EXHIBIT 99.136
--------------
[ADVANTAGE LOGO]
3100 150 - 6th Avenue SW
Calgary, AB T2P 3Y7
T: 403-261-8810 F: 403-262-0723
Advantage Energy Income Fund - Annual Report
April 28, 2004
Advantage Energy Income Fund ("Advantage" or "the Fund") is pleased to announce
its operating and financial results and reserves for the year ended December 31,
2003.
2003 HIGHLIGHTS
o Advantage replaced 144% of 2003 production through drilling and
acquisitions.
o The Fund drilled 173.8 net wells (192 gross) during 2003 achieving a
success rate of 97%.
o Natural gas production volumes increased by 21% during the year averaging
57.6 mmcf/d with light oil and NGLs production rising by 22% to 2,756
bbls/d as compared to 2002.
o The Fund closed the acquisition of MarkWest Resources Canada Corp. for
$102.5 million on December 2, 2003. Highlights of this purchase include
the following:
o Added production of approximately 4,500 boe/d comprised of 24.2
mmcf/d of natural gas and 415 bbls/d of oil and NGLs.
o Valuation of $23,000 per daily boe of production.
o Significant inventory of low risk drilling and recompletion
opportunities.
o A total of 30 new wells (20.5 net wells) have been drilled on the MarkWest
properties to March 31, 2004. Production from this activity is anticipated
to commence in the second quarter of 2004.
CASH DISTRIBUTIONS
o Cash available for distribution for the year ended December 31, 2003
increased by 59% to $3.09 per Unit. Cash distributions paid to Unitholders
were $2.71 per Unit representing an increase of 57% and a payout ratio of
88%. The balance, or $11.4 million was retained to fund capital
expenditures.
o Advantage has distributed $0.23 per Unit per month for 14 consecutive
months.
o The Fund has hedged 60% of natural gas production for the balance of 2004
at an average price of $6.12 per mcf which will enhance cash flow
stability and support cash distributions throughout 2004.
SUMMARY SINCE INCEPTION
o Since the initial equity issue in October 2001, Advantage has generated a
total return to Unitholders of 227%.
o Since its inception, the Fund has increased production by 154% to
approximately 16,000 boe/d comprised of 79.2 mmcf/d of natural gas and
2,800 bbls/d of light oil and NGLs. Growth has been accomplished through
the completion of four corporate acquisitions combined with an active
drilling program. As a result of these activities reserves have increased
219% to 53.3 million boe at a cost of $8.83 per boe.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 2 of 15
FINANCIAL AND OPERATING HIGHLIGHTS
(thousands of dollars except per Unit amounts)
Three Three Year Year
months ended months ended ended ended
Dec. 31, 2003 Dec. 31, 2002 Dec. 31, 2003 Dec. 31, 2002
------------- ------------- ------------- -------------
Financial
Revenue before royalties $ 43,479 $ 35,289 $ 166,075 $ 97,837
per Unit(1) $ 1.31 $ 1.30 $ 5.44 $ 3.64
per boe $ 34.76 $ 30.63 $ 36.81 $ 24.85
Cash flow from operations $ 25,523 $ 21,472 $ 99,440 $ 53,652
per Unit(1) $ 0.77 $ 0.79 $ 3.26 $ 1.99
per boe $ 20.41 $ 18.64 $ 22.05 $ 13.63
Cash available for distribution(3) $ 24,126 $ 20,357 $ 94,735 $ 52,537
per Unit(2) $ 0.72 $ 0.75 $ 3.09 $ 1.94
Net income (loss) $ (1,880) $ 2,810 $ 44,164 $ 12,095
per Unit(1) $ (0.10) $ 0.10 $ 1.29 $ 0.41
Cash distributions $ 22,905 $ 14,634 $ 83,382 $ 46,883
per Unit(2) $ 0.69 $ 0.54 $ 2.71 $ 1.73
Working capital deficit $ 27,551 $ 7,057
Bank debt $ 102,968 $ 114,222
Convertible debentures $ 99,984 $ 55,000
Operating
Production
Natural gas (mcf/d) 65,280 59,444 57,631 47,753
Light oil and NGLs (bbls/d) 2,714 2,617 2,756 2,255
Heavy oil (bbls/d) - - - 573
boe (6:1) 13,594 12,524 12,361 10,787
Average prices (including hedging)
Natural gas ($/mcf) $ 5.76 $ 4.87 $ 6.07 $ 3.71
Light oil & NGLs ($/bbl) $ 35.67 $ 36.05 $ 38.14 $ 33.68
Heavy oil ($/bbl) $ - $ - - $ 25.71
Proved plus probable reserves (mboe)(4)
Natural gas (bcf) 237.4 223.1
Crude oil & NGLs (mbbls) 13,697 13,995
Total mboe 53,271 51,180
Supplemental (000s)
Trust Units outstanding - end of period 36,717 27,099
Trust Units issuable for
Convertible Debentures 6,155 4,135
Trust Units outstanding and issuable for
Convertible Debentures - end of period 42,872 31,234
Weighted average Units 33,089 27,099 30,536 26,900
(1) based on weighted average number of Trust Units outstanding
(2) based on number of Trust Units outstanding at each cash distribution date
(3) cash flow from operations less interest on convertible debentures
(4) December 31, 2002 represents established reserves
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 3 of 15
RESERVES
Advantage's year end 2003 reserves were evaluated in accordance with National
Instrument 51-101, the new standards of disclosure for oil and gas activities as
mandated by the Canadian Securities Administrators. This new reporting
requirement is intended to be more stringent and is designed to improve
consistency and reliability of oil and gas reserve disclosure. The emphasis is
placed on a conservative approach in assigning proved reserves. With NI 51-101,
proved reserves are defined to have a 90% probability that actual reserves
recovered will equal or exceed the assigned estimate. Probable reserves are less
certain than proved reserves and it is equally likely that the actual reserves
recovered will be greater or less than the sum of the estimated proved plus
probable reserves. Therefore, under NI 51-101, proved plus probable reserves are
considered to represent the most realistic estimate of company reserves.
