2007 MESSAGE TO UNITHOLDERS | 2007 FINANCIAL AND OPERATING STATS
• MESSAGE TO UNITHOLDERS
In 2007, ARC had another very successful year both operationally and financially. We executed a $397 million capital program, drilling 278 operated wells without a single lost time accident for any of our employees or our contractors – an achievement that we are especially proud of. Our production averaged 62,723 boe per day and we exited the year at approximately 65,000 boe per day. Our diversified portfolio of oil and gas production allowed us to benefit from record oil prices while being able to endure relatively low natural gas prices and still deliver consistent distributions of $0.20 per month throughout the year. ARC has consistently met its production targets and has been able to do so through a disciplined approach to the execution of its capital program and its history of acquiring assets that have material upside potential not accounted for in the original purchase price.
Our operational success in 2007 is highlighted by the fact that we replaced 101 per cent of production on a proved plus probable basis, 93 per cent of which was achieved organically with the balance through several minor acquisitions. All in, 2007 finding, development and acquisition costs (“FD&A”) excluding future development capital were $19.00 per boe (15 per cent lower than 2006) which included $87 million (20 per cent of total 2007 capital expenditures) of undeveloped land acquisitions primarily in the Montney resource play in northeast British Columbia. Excluding these extraordinary land purchases for which no reserves have been booked, our FD&A costs would have been $15.24 per boe on a proved plus probable basis (23 per cent lower than 2006). With an average netback in 2007 of $35.44 per boe, ARC’s 2007 recycle ratio was 1.8 including undeveloped land purchases and 2.3 excluding undeveloped land purchases.
ARC has always been a disciplined, resource play focused oil and gas company that consistently creates value for its investors. In 2003, we established a significant operational presence in the Montney formation in northwest Alberta and northeast British Columbia. The Montney is a relatively tight marine siltstone composed of quartz, dolomite and feldspar grains. The zone has long been known to be gas-charged; however, it is only in the last few years that drilling, fracturing, and completion technology have evolved to a level where this gas can be economically produced. In 2005, ARC pioneered the use of an innovative completion technology for horizontal wells that has proven to be the key to unlocking value from this resource. The use of this completion technology has been embraced by other operators and turned a seemingly marginal resource into the hottest natural gas play in western Canada at this time.
The technology continues to improve and the costs to drill and complete the horizontal wells are coming down. ARC’s first horizontal well in Dawson cost $7.5 million to drill and complete – our most recent well came in at approximately $5 million. This first horizontal well has outperformed our expectations – to the end of 2007 this well has already produced 2.4 bcf and is still producing at 1,500 mcf per day. Including this first well, we now have 10 horizontal wells on production and have increased production at Dawson from 24 mmcf per day at the start of 2007 to almost 50 mmcf per day in early 2008.
Given our existing presence in the area and our operational expertise, we have moved aggressively to expand our exposure to the Montney formation in northeast British Columbia. Since August 2006, ARC has spent in excess of $100 million to acquire 44,000 net acres (68 net sections) of land in the Dawson area bringing our total holdings to approximately 90,000 net acres (138 net sections). Included in this number are 57,000 net acres (87 net sections) of undeveloped acreage that we believe is highly prospective for Montney gas. In addition we have another 10,000 net acres (16 net sections) of land just across the border in Alberta that may also be prospective. With successful exploratory wells drilled in 2007 at West Dawson and Sunrise, we believe we have identified over one trillion cubic feet of Discovered Gas Resource(1) on just two of our three undeveloped land blocks in the area. As at year-end 2007, no reserves have been booked for these lands.
Dawson is now our largest property on a production and reserves basis and we will be dedicating at least $85 million (22 per cent of total capital budget) in 2008 to the area to further develop the main Dawson area, delineate the lands surrounding our 2007 discoveries and drill the first evaluation well on our undrilled lands southwest of Dawson.
Another key focus area for ARC is our CO2 enhanced oil recovery (“EOR”) initiatives. Both the Federal and Provincial governments have passed environmental legislation limiting future emissions of CO2. The Alberta Government introduced Bill 3 on March 3, 2007 that states facilities emitting more than 100,000 tonnes of greenhouse gases per year must reduce their emission intensity by 12 per cent over the average emission levels of 2003, 2004 and 2005. Failure to achieve these targets will result in a fine of $15 per tonne above the 12 per cent beginning July 1, 2007. The Federal Government announced a new climate change plan that calls for individual large emitters to reduce greenhouse gas emissions starting in 2007 by six per cent, 18 per cent by 2010 and 26 per cent by 2015. The goal is to reduce Canada’s greenhouse gas emissions by 20 per cent. Both pieces of legislation are a start, but we do not believe they provide sufficient incentive for large emitters to install CO2 capture facilities. However, we believe that in the future, emission regulations will become more stringent as governments move more aggressively to reduce Canada’s CO2 emissions.
