Pearl Exploration and Production Ltd.
TSX : PXX

Pearl Exploration and Production Ltd.

February 27, 2009 02:30 ET

Pearl Announces 2008 Fourth Quarter and Annual Financial and Operating Results

CALGARY, ALBERTA--(Marketwire - Feb. 27, 2009) - Pearl Exploration and Production Ltd. ("Pearl" or the "Company") (TSX:PXX)(FIRST NORTH:PXXS) is pleased to announce its financial and operating results for the three and twelve months ended December 31, 2008.

Highlights include:

- 9% increase in 2008 daily average production volumes to 7,672 barrels per day despite selling properties that were producing 3,200 barrels per day of production during the year;

- Property dispositions of $79 million; allowing the Company to eliminate its long term debt;

- 333% increase in cash flow from operations to $72.1 million, or $0.38 per share;

- Increased our working interest to 80% at the Blackrod SAGD project and was named operator;

- Initiated two cyclic steam pilots at Onion Lake and commenced a pilot polymer flood at Mooney;

- Maintained a strong balance sheet with $6.5 million in working capital and an unused $47 million credit facility.

John Festival, new President of Pearl, commenting on the results, indicated that "2008 was an extremely volatile year for the Company. During the first nine months Pearl achieved record levels of revenues and cash flow; however, we then saw a major shift in market conditions during the fourth quarter as the recession deepened, and oil and gas prices fell quite dramatically. As a result of the downward market shift we elected to stop most of our capital programs until prices improve. Fortunately we have a strong balance sheet with no debt which will help us ride out the current low price environment."

Operations Review

Total capital expenditures in 2008 were $107.4 million. This included the drilling of 37 wells and construction of various facilities.

Mooney

Mooney is a conventional heavy oil property in northern Alberta. In 2008, Pearl produced 2,108 boe per day at Mooney. The Company has an approximate 98% working interest in this property. In 2008, Pearl drilled twelve horizontal development wells on the property. In addition, the Company initiated a pilot polymer flood at Mooney. This included converting two wells to polymer injectors and constructing injection facilities. The objective of the polymer flood is to re-pressure the reservoir which could improve production rate as well as increase overall recoveries. We are starting to see a positive response from this pilot and we will continue to monitor results over the next few months. During 2008, the Company also installed an amine facility to eliminate CO2 from the gas stream. In addition to the potential from these EOR projects there is an additional 25-50 conventional development locations to be drilled at Mooney, as well as additional resource to be delineated.

Onion Lake

Onion Lake is a core heavy oil property located in Saskatchewan near Lloydminster. During 2008, Pearl produced an average of 2,274 boe per day from 50 wells on the property. Pearl has an 87.5% to 100% working interest in 41 sections of land. Pearl initiated two single well cyclic steam stimulation ("CSS") pilots at Onion Lake in 2008.Positive results were achieved from both pilots. Each well had flow rates in excess of 200 barrels of oil per day. The second CSS cycle is expected to be completed by the end of March and the Company will use the information obtained to make a decision on commercial development of a CSS project. In addition to the potential CSS projects the Company has the potential of over 100 conventional development locations at Onion Lake.

Blackrod

Blackrod is a SAGD opportunity covering 12,800 acres (20 sections) in the Athabasca oil sands. In 2008, we increased our ownership from 30% to 65% by purchasing additional interests from our partners in the project. In early 2009, we further increased our interest to 80%. Pearl has also been designated operator of the project. We also acquired, at crown land sales, 19,840 acres (31 sections) of land adjacent to the Blackrod property. In 2009, we plan to drill 10-15 strat wells to better define the resource and to gather water source and water disposal information. In addition, in 2009, we plan to continue to advance our application for a one to three well SAGD pilot with regulatory authorities. Commencement of construction of the Blackrod pilot would not begin before 2010.

San Miguel

San Miguel is a heavy oil prospect in Texas. We undertook two steam pilots on the property during 2008.The first, the Saner pilot utilized the Fractured Assisted Steam Technology with horizontal wells and vertical wells. The second pilot was a single well pair SAGD test. In 2009, for economic and technical reasons, Pearl and its partner elected to shutdown both pilots. No further work is planned at San Miguel in the near future.

Production Volumes

Pearl's crude oil and natural gas production volumes increased by 9% in 2008, averaging 7,672 boe per day compared with an average of 7,029 boe for the 15 months ended December 31, 2007. The increase is primarily attributable to the continued development of the Onion Lake and Mooney fields.

Production in 2008 was impacted by the sale of oil and gas properties during the second quarter. At the time of the sale, the properties sold were producing approximately 3,200 boe per day. As a result of the property sale, production in the second half of the year was lower than the average for the year. Fourth quarter production averaged 6,198 boe per day.



-----------------------------------------------------------------------
Year 15 months
Three months ended ended ended
December 31, December 31,
------------------------ ---------------------
Production 2008 2007 2008 2007
-----------------------------------------------------------------------
Oil and NGL's (bbl/day)
Onion Lake 2,220 1,879 2,217 1,168
Mooney 1,595 2,069 1,674 1,674
Salt Lake 380 264 389 261
Ear Lake 366 309 360 424
Other 391 3,198 1,542 1,783
-----------------------------------------------------------------------
4,952 7,719 6,182 5,310
-----------------------------------------------------------------------
Natural gas (mcf/day)
Mooney 2,761 2,198 2,605 1,764
Long Coulee 1,972 2,682 2,233 3,275
Salt Lake 1,078 677 794 1,960
Other 1,667 5,177 3,310 3,310
-----------------------------------------------------------------------
7,478 10,734 8,942 10,309
-----------------------------------------------------------------------
Total Production (boe/d) 6,198 9,507 7,672 7,029
-----------------------------------------------------------------------


Oil and Gas Reserves

The following tables summarize the Company's oil and gas reserves as at December 31, 2008. The reserve report was prepared by DeGolyer and MacNaughton Canada Limited ("DeGolyer"). The 2008 reserves have decreased from 2007. In Canada, as a result of the slowdown in activities and the uncertainty of when these activities will re-commence, reserves booked in the past for development activities and enhanced oil recovery programs (such as waterfloods) were removed from the reserve base. Reserves from these activities will be recognized as we undertake the development work in the future. The decrease in US reserves was based on a review of technical results of 2008 activities, primarily at San Miguel and Fiddler Creek.

The complete list of schedules required under National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities will be included in our filing of the Annual Information Form.



Summary of Oil and Gas Reserves - Forecasted Prices and Costs

Canada United States Total
--------------------------------------------------------------------------
--------------------------------------------------------------------------
(Company
interest, Natural Oil & Natural Oil & Natural
before Oil & NGL Gas NGL Gas NGL Gas
royalties) Reserves Reserves Reserves Reserves Reserves Reserves
--------------------------------------------------------------------------
--------------------------------------------------------------------------
(Mbbls) (MMcf) (Mbbls) (MMcf) (Mbbls) (MMcf)
--------------------------------------------------------------------------

Proved
developed
producing 4,078 7,887 4 49 4,082 7,936
Proved
developed
non-producing 1,299 1,771 - - 1,299 1,771
Proved
undeveloped 3,378 579 - - 3,378 579
--------------------------------------------------------------------------
Total proved 8,755 10,237 4 49 8,759 10,286
Probable 14,055 10,757 3 29 14,058 10,786
--------------------------------------------------------------------------
Total proved
plus probable 22,810 20,994 7 78 22,817 21,072
Possible 85,543 10,014 - - 85,543 10,014
--------------------------------------------------------------------------
2008 total 108,353 31,008 7 78 108,360 31,086
--------------------------------------------------------------------------

boe's may be misleading, particularly if used in isolation. In accordance
with NI 51-101, a boe conversion ratio of 6 Mcf: 1barrel is based on an
energy equivalency conversion method primarily applicable at the burner tip
and does not represent a value equivalency at the wellhead.


Net Present Value of Reserves - Forecasted Prices and Costs

Net Present Values of Before Tax Future Net Revenue
----------
Discounted at
--------------------------------------------------------------------------
--------------------------------------------------------------------------
0% 5% 10% 15% 20%
--------------------------------------------------------------------------
($000's)
Proved
Developed producing 120,846 105,089 93,719 85,032 78,147
Developed
non-producing 38,513 30,182 24,462 20,378 17,356
Undeveloped 89,718 60,271 42,083 30,185 22,049
--------------------------------------------------------------------------
Total proved 249,077 195,542 160,264 135,595 117,552
Probable 490,288 305,957 207,200 149,012 112,091
--------------------------------------------------------------------------
Total proved plus
probable 739,365 501,499 367,464 284,607 229,643
Possible 3,126,931 1,188,108 542,140 285,732 167,804
--------------------------------------------------------------------------
Total 3,866,296 1,689,607 909,604 570,339 397,447

--------------------------------------------------------------------------
--------------------------------------------------------------------------

Net Present Values of After Tax Future Net Revenue
---------
Discounted at
--------------------------------------------------------------------------
--------------------------------------------------------------------------
0% 5% 10% 15% 20%
--------------------------------------------------------------------------
($000's)
Proved
Developed producing 120,846 105,089 93,719 85,032 78,147
Developed
non-producing 38,513 30,182 24,462 20,378 17,356
Undeveloped 89,718 60,271 42,083 30,185 22,049
--------------------------------------------------------------------------
Total proved 249,077 195,542 160,264 135,595 117,552
Probable 411,378 266,309 185,862 136,883 104,885
--------------------------------------------------------------------------
Total proved plus
probable 660,455 461,851 346,126 272,478 222,437
Possible 2,314,443 864,793 385,635 197,779 112,838
--------------------------------------------------------------------------
Total 2,974,898 1,326,644 731,761 470,257 335,275
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Notes:
Columns may not add due to rounding

The pricing assumptions used in the DeGolyer evaluation are summarized
below.