Sproule Associates Limited evaluated 85% of the total proved plus probable value
of year end reserves and audited all internally evaluated reserves in accordance
with NI 51-101. The following table summarizes the Fund's working interest
reserves, excluding royalty interest reserves of approximately 400 mboe.
Reserves Summary
Crude Oil & NGLs Natural Gas Total Present Value ($000)
mbbl bcf mboe 5% 10%
- -------------------------------------------------------------------------------------------
Proven producing 7,194 155.0 33,027 450.0 366.8
Total proved 8,261 184.4 38,998 516.2 422.2
Total probable 5,436 53.0 14,273 143.3 97.9
- -------------------------------------------------------------------------------------------
Total proved and probable 13,697 237.4 53,271 $ 659.5 $ 520.1
===========================================================================================
In Bantry, 19 wells were drilled and cased late in 2003, but were not fully
tested by year end. As a result, only six tested wells were assigned reserves by
Sproule. The remaining 13 wells will be evaluated in the 2004 reserve study.
Reserves Reconciliation
Crude Oil NGLs Natural Gas Proved
mbbl mbbl bcf plus probable
proved probable proved probable proved probable mboe
- --------------------------------------------------------------------------------------------------------------
Reserves at December 31, 2002(1) 9,164 2,545 1,545 741 178.4 44.7 51,180
Acquisitions 474 75 348 72 33.7 7.6 7,851
Divestments (533) (129) (23) - (0.7) (0.1) (821)
Production (837) - (198) - (22.5) - (4,789)
Capital development 357 659 - - 17.1 5.9 4,849
Revisions under NI 51-101
Technical (2,001) 2,220 177 28 (21.6) (4.8) (3,955)
50 year cut-off(2) (203) (731) (8) (43) - (0.3) (1,044)
-----------------------------------------------------------------------------------------------------------
Reserves at December 31, 2003 6,421 4,639 1,841 798 184.4 53.0 53,271
==============================================================================================================
(1) The evaluation as at December 31, 2002 was prepared using Canadian
National Policy 2-B reserves definitions. Under those definitions,
probable reserves were assigned a risk factor of 50%.
(2) Under the new NI 51-101 guidelines, all reserves exceeding 50 years are
not assigned. This cut-off has no material impact on current net asset
value.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 4 of 15
Net Asset Value
($000, except per Unit amounts) 5% 10%
- ------------------------------------------------------------------------
Present value proved and probable reserves $ 659,477 $ 520,050
Undeveloped acreage and seismic(1) 19,000 19,000
Working capital (deficit) net of
Cash distributions payable to Unitholders (19,106) (19,106)
Bank debt (102,968) (102,968)
- ------------------------------------------------------------------------
Net asset value $ 556,403 $ 416,976
========================================================================
Net asset value per Unit(2) $ 12.94 $ 9.69
========================================================================
(1) Land at $50 per acre
(2) Based on fully diluted Units and conversion of all outstanding debentures
Pricing Assumptions
The present value of future cash flow at December 31, 2003 was based upon crude
oil and natural gas pricing assumptions prepared by Sproule Associates Limited
effective January 1, 2004. These forecasts are adjusted for reserve quality,
transportation charges and the provision of any applicable sales contracts. The
price assumptions used over the next five years are summarized in the table
below:
WTI Edmonton Light Alberta Plantgate Henry Hub
Crude Oil Crude Oil Natural Gas Natural Gas
Year $US/bbl $Cdn/bbl $Cdn/mmbtu $US/mmbtu
- -------------------------------------------------------------------
2004 $ 29.63 $ 37.99 $ 5.81 $ 5.32
2005 $ 26.80 $ 34.24 $ 5.15 $ 4.81
2006 $ 25.76 $ 32.87 $ 4.59 $ 4.39
2007 $ 26.14 $ 33.37 $ 4.71 $ 4.46
2008 $ 26.53 $ 33.87 $ 4.80 $ 4.52
MANAGEMENT'S DISCUSSION AND ANALYSIS
The following Management's Discussion and Analysis ("MD & A") provides a
detailed explanation of the financial and operating results of Advantage Energy
Income Fund ("Advantage", "the Trust" or "the Fund") for the year ended December
31, 2003 and should be read in conjunction with the audited consolidated
financial statements. All per barrel of oil equivalent ("boe") amounts are
stated at 6:1 conversion rate for natural gas to oil.
Advantage was formed on May 23, 2001 as a result of the conversion of Search
Energy Corp. into an income fund. The purpose of the conversion was to create a
trust entity which distributes substantially all of its cash flow to Unitholders
on a monthly basis. The Fund's strategy is to focus on growth through the
acquisition and development of producing oil and natural gas properties while
minimizing exposure to exploration risk.
CASH DISTRIBUTIONS
Total cash distributions to Unitholders for the year ended December 31, 2003
amounted to $83.4 million or $2.71 per Unit. This represents a 78% increase over
2002 cash distributions which amounted to $46.9 million or $1.73 per Unit. Since
inception, the Fund has distributed $152.4 million or $5.89 per Unit. Cash
distributions are dependent on the Fund's current level of production and
prevailing commodity prices and are announced monthly based on cash flow
available after retaining a portion for capital expenditures and debt repayment.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 5 of 15
2003 Monthly Distributions
Cash distributions to Unitholders were declared as follows:
Distribution Taxable amount Return of capital
Period ended Payment date per Unit per Unit per Unit
- -----------------------------------------------------------------------------------
Jan. 31, 2003 Feb. 18, 2003 $ 0.18 $ 0.072 $ 0.108
Feb. 28, 2003 Mar. 17, 2003 $ 0.23 $ 0.092 $ 0.138
Mar. 31, 2003 Apr. 15, 2003 $ 0.23 $ 0.092 $ 0.138
Apr. 30, 2003 May 15, 2003 $ 0.23 $ 0.092 $ 0.138
May 31, 2003 June 16, 2003 $ 0.23 $ 0.092 $ 0.138
June 30, 2003 July 15, 2003 $ 0.23 $ 0.092 $ 0.138
July 31, 2003 Aug. 15, 2003 $ 0.23 $ 0.092 $ 0.138
Aug. 31, 2003 Sept. 15, 2003 $ 0.23 $ 0.092 $ 0.138
Sept. 30, 2003 Oct. 15, 2003 $ 0.23 $ 0.092 $ 0.138
Oct. 31, 2003 Nov. 17, 2003 $ 0.23 $ 0.092 $ 0.138
Nov. 30, 2003 Dec. 15, 2003 $ 0.23 $ 0.092 $ 0.138
Dec. 31, 2003 Jan. 15, 2004 $ 0.23 $ 0.092 $ 0.138
- ------------------------------------------------------------------------------------
$ 2.71 $ 1.084 $ 1.626
====================================================================================
For US holders of Advantage Units the distributions paid in 2003 were 56%
non-taxable return of capital and 44% taxable. Unitholders should consult their
tax advisors as to the proper treatment of Advantage distributions for income
tax purposes.
