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Exhibit 3 (INTEROIL LOGO) InterOil Corporation 2004 Managements Discussion and Analysis Overview
    
    
    2Business Environment
    
    
    3Risk Factors
    
    
    3Forward-looking statements
    
    
    9Business Plan
    
    
    9Results of Operations
    
    
    10Upstream
    
    
    10Midstream
    
    
    11Downstream
    
    
    12Corporate and consolidation
    
    
    13Consolidated income taxes
    
    
    14Quarterly Financial Summary
    
    
    14Capital Resources
    
    
    15Operating Activities
    
    
    15Investing Activities
    
    
    16Financing Activities
    
    
    18Liquidity
    
    
    19Sources of Capital
    
    
    19Capital Requirements
    
    
    20Contractual Obligations and Commitments
    
    
    21Our Material Contracts
    
    
    21Off Balance Sheet Arrangements
    
    
    22Share Capital
    
    
    22Transactions with Related Parties
    
    
    23Financial and Derivative Instruments
    
    
    23Foreign currency hedge contracts
    
    
    24Commodity hedge contracts
    
    
    24Critical Accounting Estimates
    
    
    24New Accounting Standards
    
    
    26Stock Based Compensation Plans
    
    
    26Asset Retirement Obligations
    
    
    26Inventory Costs
    
    
    27Accounting For Variable Interest Entities
    
    
    27Accounting For Exchanges of Nonmonetary Assets
    
    
    27Evaluation of Disclosure Controls and Procedures
    
    
    27Public Securities Filings
    
    
    28
 InterOil CorporationPage 1 of 28




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March 31, 2005Managements Discussion and Analysis
    
    (INTEROIL LOGO)
 The following discussion and analysis is prepared by management of our company with respect to
its financial performance for the periods covered by the financial statements, along with an
analysis of our financial position and prospects. It should be read in conjunction with our
audited annual consolidated financial statements and notes thereto. The financial statements and
the financial information herein have been prepared in accordance with generally accepted
accounting principles in Canada and are presented in United States dollars. The effect of
significant differences between Canadian and United States accounting principles is disclosed in
note 24 of the consolidated financial statements. References to we, us, our and InterOil
refer to InterOil Corporation and its subsidiaries. Overview Summary of Results Our operations are organized into three major business segments:  
    Exploration and Production, our upstream segment, which includes the
exploration for and the future production of crude oil and/or natural gas;
    Refining and Marketing, our midstream segment, which includes the refining of
crude oil and the marketing of refined products both domestically and for export;
and
    Wholesales and Retail Distribution, our downstream segment, which includes
wholesale and retail distribution of refined products in Papua New Guinea. The following table sets forth certain selected consolidated data for the past three years: Selected consolidated dataYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Total revenue
    
    
    
    71,223,284
    
    
    
    
    259,280
    
    
    
    
    384,226Sales and Operating Revenues
    
    
    
    70,644,486
    
    
    
    nil
    
    
    nilCash flows used in operations
    
    
    
    (80,230,117
    )
    
    
    
    (3,519,152
    )
    
    
    
    (2,348,959
    )Net loss before discontinued
operations and extraordinary
items
    
    
    
    (52,939,881
    )
    
    
    
    (3,517,569
    )
    
    
    
    (1,315,887
    )Net loss per share
    
    
    
    (2.09
    )
    
    
    
    (0.16
    )
    
    
    
    (0.06
    )Net loss per diluted share
    
    
    
    (2.09
    )
    
    
    
    (0.16
    )
    
    
    
    (0.06
    )Net loss
    
    
    
    (52,939,881
    )
    
    
    
    (3,517,569
    )
    
    
    
    (1,315,887
    )Net loss per share
    
    
    
    (2.09
    )
    
    
    
    (0.16
    )
    
    
    
    (0.06
    )Net loss per diluted share
    
    
    
    (2.09
    )
    
    
    
    (0.16
    )
    
    
    
    (0.06
    )Total assets
    
    
    
    385,842,184
    
    
    
    
    260,339,850
    
    
    
    
    135,074,861Long-term debt
    
    
    
    87,472,159
    
    
    
    
    90,600,000
    
    
    
    
    31,000,000Cash dividends declared per share
    
    
    nil
    
    
    nil
    
    
    nil
 We generated our first operational income in 2004 following the acquisition of BP Papua New
Guinea Limited, but were not profitable in 2004 as our refinery project remained in the
construction and pre-operating stage of development throughout the year. Sales and operating
revenues in the year ended December 31, 2004 was confined to sales from the acquired BP entity on
products that InterOil CorporationPage 2 of 28




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were not obtained from the refinery of $44.3 million and a trade out of crude feedstock during
refinery commissioning of $26.3 million. The costs of refinery testing and commissioning
activities, in addition to crude purchases and revenues generated from both PNG domestic sales and
export sales, are included in the capital costs of the refinery until the completion of the
performance testing and the issuance of the construction practical completion certificate in
January 2005. Increased costs in the year were related to our business development activities and
capital raisings, a $35.6 million impairment of our unproved oil and gas properties, and $2.9
million of geophysical and geological activities. Business Environment Risk Factors Our financial results are significantly influenced by our business environment. Risks include, but
are not limited to: We have a limited operating history. We are a development stage company, with limited financial results upon which you may judge
our potential. We may not become profitable. In the past, we have experienced delays and other
problems frequently associated with a construction project such as our refinery. We may continue
to experience many of the problems, delays and expenses encountered by any early stage business,
many of which are beyond our control. These include, but are not limited to, substantial delays
and expenses in conducting our exploration drilling program, difficulty in obtaining financing and
competition from larger and more established companies. Our refinery has not operated at full capacity for an extended period of time. We have completed the construction of our refinery in PNG. We began testing our refinery at
its approximate nameplate capacity in November 2004. In January 2005, testing of our refinery was
completed and we declared practical completion of the refinery. Our ability to continue to operate
our refinery at its nameplate capacity must be considered in light of the risks inherent in, and
the difficulties, costs, complications and delays frequently encountered by start-up companies.
These risks include, without limitation, shortages of equipment, materials or labor; delays in
delivery of equipment or materials; contractual disagreements; labor disruptions; political events;
local or political opposition; accidents and unforeseen engineering, design or environmental
problems. We were unable to operate our refinery for a period of 10 days in March 2005 as a result
of a shortage of crude feedstocks. Such shortages may occur in the future as well. Accordingly,
there can be no assurance of the future profitability of us or our refinery. Our refinery operations may not be profitable. Our refining operations are expected to be primarily affected by the difference or margin
between the sales prices of our refined products and the costs we incur to purchase crude oil and
other feedstocks. Historically, refining margins have been volatile, and we expect this volatility
will exist in the future. Therefore, we will be subject to the risk that the difference between
the cost to us of our crude oil supply and the price at which we can sell our refined products will
not be sufficient for the profitable operation of our company and to allow us to service our
indebtedness. We cannot control the prices at which our feedstocks will be purchased or at which
refined petroleum products can be sold. InterOil CorporationPage 3 of 28




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We may not be successful in our exploration for oil. We currently do not have any oil or gas reserves that are deemed proved, probable or possible
pursuant to National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities. We have
drilled one exploration well, suspended the drilling of two exploration wells and one
exploration/appraisal well, and have plans to drill at least 8 additional exploration wells in PNG
during the next two years. We cannot be certain that the exploration wells we drill will be
productive or that we will recover all or any portion of the costs to drill these wells. Because of
the high cost, topography and subsurface characteristics of the areas we are exploring, we have
limited seismic or other geoscience data to assist us in identifying drilling objectives. The lack
of this data makes our exploration activities more risky than would be the case if such information
were available. In addition, our exploration and development plans may be curtailed, delayed or cancelled as a
result of lack of adequate capital and other factors, such as weather, compliance with governmental
regulations, landowners interference, mechanical difficulties, materials shortages, delays in the
delivery of equipment, success or failure of activities in similar areas, current and forecasted
prices for oil and changes in the estimates of costs to complete the projects. We will continue to
gather information about our exploration projects, and it is possible that additional information
may cause us to alter our schedule or determine that a project should not be pursued at all. You
should understand that our plans regarding our projects are subject to change. Our investments in PNG are subject to political, legal and economic risks. Our investments in PNG involve risks typically associated with investments in developing
countries, such as uncertain political, economic, legal and tax environments; expropriation and
nationalization of assets; the risks of war, expropriation, nationalization, renegotiation or
nullification of existing contracts; taxation policies; foreign exchange restrictions;
international monetary fluctuations; currency controls and foreign governmental regulations that
favor or require the awarding of service contracts to local contractors or require foreign
contractors to employ citizens of, or purchase supplies from, a particular jurisdiction. Political conditions have at times been unstable in PNG. We attempt to conduct our business
in such a manner that political and economic events of this nature will have minimal effects on our
operations. In addition, we believe that oil exploration and refinery operations are in the long
term best interests of PNG and that we will continue to have the support of the current government.
Notwithstanding the current support, our ability to conduct operations or exploration and
development activities is subject to changes in government regulations or shifts in political
attitudes over which we have no control. There can be no assurance that we have adequate
protection against any or all of the risks described above. In addition, if a dispute arises with respect to our PNG operations, we may be subject to the
exclusive jurisdiction of foreign courts or may not be successful in subjecting foreign persons,
especially foreign oil ministries and national oil companies, to the jurisdiction of Canada or the
United States. We may not be able to market all of our refinerys output. The Project Agreement described under Material Contracts gives us certain rights to supply
the domestic market in PNG with our refined products. We have entered into domestic sales contracts
with the major distributors in PNG under which they will purchase refined products for distribution
in PNG exclusively from us. We have estimated that between 50% and 60% of the refinerys net
output will be used to supply the PNG market. We will market the balance of the InterOil CorporationPage 4 of 28