Pricing Assumptions - Forecast Prices and Costs


WTI Edmonton Hardisty
Cushing Par Price Bow River Alberta
40 degrees 40 degrees 25 degrees AECO-C Inflation Exchange
Year API API API Spot rate rate
--------------------------------------------------------------------------
--------------------------------------------------------------------------
(US$/bbl) (CDN$/bbl) (CDN$/bbl) (CDN$/MMBtu) (%/yr) (US$/Cdn$)
--------------------------------------------------------------------------
2009 57.00 69.10 51.83 7.31 0.0 0.82
2010 69.53 81.35 61.01 7.99 3.0 0.85
2011 76.38 84.39 63.29 8.09 3.0 0.90
2012 86.99 96.16 73.57 8.47 2.5 0.90
2013 94.74 104.76 81.19 8.67 2.5 0.90
Escalation rate of 2.5% thereafter
Notes:
(1) The pricing assumptions were provided by DeGolyer.
(2) None of the Company's future production is subject to a fixed or
contractually committed price.


Reconciliation of Changes in Reserves

The following table summarizes the changes in the Company's share of oil and natural gas reserves (Company's interest before deducting royalties) from December 31, 2007 to December 31, 2008.



Oil & NGL's (Mbbls)
--------------------------------------------------------------------------
Proved Plus
Probable
Proved Plus Plus
Proved Probable Probable Possible Possible
--------------------------------------------------------------------------
Balance, Dec 31, 2007 19,819 27,041 46,860 142,831 189,691

Production (2,257) - (2,257) - (2,257)
Discoveries - - - - -
Extensions 381 82 463 - 463
Technical Revisions (5,269) (2,223) (7,492) (31,395) (38,887)
Dispositions (2,472) (2,135) (4,607) (324) (4,931)

Economic Factors (1443) (8,708) (10,151) (25,569) (35,720)

--------------------------------------------------------------------------
Balance, Dec 31, 2008 8,758 14,058 22,816 85,543 108,359
--------------------------------------------------------------------------

Natural Gas (MMcf)
--------------------------------------------------------------------------
Proved Plus
Probable
Proved Plus Plus
Proved Probable Probable Possible Possible
--------------------------------------------------------------------------
Balance, Dec 31, 2007 16,537 10,280 26,817 4,528 31,345

Production (3,264) - (3,264) (3,264)
Discoveries - - - -
Extensions 43 8 51 51
Technical Revisions (770) 1,737 967 5,753 6,720
Dispositions (2,572) (1,353) (3,925) (333) (4,258)

Economic Factors 312 114 426 66 492

--------------------------------------------------------------------------
Balance, Dec 31, 2008 10,286 10,786 21,072 10,014 31,086
--------------------------------------------------------------------------


Financial Results

Annual Financial Information

As at and for the period ended
--------------------------------------
12 months 15 months 12 months
ended ended ended
December 31 December 31 September 30
($000s except per share amounts) 2008 2007 2006
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Total revenue 183,536 128,524 3,635
Cash flow from operations(1) 72,120 21,646 (1,247)
Per share - basic 0.38 0.17 (0.03)
Per share - diluted 0.38 0.17 (0.03)
Loss from continuing operations and
net loss (78,862) (227,206) (8,953)
Per share - basic (0.42) (1.73) (0.23)
Per share - diluted (0.42) (1.73) (0.23)
Capital expenditures 107,367 229,247 44,632
Total assets 472,143 575,865 129,067
Working capital 6,451 (34,152) (3,757)
Long-term debt - - 4,976
Cash dividends - - -
Common shares outstanding (000s) 189,242 189,242 51,913
--------------------------------------------------------------------------


Quarterly Financial Information
2008
-------------------------------------------
Q1 Q2 Q3 Q4 Total
--------------------------------------------------------------------------

Production (boe/day) 10,503 8,246 5,776 6,198 7,672
Average wellhead price ($/boe) 60.50 79.74 85.02 36.28 65.36

Revenues ($000s) 57,830 59,839 45,180 20,687 183,536
Net earnings ($000s) (3,790) 6,688 1,926 (83,686)(2) (78,862)
Per share - basic ($) (0.02) 0.04 0.01 (0.44) (0.42)
Per share - diluted ($) (0.02) 0.04 0.01 (0.44) (0.42)
Cash flow from operations
($000s) (1) 19,452 28,023 21,021 3,624 72,120
Per share - basic ($) 0.10 0.15 0.11 0.02 0.38
Per share - diluted ($) 0.10 0.15 0.11 0.02 0.38
Capital expenditures ($000s) 17,512 17,605 39,480 32,770 107,367
Weighted average shares
outstanding (000s) 189,242 189,242 189,242 189,242 189,242

(1) Cash flow from operations before working capital changes and cash flow
per share do not have standardized meanings prescribed by Canadian
Generally Accepted Accounting Principles ("GAAP") and therefore may
not be comparable to similar measures used by other companies. Cash
flow from operations before working capital changes includes all cash
flow from operating activities and is calculated before changes in
non-cash working capital. Cash flow from operations before working
capital changes is reconciled with net loss on the Consolidated
Statement of Cash. Management uses these non-GAAP measurements for its
own performance measures and to provide its shareholders and investors
with a measurement of the Company's efficiency and its ability to fund
a portion of its growth expenditures.

(2) Includes a $57 million writedown of oil and gas properties in the US.


2008 Financial Results

Please note that Pearl changed its year-end in 2007 from September 30 to December 31 so the comparative amounts are for the 15 month period ending December 31, 2007.

In 2008, WTI prices were strong for most of the year with WTI oil averaging US$99.65/bbl compared with US$72.31/bbl in 2007. The increase is attributable to increased worldwide demand combined with tight supplies. Late in the year, as a result of the global recession, demand for oil dropped, resulting in a dramatic decrease in WTI prices. During the fourth quarter of 2008 WTI averaged US$58.73/bbl. Pearl predominately produces heavy oil. Throughout 2008, the WTI/Western Canada Select ("WCS') differential was narrower than 2007. In 2008, the WCS reference price averaged 78% of the WTI price, compared with 68% of the WTI price in 2007.

Overall, oil and gas revenues increased 43% in 2008 to $183.5 million compared with $128.5 million in 2007. The increase is attributable to a 9% increase in boe sales volumes and a 63% increase in the average sales price.



Netbacks (per boe)
--------------------------------------------------------------------------
15 months
Three months ended Year ended Ended
December 31, December 31,
------------------------ ------------------------
2008 2007 2008 2007
--------------------------------------------------------------------------

Revenue $ 36.28 $ 40.30 $ 65.36 $ 40.01
Royalties 7.62 8.95 16.11 8.87
Transportation 1.36 0.95 1.30 1.11
Production costs 18.06 16.96 17.77 15.73
--------------------------------------------------------------------------
Field netback $ 9.24 $ 13.44 $ 30.18 $ 14.30
--------------------------------------------------------------------------


Production costs on a per boe basis averaged $17.77 for the current year which is an increase over the prior fifteen month period average of $15.73. The increase in per unit operating costs for the period is principally due to an increase in fluid hauling, fuel and electricity costs. These costs are related to the WTI price which has increased significantly in 2008. Production costs were also impacted by inflationary pressure due to high demand for services, especially during the first nine months of the year.

General and administrative costs decreased from $19.1 million in 2007 to $15 million in 2008. 2007 is based on a 15 month period and if annualized it is comparable to the 2008 amount.

DD&A expense was $85.4 million or $30.41 per boe for the current year in comparison to $92.6 million or $28.83 per boe for the prior fifteen month period. The higher rate in 2008 is a result of a reduction in proved reserves as detailed in the Company's 2008 reserve report. In addition, as a result of a reduction in oil and gas reserves, the Company was required to take a ceiling test write-down of $57.4 million on its US properties in 2008.

The Company incurred a net loss of $78.9 million or $0.42 per share for the year ended December 31, 2008 compared to a loss of $227.2 million or $1.73 per share for the fifteen months ended December 31, 2007. The net loss for the year is principally a result of the high depletion cost of $85.3 million and a write-down of the US oil and gas assets of $57.4 million.

At December 31, 2008, Pearl was debt-free and had a working capital surplus of $6.5 million.

Fourth Quarter 2008 Results

Crude oil prices decreased by 50% in the fourth quarter 2008 from the third quarter, with WTI oil averaging US$58.73 per barrel. Heavy oil prices dropped more sharply from the third quarter. The Bow River Heavy oil price differential averaged US$17.65 per barrel in the fourth quarter compared to US$16.52 per barrel in the third quarter. The decrease in commodity prices is attributable to the worldwide economic downturn, which has resulted in lower demand for commodities.

