**Exhibit 99.2**

 

MANAGEMENT’S REPORT TO THE SHAREHOLDERS

 

The preparation of the accompanying consolidated financial statementsin accordance with accounting principles generally accepted in Canada with areconciliation to generally accepted accounting principles in the United Statesis the responsibility of management. Financial information contained elsewherein this Annual Report is consistent with that in the consolidated financialstatements.

 

Management is responsible for the integrityand objectivity of the financial statements. Where necessary, the financialstatements include estimates, which are based on management’s informedjudgments. Management has established systems of internal controls, which aredesigned to provide reasonable assurance that transactions are authorized,assets are safeguarded and financial records are properly maintained to providereliable information for the preparation of financial information.

 

The Board of Directors is responsible forensuring that management fulfills its responsibilities for financial reportingand internal control. It exercises its responsibilities primarily through theAudit Committee, whose members are non-management directors. The AuditCommittee has reviewed the consolidated financial statements with managementand the auditors and has reported to the Board of Directors which has approvedthe consolidated financial statements.

 

MEYERS NORRIS PENNY LLP are independentauditors appointed by Canadian Superior Energy Inc.’s shareholders. Theauditors have audited the consolidated financial statements in accordance withCanadian generally accepted auditing standards and the standards established bythe Public Company Accounting and Oversight Board (PCAOB) to enable them toexpress an opinion on the fairness of the presentation of the financialstatements in accordance with Canadian generally accepted accountingprinciples.

 

 
|   | Greg S. Noval |
|--------|---------------|
|   | President     |

 

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REPORT OF INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS TO THESHAREHOLDERS

 

We have audited the consolidated balance sheet of Canadian SuperiorEnergy Inc. as at December 31, 2005 and the consolidated statements ofoperations and deficit and cash flows for the year then ended. These financialstatements are the responsibility of the Corporation’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.

 

We conducted our audit in accordance withCanadian generally accepted auditing standards and the standards of the PublicCompany Accounting Oversight Board (United States). These standards requirethat we plan and perform an audit to obtain reasonable assurance whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.

 

In our opinion, these consolidated financialstatements present fairly, in all material respects, the financial position ofthe Corporation as at December 31, 2005 and the results of its operationsand its cash flows for the year then ended in accordance with Canadiangenerally accepted accounting principles.

 

Thefinancial statements as at and for the year ended December 31, 2004 and2003 were audited by other auditors, who expressed an opinion withoutreservation on these statements in their reports dated March 31, 2005 and May 10,2004.

 

 
| CALGARY, CANADA     | MEYERS  NORRIS PENNY LLP                      |
|---------------------|-----------------------------------------------|
|                |                                          |
| March 10, 2006 | INDEPENDENT  REGISTERED CHARTERED ACCOUNTANTS |

 

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AUDITORS' REPORT TO THESHAREHOLDERS

 

We have audited the consolidated balance sheet of Canadian SuperiorEnergy Inc. as at December 31, 2004 and the consolidated statements ofoperations and deficit and cash flows for each of the years in the two yearperiod ended December 31, 2004.  Thesefinancial statements are the responsibility of the Corporation'smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audit.

 

We conducted our audit in accordance with Canadian generally acceptedauditing standards.  Those standardsrequire that we plan and perform an audit to obtain reasonable assurancewhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.

 

In our opinion, these consolidated financial statements present fairly,in all material respects, the financial position of the Corporation as atDecember 31, 2004 and the results of its operations and its cash flows for eachof the years in the two year period ended December 31, 2004 in accordance withCanadian generally accepted accounting principles.

 

 
| CALGARY, CANADA |   | /s/ KPMG LLP                                   |
|-----------------|--------|------------------------------------------------|
|            |   |                                           |
| March 31,  2005 |   | INDEPENDENT REGISTERED PUBLIC

ACCOUNTING FIRM |

 

 

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CONSOLIDATEDBALANCE SHEETS DECEMBER 31

 

** **
| **Thousands  of Canadian dollars**                    | ** **   | **2005**      | ** **    | **2004**      | *** *** |
|-------------------------------------------------------|--------------|---------------|---------------|---------------|--------------|
| ***Assets***                                          | ** **   | ** **    | ** **    | ** **    | *** *** |
| *Current Assets*                                      | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Cash and  short-term investments*                    | *** *** | ***$***       | ***11,798***  | *** ***  | ***$***      | ***1,725*** | *** *** |
| *Accounts  receivable*                                | *** *** | ***8,968***   | *** ***  | ***5,808***   | *** *** |
| *Prepaid  expenses*                                   | *** *** | ***774***     | *** ***  | ***593***     | *** *** |
| *** ***                                          | *** *** | ***21,540***  | *** ***  | ***8,126***   | *** *** |
| *Nova Scotia offshore term deposits (Note 4  and 12)* | *** *** | ***14,421***  | *** ***  | ***14,169***  | *** *** |
| *Petroleum and natural gas properties (Note  5)*      | *** *** | ***150,384*** | *** ***  | ***128,716*** | *** *** |
| *** ***                                          | *** *** | ***$***       | ***186,345*** | *** ***  | ***$***      | ***151,011*** | *** *** |
| ***Liabilities***                                     | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Current liabilities*                                 | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Accounts  payable and accrued liabilities*           | *** *** | ***$***       | ***15,754***  | *** ***  | ***$***      | ***10,756*** | *** *** |
| *Revolving  production loan (Note 6)*                 | *** *** | ***12,851***  | *** ***  | ***10,750***  | *** *** |
| *** ***                                          | *** *** | ***28,605***  | *** ***  | ***21,506***  | *** *** |
| *Asset  retirement obligation (Note 7)*               | *** *** | ***8,302***   | *** ***  | ***7,177***   | *** *** |
| *Future  income taxes (Note 8)*                       | *** *** | ***8,638***   | *** ***  | ***8,778***   | *** *** |
| *** ***                                          | *** *** | ***45,545***  | *** ***  | ***37,461***  | *** *** |
| ***Shareholders’ equity***                       | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Share Capital (Note 9)*                              | *** *** | ***135,815*** | *** ***  | ***114,626*** | *** *** |
| *Contributed surplus (Note 9)*                        | *** *** | ***6,391***   | *** ***  | ***3,386***   | *** *** |
| *Deficit*                                             | *** *** | ***(1,406***  | ***)***       | ***(4,462***  | ***)***      |
| *** ***                                          | *** *** | ***140,800*** | *** ***  | ***113,550*** | *** *** |
| *** ***                                          | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Contingencies and commitments (Note 12)*             | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *Subsequent events (Note 13)*                         | *** *** | *** ***  | *** ***  | *** ***  | *** *** |
| *** ***                                          | *** *** | ***$***       | ***186,345*** | *** ***  | ***$***      | ***151,011*** | *** *** |

 

*See accompanyingnotes to the consolidated financial statements*

 
| Approved by the Board |          |         |
|-----------------------|---------------|--------------|
|                  |          |         |
|                  | Greg S. Noval | Leigh Bilton |
|                  |          |         |
|                  | Director      | Director     |

 

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CONSOLIDATED STATEMENTS OF OPERATIONS ANDDEFICIT

 

