InterOil
      Corporation
                    Management
                    Discussion
      and Analysis
                    
                    For
      the Year ended December 31, 2009
                    March
      1, 2010





TABLE
OF CONTENTS





FORWARD-LOOKING
      STATEMENTS
                2OIL
      AND GAS DISCLOSURES
                3INTRODUCTION
                4BUSINESS
      STRATEGY
                4OPERATIONAL
      HIGHLIGHTS
                5SELECTED
      ANNUAL FINANCIAL INFORMATION AND HIGHLIGHTS
                7YEAR
      AND QUARTER IN REVIEW
                12LIQUIDITY
      AND CAPITAL RESOURCES
                19INDUSTRY
      TRENDS AND KEY EVENTS
                26RISK
      FACTORS
                29CRITICAL
      ACCOUNTING ESTIMATES
                29NEW
      ACCOUNTING STANDARDS
                31NON-GAAP
      MEASURES AND RECONCILIATION
                32PUBLIC
      SECURITIES FILINGS
                34DISCLOSURE
      CONTROLS AND PROCEDURES
                34GLOSSARY
      OF TERMS
                35




The
following Management Discussion and Analysis (“MD&A”) should be read in
conjunction with our audited consolidated financial statements and accompanying
notes for the year ended December 31, 2009 and annual information form for the
year ended December 31, 2009 (the “2009 Annual Information
Form”).  The MD&A was prepared by management and provides a review
of our performance in the year ended December 31, 2009, and of our financial
condition and future prospects.





Our
financial statements and the financial information contained in this MD&A
have been prepared in accordance with Canadian generally accepted accounting
principles (“GAAP”) and are presented in United States dollars (“USD”) unless
otherwise specified.  References to “we,” “us,” “our,” “Company,” and
“InterOil” refer to InterOil Corporation and/or InterOil Corporation and its
subsidiaries as the context requires.  Information presented in this
MD&A is as at and for the year ended December 31, 2009, unless otherwise
specified.





We are
not presenting all the U.S. GAAP information in this MD&A. Readers should
review note 30 - “Reconciliation to the generally accepted accounting principles
in the United States” to the audited financial statements for the year ended
December 31, 2009 for the reconciliation of the Canadian GAAP and U.S. GAAP
information.




Management
Discussion and Analysis   INTEROIL
CORPORATION     1








FORWARD-LOOKING
STATEMENTS





This
MD&A contains “forward-looking statements” as defined in U.S. federal and
Canadian securities laws.  Such statements are generally identifiable
by the terminology used such as “may,” “plans,” “believes,” “expects,”
“anticipates,” “intends,” “estimates,” “forecasts,” “budgets,” “targets” or
other similar wording suggesting future outcomes or statements regarding an
outlook.  We have based these forward-looking statements on our
current expectations and projections about future events.  All
statements, other than statements of historical fact, included in or
incorporated by reference in this MD&A are forward-looking
statements.  Forward-looking statements include, without limitation;
plans for our exploration (including drilling plans) and other business
activities and results therefrom; the construction of an LNG plant and
condensate stripping facility in Papua New Guinea; the development of such LNG
plant and stripping facility; the commercialization and monetization of any
resources; whether sufficient resources will be established; the likelihood of
successful exploration for gas and gas condensate; the potential discovery of
any commercial quantities of oil; cash flows from operations; sources of
capital; operating costs; business strategy; contingent liabilities;
environmental matters; and plans and objectives for future operations; the
timing, maturity and amount of future capital and other
expenditures.





Many
risks and uncertainties may affect the matters addressed in these
forward-looking statements, including but not limited to:





·
            our ability to finance the
      development of an LNG and condensate stripping
      facility;


·
            the uncertainty in our ability
      to attract capital;


·
            the uncertainty associated
      with the regulated prices at which our products may be
      sold;


·
            the inherent uncertainty of
      oil and gas exploration
activities;


·
            potential effects from oil and
      gas price declines ;


·
            the availability of crude
      feedstock at economic rates;


·
            our ability to timely
      construct and commission our LNG and condensate stripping
      facility;


·
            difficulties with the
      recruitment and retention of qualified
    personnel;


·
            losses from our hedging
      activities;


·
            fluctuations in currency
      exchange rates;


·
            the uncertainty of success in
      pending lawsuits and other
  proceedings;


·
            political, legal and economic
      risks in Papua New
Guinea;


·
            our ability to meet maturing
      indebtedness;


·
            stock price
      volatility;


·
            landowner claims and
      disruption;


·
            compliance with and changes in
      foreign governmental laws and regulations, including environmental
      laws;


·
            the inability of our refinery
      to operate at full capacity;


·
            the impact of
      competition;


·
            the margins for our
      products;


·
            inherent limitations in all
      control systems, and misstatements due to errors that may occur and not be
      detected;


·
            exposure to certain uninsured
      risks stemming from our
operations;


·
            contractual
      defaults.


·
            payments from exploration
      partners;


·
            interest rate
      risk;


·
            weather conditions and
      unforeseen operating
hazards;


·
            the impact of legislation
      regulating emissions of greenhouse gases on current and potential markets
      for our products;


·
            the impact of our current debt
      on our ability to obtain further
  financing;


·
            the adverse effects from
      importation of competing products contrary to our legal rights;
      and


·
            law enforcement
      difficulties.


Management
Discussion and Analysis   INTEROIL
CORPORATION     2











Forward-looking
statements and information are based on our current beliefs as well as
assumptions made by, and information currently available to, us concerning
anticipated financial conditions and performance, business prospects,
strategies, regulatory developments, the ability to attract joint venture
partners, future hydrocarbon commodity prices, the ability to obtain equipment
in a timely manner to carry out development activities, the ability to market
products successfully to current and new customers, the effects from increasing
competition, the ability to obtain financing on acceptable terms, and the
ability to develop reserves and production through development and exploration
activities. Although we consider these assumptions to be reasonable based on
information currently available to us, they may prove to be
incorrect.





Although
we believe that the assumptions underlying our forward-looking statements are
reasonable, any of the assumptions could be inaccurate, and, therefore, we
cannot assure you that the forward-looking statements will
eventuate.  In light of the significant uncertainties inherent in our
forward-looking statements, the inclusion of such information should not be
regarded as a representation by us or any other person that our objectives and
plans will be achieved.  Some of these and other risks and
uncertainties that could cause actual results to differ materially from such
forward-looking statements are more fully described under the heading “Risk
Factors” in our 2009 Annual Information Form.





Furthermore,
the forward-looking information contained in this MD&A is made as of the
date hereof, unless otherwise specified and, except as required by applicable
law, we will not update publicly or revise any of this forward-looking
information.  The forward-looking information contained in this
MD&A is expressly qualified by this cautionary statement.





OIL
AND GAS DISCLOSURES





We are
required to comply with Canadian Securities Administrators’ National Instrument
51-101 Standards for Disclosure of Oil and Gas Activities (“NI 51-101”), which
prescribes disclosure of oil and gas reserves and resources.  GLJ
Petroleum Consultants Ltd., an independent qualified reserve evaluator based in
Calgary, Canada, has evaluated our resources data as at December 31, 2009 in
accordance with NI 51-101 and is summarized in our 2009 Annual Information Form
available at www.sedar.com.  We
do not have any reserves, including proved reserves, as defined under NI 51-101,
as per the guidelines set by the United States Securities and Exchange
Commission (“SEC”) under ASC Topic 932, as at December 31, 2009.





The SEC
permits oil and gas companies, in their filings with the SEC, to disclose only
proved, possible and probable reserves that a company has demonstrated by actual
production or conclusive formation tests to be economically and legally
producible under existing economic and operating conditions.  We
include in this MD&A information that the SEC’s guidelines generally
prohibit U.S registrants from including in filings with the
SEC.  Investors are urged to consider closely the disclosure in the
Company’s Form 40-F dated March 1, 2010, available at www.sec.gov.





All
calculations converting natural gas to crude oil equivalent have been made using
a ratio of six mcf of natural gas to one barrel of crude
equivalent.  Barrels of oil equivalent may be misleading, particularly
if used in isolation.  A barrel of oil equivalent conversion ratio of
six mcf of natural gas to one barrel of crude oil equivalent is based on an
energy equivalency conversion method primarily applicable at the burner tip and
does not represent a value equivalency at the wellhead.


Management
Discussion and Analysis   INTEROIL
CORPORATION     3








INTRODUCTION





We are
developing a vertically integrated energy company in Papua New Guinea and the
surrounding region.  Our operations are organized into four major
segments:





Segments
                      
                      OperationsUpstream
                      
                      Exploration
      and Production – Explores for and appraises potential natural gas and oil
      structures in Papua New Guinea with a view to commercializing significant
      discoveries.  Current commercialization of the Elk and Antelope
      fields include the development of a proposed condensate stripping facility
      and development of gas production facilities for liquefied natural
      gas.Midstream
                      
                      Refining
      – Produces refined petroleum products at Napa Napa in Port Moresby, Papua
      New Guinea for the domestic market and for export.
                        
                        Liquefaction
      – Developing proposed onshore and/or offshore floating liquefied natural
      gas processing facilities in Papua New Guinea.Downstream
                      
                      Wholesale
      and Retail Distribution– Markets and
      distributes refined petroleum products domestically in Papua New Guinea on
      a wholesale and retail basis.Corporate
                      
                      Corporate
      – Provides support to the other business segments by engaging in business
      development and improvement activities and providing general and
      administrative services and management, undertakes financing and treasury
      activities, and is responsible for government and investor
      relations.  General and administrative and integrated costs are
      recovered from business segments on an equitable basis. Our corporate
      segment results also include consolidation
  adjustments.





BUSINESS
STRATEGY





Our
business strategy is to develop a vertically integrated energy company in Papua
New Guinea and surrounding regions, focusing on niche market opportunities which
provide financial rewards for our shareholders, while being environmentally
responsible, providing a quality working environment and contributing positively
to the communities in which InterOil operates.  A significant element
of that strategy is to establish and produce gas and condensate reserves and
develop liquefaction and condensate stripping facilities in Papua New
Guinea.  The produced LNG would be exported overseas, whilst the
condensate is planned to be used as feedstock for our Midstream -
refinery.