The decrease in heavy oil prices during the fourth quarter is also attributable to seasonal fluctuations in heavy oil demand and additional supplies of heavy oil being on the market due to increased production. As a result of these factors Pearl's average wellhead oil price dropped from $95.85 per barrel in the third quarter to $33.73 per barrel in the fourth quarter of 2008.

Pearl sold an average of 6,198 boe of oil per day during the fourth quarter, an increase of 7% over third-quarter levels. The increased sales volumes are attributable to continued development at Mooney and Ear Lake. Production revenues were $20.7 million in the fourth quarter of 2008 compared to $45.2 million in the third quarter, due to the decrease in wellhead prices. Operating costs were comparable to the third quarter, averaging $18.06 per barrel. Cash flow from operations and net earnings(loss) in the fourth quarter were $3.6 million and ($83.7) million, respectively, compared to $21.0 million and $1.9 million, respectively in the third quarter. The reduced cash flow in the fourth quarter of 2008 was due to the decrease in heavy oil prices. The significant net loss in the fourth quarter of 2008 was due to the decrease in revenues and an increase in depletion due to the downward revision of proved reserves on the reserve estimate as at December 31, 2008 and a $57.4 million writedown of the US oil and gas assets due to a ceiling test impairment.

Capital expenditures in the fourth quarter of 2008 were $32.8 million, 19% lower than in the third quarter. The decrease reflects the Company's decision to suspend its capital programs due to deteriorating economic conditions and low oil prices in the fourth quarter.

Annual Meeting

The Company's Annual and Special Meeting of Shareholders is scheduled for 10:00 AM on Wednesday, May 6, 2009 in the Viking Room of the Calgary Petroleum Club at 319 - 5th Avenue S.W., Calgary, Alberta.

Additional information on Pearl is available on the Company's website at www.pearleandp.com.

Pearl's Certified Advisor on First North is E. Ohman J:or Fondkommission AB.

Forward-looking statements: This document contains statements about expected or anticipated future events and financial results that are forward-looking in nature and as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, the regulatory process and actions, technical issues, new legislation, competitive and general economic factors and conditions, the uncertainties resulting from potential delays or changes in plans, the occurrence of unexpected events, and the Company's capability to execute and implement its future plans. Actual results may differ materially from those projected by management. For such statements, we claim the safe harbour for forward-looking statements within the meaning of the Private Securities Legislation Reform Act of 1995.

(1) "Proved" reserves are those reserves that can be estimated with a high degree of certainty to be recoverable. It is likely that the actual remaining quantities recovered will exceed the estimated proved reserves.

(2) "Probable" reserves are those additional reserves that are less certain to be recovered than proved reserves. It is equally likely that the actual remaining quantities recovered will be greater or less than the sum of the estimated proved plus probable reserves.

(3) "Possible" reserves are those additional reserves that are less certain to be recovered than probable reserves. It is unlikely that the actual remaining quantities recovered will exceed the sum of the estimated proved plus probable plus possible reserves.

(4) "Developed" reserves are those reserves that are expected to be recovered from existing wells and installed facilities or, if facilities have not been installed, that would involve a low expenditure (e.g. when compared to the cost of drilling a well) to put the reserves on production.

(5) "Developed Producing" reserves are those reserves that are expected to be recovered from completion intervals open at the time of the estimate. These reserves may be currently producing or, if shut-in, they must have previously been on production, and the date of resumption of production must be known with reasonable certainty.

(6) "Developed Non-Producing" reserves are those reserves that either have not been on production, or have previously been on production, but are shut in, and the date of resumption of production is unknown.

(7) "Undeveloped" reserves are those reserves expected to be recovered from know accumulations where a significant expenditure (for example, when compared to the cost of drilling a well) is required to render them capable of production. They must fully meet the requirements of the reserves classification (proved, probable, possible) to which they are assigned.

(8) The Net Present Value (NPV) based on D&M Forecast Pricing and costs, before taxes, discounted at 10%. The estimated NPV does not necessarily represent the fair market value of our reserves. There is no assurance that forecast prices and costs assumed in the D&M evaluations will be attained, and variances could be material.



PEARL EXPLORATION AND PRODUCTION LTD.

--------------------------------------------------------------------------
Consolidated Balance Sheet as at December 31
(unaudited)
--------------------------------------------------------------------------
(Cdn$ in thousands) 2008 2007
--------------------------------------------------------------------------

Assets
Current assets
Cash $ 24,059 $ 4,799
Accounts receivable 9,536 25,134
Income taxes and capital taxes receivable 5,607 2,618
Prepaid expenses and deposits 1,658 3,196
-----------------------
40,860 35,747

Investments (note 6) 9,619 9,363
Petroleum and natural gas properties (note 7) 421,664 528,352
Future income tax (note 12) - 2,403
-----------------------
$ 472,143 $ 575,865
-----------------------
-----------------------

Liabilities
Current liabilities
Accounts payable and accrued liabilities $ 34,409 $ 69,899

Future income tax (note 12) 4,036 -
Asset retirement obligation (note 9) 20,064 16,586
-----------------------
58,510 86,485
-----------------------

Shareholders' equity
Share capital (note 11) 723,122 723,122
Contributed surplus (note 11) 11,895 8,778
Deficit (321,382) (242,520)
-----------------------
413,635 489,380
-----------------------
$ 472,143 $ 575,865
-----------------------
-----------------------

Commitments and contingencies (note 13)
See accompanying notes to consolidated financial statements


--------------------------------------------------------------------------
Consolidated Statement of Operations, Comprehensive Loss and Deficit
(unaudited)
--------------------------------------------------------------------------
(Cdn$ in thousands) Fifteen
months
Three months ended Year ended ended
December 31, December 31, December 31,
------------------------ ------------------------
2008 2007 2008 2007
----------- ----------- ----------- -----------
Revenue
Oil and gas sales $ 20,687 $ 35,250 $ 183,536 $ 128,524
Interest income 365 551 1,511 1,120
Royalties (4,343) (7,828) (45,192) (28,494)
----------- ----------- ----------- -----------
16,709 27,973 139,855 101,150
----------- ----------- ----------- -----------

Expenses
Production 10,299 14,835 49,907 50,531
Transportation 778 829 3,664 3,567
General and
administrative 5,021 6,356 15,000 19,142
Depletion, depreciation
and accretion 27,679 22,815 85,385 92,620
Writedown of petroleum
and natural gas
properties (note 7) 57,427 - 57,427 -
Stock-based
compensation 920 830 3,116 4,047
Interest 19 708 828 3,710
Change in unrealized
loss of gas pricing
contracts - - - 536
Foreign currency
exchange (gain) loss (690) 61 (466) 501
Gain on investment - - (2,268) -
Writedown of goodwill - 172,921 - 172,921
Writedown of ABCP - - 2,575 -
Loss (gain) on sale of
assets - 8,984 - (4,286)
----------- ----------- ----------- -----------
101,453 228,339 215,168 343,289
----------- ----------- ----------- -----------

Loss before income taxes (84,744) (200,366) (75,313) (242,139)
----------- ----------- ----------- -----------

Income taxes
Future income tax
(recovery) 1,402 (13,138) 4,066 (19,518)
Income taxes and
capital taxes expense
(recovery) (2,460) (3,821) (517) 4,585
----------- ----------- ----------- -----------
(1,058) (16,959) 3,549 (14,933)
----------- ----------- ----------- -----------

Loss and comprehensive
loss for the period (83,686) (183,407) (78,862) (227,206)

Deficit, beginning of
period (237,696) (59,113) (242,520) (15,314)
----------- ----------- ----------- -----------

Deficit, end of period $ (321,382) $ (242,520) $ (321,382) $ (242,520)
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------

Basic and diluted loss
per share $ (0.44) $ (1.01) $ (0.42) $ (1.73)
Weighted average number
of common shares used
in computing loss per
share:
basic and diluted 189,241,716 181,212,075 189,241,716 131,223,521

See accompanying notes to consolidated financial statements


--------------------------------------------------------------------------
Consolidated Statements of Cash Flows
(unaudited)
--------------------------------------------------------------------------
(Cdn$ in thousands) Fifteen
months
Three months ended Year ended ended
December 31, December 31, December 31,
------------------------ ------------------------
2008 2007 2008 2007
----------- ----------- ----------- -----------
Operating activities
Net Loss $ (83,686) $ (183,407) $ (78,862) $ (227,206)
Items not involving cash:
Depletion,depreciation
and accretion 27,679 22,815 85,385 92,620
Writedown of P&NG assets 57,427 - 57,427 -
Stock-based compensation 920 830 3,116 4,047
Writedown of accounts
receivable 990 659 1,815 3,196
Writedown of ABCP - - 2,575 -
Writedown of goodwill - 172,921 - 172,921
Loss (gain) on sale of
assets - 8,984 - (4,286)
Gain on investment - - (2,268) -
Future income tax
(recovery) 1,402 (13,138) 4,066 (19,518)
Change in unrealized
loss of gas pricing
contracts - - - 536
Foreign exchange loss
(gain) (690) 61 (466) 501
Abandonment costs (419) (117) (668) (1,165)
----------- ----------- ----------- -----------
3,623 9,608 72,120 21,646
----------- ----------- ----------- -----------