ARC has strategically positioned itself to be a beneficiary of more restrictive CO2 emission targets. More stringent emission regulations could lead to a low cost, large scale supply of CO2 becoming available, something that is required for CO2 EOR to become commercially viable in Alberta. We have ownership of and operate some of what we believe are the best assets that are candidates for large-scale CO2 EOR projects in Alberta. We operate key areas of Pembina, which is Canada’s largest conventional oil field, we are the dominant operator in the Redwater Leduc reef and we have significant working interest ownership at Weyburn and Midale where CO2 injection projects are in full operation. We plan to move our CO2 initiative forward with a pilot project in the Redwater field commencing in mid-2008. If a CO2 flood is proven to be technically and economically viable in Redwater, it could gradually increase production from this field by up to 15,000 boe per day. For EOR purposes, this reservoir could take CO2 injection of between 5,000 and 15,000 tonnes per day of CO2.
The scope and scale of Redwater could make it an anchor project for major CO2 infrastructure in Alberta. Redwater may become the largest CO2 EOR project in Alberta or, according to the Alberta Research Council, it could function as a major CO2 sequestration facility, able to store the current cumulative oil sands CO2 emissions for the next 20 years. ARC is currently working with the Alberta Research Council and others to evaluate the long-term potential for CO2 sequestration in the Redwater reef.
During 2007, we completed a limited 3-D seismic survey in Redwater and identified an ideal area to initiate a pilot project. We have submitted applications to the government for partial funding of the project and also to the regulators to get the required approvals. Our goal is to begin injecting CO2 into Redwater by mid-2008. We expect it will take approximately 12 to 18 months before we see results from the pilot at which time we will make technical assessments of the viability of a full scale commercial project. The evolution of government legislation with respect to greenhouse gas emissions will dictate whether or not CO2 will be available in the volumes required and at the cost necessary to make a commercial EOR project in Redwater economically viable. We remain confident that CO2 EOR will become a major initiative in the Western Canadian Sedimentary Basin and, in our view, no company is better positioned than ARC to capitalize on these opportunities.
There are many issues facing the oil and gas sector in the future: tightening environmental legislation will require emitters to manage their emissions; an ever-declining basin presents operational and exploratory challenges; and, numerous supply and demand related issues are causing never-before-seen volatility in commodity prices. ARC actively assesses all such business risks and has a proven track record of solid performance throughout the business cycles. Our strong balance sheet will allow us to take advantage of business opportunities that may arise during these cycles. We have never been better positioned than we are today to create significant investor value through our exciting opportunities in the Montney formation in northeast British Columbia and our CO2 initiatives in Alberta.
I have been asked many times over the past year how ARC will respond to the income trust taxation legislation that comes into effect in 2011. What we are today is a vibrant, disciplined, technically competent and profitable oil and gas company that just happens to be structured as a trust. What we expect to be in 2011 is a vibrant, disciplined, technically competent and profitable oil and gas company that is delivering value to its investors in the most tax efficient manner possible. Our structure may change but our base business and who we are will not. Our goal is to continue to provide our investors with superior returns over the long-term and to keep our business plan focused on maintaining our production from internally generated opportunities. We will continue to develop our rich inventory of resource plays and we will continue to distribute a significant component of our cash flow to our investors in the most tax efficient manner possible.
On October 25, 2007, the Alberta Government announced the New Royalty Framework that outlined a new royalty structure for the Province of Alberta scheduled to go into effect on January 1, 2009 for all oil and gas production in Alberta. Under a low commodity price scenario, the changes are not material for conventional, moderate to low rate wells, which make up the bulk of our production in Alberta. However, a significant component of upside value in a higher commodity price environment will now flow to the government rather than industry investors. I believe this is an ill-advised, poorly designed and very badly timed decision, which will significantly reduce near-term government revenues from the oil and gas industry through a reduction in industry activity.
Notwithstanding the negative impact the royalty changes are having on industry activity, the nature of ARC’s Alberta assets are such that preliminary assessments of the impact of the new royalty rates are an estimated 10 per cent increase to our overall royalties from an average of 18 per cent to approximately 20 per cent. The impact of the changes has been muted by the fact that one-third of our production is derived from wells in British Columbia and Saskatchewan. With such a diverse asset base, we will deploy our capital where we expect the greatest returns, hence for 2008, we will increase our spending on our Montney gas play in northeastern British Columbia and light oil opportunities in Saskatchewan.
John P. DielwartPresident and Chief Executive Officer
(1) Discovered Resources are defined as the quantity of hydrocarbons that are estimated to be contained within a known accumulation. Discovered Resources are divided into economic and uneconomic portions, with the estimated future recoverable portion classified as reserves and contingent resources. There is no certainty that it will be economically viable or technically feasible to produce any portion of this Discovered Resource. However, analogous developments in the ARC Dawson field and the EnCana Swan Lake field have proved to be economic. The resource is not currently classified as reserves or contingent resources as further drilling is required to define the aerial extent of the play and further testing is required to confirm formation deliverability potential. ARC believes its current estimate of this resource, if proven to be correct, will be sufficient to justify full economic development and production assuming the current commodity price and regulatory environments prevail.
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