InterOil
plans to achieve this strategy by:





·
            Developing
      our position as a prudent and responsible business
  operator


·
            Enhancing
      the refining and distribution
business


·
            Maximizing
      the value of our exploration assets


·
            Building
      an export liquefaction gas business


·
            Positioning
      ourselves for long term success





Further
details of our business strategy can be found under the heading “Business Strategy” in our
2009 Annual Information Form available at www.sedar.com.





Management
Discussion and Analysis   INTEROIL
CORPORATION     4








OPERATIONAL
HIGHLIGHTS





Summary
of operational highlights





A summary
of the key operational matters and events for the year, for each of the segments
is as follows:





Upstream


·
            On
      March 2, 2009, the Antelope-1 well flowed gas at a rate equivalent to 382
      million cubic feet of gas per day with 5,000 barrels of condensate per
      day.  The well was drilled to a total depth of 8,892 feet (2,710
      meters).


·
            On
      March 5, 2009, our PPL 238, 237 and 236 licenses were re-issued for a five
      year term.


·
            On
      April 17, 2009, an indirect participation interest (“IPI”) investor waived
      conversion rights to 160,000 of our common shares under the IPI agreement
      triggering conveyance accounting for their 1.2% interest in the IPI
      program.


·
            On
      June 26, 2009, the Antelope-1 side track was completed with the
      installation of 2 7/8" tubing and the well was made ready for future
      production and/or long term flow
testing.


·
            On
      July 27, 2009, the Antelope-2 well was spudded 2.3 miles to the south of
      Antelope-1.  The purpose of this well was to help delineate the
      Antelope structure to the south and to further evaluate the condensate and
      oil observed in the Antelope-1
well.


·
            During
      August 2009, we applied for a Petroleum Retention Licence (“PRL”) over the
      declared location.  The declaration of location is a necessary
      pre-condition to the application for a PRL or a PDL.  The
      declared location was granted to us in March 2009 on our discovery block,
      and an additional 8 blocks in the license that comprised the Elk and
      Antelope fields, and a development corridor.  The PRL is yet to
      be granted.


·
            During
      September 2009, we bought back a total of 4.3364% of IPI interests held
      under the 2005 Amended and Restated Indirect Participation
      Agreement.


·
            During
      September 2009, we sold to Pacific LNG Operations Limited a 2.5% working
      interest in the Elk and Antelope fields under an option granted to it and
      announced by us on May 24, 2007.  The interest was acquired in
      exchange for cash consideration totaling $25.0 million, including $15.0
      million paid previously under the 2007 option, together with the transfer
      to us of 2.5% of Pacific LNG’s economic interest in the LNG Project joint
      venture, and payment by Pacific LNG Operations Limited of certain
      historical costs incurred in exploring and developing these
      fields.


·
            On
      September 17, 2009, the Antelope-2 well intersected the top of the
      reservoir at 6,007 feet, 345 feet higher than pre-drill
      estimates.


·
            During
      the third quarter, CGG Veritas was mobilised in preparation to execute a
      planned 100km appraisal seismic program over the Elk and Antelope
      fields.  This program progressed during fourth quarter and the
      first seismic lines were completed in December
  2009.


·
            On
      December 1, 2009 a surface flow test conducted at Antelope-2 tested
      natural gas and condensate at a rate of 705 million cubic feet of gas per
      day with 11,200 barrels of condensate per day.  Subsequent to
      the year end, the well was drilled to total depth of 8,087 feet (2,465
      meters) with preparations now in place to drill a horizontal
      extension.


·
            During
      December 2009, we bought back a further 0.5% of indirect participation
      interests held under the 2005 Amended and Restated Indirect Participation
      Agreement.


·
            During
      December 2009, IPI investors with a 6.210% IPI interest waived their
      conversion rights to 828,000 of our common shares under the IPI agreement
      triggering conveyance accounting for their interest in the IPI
      program.


·
            During
      the fourth quarter we agreed to divest our 15% non operated interest in
      PPL244. The divestment remains subject to Papua New Guinea government
      approval, and contracted pre-emptive rights, and is expected to close in
      the first quarter of 2010.


·
            Subsequent
      to year end, on February 9, 2010, we announced the purchase of our second
      drilling rig, currently located in New Zealand, for approximately $4.5
      million.





Midstream
– Refining


·
            Total
      refinery throughput during 2009 was 21,155 barrels per operating day, as
      compared with 22,034 barrels per operating day in
  2008.


Management
Discussion and Analysis   INTEROIL
CORPORATION     5








·
            Capacity
      utilization for the year, based on 36,500 barrels per day operating
      capacity, was 47% (44% for the fourth quarter of 2009) as compared to 44%
      in 2008 (57% in the same quarter of
2008).





Midstream
– Liquefaction


·
            On
      February 27, 2009, InterOil LNG Holdings Inc. and Pacific LNG Operations
      Ltd., acquired Merrill Lynch’s interest in the Joint Venture
      Company.  As part of the acquisition all matters between the
      parties were settled such that Merrill Lynch retained no ongoing economic
      interests, legal rights or involvement in the LNG
  Project.


·
            During
      September 2009, we received a 2.5% economic interest in the LNG Project
      joint venture from Pacific LNG Operations Limited as part consideration
      for the sale of a 2.5% working interest in the Elk and Antelope fields
      under an option originally granted to it and announced by us on May 24,
      2007.


·
            On
      December 23, 2009 the Government of Papua New Guinea signed the LNG
      Project Agreement (“Project Agreement”) which sets the project fiscal
      terms for a twenty year period.  It includes a 30% company tax
      rate and certain exemptions applicable to large scale projects of this
      nature.  The Agreement also sets out the terms upon which the
      Government is able to acquire up to a 20.5% ownership interest in the
      Project, and for an additional 2% interest to be acquired by affected
      landowners.





Downstream


·
            Total
      Downstream sales volumes were 588.8 million liters in 2009, compared with
      548.0 million liters in 2008.


·
            In
      March 2009 we entered into our first direct chartering shipping
      arrangement with the charter of Ipsilantis, a 3,645 dead weight tonnes
      (“DWT”) vessel, which will result in us being able to direct vessel
      movements rather than co-ordinate shipping around Papua New Guinea with
      other distributors.  The vessel is chartered for two years plus
      one optional year.


·
            In
      June 2009, the Papua New Guinea Independent Consumer and Competition
      Commission (“ICCC”) commenced a review into the pricing arrangements for
      petroleum products in PNG.  The last such review was undertaken
      during 2004 and was due to expire on December 31, 2009.  The
      purpose of the review is to consider the extent to which the existing
      regulation of price setting arrangements at both wholesale and retail
      levels should continue, or be revised for the next five year
      period.  We have provided detailed submissions to the
      ICCC.  The ICCC have most recently advised that its final report
      will be issued in March 2010.  It is possible that the ICCC may
      determine to increase regulation of pricing and reduce the margins able to
      be obtained by our distribution business.  Such a decision, if
      made, may negatively affect our downstream business and require a review
      of its operations.


·
            Subsequent
      to year end, in January 2010, we have received delivery of our second
      charter vessel Saturn, a 13,051 DWT vessel.  This vessel has
      been chartered for nine months with a further six months option to be
      called by us.





Corporate


·
            On
      January 27, 2009, the Company voluntarily delisted its common shares from
      the Toronto Stock Exchange.


·
            On
      March 31, 2009, our common shares commenced trading on the New York Stock
      Exchange and were delisted from the NYSE Alternext Stock Exchange
      (formerly the American Exchange), at the close of trading on March 31,
      2009.


·
            During
      May and June 2009, remaining outstanding debentures from the May 2008
      subordinated convertible debenture offering were converted into common
      shares.


·
            On
      June 8, 2009, we completed a registered direct stock offering of 2,013,815
      common shares to a number of institutional investors at a purchase price
      of $34.98 per share raising $70.4
million


·
            During
      the quarter ended September 30, 2009, 302,305 of the 337,252 warrants
      outstanding were exercised and converted into common shares at an exercise
      price of $21.91. All remaining unexercised warrants lapsed on August 27,
      2009.


·
            During
      2009 we reviewed and selected Microsoft Dynamics, a group wide Enterprise
      Resource Planning (“ERP”) system for implementation across all
      streams.  The implementation is expected to be completed by the
      third quarter of 2010.


Management
Discussion and Analysis   INTEROIL
CORPORATION     6








SELECTED
ANNUAL FINANCIAL INFORMATION AND HIGHLIGHTS





Consolidated
Results for the year ended December 31, 2009 compared to year ended December 31,
2008 and 2007





Consolidated – Operating results
                        
                        Year ended December 31,($ thousands, except per share data)
                        
                        2009
                        
                        
                        2008
                        
                        
                        2007Sales
      and operating revenues
                        
                        
                        688,479
                        
                        
                        
                        915,579
                        
                        
                        
                        625,526Interest
      revenue
                        
                        
                        351
                        
                        
                        
                        932
                        
                        
                        
                        2,180Other
      non-allocated revenue
                        
                        
                        4,228
                        
                        
                        
                        3,216
                        
                        
                        
                        2,667Total
      revenue
                        
                        
                        693,058
                        
                        
                        
                        919,727
                        
                        
                        
                        630,373Cost
      of sales and operating expenses
                        
                        
                        (601,983
                        )
                        
                        
                        (888,623
                        )
                        
                        
                        (573,609
                        )Office
      and administration and other expenses
                        
                        
                        (44,894
                        )
                        
                        
                        (46,691
                        )
                        
                        
                        (41,274
                        )Derivative
      gain/(loss)
                        
                        
                        1,009
                        
                        
                        
                        24,039
                        
                        
                        
                        (7,272
                        )Exploration
      costs
                        
                        
                        (209
                        )
                        
                        
                        (996
                        )
                        
                        
                        (13,305
                        )Exploration
      impairment
                        
                        
                        -
                        
                        
                        
                        (108
                        )
                        
                        
                        (1,243
                        )Gain
      on sale of oil and gas properties assets
                        
                        
                        7,364
                        
                        
                        
                        11,235
                        
                        
                        