PRODUCTION
Natural gas production for the year ended December 31, 2003 averaged 57.6
mmcf/d, an improvement of 21% over the 47.8 mmcf/d produced in 2002. The
increase in gas production over 2002 was the result of a successful drilling
program at Medicine Hat and Shouldice, Alberta and the acquisition of Best
Pacific Resources on November 18, 2002. Advantage's drilling program at Medicine
Hat and Shouldice added new production of approximately 13.0 mmcf/d in the later
half of 2003, while the Best Pacific acquisition added approximately 5.8 mmcf/d.
On December 2, 2003 Advantage acquired MarkWest Resources Canada Corp. This
acquisition did not contribute significantly to 2003 average volumes but will
add approximately 20 mmcf/d of new natural gas production to the Fund in the
first quarter of 2004. Advantage exited 2003 producing approximately 79.2 mmcf/d
of natural gas.
Oil and NGLs production in 2003 averaged 2,756 bbls/d compared with 2,828 bbls/d
produced in 2002. Light oil and NGLs production in 2003 averaged 2,756 bbls/d,
an increase of 22% over the 2,255 bbls/d produced in 2002. Increases in light
oil and NGLs production in 2003 was the result of the acquisition of Best
Pacific Resources in November of 2002. The 3% decline in total oil and NGLs
production in 2003 was the result of the disposition of substantially all of the
Fund's heavy oil production on September 1, 2002. The Fund's heavy oil
production was exchanged for increased production and working interests in the
Fund's Vermilion natural gas property. Heavy oil production in 2002 amounted to
573 bbls/d.
Daily Production
2003 2002 % Change
------------------------------------------------------
Natural gas (mcf/d) 57,631 47,753 21%
Light oil & NGLs (bbls/d) 2,756 2,255 22%
Heavy oil (bbls/d) - 573 -%
------------------------------------------------------
Total (boe/d) 12,361 10,787 15%
======================================================
COMMODITY PRICES & MARKETING
Natural Gas
Natural gas prices for the year ended December 31, 2003 averaged $6.30/mcf
($6.07/mcf including hedging), compared to $3.85/mcf ($3.71/mcf including
hedging) in the year ended December 31, 2002. Advantage's natural gas hedging
program resulted in losses of $4.8 million in 2003 or $0.23/mcf. All of the
Fund's natural gas hedging losses were incurred in the first
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 6 of 15
quarter of 2003 and related to hedges entered into in the fall of 2002. Natural
gas prices were considerably stronger in 2003 compared to 2002 but have softened
from the near record highs attained in the first quarter of 2003. Prices have
weakened since the first quarter due to higher than normal injections into
natural gas storage caused by (i) below normal summer temperatures that cut
cooling demand, reducing the need for natural gas as fuel for electricity
generation to run air conditioning, (ii) switching away from natural gas to
lower cost fuels and (iii) expectations for increased supply that has resulted
from the active winter drilling season. Natural gas storage levels are now
within the normal five year range entering into the shoulder season where strong
demand for heating has declined and the summer cooling season has not yet begun.
Advantage continues to believe that the pricing fundamentals for natural gas
remains strong. Advantage will continue to mitigate the price risk associated
with the fluctuations in natural gas prices by hedging a portion of its
production. Advantage has hedged approximately 60% of it's anticipated natural
gas production for 2004. The price the Fund receives on natural gas is primarily
based on the AECO benchmark price with approximately 25% of production sold to
aggregators and the remainder sold on the spot market. Advantage's current
production is weighted approximately 83% towards natural gas.
Average Prices - Natural Gas ($/mcf)
2003 2002 % Change
---------------------------------------------------------------------
Advantage wellhead price $ 6.30 $ 3.85 64%
Advantage hedged price $ 6.07 $ 3.71 64%
AECO monthly index $ 6.67 $ 4.26 57%
Crude Oil
Crude oil and NGLs prices averaged $38.58/bbl ($38.14/bbl including hedging) in
2003 compared with $34.46/bbl ($32.07/bbl including hedging) in 2002. Included
in crude oil sales is $0.4 million of oil hedging losses or $0.44/bbl.
Advantage's crude oil prices are based on the benchmark pricing of West Texas
Intermediate Crude ("WTI") adjusted for quality, transportation costs and
Canadian/US exchange rate. The price of WTI fluctuates based on worldwide supply
and demand fundamentals. Crude oil prices were extremely volatile in 2003 and
remain strong due to (i) record low storage levels in the US, (ii) supply
management by the OPEC cartel, (iii) ongoing civil unrest in the middle east,
Venezuela and Nigeria and (iv) increased world wide demand particularly in
China. The price of WTI averaged $US31.06/bbl in 2003 compared to $US26.10/bbl
in the period ending December 31, 2002.