YEARS ENDED DECEMBER 31

 
| **(Thousands  of Canadian dollars except per share amounts)** | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**                    | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Restated  (Note 2)** | ** ** |
| **Revenue**                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                  | ** ** |
| Oil and gas                                                   | ** ** | **$**      | **55,223** | ** ** | **$**      | **39,299**                  | ** ** | **$** | **32,313** | ** ** |
| Transportation                                                | ** ** | **(678**   | **)**      | **(615**   | **)**      | **(695**                    | **)**      |
| Royalties  net of royalty tax credit                          | ** ** | **(9,716** | **)**      | **(5,805** | **)**      | **(6,050**                  | **)**      |
| ** **                                                    | ** ** | **44,829** | ** ** | **32,879** | ** ** | **25,568**                  | ** ** |
| **Expenses**                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                  | ** ** |
| Production  and operating                                     | ** ** | **7,239**  | ** ** | **7,151**  | ** ** | **5,992**                   | ** ** |
| General and  administration (Note 5)                          | ** ** | **5,398**  | ** ** | **4,614**  | ** ** | **4,849**                   | ** ** |
| Interest                                                      | ** ** | **1,015**  | ** ** | **1,104**  | ** ** | **1,456**                   | ** ** |
| Depletion,  amortization and accretion                        | ** ** | **23,539** | ** ** | **22,177** | ** ** | **14,291**                  | ** ** |
| Stock based  compensation                                     | ** ** | **3,657**  | ** ** | **2,612**  | ** ** | **771**                     | ** ** |
| ** **                                                    | ** ** | **40,848** | ** ** | **37,658** | ** ** | **27,359**                  | ** ** |
| Income  (loss) from operations                                | ** ** | **3,981**  | ** ** | **(4,779** | **)**      | **(1,791**                  | **)**      |
| Other income  (expense) (Note 12)                             | ** ** | **(715**   | **)**      | **493**    | ** ** | **364**                     | ** ** |
| Income  (loss) before income taxes                            | ** ** | **3,266**  | ** ** | **(4,286** | **)**      | **(1,427**                  | **)**      |
| Income taxes  (reduction)                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                  | ** ** |
| Capital                                                       | ** ** | **129**    | ** ** | **261**    | ** ** | **288**                     | ** ** |
| Future  income tax (reduction) (Note 8)                       | ** ** | **81**     | ** ** | **(1,523** | **)**      | **(763**                    | **)**      |
| ** **                                                    | ** ** | **210**    | ** ** | **(1,262** | **)**      | **(475**                    | **)**      |
| Net Income (loss)                                             | ** ** | **3,056**  | ** ** | **(3,024** | **)**      | **(952**                    | **)**      |
| ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                  | ** ** |
| Deficit, beginning of year, as previously  reported           | ** ** | **(4,462** | **)**      | **(312**   | **)**      | **(17,057**                 | **)**      |
| Accounting changes (Note 2)                                   | ** ** | **—** | ** ** | **(1,126** | **)**      | **(486**                    | **)**      |
| Deficit, beginning of year, as restated                       | ** ** | **(4,462** | **)**      | **(1,438** | **)**      | **(17,543**                 | **)**      |
| Reduction in stated capital (Note 9(f))                       | ** ** | **—** | ** ** | **—** | ** ** | **17,057**                  | ** ** |
| Deficit, end of year                                          | ** ** | **$**      | **(1,406** | **)**      | **$**      | **(4,462**                  | **)**      | **(1,438** | **)** |
| Income (loss) per share (Note 9(i))                           | ** ** | **$**      | **0.03**   | ** ** | **$**      | **(0.03**                   | **)**      | **$** | **(0.01** | **)** |
| Diluted income (loss) per share (Note 9(i))                   | ** ** | **$**      | **0.03**   | ** ** | **$**      | **(0.03**                   | **)**      | **$** | **(0.01** | **)** |

 

*See accompanying notes to consolidatedfinancial statements*

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS

 

YEARS ENDED DECEMBER 31

 

 

 
| **(Thousands  of Canadian dollars)**                                                   | *** *** | **2005**      | ** **   | **2004**      | ** **   | **2003**                    | ** **   |
|----------------------------------------------------------------------------------------|--------------|---------------|--------------|---------------|--------------|-----------------------------|--------------|
| ** **                                                                             | ** **   | ** **    | ** **   | ** **    | ** **   | **Restated  (Note 2)** | ** **   |
| ***Cash provided by (used in):***                                  | ** **   | ** **    | ** **   | ** **    | ** **   | ** **                  | ** **   |
| ***Operating activities***                                                             | ** **   | ** **    | ** **   | ** **    | ** **   | ** **                  | ** **   |
| *Net Income (loss)*                                                                    | *** *** | ***$***       | ***3,056***  | *** ***  | ***$***      | ***(3,024***                | ***)***      | ***$*** | ***(952*** | ***)*** |
| *Charges or credits to income not involving  cash*                                     | *** *** | *** ***  | *** *** | *** ***  | *** *** | *** ***                | *** *** |
| *Depletion,  depreciation and accretion*                                               | *** *** | ***23,539***  | *** *** | ***22,177***  | *** *** | ***14,291***                | *** *** |
| *Stock  based compensation*                                                            | *** *** | ***3,657***   | *** *** | ***2,612***   | *** *** | ***771***                   | *** *** |
| *Future  income tax (reduction)*                                                       | *** *** | ***81***      | *** *** | ***(1,523***  | ***)***      | ***(763***                  | ***)***      |
| *Funds from operations*                                                                | *** *** | ***30,333***  | *** *** | ***20,242***  | *** *** | ***13,347***                | *** *** |
| *Change in non-cash working capital (Note 3)*                                          | *** *** | ***11***      | *** *** | ***(2,541***  | ***)***      | ***5,108***                 | *** *** |
| *** ***                                                                           | *** *** | ***30,344***  | *** *** | ***17,701***  | *** *** | ***18,455***                | *** *** |
| ***Financing activities***                                                             | *** *** | *** ***  | *** *** | *** ***  | *** *** | *** ***                | *** *** |
| *Issue of shares*                                                                      | *** *** | ***20,316***  | *** *** | ***12,673***  | *** *** | ***74,195***                | *** *** |
| *Redemption  (Issue) of Nova Scotia offshore term and security deposits, net (Note 3)* | *** *** | ***(252***    | ***)***      | ***9,670***   | *** *** | ***(11,807***               | ***)***      |
| *Increase (repayment) of revolving  production loan*                                   | *** *** | ***2,101***   | *** *** | ***(1,800***  | ***)***      | ***7,400***                 | *** *** |
| *** ***                                                                           | *** *** | ***22,165***  | *** *** | ***20,543***  | *** *** | ***69,788***                | *** *** |
| ***Investing activities***                                                             | *** *** | *** ***  | *** *** | *** ***  | *** *** | *** ***                | *** *** |
| *Acquisition of oil and gas assets*                                                    | *** *** | ***—***  | *** *** | ***(1,070***  | ***)***      | ***(54,160***               | ***)***      |
| *Exploration and development expenditures*                                             | *** *** | ***(44,083*** | ***)***      | ***(41,151*** | ***)***      | ***(29,835***               | ***)***      |
| *Change in non-cash working capital (Note 3)*                                          | *** *** | ***1,647***   | *** *** | ***(3,626***  | ***)***      | ***5,080***                 | *** *** |
| *** ***                                                                           | *** *** | ***(42,436*** | ***)***      | ***(45,847*** | ***)***      | ***(78,915***               | ***)***      |
| *Increase (decrease) in cash and short term  investments*                              | *** *** | ***10,073***  | *** *** | ***(7,603***  | ***)***      | ***9,328***                 | *** *** |
| *Cash and short term investments, beginning  of year*                                  | *** *** | ***1,725***   | *** *** | ***9,328***   | *** *** | ***—***                | *** *** |
| *Cash and short term investments, end of  year*                                        | *** *** | ***$***       | ***11,798*** | *** ***  | ***$***      | ***1,725***                 | *** *** | ***$*** | ***9,328*** | *** *** |

 

*See accompanying notes to consolidatedfinancial statements*

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARSENDED DECEMBER 31, 2005 AND 2004

 

*(Tabularamounts in thousands except per share amounts)*

 

Note 1  Accounting Policies

 

a)           Principles ofconsolidation - The consolidated financial statements include the accounts ofthe Corporation and the accounts of its wholly-owned subsidiaries.

 

b)          Cash and short-terminvestments - Cash and short-term investments consist of balances with banksand investments in highly liquid short-term deposits with a maturity date ofless than ninety days.

 

c)           Depletion and Amortization– Canadian Superior Energy Inc. is engaged in the acquisition, exploration,development and production of oil and gas principally in Canada. TheCorporation follows the full-cost method of accounting for oil and gasoperations whereby all costs relating to the acquisition of, exploration forand development of oil and gas reserves are capitalized. Such costs includeland acquisition costs, geological and geophysical expenses, carrying chargeson nonproducing properties, costs of drilling both productive and nonproductivewells, costs of production equipment and overhead charges related toacquisition, exploration and development activities.

 

The costs are amortized using theunit-of-production method based upon the estimated proved oil and gas reserves,before royalties, as determined by the Corporation’s independent engineers. Oiland gas reserves and production are converted into equivalent units based uponrelative energy content.

 

Costs of acquiring and evaluating unprovedproperties are initially excluded from depletion calculations. Theseunevaluated properties are assessed periodically to ascertain whetherimpairment has occurred. When proved reserves are assigned or the property isconsidered to be impaired, the cost of the property or the amount of theimpairment is added to costs subject to depletion calculations.