                        -Loss
      on extinguishment of IPI liability
                        
                        
                        (31,710
                        )
                        
                        
                        -
                        
                        
                        
                        -Gain
      on LNG shareholder agreement
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6,553Foreign
      Exchange gain/(loss)
                        
                        
                        (3,305
                        )
                        
                        
                        3,878
                        
                        
                        
                        5,078Earnings before interest, taxes, depreciation and
      amortization ("EBITDA" - non-GAAP measure) (1)
                        
                        
                        19,330
                        
                        
                        
                        22,461
                        
                        
                        
                        5,301Depreciation
      and amortization
                        
                        
                        (14,322
                        )
                        
                        
                        (14,143
                        )
                        
                        
                        (13,024
                        )Interest
      expense
                        
                        
                        (9,993
                        )
                        
                        
                        (20,032
                        )
                        
                        
                        (20,005
                        )Profit
      before income taxes and non-controlling interest
                        
                        
                        (4,985
                        )
                        
                        
                        (11,714
                        )
                        
                        
                        (27,728
                        )Income
      tax benefit/(expense)
                        
                        
                        11,076
                        
                        
                        
                        (82
                        )
                        
                        
                        (1,207
                        )Non-controlling
      interest
                        
                        
                        (8
                        )
                        
                        
                        (1
                        )
                        
                        
                        22Net
      profit
                        
                        
                        6,083
                        
                        
                        
                        (11,797
                        )
                        
                        
                        (28,913
                        )Net
      profit per share (dollars) (basic)
                        
                        
                        0.15
                        
                        
                        
                        (0.35
                        )
                        
                        
                        (0.96
                        )Net
      profit per share (dollars) (diluted)
                        
                        
                        0.15
                        
                        
                        
                        (0.35
                        )
                        
                        
                        (0.96
                        )Total
      assets
                        
                        
                        631,754
                        
                        
                        
                        591,843
                        
                        
                        
                        537,815Total
      liabilities
                        
                        
                        189,764
                        
                        
                        
                        364,704
                        
                        
                        
                        441,712Total
      long-term liabilities
                        
                        
                        96,225
                        
                        
                        
                        208,224
                        
                        
                        
                        174,966Gross
      margin (2)
                        
                        
                        86,496
                        
                        
                        
                        26,956
                        
                        
                        
                        51,917Cash
      flows provided by/(used in) operating activities (3)
                        
                        
                        44,500
                        
                        
                        
                        15,586
                        
                        
                        
                        (31,620
                        )U.S.
      GAAP net profit (loss)  (4)
                        
                        
                        (622
                        )
                        
                        
                        (3,943
                        )
                        
                        
                        (19,205
                        )




Notes:


(1)
            Earnings
      before interest, taxes, depreciation and amortization, or EBITDA, is a
      non-GAAP measure and is reconciled to Canadian GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.


(2)
            Gross
      Margin is a non-GAAP measure and is “sales and operating revenues” less
      ”cost of sales and operating expenses” and is reconciled to Canadian GAAP
      in the section to this document entitled ”Non-GAAP Measures and
      Reconciliation”.


(3)
            Refer
      to “Liquidity and Capital Resources – Summary of Cash Flows” for detailed
      cash flow analysis.


(4)
            We
      are not presenting all the U.S. GAAP information in this MD&A. Readers
      should review note 30 – “Reconciliation to the generally accepted
      accounting principles in the United States” to the audited financial
      statements for the year ended December 31, 2009 for the reconciliation of
      the Canadian GAAP and U.S. GAAP
information.





Analysis
of Financial Condition Comparing Year Ended December 31, 2009 and
2008





During
the year ended December 31, 2009, we strengthened our financial position with
the conversion of the remaining portion of the $95.0 million 8% convertible
subordinated debentures issued in May 2008 into our common shares, and the
completion of the $70.4 million registered direct common stock offering
completed in June 2009.  These transactions combined with the exercise
of all outstanding warrants and a net profit for the year reduced our
debt-to-capital ratio to 11% for the year ended December 2009 from 36% as at
December 31, 2008.


Management
Discussion and Analysis   INTEROIL
CORPORATION     7








As at
December 31, 2009, our total assets amounted to $631.8 million as compared to
$591.8 million as at December 31, 2008, which is an increase of $40.0 million or
6.8%.  The increase is mainly due to the increase in the value of our
oil and gas properties by $44.5 million associated with the appraisal of the Elk
and Antelope fields.  This increase is net of cash calls from IPI
investors and the $24.2 million of gain on the sale of oil and gas properties in
relation to 2.5% Elk and Antelope interest sold to Pacific LNG Operations Ltd,
during the year.  We have applied the sale proceeds against the cost
base of the Elk and Antelope fields as recovery of cost.





As at
December 31, 2009, our total liabilities amounted to $189.8 million as compared
to $364.7 million as at December 31, 2008, which is a decrease in liability of
$174.9 million or 48.0%.  The decrease was mainly the result of the
conversion of the $65.0 million remaining portion of the $95.0 million 8%
subordinated convertible debentures into common shares, $44.2 million reduction
in the working capital facility balances as at December 31, 2009 and a reduction
in the IPI liability by $33.8 million due to the waiver of conversion rights
during the year by IPI investors coupled with the buyback of 4.8364% IPI
interest.





Our
current ratio (being current assets/current liabilities), which measures the
ability to meet short term obligations, improved to 2.22 as at December 31, 2009
from 1.51 as at December 31, 2008.  The quick ratio (or acid test
ratio, being ([current assets less inventories]/current liabilities) which is a
more conservative measure of our ability to meet short term obligations,
improved to 1.47 as at December 31, 2009 from 0.98 as at December 31,
2008.





Analysis
of Consolidated Financial Results Comparing Year and Quarter Ended December 31,
2009 and 2008





Annual
Comparative


2009 was
an improved year for us in relation to our operating results, especially given
the global economic backdrop.  2009 is the first year of reporting an
annualized net profit since we were formed in May 1997.





Net
profit for the year ended December 31, 2009 was $6.1 million compared with a net
loss of $11.8 million for the same period in 2008, showing an improvement of
$17.9 million.  The operating segments of Corporate, Midstream
Refining and Downstream collectively returned a net profit for the year of $54.0
million while the development segments of Upstream and Midstream Liquefaction
yielded a net loss of $47.9 million for an aggregate net profit of $6.1
million.





Sales and
operating revenue for the year ended December 31, 2009 were $693.1 million
compared with $919.7 million for the same period in 2008 mainly due to the lower
crude price environment in the current year.  The total volume of all
products sold by us was 6.5 million barrels for fiscal year 2009 as compared to
6.6 million barrels in 2008.





EBITDA
for the year ended December 31, 2009 was $19.3 million, a reduction of $3.1
million over the $22.4 million for the same period in 2008.  EBITDA
for the year excluding the $31.7 million “Loss on extinguishment of IPI
liability” was $51.0 million as compared to $22.5 million in
2008.  ”Loss on extinguishment of IPI liability” of $31.7 million
relates to our buyback of 4.8364% IPI interest during 2009.  We have
adopted the extinguishment of liability model for accounting for this
transaction with the difference between fair value and book value of the IPI
liability for this interest being expensed.  This transaction
increases our net interest in the resource base as these IPI investors have no
further rights to the Elk and Antelope fields or the remaining eight well
exploration program provided for under the relevant 2005 Amended and Restated
Indirect Participation Interest Agreement.





The
Upstream segment had a net loss of $39.5 million in 2009 (2008 – profit of $2.2
million) mainly due to the $31.7 million loss on extinguishment of the IPI
liability as noted above, and the $5.3 million higher intercompany interest
charges due to higher loan balances from the parent entity (Corporate
segment).





Midstream
– Refining segment generated a net profit of $41.8 million in 2009 (2008 - $4.7
million) mainly on account of hedge accounted and non-hedge accounted derivative
gains realized of $18.2 million, better gross margins due to higher yielding
crude cargos and higher export premiums, and the recognition of $14.3 million of
deferred tax assets in relation to carried forward tax losses from prior
years.


Management
Discussion and Analysis   INTEROIL
CORPORATION     8








Midstream
– Liquefaction segment had a loss of $8.4 million (2008 - $7.9 million) during
the 2009 year in relation to our share of the LNG project
expenses.  As the Project Agreement was signed by the Government of
Papua New Guinea in December 2009, all direct project related costs from January
1, 2010 will be capitalized to the project rather than expensed.





Downstream
segment generated a net profit of $8.5 million in 2009 (2008 – loss of $1.2
million) mainly on the basis of the positive effect of product price movements
as applied to inventory held during the year.





The
Corporate segment generated a net profit of $4.3 million (2008 – loss of $10.6
million) primarily due to intercompany interest recharges on loans provided to
other segments and a $6.8 million reduction in the interest expense on
borrowings compared to the prior year.  The reduction in interest
expense is due to the conversion of all outstanding debentures into common
shares, and the repayment of our bridging facility in May 2008 with no
corresponding interest expense in 2009.





Quarterly
Comparative


The net
profit for the quarter ended December 31, 2009 was $19.3 million compared with a
loss of $34.2 million for the same quarter of 2008, an improvement of $53.5
million.  EBITDA for the quarter ended December 31, 2009 was $9.1
million, compared with a negative $28.8 million in the same quarter of 2008, an
improvement of $37.9 million.





The
operating segments of Corporate, Midstream - Refining and Downstream
collectively derived a net profit for the fourth quarter of 2009 of $24.5
million, and the development segments of Upstream and Midstream Liquefaction had
a net loss of $5.2 million for an aggregate net profit of $19.3
million.





Sales and
operating revenue decreased $9.3 million from $218.6 million in the quarter
ended December 31, 2008 to $209.3 million in the quarter ended December 31,
2009.  The total volume of all products sold by us was 1.8 million
barrels for quarter ended December 31, 2009 as compared to 1.7 million barrels
for the same quarter of 2008.





Variance
Analysis


A
detailed discussion of each of our business segment’s results can be found under
the section “Year and Quarter in Review”.  The following analysis
outlines the key variances, the net of which are the primary explanations for
the changes in the results between the years and quarters ended December 31,
2009 and 2008.