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refinerys output in nearby regional markets. We have signed three-year export contracts with
Shell. While we will sell refined products through our domestic retail network and other
distributors, these agreements are the only commercial agreements for the purchase of our refined
products for export. We can give no assurances that we will be able to market the refinerys
output to these nearby regional markets and we may be unable to market all of the refinerys output
we produce. If our relationship with Shell were to terminate for any reason, we cannot assure you
that we will be able to enter into other commercial agreements for the export of our refinerys
output. In addition, early termination of the Shell export agreements could have a material
adverse effect on our results of operations and financial condition. Further, our Project Agreement with the PNG government provides that if there is more than one
refinery operating in PNG during the term of the Project Agreement, the right to supply the
domestic market will be shared by the refineries in proportion to their refining capacities.
Therefore, if one or more additional refineries are built in PNG, our share of the domestic market
will be diminished. We may not be able to obtain crude feedstocks for our refinery. The Project Agreement requires the government of PNG to take action to ensure that domestic
crude oil producers sell us their PNG domestic crude production for use in our refinery and that
refined products for domestic PNG use will be purchased from us at the IPP. However, our agreement
with BP Singapore is our only commercial agreement for the delivery of crude feedstock. The BP
agreement expires on June 14, 2009. If our relationship with BP were to terminate for any reason,
we cannot assure you that we will be able to enter into other commercial agreements to supply
adequate feedstock to our refinery. In addition, early termination of the BP agreement could have
a material adverse effect on our results of operations and financial condition. PNG crude oil production rates are expected to satisfy the refinerys requirements for at
least five years after commercial start-up. Alternative crude oils that are suitable for use as
refinery feedstock are available in the nearby region. However, crude oil sourced from outside PNG
may be more expensive than domestic crude oil and may reduce our gross profit margins.
Alternatively, imported crude oil may be selected to alter the refinery product mix in response to
changing market conditions. We may not be able to obtain all of the licenses necessary to operate our business. Our operations require licenses and permits from various governmental authorities to drill
wells, operate the refinery and market our refined products. We believe that we hold, or will hold,
all necessary licenses and permits under applicable laws and regulations for our operations in PNG
and believe we will be able to comply in all material respects with the terms of such licenses and
permits. However, such licenses and permits are subject to change in various circumstances. There
can be no guarantee that we will be able to obtain or maintain all necessary licenses and permits
that may be required to commission our oil refinery facilities or to maintain continued operations
that economically justify the cost. Our refining operations will expose us to risk, not all of which are insured. Our refining operations will be subject to various hazards common to the industry, including
explosions, fires, toxic emissions, maritime hazards and uncontrollable flows of oil and gas. In
addition, our refining operations are subject to hazards of loss from earthquakes, tsunamis and
severe weather conditions. As protection against operating hazards, we maintain insurance coverage
against some, but not all of such potential losses. We may not be able to maintain or InterOil CorporationPage 5 of 28




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obtain insurance of the type and amount we desire at reasonable rates. In addition, losses may
exceed coverage limits. As a result of market conditions, premiums and deductibles for certain
types of insurance policies for refiners have increased substantially and could escalate further.
In some instances, certain insurance could become unavailable or available only for reduced amounts
of coverage. For example, insurance carriers now require broad exclusions for losses due to risk of
war and terrorist acts. If we were to incur a significant liability for which we were not fully
insured, it could have a material adverse effect on our financial position. The exploration and production, and the refining and distribution businesses are competitive. We operate in the highly competitive areas of oil exploration and production, and refining and
distribution of refined products. A number of our competitors have materially greater financial
and other resources than we possess. Such competitors have a greater ability to bear the economic
risks inherent in all phases of the industry. In our exploration and production business, the availability of alternate fuel sources, the
costs of our drilling program, the development of transportation systems to bring future production
to the market and transportation costs of oil are factors that affect our ability to compete in the
marketplace. Many of our competitors operate in areas where they are able to sell both the oil and
the natural gas that they produce. In our refining business, we will compete with numerous other companies for available supplies
of crude oil and other feedstocks and for outlets for our refined products. BP has agreed to supply
all of our feedstock. However, many of our competitors obtain a significant portion of their
feedstocks from company-owned production, which may enable them to obtain feedstocks at a lower
cost. The high cost of transporting goods to and from PNG reduces the availability of alternate
fuel sources and retail outlets for our refined products. Competitors that have their own
production or extensive distribution networks are at times able to offset losses from refining
operations with profits from producing or retailing operations, and may be better positioned to
withstand periods of depressed refining margins or feedstock shortages. In addition, new technology
is making refining more efficient, which could lead to lower prices and reduced margins. The volatility of oil prices could adversely affect our results of operations. The prices we will receive for the refined products we produce and sell are likely to be
subject to large fluctuations in response to relatively minor changes in the supply of and demand
for oil and a variety of additional factors beyond our control. These factors include but are not
limited to the condition of the worldwide economy, the actions of the Organization of Petroleum
Exporting Countries, governmental regulations, political stability in the Middle East and elsewhere
and the availability of alternate fuel sources. The prices for oil will affect:  
    our revenues, cash flows and earnings;
    our ability to attract capital to finance our operations, and the cost of such capital;
    the value of our oil properties;
    the profit or loss we incur in refining petroleum products; and
    the profit or loss we incur in exploring and developing our reserves. Weather and unforeseen operating hazards may adversely impact our operating activities. Our operations are subject to risks inherent in the oil and gas industry, such as blowouts,
cratering, explosions, uncontrollable flows of oil, gas or well fluids, fires, pollution, and other
environmental risks. These risks could result in substantial losses due to injury and loss of
life, severe damage to and destruction of property and equipment, pollution and other environmental InterOil CorporationPage 6 of 28




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damage and suspension of operations. Our PNG operations are subject to a variety of
additional operating risks such as earthquakes, mudslides, tsunamis and other effects associated
with active volcanoes, extensive rainfall or other adverse weather conditions. Our operations could
result in liability for personal injuries, property damage, oil spills, discharge of hazardous
materials, remediation and clean-up costs and other environmental damages. As a result, substantial
liabilities to third parties or governmental entities may be incurred, the payment of which could
have a material adverse effect on our financial condition and results of operations. You may be unable to enforce your legal rights against us. We are a New Brunswick, Canada corporation. Substantially all of our assets are located
outside the United States. It may be difficult for investors to enforce, outside the United
States, judgments against us that are obtained in the United States in any such actions, including
actions predicated upon the civil liability provisions of the securities laws of the United States.
In addition, most of our directors and officers are nationals or residents of countries outside of
the United States, and all, or a substantial portion of, the assets of such persons are located
outside the United States. As a result, it may be difficult for investors to affect service of
process within the United States upon such persons or to enforce judgments against them obtained in
United States courts, including judgments predicated upon the civil liability provisions of the
securities laws of the United States. We may not be able to generate cash flows if we are unable to raise capital. We make, and will continue to make, substantial capital expenditures for exploration,
development, acquisition and production of oil reserves and for further capital acquisitions and
expenses. We will need additional financing to complete our business plans. If we are unable to
obtain debt or equity financing because of lower refining margins, lower oil prices, delays,
operating difficulties, construction costs, or lack of drilling success, we may have limited
ability to expend the capital necessary to undertake or complete future drilling programs. There
can be no assurance that additional debt or equity financing or cash generated by operations will
be available to meet these requirements. Our significant debt levels and our debt covenants may limit our future flexibility in obtaining
additional financing and in pursuing business opportunities. As of December 31, 2004, we had $87 million in long-term debt, excluding current maturities.
The level of our indebtedness will have important effects on our future operations, including:  
    a portion of our cash flow will be used to pay interest and principal on our
debt and will not be available for other purposes;
    our OPIC credit facility and BNP credit facility contain financial tests which
we must satisfy in order to avoid a default under such credit facilities; and
    our ability to obtain additional financing for capital expenditures and other
purposes may be limited. If we are unable to recruit and retain qualified personnel, it could have a material adverse effect
on our operating results and stock price. Our success depends in large part on the continued services of our executive officers, our
senior managers and other key personnel. The loss of these people, especially without advance
notice, could have a material adverse impact on our results of operations and our stock price. It
is also very important that we attract and retain highly skilled personnel, including technical InterOil CorporationPage 7 of 28




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personnel, to accommodate our exploration plans and to replace personnel who leave.
Competition for qualified personnel can be intense, and there are a limited number of people with
the requisite knowledge and experience. Under these conditions, we could be unable to recruit,
train, and retain employees. If we cannot attract and retain qualified personnel, it could have a
material adverse impact on our operating results and stock price. Petroleum Independent and Exploration Corporation (P.I.E.) can affect our raising of capital
through the issuance of common shares or securities convertible into common shares. Mr. Phil E Mulacek, President and CEO of our company, controls P.I.E. P.I.E owns 433,169 of
our common shares, and has a right to exchange its remaining 5,000 shares of SP InterOil, LDC on a
one-for-one basis for our common shares. Our articles of amalgamation contain restrictions on our
issuance of common shares or securities convertible into common shares, except with, among other
things, the consent of P.I.E. Mr. Mulacek through P.I.E. also controls P.I.E. Group, LLC, which,
with Commodities Trading International Corporation, have pre-emptive rights in respect of issuances
of our common shares or securities convertible into common shares. Therefore, through his control
of P.I.E. and P.I.E. Group, LLC, Mr. Mulacek or any successor to his interest in those companies
can prevent us from raising capital through the issuance of common shares or securities convertible
into common shares. Changing regulation of corporate governance and public disclosure can cause additional expenses and
failure to comply may adversely affect our reputation and the value of our securities. Changing laws, regulations and standards relating to corporate governance and public
disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and new and changing
provisions of Canadian securities laws, are creating uncertainty because of the lack of specificity
and varying interpretations of the rules. As a result, the application of the rules may evolve
over time as new guidance is provided by regulatory and governing bodies, which could result in
continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing
revisions to disclosure and governance practices. We are committed to maintaining high standards of
corporate governance and public disclosure. As a result, our efforts to comply with evolving laws,
regulations and standards have resulted in, and are likely to continue to result in, increased
general and administrative expenses and a diversion of management time and attention from
revenue-generating activities to compliance activities. Any failure to comply with applicable laws
may materially adversely affect our reputation and the value of our securities. If we fail to comply with Section 404 of the Sarbanes-Oxley Act of 2002, our reputation and the
value of our securities may be adversely affected. Beginning with our annual report for the year ending December 31, 2006, Section 404 of the
Sarbanes-Oxley Act of 2002 will require us to include an internal control report of management with
our annual report on Form 40-F, which is to include managements assessment of the effectiveness of
our internal control over financial reporting as of the end of the fiscal year. That report will
also be required to include a statement that our independent auditors have issued an attestation
report on managements assessment of our internal control over financial reporting. In order to achieve compliance with Section 404 within the prescribed period, management is in
the process of adopting a detailed project work plan to assess the adequacy of our internal control
over financial reporting, validate through testing that controls are functioning as documented,
remediate any control weaknesses that may be identified, and implement a continuous reporting and
improvement process for internal control over financial reporting. Any failure to comply with
Section 404, including issuing the required management report and obtaining InterOil CorporationPage 8 of 28