Average Prices - Crude Oil
2003 2002 % Change
---------------------------------------------------------------------
Light oil & NGLs ($/bbl) $ 38.58 $ 35.83 8%
Heavy oil ($/bbl) - $ 29.03 -
Oil & NGLs - including hedging ($/bbl) $ 38.14 $ 32.07 19%
WTI (US$/bbl) $ 31.06 $ 26.10 19%
HEDGING
During 2003 the Fund's hedging losses amounted to $5.2 million ($4.8 million on
natural gas hedges and $0.4 million on crude oil hedges). All of the Funds
hedging losses were the result of contracts entered into in the fall of 2002
prior to the increase in winter natural gas prices and due to hedging contracts
acquired as part of the Best Pacific acquisition. Contracts entered into in
early 2003 resulted in hedging gains of $2.4 million in 2003. On February 24,
2004 the Fund announced that it had entered the following natural gas hedge
transactions for 2004 and 2005:
Natural Gas - April to December 2004
Volume 50.4 mmcf/d
Fixed price (average) $6.12/mcf
Natural Gas - January to March 2005
Volume 10.5 mmcf/d
Fixed price (average) $6.30/mcf
Advantage currently has no crude oil hedges in place.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 7 of 15
ROYALTIES
Total royalties amounted to $28.5 million for the year ended December 31, 2003
or 16.6% of pre-hedged revenue compared with $17.3 million or 16.9% of
pre-hedged revenue for the year ended December 31, 2002. Total royalties are
significantly higher in 2003 as a result of higher revenues. Advantage's low
royalty rate reflects the Fund's significant proportion of production that comes
from low rate natural gas wells at properties such as Medicine Hat, Wainwright
and Shouldice which attract lower royalty rates. The slight decline in the
Fund's royalty rate in 2003 compared to 2002 reflects a higher proportion of
Advantage's production coming from these lower rate properties. Advantage
anticipates that its royalty rate in 2004 will increase to approximately 20% as
a result of the acquisition of MarkWest Resources in December 2003. MarkWest
properties attract higher royalty rates than Advantage properties.
Royalties
2003 2002 % Change
-------------------------------------------------------------------------
Total royalties, net of ARC ($000) $ 28,491 $ 17,344 64%
per boe $ 6.31 $ 4.41 43%
As a percentage of pre-hedging revenue 16.6% 16.9% -
OPERATING COSTS
Operating costs for the year ended December 31, 2003 amounted to $25.6 million
or $5.68/boe compared with $18.5 million or $4.70/boe for the year ended
December 31, 2002. The increase in operating cost amounts reflects the Best
Pacific acquisition completed in late 2003. Per boe operating costs increased
due to higher power costs and higher field costs associated with the shortage of
supplies, services and materials that has resulted from the high level of
industry activity. The Fund expects per boe operating costs in 2004 to be
similar to 2003.
Operating Costs
2003 2002 % Change
-------------------------------------------------------------------------
Operating costs ($000) $ 25,618 $ 18,486 39%
per boe $ 5.68 $ 4.70 21%
GENERAL AND ADMINISTRATIVE AND MANAGEMENT FEES
General and administrative ("G&A") expense for the year ended December 31, 2003
amounted to $3.2 million or $0.71/boe compared with $2.6 million or $0.67/boe
for the year ended December 31, 2002. G&A expense was higher in 2003 due to
increased staff levels that resulted from the growth of the Fund.
Management fees for the year ended December 31, 2003 amounted to $1.7 million
compared to $0.9 million for the year ended December 31, 2002. On a boe basis,
management fees were $0.37/boe compared to $0.24/boe in 2002. Management fees
are calculated based on 1.5% of operating cash flow, which is defined as
revenues less royalties and operating expenses.
The Fund Manager is entitled to earn a performance fee to the extent that the
total annual return of the Fund exceeds 8%. The total annual return is
calculated at the end of each year by dividing the year over year change in Unit
price plus cash distributions by the opening Unit price. One tenth (10%) of the
amount of the total annual return in excess of 8% is multiplied by the market
capitalization (defined as the opening Unit price times the weighted average
number of Units outstanding during the year) to determine the performance fee.
For the year ending December 31, 2003 the total return of the Fund was 57% (84%
return in 2002) based on an opening unit price of $13.07 per unit ($8.02 per
unit in 2002), a closing unit price of $17.83 per unit ($13.07 per unit in 2002)
and cash distributions of $2.71 per unit for the year ($1.73 per unit in 2002).
This 57% return for Unitholders resulted in a performance fee of $19.6 million
($16.5 million in 2002) based on a total annual return to Unitholders of $227.9
million ($179.4 million in 2002). On January 21, 2003 the Fund issued 1,099,104
Advantage Trust Units to Advantage Investment Management Ltd. and the employees
of the Fund to satisfy the performance fee obligation. The Manager does not
receive any form of compensation in respect of acquisition or divestiture fees
nor is there any form of stock option plan for the Manager or the employees of
Advantage.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 8 of 15
General and Administrative Expenses
2003 2002 % Change
-------------------------------------------------------------------------
General and administrative expense ($000) $ 3,216 $ 2,624 23%
per boe $ 0.71 $ 0.67 6%
Management fees ($000) $ 1,679 $ 930 81%
per boe $ 0.37 $ 0.24 54%
Employees at December 31 49 31 58%
INTEREST
Interest expense on bank debt for the year ended December 31, 2003 amounted to
$6.4 million compared with $4.3 million for the year ended December 31, 2002.
Higher interest expense in 2003 was the result of a higher average debt balance
during the year partially offset by lower interest rates. The Fund's interest
rates are primarily based on short term Bankers Acceptance rates plus a stamping
fee. The average rate of interest on Advantage's bank debt at December 31, 2003
was approximately 4.3%.