Yearly
                                            Variance
                                            ($ millions)
                                          
                                          
                                          Quarterly
                                            Variance
                                            ($ millions)$
                                          17.9
                                          
                                          
                                          $
                                          53.5
                                          
                                          
                                          Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                                          
                                          $
                                          59.5
                                          
                                          
                                          $
                                          56.5
                                          
                                          
                                          Increase
      in gross margins mainly due to hedging gains, improving product price
      environment, lower inventory write downs, higher yielding crude cargoes
      and higher premiums on export products.Ø
                                          
                                          $
                                          (23.0
                                          )
                                          
                                          $
                                          (23.2
                                          )
                                          
                                          Lower
      derivative gains from non-hedge accounted contracts.Ø
                                          
                                          $
                                          (3.9
                                          )
                                          
                                          $
                                          6.3
                                          
                                          
                                          A
      gain of $7.4 million was made in 2009 was on account of waiver of common
      stock conversion rights for a 6.210% IPI interest.  2008 gains
      included gain on sale of PRL 4/5 for $6.5 million and waiver of 5.225% IPI
      interest resulting in a gain on conveyance of $4.7
  million.Ø
                                          
                                          $
                                          (31.7
                                          )
                                          
                                          $
                                          (3.1
                                          )
                                          
                                          Loss
      on extinguishment of IPI liability relating to buyback of 4.3346% IPI
      interest in September 2009 and a further 0.5% in December 2009, with the
      difference between fair value and book value of the IPI liability expensed
      under the extinguishment of liability accounting model.Ø
                                          
                                          $
                                          (7.2
                                          )
                                          
                                          $
                                          2.1
                                          
                                          
                                          Impact
      of foreign exchange movements as the PGK has been very volatile against
      the USD during the 2009 periods.Ø
                                          
                                          $
                                          10.0
                                          
                                          
                                          $
                                          4.4
                                          
                                          
                                          Lower
      interest expense primarily due to part conversion and repayment of the
      Merrill Lynch bridging facility which occurred in May 2008 and then the
      mandatory conversion in June 2009 of the remaining portion of the $95.0
      million 8% convertible debentures in May 2008.Ø
                                          
                                          $
                                          11.2
                                          
                                          
                                          $
                                          11.1
                                          
                                          
                                          Reduced
      income tax expense due to recognition of future income tax benefit
      relating to carried forward tax losses and other temporary
      differences.Ø
                                          
                                          $
                                          3.0
                                          
                                          
                                          $
                                          (0.6
                                          )
                                          
                                          Other
      miscellaneous variances with the decrease in yearly expenses mainly
      relating to lower legal and project related consulting
      expenses.


Management
Discussion and Analysis   INTEROIL
CORPORATION     9








Analysis
of Consolidated Cash Flows Comparing Year Ended December 31, 2009 and
2008





As at
December 31, 2009, we had cash, cash equivalents and cash restricted of $75.8
million (December 2008 – $75.3 million), of which $22.9 million (December 2008 -
$26.3 million) was restricted pursuant to the BNP Paribas working capital
facility utilization requirements, and $6.4 million (December 2008 – nil) was
restricted as cash deposit on the Overseas Petroleum Investment Corporation
(“OPIC“) secured loan.





The cash
held as a deposit for the OPIC secured loan relates to our half yearly
installment of $4.5 million and the related interest that will be payable with
the next installment on June 30, 2010.  The waiver in respect of this
deposit requirement expired in June 2009 with the completion of the capital
raising of $70.4 million.





Our cash
inflows from operations for the 2009 year ended December 31, 2009 were $44.5
million compared with $15.6 million for the year ended December 31,
2008.  The improved cash flows from operations for the year were
mainly due to improved margins generated in the Midstream Refining and
Downstream segments, and cash received on the close out of long term
hedges.





Cash
outflows for investing activities for the year ended December 31, 2009 were
$85.6 million compared with $47.4 million for 2008.  These outflows
mainly relate to the net cash expenditure on exploration activities net of IPI
cash calls, and expenditure on plant and equipment.





Cash
inflows from financing activities for the year ended December 31, 2009 were
$38.5 million compared with $36.9 million for the year ended December 31,
2008.  The financing activities section in the cash flow statement
includes the capital and debt raisings by us, exercise of warrants, as well as
the movement in the working capital facility balance with BNP
Paribas.  The cash inflows/outflows due to the working capital
facility drawdown/repayments are due to the timing of cash flows and use of
working capital from our Midstream Refining and Downstream
segments.





Management
Discussion and Analysis   INTEROIL
CORPORATION     10








Summary
of Consolidated Quarterly Financial Results for Past Eight Quarters





The
following is a table containing the consolidated results for the eight quarters
ended December 31, 2009 by business segment, and on a consolidated
basis.





Quarters
      ended
                    ($ thousands
      except per share
                  
                  2009
                  
                  
                  2008data)
                  
                  Dec-31
                  
                  
                  Sep-30
                  
                  
                  Jun-30
                  
                  
                  Mar-31
                  
                  
                  Dec-31
                  
                  
                  Sep-30
                  
                  
                  Jun-30
                  
                  
                  Mar-31Upstream
                  
                  
                  1,027
                  
                  
                  
                  1,011
                  
                  
                  
                  660
                  
                  
                  
                  611
                  
                  
                  
                  487
                  
                  
                  
                  698
                  
                  
                  
                  895
                  
                  
                  
                  618Midstream
      – Refining
                  
                  
                  173,438
                  
                  
                  
                  141,295
                  
                  
                  
                  114,347
                  
                  
                  
                  145,523
                  
                  
                  
                  194,617
                  
                  
                  
                  216,750
                  
                  
                  
                  197,864
                  
                  
                  
                  176,973Midstream
      – Liquefaction
                  
                  
                  0
                  
                  
                  
                  1
                  
                  
                  
                  2
                  
                  
                  
                  4
                  
                  
                  
                  23
                  
                  
                  
                  35
                  
                  
                  
                  19
                  
                  
                  
                  13Downstream
                  
                  
                  118,270
                  
                  
                  
                  107,712
                  
                  
                  
                  85,472
                  
                  
                  
                  78,572
                  
                  
                  
                  128,540
                  
                  
                  
                  172,528
                  
                  
                  
                  140,467
                  
                  
                  
                  116,048Corporate
                  
                  
                  10,539
                  
                  
                  
                  10,087
                  
                  
                  
                  8,640
                  
                  
                  
                  7,753
                  
                  
                  
                  9,591
                  
                  
                  
                  8,415
                  
                  
                  
                  8,334
                  
                  
                  
                  8,531Consolidation
      entries
                  
                  
                  (93,971
                  )
                  
                  
                  (86,509
                  )
                  
                  
                  (60,625
                  )
                  
                  
                  (70,801
                  )
                  
                  
                  (114,691
                  )
                  
                  
                  (134,695
                  )
                  
                  
                  (102,565
                  )
                  
                  
                  (109,769
                  )Sales
      and operating revenues
                  
                  
                  209,303
                  
                  
                  
                  173,597
                  
                  
                  
                  148,496
                  
                  
                  
                  161,662
                  
                  
                  
                  218,567
                  
                  
                  
                  263,731
                  
                  
                  
                  245,014
                  
                  
                  
                  192,414Upstream
                  
                  
                  574
                  
                  
                  
                  (29,097
                  )
                  
                  
                  (669
                  )
                  
                  
                  (469
                  )
                  
                  
                  (2,483
                  )
                  
                  
                  231
                  
                  
                  
                  10,164
                  
                  
                  
                  (1,135
                  )Midstream
      – Refining
                  
                  
                  8,492
                  
                  
                  
                  8,199
                  
                  
                  
                  14,134
                  
                  
                  
                  14,747
                  
                  
                  
                  (13,976
                  )
                  
                  
                  17,516
                  
                  
                  
                  16,329
                  
                  
                  
                  5,724Midstream
      – Liquefaction
                  
                  
                  (1,200
                  )
                  
                  
                  (2,119
                  )
                  
                  
                  (1,379
                  )
                  
                  
                  (2,361
                  )
                  
                  
                  (2,501
                  )
                  
                  
                  (1,570
                  )
                  
                  
                  (1,784
                  )
                  
                  
                  (1,636
                  )Downstream
                  
                  
                  4,391
                  
                  
                  
                  6,542
                  
                  
                  
                  4,150
                  
                  
                  
                  3,241
                  
                  
                  
                  (7,244
                  )
                  
                  
                  610
                  
                  
                  
                  7,893
                  
                  
                  
                  4,529Corporate
                  
                  
                  1,765
                  
                  
                  
                  1,980
                  
                  
                  
                  1,897
                  
                  
                  
                  3,051
                  
                  
                  
                  226
                  
                  
                  
                  764
                  
                  
                  
                  (2,155
                  )
                  
                  
                  1,796Consolidation
      entries
                  
                  
                  (4,884
                  )
                  
                  
                  (4,092
                  )
                  
                  
                  (278
                  )
                  
                  
                  (7,285
                  )
                  
                  
                  (2,865
                  )
                  
                  
                  (737
                  )
                  
                  
                  (3,093
                  )
                  
                  
                  (2,143
                  )EBITDA
      (1)
                  
                  
                  9,138
                  
                  
                  
                  (18,587
                  )
                  
                  
                  17,855
                  
                  
                  
                  10,924
                  
                  
                  
                  (28,843
                  )
                  
                  
                  16,814
                  
                  
                  
                  27,354
                  
                  
                  
                  7,135Upstream
                  
                  
                  (3,626
                  )
                  
                  
                  (31,392
                  )
                  
                  
                  (2,382
                  )
                  
                  
                  (2,133
                  )
                  
                  
                  (4,003
                  )
                  
                  
                  (1,039
                  )
                  
                  
                  9,188
                  
                  
                  
                  (1,993
                  )Midstream
      – Refining
                  
                  
                  18,070
                  
                  
                  
                  3,762
                  
                  
                  
                  9,624
                  
                  
                  
                  10,350
                  
                  
                  
                  (19,490
                  )
                  
                  
                  12,660
                  
                  
                  
