------------------------------------------------------------------------
Oil equivalent (Boe/d) 2,130 1,540 38
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/Mcf) 7.35 6.65 11
Natural gas including
financial instruments ($/Mcf) 7.35 6.54 12
Oil and NGLs ($/Bbl) 51.78 80.32 (36)
----------------------------------------------------------------------------
Oil equivalent ($/Boe) 45.75 45.52 1
Oil equivalent including
financial instruments ($/Boe) 45.75 44.95 2
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the three months ended December 31, 2008, Monterey's average daily production was 2,130 boe per day, a 590 boe per day or 38 percent increase compared to the average daily production for the fourth quarter of 2007. The increase in production relative to the fourth quarter of 2007 represents the combination of additions from the 2008 drilling operations and the acquisition of Upper Lake Oil & Gas Ltd. which closed on August 29, 2008 net of the loss of approximately 100 boe per day in 2008 due to a labor strike at a major third party gas processing facility in NEBC.

Realized Prices

Monterey's average natural gas price including financial instruments during the fourth quarter of 2008 was $7.35 per mcf, an increase of 12 percent in relation to the average natural gas price during the comparative quarter in 2007. North American natural storage inventories were high, relative to historical norms, at November 1, 2007, the start of the 2007/08 gas heating season, leading to softer prices in the fourth quarter of 2007.

Monterey's average realized liquids price decreased by 36 percent in comparison to the fourth quarter of 2007, as a result of sufficient worldwide supply of crude stocks and falling demand for energy due to the worldwide economic recession.

Royalties

Monterey's average royalty rate in the fourth quarter of 2008 was the same as the 17 percent average royalty rate during the fourth quarter of 2007.

Operating Costs

Relative to the fourth quarter of 2007, operating costs per boe increased by $1.01 or seven percent during the current quarter to $14.61. The 2008 increase is explained by workover activities completed at Monterey's Harmattan area during the current quarter, as well the absorption of NEBC fixed costs on production lost due to the strike at the third party processing facility, discussed above, when compared to the fourth quarter of 2007.

Transportation Costs

Transportation costs of $1.78 per boe for the fourth quarter of 2008 increased by six percent from costs incurred during the fourth quarter of 2007. The increase is the result of production volumes added from Monterey's Brassey area, which has higher overall transportation costs in relation to the Corporations remaining base production. The increase was partially offset by the expiry of Monterey's remaining firm service transportation agreements in 2007; the cost of the firm service transportation rendered a higher average transportation cost per boe.

Operating Income

On a per boe basis Monterey's average operating income for the fourth quarter of 2008 decreased by $0.69 per boe to $21.38, predominately due to the decrease in the prices received for the Corporation's liquids volumes over the comparative quarter of 2007.



Three Three
months Change due to: months
ended ------------------- ended
Dec 31, Price/ Dec 31,
($000's) 2008 Cost Volume 2007
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 6,805 639 1,281 $ 4,885
Oil and NGLs sales 2,160 (1,191) 1,788 1,563
Gain / (loss) from financial
instruments - 82 - (82)
----------------------------------------------------------------------------
8,965 (470) 3,069 6,366

Royalties 1,563 76 412 1,075
Operating costs 2,863 197 739 1,927
Transportation costs 348 19 91 238
----------------------------------------------------------------------------

Operating income $ 4,191 (762) 1,827 $ 3,126
----------------------------------------------------------------------------
$/boe $ 21.38 $ 22.07
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Depletion, Depreciation and Accretion Expense
----------------------------------------------
Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Oil and gas properties $ 5,274 $ 3,152
Office equipment 32 10
Asset retirement accretion 125 68
----------------------------------------------------------------------------
$ 5,431 $ 3,230
----------------------------------------------------------------------------
$/boe $ 27.72 $ 22.80
----------------------------------------------------------------------------


In comparison to the three months ended December 31, 2007, the DD&A provision in 2008 increased 68 percent due to the combination of the 22 percent increase in the unit DD&A expense per boe and the 38 percent growth in production volumes. The DD&A expense per boe increased by $4.92 as proved reserves added from 2008 exploration and development activities and acquired in the Upper Lake transaction had a higher average cost relative to Monterey existing total proved reserves.

General & Administrative

Total General and Administrative expense for the fourth quarter of 2008 was $0.1 million lower than total G&A expense for the same quarter during 2007. The average cost per boe for 2008 total G&A costs fell 34 percent to $5.09 per boe reflecting economies of scale as 2008 production grew 38 percent.

The reduction in the stock-based compensation provision is a result of a disproportionately higher amount of the expense is recognized during the earlier years of the stock option term than in subsequent years. The following table summarizes the G&A costs recorded for each of the fourth quarters of 2008 and 2007.



Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 433 $ 496
Stock-based compensation 136 183
----------------------------------------------------------------------------
Total expensed G&A $ 569 $ 679
----------------------------------------------------------------------------
$/boe $ 2.90 $ 4.79
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 344 $ 276
Stock-based compensation and income tax
adjustment 85 134
----------------------------------------------------------------------------
Total capitalized G&A $ 429 $ 410
----------------------------------------------------------------------------
$/boe $ 2.19 $ 2.90
----------------------------------------------------------------------------
Total G&A costs $ 998 $ 1,089
----------------------------------------------------------------------------
$/boe $ 5.09 $ 7.69
----------------------------------------------------------------------------

The capitalized general and administrative costs include both general and
administrative cash expenditures and non-cash stock-based compensation
associated with exploration and development activities. The table below
provides additional disclosure of the components of capitalized general and
administrative costs.

Three Months Three Months
ended Dec 31, ended Dec 31,
(in $000's) 2008 2007
----------------------------------------------------------------------------
Salaries and employment costs $ 294 $ 232
Office rent 48 22
Other general and administrative costs 2 22
----------------------------------------------------------------------------
Capitalized cash general and administrative
costs $ 344 $ 276
----------------------------------------------------------------------------
Capitalized stock-based compensation 59 90
Stock-based compensation income tax adjustment 26 44
----------------------------------------------------------------------------
Capitalized non-cash costs $ 85 $ 134
----------------------------------------------------------------------------
Total capitalized general and administrative
costs $ 429 $ 410
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest

Three months Three months
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Interest expense $ 276 $ 227
Interest income - (2)
----------------------------------------------------------------------------
Net interest expense / (income) $ 276 $ 225
----------------------------------------------------------------------------
$/boe $ 1.40 $ 1.59
----------------------------------------------------------------------------


Interest expense for the fourth quarter of 2008 exceeded net interest expenses during the comparative quarter of 2007 due to an increase in the amount of Monterey's bank debt. The increase in Monterey's production volumes from the fourth quarter of 2007 helped reduce the Corporation's interest expense per boe by 12% to $1.40.



FUNDS FLOW FROM OPERATIONS
Three months ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------

Operating income $ 4,191 $ 3,126
Unrealized (gain)/loss on financial instruments 212 183
General and administrative expenses (1) (433) (496)
Interest expense (276) (225)
----------------------------------------------------------------------------
Funds flow from operations $ 3,694 $ 2,588
----------------------------------------------------------------------------

Operating income per boe $ 21.38 $ 22.07
Unrealized loss on financial instruments 1.08 1.29
General and administrative expenses (1) (2.21) (3.50)
Interest expense (1.40) (1.59)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 18.85 $ 18.27
----------------------------------------------------------------------------
(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.


The Corporation's funds flow from operations for the current quarter of $3.7 million was 43 percent higher than the $2.6 million reported during same quarter of 2007, the increase was due to higher sales volumes following the acquisition of Upper Lake Oil and Gas Ltd. and from Monterey's 2008 capital activities at Brassey, Laprise and Squirrel.

On a per unit basis, funds flow from operations was three percent higher during the fourth quarter of 2008, from lower general and administrative and interest expenses.



YEAR ENDED DEC 31, 2008 VERSUS YEAR ENDED DEC 31, 2007

Year ended
Dec 31, Dec 31, Percentage
2008 2007 Change
----------------------------------------------------------------------------
Average sales volumes:
Natural gas (Mcf/d) 8,062 7,410 9
Oil and NGLs (Bbl/d) 292 246 19
----------------------------------------------------------------------------
Oil equivalent (Boe/d) 1,636 1,481 10
----------------------------------------------------------------------------

Average sales prices:
Natural gas ($/Mcf) 8.61 6.91 25
Natural gas including financial instruments
($/Mcf) 8.39 7.18 17
Oil and NGLs ($/Bbl) 78.90 67.47 17
----------------------------------------------------------------------------
Oil equivalent ($/Boe) 56.71 45.90 24
Oil equivalent including financial instruments
($/Boe) 55.60 47.25 18
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Sales Volumes

For the year ended December 31, 2008, Monterey's average daily production was 1,636 boe/d, 155 boe/d or 10 percent higher than the average daily production for 2007. Increased sales volumes relative to 2007 resulted from the combination of additions associated with the acquisition of Upper Lake, as well as successful drilling and tie in of development activities at the Corporation's Brassey, Laprise, and Squirrel areas.

Realized Prices

Monterey's average realized natural gas price including financial instruments during the year ended 2008 was $8.39 per mcf, an increase of 17 percent in relation to the average realized natural gas price during the comparative period in 2007. Natural gas prices were at their lowest levels during 2007 in comparison to recent years. In 2007 increased imports into North America of liquefied natural gas during the summer heating season contributed to a higher than normal level of North American natural gas storage and led to softened natural gas prices.

In 2008 the Corporation's natural gas hedges were at prices below market resulting in a loss from natural gas hedging activities (financial instruments) of nearly $0.7 million whereas Monterey recorded a gain of $0.7 million in 2007.

Monterey's average realized liquids price increased by 17 percent, in comparison to 2007 as crude prices set new record highs during the summer of 2008.

The 18 percent increase in Monterey's 2008 average realized sales price per boe over 2007 was the result of stronger demand for oil in the first half of 2008 and lower than anticipated levels of North American natural gas in storage at the end of the 2007/08 natural gas heating season in March 2008. However prices for natural gas, crude oil and NGL fell dramatically over the last half of 2008 due to high product inventories and reduced demand resulting from the worldwide recession.