NETBACKS
Netbacks ($/boe)
2003 2002
($000s) ($/boe) ($000s) ($/boe)
- -----------------------------------------------------------------------------------
Revenue $ 171,277 $ 37.96 $ 102,717 $ 26.09
Hedging (5,202) (1.15) (4,880) (1.24)
Royalties (28,491) (6.31) (17,344) (4.41)
Operating costs (25,618) (5.68) (18,486) (4.70)
- -----------------------------------------------------------------------------------
Operating $ 111,966 $ 24.82 $ 62,007 $ 15.74
General and administrative (3,216) (0.71) (2,624) (0.67)
Management fees (1,679) (0.37) (930) (0.24)
Interest expense (6,378) (1.41) (4,272) (1.09)
Taxes (1,253) (0.28) (529) (0.13)
- -----------------------------------------------------------------------------------
Cash flow from operations $ 99,440 $ 22.05 $ 53,652 $ 13.61
Interest on convertible debentures (4,705) (1.04) (1,115) (0.28)
- -----------------------------------------------------------------------------------
Cash available for distribution $ 94,735 $ 21.01 $ 52,537 $ 13.33
- -----------------------------------------------------------------------------------
DEPLETION, DEPRECIATION AND SITE RESTORATION
Depletion and depreciation of property and equipment is provided on the unit of
production method based on total proved reserves. The depletion, depreciation
and site restoration provision for 2003 increased to $53.8 million from $41.1
million in 2002. The increased provision in 2003 is the result of higher
production volumes in 2002 and a higher per boe rate. The depletion,
depreciation and amortization rate (DD&A) for the year ended December 31, 2003
was $11.86/boe compared with $10.43/boe in 2002. DD&A includes a provision for
future site restoration and abandonments of $0.29/boe ($0.24/boe in 2002).
TAXES
Current taxes paid or payable for the period ending December 31, 2003 primarily
represent capital tax and amounted to $1.3 million, compared to $0.5 million
expensed in 2002. Capital taxes are based on debt and equity levels at the end
of the year and are higher in 2003 due to Advantage's growth during the year. As
a result of new legislation in 2003, capital taxes are to be gradually
eliminated over the next five years.
Future income taxes arise from differences between the accounting and tax bases
of the operating company's assets and liabilities. For the year ended December
31, 2003 the Fund recognized an income tax recovery of $18.1 million compared to
a $16.0 million recovery in 2002. In the Fund's structure, payments are made
between the operating company and the Trust transferring both income and future
income tax liability to the Unitholders. Therefore, it is expected, based on
current legislation that no cash income taxes are to be paid by the operating
company in the future, and as such, the future income tax
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 9 of 15
liability recorded on the balance sheet will be recovered through earnings over
time. As at December 31, 2003 the operating company had a future income tax
liability balance of $77.4 million. Canadian generally accepted accounting
principles require that a future income tax liability be recorded when the book
value of assets exceeds the balance of tax pools. It further requires that a
future tax liability be recorded on an acquisition when a corporation acquires
assets with associated tax pools that are less than the purchase price. As a
result of the MarkWest acquisition, Advantage recorded a future tax liability of
$18.5 million.
CAPITAL EXPENDITURES
Capital expenditures including acquisitions for the year ended December 31, 2003
totalled $169.0 million net of property dispositions of $6.1 million compared to
$167.8 million net of property dispositions of $0.8 million in 2002.
Expenditures on property and equipment in 2003 amounted to $76.2 million. The
majority of the capital expenditures were incurred on natural gas development
drilling, completions and tie-ins at Medicine Hat, Shouldice, Wainwright and
Vermilion.
Capital Expenditures ($ thousands)
2003 2002
-----------------------------------------------------------------------
Land and seismic $ 7,502 $ 1,359
Drilling, completions and workovers 47,123 30,719
Well equipping and facilities 21,094 10,456
Other 493 118
-----------------------------------------------------------------------
$ 76,212 $ 42,652
Acquisition of Best Pacific Resources Ltd. - 53,448
Acquisition of Gascan Resources Ltd. - 63,799
Acquisition of MarkWest Canada Resources Corp. 97,025 -
Property acquisitions 1,848 8,698
Property dispositions (6,112) (800)
-----------------------------------------------------------------------
Total capital expenditures $ 168,973 $ 167,797
=======================================================================
ACQUISITIONS
MarkWest Resources Canada Corp.
On December 2, 2003 Advantage acquired all of the issued and outstanding shares
of MarkWest Resources Canada Corp. for cash consideration of $97.0 million. The
acquisition was financed through the issuance of 5.1 million Advantage Trust
Units at a price of $15.75 per Unit and the issuance of $60 million of 8.25%
unsecured subordinated convertible debentures. The debentures are convertible
into Advantage Trust units at a conversion price of $16.50 per Trust Unit.
The Fund recorded goodwill on the acquisition of $27.8 million as the result of
purchasing tax pool deficient oil and gas reserves. The goodwill value was
determined based on the excess of total consideration plus the future income tax
liability recorded upon acquisition less the deemed fair value for accounting
purposes of the MarkWest assets. The fair value for accounting purposes of the
MarkWest assets of $105.6 million was determined based on a 10% discounted value
of established reserves as per an independent reserve evaluation. Result of
operations of MarkWest have been included in the Fund's consolidated financial
statements effective December 2, 2003, the closing date of the transaction.
LIQUIDITY AND CAPITAL RESOURCES
On July 8, 2003 Advantage issued $30 million principle amount of 9% unsecured
subordinated convertible debentures. The debentures mature on August 1, 2008,
pay interest semi-annually and are convertible at the option of the holder into
Trust Units of Advantage at $17.00 per Unit plus accrued and unpaid interest.
Proceeds of the debenture offering were used to fund drilling and exploitation
activities in the Trust's core areas. On December 2, 2003 the Fund issued 5.1
million Trust Units at a price of $15.75 per Trust Unit generating net proceeds
of $76.1 million. Also on December 2, 2003 the Fund issued $60 million principle
amount of 8.25% unsecured subordinated convertible debentures. The debentures
mature on February 1, 2009, pay interest semi-annually and are convertible at
the option of the holder into Trust Units of Advantage at $16.50 per Unit plus
accrued and unpaid interest. A portion of the proceeds of the December 2, 2003
offering were used to fund the acquisition of MarkWest Resources Canada Corp.
with the balance of net proceeds used to reduce outstanding bank debt and to
fund drilling and exploitation capital expenditures in the Fund's core areas. As
at December 31, 2003 the Fund had 36.7 million Trust Units
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 10 of 15
outstanding. On January 27, 2004 Advantage issued 1,099,104 Units to the Fund's
Manager and Advantage employees to satisfy the obligation related to the 2003
performance incentive fee.
At December 31, 2003 Advantage had bank debt outstanding of $103.0 million.