                  11,344
                  
                  
                  
                  202Midstream
      – Liquefaction
                  
                  
                  (1,591
                  )
                  
                  
                  (2,481
                  )
                  
                  
                  (1,765
                  )
                  
                  
                  (2,552
                  )
                  
                  
                  (2,597
                  )
                  
                  
                  (1,677
                  )
                  
                  
                  (1,909
                  )
                  
                  
                  (1,728
                  )Downstream
                  
                  
                  2,371
                  
                  
                  
                  3,440
                  
                  
                  
                  1,742
                  
                  
                  
                  964
                  
                  
                  
                  (5,901
                  )
                  
                  
                  (886
                  )
                  
                  
                  3,383
                  
                  
                  
                  2,198Corporate
                  
                  
                  3,036
                  
                  
                  
                  1,602
                  
                  
                  
                  (677
                  )
                  
                  
                  349
                  
                  
                  
                  (2,275
                  )
                  
                  
                  (1,759
                  )
                  
                  
                  (5,164
                  )
                  
                  
                  (1,390
                  )Consolidation
      entries
                  
                  
                  1,047
                  
                  
                  
                  (237
                  )
                  
                  
                  2,894
                  
                  
                  
                  (4,332
                  )
                  
                  
                  37
                  
                  
                  
                  1,928
                  
                  
                  
                  (1,241
                  )
                  
                  
                  315Net
      profit/(loss) per segment
                  
                  
                  19,307
                  
                  
                  
                  (25,306
                  )
                  
                  
                  9,436
                  
                  
                  
                  2,646
                  
                  
                  
                  (34,229
                  )
                  
                  
                  9,227
                  
                  
                  
                  15,601
                  
                  
                  
                  (2,396
                  )Net
      profit/(loss) per share (dollars)Per
      Share – Basic
                  
                  
                  0.45
                  
                  
                  
                  (0.60
                  )
                  
                  
                  0.25
                  
                  
                  
                  0.07
                  
                  
                  
                  (0.96
                  )
                  
                  
                  0.26
                  
                  
                  
                  0.48
                  
                  
                  
                  (0.08
                  )Per
      Share – Diluted
                  
                  
                  0.43
                  
                  
                  
                  (0.60
                  )
                  
                  
                  0.24
                  
                  
                  
                  0.07
                  
                  
                  
                  (0.96
                  )
                  
                  
                  0.22
                  
                  
                  
                  0.40
                  
                  
                  
                  (0.08
                  )


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.




Management
Discussion and Analysis   INTEROIL
CORPORATION     11








YEAR
AND QUARTER IN REVIEW





The
following section provides a review of the year and quarter ended December 31,
2009 for each of our business segments.





UPSTREAM
– YEAR AND QUARTER IN REVIEW





Upstream – Operating results
                
                Year ended December 31,($ thousands, unless otherwise
      indicated)
                
                2009
                
                
                2008Other
      non-allocated revenue
                
                
                3,309
                
                
                
                2,697Total
      revenue
                
                
                3,309
                
                
                
                2,697Office
      and administration and other expenses
                
                
                (7,111
                )
                
                
                (5,919
                )Exploration
      costs
                
                
                (209
                )
                
                
                (996
                )Exploration
      impairment
                
                
                -
                
                
                
                (108
                )Gain
      on sale of oil and gas properties
                
                
                7,364
                
                
                
                11,235Loss
      on extinguishment of IPI liability
                
                
                (31,710
                )
                
                
                -Foreign
      Exchange gain/(loss)
                
                
                (1,304
                )
                
                
                (132
                )EBITDA (non-GAAP measure) (1)
                
                
                (29,661
                )
                
                
                6,777Depreciation
      and amortization
                
                
                (538
                )
                
                
                (597
                )Interest
      expense
                
                
                (9,335
                )
                
                
                (4,027
                )Loss
      before income taxes and non-controlling interest
                
                
                (39,534
                )
                
                
                2,153Income
      tax expense
                
                
                -
                
                
                
                -Net
      (loss)/profit
                
                
                (39,534
                )
                
                
                2,153


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.




Analysis
of Upstream Financial Results Comparing Quarter and Year Ended December 31, 2009
and 2008





The
following analysis outlines the key movements, the net of which primarily
explains the difference in the results between the years and quarters ended
December 31, 2009 and 2008.





Yearly
                                    Variance
                                    ($ millions)
                                  
                                  
                                  Quarterly
                                    Variance
                                    ($ millions)$
                                  (41.7
                                  )
                                  
                                  $
                                  0.4
                                  
                                  
                                  Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                                  
                                  $
                                  (3.9
                                  )
                                  
                                  $
                                  6.3
                                  
                                  
                                  A
      gain of $7.4 million was made in 2009 due to waiver of common stock
      conversion rights for 6.210% IPI interest.  2008 gains included
      gain on sale of PRL 4/5 for $6.5 million and waiver of 5.225% IPI interest
      resulting in a gain on conveyance of $4.7 million.Ø
                                  
                                  $
                                  (31.7
                                  )
                                  
                                  $
                                  (3.1
                                  )
                                  
                                  Loss
      on extinguishment of IPI liability relating to buyback of 4.3346% IPI
      interest in September 2009 and a further 0.5% in December 2009, with the
      difference between fair value and book value of the IPI liability expensed
      under the extinguishment of liability accounting model.Ø
                                  
                                  $
                                  (5.3
                                  )
                                  
                                  $
                                  (2.7
                                  )
                                  
                                  Higher
      interest expense due to an increase in inter-company loan
      balances.








Management
Discussion and Analysis   INTEROIL
CORPORATION     12











MIDSTREAM
REFINING – YEAR AND QUARTER IN REVIEW





Midstream Refining – Operating results
                    
                    Year ended December 31,($ thousands, unless otherwise indicated)
                    
                    2009
                    
                    
                    2008External
      sales
                    
                    
                    299,673
                    
                    
                    
                    358,896Inter-segment
      revenue
                    
                    
                    274,736
                    
                    
                    
                    427,218Interest
      and other revenue
                    
                    
                    194
                    
                    
                    
                    90Total
      segment revenue
                    
                    
                    574,603
                    
                    
                    
                    786,204Cost
      of sales and operating expenses
                    
                    
                    (516,349
                    )
                    
                    
                    (779,832
                    )Office
      and administration and other expenses
                    
                    
                    (9,901
                    )
                    
                    
                    (10,081
                    )Derivative
      gain/(loss)
                    
                    
                    1,009
                    
                    
                    
                    24,039Foreign
      Exchange gain/(loss)
                    
                    
                    (3,790
                    )
                    
                    
                    5,264EBITDA
      (non-GAAP measure) (1)
                    
                    
                    45,572
                    
                    
                    
                    25,594Depreciation
      and amortization
                    
                    
                    (10,932
                    )
                    
                    
                    (10,969
                    )Interest
      expense
                    
                    
                    (7,150
                    )
                    
                    
                    (9,908
                    )Profit
      before income taxes and non-controlling interest
                    
                    
                    27,490
                    
                    
                    
                    4,717Income
      tax expense
                    
                    
                    14,316
                    
                    
                    
                    -Non-controlling
      interest
                    
                    
                    -
                    
                    
                    
                    -Net
      profit
                    
                    
                    41,806
                    
                    
                    
                    4,717Gross
      Margin (2)
                    
                    
                    58,060
                    
                    
                    
                    6,282


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.


(2)
            Gross
      Margin is a non-GAAP measure and is external sales and inter-segment
      revenue less cost of sales and operating expenses and is reconciled to
      Canadian GAAP in the section to this document entitled “Non-GAAP Measures
      and Reconciliation”.





Midstream
Refining Operating Review





Quarter
      ended
                        December
      31,
                      
                      
                      Year
      ended
                        December
      31,Key
      Refining Metrics
                      
                      2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Throughput
      (barrels per day)(1)
                      
                      
                      20,966
                      
                      
                      
                      21,206
                      
                      
                      
                      21,155
                      
                      
                      
                      22,034Capacity
      utilization (based on 36,500 barrels per day operating
      capacity)
                      
                      
                      44
                      %
                      
                      
                      57
                      %
                      
                      
                      47
                      %
                      
                      
                      44
                      %Cost
      of production per barrel(2)
                      
                      $
                      2.92
                      
                      
                      $
                      2.45
                      
                      
                      $
                      3.18
                      
                      
                      $
                      2.97Working
      capital financing cost per barrel of production(2)
                      
                      $
                      0.49
                      
                      
                      $
                      0.57
                      
                      
                      $
                      0.40
                      
                      
                      $
                      1.01Distillates
      as percentage of production
                      
                      
                      61.00
                      %
                      
                      
                      53.60
                      %
                      
                      
                      58.63
                      %
                      
                      
                      56.00
                      %


(1)
            Throughput
      per day has been calculated excluding shut down days.  During
      2009 and 2008, the refinery was shut down for 80 days and 101 days,
      respectively.


(2)
            Our
      cost of production per barrel and working capital financing cost per
      barrel have been calculated based on a notional throughput.  Our
      actual throughput has been adjusted to include the throughput that would
      have been necessary to produce the equivalent amount of diesel that we
      imported during the year.


Management
Discussion and Analysis   INTEROIL
CORPORATION     13








Analysis
of Midstream - Refining Financial Results Comparing the Year and Quarter Ended
December 31, 2009 and 2008





The
following analysis outlines the key movements, the net of which primarily
explains the improvements in the results between the year and quarter ended
December 31, 2009 and 2008.