Changes in non-cash
working capital
balances related to
operations 3,445 (11,901) (2,613) (27,774)
Long term accounts
receivable - - - 1,144
----------- ----------- ----------- -----------
7,068 (2,293) 69,507 (4,984)
----------- ----------- ----------- -----------

Financing activities
Advances of bank loan - - 25,000 66,532
Advance of bridge loan - - - 10,000
Repayments of bank loan - (60,000) (25,000) (171,215)
Proceeds from equity
financings, net of issue
costs - 105,793 - 270,787
Proceeds from sale of
investments - 2,016 - -
Proceeds from exercise of
stock options - - - 708
Proceeds from exercise of
warrants - 102 - -
----------- ----------- ----------- -----------
- 47,911 - 176,812
----------- ----------- ----------- -----------

Investing activities
Additions to petroleum
and natural gas
properties (32,769) (61,779) (107,367) (217,320)
Proceeds from sale of
petroleum and natural
gas properties - - 79,097 -
Acquisition of Watch
Resources Ltd. - (1,736) - (192)
Acquisition of Atlas
Energy Ltd. - - - (2,926)
Acquisition of Cipher
Exploration Inc. - - - (8,808)
Acquisition of Serrano
shares - - - (2,500)
Proceeds from sale of
investments - - - 12,016
Changes in non-cash
working capital from
investing (2,529) 13,437 (21,977) 43,984
----------- ----------- ----------- -----------
(35,298) (50,078) (50,247) (175,746)
----------- ----------- ----------- -----------

Net increase (decrease)
in cash (28,230) (4,460) 19,260 (3,918)
Cash, beginning of
period 52,289 9,259 4,799 8,717
----------- ----------- ----------- -----------
Cash, end of period $ 24,059 $ 4,799 $ 24,059 $ 4,799
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------

Supplementary
Information
Cash interest paid $ 19 $ 708 $ 828 $ 3,654
Cash capital taxes
paid $ - $ 288 $ 1,010 $ 369

See accompanying notes to consolidated financial statements


PEARL EXPLORATION AND PRODUCTION LTD.

Notes to the Consolidated Financial Statements

(unaudited)

(tabular amounts in thousands of Cdn$, except as noted)

1. NATURE OF OPERATIONS

Pearl Exploration and Production Ltd. (collectively with its subsidiaries, the "Company" or "Pearl") is listed and traded on the TSX Exchange under the trading symbol "PXX" and on the First North (OMX Nordic Exchange) under the symbol "PXXS". The Company is engaged in the business of oil and gas exploration, development and production in North America.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in Canada ("Canadian GAAP"). The significant accounting policies used in these consolidated financial statements are as follows:

(a) Consolidation

These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.

(b) Cash and cash equivalents

Cash and cash equivalents include short-term highly liquid interest-bearing investments with maturities of three months or less from the date of acquisition. Cash and cash equivalents are designated as held-for-trading and are carried at fair value.

(c) Measurement Uncertainty

The preparation of consolidated financial statements in conformity with Canadian GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and the disclosure of contingencies. These estimates are subject to measurement uncertainty. Actual results could differ from and affect the results reported in these consolidated financial statements.

Significant estimates used in the preparation of the consolidated financial statements include asset retirement obligations, future income taxes, stock-based compensation, the estimate of oil and gas reserves and the related depletion, depreciation and accretion, asset impairment.

(d) Foreign Currency Translation

The Company's reporting currency is Canadian dollars.

The Company's U.S. operations are considered integrated. Accordingly, the Company uses the temporal method of accounting for the foreign currency transactions of its U.S. subsidiaries. Under the temporal method, monetary assets and liabilities are translated at the exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are translated at the historical exchange rates. Revenues and expenses are translated at the average rate for the period, except for charges related to non-monetary assets which are translated at the historical rate for the assets to which the charge relates, and material items where a specific date can be identified for the transaction which is translated at the rate on that specific date. Exchange gains or losses are included in the determination of net income.

(e) Joint Interests

A substantial portion of the Company's activities are conducted jointly with others through joint ventures. These consolidated financial statements reflect only the Company's proportionate interest in such activities.

(f) Petroleum and Natural Gas Properties

The Company follows the full cost method of accounting for its petroleum and natural gas properties whereby, all costs relating to the exploration for and development of oil and gas reserves are capitalized in country-by-country cost centres and charged against income as set out below. Capitalized costs include lease acquisition costs, geological and geophysical expenditures, costs of drilling exploration and development wells, gathering and production facilities and other development expenditures. Gains and losses are not recognized upon disposition of petroleum and natural gas properties unless such a disposition would alter the rate of depletion by 20 percent or more.

Depreciation, Depletion and Amortization

Capitalized costs, along with estimated future costs to develop proved reserves, are depleted on a unit-of-production basis using estimated proved oil and gas reserves before royalties, as determined by independent engineers. Natural gas reserves and production are converted to equivalent barrels of oil based upon the relevant energy content (6:1). Costs of acquiring and evaluating unproved properties are excluded from costs subject to depletion until it is determined whether proved reserves are attributable to the properties or impairment occurs. Unproved properties are evaluated for impairment on at least an annual basis. If an unproved property is considered to be impaired, the amount of the impairment is added to costs subject to depletion.

Office furniture and equipment is depreciated on the declining balance basis at rates ranging from 10 to 30 percent per year.

Ceiling Test

The net amount at which petroleum and natural gas properties are carried is subject to a cost recovery test (the "ceiling test"). The ceiling test is an impairment test whereby the carrying amount of petroleum and natural gas properties, excluding the cost of unproved properties, is compared to the undiscounted cash flows from proved reserves using future forecast prices, adjusted for the Company's contract prices and quality differentials. If the carrying value exceeds the undiscounted cash flows, an impairment loss would be recorded against income. The impairment is measured as the amount by which the carrying amount of petroleum and natural gas properties exceeds the discounted cash flows from proved and probable reserves. The Company's risk-free interest rate is used to arrive at the net present value of future cash flows.

(g) Revenue Recognition

Revenue from the sale of petroleum and natural gas is recorded when title passes to an external party.

(h) Investments

Long-term investments include interest-bearing investments with maturities longer than one year. Long-term investments whereby the Company has significant influence are accounted for using the equity method. All other long-term investments are designated as held-for-trading and available-for-sale and are carried at fair value (see note 14(a) for classification).

(i) Stock-based Compensation

Stock options granted are accounted for using the fair value method. Fair values are determined, at the grant date, using the Black-Scholes option-pricing model. The compensation expense associated with these options is charged to earnings over the vesting period with a corresponding increase in contributed surplus. On the exercise of stock options, consideration paid and the associated contributed surplus is credited to common shares.

(j) Asset Retirement Obligations

The fair values of estimated asset retirement obligations are recorded as liabilities when incurred and the associated cost is capitalized as part of the cost of the related asset. Over time, the liabilities are accreted for the change in their present value and the initial capitalized costs are depleted on a unit-of-production basis over the life of the reserves. The associated accretion is charged to earnings in the period. Actual expenditures incurred are charged against the accumulated obligation. Revisions to the estimated timing of cash flows or the original estimated undiscounted cost would also result in an increase or decrease to the obligation and related asset.

(k) Earnings per Share

Basic earnings per share is calculated using the weighted average number of common shares outstanding during the year. Diluted earnings per share is calculated based upon the treasury stock method which assumes that any proceeds from the exercise of in-the-money stock options or warrants would be used to purchase the Company's common shares at the average market price during the year (or period if applicable). Diluted earnings per share do not include any anti-dilutive conversions, nor is diluted earnings per share presented where the total effect would be anti-dilutive.

(l) Flow-through Shares

The resource expenditure deductions for income tax purposes related to exploratory activities funded by flow-through share arrangements are renounced to investors in accordance with tax legislation. A future tax liability is recognized upon the filing of the renunciation with the tax authorities and share capital is reduced by the estimated costs of the renounced tax deductions.

(m) Income Taxes

The Company follows the liability method of accounting for income taxes. Under this method, future income tax liabilities and assets are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Future tax liabilities and assets are measured using enacted or substantially enacted tax rates. The effect on future tax liabilities and assets of a change in tax rates is recognized in income in the period that the change occurs.

(n) Goodwill

Goodwill represents the excess purchase price over the fair value of identifiable assets and liabilities acquired in business combinations. Goodwill is not amortized but is assessed for impairment annually at year-end or more frequently if economic events dictate. The test for impairment is conducted by the comparing the book value of the entity to the fair value. If the fair value is less than the book value, impairment is deemed to have occurred. The extent of the impairment is measured by allocation of the fair value of the entity to the identifiable assets and liabilities at their fair values. Any remainder of this allocation is the implied value of goodwill. Any excess of the book value of goodwill over this implied value is the impairment amount. Impairment is charged to earnings in the period in which it occurs.

(o) 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. Financial assets and financial liabilities are recognized on the consolidated balance sheet at the time the Company becomes a party to the contractual provisions. Upon initial recognition, financial instruments are measured at fair value. Measurement in subsequent periods is dependent on the classification of the financial instrument. These instruments will be classified into one of the following five categories: held-for-trading, held-to-maturity, loans and receivables, available-for-sale or other financial liabilities.