Financial Instruments

During 2008, Monterey realized a total loss on financial instruments of approximately $0.7 million compared to a realized total gain during the previous year ended December 31, 2007 of approximately $0.7 million. The loss recorded in 2008 reflects higher than anticipated natural gas prices at AECO during the months of March through to August. The following table details information concerning the Corporation's participation in forward commodity price contracts during 2008 and 2007:



Realized
Volume Contract Prices Gain (Loss)
Term Instrument (GJ per day) ($ per GJ) $000's
----------------------------------------------------------------------------
April 1 -
October 31, 2008 Fixed Price 4,000 7.63 ($662)
----------------------------------------------------------------------------
----------------------------------------------------------------------------
February 1 -
March 31, 2007 Fixed Price 2,000 7.24 $40
April 1 -
October 31, 2007 Collars 2,780 7.00 - 8.75 $691
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Royalties

Monterey's average royalty rate for the year ended December 31, 2008 was 18 percent, a one percent increase compared to the 17 percent average royalty rate during the year ended 2007. The increase in Monterey's average royalty rate is primarily the result of higher average royalty rates associated with new production from the Smoky area of Alberta, a new operating area for the Corporation in 2008. During the year ended December 31, 2008, Monterey's average unit royalty expense was $10.08 per boe.

Operating Costs

Relative to the year ended December 31, 2007, operating costs per boe increased by 16 percent in 2008 to $13.56. The increase is primarily attributed to: an increase in the number of workover activities performed in the current year, higher gathering and compression costs from new production additions in 2008 and lastly, from the impact of fixed costs associated with: a major facility turnaround during the second quarter of 2008, the labor strike at the Spectra facility in December and natural production declines in relatively high fixed operating cost areas such as Dahl, Redeye and Silver all in NEBC.

Transportation Costs

Transportation costs for the year ended December 31, 2008 averaged $1.73 per boe, down from $1.77 per boe during 2007. The expiry of fixed rate transportation agreements in 2007 was the primary reason for the favorable variance.

Operating Income

On a per boe basis Monterey's average operating income for the year ended December 31, 2008 increased by $4.10 per boe to $30.23. Of the total increase in operating income, approximately 59 percent was attributed to higher commodity prices in 2008, with the remainder of the increase being associated with higher sales volumes.



Year ended Change due to: Year ended
Dec 31, -------------------- Dec 31,
($000's) 2008 Price/Cost Volume 2007
----------------------------------------------------------------------------
Operating Income:
Production revenue
Natural gas sales $ 25,516 5,051 1,707 $ 18,758
Oil and NGLs sales 8,434 1,221 1,165 6,048
Gain / (loss) from financial
instruments (662) (1,392) - 731
----------------------------------------------------------------------------
33,289 4,880 2,872 25,537

Royalties 6,037 1,480 443 4,114
Operating costs 8,119 1,091 684 6,344
Transportation costs 1,033 (26) 103 957
----------------------------------------------------------------------------

Operating income $ 18,099 2,335 1,642 $ 14,122
----------------------------------------------------------------------------
$/boe $ 30.23 $ 26.13
----------------------------------------------------------------------------
----------------------------------------------------------------------------

May not add due to rounding.

Depletion, Depreciation and Accretion Expense

Year ended Year ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Oil and gas properties $ 14,926 $ 11,380
Office equipment 58 37
Asset retirement accretion 364 245
----------------------------------------------------------------------------
$ 15,348 $ 11,662
----------------------------------------------------------------------------
$/boe $ 25.64 $ 21.58
----------------------------------------------------------------------------


The 2008 DD&A provision of $15,348,000 is 32 percent more than the $11,662,000 recorded in 2007. The increase in the 2008 provision can largely be explained by the growth in production volumes in 2008. In comparison to the year ended December 31, 2007, DD&A unit cost per boe increased 18 percent or $4.06 to $25.64 per boe. The unit cost increase is mainly attributed to the cost of proved reserves from the acquisition of Upper Lake.

General & Administrative

Total General and Administrative costs in 2008 of almost $3.8 million was approximately $0.1 million lower than total G&A costs in 2007. Lower stock-based compensation costs partially offset by additional office rent expenses following the acquisition of Upper Lake accounted for the net decrease in total G&A costs over the previous year.

The 2008 unit G&A cost fell 13 percent to $6.33 per boe. This desirable variance reflects the benefit of economies of scale associated with increased production.



Year ended Year ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Expensed G&A:
General and administrative expenses $ 2,075 $ 1,740
Stock-based compensation 435 695
----------------------------------------------------------------------------
Total expensed G&A $ 2,510 $ 2,435
----------------------------------------------------------------------------
$/boe $ 4.19 $ 4.50
----------------------------------------------------------------------------
Capitalized G&A:
General and administrative expenses $ 1,021 $ 953
Stock-based compensation and income tax
adjustment 258 533
----------------------------------------------------------------------------
Total capitalized G&A $ 1,279 $ 1,486
----------------------------------------------------------------------------
$/boe $ 2.14 $ 2.75
----------------------------------------------------------------------------

Total G&A costs $ 3,789 $ 3,921
----------------------------------------------------------------------------
$/boe $ 6.33 $ 7.25
----------------------------------------------------------------------------


The capitalized general and administrative costs include both general and
administrative cash expenditures and non-cash stock-based compensation
associated with exploration and development activities. The table below
provides additional disclosure of the components of capitalized general and
administrative costs.


Year ended Year ended
Dec 31, Dec 31,
(in $000's) 2008 2007
----------------------------------------------------------------------------
Salaries and employment costs $ 865 $ 783
Office rent 128 87
Other general and administrative costs 28 83
----------------------------------------------------------------------------
Capitalized cash general and administrative
costs $ 1,021 $ 953
----------------------------------------------------------------------------
Capitalized stock-based compensation 174 357
Stock-based compensation income tax
adjustment 84 176
----------------------------------------------------------------------------
Capitalized non-cash costs $ 258 $ 533
----------------------------------------------------------------------------

Total capitalized general and administrative
costs $ 1,279 $ 1,486
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Interest

Year Year
ended Dec 31, ended Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------
Interest expense $ 1,034 $ 595
Interest income (15) (65)
----------------------------------------------------------------------------
Net interest expense $ 1,019 $ 530
----------------------------------------------------------------------------
$/boe $ 1.70 $ 0.98
----------------------------------------------------------------------------


Net interest expense for the year ended December 31, 2008 exceeded net interest expense during the 2007 by approximately $0.5 million. The increase in interest expense primarily results from increased outstanding bank debt in 2008.



FUNDS FLOW FROM OPERATIONS

Year ended
Dec 31, Dec 31,
(in $000's except per boe amounts) 2008 2007
----------------------------------------------------------------------------

Operating income $ 18,099 $ 14,122
General and administrative expenses (1) (2,075) (1,740)
Interest expense (1,019) (530)
----------------------------------------------------------------------------
Funds flow from operations (3) $ 15,004 $ 11,852
----------------------------------------------------------------------------

Operating income per boe $ 30.23 $ 26.13
General and administrative expenses (1) (3.47) (3.22)
Interest expense (1.70) (0.98)
----------------------------------------------------------------------------
Funds flow from operations per boe (2) $ 25.06 $ 21.93
----------------------------------------------------------------------------
(1) Excluding stock-based compensation.
(2) Funds flow from operations per boe is equal to cash provided by
operating activities less asset retirement expenditures and change in
non-cash working capital divided by total boe production in the period.
(3) May not add due to rounding.


Relative to 2007, Monterey's funds flow from operations for 2008 increased by 27 percent and by 14 percent on a per boe basis, primarily due to higher average sales prices, and the growth in production from the acquisition of Upper Lake and successful exploration and development activities at Brassey, Laprise and Squirrel in NEBC.

INCOME TAXES

During the three months and year ended December 31, 2008 Monterey did not pay any cash taxes and currently does not anticipate the payment of any cash income taxes in the foreseeable future. At December 31, 2008 Monterey has tax pools totaling approximately $198.6 million available to be utilized against future taxable income. The tax pools include approximately $57.5 million in non-capital losses to reduce future taxable income, $54.7 million in Canadian exploration and development expenses, $52.7 million in oil and gas property expenses, $32.2 million in tangible expenses and $1.5 million of share issue costs.

In accordance with GAAP the financial statements do not reflect the full value of benefit of the tax pools. In order to recognize the value of the pools in the financial statements, the Corporation has to demonstrate that it may generate consistent, future annual profitability to utilize such pools.

Based upon the application of the December 31, 2008 tax pools against future net funds flow from operations that will be generated from estimated proved developed producing reserves, approximately $12.5 million, $16.0 million, $28.3 million and $0.7 million of the non-capital losses may expire unutilized at the end of 2009, 2010, 2011 and 2012 respectively. Nonetheless, Management anticipates that increased funds flow from operations resulting from future successful exploration and development activities and acquisitions will reduce this risk of non-capital losses expiring unutilized.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2008 had total capitalization of nearly $137 million consisting of $37.9 million in net debt and $99.1 million in equity. Management reviews its net debt to equity ratio and net debt to forward cash flow and compares the ratios to accepted prudent financial ratios, against the ratios of similar sized publicly listed entities operating in the upstream oil and gas exploration and development industry and the anticipated business environment, opportunities and operations of the Corporation. If any of Monterey's ratios did not meet Management's expectations then action such as an equity financing, disposition of oil and gas properties, reduction of capital expenditure programs would be undertaken to ensure the Corporation is able to settle it obligations when due and to carry on conducting business.



Capitalization Dec 31, 2008 Dec 31, 2007
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Net current deficiency $ 2,414 $ 1,517
Bank indebtedness 35,286 13,625
Obligations under capital lease 224 -
Share capital 92,944 65,193
Contributed surplus 3,678 3,177
Retained earnings 2,441 1,538
----------------------------------------------------------------------------
Total Capitalization $ 136,987 $ 85,050
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Net current deficiency

As at December 31, 2008 Monterey had a net current deficiency of $2.4 million. The capital expenditures incurred in late 2008 led to an increase in accounts payable, which accounts for the change in Monterey's net current deficiency relative to December 31, 2007.

Bank indebtedness

At December 31, 2008, the Corporation had total bank indebtedness of $35.3 million, resulting from Canadian prime rate overdraft drawings against the credit facility. During the third quarter of 2008, the Canadian Banking institution (the "Lender") with which Monterey has a secured revolving operating facility (the "Facility") increased the funds available under the Facility to $45 million from $30 million. During 2008, Monterey's also made borrowings in the form of guaranteed notes that mature within 90 days; however; as at December 31, 2008 the Corporation did not have any borrowings made in the form of guaranteed notes, thus the entire $35.3 million of bank indebtedness consisted of Canadian prime rate overdraft drawings against the Facility. The increase in bank indebtedness over the previous year is due to the financing of Monterey's 2008 capital program with drawings against the Corporation's Facility.