Advantage has an agreement with a syndicate of three Canadian chartered banks
that provides for a $180 million facility consisting of $170 million extendible
revolving loan facility and a $10 million operating loan facility both of which
mature on May 28, 2004. The credit facilities are secured by a $250 million
floating charge demand debenture, a general security agreement and a
subordination agreement from the Trust covering all assets and cash flows. At
December 31, 2003 Advantage also had a working capital deficiency of $24.9
million. The following table outlines Advantage's sources and uses of funds
during 2003:
Sources and Uses of Funds ($ thousands)
Sources of funds
Cash flow from operations $ 99,440
Units issued, net of costs 76,436
Debentures issued, net of costs 85,982
Decrease in working capital 2,119
Property dispositions, net of acquisitions 4,264
-----------
$ 268,241
-----------
Uses of funds
Capital expenditures $ 76,212
Acquisition of MarkWest Resources 97,025
Distributions paid to Unitholders 79,815
Interest paid to debenture holders 3,935
Decrease in bank debt 11,254
-----------
$ 268,241
-----------
ANNUAL FINANCIAL INFORMATION
The following is a summary of selected financial information of the Fund for the
periods indicated.
For the For the For the period
year ended year ended from May 24
Dec. 31, 2003 Dec. 31, 2002 to Dec. 31, 2001(1)
- ---------------------------------------------------------------------------------------------
Total revenue (before royalties) ($000) 166,075 97,837 38,595
Cash flow from operations ($000) 99,440 53,652 20,342
Per unit - basic 3.26 1.99 1.31
Per unit - diluted 2.92 1.93 1.31
Net income ($000) 44,164 12,095 9,567
Per unit - basic and diluted 1.29 0.41 0.62
Total assets ($000) 574,752 411,849 234,324
Cash distributions per unit 2.71 1.73 1.45
(1) The Reorganization of Advantage Oil and Gas Ltd. (formerly Search Energy
Corp.) into an income trust structure occurred effective May 24, 2001. The
data presented for the period ended December 31, 2001 represents data from
Advantage's first financial year of May 24, 2001 to December 31, 2001.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 11 of 15
QUARTERLY FINANCIAL INFORMATION
The following is a summary of selected financial information of Advantage for
the periods indicated.
Total Net Net Cash flow from Cash flow from
Revenues Net Income Income Cash flow operations operations
(before Income (loss) per per Unit from per Unit per Unit
royalties) (loss) Unit basic diluted operations basic diluted
- --------------------------------------------------------------------------------------------------------
($000) ($000) ($000)
2003
1st quarter 42,079 15,630 0.50 0.48 25,141 0.89 0.78
2nd quarter 39,654 20,805 0.67 0.64 24,210 0.82 0.75
3rd quarter 40,863 9,609 0.28 0.28 24,567 0.79 0.76
4th quarter 43,479 (1,880) (0.10) (0.10) 25,522 0.77 0.65
2002
1st quarter 18,625 3,223 0.12 0.12 9,889 0.36 0.36
2nd quarter 22,474 705 0.03 0.03 11,691 0.43 0.43
3rd quarter 21,449 5,357 0.20 0.20 10,600 0.39 0.39
4th quarter 35,289 2,810 0.10 0.10 21,472 0.79 0.79
RISK FACTORS
The following is a summary of certain risk factors relating to the business of
the Trust.
Exploitation and Development
Exploitation and development risks are due to the uncertain results of searching
for and producing oil and natural gas using imperfect scientific methods. These
risks are mitigated by using highly skilled staff, focusing exploitation efforts
in areas in which Advantage has existing knowledge and expertise or access to
such expertise, using up to date technology to enhance methods, and controlling
costs to maximize returns. Advanced oil and natural gas related technologies
such as three-dimensional seismography, reservoir simulation studies and
horizontal drilling have been used by Advantage and will be used by Advantage to
improve its ability to find, develop and produce oil and natural gas.
Operations
Advantage's operations are subject to all of the risks normally incident to the
operation and development of oil and natural gas properties and the drilling of
oil and natural gas wells, including encountering unexpected formations or
pressures, blowouts, craterings and fires, all of which could result in personal
injuries, loss of life and damage to the property of the Fund and others.
Advantage has both safety and environmental policies in place to protect its
operators and employees, as well as to meet the regulatory requirements in those
areas where it operates. In addition, the Fund has liability insurance policies
in place, in such amounts as it considers adequate, however, it will not be
fully insured against all of these risks, nor are all such risks insurable.
Continuing production from non-operated properties, and, to some extent the
marketing of production therefrom, are largely dependent upon the ability of the
operator of the property. To the extent the operator fails to perform these
functions properly, revenue may be reduced. Payments from production generally
flow through the operator and there is a risk of delay and additional expense in
receiving such revenues if the operator becomes insolvent. Although satisfactory
title reviews are generally conducted in accordance with industry standards,
such reviews do not guarantee or certify that a defect in the chain of title may
not arise to defeat the claim of Advantage to certain properties. A reduction of
cash flow could result in such circumstances. Advantage mitigates this risk by
operating a high percentage of its properties.
Oil and Natural Gas Prices
The price of oil and natural gas will fluctuate and price and demand are factors
beyond Advantage's control. Such fluctuations will have a positive or negative
effect on the revenue to be received by it. Such fluctuations will also have an
effect on the acquisition costs of any future oil and natural gas properties
that Advantage may acquire. As well, cash distributions from the Trust will be
highly sensitive to the prevailing price of crude oil and natural gas. Advantage
mitigates this risk by maintaining a hedging program.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 12 of 15
Marketing
The marketability and price of oil and natural gas that may be acquired or
discovered by Advantage will be affected by numerous factors beyond its control.
These factors include demand for oil and natural gas, market fluctuations, the
proximity and capacity of oil and natural gas pipelines and processing equipment
and government regulations, including regulations relating to environmental
protection, royalties, allowable production, pricing, importing and exporting of
oil and natural gas. Advantage mitigates this risk by maintaining a portfolio of
assets that are geographically diversified.
Capital Investment
The timing and amount of capital expenditures will directly affect the amount of
income for distribution to Trust Unitholders. Distributions may be reduced, or
even eliminated, at times when significant capital or other expenditures are
made.