Yearly
                        Variance
                        ($ millions)
                      
                      
                      Quarterly
                        Variance
                        ($ millions)$
                      37.1
                      
                      
                      $
                      37.6
                      
                      
                      Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                      
                      $
                      51.8
                      
                      
                      $
                      42.8
                      
                      
                      Change
      in Gross Margin was due to the following contributing
factors:
                        +Less
      volatility in crude prices in 2009. The rapid fall in crude prices in the
      fourth quarter of 2008 reduced the gross margins of our refinery
      operations by approximately $45.9 million.  This includes a
      year-end inventory devaluation of $4.2 million.
                        +Availability
      of preferred crude feedstock resulting in stronger refining yield
      structure and higher distillate production percentage in
2009.
                        +Hedge gains realized on close out of long term hedges in early
      2009.
                        +Improved Naphtha premium in 2009 contract.
                        -    
      The above improvements have been partly offset by weaker distillate
      margins in 2009 which has adversely affected the refining industry in
      general due to lower worldwide demand.Ø
                      
                      $
                      (23.0
                      )
                      
                      $
                      (23.2
                      )
                      
                      Decrease
      in derivative gains from non-hedge accounted contracts.Ø
                      
                      $
                      2.8
                      
                      
                      $
                      0.8
                      
                      
                      Reduction
      in interest expense as a result of a decrease in inter-company loans (due
      to conversion of debt to equity on certain intercompany balances) and
      principal repayments made on the OPIC secured loan.Ø
                      
                      $
                      (9.1
                      )
                      
                      $
                      3.0
                      
                      
                      (Reduction)/increase
      in foreign exchange gains due to the currency fluctuations between PGK and
      the U.S. Dollar.Ø
                      
                      $
                      14.3
                      
                      
                      $
                      14.3
                      
                      
                      Recognition
      of future income tax benefit relating to carried forward tax losses and
      other temporary differences as management now considers it is
      more likely than not that the deferred tax assets will be
      realized.




Management
Discussion and Analysis   INTEROIL
CORPORATION     14










MIDSTREAM
LIQUEFACTION – YEAR AND QUARTER IN REVIEW




Midstream Liquefaction – Operating results
                    
                    Year ended December 31,($ thousands, unless otherwise indicated)
                    
                    2009
                    
                    
                    2008Interest
      and other revenue
                    
                    
                    8
                    
                    
                    
                    91Total
      segment revenue
                    
                    
                    8
                    
                    
                    
                    91Office
      and administration and other expenses
                    
                    
                    (7,108
                    )
                    
                    
                    (7,022
                    )Foreign
      Exchange gain/(loss)
                    
                    
                    41
                    
                    
                    
                    (560
                    )EBITDA (non-GAAP measure) (1)
                    
                    
                    (7,059
                    )
                    
                    
                    (7,491
                    )Depreciation
      and amortization
                    
                    
                    (57
                    )
                    
                    
                    (69
                    )Interest
      expense
                    
                    
                    (1,218
                    )
                    
                    
                    (241
                    )Loss
      before income taxes and non-controlling interest
                    
                    
                    (8,334
                    )
                    
                    
                    (7,801
                    )Income
      tax expense
                    
                    
                    (55
                    )
                    
                    
                    (110
                    )Net
      loss
                    
                    
                    (8,389
                    )
                    
                    
                    (7,911
                    )


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.





Analysis
of Midstream Liquefaction Financial Results Comparing the Years and Quarters
Ended December 31, 2009 and 2008





This
segment results include the proportionate consolidation of PNG LNG Inc., the
Joint Venture Entity, and InterOil LNG Holdings Inc., holding company for our
interest in the Joint Venture.





All costs
incurred, subsequent to the execution of the shareholders’ agreement on July 31,
2007, during the pre-acquisition and construction stage have been expensed as
incurred, unless they were directly identified with the property, plant and
equipment of the LNG Project.  As at December 31, 2009, we had
capitalized $2.3 million of such direct costs to the project and expensed costs
relating to employees, office premises and consultants.





The
following analysis outlines the key movements, the net of which primarily
explains the variance in the results between the year and quarter ended December
31, 2009 and 2008.





Yearly
                        Variance
                        ($ millions)
                      
                      
                      Quarterly
                        Variance
                        ($ millions)$
                      (0.5
                      )
                      
                      $
                      1.0
                      
                      
                      Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                      
                      $
                      1.5
                      
                      
                      $
                      0.9
                      
                      
                      Reduction
      in office, administration and other expenses due to the reduced consulting
      expenses incurred in furthering the liquefaction
      facility.  During second quarter of 2009, the Australian project
      office was closed and work transferred to our newly established project
      office in Singapore.Ø
                      
                      $
                      (1.5
                      )
                      
                      
                      -
                      
                      
                      Relates
      to the increased loss on proportionate consolidation of PNG LNG Inc.
      subsequent to the acquisition of Merrill Lynch’s
      interest.  These losses be recouped as the remaining joint
      venture partner equalizes its interests through payment of cash
      calls.Ø
                      
                      $
                      (1.0
                      )
                      
                      $
                      (0.3
                      )
                      
                      Increase
      in interest expense charged from the Corporate Segment due to higher
      inter-company loan balances following the Merrill Lynch interest
      acquisition.




Management
Discussion and Analysis   INTEROIL
CORPORATION     15








DOWNSTREAM
YEAR AND QUARTER IN REVIEW





Downstream – Operating results
                  
                  Year ended December 31,($ thousands, unless otherwise indicated)
                  
                  2009
                  
                  
                  2008External
      sales
                  
                  
                  388,806
                  
                  
                  
                  556,683Inter-segment
      revenue
                  
                  
                  185
                  
                  
                  
                  185Interest
      and other revenue
                  
                  
                  1,035
                  
                  
                  
                  715Total
      segment revenue
                  
                  
                  390,026
                  
                  
                  
                  557,583Cost
      of sales and operating expenses
                  
                  
                  (359,623
                  )
                  
                  
                  (536,920
                  )Office
      and administration and other expenses
                  
                  
                  (12,911
                  )
                  
                  
                  (14,669
                  )Foreign
      Exchange gain/(loss)
                  
                  
                  832
                  
                  
                  
                  (207
                  )EBITDA (non-GAAP measure) (1)
                  
                  
                  18,324
                  
                  
                  
                  5,787Depreciation
      and amortization
                  
                  
                  (2,650
                  )
                  
                  
                  (2,571
                  )Interest
      expense
                  
                  
                  (4,130
                  )
                  
                  
                  (4,838
                  )Profit
      before income taxes and non-controlling interest
                  
                  
                  11,544
                  
                  
                  
                  (1,622
                  )Income
      tax expense
                  
                  
                  (3,027
                  )
                  
                  
                  414Net
      profit
                  
                  
                  8,517
                  
                  
                  
                  (1,208
                  )Gross
      Margin (2)
                  
                  
                  29,368
                  
                  
                  
                  19,948


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.


(2)
            Gross
      Margin is a non-GAAP measure and is “external sales” and “inter-segment
      revenue” less “cost of sales and operating expenses” and is reconciled to
      Candadian GAAP in the section to this document entitled “Non-GAAP Measures
      and Reconciliation”.




Downstream
Operating Review





Quarter
      Ended
                    December
      31,
                  
                  
                  Year
      Ended
                    December
      31,Key Downstream
      Metrics
                  
                  2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Sales
      volumes (millions of liters)
                  
                  
                  159.1
                  
                  
                  
                  151.4
                  
                  
                  
                  588.8
                  
                  
                  
                  548.0Cost
      of distribution per liter ($ per liter)(1)
                  
                  $
                  0.06
                  
                  
                  $
                  0.07
                  
                  
                  $
                  0.06
                  
                  
                  $
                  0.06




(1)
            Cost
      of distribution per liter includes land based freight costs and
      operational costs. It excludes depreciation and
  interest.




Analysis
of Downstream Financial Results Comparing the Years and Quarters Ended December
31, 2009 and 2008





The
following analysis outlines the key movements, the net of which primarily
explains the variance in the results between the years and quarters ended
December 31, 2009 and 2008.




Yearly
                          Variance
                          ($ millions)
                        
                        
                        Quarterly
                          Variance
                          ($ millions)$
                        9.7
                        
                        
                        $
                        8.3
                        
                        
                        Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                        
                        $
                        9.4
                        
                        
                        $
                        12.6
                        
                        
                        Increase
      in gross margin mainly due to the positive effect of product price
      movements as applied to the inventory sold during the
      period.  The fourth quarter of 2008 saw a significant fall in
      product prices resulting in the negative gross margin for the year and
      quarter ended December 31, 2008.  The less volatile and
      gradually increasing price environment has improved the Downstream gross
      margins compared to prior periods.Ø
                        
                        $
                        1.8
                        
                        
                        $
                        (1.4
                        )
                        
                        Reduction
      in office and administration and other expenses for the year mainly due to
      lower provisions for doubtful debts.Ø
                        
                        $
                        0.8
                        
                        
                        $
                        1.3
                        
                        
                        Reduction
      in interest expense compared with prior periods due to lower working
      capital requirements in lower pricing environment.Ø
                        
                        $
                        (3.4
                        )
                        
                        $
                        (4.7
                        )
                        
                        Increase
      in income tax expense in line with movements in Downstream operating
      profits.Ø
                        
                        $
                        1.0
                        
                        
                        $
                        (0.1
                        )
                        
                        Foreign
      exchange movements during the periods due to the currency fluctuations
      between PGK and the
USD.




Management
Discussion and Analysis   INTEROIL
CORPORATION     16








CORPORATE
– YEAR AND QUARTER IN REVIEW





Corporate – Operating results
                
                Year ended December 31,($ thousands, unless otherwise indicated)
                
                2009
                
                
                2008Inter-segment
      revenue
                
                
                21,194
                
                
                
                24,568Interest
      revenue
                
                
                15,825
                
                
                
                10,303Total
      revenue
                
                
                37,019
                
                
                
                34,871Office
      and administration and other expenses
                
                
                (29,241
                )
                
                
                (33,753
                )Foreign
      Exchange gain/(loss)
                
                
                915
                
                
                
                (486
                )EBITDA (non-GAAP measure) (1)
                
                
                8,693
                
                
                
                632Depreciation
      and amortization
                
                
                (275
                )
                
                
                (66
                )Interest
      expense
                
                
                (3,952
                )
                
                
                (10,766
                )Profit/(loss)
      before income taxes and non-controlling interest
                
                
                4,466
                
                
                
                (10,200
                )Income
      tax expense
                
                
                (158
                )
                
                
                (386
                )Net
      profit/(loss)
                
                
                4,308
                
                
                
                (10,586
                )


(1)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.