The Facility allows Monterey to enter into foreign exchange forward contracts or interest and commodity derivatives contracts with the Lender. The Facility includes covenants that limit the commodity derivative contracts entered into by the Corporation to a maximum of 50% of Monterey's average production, before royalties, reported in the most recently completed fiscal quarter and that the term of any commodity contract will not exceed a period of two years.

The tightening of the availability of credit and the impact on Monterey's revenues as a result of lower commodity prices due to the global recession has impacted the Corporation. Management has taken a number of steps during the first quarter of 2009 to reduce the uncertainty in respect of the amount and cost of the bank indebtedness available to Monterey. Steps taken included: (i) reduction in the amount of borrowings under its credit facility by disposing of a non-core producing oil and gas property for approximately $6 million; (ii) temporarily reduced the capital expenditure program to minimize additional borrowings; (iii) issue of guaranteed notes to reduce its cost of debt and eliminate the risk of changing interest rates (as of the date of this MD&A, Monterey has issued $30.0 million in guaranteed notes, providing net proceeds of approximately $29.4 million with effective interest rates ranging from 2.21% to 2.49% per annum and maturing in various amounts over the August 2009 to March 2010 period); (iv) Management requested the Lender to accelerate and perform its annual review of the Facility during the first quarter of 2009.

The result of the Lender's review is that Monterey, subject to completion of documentation, has agreed to a new $45 million credit facility ("the New Facility"). Relative to the Facility, there will be no changes in the security provided by Monterey or covenants for the New Facility. Under the New Facility the interest rate on amounts borrowed up to $40.5 million via prime rate overdraft borrowings will increase to the bank prime rate plus 1.25% per annum and the stamping fee on the issue of guaranteed notes and LIBOR borrowings will increase to 2.50% per annum. In respect of borrowings exceeding $40.5 million the interest rates and stamping fees will increase by an additional 1.00% per annum. The stand-by fee on the unutilized portion of the new $45 million facility will be 0.35% per annum. The commitment fee for the New Facility will be approximately $0.1 million and will be paid by Monterey upon the completion of the documentation. The Lender will review the New Facility prior to May 31, 2010.

Currently the undrawn amount available under the new facility and the anticipated funds flow from operations will be sufficient for Monterey to complete its planned capital expenditure program and settle its obligations for 2009 and nearly the first half of 2010. In the event that business conditions continue to deteriorate to the point where the Lender felt that it was unable to advance all of the funds under the New Facility, if necessary, Management would consider additional dispositions of non-core properties or delay the timing of the planned exploration and development program to ensure that the Corporation remains a going concern.

Capital lease

In association with the acquisition of Upper Lake on August 29, 2008, Monterey assumed a capital lease obligation that has no early retirement provision. The lease expires at the end of March 2010, and requires monthly payments of approximately $16,000. The capital lease has an implicit interest rate of 7.56% per annum.

Share Capital

During the year ended December 31, 2008, 7,848,338 common shares were issued. Of this total, 7,795,704 common shares were issued to the former shareholders of Upper Lake Oil & Gas Ltd. upon the acquisition of Upper Lake by Monterey on August 29, 2008. In addition, during the first quarter, 52,634 common shares were issued from treasury upon the exercise of stock options. The Corporation received net proceeds of approximately $123,000 for the exercise of these options. In association with the October 30, 2007 flow-through share issuance, during the first quarter of 2008 the Corporation renounced expenditures having an income tax value of approximately $1,710,000.

On September 4, 2008 Monterey was listed on the Toronto Stock Exchange and on November 5, 2008 the Corporation filed notice to be qualified to be a short form prospectus issuer. These actions will enhance Monterey's ability to more quickly raise equity than previously experienced as a private corporation.

At March 19, 2009, Monterey had 32,902,500 voting common shares, and 3,135,666 stock options (1,526,333 exercisable at December 31, 2008) outstanding.

Contributed Surplus

The Corporation's contributed surplus is equal to the fair value of stock options accrued over the vesting period of the stock options. The fair value of the stock options is estimated at the date the options are granted using the Black-Scholes option pricing model. When shares are issued as a result of the exercise of stock options the fair value of the stock option reflected in contributed surplus is credited to share capital and the contributed surplus balance reduced.



CAPITAL EXPENDITURES
Three Months ended Year ended
Dec 31, Dec 31, Dec 31, Dec 31,
2008 2007 2008 2007
----------------------------------------------------------------------------
Land and retention $ 1,181 $ 536 $ 6,452 $ 723
Geological and geophysical 78 168 840 1,329
Drilling and completions 6,426 2,063 19,390 19,172
Production equipment and
facilities 2,967 1,078 5,145 6,319
Capitalized G&A 344 276 1,021 953
----------------------------------------------------------------------------

Exploration and development
expenditures $ 10,996 $ 4,121 $ 32,848 $ 28,496
Property acquisitions 100 - 377 7,990
Office furniture, equipment and
software 188 3 201 40
----------------------------------------------------------------------------

Capital expenditures before
dispositions $ 11,284 $ 4,124 $ 33,426 $ 36,526
Property dispositions (315) (509) (1,582) (509)
----------------------------------------------------------------------------

Capital expenditures $ 10,969 $ 3,615 $ 31,844 $ 36,017
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Monterey's total capital spending during the fourth quarter of 2008 was approximately $11.0 million. Exploration and development activities during the quarter included the drilling of 1.0 net well in the Ferrybank area, the re-entry and tie in of a vertical well at Brassey, and the completion and tie in of the Corporation's first horizontally drilled at Brassey, which was drilled during the third quarter.

In addition to the drilling of Monterey's first horizontal, multi-stage fracture completion well at Brassey during the third quarter, the Corporation also drilled 3 wells at Laprise (2.25 net) during the third quarter, while drilling and completing wells in the Squirrel area during the first half of 2008.

Exploration and development expenditures during the first nine months of 2008 were focused on building the Corporation's project inventory through the acquisition of undeveloped crown lands, participation in the drilling and tie-in of three wells in the Corporation's new Smoky project area located in Alberta, and two wells in NEBC at Squirrel and Nig. Nearly all of the undeveloped lands acquired during the first quarter were located in British Columbia targeting the tight gas Montney formation. Second quarter activities were primarily directed to the completion of a horizontal well, using multi-stage fracturing techniques, and the drilling of an unsuccessful well, both wells were located in the Squirrel area of NEBC.



COMMITMENTS

As at December 31, 2008 Monterey has the following contractual obligations:

Recognized Less
in than
financial 1 1 - 3 4 - 5 After 5
($000's) statements Year years years years Total
----------------------------------------------------------------------------
Credit Facility(1) Yes $ 35,286 $ - $ - $ - $ 35,286
Asset retirement(2) Yes 304 707 620 6,581 8,212
Leases No 529 745 700 290 2,264
----------------------------------------------------------------------------
Total $ 36,119 $ 1,452 $ 1,320 $ 6,871 $ 45,762
----------------------------------------------------------------------------
(1) Excludes interest due to the floating interest rate on the Facility.
(2) Asset retirement costs shown are undiscounted.


Qualified Exploration Expenditures

In connection with the October 30, 2007 flow-through share issuance, Monterey had a commitment to spend approximately $5,653,000 on eligible Canadian exploration expenditures prior to December 31, 2008. As at December 31, 2008, the Corporation has fulfilled its flow-through spending commitment.

Leases

In association with the acquisition of Upper Lake, Monterey is committed to future payments under an operating sublease for office space and parking facilities totaling approximately $2.0 million ($0.4 million per year until October 30, 2014). In addition to the office lease, Monterey also assumed a capital lease obligation on oil and gas equipment that expires at the end of March 2010, with a total obligation of approximately $0.2 million.

Ferrybank Commitment

During August 2008, Monterey entered into a farm-in agreement with an arm's-length third party, whereby Monterey was committed to drill a test well in the Ferrybank area of Alberta, and assume an abandonment liability of an existing well of the other party to the farm-in agreement. Under the terms of the farm-in agreement, Monterey was required to fulfill its commitments on or before October 31, 2008 or pay a penalty of approximately $500,000 to the arm's-length third party. During the fourth quarter of 2008, Monterey fulfilled its obligations under this farm-in by drilling a successful well that was placed on production in January 2009.

Brassey Farmout

As at December 31, 2008, the Corporation had fulfilled its contractual obligations under the December 2006 farmout agreement ("Brassey") with an unrelated third party (the "Farmor") oil and gas corporation. Under Brassey, Monterey was committed to incur $16.0 million in exploration, development and equipping expenditures prior to the end of 2008 to earn the Farmor's working interest in the farmout lands subject to an 8% gross overriding royalty (payable to the Farmor) on production from the Brassey lands.

RELATED PARTY TRANSACTIONS

Legal Services

A director of Monterey is a partner at a law firm that provides legal services to the Corporation. During 2008, the Corporation had incurred and paid approximately $210,000 (2007 - $47,879) in legal services received from this related party. At December 31, 2008 Monterey had approximately $10,000 in accrued liabilities for legal fees incurred, but not yet billed to the Corporation.

Corporate Shareholder

During the year, the Corporation had transactions totaling approximately $479,000 (2007 - $102,000) with an entity that holds approximately 24% of the outstanding common shares of Monterey. The transactions primarily consisted of Monterey's participation in the joint exploration, development and production of petroleum and natural gas properties. All transactions were completed on an arm's length basis consistent with normal industry terms. The value of the transactions between Monterey and the related party were recorded at the carrying amount, which approximated their fair value. At December 31, 2008, Monterey's records include $6,000 in accounts receivable and $26,000 in accounts payable with this corporate shareholder.

Corporate Management and Directors

Certain directors of Monterey are also the directors or management of other entities that participate in joint operations with the Corporation. Transactions with these related parties are on terms that are consistent with parties dealing at arm's-length. During 2008, the aggregate value of transactions entered into between Monterey and these entities was approximately $5,458,000 (2007 - $1,094,000), and Monterey had outstanding payables to the related parties of $53,000 and accounts receivables due to Monterey of approximately $206,000 at December 31, 2008.