 

The Corporation performs a ceiling test in atwo-stage test performed at least annually:

 

i)        Impairment is recognizedif the carrying value of the oil and gas assets less accumulated depletion andamortization and the lesser of cost and fair value of unproven propertiesexceeds the estimated future cash flows from proved oil and gas reserves, on anundiscounted basis, using forecast prices and costs.

 

ii)     If impairment is indicated byapplying the calculations described in i) above, the Corporation will measurethe amount of the impairment by comparing the carrying value of the oil and gasassets less accumulated depletion and amortization and the lesser of cost andfair value of unproven properties to the estimated future cash flows from theproved and probable oil and gas reserves, discounted at the Corporation’scredit-adjusted risk-free rate of interest, using forecast prices and costs.Any impairment is included in earnings for the year.

 

Proceeds received from disposals ofproperties and equipment are credited against capitalized costs unless thedisposal would alter the rate of depletion and depreciation by more than 20percent, in which case a gain or loss on disposal is recorded.

 

Amortization of other equipment is providedon a diminishing balance basis at rates ranging from 20% to 100% per annum.Gains and losses from disposals are included in income.

 

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d)          Joint Ventures - TheCorporation’s exploration and development activities related to oil and gas areconducted jointly with others, which may include related parties (See:Note 10, Below). The accounts reflect only the Corporation’s proportionateinterest in such activities.

 

e)           Income Taxes - TheCorporation follows the liability method of accounting for income taxes.Temporary differences arising from the differences between the tax basis of anasset or liability and its carrying amount on the balance sheet are used tocalculate future income tax assets or liabilities. Future income tax assets orliabilities are calculated using tax rates anticipated to apply in the periodsthat the temporary differences are expected to reverse.

 

f)             Revenue recognition -Revenue from the sale of oil and gas is recognized based on volumes deliveredto customers at contractual delivery points and rates. The costs associatedwith the delivery, including operating and maintenance costs, transportation,and production-based royalty expenses are recognized in the same period inwhich the related revenue is earned and recorded.

 

g)          Flow-through shares -The Corporation, from time to time, issues flow-through shares to finance aportion of its oil and gas exploration activities. The exploration anddevelopment expenditures funded by flow-through shares are renounced tosubscribers in accordance with the Income Tax Act (Canada). The estimated valueof the tax pools foregone is reflected as a reduction in share capital with acorresponding increase in the future income tax liability at the time the relatedexpenditures are renounced.

 

h)          Measurement Uncertainty- The preparation of financial statements in conformity with Canadian generallyaccepted accounting principles requires the Corporation’s management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ materially from thoseestimates. The amounts recorded for depletion and depreciation of petroleum andnatural gas properties and the provision for asset retirement obligation arebased on estimates. The ceiling test is based on estimates of proven reserves,production rates, oil and gas prices, future costs and other relevantassumptions. By their nature, these estimates are subject to measurementuncertainty and the effect on the financial statements of changes in suchestimates, in future periods, could be significant.

 

i)              Per Share Amounts –The Corporation follows the treasury stock method for the computation ofdiluted per share amounts. This method assumes the proceeds from the exerciseof dilutive options and warrants are used to purchase common shares at the weightedaverage market price during the period.

 

j)                 Foreign CurrencyTranslation - Transaction amounts denominated in foreign currencies aretranslated into their Canadian dollar equivalents at exchange rates prevailingat the transaction dates. Carrying values of monetary assets and liabilitiesreflect the exchange rates at the balance sheet date. Gains and losses ontranslation or settlement are included in the determination of net income forthe current period.

 

k)              Recent AccountingPronouncements - In January 2005, the Canadian Institute of CharteredAccountants issued new recommendations for the recognition and measurement offinancial instruments, and amendments to the existing presentation

 

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and disclosure standards, effective forinterim and annual financial statements with fiscal years beginning on or afterOctober 1, 2006. Section 3855 Financial Instruments – Recognition andMeasurement establishes standards for recognizing and measuring financialassets, financial liabilities and non-financial derivatives. Section 3861Financial Instruments – Presentation and Disclosure discusses the presentationand disclosure of these items. The application of hedge accounting is coveredin Section 3865 Hedges. Section 1530 Comprehensive Income establishesstandards for reporting and displaying certain gains and losses, such asunrealized gains and losses related to hedges or other derivative instruments,outside of net income, in a statement of comprehensive income. Section 3251Equity establishes standards for the presentation of equity and changes inequity, including changes arising from those items recorded in comprehensiveincome. There have also been numerous consequential amendments made to otherSections. Transitional provisions are complex and vary based on the type offinancial instruments under consideration. Therefore, the Corporation has notyet determined the effect of these new standards on its consolidated financialstatements.

 

Note 2 -Changes in Accounting Policies

 

**a)****             ****Stock BasedCompensation and other Stock Based Payments**

 

Effective January 1, 2004, the Corporation retroactively adopted thenew Canadian standard for “Stock Based Compensation”. This standard requiresthat companies measure all stock based payments using the fair value method of accountingand recognize the compensation expense in their financial statements. Per thetransitional provisions, adoption requires that compensation expense becalculated and recorded in the statement of operations for options and warrantsissued on or after January 1, 2003.

 

**b)****             ****AssetRetirement Obligations**

 

Effective January 1, 2004 the Corporation retroactively adopted thenew Canadian standard for “Asset Retirement Obligations”. This standardrequires the recognition of the fair value of obligations associated with theretirement of tangible long-lived assets to be recorded in the period the assetis put to use, with the corresponding increase to the carrying amount of therelated asset. The obligations recognized are statutory, contractual or legalobligations. The liability is accreted over time for changes in the fair valueof the liability through charges to asset retirement accretion which isincluded in depletion, amortization and accretion expense. The costscapitalized to the related assets are amortized to earnings in a mannerconsistent with the depreciation and amortization of the underlying assets.Revisions to the estimated timing of cash flows or to the original estimatedundiscounted costs could also result in an increase or decrease to the obligation.Actual costs incurred upon settlement of the retirement obligation are chargedagainst the obligation to the extent of the liability recorded. Prior to January 1,2004, the Corporation provided for future site restoration and abandonmentcosts over the life of the proved reserves on a unit-of-production basis.

 

**c)****             ****Hedgingrelationships**

 

The Corporation has implemented new Canadian accounting guidelines forhedging relationships, which addresses the identification, designation, documentation and effectivenessof hedging transactions for the purposes of applying hedge accounting. It alsoestablished conditions for applying or discontinuing hedge accounting. Underthe new guideline, hedging transactions must be documented and it must bedemonstrated that the hedges are sufficiently effective in order to continueaccrual accounting for position hedges with derivatives.

 

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**d)****             ****Impactof  policy changes on 2003 FinancialStatements**

 

The adoption of the new accounting policies for stock based compensationand asset retirement obligations has been applied retroactively with thefollowing impact on the 2003 comparative figures:

 
| **Balance  Sheet - debit (credit)**     | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| *Petroleum  and natural gas properties* | ** ** | **$**      | **4,797**  | ** ** |
| Asset  Retirement Obligation            | ** ** | **(5,979** | **)**      |
| Provision  for Future Site Restoration  | ** ** | **1,634**  | ** ** |
| Future  Income Taxes                    | ** ** | **(174**   | **)**      |
| Contributed  Surplus                    | ** ** | **(1,404** | **)**      |
| Deficit, end  of year                   | ** ** | **1,126**  | ** ** |
| Deficit,  beginning of year             | ** ** | **486**    | ** ** |
|                                         |            |            |            |  |

 
| **Statement  of operations - debit (credit)** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------|------------|
| Depletion, amortization and accretion         | ** ** | **$**      | **1,027**  | ** ** |
| Future site restoration                       | ** ** | **(1,223** | **)**      |
| Stock based compensation                      | ** ** | **771**    | ** ** |
| Future income tax reduction                   | ** ** | **65**     | ** ** |
| Decrease in net income                        | ** ** | **$**      | **640**    | ** ** |
| Loss per share - basic and diluted            | ** ** | **$**      | **(0.01**  | **)** |

 

**e)****             ****Adjust 2004and 2003 earnings to reflect transportation charges**

 

The Corporation has implemented new Canadian accounting standard relatingto the presentation of transportation costs. In prior years it was Canadianindustry practice to net these costs out of revenues. The Corporation hasrestated revenues for the current and prior years to reflect this change.Transportation costs were $0.6 million in 2004 ($0.7 million in 2003). Thischange has no impact on net income or cash flow.