Held-for-trading instruments are financial assets and liabilities typically acquired with the intention of generating revenues in the short-term. However, an entity is allowed to designate any financial instrument as held-for-trading on initial recognition even if it would otherwise not satisfy the definition. As at December 31, 2008, the Company does not hold any financial instruments that do not satisfy the definition. Financial assets and financial liabilities required to be classified or designated held-for-trading are measured at fair value, with gains and losses recorded in net earnings for the period in which the change occurs.

Held-to-maturity investments are non-derivative financial assets, with fixed or determinable payments and fixed maturity that an entity has the intention and ability to hold to maturity. These financial assets are measured at amortized cost using the effective interest method. As at December 31, 2008, the Company does not have any financial assets classified as held-to-maturity.

Available-for-sale financial assets are non-derivative assets that are designated as available-for-sale or that are not classified as loans and receivables, held-to-maturity investments or held-for-trading. Available-for-sale financial assets are carried at fair value with unrealized gains and losses included in other comprehensive income (OCI) until such gains or losses are realized or an other than temporary impairment is determined to have occurred. Available-for-sale assets are measured at fair value, except for assets that do not have a readily determinable fair value which are recorded at cost.

Financial assets classified as loans and receivables are measured at amortized cost using the effective-interest method.

Other financial liabilities are measured at amortized cost using the effective interest method and include all liabilities other than derivatives or liabilities that have been identified as held-for-trading.

The Company will assess at each reporting period whether there is any objective evidence that a financial asset, other than those classified as held-for-trading, is impaired.

3. CHANGES IN ACCOUNTING POLICIES

On January 1, 2008, the Company adopted the following CICA Handbook Sections:

- Section 3862 "Financial Instruments - Disclosures" and Section 3863 "Financial Instruments - Presentation," which replace Section 3861 "Financial Instruments - Disclosure and Presentation." The new disclosure standard increases the emphasis on the risks associated with financial instruments and how those risks are managed (See Note 14). The new presentation standard carries forward the former presentation requirements.

- Section 1535 "Capital Disclosures," The new standard requires the Company to disclose its objectives, policies and processes for managing its capital structure (See Note 14(g)).

4. RECENT ACCOUNTING PRONOUNCEMENTS

As of January 1, 2009, the Company will be required to adopt the CICA Handbook Section 3064, "Goodwill and Intangible Assets", which will replace the existing Goodwill and Intangible Assets standard. The new standard revises the requirement for recognition, measurement, presentation and disclosure of intangible assets. The adoption of this standard should not have a material impact on the Company's Consolidated Financial Statements.

In January 2006, the CICA Accounting Standards Board ("AcSB") adopted a strategic plan for the direction of accounting standards in Canada. As part of that plan, accounting standards in Canada for public companies are expected to converge with International Financial Reporting Standards ("IFRS") for fiscal periods commencing on or after January 1, 2011. The Company is assessing the potential impacts of this changeover and developing a plan for the conversion.

In January 2009, the AcSB issued Section 1582, Business Combinations, which replaces former guidance on business combinations. Section 1582 establishes principles and requirements of the acquisition method for business combinations and related disclosures. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after January 2011 with earlier application permitted. The adoption of this standard should not have a material impact on the Company's Consolidated Financial Statements

In January 2009, the AcSB issued Sections 1601, Consolidated Financial Statements, and 1602, Non-controlling Interests, which replaces existing guidance. Section 1601 establishes standards for the preparation of consolidated financial statements. Section 1602 provides guidance on accounting for a non-controlling interest in a subsidiary in consolidated financial statements subsequent to a business combination. These standards are effective on or after the beginning of the first annual reporting period beginning on or after January 2011 with earlier application permitted. The adoption of this standard should not have a material impact on the Company's Consolidated Financial Statements.

5. ACQUISITIONS

(i) Atlas Acquisition - On December 22, 2006 the Company acquired all of the issued and outstanding shares of Atlas Energy Ltd. ("Atlas"), a publicly traded junior oil and gas company with producing and development assets in Western Canada, on the basis of 0.82 of a Pearl share for each Atlas share. The Company issued 55,670,226 common shares at a price of $4.74 per common share, determined based on the weighted average trading price of the Company's common shares shortly before and after the announcement of the acquisition. On January 1, 2007 Atlas was amalgamated with Pearl E&P Canada Ltd.

The consideration, including transaction costs, for the Atlas acquisition totaled $267.0 million. The allocation of the purchase price is as follows:



--------------------------------------------------------------------------
Net assets acquired
Petroleum and natural gas properties $ 243,001
Working capital deficiency (92,046)
Asset retirement obligation (9,389)
Future income tax (12,745)
Goodwill 138,190
--------------------------------------------------------------------------
Total net assets acquired $ 267,011
--------------------------------------------------------------------------

Consideration
Shares 264,085
Acquisition costs, net of interest earned on escrowed funds 2,926
--------------------------------------------------------------------------
Total purchase price $ 267,011
--------------------------------------------------------------------------


(ii) Cipher Acquisition - On March 1, 2007, the Company acquired all the issued and outstanding shares of Cipher Exploration Inc. ("Cipher"), a privately-held oil and gas company with heavy oil assets in western Canada, for a gross purchase price of $18.6 million, including an amount equal to the aggregate of all outstanding long and short term debt of Cipher. At closing, the Company issued 2,047,502 common shares to the Cipher shareholders at a price of approximately $4.78 per share, based on the weighted average trading price of Pearl's shares shortly before and after the announcement of the acquisition, and assumed $8.3 million of debt.

The consideration, including transaction costs, for the Cipher acquisition totaled $18.6 million. The allocation of the purchase price is as follows:



--------------------------------------------------------------------------
Net assets acquired
Petroleum and natural gas properties $ 20,000
Working capital deficiency (2,382)
Asset retirement obligation (1,579)
Future income tax (181)
Goodwill 2,743
--------------------------------------------------------------------------
Total net assets acquired $ 18,601
--------------------------------------------------------------------------

Consideration
Shares 9,792
Repayment of Cipher debt 8,294
Acquisition costs 515
--------------------------------------------------------------------------
Total purchase price 18,601
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(iii) Watch Acquisition - On October 19th, 2007, the Company acquired all of the issued and outstanding shares of Watch Resources Ltd. ("Watch"), a junior oil and gas company with conventional heavy oil interests in north-central Alberta, in an all-share transaction at an exchange ratio of 0.23 common shares of Pearl for each common share of Watch. At closing, the Company issued 10,542,927 common shares of Pearl to former Watch shareholders at a price of $4.76 per share, based on the weighted average trading price of Pearl's shares shortly before and after the announcement of the acquisition.

The consideration, including transaction costs, for the Watch acquisition totaled $51.0 million. The allocation of the purchase price is as follows:



--------------------------------------------------------------------------
Net assets acquired
Petroleum and natural gas properties $ 34,919
Investment 3,863
Working capital deficiency (1,394)
Asset retirement obligation (760)
Future income tax 1,265
Goodwill 13,058
--------------------------------------------------------------------------
Total net assets acquired $ 50,951
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Consideration
Shares 50,184
Stock options 575
Transaction costs 192
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Total purchase price $ 50,951
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(iv) Property Acquisitions and Dispositions

(a) On August 2nd, 2007, the Company purchased a 24% working interest in the Mooney oil field from Ravenwood Energy Corp. ("Ravenwood") for $20 million. After standard industry adjustments, the net purchase price paid was $7.5 million in cash and $7.5 million by the issuance of 1,475,108 Pearl common shares at a price of $5.12 per share. The remaining $5.0 million in consideration was by way of settlement of certain accounts receivables. The price per share was determined based on the weighted average trading price of the shares shortly before and after the announcement of the acquisition.

(b) On November 6th, 2007, the Company acquired heavy oil assets in the states of Montana and Utah from PetroHunter Energy Corporation ("PetroHunter"). The purchase price is a maximum of US $30 million, payable as follows: (a) US $7.5 million in cash at closing; (b) the issuance of up to 2.5 million common shares of Pearl, the equivalent of up to US $10 million based on US $4.00 per share; and (c) a performance payment of US $12.5 million in cash at such time as either: (i) production from the assets reaches 5,000 barrels of oil per day; or (ii) proven reserves from the assets is greater than 50 million barrels of oil. Of the 2.5 million common shares potentially issuable, 1,539,975 were ultimately issued. In addition, 294,117 common shares were issued to a third party as a finder's fee. The outcome of the performance payment could not be determined beyond a reasonable doubt and therefore no value was assigned to it.

(c) In May 2007, the Company sold its Gulf of Mexico leases to Bayou Bend Petroleum Ltd. ("Bayou Bend") in exchange for ten million shares of Bayou Bend having a value of $2.20 per share for total consideration of $22.0 million. The share price was determined based on the trading price of the Bayou Bend shares shortly before and after the acquisition was announced. The disposition of the Gulf of Mexico assets resulted in a gain of $14.3 million The Bayou Bend shares were subsequently sold in two transactions for cash proceeds of $12.0 million, resulting in a loss on sale of $10.0 million.

(d) On May 22, 2008 the Company sold assets in the Lloyminster, Celtic, Pike's Peak and Thunderchild areas of Saskatchewan for approximately $75 million. These assets represented 10% of Pearl's proved plus probable reserves and 30% of existing oil production. The sale resulted in the elimination of the Company's outstanding debt. The sale did not result in a change in the Company's depletion rate by 20% or more and, as a result, no gain or loss was recorded in the financial statements.