Seismic Services

The Corporation periodically purchases seismic data from a seismic company in which a Monterey director is a director. All purchases made by Monterey are at terms consistent with those that would be transacted by arm's-length parties. During the year ended December 31, 2008, Monterey had transactions with the related party totaling approximately $346,000 ($65,000 - December 31, 2007). At December 31, 2008 the Corporation did not have any outstanding payable or receivable amounts with this related party.

SUBSEQUENT EVENTS

Asset disposition

On January 30, 2009 Monterey completed the disposal of non-core oil and gas properties in the Dawson area of northeast British Columbia for proceeds of approximately $6.0 million. The undeveloped properties had associated proved plus probable reserves at December 31, 2008 of approximately 1.0 mmboe, with no associated production. The proceeds from the disposition were used to reduce bank indebtedness.

New bank facility

As discussed in detail under Bank indebtedness of the Liquidity and Capital Resources section of this MD&A, in March 2009, upon the request of Monterey, the Lender of the Corporation's demand revolving credit facility performed the annual review of the Facility. As a result of the review, Monterey and the Lender agreed upon the $45 million New Facility.

OUTLOOK

The Corporation is maintaining its previous announced 2009 capital expenditure guidance of $10 million with $4-5 million being allocated to the first half of the year. With this first half capital program, production is expected to decline modestly from the current levels of approximately 2,400 boe/d. Monterey's production for the first six months of 2009 is forecast to average 2,200 boe/d, which is slightly higher than the 2,130 boe/d recorded in the fourth quarter of 2008.

During this time of continued uncertainty in the credit and equity markets as well as extreme volatility in the commodity prices of both oil and natural gas, the Corporation will continue to conserve capital and preserve balance sheet strength to maintain financial flexibility while moving forward the key projects that have the potential of adding significant future value to the entity. Monterey has a high quality producing asset base and a deep inventory of drill ready natural gas prospects and will continue to execute its business plan in a manner focused on adding value to Monterey's current and future shareholders.

SENSITIVITY ANALYSIS

Monterey's financial performance is impacted by changes in production and the business environment. The table below indicates the key factors impacting Monterey's financial performance for the first six months of 2009. The table below indicates Monterey's assumptions and the impact to funds flow from operations over the January 1, 2009 to June 30, 2009 period as a result of a change in each key item.



Impact on
Funds flow from
Monterey operations
Variable Assumption Variance ($000's)
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Natural gas production 10.5 - 11.5 mmcf/d 1.0 mmcf/d 525
Natural gas prices $5.67 mcf $1.00/mcf 1,725
WTI oil price $42.50US $1.00US 50
Foreign exchange rate $ 1.25Cdn : $1.00US $0.01Cdn 150
Bank prime lending rate 2.66% 1.00% 2


QUARTERLY SUMMARY INFORMATION

----------------------------------------------------------------------------
----------------------------------------------------------------------------
(in thousands, except for Three Months Ended
commodity prices, per share -----------------------------------------
amounts, or unless otherwise Dec. 31, Sept. 30, Jun. 30, Mar. 31,
noted) 2008 2008 2008 2008
----------------------------------------------------------------------------

Average sales volumes:
Light oil and NGL (bbl/d) 453 292 181 241
Natural gas (mcf/d) 10,058 8,400 6,598 7,168
----------------------------------------------------------------------------
Oil equivalent (boe/d) 2,130 1,691 1,280 1,435
----------------------------------------------------------------------------

Average sales prices:
Light oil and NGL ($/bbl) $ 51.78 $ 101.08 $ 105.92 $ 83.07
Natural gas ($/mcf)(1) $ 7.35 $ 10.24 $ 9.03 $ 7.09
----------------------------------------------------------------------------
Oil equivalent ($/boe)(1) $ 45.75 $ 68.45 $ 62.03 $ 49.34
----------------------------------------------------------------------------

Financial:
Production revenue(1) $ 8,965 $ 10,652 $ 7,227 $ 6,444
Operating income(1) $ 4,191 $ 6,445 $ 4,163 $ 3,301
Funds flow from operations $ 3,694 $ 3,345 $ 4,417 $ 3,547
Net earnings / (loss) $ (2,110) $ 1,301 $ 601 $ 1,111
Total capital expenditures $ 10,900 $ 40,930 $ 2,165 $ 12,586
Net current surplus / (deficit) $ (2,414) $ (7,486) $ (3,961) $ (5,874)
Bank debt $ 35,510 $ 22,606 $ 18,038 $ 18,227
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Per share:
Funds flow from operations:
Basic $ 0.11 $ 0.12 $ 0.18 $ 0.14
Diluted $ 0.11 $ 0.12 $ 0.17 $ 0.14
Earnings / (loss):
Basic $ (0.06) $ 0.05 $ 0.02 $ 0.04
Diluted $ (0.06) $ 0.05 $ 0.02 $ 0.04
----------------------------------------------------------------------------

Share data:
Outstanding:
Common shares 32,903 32,903 25,107 20,046
Non-voting common shares - - - 5,061
----------------------------------------------------------------------------
Total outstanding 32,903 32,903 25,107 25,107

Equalization warrants - - - -

Stock options 3,136 2,771 2,151 2,151
----------------------------------------------------------------------------

Total diluted shares outstanding 36,039 35,674 27,258 27,258
----------------------------------------------------------------------------
Weighted average:

Basic 32,903 27,818 25,107 25,058

Diluted 32,904 27,818 25,329 25,255
----------------------------------------------------------------------------
----------------------------------------------------------------------------


----------------------------------------------------------------------------
----------------------------------------------------------------------------
(in thousands, except for Three Months Ended
commodity prices, per share -----------------------------------------
amounts, or unless otherwise Dec. 31, Sept. 30, Jun. 30, Mar. 31,
noted) 2007 2007 2007 2007
----------------------------------------------------------------------------

Average sales volumes:
Light oil and NGL (bbl/d) 212 288 234 248
Natural gas (mcf/d) 7,969 7,484 8,055 6,111
----------------------------------------------------------------------------
Oil equivalent (boe/d) 1,540 1,535 1,577 1,267
----------------------------------------------------------------------------

Average sales prices:
Light oil and NGL ($/bbl) $ 80.32 $ 67.84 $ 62.30 $ 60.77
Natural gas ($/mcf)(1) $ 6.54 $ 6.00 $ 8.45 $ 7.82
----------------------------------------------------------------------------
Oil equivalent ($/boe)(1) $ 44.95 $ 42.17 $ 52.49 $ 49.83
----------------------------------------------------------------------------

Financial:
Production revenue(1) $ 6,366 $ 5,957 $ 7,531 $ 5,682
Operating income(1) $ 3,126 $ 3,716 $ 4,221 $ 3,058
Funds flow from operations $ 2,588 $ 3,327 $ 3,283 $ 2,653
Net earnings / (loss) $ (1,101) $ (113) $ 597 $ 1,420
Total capital expenditures $ 3,615 $ 12,956 $ 3,286 $ 16,160
Net current surplus / (deficit) $ (1,517) $ (4,492) $ 516 $ 2,526
Bank debt $ 13,625 $ 14,875 $ 10,170 $ 3,380
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Per share:
Funds flow from operations:
Basic $ 0.11 $ 0.14 $ 0.14 $ 0.11
Diluted $ 0.11 $ 0.14 $ 0.11 $ 0.09
Earnings / (loss):
Basic $ (0.04) $ (0.00) $ 0.03 $ 0.06
Diluted $ (0.04) $ (0.00) $ 0.02 $ 0.05
----------------------------------------------------------------------------

Share data:
Outstanding:
Common shares 19,993 18,378 18,378 18,378
Non-voting common shares 5,061 5,061 5,061 5,061
----------------------------------------------------------------------------
Total outstanding 25,054 23,439 23,439 23,439

Equalization warrants - - 5,266 5,266

Stock options 2,296 1,676 1,676 1,676
----------------------------------------------------------------------------

Total diluted shares outstanding 27,350 25,115 30,381 30,381
----------------------------------------------------------------------------
Weighted average:

Basic 24,528 23,439 23,439 23,439

Diluted 24,684 23,474 29,023 28,961
----------------------------------------------------------------------------
----------------------------------------------------------------------------
(1) Includes gains and losses from financial instruments


AUDITED FINANCIAL STATEMENTS

MONTEREY EXPLORATION LTD.
Balance Sheet
($000's)

December 31, December 31,
2008 2007
----------------------------------------------------------------------------
Assets
Current assets:
Cash and cash equivalents $ - $ 7
Accounts receivable 4,980 3,015
Prepaid expenses and deposits 681 540
----------------------------------------------------------------------------

5,661 3,562

Property and equipment (Note 5) 141,458 87,416
----------------------------------------------------------------------------

$ 147,119 $ 90,978
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Liabilities and Shareholders' Equity
Current liabilities:
Bank indebtedness (Note 6) $ 35,286 $ 13,625
Accounts payable and accrued liabilities 8,075 5,079
Obligation under capital lease (Note 12) 179 -
----------------------------------------------------------------------------

43,540 18,704

Obligation under capital lease (Note 12) 45 -
Asset retirement obligations (Note 7) 4,471 2,366

Shareholders' equity:
Share capital (Note 8) 92,944 65,193
Contributed surplus (Note 8) 3,678 3,177
Retained earnings 2,441 1,538
----------------------------------------------------------------------------

99,063 69,908
----------------------------------------------------------------------------
Commitments (Note 12)
Subsequent events (Note 14)
$ 147,119 $ 90,978
----------------------------------------------------------------------------
----------------------------------------------------------------------------

See accompanying notes to the financial statements


Approved on behalf of the Board:

(signed) "Chris G. Webster" (signed) "William V. Bradley"
Chris G. Webster, Director William V. Bradley, Director


Monterey Exploration Ltd.
Statements of Earnings and Retained Earnings
For the year ended
($000's)

December 31, December 31,
2008 2007
----------------------------------------------------------------------------
Revenues:
Production $ 33,949 $ 24,806
Royalties (6,037) (4,114)
Realized gain (loss) on financial instruments (662) 731
Interest 15 65
----------------------------------------------------------------------------

27,265 21,488
----------------------------------------------------------------------------
Expenses:
Operating 8,119 6,344
Transportation costs 1,033 957
General and administrative 2,510 2,435
Interest 1,034 595
Depreciation, depletion and accretion 15,348 11,662
----------------------------------------------------------------------------