 

Note 3 - Changes in Non-Cash Working Capital and other Cash FlowInformation

 
| ** **                                      | ** ** | **2005  Change** | ** ** | **2004  Change** | ** ** | **2003  Change** | ** ** |
|-------------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| Accounts Receivable                             |       | $                | (3,160     | )                | $          | (2,268           | )          | $ | 714 |   |
| Nova Scotia offshore drilling security  deposit |       | —           |       | 10,000           |       | (10,000          | )          |
| Prepaid expenses                                |       | (181             | )          | (25              | )          | 1,156            |       |
| Accounts payable                                |       | 4,999            |       | (3,874           | )          | 8,318            |       |
| Change in non-cash  working capital             |       | $                | 1,658      |             | $          | 3,833            |       | $ | 188 |   |
| Related to:                                     |       |             |       |             |       |             |       |
| Operating  activity                             |       | $                | 11         |             | $          | (2,541           | )          | $ | 5,108 |   |
| Financing  activity                             |       | —           |       | 10,000           |       | (10,000          | )          |
| Investing  activity                             |       | 1,647            |       | (3,626           | )          | 5,080            |       |
| Change in  non-cash working capital             |       | $                | 1,658      |             | $          | 3,833            |       | $ | 188 |   |
|                                            |       |             |       |             |       |             |       |
| Other Cash Flow Information                     |       |             |       |             |       |             |       |
| Interest paid                                   |       | $                | 854        |             | $          | 1,104            |       | $ | 1,456 |   |
| Taxes paid                                      |       | $                | 143        |             | $          | 271              |       | $ | 76 |   |
|                                                 |            |                  |            |                  |            |                  |            |  |  |  |  |

 

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Note 4 – Nova Scotia Offshore Term Deposits

 

Under the terms of the licenses referred to in Note 12(a), theCorporation has assigned term deposits totaling $14,421,000 (2004 -$14,169,000). Accordingly, this amount has been classified as a noncurrentasset. To the extent that the expenditures are not incurred within the periodallowed, the Corporation would forfeit its proportionate share of any remainingdeposits relating to the unexpended work commitment.

 

Note 5 – Petroleum and Natural Gas Properties

 
| ** **                                      | ** ** | **Cost** | ** ** | **Accumulated Depletion and  Amortization** | ** ** | **Net** | ** ** |
|-------------------------------------------------|------------|----------|------------|---------------------------------------------|------------|---------|------------|
| 2005                                            |       |     |       |                                        |       |    |       |
| Petroleum and natural gas properties-  Canada   |       | $        | 202,408    |                                        | $          | 67,418  |       | $ | 134,990 |   |
| Petroleum and natural gas properties-  Trinidad |       | 15,394   |       | —                                      |       | 15,394  |       |
| Total                                           |       | $        | 217,802    |                                        | $          | 67,418  |       | $ | 150,384 |   |
| 2004                                            |       |     |       |                                        |       |    |       |
| Petroleum and natural gas properties-  Canada   |       | $        | 170,466    |                                        | $          | 44,441  |       | $ | 126,025 |   |
| Petroleum and natural gas properties-  Trinidad |       | 2,691    |       | —                                      |       | 2,691   |       |
| Total                                           |       | $        | 173,157    |                                        | $          | 44,441  |       | $ | 128,716 |   |

 

Future development costs related to provenreserves of $7,146,000 (2004 - $3,647,000) have been included in the depletionbase calculation at December 31, 2005.

 

At December 31, 2005, the Corporationhas excluded $42,777,000 (2004 - $28,746,000) of oil and gas propertiesrelating to unproved properties from costs subject to depletion, including$15.4 million relating to its interests in Trinidad and Tobago. General andadministrative expenses totaling $5,937,000 (2004 - $4,445,000, 2003 –$4,063,000), of which $965,000 (2004 - $767,000, 2003 – $390,000) pertained tothe Nova Scotia project, that were directly related to exploration and developmentactivities, have been capitalized for the year ended December 31, 2005.

 

The benchmark prices, on which the ceiling test is based, are asfollows:

 
| ** ** | ** ** | **WTI Crude Oil** | ** ** | **Exchange Rate** | ** ** | **Edmonton Light Crude** | ** ** | **AECO Natural Gas** | ** ** |
|------------|------------|-------------------|------------|-------------------|------------|--------------------------|------------|----------------------|------------|
| **Year**   | ** ** | **US$/bbl**       | ** ** | **US$/CDN$**      | ** ** | **CDN$/bbl**             | ** ** | **CDN$/mmbtu**       | ** ** |
| 2006       |       | 57.00             |       | 0.85              |       | 66.25                    |       | 10.60                |       |
| 2007       |       | 55.00             |       | 0.85              |       | 64.00                    |       | 9.25                 |       |
| 2008       |       | 51.00             |       | 0.85              |       | 59.25                    |       | 8.00                 |       |
| 2009       |       | 48.00             |       | 0.85              |       | 55.75                    |       | 7.50                 |       |
| 2010       |       | 46.50             |       | 0.85              |       | 54.00                    |       | 7.20                 |       |
| 2011       |       | 45.00             |       | 0.85              |       | 52.25                    |       | 6.90                 |       |

 

----

 

Benchmark prices increase at a rate of 2.0% per year for both oil andnatural gas after 2011. Adjustments were made to the benchmark prices above,for purposes of the ceiling test, to reflect forward contracts the Corporationhas in place, varied delivery points and quality differentials in the productsdelivered. For the years ended December 31, 2005 and 2004, no ceiling testwrite-down was required.

 

Note 6 – Revolving Production Loan

 

At December 31, 2005 the Corporation had a demand revolvingproduction loan facility (the “facility”) with a Canadian chartered bank of$25,000,000 of which it had drawn $12,851,000. The facility bears interest atprime plus 1.0%. The facility is secured by a $100 million first floatingcharge demand debenture on the assets of the Corporation and a general securityagreement covering all of the assets of the Corporation. The facility expires April 30,2006 unless extended.

 

Note 7 – Asset Retirement Obligation

 

The following table presents the reconciliation of thebeginning and ending aggregate carrying amount of the obligation associatedwith the retirement of oil and gas properties.

 
| **As at December 31 ($000’s)**        | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Asset Retirement Obligation, beginning of  year |       | $        | 7,177      |     | $          | 5,979 |   |
| Liabilities Incurred                            |       | 563      |       | 900      |       |
| Accretion expense                               |       | 562      |       | 456      |       |
| Technical revision                              |       | —   |       | (158     | )          |
| Asset Retirement Obligation, end of year        |       | $        | 8,302      |     | $          | 7,177 |   |

 

The technical revision in 2004 was the result of adjustingthe credit adjusted risk free rate to 8.5% for wells drilled in 2004 from 7.0%used in 2003 and prior. The Corporation estimates the total undiscounted amountof cash flows required to settle its asset retirement obligation isapproximately $15,746,000 (2004 – 14,197,000) which will be incurred between2016 and 2018.

 

Note 8  Income Taxes

 

 The net future income taxliability is comprised of:

 

a)              Summary of temporary differences givingrise to future income tax liability:

 
| ** **                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| **Future Tax Liabilities**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Oil and gas  assets in excess of tax balances | ** ** | **$**      | **12,756** | ** ** | **$**      | **12,628** | ** ** |
| **Future Tax Assets**                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Share Issue  Costs                            | ** ** | **(1,327** | **)**      | **(1,437** | **)**      |
| Asset  Retirement Obligation                  | ** ** | **(2,791** | **)**      | **(2,413** | **)**      |
| ** **                                    | ** ** | **(4,118** | **)**      | **(3,850** | )          |
| Net future income tax liability               | ** ** | **$**      | **8,638**  | ** ** | **$**      | **8,778** | ** ** |

 

----

 

b)             Reconciliation of income taxes calculatedat the Canadian statutory rate of 37.6% (2004 – 38.6%) with actual incometaxes:

 

| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**               | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|------------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** | **Restated  (Note 2)** | ** ** |
| Income (loss) before income taxes                | ** ** | **$**      | **3,266**  | ** ** | **$**      | **(4,286**             | **)**      | **$** | **(1,427** | **)** |
| Combined federal and provincial income tax  rate | ** ** | **37.6**   | **%**      | **38.6**   | **%**      | **40.6**               | **%**      |
| Computed income tax expense (reduction)          | ** ** | **$**      | **1,228**  | ** ** | **$**      | **(1,654**             | **)**      | **$** | **(579** | **)** |
| Increase (decrease) resulting from:              | ** ** | ** ** | ** ** | ** ** | ** ** | ** **             | ** ** |
| Non  deductible Crown Royalties, net             | ** ** | **1,863**  | ** ** | **1,224**  | ** ** | **1,755**              | ** ** |
| Resource  Allowance                              | ** ** | **(2,168** | **)**      | **(1,397** | **)**      | **(1,474**             | **)**      |
| Stock based  compensation                        | ** ** | **1,376**  | ** ** | **1,008**  | ** ** | **313**                | ** ** |
| Tax  reassessments                               | ** ** | **(2,313** | **)**      | **—** | ** ** | —                 | ** ** |
| Tax  adjustment from rate change and other       | ** ** | **95**     | ** ** | **(704**   | **)**      | **(778**               | **)**      |
| ** **                                       | ** ** | **$**      | **81**     | ** ** | **$**      | **(1,523**             | **)**      | **$** | **(763** | ) |

 

During 2005, Canada Revenue Agency completed a review of certain of theCorporations tax filings for the years 2000 to 2002. As a result of thesereviews, the Corporation’s tax pools increased resulting in a future income taxrecovery of approximately $2.3 million.

 

Note 9  Share Capital

 

a)              Authorized:

 

Unlimited number of common shares

 

Unlimited number of preferred shares

 

b)             Voting common sharesissued:

 

| ** **                                         | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                         | ** ** | **Number**                 | ** ** | **Amount**                 | ** ** | **Number** | ** ** | **Amount** | ** ** |
| Balance, beginning of year                         |       | 109,806                    |       | $                          | 114,626    |   | 96,101 |   | $ | 80,095 |   |
| Issued for cash on special warrants                |       | 5,500                      |       | 10,835                     |       | 7,543 |   | 22,834 |   |
| Issued upon exercise of stock options              |       | 852                        |       | 1,044                      |       | 1,299 |   | 1,462 |   |
| Issued for cash on flow-through shares             |       | 2,977                      |       | 8,929                      |       | 1,377 |   | 3,443 |   |
| Issue costs, net of future tax reduction of  $221  |       | —                     |       | (436                       | )          | — |   | — |   |
| Issued upon exercise of $2.00 purchase  warrants   |       | —                     |       | —                     |       | 3,002 |   | 6,004 |   |
| Issued upon exercise of $3.20 purchase  warrants   |       | —                     |       | —                     |       | 484 |   | 1,549 |   |
| Tax benefits renounced on flow-through  shares     |       | —                     |       | —                     |       | — |   | (1,188 | ) |
| Issue costs, net of future tax reduction of  $106  |       | —                     |       | —                     |       | — |   | (203 | ) |
| Value of stock compensation for exercised  options |       | —                     |       | 652                        |       | — |   | 630 |   |
| Balance, end  of year                              |       | 119,135                    |       | $                          | 135,650    |   | 109,806 |   | $ | 114,626 |   |

 

----

 

c)              Special warrants issued:

 
| ** **                               | ** ** | **Number** | ** ** | **Amount** | ** ** | **Number** | ** ** | **Amount** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Balance, beginning of year               |       | —     |       | $          | —     |       | 7,368      |       | $          | 22,309 |   |
| Special warrants issued for cash (i)     |       | 5,500      |       | 11,000     |       | —     |       | —     |       |
| Special warrants issued for cash (ii)    |       | —     |       | —     |       | 175        |       | 525        |       |
| Converted upon issuance of common shares |       | (5,500     | )          | (11,000    | )          | (7,543     | )          | (22,834    | )          |
| Balance, end of year                     |       | —     |       | $          | —     |       | —     |       | $          | — |   |

 

d)             Purchase warrants issued:

 
| ** **                         | ** ** | **Number** | ** ** | **Amount** | ** ** | **Number** | ** ** | **Amount** | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Balance, beginning of year         |       | —     |       | $          | —     |       | —     |       | $          | — |   |
| Issued August 30, 2005 (iv)   |       | 2,750      |       | 165        |       | —     |       | —     |       |
| Issued February 6, 2004 (iii) |       | —     |       | —     |       | 2,467      |       | —     |       |
| Exercised                          |       | —     |       | —     |       | (484       | )          | —     |       |
| Expired                            |       | —     |       | —     |       | (1,983     | )          | —     |       |
| Balance, end of year               |       | 2,750      |       | $          | 165        |       | —     |       | $          | — |   |
| Share Capital, end of year         |       |       |       | $          | 135,815    |       |       |       | $          | 114,626 |   |

 

e) Special Warrants

 

(i) On August 30, 2005 the Corporation filed a short form prospectusqualifying the distribution of 5,500,000 common shares and 2,750,000 commonshare purchase warrants upon the exercise of the 5,500,000 special warrantsissued on July 5th, 6th and 12th, 2005. (ii) OnFebruary 6, 2004 the Corporation filed a short form prospectusqualifying the distribution of 7,400,180 common shares and 2,466,726 commonshare purchase warrants upon the exercise of the 7,225,180 special warrantsissued on December 16th and 24th, 2003 (as above)and an additional 175,000 special warrants issued on January 12, 2004 and142,857 flow-through common shares upon the exercise of 142,857 flow throughspecial warrants issued on December 31, 2003..

 

f) Purchase Warrants 

 

(iii)       As described in Note 9(e) in February 2004,the Corporation filed a short form prospectus qualifying the distributionof 2,466,726 common share purchase warrants.

 

(iv)      As described in Note 9(e) in August 2005,the Corporation filed a short form prospectus qualifying the distributionof 2,750,000 common share purchase warrants which will expire on June 30, 2006.

 

e)              Stock options:

 

The Corporation has a stock option plan forits directors, officers, employees and key consultants. The exercise price forstock 

 

----

 

options granted is no less than the quotedmarket price on the grant date with options vesting either on the grant date orin equal increments over a three year period. An option’s maximum term is tenyears.

 
| ** **                         | ** ** | **2005**               | ** ** | **2004**                    | ** ** |
|------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **Number of  Options** | ** ** | **Weighted  Average price** | ** ** | **Number of  Options** | ** ** | **Weighted  Average price** | ** ** |
| Balance, beginning of year         |       | 7,371                  |       | $                           | 1.66       |   | 5,133 |   | $ | 1.29 |   |
| Forfeited                          |       | (613                   | )          | 1.82                        |       | (2,170 | ) | 1.57 |   |
| Exercised                          |       | (852                   | )          | 1.22                        |       | (1,299 | ) | 1.13 |   |
| Prior period  option reinstatement |       | 200                    |       | 0.80                        |       | 0 |   | 0.00 |   |
| Granted                            |       | 3,382                  |       | 2.11                        |       | 5,707 |   | 1.85 |   |
| Balance, end of year               |       | 9,488                  |       | $                           | 1.83       |   | 7,371 |   | $ | 1.66 |   |

 

The following table summarizes informationabout the stock options outstanding at December 31, 2005:

 
| **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|-------------------------|------------|
| **Exercise Price**      | ** ** | **Number of  options**  | ** ** | **Weighted Average of  Remaining  Contractual Life  (years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $                       | 0.80-1.00  |                    |       | 655 |   | 4.28 |   | $ | 0.82 |   | 655 |   | $ | 0.82 |   |
| 1.01-1.50               |       |                    | 1,145      |   | 6.89 |   | 1.30 |   | 985 |   | 1.29 |   |
| 1.51-2.00               |       |                    | 4,811      |   | 8.63 |   | 1.79 |   | 2,209 |   | 1.75 |   |
| 2.00-3.00               |       |                    | 2,877      |   | 9.00 |   | 2.35 |   | 1,984 |   | 2.40 |   |
| $                       | 0.80-3.00  |                    |       | 9,488 |   | 8.32 |   | $ | 1.83 |   | 5,833 |   | $ | 1.79 |   |

 