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the attestation report on managements assessment from our independent auditors, may
materially adversely affect our reputation and the value of our securities. Forward-looking statements Certain statements contained in this report are forward-looking statements as defined in the U.S.
federal securities laws. All statements, other than statements of historical facts, included
herein or incorporated by reference herein, including without limitation, statements regarding our
drilling plans, business strategy, plans and objectives of management for future operations and
those statements preceded by, followed by or that otherwise include the words believe, expects,
anticipates, intends, estimates or similar expressions or variations on such expressions are
forward-looking statements. We can give no assurances that such forward-looking statements will
prove to be correct. Each forward-looking statement reflects our current view of future events and is subject to risks,
uncertainties and other factors that could cause actual results to differ materially from any
results expressed or implied by our forward-looking statements. Risks and uncertainties include,
but are not limited to:  
    our lack of substantial operating history;
    the operation of our refinery at less than full capacity;
    refinery and additional construction costs;
    profitability of our refinery;
    our ability to market refinery output;
    the success of our exploration prospects;
    political, legal and economic risks related in Papua New
Guinea;
    anticipated markets for our refined products;
    dependence on exclusive relationships with our supplier and customers;
    ability to obtain necessary licenses;
    uninsured risks;
    the impact of competition;
    the enforceability of legal rights;
    the volatility of oil prices;
    weather and unforeseen operating hazards;
    debt covenants limiting ability to raise additional financing;
    the cyclical nature of the refining business; and
    other factors. Important factors that could cause the actual results to differ from materially from our
expectations are disclosed in more detail set forth under the heading Risk Factors in herein.
Our forward-looking statements are expressly qualified in their entirety by this cautionary
statement. We currently have no reserves as defined in Canadian National Instrument 51-101 Standards of
Disclosure for Oil and Gas Activities (NI 51-101). All information contained herein regarding
resources are references to undiscovered resources under NI 51-101, whether stated or not. See our
filings with the Canadian securities regulators for additional risks and information about our
business. Business Plan Our goal continues to be the development of a vertically-integrated energy company whose focus is
PNG and the surrounding region. Our strategy is to continue oil and gas exploration in PNG,
operation and marketing of refined product from our oil refinery, and the wholesale and retail InterOil CorporationPage 9 of 28




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distribution of refined petroleum products in PNG. Our most significant activity in this regard
during 2004 was related to our acquisition of BP Papua New Guinea Limited on April, 28, 2004. This
acquisition commenced our direct participation in the PNG refined product distribution business. Results of Operations Upstream 2004 compared with 2003 Our net loss from the upstream segment increased by $39.4 million to $40.1 million in 2004 from
$0.70 million in 2003. The following table sets forth the results for our upstream segment for the years ended December
31, 2004, 2003, and 2002: UpstreamYear-ended December 31 ($thousands)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Operating resultsExternal sales
    
    
    
    
    
    
    
    
    
    
    
    
    
    Inter-segment revenue
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total segment revenue
    
    
    
    0
    
    
    
    
    0
    
    
    
    
    0Cost of sales and operating expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    Office and administration and other expenses
    
    
    
    1,649
    
    
    
    
    520
    
    
    
    
    (216
    )Geological and geophysical expenses
    
    
    
    2,903
    
    
    
    
    
    
    
    
    
    Depreciation and amortization
    
    
    
    13
    
    
    
    
    10
    
    
    
    
    Exploration write off
    
    
    
    35,567
    
    
    
    
    165
    
    
    
    
    93Interest expense
    
    
    
    5
    
    
    
    
    
    
    
    
    
    Loss from ordinary activities before income taxes
    
    
    
    (40,137
    )
    
    
    
    (696
    )
    
    
    
    123Income tax expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total net income (loss)
    
    
    
    (40,137
    )
    
    
    
    (696
    )
    
    
    
    123
 Revenues We have not discovered any oil and gas reserves that are deemed to be proved, probable or possible
and therefore we have not generated operational revenues from the upstream operations. Expenses Total expenses from our upstream segment were $40.1 million in 2004 compared with $0.7 million in
2003. Our 2004 expenses are primarily related to our geological and geophysical activities and to
adjustments related to the impairment of our oil and gas properties. Geological and geophysical expenses in the year ended December 31, 2004 were on our Puri, Elk, and
Moose Prospects. We follow the successful efforts method of accounting for oil and gas exploration and development
activities, and in accordance with the capitalization requirements of this policy have expensed
$35.6 million in 2004 compared to $0.17 million in 2003. The 2004 adjustments were mainly related
to capitalized drilling expenditures on Moose  1, on Moose  2 and on Sterling Mustang  1.
Based on the Statement of Financial Accounting Standards No. 19, in compliance with US InterOil CorporationPage 10 of 28




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GAAP, it was necessary to expense these drilling expenditures that were previously capitalized as
the recent activity on these prospects has been geological and geophysical in nature whilst waiting
the arrival of new drilling equipment. The passage of time in recommencing drilling activities,
and not having a definite plan for recommencing drilling of the suspended wells at December 31,
2004 has triggered the expensing requirement. In addition, in 2004, oil and gas costs previously
capitalized on Petroleum Retention Licenses 4 and 5 have been expensed due to the lack of
commercial gas contracts and no immediate development plans for these licenses. Midstream 2004 compared with 2003 Our net loss from the midstream segment increased by $5.4 million to $5.7 million in 2004 from
$0.23 million in 2003. The following table sets forth the results for our midstream segment for the years ending December
31, 2004, 2003, and 2002: MidstreamYear-ended December 31 ($thousands)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Operating resultsExternal sales
    
    
    
    26,310
    
    
    
    
    
    
    
    
    
    Inter-segment revenue
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total segment revenue
    
    
    
    26,310
    
    
    
    
    0
    
    
    
    
    0Cost of sales and operating expenses
    
    
    
    27,686
    
    
    
    
    
    
    
    
    
    Office and administration and other expenses
    
    
    
    3,133
    
    
    
    
    222
    
    
    
    
    (124
    )Depreciation and amortization
    
    
    
    312
    
    
    
    
    8
    
    
    
    
    Interest expense
    
    
    
    844
    
    
    
    
    
    
    
    
    
    Loss from ordinary activities before income taxes
    
    
    
    (5,665
    )
    
    
    
    (230
    )
    
    
    
    124Income tax expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total net income (loss)
    
    
    
    (5,665
    )
    
    
    
    (230
    )
    
    
    
    124
 Revenues Throughout the year we were in the construction and pre-operating stage of the development of our
oil refinery. Project costs, net of any recoveries generated through the sale of refined products,
incurred during this construction and pre-operating stage were capitalized as plant and equipment.
The $26.3 million of external sales was generated from a trade out of a crude cargo during
commissioning. Our refinery completed its reliability testing on January 6, 2005 and we issued the refinerys
practical completion certificate on January 31, 2005. Expenses Total expenses from our midstream segment were $32.0 million in 2004 compared with $0.2 million in
2003. Our 2004 cost of sales and operating expenses of $27.7 million was related to the crude
cargo trade out in the year. The majority of the other expenses in the 2004 year are primarily
related to the financing costs on the crude feedstock supplied to the refinery during the
commissioning process. While the cost of crude feedstock is capitalized to the refinery in the
year ended December 31, 2004, the associated financing costs are expensed as incurred. InterOil CorporationPage 11 of 28




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##### 



Downstream 2004 compared with 2003 Our downstream earnings increased to $3.7 million in 2004 from a loss of $0.02 million in 2003. On April 28, 2004 through our wholly owned subsidiary, SPI Distribution Limited, we acquired 100%
of the outstanding common shares of BP Papua New Guinea Limited which was subsequently renamed
InterOil Products Limited (IPL). IPL is a distributor of refined petroleum products in Papua New
Guinea. The results of IPLs operations have been included in the consolidated financial
statements since April 28, 2004; the date control of IPLs shares was transferred to InterOil. The following table sets forth the results for our downstream segment for the years ended December
31, 2004, 2003, and 2002: DownstreamYear-ended December 31 ($thousands)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Operating resultsExternal sales
    
    
    
    62,410
    
    
    
    
    
    
    
    
    
    Inter-segment revenue
    
    
    
    489
    
    
    
    
    
    
    
    
    
    Total segment revenue
    
    
    
    62,899
    
    
    
    
    0
    
    
    
    
    0Cost of sales and operating expenses
    
    
    
    53,159
    
    
    
    
    
    
    
    
    
    Office and administration and other expenses
    
    
    
    3,147
    
    
    
    
    25
    
    
    
    
    3Depreciation and amortization
    
    
    
    224
    
    
    
    
    
    
    
    
    
    Interest expense
    
    
    
    455
    
    
    
    
    
    
    
    
    
    Loss from ordinary activities before income taxes
    
    
    
    5,914
    
    
    
    
    (25
    )
    
    
    
    (3
    )Income tax expenses
    
    
    