Debt Service
Advantage has credit facilities in the amount of $180,000,000. Variations in
interest rates and scheduled principal repayments could result in significant
changes in the amount required to be applied to debt service before payment of
any amounts to Unitholders. Although it is believed that the bank line of credit
is sufficient, there can be no assurance that the amount will be adequate for
the financial obligations of Advantage or that additional funds can be obtained.
The lenders have been provided with security over substantially all of the
assets of Advantage. If Advantage becomes unable to pay its debt service charges
or otherwise commits an event of default such as bankruptcy, the lenders may
foreclose on or sell the properties of the Fund.
Reserves
Although Sproule Associates Limited and the Trust have carefully prepared the
reserve figures included herein and believe that the methods of estimating
reserves have been verified by operating experience, such figures are estimates
and no assurance can be given that the indicated levels of reserves will be
produced. Probable reserves estimated for properties may require revision based
on the actual development strategies employed to prove such reserves. Declines
in the reserves of Advantage which are not offset by the acquisition or
development of additional reserves may reduce the underlying value of Trust
Units to Trust Unitholders. Trust Units will have no value once all of the oil
and natural gas reserves of Advantage have been produced. As a result, holders
of Trust Units will have to obtain the return of capital invested out of cash
flow derived from their investment in such Trust Units.
Environmental Concerns
The oil and natural gas industry is subject to environmental regulation pursuant
to local, provincial and federal legislation. A breach of such legislation may
result in the imposition of fines or issuance of clean-up orders in respect of
Advantage or the properties. Such legislation may be changed to impose higher
standards and potentially more costly obligations on Advantage. There can be no
assurance that the Trust will be able to satisfy its actual future environmental
and reclamation obligations.
Depletion of Reserves
The Trust has certain unique attributes that differentiate it from other oil and
gas industry participants. Distributions of cash flow in respect of the oil and
gas properties, absent commodity price increases or cost effective acquisition
and development activities will decline over time in a manner consistent with
declining production from typical oil, natural gas and natural gas liquids
reserves. Advantage will not be reinvesting cash flow in the same manner as
other industry participants. Accordingly, absent capital injections, Advantage's
initial production levels and reserves will decline.
Advantage's future oil and natural gas reserves and production, and therefore
its cash flows, will be highly dependent on Advantage's success in exploiting
its reserve base and acquiring additional reserves. Without reserve additions
through acquisition or development activities, Advantage's reserves and
production will decline over time as reserves are exploited.
To the extent that external sources of capital, including the issuance of
additional Trust Units, become limited or unavailable, Advantage's ability to
make the necessary capital investments to maintain or expand its oil and natural
gas reserves will be impaired. To the extent that Advantage is required to use
cash flow to finance capital expenditures or property acquisitions, the level of
cash available for distribution will be reduced.
There can be no assurance that Advantage will be successful in developing or
acquiring additional reserves on terms that meet the Trust's investment
objectives.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 13 of 15
Changes in Legislation
New legislation has been proposed that restricts levels of non-resident
ownership for the Trust to be able to maintain its status under the Tax Act as a
"mutual fund trust". If the Trust ceases to qualify as a "mutual fund trust"
under the Tax Act, the Trust Units will cease to be qualified investments for
registered retirement savings plans, registered education savings plans,
deferred profit sharing plans and registered retirement income funds.
Regulatory Matters
The Corporation's operations are subject to a variety of federal and provincial
laws and regulations, including laws and regulations relating to the protection
of the environment.
CORPORATE GOVERNANCE
Advantage Investment Management Ltd. has been retained by the Trustee of the
Fund and by Advantage Oil & Gas ("AOG") to provide advisory and management
services to the Fund and to AOG. The Board of Directors' mandate is to supervise
the management of the business and affairs of the Fund including the business
and affairs of the Fund delegated to AOG. In particular, all decisions relating
to: (i) the acquisition and disposition of properties for a purchase price or
proceeds in excess of $2 million; (ii) the approval of annual operating and
capital expenditure budgets; and (iii) the establishment of credit facilities,
will be made by the Board.
Computershare Trust Company of Canada, the Trustee of the Fund, has delegated
certain matters to the Board of Directors. These include all decisions relating
to issuance of additional Trust Units and the determination of the amount of
distributions. Any amendment to any material contract to which the Fund is a
party will require the approval of the Board of Directors and, in some cases,
Unitholder approval.
The Board of Directors meets regularly to review the business and affairs of the
Fund and AOG and to make any required decisions.
The Board of Directors consists of seven members, five of whom are unrelated to
the Fund. The Audit Committee and the Independent Reserve Evaluation Committee
each have three members, all of whom are independent. The Human Resources,
Compensation and Corporate Governance Committee has two members, all of whom are
independent. In addition, the Chairman of the Board is not related and is not an
executive officer of the Fund.
A further discussion of the Fund's corporate governance practices can be found
in the Management Proxy Circular.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in accordance with GAAP requires
management to make certain judgments and estimates. Changes in these judgments
and estimates could have a material impact on the Trust's financial results and
financial condition. The process of estimating reserves is critical to several
accounting estimates. The process of estimating reserves is complex and requires
significant judgments and decisions based on available geological, geophysical,
engineering and economic data. These estimates may change substantially as
additional data from ongoing development and production activities becomes
available, and as economic conditions impact oil and natural gas prices,
operating costs, and royalty burdens change. Reserve estimates impact net income
through depletion, the provision for site reclamation and abandonment and in the
application of the ceiling test, whereby the value of the oil and natural gas
assets are subjected to an impairment test. The reserve estimates are also used
to assess the borrowing base for the Trust's credit facilities. Revision or
changes in the reserve estimates can have either a positive or a negative impact
on net income or the borrowing base of the Trust.
FINANCIAL REPORTING AND REGULATORY UPDATE
During 2003 there were a number of changes to financial reporting and regulatory
requirements. The changes that will impact Advantage are noted below.