28,044 21,993
----------------------------------------------------------------------------
Loss before income taxes: (779) (505)
Future income tax recovery (Note 10) 1,682 1,311
----------------------------------------------------------------------------
Net earnings 903 806
Retained earnings, beginning of year 1,538 732
----------------------------------------------------------------------------

Retained earnings, end of year $ 2,441 $ 1,538
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Net earnings per share (Note 8)
Basic and diluted $ 0.03 $ 0.03
----------------------------------------------------------------------------

See accompanying notes to the financial statements


Monterey Exploration Ltd.
Statements of Cash Flows
For the year ended
($000's)

December 31, December 31,
2008 2007
----------------------------------------------------------------------------

Cash provided by (used in):

Operating activities:
Net earnings $ 903 $ 806
Items not requiring cash from operations:
Stock-based compensation 435 695
Depreciation, depletion and accretion 15,348 11,662
Future income tax recovery (1,682) (1,311)
Asset retirement expenditures (442) (99)
Change in non-cash working capital items
(Note 11) (3,085) 674
----------------------------------------------------------------------------

11,477 12,427
----------------------------------------------------------------------------

Financing activities:
Increase in bank indebtedness 21,661 13,625
Share issue costs (395) (446)
Issue of common shares 123 5,653
Obligation under capital lease repayments (57) -
Change in non-cash working capital items
(Note 11) - (37)
----------------------------------------------------------------------------

21,332 18,795
----------------------------------------------------------------------------

Investing activities:
Property and equipment additions (33,049) (28,536)
Oil and natural gas property acquisitions (377) (7,990)
Oil and natural gas property dispositions 1,582 509
Upper Lake Oil & Gas Ltd. transaction costs
(Note 4) (649) -
Change in non-cash working capital items
(Note 11) (323) (2,432)
----------------------------------------------------------------------------

(32,816) (38,449)
----------------------------------------------------------------------------

Change in cash and cash equivalents (7) (7,227)
Cash and cash equivalents, beginning of year 7 7,234
----------------------------------------------------------------------------

Cash and cash equivalents, end of year $ - $ 7
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Supplemental cash flow disclosure (Note 11)

See accompanying notes to the financial statements


MONTEREY EXPLORATION LTD.
Notes to the Financial Statements
For the year ended December 31, 2008


1. NATURE OF OPERATIONS AND RE-ORGANIZATION

Monterey Exploration Ltd. (the "Corporation" or "Monterey") is incorporated under the Business Corporations Act (Alberta) and is engaged in the acquisition, exploration, development and production of natural gas, natural gas liquids and crude oil in the Western Canadian Sedimentary Basin.

2. SIGNIFICANT ACCOUNTING POLICIES

a) Basis of presentation

Management has prepared the financial statements in accordance with Canadian generally accepted accounting principles and all amounts are stated in Canadian dollars, except where otherwise indicated.

b) Measurement uncertainty

The preparation of financial statements requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. Actual amounts could differ from those estimates.

The amounts recorded for stock-based compensation, depletion, depreciation and accretion, the provision for asset retirement obligations and determining whether the carrying value of oil and natural gas interests is impaired are based upon estimates of proved oil and natural gas reserves, production rates, commodity prices, future costs and other relevant assumptions. Future income tax expense is calculated using income tax rates based on the estimated timing of reversal of temporary differences between accounting and tax values of certain assets and liabilities and involves forecasting the amount of the future income tax asset that will be realized. By their nature, these estimates are subject to measurement uncertainty, and the impact on the financial statements of future periods could be material.

c) Cash and cash equivalents

Cash and cash equivalents are composed of cash and short-term investments with original maturities of less than three months.

d) Joint operations accounting

A portion of Monterey's exploration, development and production activities are conducted jointly with others and accordingly the financial statements reflect only the Corporation's proportionate working interest in such activities.

e) Oil and natural gas properties and equipment

i) Capitalized costs:

Monterey follows the full cost method of accounting, whereby all costs associated with the exploration and development of oil and natural gas reserves are capitalized in cost centers on a country-by-country basis. Such costs include lease acquisition costs, geological and geophysical costs, carrying charges of non-producing properties, costs of drilling both productive and non-productive wells, the cost of petroleum and natural gas production equipment and overhead charges directly related to exploration and development activities. Gains or losses are not recognized upon the disposition of oil and natural gas properties unless crediting the proceeds against accumulated costs would result in a change in the rate of depletion and depreciation by 20% or more.

ii) Depletion and depreciation:

Costs capitalized under the full cost method of accounting, together with estimated future capital costs associated with proved reserves, are depreciated and depleted using the unit-of production method which is based on gross production and estimated proved oil and natural gas reserves as determined by independent reserve evaluators. When proved reserves are assigned or the property is considered impaired the costs of the property or the amount of the impairment is added to the costs subject to depletion. For purposes of the depletion and depreciation calculations, oil and natural gas reserves are converted to a common unit of measure on the basis of their relative energy content, being six thousand cubic feet of natural gas to one barrel of oil equivalent. The cost of unproven properties is excluded from the depreciation and depletion base. These unproven properties are assessed periodically to ascertain if impairment has occurred.

Depreciation of office furniture and equipment is provided for over the estimated useful lives of the assets using the declining balance method at a rate of 25%.

iii) Ceiling Test:

Oil and natural gas properties and equipment are evaluated at least annually at year-end to determine whether the carrying amount in a cost centre is recoverable and does not exceed the fair market value of the properties in the cost centre. The carrying amounts are assessed to be recoverable when the sum of the undiscounted cash flows expected from the properties and the lower of cost and market of unproved properties exceeds the carrying amount of the cost centre. When the carrying amount is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying amount of the cost centre exceeds the sum of the discounted cash flows expected from the production of proved plus probable reserves, and the lower of cost and market of unproved properties of the cost centre. The cash flows are estimated using expected future product prices and costs and are discounted using a risk free interest rate.

f) Asset retirement obligations

The Corporation records a liability for the fair value of legal obligations associated with the abandonment of oil and gas properties in the period in which they are incurred, normally when the asset is purchased or developed. Upon recognition of the liability there is a corresponding increase in the carrying amount of the related asset known as the asset retirement cost which is depleted on a unit-of production basis over the life of the reserves. The liability is adjusted each reporting period to reflect the passage of time, with accretion charged to earnings, and for revisions to the estimated future cash flows. Actual costs incurred upon the settlement of the obligations are charged against the liability.

g) Flow-through shares

The Corporation may finance a portion of its exploration and development activities through the issuance of flow-through common shares. Under the terms of the flow-through share agreements, the resource expenditures deductions for income tax purposes are renounced to subscribers in accordance with the appropriate income tax legislation. A future income tax liability is recorded and share capital is reduced by the estimated tax benefits transferred to the flow-through common share subscribers at the time the qualifying expenditures are renounced to such subscribers.

h) Revenue recognition

Revenue for the sale of oil and natural gas production of the Corporation is recognized based on volumes delivered to customers at contractual delivery points and rates, whereby title passes from the Corporation to its customers and collection of funds is reasonably assured.

i) Stock-based compensation

The Corporation has an equity incentive plan that is described in Note 8c). The Corporation accounts for its stock-based compensation plan using the fair value method. Under the fair value method, the fair value of stock options is charged to earnings over the vesting period with a corresponding increase in contributed surplus. The fair value of options granted is estimated at the date of grant using the Black-Scholes evaluation model. Upon the exercise of the stock option, consideration paid by the option holder together with the amount previously recognized in contributed surplus, is credited to share capital.

j) Income taxes

Monterey follows the asset and liability method of accounting for income taxes. Under this method, income tax liabilities and assets are recognized for the estimated income tax consequences attributable to differences between the amounts reported in the financial statements of Monterey and its respective tax base using substantively enacted future income tax rates. The effective change in income tax rates on future income tax liabilities and assets is recognized in income in the period in which the change occurs. Temporary differences arising on acquisitions result in future income tax assets and liabilities. Future income tax assets are recognized to the extent that realization of such assets is more likely than not.

k) Per share amounts

Basic per share amounts are calculated using the weighted average number of common shares outstanding. The treasury stock method is used to determine the dilutive effect of stock options and other dilutive instruments. This method assumes that the proceeds from the exercise of "in-the-money" stock options plus the unamortized stock-based compensation are used to repurchase the Corporation's shares at the weighted average market price during the period.

l) Financial instruments

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument to another entity. Upon initial recognition, all financial instruments, including all derivatives, are recognized on the balance sheet at fair value. Subsequent measurement is then based on the financial instruments being classified into one of five categories: held for trading, held to maturity, loans and receivables, available for sale, and other financial liabilities. "Held for trading" financial assets and financial liabilities are measured at fair value with changes in fair value recognized in earnings / (loss). Financial assets classified as being "Available for sale" are measured at fair value, with changes in fair value recognized in other comprehensive income/loss. "Held to maturity" financial assets and "loans and receivables" and "other financial liabilities" are measured at amortized cost.

The Corporation may enter into certain financial derivative or physical delivery sales contracts in order to reduce its exposure to market risks from fluctuations in commodity prices. These instruments are not used for trading or speculative purposes. The Corporation will not designate its financial derivative contracts as effective accounting hedges. As a result, all financial derivative contracts will be classified as held for trading and will be recorded on the balance sheet at fair value, with changes in the fair value recognized in petroleum and natural gas revenue. Settlements of financial derivative contracts will be recognized in petroleum and natural gas revenue at the time each transaction under contract is settled.

Also from time to time, Monterey may enter into physical delivery sales contracts, for the purpose of receipt or delivery of oil or natural gas. Settlements of physical sale contracts will be recognized in petroleum and natural gas sales at the time of the settlement and there will be no recognition of fair value on the balance sheet.

m) Changes in accounting policies

On January 1, 2008 the Corporation adopted the new Section 3862, "Financial Instruments - Disclosures" and Section 3863, "Financial Instruments - Presentation" issued by the CICA. These new sections replace Section 3861, "Financial Instruments - Disclosure and Presentation", and place greater emphasis on disclosure of risks arising from financial instruments and how the entity manages its exposure.

Section 3862 details the required disclosures for the assessment of the significance of financial instruments to an entity's financial position and performance, in addition to the nature and extent of risks arising from financial instruments to which the entity is exposed and how the entity plans to mitigate those risks.

Section 3863 establishes standards for the presentation of financial instruments and non-financial derivatives. It carries forward the presentation related requirements of Section 3861.