Analysis
of Corporate Financial Results Comparing the Years and Quarters Ended December
31, 2009 and 2008





The
following table outlines the key movements, the net of which primarily explains
the variance in the results for between the years and quarters ended December
31, 2009 and 2008.





Yearly
                        Variance
                        ($ millions)
                      
                      
                      Quarterly
                        Variance
                        ($ millions)$
                      14.9
                      
                      
                      $
                      5.3
                      
                      
                      Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                      
                      $
                      12.3
                      
                      
                      $
                      5.3
                      
                      
                      Reduced
      interest expenses (net of recharged intercompany interest revenue from
      other segments) due to part conversion, and part repayment of Merrill
      Lynch bridging facility in May 2008 plus mandatory conversion in June 2009
      on the remaining portion of the $95.0 million debentures issued in May
      2008.Ø
                      
                      $
                      1.1
                      
                      
                      $
                      (0.6
                      )
                      
                      Reduction
      in net office and administration and other expenses after recharges to
      other streams (included in inter-segment revenue) for the year mainly due
      to lower legal consulting costs.Ø
                      
                      $
                      1.4
                      
                      
                      $
                      (0.8
                      )
                      
                      Increase/(Decrease)
      in foreign exchange gains due to the currency fluctuations between
      Australian Dollar (“AUD”) and the U.S. Dollar.Ø
                      
                      $
                      0.2
                      
                      
                      $
                      1.5
                      
                      
                      Reduction
      in income tax expense during the period primarily due to a the recognition
      of future income tax
benefits.




Management
Discussion and Analysis   INTEROIL
CORPORATION     17








CONSOLIDATION
ADJUSTMENTS – YEAR AND QUARTER IN REVIEW





Consolidation adjustments – Operating results
                        
                        Year ended December 31,($ thousands, unless otherwise indicated)
                        
                        2009
                        
                        
                        2008Inter-segment
      revenue (1)
                        
                        
                        (296,115
                        )
                        
                        
                        (451,970
                        )Interest
      revenue (5)
                        
                        
                        (15,792
                        )
                        
                        
                        (9,748
                        )Other
      non-allocated revenue
                        
                        
                        -
                        
                        
                        
                        -Total
      revenue
                        
                        
                        (311,907
                        )
                        
                        
                        (461,718
                        )Cost
      of sales and operating expenses (1)
                        
                        
                        273,989
                        
                        
                        
                        428,129Office
      and administration and other expenses (2)
                        
                        
                        21,379
                        
                        
                        
                        24,753Foreign
      Exchange gain/(loss)
                        
                        
                        -
                        
                        
                        
                        -EBITDA
      (non-GAAP measure) (3)
                        
                        
                        (16,539
                        )
                        
                        
                        (8,836
                        )Depreciation
      and amortization(4)
                        
                        
                        130
                        
                        
                        
                        130Interest
      expense(5)
                        
                        
                        15,792
                        
                        
                        
                        9,747Profit/(loss)
      before income taxes and non-controlling interest
                        
                        
                        (617
                        )
                        
                        
                        1,041Income
      tax expense
                        
                        
                        -
                        
                        
                        
                        -Non-controlling
      interest
                        
                        
                        (8
                        )
                        
                        
                        (1
                        )Net
      profit/(loss)
                        
                        
                        (625
                        )
                        
                        
                        1,040Gross
      Margin (6)
                        
                        
                        (22,126
                        )
                        
                        
                        (23,841
                        )


(1)
            Represents
      the elimination upon consolidation of our refinery sales to other segments
      and other minor inter-company product
sales.


(2)
            Includes
      the elimination of inter-segment administration service
    fees.


(3)
            EBITDA
      is a non-GAAP measure and is reconciled to GAAP in the section to this
      document entitled “Non-GAAP Measures and
  Reconciliation”.


(4)
            Represents
      the amortization of a portion of costs capitalized to assets on
      consolidation.


(5)
            Includes
      the elimination of interest accrued between
  segments.


(6)
            Gross
      Margin is a non-GAAP measure and is “inter-segment revenue elimination”
      less “cost of sales and operating expenses” and represents elimination
      upon consolidation of our refinery sales to other
      segments.  This measure is reconciled to Canadian GAAP in the
      section to this document entitled “Non-GAAP Measures and
      Reconciliation”.




Analysis
of Consolidation Adjustments Comparing the Years and Quarters Ended December 31,
2009 and 2008





The
following table outlines the key movements, the net of which primarily explains
the variance in the results for between the years and quarters ended December
31, 2009 and 2008.





Yearly
                        Variance
                        ($ millions)
                      
                      
                      Quarterly
                        Variance
                        ($ millions)$
                      (1.7
                      )
                      
                      $
                      1.0
                      
                      
                      Net
      profit/(loss) variance for the comparative periods primarily due
      to:Ø
                      
                      $
                      1.7
                      
                      
                      $
                      3.0
                      
                      
                      Increase
      in net income due to recognition of intra-group profit eliminated on
      consolidation between Midstream – Refining and Downstream segments in the
      prior periods relating to the Midstream – Refining segment’s profit
      component of inventory on hand in the Downstream segment at period
      ends.Ø
                      
                      $
                      (3.4
                      )
                      
                      $
                      (2.0
                      )
                      
                      Elimination
      of inter-segment administration service
fees.


Management
Discussion and Analysis   INTEROIL
CORPORATION     18







LIQUIDITY
AND CAPITAL RESOURCES
 
 Summary
of Debt Facilities
 
 Summarized
below are the debt facilities available to us and the balances outstanding as at
December 31, 2009.
 
 Organization
                    
                    Facility
                    
                    
                    Balance
                      Outstanding
                      December 31,2009
                    
                    Maturity dateOPIC
      secured loan
                    
                    $
                    53,500,000
                    
                    
                    $
                    53,500,000
                    
                    December
      2015BNP
      Paribas working capital facility
                    
                    $
                    190,000,000
                    
                    
                    $
                    16,794,153
                    (1)
                    December
      2010Westpac
      working capital facility
                    
                    $
                    29,600,000
                    
                    
                    $
                    7,832,266
                    
                    October
      2011BSP
      working capital facility
                    
                    $
                    18,500,000
                    
                    
                    $
                    0
                    
                    August
      2010
 
 (1) Excludes letters of credit
totaling $56.7 million.
 
 OPIC
Secured Loan (Midstream)
 
 On
September 12, 2001, we entered into a loan agreement with OPIC with respect to
an $85.0 million project financing facility for the development of our refinery
in PNG.  The loan is secured by the assets of the
refinery.  The interest rate on the loan is equal to the agreed U.S.
Government treasury cost applicable to each promissory note outstanding plus 3%,
and is payable quarterly in arrears.  Principal repayments of $4.5
million each are due on June 30 and December 31 of each year until December 31,
2015.  During the year ended December 31 2009, two installments of
$4.5 million each and the accrued interest on the loan were paid.
 
 BNP
Paribas Working Capital Facility (Midstream)
 
 This
working capital facility is used to finance purchases of crude feedstock for our
refinery.  In accordance with the agreement with BNP Paribas, the
total facility is split into two components, Facility 1 and Facility
2.  Facility 1 is for $130.0 million and can be used for the issuance
of documentary letters of credit and or standby letters of credit, short term
advances, advances on merchandise, freight loans, receivables financing and a
sublimit of Euro 18.0 million or USD equivalent for hedging transactions via BNP
Paribas Commodity Indexed Transaction Group or other acceptable counter
parties.  Facility 2 amounts to $60.0 million and can be used for
partly cash-secured short term advances and for discounting of any monetary
receivables acceptable to BNP Paribas.  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 is renewable annually.  During the quarter ended December 31,
2009, the facility was renewed for a period of fifteen months to December 31,
2010.
 
 As of
December 31, 2009, $116.5 million remained available for use under the
facility.  The weighted average interest rate under the working
capital facility was 2.13% for the year ended December 31, 2009 compared to
5.11% for 2008.  The interest rate applicable to this facility has
declined in line with the reduction in LIBOR rates during the year.
 
 Bank
South Pacific and Westpac Working Capital Facility (Downstream)
 
 On
October 24, 2008, we secured a PGK 150.0 million (approximately $55.5 million)
combined revolving working capital facility for our Downstream wholesale and
retail petroleum products distribution business in Papua New Guinea from Bank of
South Pacific Limited and Westpac Bank PNG Limited.  The facility
limit as at December 31, 2009 was PGK 130.0 million (approximately $48.1
million).
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     19
  
 
 The
Westpac facility limit is PGK 80.0 million (approximately $29.6 million) and the
BSP facility limit was initially PGK 70.0 million (approximately $25.9
million).  The Westpac facility is for an initial term of three years
and is due for renewal in October 2011.  The BSP facility is renewable
annually and was renewed in October 2009 at a lower limit of Papua New Guinea
Kina 50.0 million (approximately $18.5 million).  As at December 31,
2009, only $7.8 million of this combined facility had been utilized, and the
remainder was available for use.  The weighted average interest rate
under the Westpac facility was 9.16% for the year to December 31,
2009.  The weighted average interest rate under the BSP facility was
9.27% for the year to December 31, 2009.
 
 While
cash flows from operations are expected to be sufficient to cover our operating
commitments, should there be a major deterioration in refining or downstream
margins, our operations may not generate sufficient cash flows to cover all of
the interest and principal payments under our debt facilities noted
above.  As a result, we may be required to raise additional capital
and/or refinance these facilities in the future.  We can provide no
assurances that we will be able to obtain such additional capital or that our
lenders will agree to refinance these debt facilities, or, if available, that
the terms of any such capital raising or refinancing will be acceptable to
us.
 
 Other
Sources of Capital
 
 Upstream
 
 Currently
our share of expenditures on exploration wells, appraisal wells and extended
well programs are funded from equity raising activities, operational cash flows
and asset sales.
 