    (2,251
    )
    
    
    
    
    
    
    
    
    Total net income (loss)
    
    
    
    3,663
    
    
    
    
    (25
    )
    
    
    
    (3
    )
 Revenues Our increase in sales and operating revenue over 2003 is a result of the operations of InterOil
Products Limited, a subsidiary we purchased during the year. IPL sold the following volumes of
product since InterOil gained control of the subsidiary: Sales volumes (liters)
    
    
    May 1, 2004 thru December 31, 2004Diesel
    
    
    
    91,909,146Fuel Oil
    
    
    
    26,487,621Gasoline
    
    
    
    13,886,660DPK
    
    
    
    9,103,003Lubricants
    
    
    
    1,122,786Total
    
    
    
    142,509,216
 Following the confirmation of our midstream business refinery having refined products
available for the PNG market, the Papua New Guinea Independent Consumer & Competition Committee
(ICCC) introduced on September 8, 2004 a new pricing regime in the downstream sector over three
petroleum products (diesel, gasoline and kerosene). This new pricing regime establishes a maximum
wholesale margin of 24 toea per liter (previously 30 to 50 toea per liter), and includes InterOil CorporationPage 12 of 28




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##### 



components to capture both sea and land freights. As this new pricing template impacts the entire
Papua New Guinea distribution business, IPLs sales from September 8, 2004 forward have been
impacted. Expenses The increase in expenses over 2003 is a result of the operations of InterOil Products Limited, a
subsidiary purchased in the year. The cost of sales and operating expenses is derived from either
importing or purchasing products from our refinery for wholesale distribution in PNG. In August
2004 our distribution subsidiary, IPL, started purchasing products from our refinery at the import
parity price. By December 31, 2004 our refinery was supplying 100% of IPLs diesel, gasoline and
DPK requirements. IPL will continue to import its fuel oil and lubricant products as these
products are not produced by our refinery. Corporate and consolidation Year-ended December 31 ($thousands)
    
    
    2004
    
    
    
    2003
    
    
    
    2002External sales  elimination (1)
    
    
    
    (18,075
    )
    
    
    
    
    
    
    
    
    Inter-segment revenue elimination (2)
    
    
    
    (489
    )
    
    
    
    
    
    
    
    
    Interest revenue
    
    
    
    382
    
    
    
    
    247
    
    
    
    
    373Other unallocated revenue
    
    
    
    196
    
    
    
    
    12
    
    
    
    
    11Total segment revenue
    
    
    
    (17,986
    )
    
    
    
    259
    
    
    
    
    384Cost of sales and operating expenses (1)
    
    
    
    (15,500
    )
    
    
    
    
    
    
    
    
    Office and administration and other expenses
    
    
    
    6,773
    
    
    
    
    2,651
    
    
    
    
    1,862Depreciation and amortization
    
    
    
    90
    
    
    
    
    55
    
    
    
    
    85Interest expense
    
    
    
    1,899
    
    
    
    
    105
    
    
    
    
    Loss from ordinary activities before income taxes
    
    
    
    (11,248
    )
    
    
    
    (2,552
    )
    
    
    
    (1,563
    )Income tax expenses
    
    
    
    376
    
    
    
    
    (37
    )
    
    
    
    (1
    )Other unallocated expenses
    
    
    
    70
    
    
    
    
    22
    
    
    
    
    5Total net income (loss)
    
    
    
    (10,802
    )
    
    
    
    (2,567
    )
    
    
    
    (1,559
    )
 Notes 
  Expenses Our total corporate office and administration and other expenses were $6.8 million in 2004 compared
to $2.6 million in 2003. The $4.2 million increase was due to:  
    increase in legal and professional services related to the Toronto Stock
Exchange and the American Stock Exchange listings, and financing activities;
    stock based compensation recorded in 2004 (refer to the section New Accounting
Standards);
    higher administrative expenses; and
    the difference attributable to a one-time adjustment in 2003 where P.I.E.
Corporation, a related party, waived prior years management fees totaling $840,000
that had previously been accrued.   InterOil CorporationPage 13 of 28




---



##### 



Consolidated income taxes The consolidated income tax expense in the consolidated statements of operations reflects an
effective tax rate which differs from the expected statutory rate (combined federal and provincial
rates). Differences for the years ended December 31, 2004, 2003 and 2002 were accounted for as
follows: Income taxYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Loss before income taxes
    
    
    
    (51,134,909
    )
    
    
    
    (3,503,131
    )
    
    
    
    (1,319,824
    )Statutory income tax rate
    
    
    
    35.12
    %
    
    
    
    35.12
    %
    
    
    
    38.62
    %Expected income tax (benefit)
    
    
    
    (17,958,580
    )
    
    
    
    (1,230,300
    )
    
    
    
    (509,716
    )Effect on income tax of:Losses (profits) in foreign jurisdictions not deductible (taxable)
    
    
    
    2,273,530
    
    
    
    
    (56,527
    )
    
    
    
    (183,802
    )Non-deductible stock compensation expense
    
    
    
    424,924
    
    
    
    
    (13,926
    )
    
    
    
    236,431Gains and losses on foreign exchange
    
    
    
    58,659
    
    
    
    
    302,499
    
    
    
    
    Tax rate differential in foreign jurisdictions
    
    
    
    (341,613
    )
    
    
    
    143,502
    
    
    
    
    188,788Over provision in prior year
    
    
    
    (42,874
    )
    
    
    
    
    
    
    
    
    (332
    )Tax losses for which no future tax benefit has been brought to
account
    
    
    
    2,696,330
    
    
    
    
    836,142
    
    
    
    
    346,526Temporary differences for which no future tax benefit has been
brought to account
    
    
    
    14,552,726
    
    
    
    
    
    
    
    
    
    158,204Temporary difference brought to account on acquisition of
subsidiary
    
    
    
    (488,027
    )
    
    
    
    
    
    
    
    
    Other  net
    
    
    
    699,988
    
    
    
    
    55,949
    
    
    
    
    (234,653
    )Income tax expense
    
    
    
    1,875,063
    
    
    
    
    37,339
    
    
    
    
    1,446
 Quarterly Financial Summary The following table summarizes financial information for each quarter of 2004 and 2003: Quarters ended
    
    
    2004
    
    
    
    200331-Dec
    
    
    
    30-Sep (1)
    
    
    
    30-Jun
    
    
    
    31-Mar
    
    
    
    31-Dec
    
    
    
    30-Sep
    
    
    
    30-Jun
    
    
    
    31-MarTotal Revenue
    
    
    
    22,151,046
    
    
    
    
    36,226,109
    
    
    
    
    12,690,533
    
    
    
    
    155,596
    
    
    
    
    203,964
    
    
    
    
    13,349
    
    
    
    
    27,717
    
    
    
    
    14,250Net Income (Loss)
before discontinued
operations and
extraordinary items
    
    
    
    (43,855,413
    )
    
    
    
    (4,917,262
    )
    
    
    
    (2,522,279
    )
    
    
    
    (1,644,927
    )
    
    
    
    (1,489,036
    )
    
    
    
    (1,510,516
    )
    
    
    
    (1,204,678
    )
    
    
    
    686,659Net Income (Loss)
per share
    
    
    
    (1.73
    )
    
    
    
    (0.19
    )
    
    
    
    (0.10
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.05
    )
    
    
    
    0.03Diluted Income
(Loss) per share
    
    
    
    (1.73
    )
    
    
    
    (0.19
    )
    
    
    
    (0.10
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.05
    )
    
    
    
    0.03Net Income (Loss)
    
    
    
    (43,855,413
    )
    
    
    
    (4,917,262
    )
    
    
    
    (2,522,279
    )
    
    
    
    (1,644,927
    )
    
    
    
    (1,489,036
    )
    
    
    
    (1,510,516
    )
    
    
    
    (1,204,678
    )
    
    
    
    686,659Net Income (Loss)
per share
    
    
    
    (1.73
    )
    
    
    
    (0.19
    )
    
    
    
    (0.10
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.05
    )
    
    
    
    0.03Diluted Net Income
(Loss) per share
    
    
    
    (1.73
    )
    
    
    
    (0.19
    )
    
    
    
    (0.10
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.07
    )
    
    
    
    (0.05
    )
    
    
    
    0.03
 Notes  (1)
    It was identified in the fourth quarter 2004 that the statement of operations for the
quarter ending September 30, 2004 included sales and cost of sales of our refined products
sold by InterOil downstream subsidiaries during the commissioning of the refinery and this
activity was adjusted to plant and equipment in the fourth quarter 2004. For comparative
purposes the September 30, 2004 amounts in the table include subsequent period adjustments InterOil CorporationPage 14 of 28




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##### 



of revenue ($11,336,839) and cost of sales ($9,397,373). The net impact of these adjustments
has increased the net loss by $1,939,466. Revenue  
    September 30, 2004 to December 31, 2004  IPL revenue on refined products was not
produced at our refinery. Refinery remains in the construction and development stage.
    June 30, 2004 to September 30, 2004  increase in revenue related to $26.3 million of
external sales was generated from a trade out of a crude cargo during refinery
commissioning.
    March 31, 2004 to June 30, 2004  increase in revenue generated from acquisition of
lPL on April 28, 2004. Refinery remains in the construction and development stage.
    January 1, 2003 to March 31, 2004  revenue per quarter is primarily interest on
investments as the company remains in the construction and development stage. Expenses  
    September 30, 2004 to December 31, 2004  A $35.6 million expense of oil and gas
exploration and development activities that were previously capitalized. An increase in
legal and professional expenses related to the American Stock Exchange listing and the
convertible debenture transaction.
    June 30, 2004 to September 30, 2004  increase in cost of sales and operating expenses
of revenue relate to $27.7 million from a trade out of a crude cargo during refinery
commissioning. Increase in legal and professional expenses associated with the Toronto
Stock Exchange listing.
    March 31, 2004 to June 30, 2004  increase in cost of sales and operating expenses from
the acquisition of lPL on April 28, 2004. A $1.4 million expense of oil and gas
exploration and development activities that were previously capitalized.
    December 31, 2003 to March 31, 2004  legal and professional fees were incurred
relating to 2003 capital raisings that matured in the first quarter of 2004.
    September 30, 2003 to December 31, 2003  A $164,992 expense was recorded for oil and
gas exploration and development activities that were previously capitalized.
    March 31, 2003 to June 30, 2003  there was a foreign currency loss of $252,938 at
June 30, 2003 versus a gain of $554,296 at March 31, 2003. The difference is attributable
to a one-time adjustment at March 31, 2003 where P.I.E., a related party, waived prior
years management fees totaling $840,000 that had previously been accrued. Capital Resources Operating Activities In 2004 net cash used by our operating activities was $80.2 million, compared to $3.5 million
recorded in 2003. The positive operational cash flows derived from our acquisition of InterOil
Products Limited on April 28, 2004 were insufficient to prevent a consolidated deficit as our
refinery project remained in the pre-operating stage throughout the year. Operational cash flows
from our refinery commenced in January 2005. Cash flows from/(used in) operating activitiesYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Net (loss)
    