The following table summarizes informationabout the stock options outstanding at December 31, 2004:

 
| **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|-------------------------|------------|
| **Exercise Price**      | ** ** | **Number of  options**  | ** ** | **Weighted Average of  Remaining  Contractual Life  (years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $                       | 0.80-1.00  |                    |       | 762 |   | 4.32 |   | $ | 0.82 |   | 762 |   | $ | 0.82 |   |
| 1.01-1.50               |       |                    | 1,533      |   | 7.73 |   | 1.29 |   | 1,041 |   | 1.27 |   |
| 1.51-2.00               |       |                    | 3,854      |   | 9.17 |   | 1.73 |   | 1,048 |   | 1.79 |   |
| 2.00-3.00               |       |                    | 1,222      |   | 8.82 |   | 2.45 |   | 446 |   | 2.69 |   |
| $                       | 0.80-3.00  |                    |       | 7,371 |   | 8.35 |   | $ | 1.66 |   | 3,297 |   | $ | 1.52 |   |

 

----

 

A modified Black-Scholes option pricingmodel, with the following weighted average assumptions, was used to estimatethe fair value of options on the date of the grant, for the inclusion as stockbased compensation expense:

 
| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |
| Risk free interest rate (%) |       | 4.0      |       | 4.0      |       |
|                        |       |     |       |     |       |
| Expected lives (years)      |       | 10.0     |       | 10.0     |       |
|                        |       |     |       |     |       |
| Expected volatility (%)     |       | 57.0     |       | 93.9     |       |
|                        |       |     |       |     |       |
| Dividend per share          |       | 0.00     |       | 0.00     |       |

 

The grant date weighted average fair value ofoptions issued during 2005 was $1.08 (2004: $1.31) per option.

 

The impact of stock based compensation onContributed Surplus is:

 
| **Contributed Surplus**                  | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|------------------------------------------|------------|-----------|------------|------------|------------|
| Opening Balance                          | ** ** | **$**     | **3,386**  | ** ** | **$**      | **1,404** | ** ** |
| Additions from issuance of stock options | ** ** | **3,657** | ** ** | **2,612**  | ** ** |
| Reduction from exercise of stock options | ** ** | **(652**  | **)**      | **(630**   | **)**      |
| Closing balance                          | ** ** | **$**     | **6,391**  | ** ** | **$**      | **3,386** | ** ** |

 

 

g)         On June 27, 2003, atthe Corporation’s Annual Meeting of Shareholders, a special resolution wasapproved authorizing a reduction in the stated capital account for the commonshares of the Corporation of $17,057,000, being the Corporation’s deficit as atDecember 31, 2002.

 

h)         During the year ended December 31,2005, the Corporation entered into flow-through share agreements to issue2,976,400 common shares for cash consideration of $8,929,200 and to renounce$8,929,200 of qualified expenditures.

 

i)                During the yearended December 31, 2004, the Corporation entered into flow-through shareagreements to issue 1,377,000 common shares for cash consideration of$3,442,500 and to renounce $3,442,500 of qualified expenditures.

 

j)             Per share amounts forLoss per share were calculated using the weighted average number of commonshares outstanding of 112,170,000 for 2005 and 106,465,000 for 2004 and85,082,000 for 2003. In calculating the diluted earnings per share amounts for2005, 2,109,252 shares were required to be added to the weighted average numberof common shares outstanding.

 

Note 10  Related PartyTransactions

 

a)                                      During the yearended December 31, 2005, the Corporation paid $691,000 (2004 - $628,000,2003 - $912,000) for oilfield equipment rentals to a company controlled by adirector, for oilfield construction to a company controlled by a director andfor aircraft rentals to a company controlled by an officer and director of theCorporation. During the year, the Corporation paid nil (2004 - $107,000, 2003 –nil) to a Company controlled by an officer and director of the Corporation forconsulting services.

 

----

 

b)                                     In November 2004,the Corporation entered into a participation agreements in the normal course ofoperations with a Company controlled by an officer and director of theCorporation in respect of the Corporation’s offshore Nova Scotia and offshoreTrinidad and Tobago prospects. Pursuant to the 2004 agreements, the Company hadthe right to participate on a promoted basis for 16 2/3% of Canadian Superior’scosts of the East Coast wells (this was subsequently increased to 33 1/3%) andthe related party Company has the right to participate on a promoted basis for33 1/3% of Canadian Superior’s costs of certain earning wells in Trinidad.

 

Thetransactions were in the normal course of operations and agreed to by therelated Company and the Corporation based on extensive negotiations and Boardapproval and approval by the Corporation with legal counsel involved andaccordingly had been measured at the exchange amount...

 

Note 11  Risk Management

 

The carrying values of financial assets and liabilities approximatetheir fair value due to their short periods to maturity, or the market interestrate on the revolving production loan.

 

A substantial portion of the Corporation’saccounts receivable are with customers and joint venture partners in the oiland gas industry and are subject to normal industry credit risks. Purchasers ofthe Corporation’s oil, gas and natural gas liquids are subject to an internalcredit review to minimize the risk of nonpayment.

 

The Corporation is exposed to foreigncurrency fluctuations as oil and gas prices received are referenced to U.S.dollar denominated prices. The Corporation is exposed to a floating interestrate on its revolving production loan.

 

The Corporation enters into commodity salesagreements and certain derivative financial instruments to reduce its exposureto commodity price volatility. These financial instruments are entered intosolely for hedging purposes and are not used for trading or other speculativepurposes.

 

At December 31, 2005, the Corporationhad the following contracts in place:

 
| **Contract**    | ** ** | **Volume**        | ** ** | **Price**  | ** **       | **Term**   | ** **                                 |
|-----------------|------------|-------------------|------------|------------|------------------|------------|--------------------------------------------|
| ** **      | ** ** | ** **        | ** ** | ** ** | ** **       | ** ** | ** **                                 |
| **Natural Gas** |       |              |       |       |             |       |                                       |
| ** **      |       |              |       |       |             |       |                                       |
| Fixed Price     |       | 1,000 gj per  day |       | $          | 10.08/gj  (Aeco) |       | January 1  – March 31, 2006 |   |
|                 |            |                   |            |            |                  |            |                                            |  |

 

At December 31, 2005, the estimated fairvalue of the above financial instruments indicates an unrealized gain of$23,140.

 

During 2005, the Corporation’s hedging activities resulted in a loss of$22,696 (2004: $496,000; and an income of $269,000 in 2003) which was recordedas a decrease (increase in 2003) in oil and gas revenues during the period.

 

Note 12  Contingencies andCommitments

 

a)             NovaScotia:  During 2000, 2001 and 2003, theCorporation acquired six exploration licenses from the Canada-Nova ScotiaOffshore Petroleum Board. These licenses are for a period of nine years intotal, subject to certain requirements being met during the first five years.As a condition of the licenses, the Corporation is required to post security inthe amount of 25% of its work expenditure bids. The deposit is refundable onlyto the extent of approved allowable expenditures. The duration of the initialfive year term, for a given license, can be extended one additional year to sixyears by posting an additional security deposit in an

 

----

 

amount of $250,000. At December 31,2005, as a result of the Corporation having made certain expenditures, theCorporation had fulfilled its work expenditures on two of the six explorationlicenses. The remaining four exploration licenses are currently owned 100percent by the Corporation and have aggregate work expenditure outstanding of$57,684,000, and as such the Corporation has $14,421,000 in term depositsassigned to the Canada – Nova Scotia Offshore Petroleum Board.

 

b)            Trinidad and Tobago: The Corporation is committed to drill3 exploration wells on its “Intrepid” Block 5(c) under its Block 5(c) ProductionSharing Contract (“PSC”) with the Government of Trinidad and Tobago, funded in part arelated party (See: Note 10, above) participating on a promoted basis, paying1/3 of Canadian Superior’s block 5(c) exploration program to obtain 25% ofCanadian Superior’s net revenue share of these prospects. Also, once approvedby the Government of Trinidad and Tobago, the Corporation has an exploration drillingcommitment to drill 2 wells on the “Mayaro/Guayaguayare” blocks from a jointventure with the Petroleum Company of Trinidad and Tobago Limited (“Petrotrin”).

 

c)             Flow-through Expenditures: At December 31, 2005, the Corporation had yet to incur approximately$8.9 million of Canadian exploration expenses in relation to flow throughshares issued. These expenses must be incurred by December 31, 2006.

 

d)            Litigationand Claims:  The Corporation is involvedin various claims and litigation arising in the ordinary course of business. Inthe opinion of Canadian Superior the various claims and litigations arisingtherefrom are not expected to have a material adverse effect on the Corporation’sfinancial position. The Corporation maintains insurance, which in the opinionof the Corporation, is in place to address unforeseen claims.