On January 1, 2008 Monterey adopted the new Section 1535, "Capital Disclosures", issued by the CICA. The section establishes standards for disclosing information regarding an entity's capital and how it is managed. The new account standard addresses only disclosures and has no impact on the Corporation's financial results.

On January 1, 2008 Section 3031 - Inventories requires the measurement of inventories at the lower of cost and net realizable value with additional guidance on the determination of cost, including allocation of overheads and other costs to inventory. Monterey's adoption of the standard in 2008 did not result in an impact to the valuation of the Corporation's inventory as at January 1, 2008 or to Monterey's reported earnings for the current or prior periods.

On January 1, 2009, Monterey will be required to adopt Section 3064 "Goodwill and Other Intangible Assets" issued by the CICA. Under the new accounting standard, criteria for the recognition, measurement and disclosure of Goodwill and Other Intangible Assets are clarified.

On or before January 1, 2011, Monterey will be required to adopt Section 1582 "Business Combinations". Adoption of the section intends to enhance the relevance, reliability and comparability of information reporting entities provide in financial statements about business combinations and their effects. The section establishes criteria for the recognition and measurement of identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree, and goodwill (if any) acquired in the business combination or a gain from a bargain purchase. The section also specifies disclosure requirements concerning business combinations.

On January 1, 2011, the Corporation will be required to adopt International Financial Reporting Standards ("IFRS") and prepare its financial statements under this new set of standards, thereby replacing the preparation of Monterey's financial statements using Canadian generally accepted accounting principles.

3. FINANCIAL INSTRUMENTS

At December 31, 2008, Monterey's financial instruments include cash and cash equivalents, accounts receivable, accounts payable, bank indebtedness and capital leases. The Corporation's financial instruments have been classified accordingly: i) held for trading - cash and cash equivalents, and ii) loans and receivables - accounts receivable, and iii) other liabilities - accounts payable and bank indebtedness.

The Corporation's derivative financial instruments are initially recorded at their fair value, and are subsequently marked to market, while Monterey's loans and receivables are recorded at their amortized cost.

Monterey has exposure to market risk, credit risk, and liquidity risk. A discussion of how the Corporation is exposed and manages each type of risk is noted below:

a) Market risk

(i) Commodity price risk:

The Corporation is primarily exposed to market risk in the form of commodity price volatility. Monterey's objective for commodity price risk management is to ensure that sufficient protection exists to enable the Corporation to meet budgeted capital expenditures in the event of downward movements in commodity prices. The Corporation's Board of Directors ("Board") has authorized Management to enter into forward financial and physical risk management contracts on Monterey's production. Management may, subject to approval by the Corporation's Board, commit up to 50 percent of Monterey's annualized, production before royalties as reported in the most recently completed calendar quarter to a forward risk management contract. In addition, the term of any commodity contract cannot exceed a period of two years.

During the first quarter of 2008, the Corporation entered into three fixed price derivative contracts associated with future production. The fixed price contracts expired on October 31, 2008 with a total realized loss of $0.7 million being recorded during 2008. As at December 31, 2008, the Corporation did not have any outstanding commodity contracts with respect to the sale of Monterey's sales production.

(ii) Interest rate risk:

Monterey's capital and operating expenditures are funded by any combination of the following: bank indebtedness, working capital, cash flow from operations and the issuance of equity. To the extent that expenditures are funded by incurring additional bank indebtedness, the Corporation has a contractual obligation to repay those funds borrowed plus interest on those borrowings. Changes in Canadian interest rates result in variation in the interest expense on funds borrowed by the Corporation.

Monterey's Board manages the Corporation's exposure to interest rate risk by restricting budgeted expenditures, and in turn controlling the amount of bank indebtedness that Monterey may incur. The Corporation may also minimize its exposure to interest rate risk by issuing equity or selling assets to reduce bank indebtedness or by fixing the interest rate on short-term borrowings through the issue of guaranteed notes.

At December 31, 2008, Monterey had total bank indebtedness of approximately $35.3 million. Assuming that the Corporation maintained its existing bank indebtedness for one year, a 1.00% change in Canadian interest rates would result in a variance of approximately $0.4 million in Monterey's average annualized interest expense.

b) Credit risk

A substantial majority of Monterey's petroleum and natural gas production is marketed under standard industry terms, with a pre-arranged monthly settlement day for payment of revenues from Monterey's purchasers of its sales volumes. As a result, the Corporation is exposed to credit risk as a financial loss would result if Monterey's customers or joint venture partners failed to meet their contractual obligations to reimburse the Corporation for its accounts receivables. At December 31, 2008, approximately $0.3 million, or 6% of the Corporation's accounts receivables were over 90 days, with a significant majority of receivables outstanding for less than 30 days. Since inception, the Corporation has never written off an accounts receivable amount to bad debt expense.

Monterey's accounts receivable are with established customers and joint operating partners in the petroleum and natural gas industry and are subject to normal industry credit risks.

Monterey's policy is to manage its credit risk by transacting with customers and entities that have good established credit ratings, and by diversifying its sales with a large group of customers.

The Corporation may further mitigate its credit risk by withholding production from joint venture partners in the event of non-payment. At December 31, 2008, Monterey did not have a provision for doubtful accounts as the majority of its receivables have been outstanding for less than 30 days, and the Corporation has a favorable collection history.

c) Liquidity risk

Liquidity risk is the risk that Monterey cannot meet its financial obligations as they come due. During times of extreme downward volatility in commodity prices, the Corporation manages this risk by maintaining total net debt (bank debt plus capital lease obligation and non-cash working capital deficit or less non-cash working capital surplus) below the size of the Corporation's total available borrowings under its credit facility. The Corporation may reduce its net debt through the issuance of equity, the disposal of assets and by reducing anticipated capital expenditures to an amount less than cash flow generated from operations.

Under normal circumstances, the Corporation will manage its liquidity risk by maintaining a ratio of total net debt to estimated forward cash flow (being the current month cash flow from operations plus asset retirement expenditures, changes in non-cash working capital and adjusted for one time or extraordinary items, the net amount is then annualized) of less than 2.5. Should the ratio calculated exceed 2.5 the Board and Management of Monterey can reduce capital expenditures, or endeavor to issue equity, or seek buyers for the Corporation's assets to reduce the Corporation's net debt to meet the net debt to forward cash flow ratio of 2.5. As at December 31, 2008 the ratio of net debt to forward cash flow is less than 2.5.

4. ACQUISITION OF UPPER LAKE OIL & GAS LTD. ("UPPER LAKE")

On August 29, 2008, Monterey acquired all of the common shares of Upper Lake, a Canadian publicly traded oil and gas exploration corporation active in the Western Canadian Sedimentary Basin, through the issuance of 7,795,704 common shares at a total fair value of approximately $29,513,000 ($30,162,000 including transaction costs).

The acquisition was accounted for using the purchase method, with results of operations included from the date of acquisition. The allocation of the purchase price is based on Management's best estimate and information available at the time of preparing these audited financial statements; when the allocation is finalized, changes could be material. The allocation to assets and liabilities is as follows:



($000's)
----------------------------------------------------------------------------
Purchase consideration:
Issue of common shares $ 29,513
Transaction costs 649
----------------------------------------------------------------------------

Total purchase consideration $ 30,162
----------------------------------------------------------------------------
----------------------------------------------------------------------------

($000's)
----------------------------------------------------------------------------
Net assets acquired:
Oil and natural gas properties $ 36,347
Working capital deficit (1,826)
Bank indebtedness (2,469)
Obligations under capital lease (280)
Asset retirement obligation (1,610)
----------------------------------------------------------------------------

Net assets acquired $ 30,162
----------------------------------------------------------------------------
----------------------------------------------------------------------------


5. PROPERTY AND EQUIPMENT

Accumulated
depletion and
($000's) Cost depreciation Net book value
----------------------------------------------------------------------------
Oil and natural gas properties $ 175,118 $ 33,935 $ 141,183
Office furniture and equipment 387 112 275
----------------------------------------------------------------------------

December 31, 2008 $ 175,505 $ 34,047 $ 141,458
----------------------------------------------------------------------------
----------------------------------------------------------------------------


Accumulated
depletion and
($000's) Cost depreciation Net book value
----------------------------------------------------------------------------
Oil and natural gas properties $ 106,295 $ 19,009 $ 87,286
Office furniture and equipment 185 55 130
----------------------------------------------------------------------------

December 31, 2007 $ 106,480 $ 19,064 $ 87,416
----------------------------------------------------------------------------
----------------------------------------------------------------------------


During the year ended December 31, 2008, Monterey capitalized, to the cost of oil and natural gas properties, approximately $1,279,000 of general and administrative expenses that were directly related to exploration and development activities (2007 - $1,485,000). This amount includes approximately $258,000 (2007 - $533,000) of non-cash expenditures comprised of $175,000 (2007 - $357,000) of stock-based compensation expenses and $83,000 (2007 - $176,000) in future income tax liability associated with the stock-based compensation that is without tax basis.

Undeveloped property costs of $9,718,000 were excluded from the depletion and depreciation calculation of oil and natural gas properties at December 31, 2008 (2007 - $6,065,000). Future costs of $24,042,000 to develop proved undeveloped reserves have been included in the depletion and depreciation calculation of oil and natural gas properties at December 31, 2008 (2007 - $15,376,000).

The Corporation has performed the ceiling test as at December 31, 2008 to assess the recoverable value of the property and equipment. The crude oil and natural gas future prices are based on the January 1, 2009 commodity price forecast of Monterey's independent reserve evaluators as outlined in the following table. Based on these assumptions, the undiscounted value of the future net revenues from the Corporation's estimated proved reserves exceeded the carrying value or property and equipment as at December 31, 2008.