    
    
    (52,939,881
    )
    
    
    
    (3,517,569
    )
    
    
    
    (1,315,887
    )Adjustments for non-cash transactionsNon-controlling interest
    
    
    
    (70,091
    )
    
    
    
    (22,901
    )
    
    
    
    (5,383
    )Depreciation and amortization
    
    
    
    639,075
    
    
    
    
    73,068
    
    
    
    
    85,657Future income tax benefit
    
    
    
    (663,347
    )
    
    
    
    
    
    
    
    
    
 InterOil CorporationPage 15 of 28




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##### 



Cash flows from/(used in) operating activitiesYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Gain on sale of other assets
    
    
    
    (94,260
    )
    
    
    
    
    
    
    
    
    Amortization of discount on debt
    
    
    
    604,045
    
    
    
    
    
    
    
    
    
    Amortization of deferred financing costs
    
    
    
    268,873
    
    
    
    
    
    
    
    
    
    Debt conversion expense  debentures
    
    
    
    77,589
    
    
    
    
    
    
    
    
    
    Management fees for prior periods waived
    
    
    
    
    
    
    
    
    (840,000
    )
    
    
    
    Stock compensation expense
    
    
    
    1,209,921
    
    
    
    
    (39,654
    )
    
    
    
    612,197Capitalized oil and gas properties expensed
    
    
    
    35,566,761
    
    
    
    
    164,992
    
    
    
    
    92,673Ineffective hedge loss
    
    
    
    40,715
    
    
    
    
    
    
    
    
    
    678,648Interest expense forfeited by debenture holders
    
    
    
    998,438
    
    
    
    
    
    
    
    
    
    Unrealized foreign exchange loss (gain)
    
    
    
    392,805
    
    
    
    
    678,774
    
    
    
    
    (1,773,435
    )Change in non-cash working capitalDecrease (increase) in trade receivables
    
    
    
    (50,456,671
    )
    
    
    
    
    
    
    
    
    Decrease (increase) in other assets and prepaid expenses
    
    
    
    982,014
    
    
    
    
    220,196
    
    
    
    
    709,782Decrease (increase) in inventories
    
    
    
    (22,666,150
    )
    
    
    
    
    
    
    
    
    Increase (decrease) in accounts payable, accrued
liabilities and income tax payable
    
    
    
    5,880,047
    
    
    
    
    (236,058
    )
    
    
    
    (1,433,211
    )Total
    
    
    
    (80,230,117
    )
    
    
    
    (3,519,152
    )
    
    
    
    (2,348,959
    )
 Investing Activities Cash used in investing activities amounted to $23.8 million in 2004, a decrease of $97.0 million
from the $120.8 million in 2003. Cash flows used in investing activitiesYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Expenditure on oil and gas properties
    
    
    
    (19,154,106
    )
    
    
    
    (19,987,946
    )
    
    
    
    (875,105
    )Expenditure on plant and equipment
    
    
    
    (38,484,704
    )
    
    
    
    (81,843,608
    )
    
    
    
    (42,372,277
    )Proceeds on sale of other assets
    
    
    
    405,353
    
    
    
    
    
    
    
    
    
    Redemption of short term investments
    
    
    
    24,723,572
    
    
    
    
    (17,617,871
    )
    
    
    
    9,894,299Acquisition of InterOil Products Limited, net of cash received
    
    
    
    4,631,904
    
    
    
    
    
    
    
    
    
    Increase
(decrease) in accounts payable and accrued liabilities
    
    
    
    4,094,594
    
    
    
    
    (1,351,521
    )
    
    
    
    4,749,199Total
    
    
    
    (23,783,387
    )
    
    
    
    (120,800,946
    )
    
    
    
    (28,603,884
    )
 Upstream Capital Expenditures During 2004, our capital expenditures for exploration and development in Papua New Guinea totaled
$19.2 million compared with $20.0 million during 2003. We spudded our second exploration well on the Moose structure, Moose  2 in late 2003. Results
from this well confirmed the oil shows and fractured limestone reservoir we identified in Moose 
1, which we believe demonstrates the lateral extent of the potential limestone resource. Moose 
2 is located 2.5 miles (4 kilometers) to the southeast of Moose  1. Difficult drilling
conditions resulted in the primary target sandstones not being penetrated. The palynological
dating indicates that the shales are equivalent in age to the Pale Sandstone. Since this shale
unit was not completely penetrated the presence or absence of the Pale Sandstone remains
conjectural and the presence of the Subu Sandstone untested. After a review of results it was
decided that our next step in appraising the structure was to acquire 2D seismic data. In
September 2004, we completed a seismic program across the Moose and adjacent structures as a
further step in the full appraisal of the prospect and to delineate the primary target sandstones. InterOil CorporationPage 16 of 28




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##### 



We spudded our third exploration well and the first on the Sterling Mustang structure in January
2004. This well was drilled to 9,704 feet (2,958 meters) but did not encounter the planned targets
before the rig hit depth and pressure limits. A seismic program is planned over this prospect for
2005. Midstream Capital Expenditures Our refinery is our primary asset and is centrally located across the harbor from Port Moresby, the
capital city of Papua New Guinea and is 15 miles (24 kilometers) by road and 2.5 miles (4
kilometers) by water from Port Moresby. Our refinery consists of a nameplate 32,500 barrel per stream day crude distillation unit, a 3,500
barrel per stream day hydro-desulphurization unit, a 3,500 barrel per stream day catalytic
reforming unit, two jetties with ship loading and off-loading facilities and a road tanker loading
system. Our tank farm has an overall storage capacity approaching 1.9 million barrels. We are
also self sufficient with a reverse osmosis desalination unit for water, steam and power generation
for electricity, and other site infrastructure and support facilities including laboratory,
workshops, an administration building, waste water treatment plant, staff accommodation and a fire
station. Our refinery is operated from a central computerized control center. The third and fourth quarters of 2004 were a major challenge for us as we transformed the refinery
through the commissioning process from a construction project to an operational industrial facility
in January 2005. Various components of the refinery were progressively put into service. On July
1, 2004, oil was first processed at the refinery. This processing was followed through the
commissioning process by the production and sale of refined product. Although the commissioning
process was gradual and extended over several months, no major obstacles were encountered, and by
year-end 2004 the refinery had processed over 3.3 million barrels of crude, achieved stable
operations on all its process units and utility systems, and had operated at throughputs averaging
over 30,000 barrels a day during the months of November and December, 2004. During December 2004,
our refinery successfully completed its performance test run, operating at the name-plate capacity
of 32,500 barrels per day and meeting yield structures and energy utilization as per its design.
It also proved its flexibility to process crude other than Kutubu blend. On January 31, 2005, our
refinery achieved practical completion. Practical completion means construction of the refinery
has been completed and that the refinery has satisfactorily completed the reliability and
performance tests which were conducted as part of the acceptance and handover process. During 2004, capital expenditures for the midstream refinery totaled $40.5 million compared with
$81.2 million during 2003. The total capital cost of the refinery at December 31, 2004 was $236.7
million. Downstream Capital Expenditures During 2004, capital expenditures for our downstream business were related to the acquisition of
InterOil Products Limited. The adjusted purchase price was $13,226,854, including a service
agreement for $1,000,000 related to the purchase. A deposit of $1,000,000 of the purchase price
has been paid. The remaining $12,226,854 (discounted amount $12,123,106) was paid on March 1, 2005
and is included in current liabilities in the financial statements at December 31, 2004. The following table summarizes the estimated fair value of the assets acquired and liabilities
assumed at the date of acquisition: InterOil CorporationPage 17 of 28




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##### 



Estimated fair value
    
    
    $Cash
    
    
    
    5,859,517Trade receivables
    
    
    
    8,241,400Inventory
    
    
    
    6,759,089Other assets
    
    
    
    1,614,249Future income tax benefit
    
    
    
    640,284Property, plant and equipment
    
    
    
    3,180,530Total assets acquired
    
    
    

26,295,069Accounts payable and accrued liabilities
    
    
    

(13,399,720
    )Net assets acquired
    
    
    

12,895,349
 The net cash received from the purchase of IPL of $4,631,904 is comprised of $5,859,517 held
by IPL at the time of acquisition less $1,000,000 paid relating to the acquisition price and
$227,613 paid in transaction costs and in stamp duty. Financing Activities Cash generated from financing activities was $114.4 million compared to $130.3 million in 2003. Cash Flows from Financing ActivitiesYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Proceeds from secured loan (1)
    
    
    
    2,000,000
    
    
    
    
    52,000,000
    
    
    
    
    30,240,000Proceeds from senior convertible debenture (2)
    
    
    
    45,000,000
    
    
    
    
    
    
    
    
    
    Senior convertible debenture issuance costs (2)
    
    
    
    (3,259,766
    )
    
    
    
    
    
    
    
    
    Proceeds from indirect participation interest (3)
    