(e) On August 20, 2008 the Company acquired an additional 30% interest in the Blackrod area to bring its total interest to 65%. This was done through the acquisition of 100% of the outstanding shares of CODA Holdings Corp ("CODA"). Consideration paid for CODA was $4.5 million in cash and 2.5 million shares of Pearl valued at $0.60 per share. (See note 16(a)).

(f) On December 30, 2008 the Company sold all of its interests in certain lands, including wells, pipelines and other associated equipment located in the Palo Duro Basin area of Texas. In exchange, Pearl received 18,756,414 common shares of Tyner Resources Ltd. These shares are valued at a price of $0.03 per share.

6. INVESTMENTS



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

Investment in Serrano Energy Ltd. ("Serrano") $ 7,768 $ 5,500
Asset-backed commercial paper ("ABCP") 1,288 3,863
Investment in Tyner Resources Ltd. ("Tyner") 563 -
------------------------
$ 9,619 $ 9,363
------------------------


(a) The Company owns 4,037,346 common shares of Serrano. On August 20, 2008, a third party participated in a private placement of common shares in Serrano for an amount of $55.0 million. The Company's ownership position, formerly 37 percent, was reduced to approximately 18 percent. As the shares issued under the placement were sold at a per share price greater than the per share price of the Company's initial investment, the Company recognized a dilution gain of $2.3 million. Subsequent to December 31, 2008, the Company sold its investment in Serrano in exchange for an additional 15% working interest in the Blackrod area lands (see Note 16 (b)).

(b) The Company acquired an investment in ABCP, with a face value of $5 million, as part of the Watch acquisition on October 19, 2007. Prior to the acquisition of Watch, major participants in the third party sponsored ABCP market announced a proposed solution to the liquidity problem in the ABCP market. A restructuring plan was ultimately submitted to the Ontario Superior Court of Justice under the Companies Creditors Arrangement Act (CCAA) which was sanctioned on June 5, 2008. On June 18, 2008 proceedings were taken by a number of corporate noteholders to the Ontario Court of Appeal seeking to challenge the Courts decision that sanctioned the restructuring plan. On August 18, 2008, the Ontario Court of Appeal dismissed the appeal. On September 2, 2008, a number of unsuccessful appellants sought leave to appeal the decision to the Supreme Court of Canada. On September 19, 2008 the Supreme Court announced that it would not grant leave to hear the appeal. The ABCP investment will be converted into notes with maturities matching the underlying assets. The notes will bear interest rates commensurate with the nature of the underlying assets including the cost of a margin funding facility.

At the time of the acquisition of Watch the Company determined that the estimated fair value of the ABCP was $1.1 million less than the face value. The valuation technique used by the Company to estimate the fair value of its investments in ABCP incorporates probability - weighted discounted cash flows considering the best available public information regarding market conditions and other factors that a market participant would consider for such investments. As at September 30, 2008 the Company determined that a further downward adjustment of $2.6 million was required. As at December 31, 2008 no further adjustment is deemed necessary. The historical decrease that has affected all the capital markets provides significant uncertainties regarding the value of the assets which underlie the ABCP, the potential development of a liquid market for the replacement notes and as a result the amount and timing of cash flows and the outcome of the restructuring process may give rise to a further decrease in the value of the Company's investment in ABCP.

On January 21, 2009, the Pan-Canadian Investors Committee implemented the ABCP restructuring plan. Pursuant to the terms of the plan, the Company received the following replacement notes: Class A-1 $ 1.5 million par value, Class A-2 $2.8 million par value, Class B $0.5 million par value, and Class C $0.1 million par value. The interest rate on the replacement Class A and B notes will be Bankers Acceptance rates plus 0.5% per annum, and the interest rates on the Class C notes are Bankers Acceptance rates plus 20% per annum. The notes mature in 2017.

(c) On December 30, 2008 the Company sold all of its interests in certain lands, wells, pipelines and other associated equipment located in the Palo Duro Basin area of Texas. In exchange, Pearl received 18,756,414 common shares of Tyner Resources Ltd. These shares are valued at a price of $0.03. The share price was calculated by using the weighted average share price for the five days before and after the transaction date. The disposition of assets did not result in a change of 20% or more in the company's depletion rate, and, as a result, no gain or loss has been recorded on the dispositions. This investment is subject to equity accounting as significant influence exists.

7. PETROLEUM AND NATURAL GAS PROPERTIES



December 31, 2008
-------------------------------------------
Accumulated
depreciation and
Cost depletion Net book value
Petroleum and natural gas
properties $600,297 $180,581 $419,716
Office equipment 2,739 791 1,948
-------------------------------------------
$603,036 $181,372 $421,664
-------------------------------------------

December 31, 2007
-------------------------------------------
Accumulated
depreciation and
Cost depletion Net book value
Petroleum and natural gas
properties $623,916 $96,764 $527,152
Office equipment 1,520 320 1,200
-------------------------------------------
$625,436 $97,084 $528,352
-------------------------------------------


The depletion and ceiling test calculations have excluded the cost of unproved properties of $31.1 million (December 31, 2007 - $61.0 million) and included the cost of future development costs of $34.7 million (December 31, 2007 - $145.0 million).

The Company performed the ceiling test calculations at December 31, 2008 and 2007 to assess whether the carrying value of the petroleum and natural gas properties were recoverable. At December 31, 2008, the Company realized a significant reduction in the proved plus probable reserves in the US. As a result, the carrying value of these petroleum and natural gas assets have been reduced to reflect the expected future discounted cash flows from existing reserves at estimated market prices as well as expected salvage values of these assets. A writedown in the amount of $57.4 million of the US assets has been reflected in the Company's financial statements. The following represent the prices that were used in the December 31, 2008 ceiling test:



--------------------------------------------------------------------------
Average Price Forecast (1)
2009 2010 2011 2012 2013 2014+(2)
--------------------------------------------------------------------------
WTI ($USD/bbl) 57.00 69.53 76.38 86.99 94.74 2.5%
AECO ($Cdn/mcf) 7.31 7.99 8.09 8.47 8.67 2.5%
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(1) The benchmark prices listed above are adjusted for quality
differentials, heat content, distance to market and other factors in
performing our ceiling test.
(2) Percentage change represents the change in each year after 2013 to the
end of the reserve life.


8. BANK CREDIT FACILITY

The Company has a credit facility with a Canadian chartered bank which is comprised of a $37 million revolving 364-day extendible term facility, and a $10 million demand revolving operating facility. The Company may borrow, repay and re-borrow advances with the aggregated outstanding not to exceed the total credit facility. The facility bears interest at the bank prime rate payable monthly and is secured by a general securities agreement. At December 31, 2008, there were no advances outstanding under this facility.

The facility is subject to annual reviews. The next scheduled review will take place on May 31, 2009.

9. ASSET RETIREMENT OBLIGATION

The total future asset retirement obligation was estimated based on the Company's net ownership interest in all wells and facilities, the estimated costs to abandon and reclaim the wells and facilities and the estimated timing of the costs to be incurred in future periods. The total undiscounted amount of the estimated cash flows required to settle the asset retirement obligations is approximately $34.6 million which will be incurred over the next 28 years with the majority of costs incurred between 2009 and 2024. A credit adjusted risk-free rate of 6.5 percent and an inflation factor of 2 percent was used to calculate the fair value of the asset retirement obligation.

Changes to the asset retirement obligation were as follows:



2008 2007
---------- ----------
Asset retirement obligation at beginning of period $ 16,586 $ 3,772
Liabilities acquired through acquisitions, net of
dispositions (6,464) 9,823
Liabilities incurred during the period 896 2,988
Adjustment for change in reserve life, abandonment
costs, inflation and discount rates 8,545 -
Actual remediation costs (668) (1,165)
Accretion 1,169 1,168
--------------------------------------------------------------------------
Asset retirement obligation at end of period $ 20,064 $ 16,586
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The following significant assumptions were assumed for the purpose of estimating the asset retirement obligations:



2008 2007
---------- ----------
Undiscounted abandonment costs 34,600 32,400
Credit adjusted risk-free rate 6.5% 8%
Inflation rate 2% 1.5%
Average years to reclamation 14 20


10. RELATED PARTY TRANSACTIONS

During the twelve months ended December 31, 2008 the Company entered into the following transactions with related parties in the normal course of business, which are recorded at the exchange amount established and agreed to by the related parties:

(a) The Company paid $81 (2007 - $271) to Tanganyika Oil Company Ltd. ("Tanganyika") for administrative and other services. The Company and Tanganyika had during 2008 certain officers and directors in common. On December 19, 2008, all of the outstanding shares of Tanganyika were sold to a third party. As a result, it is no longer considered to be a related party as of December 31, 2008.

(b) The Company paid $180 (2007 - $117) to Namdo Management Services Ltd. ("Namdo") for executive and support services pursuant to a services agreement. Namdo is a private corporation owned by Lukas H. Lundin, a director of the Company.

11. SHARE CAPITAL

(a) Authorized:

The Company is authorized to issue an unlimited number of common shares.