Full Cost Accounting Guideline
In September 2003 the CICA issued Accounting Guideline 16, "Oil and Gas
Accounting - Full Cost" which is effective for fiscal years beginning on or
after January 1, 2004. The new Guideline limits the carrying value of oil and
natural gas properties to their fair value. The fair value is equal to estimated
future cash flows from proved plus probable reserves using future price
forecasts and costs discounted at a risk-free rate. This differs from the
current cost recovery ceiling test that uses undiscounted cash flows and
constant prices and costs less general and administrative and financing costs.
There is no write-down of the Fund's oil and gas assets under either method at
December 31, 2003.
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 14 of 15
Asset Retirement Obligations
In March 2003 the CICA issued handbook section 3110 "Asset Retirement
Obligations" which requires liability recognition for retirement obligations
associated with the Fund's property and equipment. The obligations are initially
measured at fair value, which is the discounted future value of the liability.
The fair value is capitalized as part of the cost of the related assets and
depleted to earnings over the assets useful life. The liability accretes until
the retirement obligations are settled. Advantage will adopt the new standard in
the first quarter of 2004. The accrued site restoration liability on the balance
sheet at December 31, 2003 has been calculated on a unit of production basis and
will be reversed in the first quarter of 2004. Property and equipment will be
increased and a liability set up for the amount calculated under the new
standard. The comparative numbers for 2003 will be restated to reflect the new
standard.
Hedging Relationships
Effective for the Fund's 2004 fiscal year, the new CICA Accounting Guideline 13
"Hedging Relationships" requires that hedging relationship be identified,
designated, documented and measured in order for the Fund to apply hedge
accounting. All of the hedges Advantage enters into are effective economic
hedges and Advantage has elected to use the fair value method of accounting for
all derivative transactions as the Fund believes this method provides better
information to readers of the Fund's financial statements. Effective the first
quarter of 2004 Advantage will record the fair value of the derivative financial
instruments at each balance sheet date. The change in fair value from period to
period will be recorded in the income statement on a separate line as unrealized
gains/losses.
Stock Based Compensation
In September 2003 the CICA issued an amendment to section 3870 "Stock Based
compensation and other stock based payments". The amended section is effective
for years beginning on or after January 1, 2004 and requires that companies
measure all stock based payments using the fair value method of accounting and
recognize the compensation expense in their financial statements. The Trust
implemented this standard in 2003.
Continuous Disclosure Obligations
Commencing in the first quarter of 2004 Advantage will be subject to new
disclosure requirements as per National Instrument 51-102 "Continuous Disclosure
Obligations". This new instrument requires shorter reporting periods for filing
annual and interim financial statements, MD&A and Annual Information Form (AIF).
The Instrument also proposes enhanced disclosure in the annual and interim
financial statements, MD&A and AIF.
OUTLOOK
Advantage's objective is to become the leading choice among investors in the oil
and gas trust sector. This will be accomplished through the acquisition,
development and management of long life, low cost reserves with an emphasis on
natural gas and light oil. Significant strides have been made since the
inception of the Fund in May 2001 in accomplishing this objective. The
acquisition of Due West, Gascan, Best Pacific and MarkWest combined with
development drilling has increased established reserves by 46.7 mmboe at a cost
of $8.83 per boe. Since inception of the Fund on May 24, 2001 daily production
has grown by 154% from 6,300 boe/d to the 2003 exit rate of approximately 16,000
boe/d.
In 2004, Advantage will continue to follow its strategy of acquiring properties
that provide low risk development opportunities and enhance long-term cash flow.
Production will also be added through low risk exploitation and development
drilling. To ensure stability of cash distributions and return to Unitholders,
the Fund will maintain a hedging plan to guard against the downward volatility
of commodity prices.
There are a number of trends that have been developing in the oil and gas
royalty trust sector that appear to be shaping the near future of the business
and will have an impact on Advantage's cash available for distribution
including:
o Strong crude oil and natural gas prices which will have a positive
impact for Unitholders.
o Low interest rates which has increased the demand for yield-based
investments.
o An active, but extremely competitive market for the acquisition of
oil and gas properties.
o A structural advantage for income trusts and a lower cost of capital
when competing with E & P companies for these acquisitions.
With the continued strength of natural gas prices and the anticipated increases
in natural gas production from the 2004 drilling program, Advantage is well
positioned for strong growth in 2004. The level of cash flow available to
Unitholders will be affected
Annual Report April 28, 2004
ADVANTAGE ENERGY INCOME FUND Page 15 of 15
by oil and natural gas prices, the $Cdn/US exchange rate and the Fund's ability
to continue to add production and reserves in a cost effective manner. The
following table indicates the Fund's cash flow sensitivity to changes in prices
and production of natural gas, crude oil and NGLs, exchange rates and interest
rates for 2004 based on production of 79,200 mcf/d of natural gas and 2,800
bbls/d of crude oil and NGLs and before hedging. Advantage is considerably more
sensitive to changes in natural gas prices as compared to oil due to the Fund's
higher natural gas weighting.
Sensitivities
Annual Annual
Cash flow Cash flow per Unit
($000) ($/Unit)
- --------------------------------------------------------------------------------
Natural gas
AECO price change of $0.25/mcf $ 5,600 $ 0.15
Production change of 1,000 mcf/d $ 1,200 $ 0.03
Crude oil
WTI price change of US$1.00/bbl $ 1,100 $ 0.03
Production change of 200 bbl/d $ 1,800 $ 0.04
Cdn$0.01 change in the Cdn$/US$ exchange rate $ 2,000 $ 0.05
1% change in interest rate $ 1,300 $ 0.03
Non-GAAP Measures
Cash flow from operations and per Unit cash flow from operations and cash
available for distribution and per Unit cash available for distribution are not
recognized measures under the Canadian generally accepted accounting principles
(GAAP). Management believes that cash flow from operations and cash available
for distribution are useful supplemental measures to analyse operating
performance and provide an indication of the results generated by the Trust's
principal business activities prior to the consideration of how those activities
are financed or how the results are taxed. Investors should be cautioned,
however, that these measures should not be construed as an alternative to net
income determined in accordance with GAAP as an indication of Advantage's
performance. Advantage's method of calculating these measures may differ from
other companies, and accordingly, they may not be comparable to measures used by
other companies.