    
    
    16,984,852
    
    
    
    
    16,300,000
    
    
    
    
    Proceeds from related party borrowings (4)
    
    
    
    1,775,565
    
    
    
    
    
    
    
    
    
    2,900,000Repayments to related party (4)
    
    
    
    (2,198,065
    )
    
    
    
    (776,902
    )
    
    
    
    (878,276
    )Proceeds from issue of common shares  stock options (5)
    
    
    
    2,020,316
    
    
    
    
    62,822,143
    
    
    
    
    1,312,223Proceeds from short term borrowing (6)
    
    
    
    5,100,000
    
    
    
    
    
    
    
    
    
    Repayments of short term borrowings (6)
    
    
    
    (5,100,000
    )
    
    
    
    
    
    
    
    
    Proceeds from (repayments of) short term working capital facility (7)
    
    
    
    76,520,541
    
    
    
    
    
    
    
    
    
    Cash held as security for working capital facility (7)
    
    
    
    (24,407,709
    )
    
    
    
    
    
    
    
    
    Total
    
    
    
    114,435,734
    
    
    
    
    130,345,241
    
    
    
    
    33,573,947
 Notes  (1)
    On June 12, 2001, we entered into a loan agreement with the Overseas Private Investment
Corporation (OPIC), an agency of the US Government, to secure a project financing facility
of $85,000,000. The remaining balance of $2.0 million was drawndown in 2004, and the
facility was fully drawn down at December 31, 2004. The loan is secured over the assets of
the refinery project which have a carrying value of $236,683,247 at December 31, 2004 (2003
  $196,409,513, 2002  $121,035,944).(2)
    On August 28, 2004 and September 4, 2004 we issued a total of $45.0 million in senior
convertible debentures. The debentures were to mature on August 28, 2009 and bore interest
at a rate of 8.875% per annum, payable quarterly. The debentures were converted into
2,232,143 of our common shares at a fixed conversion price of US$20.16 per share on
December 31, 2004 at the investors option. We also issued 180,000 additional shares to
debenture holders in connection with their conversion of the debt to equity. As a result of
the issuance of the 180,000 additional shares, share capital increased by $6,976,800 which
represents the fair market value of the shares on the date they were issued. In connection
with these additional shares $77,589 was recognized as a debt conversion expense during the
year ended December 31, 2004, and an adjustment to accumulated
deficit of $6,899,211.

In connection with the issuance of the senior convertible debentures, we issued to the
investors five-year warrants to purchase 359,415 common shares at an exercise price equal to
US$21.91. All warrants were InterOil CorporationPage 18 of 28




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##### 



outstanding at December 31, 2004 and were not impacted by the debt conversion. The warrants
are exercisable between August 27, 2004 and August 27, 2009. The warrants are recorded at
the fair value calculated at inception as a separate component of equity. The fair value was
calculated using a Black-Scholes pricing model with the following assumptions: risk-free
interest rate of 2.5%, dividend yield of nil, volatility factor of the expected market price
of our common shares of 45%, and a weighted average expected life of the warrants of five
years.(3)
    On March 2004, we received an additional $3,235,000 from PNG Drilling Ventures Limited
(PNGDV) relating to PNGDVs indirect interest in our phase one exploration program within
the area governed by Petroleum Prospecting Licenses 236, 237 and 238. This additional
receipt brought the total invested by PNGDV in the indirect participation interest to
$12,185,000. This interest is subject to the terms of the agreement dated July 21, 2003
between us and PNG Drilling Ventures Limited, under which all or part of the indirect
participation interest, up to a maximum of $11,620,000 may be converted to our common
shares at a price no less than C$20.85 per common share. Alternatively, an amount up to
$1,969,000 of the indirect participation interest may be converted to debt due in December
2005 and December 2006. Should neither of these conversion rights be exercised, the
indirect participation in the drilling program will be maintained and distributions will be
paid in accordance with the agreements. In January 2004, $75,500 of the PNGDV interest was
converted into 5,000 of our common shares and a further $1,500,670 of the interest was
converted to 84,545 common shares on September 30, 2004 in accordance with the indirect
participation interest agreement. The balance of PNGDVs indirect participation interest
at December 31, 2004 is $10,608,830 (December 31, 2003  $8,950,000).  Prior to December 31, 2004, we received deposits of $13,749,852 toward an additional indirect
participation interest.(4)
    During the year ended December 31, 2004, Petroleum Independent and Exploration
Corporation (P.I.E.) advanced us $1,775,568, which was repaid prior to December 31, 2004.
The advance had interest charged at a rate of 6% per annum which was the cost of P.I.E. and
included no premium. During the year we incurred total interest to P.I.E. amounting to
$246,745 (2003  $105,374, 2002  $127,639). P.I.E. is controlled by one of our officers
and directors.(5)
    During the year the company received $2,020,316 from the exercise of stock options.(6)
    On June 24, 2004, we entered into a loan agreement with Clarion Finanz AG for
$3,000,000. On July 30, 2004 we increased it to $4,500,000. Interest was calculated at 12%
per annum compounded daily. The loan was repaid in full on August 31, 2004. On June 29,
2004 we entered into a promissory note for $600,000 with Global Asset Management LLC. The
fees related to this promissory note were $67,500. The loan was repaid in full on August
31, 2004.(7)
    During the year ended December 31, 2004, we obtained a working capital credit facility
with BNP Paribas (Singapore branch) with a maximum availability of $100,000,000. This
financing facility supports our ongoing procurement of crude oil for our refinery and
includes related hedging transactions. Liquidity Sources of Capital Upstream We entered into investment agreements in respect of our ongoing exploration program in Papua New
Guinea on February 28, 2005. Under these agreements, certain institutional and accredited
investors have agreed to invest $125,000,000 for an aggregate 25% indirect participation interest
in an eight well exploration program to be completed by the end of 2006. Midstream During the year ended December 31, 2004, we obtained a working capital credit facility with BNP
Paribas (Singapore branch) with a maximum availability of $100,000,000. This financing facility
supports our ongoing procurement of crude oil for our refinery and includes related hedging
transactions. The facility comprises a base facility to accommodate the issuance of letters of
credit followed by secured loans in the form of short term advances. In addition to the base
facility, the agreement offers both a cash secured short term facility and a discounting facility
on specific InterOil CorporationPage 19 of 28




---



##### 



monetary receivables. The facility is secured by sales contracts, purchase contracts, certain cash
accounts associated with the refinery, all crude and refined products of the refinery and trade
receivables. The facility bears interest at LIBOR + 2.5% on the short term advances. During the year the
weighted average interest rate was 4.36%. At December 31, 2004, $9,479,459 of the total facility remained available for use. At December 31, 2004, we had one letter of credit outstanding for $14,000,000. Cash totaling
$24,407,709 was being maintained as a security margin for the balance open on the facility. In
addition, crude and product inventories of $20,368,957 and receivables of $46,911,393 secured the
facility. Subsequent to December 31, 2004, our refinery completed its reliability testing and we issued the
practical completion certificate. With the completion of this event, starting in January 2005 the
refinery construction and commissioning came to an end and the refinery commenced full operations. Downstream Our downstream working capital and capital programs are funded by cash provided through operating
activities. As a result of the new pricing regime introduced in September 2004 (see downstream
results of operations above), the expected annual 2005 cash flows in the downstream business will
be lower than the annualized cash flows generated in 2004 but will continue to support the ongoing
business activities. Corporate On January 28, 2005 we obtained a $20 million Term Loan Facility from Clarion Finanz AG of which a
tranche of $10 million was received on January 31, 2005 and the balance of $10 million was received
on February 25, 2005. The loan has an interest rate equal to 5% per annum payable quarterly in
arrears, and includes a 1% arrangement fee of the face amount. The term of the loan is fifteen
months from the disbursement dates, and is repayable at any time prior to expiry with no penalty.
In addition we have provided to Clarion Finanz AG an irrevocable right to participate in our next
equity financing for an amount up to $40 million. Capital Requirements Upstream We are obligated under our agreement with indirect participation holders to drill eight exploration
wells. We expect to drill these eight wells through year-end 2006 and we believe that the funding
raised from the interest holders, $125 million, is sufficient to meet these obligation. Midstream As we completed construction on our refinery and obtained practical completion on January 31, 2005,
we see no immediate material specific capital need for 2005. However, we will continue to assess
this as we move further into operations and may need to make capital additions. InterOil CorporationPage 20 of 28




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##### 



Downstream Under our acquisition agreement of BP Papua New Guinea Limited in 2004, we agreed to finalize
payment of the acquisition of $12.2 million in March 2005. This payment was made on March 1, 2005.
We are in negotiations with Shell for the acquisition of their wholesale and retail assets in
Papua New Guinea and expect to close this acquisition in mid-year 2005 requiring a capital payment
of $2.8 million. Contractual Obligations and Commitments The following table contains information on payments for contracted obligations we have over the
next five years and it should be read in conjunction with our financial statements and the notes
thereof. Payment due by periodLess than
    
    
    
    
    
    
    
    
    
    
    
    
    
    More thanContractual obligations
    
    
    Total
    
    
    
    1 year
    
    
    
    1  3 years
    
    
    
    3  5 years
    
    
    
    5 yearsLong-Term Debt Obligations
    
    
    $
    85,000,000
    
    
    
    $
    9,000,000
    
    
    
    $
    18,000,000
    
    
    
    $
    18,000,000
    
    
    
    $
    40,000,000Indirect Participation
Interests(1)
    
    
    $
    6,885,000
    
    
    
    $
    3,442,500
    
    
    
    $
    3,442,500
    
    
    
    
    nil
    
    
    
    
    nilAcquisition of BP assets
in PNG(2)
    
    
    $
    12,226,854
    
    
    
    $
    12,226,854
    
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nilBP Services Agreement(3)
    
    
    $
    1,000,000
    
    
    
    $
    1,000,000
    
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nilAcquisition of Shell
assets in PNG(4)
    
    
    $
    18,000,000
    
    
    