(b) Common Shares Issued:



--------------------------------------------------------------------------
Number of Attributed
Shares Value
--------------------------------------------------------------------------
Balance as at September 30, 2006 51,913,016 112,614
Shares issued through equity financings (i) 65,553,845 281,850
Shares issued for Atlas acquisition (note 6(i)) 55,670,226 264,086
Shares issued for Cipher acquisition (note 6(ii)) 2,047,502 9,792
Shares issued for Watch acquisition (note 6(iii)) 10,542,927 50,184
Shares issued for property acquisitions
(note 6(iv)) 3,309,200 14,247
Shares issued upon exercise of options 205,000 1,343
Tax effect of flow-through (i) - (3,106)
Share issue costs - (7,888)
--------------------------------------------------------------------------
Balance as at December 31, 2008 and December 31,
2007 189,241,716 723,122
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(c) Warrants Outstanding:



--------------------------------------------------------------------------
Weighted
average
exercise
Number of whole price per
warrants share
--------------------------------------------------------------------------
Outstanding at December 31, 2007 and
September 30, 2006 4,091,800 $ 0.98
Expired (4,091,800) 0.98
--------------------------------------------------------------------------
Outstanding at December 31, 2008 0 $ 0.00
--------------------------------------------------------------------------


(i) Four million warrants were issued pursuant to the acquisition of properties at San Miguel in November 2005. Each warrant entitled the holder to purchase an additional common share of the Company at a price of $1.00, exercisable from the date the San Miguel heavy oil project achieves an average daily producing rate of 5,000 barrels of oil per day, over 30 consecutive days, until November 18, 2008. There was no production by November 18, 2008 and the warrants expired.

(ii) In connection with the December, 2005 Palo Duro acquisition, the Company issued 270,000 warrants. This number was subsequently reduced by 66% to 91,800 when the vendor exercised a back-in right on March 3, 2006. Each remaining warrant provides the warrant holder with the right to receive an additional common share of the Company, within 75 days of September 15, 2008, for no additional consideration, if the average production rate per well drilled in the Palo Duro shale gas project is at least 1.5 million cubic feet equivalent per day, based on the initial 60 days of production. The number of warrants ultimately issued will be reduced pro rata to the actual average production rate if the actual average production rate per well drilled by September 15, 2008 is less than 1.5 million cubic feet equivalent per day. There was no production by September 15, 2008 and the warrants expired.

(d) Stock Options Outstanding

The Company has a stock option plan (the "Plan") available to directors, officers, consultants and employees of the Company and its subsidiaries. Under the Plan, the number of common shares to be reserved and authorized for issuance pursuant to options granted under the Plan cannot exceed ten percent of the total number of issued and outstanding shares in the Company. All issued stock options have terms of two to five years, vest over periods of up to three years and both the term and the vesting period are determined at the discretion of the board of directors. The stock options are exercisable at the market prices of the shares on the dates that the options were granted.



The continuity of stock options issued and outstanding is as follows:

--------------------------------------------------------------------------
Weighted Average
Number of Options Exercise Price ($)
--------------------------------------------------------------------------
Outstanding September 30, 2006 1,752,500 4.11
Granted 6,902,690 4.04
Exercised (205,000) 3.45
Forfeit (723,833) 5.04
--------------------------------------------------------------------------
Outstanding at December 31, 2007 7,726,357 3.98
Granted 6,484,500 0.95
Forfeit (1,620,751) 4.12
Expired (1,451,670) 4.21
--------------------------------------------------------------------------
Outstanding at December 31, 2008 11,138,436 2.16
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The following stock options were outstanding at December 31, 2008:

Options Outstanding Options Exercisable
--------------------------------------------------------------------------

Weighted- Weighted- Weighted- Weighted-
Range of Average Average Average Average
Exercise Exercise Life Exercise Life
Prices ($) Number Price ($) (Years) Number Price ($) (Years)
--------------------------------------------------------------------------

0.40 - 1.50 5,030,000 0.71 4.96 500,000 0.77 4.97
1.51 - 3.00 3,109,500 2.19 4.22 573,333 2.53 3.98
3.01 - 4.50 1,250,936 3.83 2.82 750,936 4.03 2.21
4.51 - 5.28 1,748,000 5.10 3.04 1,100,000 5.13 3.01
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11,138,436 2.16 4.21 2,924,269 3.59 3.33
--------------------------------------------------------------------------


(e) Stock Based Compensation

Stock based compensation expense of $3,116, net of recoveries of $633 for cancelled stock options, has been recorded in the Consolidated Statements of Operations and Deficit for the year ended December 31, 2008 (2007 - $4,047). The fair value of common share options granted is estimated on the date of grant using the Black-Scholes option pricing model. The weighted average fair value of options granted during 2008 and the assumptions used in their determination are noted below:



Year Ended Fifteen Months ended
December 31, 2008 December 31, 2007
---------------------------------------
Weighted average fair value of
stock options granted
(per option) $0.73 $1.65
Expected life of stock
options (years) 5.00 3.44
Volatility (weighted average) 117% 62%
Risk free rate of return
(weighted average) 1.69% 4.00%
Expected dividend yield 0% 0%


(f) Contributed Surplus Continuity



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

Balance, beginning of the period $ 8,778 $ 4,791
Stock-based compensation 3,749 4,637
Stock-based compensation allocated to contributed
surplus as part of Watch acquisition - 575
Recovery of expense on forfeited stock options (633) (590)
Transfer to share capital on exercise of options - (635)
---------- ----------
Balance, end of period $ 11,895 $ 8,778
---------- ----------


12. INCOME TAXES

(a) Future income tax expense:

The provision for income taxes reflects an effective income tax rate which differs from Federal and Provincial statutory tax rates. The main differences are as follows:



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

Income (loss) before income taxes (75,315) (242,139)
Corporate income tax rate 30.88% 34.03%
Computed income tax recovery (23,257) (82,400)
Increase (decrease) resulting from:
Change in valuation allowance 27,992 (1,398)
Write-off of Goodwill - 58,846
Gain on sale of USA properties - 1,654
Non-deductible crown charges - 95
Non-deductible compensation expense 962 1,377
Resource allowance - (120)
Foreign exchange (144) 170
Change in enacted tax rates (2,136) 3,009
Capital tax and Saskatchewan Resource Surcharge 1,642 1,837
Other (1,510) 1,997
--------------------------------------------------------------------------
Income tax expense (recovery) 3,549 (14,933)
--------------------------------------------------------------------------


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



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

Future Income Tax Assets:
Non-capital losses 11,370 12,818
Share issue costs 2,729 3,562
Asset retirement obligation 5,863 4,343
Other 398 290
Valuation allowance (29,032) (1,241)
---------------------------------------------------------------------
(8,672) 19,772
Future Income Tax Liabilities:
Property, plant and equipment 4,636 (17,369)
---------------------------------------------------------------------
Net future tax asset (liability) (4,036) 2,403
---------------------------------------------------------------------


The Company has $37.1 million of non-capital losses that expire each year from 2009 to 2018.

13. COMMITMENTS AND CONTINGENCIES

The Company enters into commitments and contractual obligations in the normal course of business, including the purchase of services, farm-in agreements, royalty agreements, operating agreements, transportation agreements, processing agreements, right of way agreements and lease agreements for vehicles.

(a) The Company has a nine-year operating lease for office space as at December 31, 2008, the payments (net of sublease proceeds) due under this lease agreement (including an estimate for operating costs) are as follows:



----------------------------------------------------------------------
Subsequent
2009 2010 2011 2012 2013 to 2013
----------------------------------------------------------------------
Office rent $1,457 $1,457 $1,525 $1,593 $1,593 $4,474
----------------------------------------------------------------------


(b) The Company has contracted drilling rig services over the next two years. In the event that the Company does not utilize the minimum contracted days, the Company would be obligated to pay the rig operator a variable rate based on days not utilized under the contracts. The maximum commitment at December 31, 2008 related to these contracts is approximately $3.5 million.

(c) In connection with the November, 2007 property acquisition from PetroHunter, the Company may be required to pay a performance payment of US $9.8 million in cash at such time prior to November 6, 2010 if either: (i) production from the assets reaches 5,000 barrels of oil per day; or (ii) proven reserves from the assets is greater than 50 million barrels of oil.

14. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT

The Company is exposed to financial and market risk in a range of financial instruments including cash, accounts receivable, certain investments and accounts payable. The Company manages its risk through its policies and processes, but the Company generally has not used derivative financial instruments to manage these risks.

(a) Fair value of financial instruments

The following tables set out the Company's classification carrying amount and fair values of its financial assets and liabilities as at December 31, 2008 and 2007:



--------------------------------------------------------------------------
2008 2007
--------------------------------------------------------------------------
Carrying Fair Carrying Fair
Classification Amount Value Amount Value
--------------------------------------------------------------------------
Cash and cash
equivalents Held-for-trading (i) $24,059 $24,059 $4,799 $4,799
--------------------------------------------------------------------------
Accounts
receivable Loans and receivables (i) 9,536 9,536 25,134 25,134
--------------------------------------------------------------------------
Investment in
ABCP Held-for-trading (ii) 1,288 1,288 3,863 3,863
--------------------------------------------------------------------------
Other
investments Available-for-sale (iii) 7,768 7,768 - -
--------------------------------------------------------------------------
Accounts
payable and
accrued Other financial
liabilities liabilities (iv) (34,409) (34,409) (69,899) (69,899)
--------------------------------------------------------------------------


The fair values of financial assets and financial liabilities are calculated on the basis of information available at the balance sheet date using the following methods:

(i) The fair value of cash and cash equivalents and accounts receivable approximates their carrying amounts due to the short-term nature of the instruments.