----------------------------------------------------------------------------
WTI Edmonton Monterey's AECO Monterey's Exchange
Oil Price Oil Price Oil Price Gas Price Gas Price Rate
Year ($US/bbl) ($Cdn/bbl) ($Cdn/bbl) ($Cdn/mmbtu) ($Cdn/mcf) ($US/$Cdn)
----------------------------------------------------------------------------
2009 57.50 68.61 60.84 7.58 7.66 1.212
2010 68.00 78.94 72.07 7.94 8.04 1.176
2011 74.00 83.54 77.40 8.34 8.50 1.143
2012 85.00 90.92 85.30 8.70 8.90 1.081
2013 92.01 95.91 90.69 8.95 9.17 1.053
2014 93.85 97.84 92.81 9.14 9.38 1.053
2015 95.73 99.82 94.96 9.34 9.60 1.053
2016 97.64 101.83 97.12 9.54 9.81 1.053
2017 99.59 103.89 99.31 9.75 10.03 1.053
2018 101.59 105.99 101.93 9.95 10.28 1.053
2019+ +2.00% escalation per year 1.053
----------------------------------------------------------------------------


6. BANK INDEBTEDNESS, BANK DEBT & DERIVATIVES FACILITY

The Corporation has access to a demand revolving credit facility (the "Facility") of $45 million and a derivatives facility with a Canadian banking institution (the "Lender"). The Facility permits Canadian and U.S. dollar borrowings to finance the Corporation's operations.

During 2008, Monterey made drawings against the Facility in the form of prime based loans and guaranteed rate term notes with maturities not exceeding 90 days. As at December 31, 2008, Monterey had bank indebtedness of approximately $35.3 million (2007 - $13.6 million) from prime based loan borrowings.

Borrowings are subject to a maximum amount equal to Monterey's borrowing base as calculated by the Lender. The Corporation's borrowings may be made in the form of: (i) prime based loans in multiples of $25,000, bearing interest at the Lenders' annual prime rate, payable on the last day of each month; (ii) U.S. prime based loans in U.S. dollars in multiples of $25,000 U.S. dollars, bearing interest at the Lenders U.S. prime rate, payable on the last day of each month; (iii) issue of up to $25 million in guaranteed notes with terms up to one year and in multiples of $100,000, subject to a minimum of $1.0 million, the guaranteed notes bear interest equal to the lender's base rate plus 1.25% per annum; (iv) LIBOR based loans in U.S. dollars with terms from 30 to 180 days and in multiples of $100,000, subject to a minimum of $1.0 million U.S. dollars, bearing interest at LIBOR rate plus 1.25% per annum; and (v) letters of credit/guarantee for periods of up to one year for a fee of 1.25% per annum subject to a minimum fee of $200 per letter of credit/guarantee. Monterey pays a monthly stand-by fee of 0.125% per annum on the average unused portion of the Facility.

The Lender has the right to demand repayment of all borrowings at any time without notice or terminate the availability of the unused portion of the Facility five business days after serving notice to the Corporation. Monterey has the right to draw against the Facility, repay amounts borrowed or convert the type of borrowings subject to providing same day notice for borrowings less than $5.0 million and one business day notice for borrowings of $5.0 million or more.

The Facility is guaranteed by a Monterey general security agreement providing a floating charge on all the Corporation's lands and a security interest over all present and subsequently acquired personal property. Under the terms of the Facility, Monterey is obligated to meet certain covenants including providing certain financial and engineering information in a timely manner, the Facility does not require Monterey to meet any specific numerical financial covenants, such as a debt to equity ratio or minimum working capital or liquidity amounts.

The Lender reviews the Facility at least annually. The next annual review is scheduled to be completed prior to June 1, 2009.

The Facility permits Monterey to enter into U.S. foreign exchange forward contracts or interest and commodity derivatives contracts with the Lender. The Facility includes covenants that limit the commodity derivatives contracts entered into by the Corporation to a maximum of 50% of Monterey's annualized net production as reported in the most recently completed calendar quarter and that the term of any commodity contract will not exceed a period of two years.

At Management's request the Lender conducted the annual review of the Facility in March 2009. As a result of the review Monterey and the Lender agreed to a new $45 million demand revolving credit facility (the "New Facility") more fully described in Note 14. The annual review of the New Facility is scheduled to be completed prior to June 1, 2010.

7. ASSET RETIREMENT OBLIGATIONS

Monterey's asset retirement obligation results from net ownership interests in oil and natural gas properties including well sites, gathering systems, compression and processing facilities. The Corporation estimates that at December 31, 2008 the total undiscounted amount of cash flows required to settle its asset retirement obligations is approximately $8.2 million (inflation adjusted). The timing for settlement of these obligations is based on the economic lives of the underlying assets. The majority of the costs associated with the asset retirement obligations are anticipated to be incurred between the next 15 to 20 years. Monterey used a credit-adjusted risk-free rate of 8.75% and an inflation rate of 2% to calculate the fair value of the asset retirement obligations.

The changes in the asset retirement obligation for the year ended December 31, 2008, is as follows:



Year ended Year ended
($000's) December 31, 2008 December 31, 2007
----------------------------------------------------------------------------
Balance, beginning of year $ 2,366 $ 2,244

Liabilities incurred and acquired 1,729 223
Liabilities disposed (23) -
Accretion expense 364 246
Liabilities settled (442) (99)
Revisions 477 (248)
----------------------------------------------------------------------------

Balance, end of year $ 4,471 $ 2,366
----------------------------------------------------------------------------
----------------------------------------------------------------------------


8. SHARE CAPITAL

a) Authorized

Monterey is authorized to issue an unlimited number of common shares and unlimited number of non-voting common shares.



b) Issued
Common shares Number ($000's)
----------------------------------------------------------------------------
Voting common shares, December 31, 2006 18,378,066 53,486
Non-voting common shares, December 31, 2006 5,061,096 8,003
----------------------------------------------------------------------------

Voting and non-voting shares, December 31, 2006 23,439,162 $ 61,489
----------------------------------------------------------------------------
February 28, 2007 flow-through share
renouncement - (1,649)
October 30, 2007 flow-through share private
placement 1,615,000 5,653
Issue costs, net of income tax benefit of
$147,000 - (300)
----------------------------------------------------------------------------
Voting common shares, December 31, 2007 19,993,066 57,190
Non-voting common shares, December 31, 2007 5,061,096 8,003
----------------------------------------------------------------------------

Voting and non-voting common shares,
December 31, 2007 25,054,162 $ 65,193
----------------------------------------------------------------------------
February 29, 2008 flow-through share
renouncement - (1,710)
Exercise of stock options 52,634 123
Exercise of stock options, from contributed
surplus - 109
Issued to acquire Upper Lake (Note 4) 7,795,704 29,513
Issue costs, net of income tax benefit of
$111,000 - (284)
----------------------------------------------------------------------------

Share capital, December 31, 2008 32,902,500 $ 92,944
----------------------------------------------------------------------------
----------------------------------------------------------------------------


(i) Common shares

During the first quarter of 2008, 52,634 common shares were issued from treasury following the exercise of stock options. Cash proceeds of approximately $123,000 were received upon the exercise of options.

On February 29, 2008, in association with the October 30, 2007 flow-through share issuance, the Corporation renounced $5,653,000 of exploration expenditures with a future income tax liability of approximately $1,710,000.

(ii) Reorganization of non-voting common shares

During the second quarter of 2008, the shareholders of Monterey voted in favor of reorganizing the Corporation's capital structure. Under the reorganization, Monterey's outstanding non-voting shares were exchanged on a one-to-one basis for common shares of the Corporation, thus eliminating the non-voting shares of Monterey from the Corporation's share capital.

(iii) Common shares held in escrow

At December 31, 2008, there were 5,061,096 Common Shares held by directors, management, employees and consultants (the "Service Providers") of the Corporation held in escrow pursuant to an escrow agreement dated December 29, 2005. The common shares are scheduled to be released from escrow on the date that is the earlier of:

a. September 4, 2009 being the first anniversary date that the Corporation's common shares were listed on a recognized stock exchange; and

b. January 12, 2009.

These common shares will also be released from escrow upon the death of the Service Provider or upon a change of control of Monterey. In addition, if a holder of the common shares ceases to be a Service Provider then a certain number, as determined in the escrow agreement, of the Service Provider's shares will be released from escrow and Monterey will have the right, but not the obligation, to purchase for cancellation a portion, as determined by the escrow agreement, of the Service Provider's common shares for a price equal to the lesser of:

a. the market price (weighted average price of the common shares on a recognized stock exchange for the five trading days immediately preceding the Service Provider's final service date); or

b. the original amount paid by the Service Provider to subscribe for the unvested common shares.

In accordance with the terms of the escrow agreement all of the 5,061,096 Common Shares held in escrow were released on January 12, 2009.

c) Stock options

Monterey has established a stock option plan whereby employees, management, directors and consultants may be granted options to purchase common shares. Options granted vest in equal amounts annually over a three-year period and expire five years from the date of grant. The stock options outstanding may not exceed 10% of the outstanding common shares.

The following table provides a summary of the outstanding stock options as at December 31, 2008:



Weighted average
exercise price
Number ($ per share)
----------------------------------------------------------------------------

Outstanding, December 31, 2006 1,555,000 $2.37
----------------------------------------------------------------------------
Options issued 749,000 3.00
Options forfeited (8,334) (2.33)
----------------------------------------------------------------------------

Outstanding, December 31, 2007 2,295,666 $2.58
----------------------------------------------------------------------------
Options exercised (52,634) (2.33)
Options forfeited (262,366) (2.58)
Options issued 1,155,000 1.33
----------------------------------------------------------------------------

Outstanding, December 31, 2008 3,135,666 $2.12
----------------------------------------------------------------------------


The following table summarizes the stock options outstanding and exercisable
under the stock option plan at December 31, 2008:

Options outstanding Options exercisable
----------------------------------------------------------------------------
Number Weighted
outstanding average Weighted Number Weighted
Range of at remaining average exercisable at average
exercise December contractual exercise December exercise
prices 31, 2008 life price 31, 2008 price
----------------------------------------------------------------------------

$0.55 535,000 5.0 $ 0.55 - $ 0.55
$2.00 - $2.90 2,479,666 3.1 $ 2.39 1,485,002 $ 2.41
$3.49 121,000 3.1 $ 3.49 40,334 $ 3.49
----------------------------------------------------------------------------
3,135,666 3.4 $ 2.12 1,526,336 $ 2.46
----------------------------------------------------------------------------
----------------------------------------------------------------------------


d) Stock-based compensation

The Corporation uses the fair value based method for the determination of the stock-based compensation costs. The fair value of each option granted was estimated on the date of grant using the Black-Scholes option pricing model. In 2007 and prior years, the Corporation was private and determined the share price volatility using the minimum value method.