    $
    2,800,000
    
    
    
    $
    15,200,000
    
    
    
    
    nil
    
    
    
    
    nilPurchase Obligations(5)
    
    
    $
    5,000,000
    
    
    
    $
    1,000,000
    
    
    
    $
    2,000,000
    
    
    
    $
    2,000,000
    
    
    
    
    nilCapital Lease Obligations
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nilOperating Leases
    
    
    $
    300,000
    
    
    
    $
    300,000
    
    
    
    
    nil
    
    
    
    
    nil
    
    
    
    
    nilPetroleum Prospecting and
Retention License(6)
    
    
    $
    8,233,937
    
    
    
    
    nil
    
    
    
    $
    8,233,937
    
    
    
    
    nil
    
    
    
    
    nilTotal
    
    
    $
    136,645,791
    
    
    
    $
    29,769,354
    
    
    
    $
    46,876,437
    
    
    
    $
    20,000,000
    
    
    
    $
    40,000,000
 Notes  (1)
    The Indirect Participation Interest terms provide for various conversion options. The
amount provided is the maximum amount that can be converted to debt and differs to the
amount presented in the 31 December 2004 Consolidated Balance Sheet due to conversion
requirements into our fully paid common shares.(2)
    The adjusted purchase price was $13,226,854. A down payment of $1,000,000 of the
purchase price was paid in 2004.(3)
    Management service agreement with BP.(4)
    The acquisition is expected to take place within 6 months following practical
completion of the refinery.(5)
    Arises from management fees payable under the 5 year refinery facilities and management
contract.(6)
    Amount necessary for the next 2 years under the work program to maintain our
exploration licenses. Our Material Contracts Date
    
    
    Description
    
    
    PartiesFebruary 25, 2005
    
    
    Indirect Participation Interest
Agreement
    
    
    InterOil
Corporation and the
investors signatory
theretoFebruary 25, 2005
    
    
    Registration Rights Agreement
    
    
    InterOil
Corporation and the
investors signatory
theretoJuly 31, 2004
    
    
    Purchase and Sale Agreement
    
    
    InterOil
Corporation and
Shell Overseas
Holdings LimitedMarch 10, 2004
    
    
    Share Sale Agreement
    
    
    InterOil
Corporation, SPI
Distribution
Limited, Gas Tank
Nederland B.V. and
BP Papua New Guinea
LimitedNovember 9, 2003
    
    
    Facilities Management Contract
    
    
    InterOil Limited
and Petrofac
Niugini Limited
 InterOil Corporation Page 21 of 28




---



##### 



Date
    
    
    Description
    
    
    PartiesMarch 26, 2002
    
    
    Engineering Procurement and
Construction Contract
    
    
    InterOil Limited
and Clough Niugini
LimitedDecember 21, 2001
    
    
    Crude Supply Agency and Sales
Agreement
    
    
    EP InterOil, Ltd.
and BP Singapore
Pte LimitedApril 9, 2001
    
    
    Domestic Sales Agreement
    
    
    InterOil Limited
and Shell Papua New
Guinea LimitedMarch 26, 2001
    
    
    Export Marketing and Shipping
Agreement
    
    
    EP InterOil, Ltd.
and Shell
International
Eastern Trading
CompanyFebruary 8, 2001
    
    
    Agreement for the Sale and
Purchase of Naphtha
    
    
    EP InterOil, Ltd.
and Shell
International
Eastern Trading
CompanyMay 29, 1997
    
    
    Refinery State Project Agreement
    
    
    InterOil Limited
and EP InterOil,
Ltd. and The
Independent State
of Papua New Guinea
 Off Balance Sheet Arrangements At December 31, 2004 and 2003, we did not have any off balance sheet arrangements, including any
relationships with unconsolidated entities or financial partnerships to enhance perceived
liquidity. Share Capital Our authorized share capital consists of an unlimited number of common shares with no par
value. As of December 31, 2004 we had 28,310,884 common shares outstanding with 30,367,689 diluted common shares at March 16, 2005. Share Capital
    
    
    Number of sharesBalance, January 1, 2002
    
    
    
    20,186,870Shares issued for cash
    
    
    
    399,073Balance, December 31, 2002
    
    
    
    20,585,943Shares issued for cash
    
    
    
    3,817,500Shares issued for debt
    
    
    
    31,240Shares issued on exercise of options
    
    
    
    381,278Balance, December 31, 2003
    
    
    
    24,815,961Shares issued for debt
    
    
    
    3,184,828Shares issued on exercise of options
    
    
    
    310,095Balance, December 31, 2004
    
    
    
    28,310,884Shares issued on exercise of options (Jan-Mar 15, 2005)
    
    
    
    162,709Shares issued on exercise of warrants (Jan-Mar 15 2005)
    
    
    
    19,168Balance, March 16, 2005
    
    
    
    28,492,761Remaining stock options authorized
    
    
    
    1,529,681Remaining warrants issued
    
    
    
    340,247Other
    
    
    
    5,000Diluted March 16, 2005 (1)
    
    
    
    30,367,689
 Notes  (1)
    In 2003 and 2005, we sold indirect working participation interest in our exploration
program. Investors have the right to convert, under certain circumstances, their interest
to our common shares. If 100% of the investors choose to convert their interest, we would
be required to issue an additional 3,961,639 common shares. InterOil Corporation Page 22 of 28




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##### 



Transactions with Related Parties Amounts due to related parties of $1,056,251 (2003  $1,478,751, 2002  $2,784,560) represents
monies owed to Petroleum Independent and Exploration Corporation (P.I.E.) which acts as a sponsor
of the Companys oil refinery project. P.I.E. is controlled by Phil E Mulacek, an officer and
director of InterOil. During the year ended December 31, 2004, $422,500 of the loan to P.I.E. was
repaid. The loan charges interest at a rate of 5.75% (2003  5.75%, 2002  5.75%) per annum.
During the year ended December 31, 2004, P.I.E. also advanced us $1,775,565, which was repaid prior
to December 31, 2004. The advance had interest charged at a rate of 6% per annum. During the year
we incurred total interest to P.I.E. amounting to $246,745 (2003  $105,374, 2002  $127,639). SPI does not have a Board of Directors. Instead, its articles of association provide for the
business and affairs of SPI to be managed by a general manager appointed by the shareholders of SPI
and its the US sponsor under the OPIC loan. P.I.E. has been appointed as the general manager of
SPI. Under the laws of the Commonwealth of The Bahamas, the general manager exercises all powers
which would typically be exercised by a Board of Directors, being those which are not required by
laws or by SPIs constituting documents to be exercised by the members (shareholders) of SPI.
During the year, $150,410 (2003  $150,000, 2002  $150,000) was expensed for the sponsors
(P.I.E.) legal, accounting and reporting costs. This amount was included in accounts payable and
accrued liabilities at December 31, 2004. During 2003, P.I.E. also waived $840,000 of management
fees due to it for prior periods and this was reflected in the Consolidated Statement of
Operations. Breckland Limited provides technical and advisory services to us and/or our subsidiaries on normal
commercial terms. This party is related by virtue of common directorships, Roger N Grundy.
Amounts paid or payable to Breckland during the year amounted to $120,426 (2003  $131,250, 2002 -
$204,522). Financial and Derivative Instruments With the exception of cash and cash equivalents and short term investments, all financial
assets are non interest bearing. Cash and cash equivalents earned average interest rates of 1.6%
per annum (2003  1.5%, 2002  3.5%). Temporary investmentsYear-ended December 31 ($)
    
    
    2004
    
    
    
    2003
    
    
    
    2002Cash deposit on working capital facility (1.98%)
    
    
    
    24,407,709
    
    
    
    
    
    
    
    
    
    Managed trust (1.5%)
    
    
    
    
    
    
    
    
    24,626,154
    
    
    
    
    Pledged deposit (1.6%)
    
    
    
    
    
    
    
    
    97,418
    
    
    
    
    7,105,701Total
    
    
    
    24,407,709
    
    
    
    
    24,723,572
    
    
    
    
    7,105,701
 Cash held as deposit on the working capital facility supports our working capital facility
with BNP Paribas. The balance is initially based on 20% of the outstanding balance of the facility
subject to fluctuations or variations in inventories and accounts receivables. Credit risk is minimized as all cash amounts and certificate of deposit are held with large banks
which have acceptable credit ratings determined by a recognized rating agency. The carrying values of cash and cash equivalents, trade receivables, all other assets, accounts
payable and accrued liabilities, short and long term debt and amounts due to related parties
approximate fair values due to the short term maturities of these instruments. InterOil Corporation Page 23 of 28




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##### 



Foreign currency hedge contracts We had no outstanding foreign currency forward contracts at December 31, 2004 and 2003. At
December 31, 2002, we had contracts valued at $62,000,000 to acquire Australian dollar amounts
payable pursuant to the refinery construction. These hedging contracts have all matured during
2003. At December 31, 2002, we had an unrealized loss of $4,001,462 resulting from hedge contracts.
An unrealized exchange loss of $678,648 was recognized on the balance sheet for contracts in excess
of specific commitments at December 31, 2002. To define a maximum potential amount payable on the outstanding hedge contracts, we acquired
Australia dollar put options during the year ended December 31, 2003 for total premiums of $218,430
(2002  $85,000). The maturity dates and nominal amounts of the put options coincided with the
exercise dates and nominal amounts of the outstanding hedge contracts. There were no outstanding
put options at December 31, 2003 or December 31, 2004. At December 31, 2002, as a requirement of the hedging contracts a collateral arrangement was
entered into whereby an amount of $7,105,701 was held on deposit and had been pledged in favor of
the provider of the hedge and recorded as cash. Funds required to be held on deposit as collateral
reduced over time as project expenditure was undertaken and the foreign currency forward contracts
were closed out. These amounts had reduced to nil as at December 31, 2003 and December 31, 2004. Commodity hedge contracts We use derivative commodity instruments to manage exposure to price volatility on a portion of its
refined product. As at December 31, 2004, we had entered into naphtha and crude swap agreements to
hedge a portion of the anticipated January and February 2005, sales of naphtha and the purchase of
associated crude feedstock. The unrealized gain on hedge contracts deemed to be effective at
December 31, 2004 amounted $537,358 (2003  $nil, 2002  $nil) and is recognized in the financial
statements under deferred hedge gain. A summary of the outstanding hedge contracts is as follows: Notional
    