(ii) The fair value of the Company's investment in ABCP is determined by a probability-weighted discounted cash flows considering the best available public information regarding market conditions and other factors that a market participant would consider for such investments.

(iii) Investment in shares of a private company are valued at fair market value based on some comparable transactions involving the issuance of additional shares of the private company.

(iv) The fair value of accounts payable and accrued liabilities approximates their carrying amounts due to the short-term nature of the instruments.

(b) Commodity price risk

Commodity price risk is the risk that future cash flows will fluctuate as a result of changes in the price of oil and natural gas. Commodity prices are impacted by world economic events that effect supply and demand, which are generally beyond the Company's control. Changes in crude oil and natural gas prices may significantly affect the Company's results of operations, costs generated from operating activities, capital spending and the Company's ability to meet its obligations. The majority of the Company's production is sold under short-term contracts, consequently Pearl is at risk to near term price movements. The Company manages this risk by constantly monitoring commodity prices and factoring them into operational decisions, such as contracting or expanding its capital expenditures program. At this time, the Company does not use derivative financial instruments to manage its exposure to this risk.

(c) Foreign currency exchange risk

The Company is exposed to risks arising from fluctuations in foreign currency exchange rates and the volatility of those rates. This exposure primarily relates to: (i) prices received for its crude oil and natural gas are primarily determined in reference to US dollars; (ii)certain expenditure commitments, deposits, accounts receivable, and accounts payable which are denominated in US dollars, and (iii) its operations in the United States. The Company manages this risk by monitoring foreign exchange rates and evaluating their effects on using Canadian or US vendors as well as timing of transactions. At this time, the Company has not entered into any fixed rate contracts.

(d) Credit Risk

Credit risk is the risk that a third party fails to meet its contractual obligations that could result in the Company incurring a loss.

The Company's accounts receivable are primarily with oil and gas marketers and joint venture partners. Receivables from oil and gas marketers are generally collected on the 25th day of the month following production. The Company attempts to mitigate this risk by assessing the financial strength of its counterpart and entering into relationships with larger purchasers with established credit history. During 2008, the Company recorded an allowance for doubtful accounts in the amount of $0.6 million related to a balance owing by one of its marketers that filed for creditor protection. The Company has not experienced any other collection issues with its marketers. Receivables from joint venture partners arise when the Company conducts joint operations on behalf of its partners and invoices them for their share of costs. To mitigate the risk of non-payment from joint venture partners the Company can require partners to pay certain costs in advance as well as the Company has the ability to withhold production from partners in the event of non-payment. In 2008, the Company made a provision for doubtful accounts from joint venture partners in the amount of $1.2 million. These amounts primarily relate to receivables inherited from other companies that were acquired by Pearl over the last two years.

The Company typically does not obtain collateral or security from its joint venture partners or oil and gas marketers. The carrying amounts of accounts receivable represent the maximum credit exposure.

As at December 31, 2008, the Company holds $24 million in cash at various major banks throughout Canada and the USA, as well as $1.3 million in ABCP. At December 31, 2008, one Canadian chartered bank held approximately 93% of our cash and short term deposits. Cash balances in excess of the Company's day to day requirements are invested at the bank in short-term deposits of less than 30 days.

(e) Interest Rate Risk

The Company is exposed to interest rate risk in relation to interest expense on its revolving credit facility. At this time, the Company is not drawn on this facility and, as a result, the Company considers this risk to be limited. In addition, the Company is exposed to interest rate risk on its excess cash balances and certain investments. As at December 31, 2008, if interest rates had been 1% lower with all other variables held constant, after tax earnings for the period would have been approximately $224,000 higher, due to lower interest expense. An equal opposite impact would have occurred to net earnings had interest rates been 1% higher. The Company considers this risk to be limited and does not hedge this risk.

(f) Liquidity Risk

Liquidity risk is the risk the Company is unable to meet its financial obligations as they come due. The Company uses operating cash flows, bank credit facilities and equity offerings to fund its capital requirements.

The Company manages this risk by maintaining a conservative balance sheet with minimal use of long term debt. As at December 31, 2008, the Company had a $47 million credit facility with no amounts outstanding, and a positive working capital position of $6.5 million. The Company believes it has sufficient funding from these sources to meet its foreseeable obligations. The maturity dates for the Company's financial liabilities are as follows:



----------------------------------------------------------------------
less than 6 6 months-
Months 1 Year 1-2 Years
----------------------------------------------------------------------
Accounts payable and accrued
liabilities $34,409 - -
----------------------------------------------------------------------


During 2008, the Company sold certain oil and gas assets for $75 million to eliminate its bank debt at the time. The Company also has the ability to reduce its capital expenditure program if necessary.

(g) Capital management

The Company defines capital as working capital, total debt and equity. The current capital management strategy is designed to minimize the use of long term debt and maintain positive working capital. This strategy should provide the financial flexibility to fund the Company's capital program and profitable growth opportunities. The unutilized $47 million credit facility capacity provides liquidity to the Company. This structure can be adjusted as a result of changes in economic conditions or risks associated with its oil and gas assets. During 2008, the Company elected to eliminate its existing bank debt from the sale of certain non-strategic assets. In order to maintain or adjust its capital structure, the Company may from time to time issue additional common shares. As a result of the economic global downturn access to its capital markets may be limited. In addition, the Company's credit facilities are based on its petroleum and natural gas reserves whose values are impacted by, among other things, global commodity prices. The Company will adjust it's capital spending if access to external capital sources is unavailable. In order to manage the balance in the Company's capital structure, some of the financial tests that Pearl considers is debt to equity ratios, debt to cash flow from operating activities and interest coverage tests.

Financial covenants associated with the Company's credit facility are reviewed regularly and controls are in place to maintain compliance with these covenants. The only financial covenant in the Company's credit facility is to maintain a working capital ratio of 1:1 at the end of each fiscal quarter. Working capital is defined as current assets plus unutilized credit under the credit facilities compared to current liabilities.

15. SEGMENTED INFORMATION

The Company presently has one reportable business segment, that being oil and gas exploration, development and production. The Company's operations are carried on in the following geographic locations:



Year Ended December 31, 2008
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of royalties $ 137,951 $ 1,904 $ 139,855

Expenses 152,122 5,778 157,900
Foreign currency loss (gain) 8 (474) (466)
Write-downs 2,575 57,427 60,002
Gain on investment (2,268) - (2,268)
-------------------------------------
Net income (loss) before income taxes (14,486) (60,827) (75,313)
Income taxes 6,435 (2,886) 3,549
-------------------------------------
Net income (loss) (20,921) (57,941) (78,862)
-------------------------------------
-------------------------------------

Segment assets 459,659 12,484 472,143
-------------------------------------
Segment petroleum and natural gas
Properties 418,444 3,220 421,664
-------------------------------------
Capital additions $ 86,765 $ 20,602 $ 107,367
-------------------------------------

Fifteen Months Ended December 31, 2007
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of royalties $ 99,307 $ 1,843 $ 101,150

Expenses 171,522 2,631 174,153
Foreign currency loss 586 (85) 501
Gain on sale of assets - (4,286) (4,286)
Write-downs 172,921 - 172,921
-------------------------------------
Income (loss) before income taxes (245,722) 3,583 (242,139)
Income taxes (recovery) (17,790) 2,857 (14,933)
-------------------------------------
Net income (loss) (227,932) 726 (227,206)
-------------------------------------
-------------------------------------

Segment assets 522,075 53,790 575,865
-------------------------------------
Segment petroleum and natural gas
Properties 482,506 45,847 528,353
-------------------------------------
Capital additions $ 502,605 $ 25,130 $ 527,735
-------------------------------------


16. SUBSEQUENT EVENTS

(a) On January 8, 2009, the Company acquired all of the issued and outstanding shares of BlackCore Resources Inc. in exchange for 17,600,000 common shares of the Company, as well as 5,000,160 Class A and 5,000,160 Class B share purchase warrants. Each warrant will allow the holder to acquire one Pearl share for a price of $0.60 when the Pearl share price reaches a volume weighted average price for 30 consecutive days of $1.50 and $2.00, respectively. In addition, 2,500,000 common shares of the Company were issued to extinguish the potential contingency payments related to the purchase of lands in the Blackrod area (see note 5 (iv) (e)).

(b) On January 28, 2009, the Company closed an agreement with Serrano Energy Ltd. ("Serrano") to exchange the Company's equity interest in Serrano for a 15% increased interest in the Blackrod area lands and a carried work commitment of $5 million. The Company has become the operator of the Blackrod project.

17. COMPARATIVE FIGURES

Certain comparative figures have been reclassified to conform to the presentation adopted in 2008.

Contact Information

  • Pearl Exploration and Production Ltd.
    John Festival
    President and Chief Executive Officer
    (403) 215-8313
    Email: john.festival@pxx.ca
    or
    Pearl Exploration and Production Ltd.
    Don Cook
    Chief Financial Officer
    (403) 215-8313
    (403) 265-8324 (FAX)
    Email: don.cook@pxx.ca
    Website: www.pearleandp.com