During the year ended December 31, 2008, 1,155,000 (2007 - 749,000) stock options were granted to directors and employees of the Corporation. In the pricing model used to determine the value of the option grants during 2008, the following average metrics were used: risk free interest rate used for options granted was 2.7% (2007 - 3.9%), volatility of 66.0% (2007 - 0.0%), an expected life of 5.0 years and no dividends (2007 - 5.0 years and no dividends). The average fair value of the options issued in 2008 was determined to be $0.65 per option (2007 - $0.60).

e) Contributed surplus

The following table reconciles the contributed surplus at December 31, 2008:



($000's)
----------------------------------------------------------------------------
Balance, December 31, 2007 $ 3,177
Stock-based compensation recognized during 2008 610
Stock options exercised during 2008 (109)
----------------------------------------------------------------------------
Balance, December 31, 2008 $ 3,678
----------------------------------------------------------------------------
----------------------------------------------------------------------------


f) Per share amounts

For the year ended December 31, 2008 there were 27,735,885 basic and 27,736,277 diluted weighted average shares outstanding. For the year ended December 31, 2007 there were 23,713,491 basic and 23,878,617 diluted weighted average shares outstanding.

9. CAPITAL DISCLOSURES

Effective January 1, 2008, Monterey adopted CICA Handbook Section 1535 - Capital Disclosures. Monterey's objectives for managing its capital consist of:

a. Providing an adequate level of return to shareholders of the Corporation, relative to the risk of Monterey's assets.

b. Preserving a strong balance sheet with sufficient capital from shareholders to develop existing and prospective assets.

Monterey's main objective is to build a profitable growing energy corporation. As such, the Corporation's primary capital management objective is to promote investor, lender and stakeholder confidence that Monterey is able to meet its obligations and will continue to carry on its business.

Monterey manages its capital structure by issuing new equity or debt, adjusting planned capital spending, or through the sale of assets to reduce debt. Processes primarily utilized to effectively manage capital include ongoing calculation of certain key financial ratios such as total debt to equity and net debt (Note 3) to forward cash flow (Note 3) and comparing the Corporation's ratios against: (i) accepted prudent financial management ratios; (ii) the ratios of similar sized publicly listed entities operating in the Canadian upstream oil and gas industry; and (iii) the anticipated business environment, opportunities and the operations of the Corporation. In addition to the key financial ratios Monterey will also periodically review other measures such as net asset value, funds flow per share and debt adjusted funds flow per share to provide additional indications that that the Corporation's capital structure supports investor, lender and stakeholder confidence.

At December 31, 2008, the Corporation's share capital exceeded total liabilities by approximately $48.0 million, had a total debt to equity ratio of 0.48, a net debt to forward cash flow ratio of 2.46 on net debt of $37.9 million and met its objectives on the management of capital resources.

10. INCOME TAXES

The provision for income tax differs from the result that would be obtained by applying the applicable statutory federal and provincial income tax rates to net earnings before income taxes. This difference results from the following items for the year ended December 31, 2008 and December 31, 2007:



($000's) 2008 2007
----------------------------------------------------------------------------
Loss before income taxes $ (779) $ (505)

Combined federal and provincial statutory tax rate 30.24% 32.93%
----------------------------------------------------------------------------

Expected income tax recovery $ (235) $ (166)

Increase (decrease) resulting from the tax effect of:
Stock-based compensation expense 131 229
Other 3 22
Effect of change in enacted income tax rate 879 1,305
Change in valuation allowance (2,460) (2,701)
----------------------------------------------------------------------------
Income tax recovery $ (1,682) $ (1,311)
----------------------------------------------------------------------------
----------------------------------------------------------------------------


The components of the Corporation's future income tax assets and
liabilities, as at December 31, 2008 and December 31, 2007 are as follows:


($000's) 2008 2007
----------------------------------------------------------------------------
Future income tax assets:
Share issue costs $ 416 $ 493
Non-capital losses 15,966 20,657
Asset retirement obligation 1,148 628
Valuation allowance (16,471) (18,931)
----------------------------------------------------------------------------
$ 1,059 $ 2,847

Future income tax liability:
Property and equipment (1,059) (2,847)
----------------------------------------------------------------------------

Net future income tax asset $ - $ -
----------------------------------------------------------------------------
----------------------------------------------------------------------------


At December 31, 2008, subject to confirmation by income tax authorities, Monterey has approximately $198,581,000 of income tax deductions, including non-capital losses of approximately $57,488,000, available for application against future taxable income. The full benefit of which has not been included in these financial statements.

The Corporation's non-capital losses, if not utilized, expire as follows:



($000's)
----------------------------------------------------------------------------
2009 $ 12,519
2010 15,986
2011 28,318
2012 665
----------------------------------------------------------------------------

Non-capital losses available $ 57,488
----------------------------------------------------------------------------
----------------------------------------------------------------------------


11. SUPPLEMENTAL CASH FLOW INFORMATION

a) Increase (decrease) in non-cash working capital items:

Year Year
ended ended
($000's) Dec 31, 2008 Dec 31, 2007
----------------------------------------------------------------------------
Change in non-cash working capital:
Accounts receivable $ 3,451 $ 1,657
Prepaid expenses and deposits 355 (116)
Accounts payable (7,214) (3,336)
----------------------------------------------------------------------------
$ (3,408) $ (1,795)
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Changes in non-cash working capital related to:
Operating activities $ (3,085) $ 674
Financing activities - (37)
Investing activities (323) (2,432)
----------------------------------------------------------------------------
$ (3,408) $ (1,795)
----------------------------------------------------------------------------
----------------------------------------------------------------------------


b) Supplementary cash flow information:

Year Year
ended ended
($000's) Dec 31, 2008 Dec 31, 2007
----------------------------------------------------------------------------
Interest paid $ 962 $ 590
----------------------------------------------------------------------------


12. COMMITMENTS

a) Office lease

In association with the acquisition of Upper Lake, Monterey is committed to future payments under an operating lease for head office space and parking facilities totaling approximately $2.0 million until October 30, 2014. Of this total, Monterey has committed lease payments of $350,000 for each of the years from 2009 to 2013, and $292,000 million in 2014.

b) Capital lease

Upon the acquisition of Upper Lake, Monterey assumed an existing capital lease obligation with an April 2010 expiry. The implicit interest rate for the lease is 7.56% per annum and the leased equipment is the underlying security to the agreement. During 2009, Monterey is committed to monthly lease payments totaling approximately $179,000, with remaining monthly payments totaling $45,000 from January 2010 until the end of March 2010.

13. RELATED PARTY TRANSACTIONS

a) Legal services

A director of Monterey is a partner at a law firm that provides legal services to the Corporation. During 2008, the Corporation incurred approximately $210,000 (2007 - $47,879) in legal services and disbursements received from this related party. At December 31, 2008 Monterey's accrued liabilities include $10,000 (2007 - $43,000) to the law firm for legal fees and disbursements which have not been billed.

b) Transactions with shareholder

During the year, the Corporation had transactions totaling approximately $479,000 (2007 - $102,000) with an entity that holds approximately 24% of the outstanding common shares of Monterey. The transactions primarily consisted of Monterey's participation in the joint exploration, development and production of petroleum and natural gas properties. All transactions were completed on an arm's length basis consistent with normal industry terms. The value of the transactions between Monterey and the related party were recorded at the carrying amount, which approximated their fair value. At December 31, 2008, Monterey's records include $6,000 in accounts receivable (2007 - $58,000) and $26,000 in accounts payable (2007 - $19,000) with this corporate shareholder.

c) Common management and directors

Certain directors of Monterey are also the directors or management of other entities that participate in joint operations with the Corporation. Transactions with these related parties are on terms that are consistent with parties dealing at arm's-length. During 2008, the aggregate value of transactions entered into between Monterey and these entities was approximately $5,458,000 (2007 - $1,094,000), and Monterey had outstanding payables to the related parties of $53,000 and accounts receivables due to Monterey of approximately $206,000 at December 31, 2008 (2007 - $nil receivable and payable).

The Corporation periodically purchases seismic data from a seismic company in which a Monterey director is a director. All purchases made by Monterey are at terms consistent with those that would be transacted by arm's-length parties. During the year ended December 31, 2008, Monterey had transactions with the related party totaling approximately $346,000 (2007 - $65,000). At December 31, 2008 the Corporation did not have any outstanding payable or receivable amounts with this related party (2007 - $nil receivable and payable).

14. SUBSEQUENT EVENTS

a) Asset disposition

In January 2009, Monterey disposed of undeveloped properties to an unrelated third party for cash proceeds of approximately $6.0 million. The proceeds from the disposition will initially be used to reduce bank indebtedness, and subsequently to fund a portion of the Corporation's 2009 capital expenditure program.

b) New Bank Credit Facility

In March 2009, upon the request of Monterey, the Lender of the Corporation's demand revolving credit facility (the "Facility), as described in Note 7, performed the annual review of the Facility. As a result of the review, Monterey and the Lender negotiated a new bank credit facility (the "New Facility"). Subject to completion of necessary documentation and the payment of a $0.1 million facility commitment fee Monterey will continue to have the ability to borrow from the Lender up to $45 million in the form of: (i) revolving prime based and US prime based borrowing in multiples of $25,000; (ii) issue of guaranteed notes and LIBOR borrowing subject to minimum borrowings of $1 million and additional amounts in multiples of $0.1 million having terms to maturity from 15 to 365 days from the date of issue; and (iii) letters of credit/guarantee for a period of up to one year. The New Facility will also continue Monterey's access to the previously established derivates facility.

Under the New Facility interest rates on: (i) Canadian and US dollar prime based borrowing will be at the applicable Lender's prime lending rate plus 1.25%; (ii) on the issue of guaranteed notes or LIBOR borrowing Monterey will pay the base rate plus a stamping fee of 2.5% per annum; and a fee equal to 1.25% per annum, payable at issue, on letters of credit/guarantee. Monterey borrowings in excess of $40.5 million will incur interest at an additional 1% per annum. Monterey will also pay a monthly stand-by fee on the average unused portion of the New Facility at a rate of 0.35% per annum.

The covenants and requirements under the New Facility remain unchanged from those in the existing Facility. The annual review of the New Facility is scheduled to be completed prior to June 1, 2010.

Contact Information

  • Monterey Exploration Ltd.
    Patrick Manuel
    President and Chief Executive Officer
    (403) 691-7725
    or
    Monterey Exploration Ltd.
    David Fisher
    Vice President, Finance & Chief Financial Officer
    (403) 691-7725
    Website: www.montereyexploration.com