 

During 2004, a number of class action proceedingswere initiated against Canadian Superior and certain of its directors andofficers in the United States District Court, Southern District of New York, inthe Ontario Superior Court of Justice and the Quebec Superior Court byplaintiffs alleging to have purchased securities of the Corporation and theyallege that they suffered extensive damages resulting from statements andactions taken by the Corporation and of it Officers and Directors of CanadianSuperior regarding the Corporation’s Mariner I-85 exploration well drilledoffshore Nova Scotia. On June 8, 2005, Canadian Superior and its insurersreached an agreement with no admission of liability by all parties to settleall securities class action litigation pending in the United Statesagainst the Corporation, and on September 6, 2005, a similar settlementwas reached in Canada. The settlement for the two actions totaled $3.2 millionU.S. and $2.15 million Canadian respectively, and was covered by theCorporation’s insurance.

 

Asat December 31, 2005, the Corporation accrued $1,012,000 (inclusive oflegal costs) as a one time charge to recognize the settlement of a formeremployee’s alleged compensation claims, which was settled subsequent to yearend. This amount has been included as an expense in other income (expense) inthe statement of operations.

 

e)             ProspectCommitment Fee:  During 2002, theCorporation received a $10 million prospect commitment fee related to its “Marquis”Prospect Offshore Nova Scotia. In the event that any natural gas or otherhydrocarbons in commercial quantities are produced from a well on the “Marquis”Prospect, the Corporation will be obligated to repay the amount in 12 quarterlyinstallments following commencement of commercial production.

 

f)               LeaseObligations:  The Corporation has enteredinto agreements to lease premises and equipment requiring future minimumpayments totaling $3,370,000. Minimum annual payments during the next fivefiscal years are as follows:

 

----

 
| 2006   |   | $      | 1,197,000 |   |
|--------|--------|--------|-----------|--------|
|   |   |   |      |
| 2007   |   | $      | 1,019,000 |   |
|   |   |   |      |
| 2008   |   | $      | 888,000   |   |
|   |   |   |      |
| 2009   |   | $      | 237,000   |   |
|   |   |   |      |
| 2010   |   | $      | 28,000    |   |

 

Note 13  Subsequent Events

 

a)        On December 6, 2005the Corporation secured a US$15 million equity commitment, On February 1,2006, the Corporation completed this financing in the form of a privateplacement in the amount of US $15,000,000 by way of the issuance of Unitsconsisting of ten 5% US Cumulative Redeemable Convertible Preferred Shares (the“Preferred Shares”) and 80 Common Share Purchase Warrants. Each Preferred Sharewill be convertible into forty Common Shares of Canadian Superior (6,000,000Common Shares in aggregate) at a price of US $2.50 per Common Share. If CanadianSuperior elects, it also has the option to pay the quarterly dividend by way ofissuance of Common Shares at market, based on a 5.75% annualized dividend ratein lieu of the 5% annualized cash dividend rate. In addition, the PreferredShares are redeemable and retractable five years from the date of issue orearlier, subject to earlier redemption or retraction subject to certain events.10,000 Units, each consisting of 10 US $100 Preferred Shares, along with800,000 Common Share Purchase Warrants are being issued to West Coast AssetManagement, Inc.. The Warrants comprising part of the Units areexercisable for a period of thirty (36) months from the date of issue at anexercise price of US $3.00 per Common Share.

 

b)       Also in December 2005,the Corporation secured an equity financing commitment of $2.4 million, and on February 9,2006 the Corporation completed this financing in the form of a privateplacement of 1,000,000 Units at a price of $2.40 per Unit for gross proceeds of$2,400,000. Each Unit consists of one Common Share and one-half of one CommonShare Purchase Warrant. The Warrants comprising part of the Units areexercisable until December 31, 2006 at an exercise price of $2.80 perCommon Share.

 

c)              Subsequent to yearend, the Corporation settled an outstanding lawsuit (see Note 12c).

 

Note 14  Comparative Figures

 

Certaincomparative figures have been reclassified to conform with current yearpresentation.

 

Note 15  Reconciliation withUnited States Generally Accepted Accounting Principals

 

The Corporation follows Canadian generally accepted accountingprinciples (Canadian GAAP) which differs in some respects from generallyaccepted accounting principles in the United States (U.S. GAAP). Significantdifferences in accounting principles that impact the Corporation’s financialstatements are described below:

 

(Tabular amounts in thousands of Canadian dollars except per shareamounts)

 

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| ** **                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**     | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Net income (loss) in accordance with  Canadian GAAP, as reported  |       | $        | 3,056      |     | $          | (3,024       | )          | $ | (952 | ) |
| Flow Through Shares (a)                                           |       |     |       |     |       |         |       |
| Income Taxes                                                      |       | (1,283   | )          | (417     | )          | (3,757       | )          |
| Property Acquisitions (b)                                    |       |     |       |     |       |         |       |
| Depletion,  amortization and accretion expense                    |       | 452      |       | 599      |       | 525          |       |
| Income taxes                                                      |       | (152     | )          | (206     | )          | (189         | )          |
|                                                              |       |     |       |     |       |         |       |
| Ceiling Test (c)                                                  |       |     |       |     |       |    |       |
| Write down  of petroleum and natural gas properties               |       | —   |       | (10,000  | )          | (34,100      | )          |
| Income Taxes                                                      |       | —   |       | 1,439    |       | 12,089       |       |
| Depletion,  amortization and accretion expense                    |       | 5,181    |       | 4,853    |       | (770         | )          |
| Income Taxes                                                      |       | (1,742   | )          | (1,675   | )          | 277          |       |
| Stock based compensation (d)                                      |       | 3,657    |       | 2,612    |       | 771          |       |
| Change in valuation allowance                                     |       | 1,754    |       | —   |       | —       |       |
| Net loss before cumulative effect of change  in accounting policy |       | 10,923   |       | (5,819   | )          | (26,106      | )          |
| Cumulative effect of change in accounting  policy, net of tax (e) |       | 0        |       | 0        |       | 147          |       |
| Net income (loss) in accordance with U.S.  GAAP                   |       | $        | 10,923     |     | $          | (5,819       | )          | $ | (25,959 | ) |
| Net income (loss) per share in accordance  with U.S. GAAP         |       |     |       |     |       |         |       |
| Basic                                                             |       | $        | 0.10       |     | $          | (0.05        | )          | $ | (0.31 | ) |
| Diluted                                                           |       | $        | 0.10       |     | $          | (0.05        | )          | $ | (0.31 | ) |

 

Years ended December 31, 2005 and 2004

 

The application of U.S. GAAP results in the following differences tothe following balance sheet items:

 
| ** **                           | ** ** | **2005**     | ** ** | **2004**          | ** ** |
|--------------------------------------|------------|--------------|------------|-------------------|------------|
| ** **                           | ** ** | **Canadian** | ** ** | **United States** | ** ** | **Canadian** | ** ** | **United States** | ** ** |
| Petroleum and natural gas properties |       | $            | 150,384    |              | $          | 119,033 |   | $ | 128,716 |   | $ | 91,732 |   |
| Future income tax liability          |       | 8,638        |       | —            |       | 8,778 |   | — |   |
| Share capital (e)                    |       | 135,815      |       | 177,304           |       | 114,626 |   | 155,485 |   |
| Contributed Surplus (f)              |       | 6,391        |       | —            |       | 3,386 |   | — |   |
| Retained Earnings (deficit)          |       | 1,406        |       | (59,218           | )          | (4,462 | ) | (70,141 | ) |
|                                      |            |              |            |                   |            |  |  |  |  |  |  |  |  |

 

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(a)          Flow Through Shares

 

The Corporation finances a portion of its activities with flow throughshare issues whereby the tax deductions are renounced to the share subscribers.The tax cost of the deductions renounced to shareholders is reflected as anincrease in the future income tax liability and a reduction in the stated valueof the shares. Under U.S. GAAP, share capital for flow through shares issuedafter 1998 is stated at the quoted value of the shares at the date of issuance;the tax cost resulting from deduction renouncements, less any proceeds receivedin excess of the quoted value of the shares, must be included in thedetermination of the tax expense.

 

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(b)         Property Acquisitions

 

In prior years, the Corporation recorded property acquisitions fromrelated parties in exchange for common shares at the exchange amount, pursuantto Canadian GAAP. Under U.S. GAAP, these related party acquisitions arerecorded at the seller’s carrying amount. The resulting differences in therecorded carrying amounts of the properties results in differences in depletionand amortization expense in subsequent years.