    
    
    
    
    
    
    Price USDDerivative
    
    
    Type
    
    
    Volumes (bbls)
    
    
    Expiry
    
    
    per Barrel
    
    
    ReceivableNaphtha fixed price
    
    
    Sell
    
    
    
    50,000
    
    
    
    Jan-05
    
    
    $
    43.90
    
    
    
    $
    280,000Naphtha fixed price
    
    
    Sell
    
    
    
    50,000
    
    
    
    Feb-05
    
    
    $
    41.00
    
    
    
    $
    112,500Crude fixed price
    
    
    Buy
    
    
    
    50,000
    
    
    
    Feb-05
    
    
    $
    38.90
    
    
    
    $
    111,000TOTAL
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    503,500
 Critical Accounting Estimates  (a)
    Inventories Crude oil and refined petroleum products are valued at the lower of cost, on a first-in, first-out
basis, or net realizable value. The cost of midstream refined petroleum product consists of raw
material, labor, direct overheads and transportation costs. Cost of downstream refined petroleum
product includes the cost of the product plus related freight, wharfage and insurance. InterOil Corporation Page 24 of 28




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##### 



(b)
    Revenue recognition The following particular accounting policies, which significantly affect the measurement of profit
and of financial position, have been applied. Revenue from midstream operations: Revenue from sales of products is recognized when products are shipped and the customer takes
ownership and assumes risk of loss, collection of the relevant receivable is probable, persuasive
evidence of an arrangement exists and the sales price is fixed or determinable. Sales between our
business segments are eliminated from sales and operating revenues and cost of sales and between
the asset for the refinery as all revenues and expenses relating to the refinery have been
capitalized for the period to December 31, 2004. Revenue from downstream operations: Sales of goods are recognized when we have delivered products to the customer, the customer takes
ownership and assumes risk of loss, collection of the receivable is probable, persuasive evidence
of an arrangement exists and the sale price is fixed or determinable. It is not our policy to sell
products with a right of return. Interest income Interest income is recognized on a time-proportionate basis using the effective interest method.  (c)
    Income taxes We use the asset and liability method of accounting for income taxes. Under the asset and
liability method, future tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Future tax assets and liabilities are measured using
enacted or substantively enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The effect on future
tax assets and liabilities of a change in tax rates is recognized in income in the period that
includes the date of enactment or substantive enactment. A valuation allowance is provided against
any portion of a future tax asset which will more likely not be recovered.  (d)
    Oil and gas properties We use the successful-efforts method to account for its oil and gas exploration and development
activities. Under this method costs are accumulated on a field-by-field basis with certain
exploratory expenditures and exploratory dry holes being expensed as incurred. We continue to carry
as an asset the cost of drilling exploratory wells if the required capital expenditure is made and
drilling of additional exploratory wells is underway or firmly planned for the near future or when
exploration and evaluation activities have not yet reached a stage to allow reasonable assessment
regarding the existence of economical reserves. Capitalized costs for producing wells will be
subject to depletion on the units-of-production method. Geological and geophysical costs are
expensed as incurred.  (e)
    Plant and equipment Refinery assets Our most significant item of plant and equipment is our oil refinery in Papua New Guinea. In 2004,
we were considered to be in the construction and pre-operating stage of development of our oil
refinery. Project costs, net of any recoveries, incurred during this
pre-operating stage are being capitalized as part of plant and equipment. Administrative and general costs are expensed as
incurred. The refinery assets are InterOil Corporation Page 25 of 28




---



##### 



recorded at cost. Development costs and the costs of acquiring
or constructing support facilities and equipment are capitalized. Interest costs relating to the
construction and pre-operating stage of the development project prior to commencement of commercial
operations are capitalized as part of the cost of such plant and equipment. Refinery related
assets will be depreciated on a straight line basis over their useful lives, at 4% per annum. Our
refinery is built on land leased from the Independent State of Papua New Guinea. The lease expires
on July 26, 2097 and does not outline any terms for restoration and closure costs. Repairs and maintenance costs, other than major turnaround costs, are charged to earnings as
incurred. Major turnaround costs will be deferred to other assets when incurred and amortized over
the estimated period of time to the next scheduled turnaround. No major turnaround costs had been
incurred at December 31, 2004. New Accounting Standards Stock Based Compensation Plans In September 2003, the AcSB released CICA section 3870 that revised transitional provisions to
these standards to provide the same alternative methods of transition as is provided in the US for
voluntary adoption of the fair value based method of accounting. These provisions permit either
retroactive (with or without restatement) or prospective application of the recognition provisions
to awards not previously accounted for at fair value. Prospective application is available only to
enterprises that elect to apply the fair value based method of accounting to that type of award for
fiscal years beginning before January 1, 2004. The AcSB has also amended the standards to require
that all transactions whereby goods and services are received in exchange for stock-based
compensation and other payments result in expenses that should be recognized in financial
statements, and that this requirement would be applicable for financial periods beginning on or
after January 1, 2004. The standards require that share-based transactions should be measured on a
fair value basis. After January 1, 2004 the fair value of stock-based compensation will be
recognized as an expense in the financial statements. In accordance with one of the transitional options permitted under amended Section 3870, we have
retroactively applied the fair value based method to all employee stock options granted on or after
January 1, 2002, without restatement to prior periods. The effect of retroactively adopting the
fair value based method, without restatement, is to increase the opening deficit accumulated during
the development stage by $737,650, increase contributed surplus by $645,216 and increase share
capital by $92,434. Asset Retirement Obligations In March 2003, the AcSB issued CICA section 3110, which harmonizes Canadian GAAP with SFAS No. 143,
Accounting for Asset Retirement Obligations. The standards were established for the recognition,
measurement and disclosure of liabilities for asset retirement obligations and the associated asset
retirement costs. The standards apply to legal obligations associated with the retirement of a
tangible long-lived asset that results from acquisition, construction, development or normal
operations. The standards require an entity to record the fair value of a liability for an asset
retirement obligation in the period in which it is incurred and when a reasonable estimate of fair
value can be made. The standards describe the fair value of a liability for an asset retirement
obligation as the amount at which that liability could be settled in a current transaction between
willing parties, that is, other than in a forced or liquidation transaction. An entity is
subsequently required to allocate that asset retirement cost to expense using a systematic and
rational method InterOil Corporation Page 26 of 28




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over the estimated useful life of the related asset. The standards are effective for fiscal years
beginning on or after January 1, 2004. We estimate there are no legal obligations associated with the retirement of the refinery,
downstream business or with its normal operations relating to future restoration and closure costs.
The refinery is being built on land leased from the Independent State of Papua New Guinea. The
lease expires on July 26, 2097 and does not outline any terms for restoration or closure costs.
There are no environmental remediation laws or regulations in PNG, requiring restoration of the
land on which we operate. Inventory Costs In November 2004, the FASB issued FAS 151, Inventory Costs that clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted material as they
relate to inventory costing. FAS 151 requires these items to be recognized as current period
expenses. Additionally, the allocation of fixed production overheads to the cost of inventory
should be based on the normal capacity of the production facilities. Our management is in the process of determining the impact of this change as operations come
on-line in 2005. Accounting For Variable Interest Entities In January 2003, the FASB issued Financial Interpretation 46, Accounting for Variable Interest
Entities (FIN 46) that requires the consolidation of Variable Interest Entities (VIEs). VIEs
are entities that have insufficient equity or their equity investors lack one or more of the
specified elements that a controlling entity would have. The VIEs are controlled through financial
interests that indicate control (referred to as variable interests). Variable interests are the
rights or obligations that expose the holder of the variable interest to expected losses or
expected residual gains of the entity. The holder of the majority of an entitys variable
interests is considered the primary beneficiary of the VIE and is required to consolidate the VIE.
In December 2003, the FASB issued FIN 46(R) which superseded FIN 46 and restricts the scope of the
definition of entities that would be considered VIEs that require consolidation. The Canadian Accounting Standards Board issued Accounting Guideline 15, Consolidation of Variable Interest Entity (Ac-G 15), which is similar to FIN 46(R). This standard effective is for us beginning January 1, 2005. We do not believe FIN 46(R) or Ac-G 15 result in the consolidation of any additional entities. Accounting For Exchanges of Nonmonetary Assets In December 2004, the FASB issued FAS 153 which deals with the accounting for the exchanges of
nonmonetary assets. FAS 153 is an amendment of APB Opinion 29 requires that exchanges of
nonmonetary assets should be measured based on the fair value of the assets exchanged. FAS 153
amends APB Opinion 29 to eliminate the exception from using fair market value for nonmonetary
exchanges of similar productive assets and introduce a broader exception for exchanges of
nonmonetary assets that do not have commercial substance. FAS 153 is effective for nonmonetary
asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe that the application of FAS 153 will have a material impact on our financial
statements. Evaluation of Disclosure Controls and Procedures The term disclosure controls and procedures is defined in Rules 13a-15(e) and 15d-15(e) of
the Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and InterOil Corporation Page 27 of 28




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procedures of a company that are designed to ensure that information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified by the Securities and Exchange
Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, have
evaluated the effectiveness of our disclosure controls and procedures as of the end of the period
covered by this annual report. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures were effective as of
the end of the period covered by this annual report. There were no changes to our internal control over financial reporting during our last fiscal
quarter that have materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting. Public Securities Filings You may access additional information about us, including our Annual Information Form, which is
filed with the Canadian Securities Administrators at www.sedar.com and the Form 40-F, which is
filed with the United States Securities and Exchange Commission at www.sec.gov. InterOil Corporation Page 28 of 28