 

(c)          Ceiling Test

 

At December 31, 2005, the Corporation applied a ceiling test toits petroleum and natural gas properties. Under Canadian GAAP, the applicationof this test required no adjustment to the carrying value of the Corporation’spetroleum and natural gas properties.

 

For U.S. GAAP purposes, the ceiling test used December 31, 2005prices of:

 
| Gas (per  thousand cubic feet)           |   | $      | 10.35 CDN |   |
|------------------------------------------|--------|--------|-----------|--------|
|                                     |   |   |      |
| Oil and natural gas liquids (per barrel) |   | $      | 66.25 CDN |   |

 

The application of the test resulted in no reduction being in thecarrying value of the Corporation’s petroleum and natural gas properties undereither U.S. or Canadian GAAP for 2005.

 

 At December 31, 2004, theCorporation applied a ceiling test to its petroleum and natural gas propertiesusing December 31, 2004 prices of:

 
| Gas (per  thousand cubic feet)           |   | $      | 6.35 CDN  |   |
|------------------------------------------|--------|--------|-----------|--------|
|                                     |   |   |      |
| Oil and natural gas liquids (per barrel) |   | $      | 50.25 CDN |   |

 

The application of the test resulted in a $10.0 million pre-taxreduction ($8.6 million after tax) in the carrying value of the Corporation’spetroleum and natural gas properties under U.S. GAAP. Under Canadian GAAP, theapplication of this test required no adjustment to the carrying value of theCorporation’s petroleum and natural gas properties.

 

At December 31, 2003, the Corporation applied the ceiling test toits petroleum and natural gas properties using December 31, 2003 pricesof:

 
| Gas (per  thousand cubic feet)           |   | $      | 6.10 CDN  |   |
|------------------------------------------|--------|--------|-----------|--------|
|                                     |   |   |      |
| Oil and natural gas liquids (per barrel) |   | $      | 34.92 CDN |   |

 

The application of the test resulted in a $34.1 million pre-taxreduction ($22.0 million after tax) in the carrying value of the Corporation’spetroleum and natural gas properties under U.S. GAAP. Under Canadian GAAP, theapplication of this test required no adjustment to the carrying value of theCorporation’s petroleum and natural gas properties.

 

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The resulting differences in the recorded carrying amounts of theproperties results in differences in depletion, amortization and accretionexpenses in subsequent years.

 

(d)   Stock Based Compensation

 

UnderU.S. GAAP, FAS 123 establishes financial accounting and reporting standards forstock-based employee compensation plans as well as transactions in which anentity issues its equity instruments to acquire goods or services fromnon-employees. As permitted by FAS 123, the Corporation elected to follow theintrinsic value method of accounting for stock-based compensation arrangements,as provided for in Accounting Principles Board (“APB”) Opinion 25. Since alloptions were granted with exercise prices equal to the market price when theoptions were granted, no compensation expense has been charged to income at thetime of the option grants.

 

EffectiveJanuary 1, 2004, the Corporation retroactively adopted the Canadian GAAPpolicy for “Stock Based Compensation”. This standard requires the Corporationto measure all stock based payments using the fair value method of accounting,and recognize the compensation expense over the vesting period of the relatedoptions with a corresponding increase in contributed surplus. This change hasresulted in a U.S. GAAP difference and has reduced both the reported net lossand contributed surplus by $3,657,000 (2004 –$2,612,000, 2003 - $771,000) forthe year ended December 31, 2005.

 

(e)                AssetRetirement Obligation

 

TheCorporation adopted with retroactive application the U.S. GAAP policy for assetretirement obligations as of January 1, 2003  The change to the January 1, 2003reported values were to increase: petroleum and natural gas properties by$888,000, asset retirement obligation by $632,000, future income tax liabilityby $109,000 and net loss by $147,000. This application did not have asignificant impact on the Corporation’s earnings and did not impact theCorporation’s net loss per share. This policy was adopted under Canadian GAAPeffective January 1, 2004 and as such, is no longer a reconciling itembetween Canadian GAAP and U.S. GAAP.

 

**AdditionalU.S. GAAP Disclosures**

 

FAS133

 

Attimes the Corporation will use derivative financial instruments to managecommodity price exposure. Effective January 1, 2001 the Corporationadopted the provisions of FAS 133 which requires that all derivatives berecognized as assets and liabilities on the balance sheet and measured at fairvalue. Gains or losses, including unrealized amounts, on derivatives that havenot been designated as hedges, or were not effective as hedges, are included inincome as they arise.

 

Forderivatives designated as fair value hedges, changes in the fair value arerecognized in income together with changes in the fair value of the hedgeditem. For derivatives designated as cash flow hedges, changes in the fair valueof the derivatives are recognized in other comprehensive income until thehedged items are recognized in income. Any change in the fair value of thederivatives that is not effective in hedging the changes in future cash flowsis included in income as they arise.

 

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At December 31,2005 and 2004 the Corporation did not have any derivative financial instrumentsthat were not designated as fair value hedges.

 

FAS123 (R)

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued FAS 123(R), “Share-basedPayment”, which replaces FAS 123 and supersedes APB Opinion 25. FAS 123(R)requires compensation cost related to share-based payments be recognized in thefinancial statements and that the cost must be measured based on the fair valueof the equity or liability instruments issued. Under FAS 123(R) all share-basedpayment plans must be valued using option-pricing models. FAS 123(R) iseffective for the financial year beginning January 1, 2006. TheCorporation has not yet determined what, if any impact this change will have onthe reconciliation with U.S. GAAP

 

FIN46- Accounting for Variable Interest Entities

 

In January 2003,the FASB issued Financial Interpretation 46 “Accounting for Variable InterestEntities” (“FIN 46”) that requires the consolidation of Variable InterestEquities (“VIEs”). VIEs are entities that have insufficient equity or theirequity investors lack one or more of the specified elements that a controllingentity would have. The VIEs are controlled through financial interests thatindicate control (referred to as “variable interests”). Variable interests arethe rights or obligations that expose the holder of the variable interest toexpected losses or expected residual gains of the entity. The holder of themajority of an entity’s variable interests is considered the primary beneficiaryof the VIE and is required to consolidate the VIE. In December 2003 theFASB issued FIN 46R which superseded FIN 46 and restricts the scope of thedefinition of entities that would be considered VIEs that requireconsolidation. The Corporation does not believe FIN 46R results in theconsolidation of any additional entities.

 

SAB106

 

In September 2004,the Securities and Exchange Commission issued Staff Accounting Bulletin 106 (“SAB106”) regarding the application of FAS 143 by oil and gas producing entitiesthat follow the full cost accounting method. SAB 106 states that after theadoption of FAS 143 the future cash flows associated with the settlement ofasset retirement obligations that have been accrued on the balance sheet shouldbe excluded from the computation of the present value of estimated future netrevenues for purposes of the full cost ceiling test calculation. TheCorporation excludes the future cash outflows associated with settling assetretirement obligations from the present value of estimated future net cashflows and does not reduce the capitalized oil and gas costs by the assetretirement obligation accrued on the balance sheet. Costs subject to depletionand depreciation include estimated costs required to develop proved undevelopedreserves and the associated addition to the asset retirement obligations. Theadoption of SAB 106 in the fourth quarter of 2004 did not have a materialeffect on the results of the ceiling test or depletion, depreciation andamortization calculations.

 

FAS153

 

In December 2004, the FASB issued FAS 153 whichdeals with the accounting for the exchanges of nonmonetary assets. FAS 153 isan amendment of APB Opinion 29. APB Opinion 29 requires that exchanges ofnonmonetary assets should be

 

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measured based on the fair value of the assetsexchanged. FAS 153 amends APB Opinion 29 to eliminate the exception from usingfair market value for nonmonetary exchanges of similar productive assets andintroduces a broader exception for exchanges of nonmonetary assets that do nothave commercial substance. FAS 153 is effective for nonmonetary asset exchangesoccurring in fiscal periods beginning after June 15, 2005. The Corporationdoes not believe that the application of FAS 153 will have an impact on thefinancial statements.

 

PRESENTATION

 

Thereare different presentations between Canadian and U.S. GAAP which are asfollows:

 

1)                                      Nosubtotal is permitted under U.S. GAAP within cashflow from operations on thestatement of cashflows.

 

2)                                      UnderU.S. GAAP, there is no difference between net income and other comprehensiveincome.

 

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