 On
October 30, 2008, Petromin PNG Holdings Limited (“Petromin“), a government
entity mandated to invest in resource projects on behalf of the Independent
State of Papua New Guinea (“the State“), entered into an agreement to take a
20.5% direct interest in the Elk and Antelope fields.  If certain
conditions in the agreement are met, Petromin has agreed to fund 20.5% of the
costs of developing the Elk and Antelope fields.  The State’s right to
invest arises under legislation and is exercisable upon issuance of the
Petroleum Development License (“PDL”), which has not yet
occurred.  The agreement contains certain provisions applicable in the
event that the PDL is not issued within a certain timeframe. During 2009, the
State confirmed Petromin’s nomination to exercise its interest in the Elk and
Antelope fields.  On grant of a PDL, Petromin has agreed to pay us
20.5% of all other sunk costs incurred by InterOil prior to entering into the
agreement.  Until the PDL is granted, any payment made by Petromin is
to be separately held in a liability account in accordance with the provisions
of the agreement.  Once the PDL is granted, the conveyance of this
interest to the State is able to be formalized, and we are obliged to distribute
the proceeds received from Petromin between the existing interest holders
(InterOil, IPI holders and PNGDV) on a pro-rata basis based on the interest
surrendered by each to the State.  The State may also elect to
participate in a further 2.0% working interest on behalf of the landowners of
the licensed areas.  As at December 31, 2009, $10.4 million had been
received from Petromin.
 
 Cash
calls are made on IPI investors, Pacific LNG Operations Ltd (for its 2.5% direct
interest acquired during the year) and Petromin for their share of amounts spent
on appraisal wells and extended well programs pursuant to the relevant
agreements in place with them.
 
 Summary
of Cash Flows
 
 Year ended December 31($ thousands)
                    
                    2009
                    
                    
                    2008
                    
                    
                    2007Net
      cash inflows/(outflows) from:Operations
                    
                    
                    44,500
                    
                    
                    
                    15,586
                    
                    
                    
                    (31,620
                    )Investing
                    
                    
                    (85,567
                    )
                    
                    
                    (47,391
                    )
                    
                    
                    (34,370
                    )Financing
                    
                    
                    38,546
                    
                    
                    
                    36,913
                    
                    
                    
                    78,170Net cash movement
                    
                    
                    (2,521
                    )
                    
                    
                    5,108
                    
                    
                    
                    12,180Opening
      cash
                    
                    
                    48,970
                    
                    
                    
                    43,862
                    
                    
                    
                    31,682Closing
      cash
                    
                    
                    46,449
                    
                    
                    
                    48,970
                    
                    
                    
                    43,862
 
 Analysis
of Cash Flows Provided By/(Used In) Operating Activities Comparing the Years
Ended December 31, 2009 and 2008
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     20
  
 
 The
following table outlines the key variances in the cash flows from operating
activities between year ended December 31, 2009 and 2008:
 
 Yearly
                                      Variance
                                      ($
      millions)$
                                    28.9
                                    
                                    Variance
      for the comparative periods primarily due to:Ø
                                    
                                    $
                                    65.0
                                    
                                    Increase
      in cash provided by operations prior to changes in operating working
      capital due to improved margins from operations.Ø
                                    
                                    $
                                    (36.1
                                    )
                                    (Increase)/Decrease
      in cash used by operations due to the timing of receipts, payments and
      inventory
purchases.
 
 Analysis
of Cash Flows Provided By/(Used In) Investing Activities Comparing the Years
Ended December 31, 2009 and 2008
 
 The
following table outlines the key variances in the cash flows from investing
activities between year ended December 31, 2009 and 2008:
 
 Yearly
                                                        Variance
                                                        ($
      millions)$
                                                      (38.2
                                                      )
                                                      Variance
      for the comparative periods primarily due to:Ø
                                                      
                                                      $
                                                      (27.9
                                                      )
                                                      Higher
      cash outflows for the year to December 31, 2009 on exploration
      expenditures compared to the prior year period.  The outflows
      related to the Antelope -1 and 2 drilling and extended well drilling
      program.  The extended well program is partly funded by cash
      calls to the IPI investors.Ø
                                                      
                                                      $
                                                      (2.9
                                                      )
                                                      Lower
      cash calls and related inflows from IPI investors as compared to prior
      year.Ø
                                                      
                                                      $
                                                      (6.6
                                                      )
                                                      Higher
      expenditure on acquisition of plant and equipment as compared to prior
      periods mainly related to the purchase of land and improvements associated
      with our service stations in Papua New Guinea, purchase of refinery
      laboratory equipments and implementation of a new enterprise resource
      planning (“ERP”) system.Ø
                                                      
                                                      $
                                                      (6.5
                                                      )
                                                      Proceeds
      from sale of our interest in PRL’s 4 and 5 during the year ended December
      31, 2008.Ø
                                                      
                                                      $
                                                      0.9
                                                      
                                                      Lower
      cash outflows in the year due to movement in our secured cash restricted
      balances in line with the usage of the BNP working capital facility at
      period ends.Ø
                                                      
                                                      $
                                                      5.2
                                                      
                                                      Reduction
      in cash used in our Upstream development segment for working capital
      requirements.  This working capital relates to movements in
      accounts payable and accruals in our Upstream
  operations.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     21
  
 
 Analysis
of Cash Flows Provided By/(Used In) Financing Activities Comparing the Years
Ended December 31, 2009 and 2008
 
 The
following table outlines the key variances in the cash flows from financing
activities between years ended December 31, 2009 and 2008:
 
 Yearly
                                            Variance
                                            ($
      millions)$
                                          1.6
                                          
                                          Variance
      for the comparative periods primarily due to:Ø
                                          
                                          $
                                          (46.5
                                          )
                                          Higher
      repayments made in respect of BNP Paribas working capital facility as
      compared to the prior year.Ø
                                          
                                          $
                                          70.0
                                          
                                          Repayment
      of the Merrill Lynch bridging facility during the year ended December 31,
      2008.Ø
                                          
                                          $
                                          (9.4
                                          )
                                          Lower
      cash inflows relating to the LNG Project joint venture cash
      calls.  There were no cash calls in the year ended December 31,
      2009 compared with $9.4 million during 2008.Ø
                                          
                                          $
                                          (1.9
                                          )
                                          Lower
      cash inflows relating to the option and final agreement with Pacific LNG
      Operations Ltd under which it agreed to pay cash consideration of $25.0
      million to acquire a 2.5% interest in the Elk and Antelope
      fields.  Cash inflows were $3.6 million in the year ended
      December 31, 2009 compared with $5.5 million in 2008.Ø
                                          
                                          $
                                          2.4
                                          
                                          Net
      payments received from Petromin during 2009 for contributions towards cash
      calls made with respect to Elk and Antelope fields development
      activities.Ø.
                                          
                                          $
                                          81.8
                                          
                                          Net
      proceeds from the issuance of common shares during 2009 including $70.4
      million from a private placement offering in June 2009 and $6.6 proceeds
      received on exercise of warrants in August 2009.Ø
                                          
                                          $
                                          (94.8
                                          )
                                          Net
      proceeds from the issuance of 8% debentures during
  2008.
 
 Capital
Expenditures
 
 Upstream
Capital Expenditures
 
 Gross
capital expenditures for exploration in Papua New Guinea for the year ended
December 31, 2009 were $91.8 million compared with $63.9 million during the same
period of 2008.
  The
following table outlines the key expenditures in the year ended December 31,
2009:
 
 Yearly
                                              ($
      millions)$
                                            91.8
                                            
                                            Expenditures
      in the year ended December 31, 2009 due to:Ø
                                            
                                            $
                                            5.5
                                            
                                            Preparatory/drilling
      costs on the Antelope-1 appraisal well.Ø
                                            
                                            $
                                            11.3
                                            
                                            Testing
      of the Antelope-1 appraisal well.Ø
                                            
                                            $
                                            19.9
                                            
                                            Preparatory/drilling
      costs on the Antelope-1 appraisal well side track.Ø
                                            
                                            $
                                            43.2
                                            
                                            Preparatory/drilling
      costs on the Antelope-2 appraisal well.Ø
                                            
                                            $
                                            2.1
                                            
                                            Costs
      incurred in developing the PDL for the Elk and Antelope
      fields.Ø
                                            
                                            $
                                            3.3
                                            
                                            Site
      preparation costs for the Antelope-3 appraisal wellØ
                                            
                                            $
                                            2.8
                                            
                                            Costs
      for early works on Antelope condensate stripping
projectØ
                                            
                                            $
                                            3.7
                                            
                                            Other
      expenditure, including fixed assets and drilling consumable
      purchases.
 
 IPI
investors and Pacific LNG Operations (2.5% direct interest in Elk and Antelope
fields) are required to fund 25.8386% as at December 31, 2009 of the Elk and
Antelope extended well program costs to maintain their interest in that well
program.  This is the net interest to be funded by third parties after
the completion of IPI buyback of 4.8364% by us and the sale of 2.5% interest to
Pacific LNG Operations Limited in September 2009 pursuant to the option
agreement of 2007. The amounts capitalized in our books, or expensed as
incurred, in relation to the extended well program are the net amounts after
adjusting these interest in the program.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     22
  
 
 Petromin
PNG Holdings Limited (“Petromin”) will fund 20.5% of ongoing costs for
developing the fields.  Petromin contributed $10.4 million in the year
ended December 31, 2009.  All funds received are being treated as a
deposit until a PDL is granted.
 
 Midstream
Capital Expenditures
 
 Capital
expenditures totaled $2.2 million in our Midstream refinery segment for the year
ended December 31, 2009 mainly in relation to tank upgrades and the purchase of
laboratory equipment.  All costs incurred during the year in relation
to the Midstream Liquefaction segment have been expensed.  Since the
Project Agreement with the State of Papua New Guinea in relation to the
development of the proposed liquefaction facilities was executed on 23 December
2009, all associated development costs from 1 January 2010 will now be
capitalized.
 
 Downstream
Capital Expenditures
 
 Capital
expenditures for the Downstream segment totaled $6.9 million for the year ended
December 31, 2009.  These expenditures mainly related to the purchase
of land and improvements associated with service stations acquired in Papua New
Guinea.
 
 Corporate
Capital Expenditures
 
 Capital
expenditures for the Corporate segment totaled $2.5 million for the year ended
December 31, 2009.  These expenditures mainly related to project costs
in relation to the ERP implementation across all streams.  The
implementation is expected to be completed by the third quarter of
2010.
 
 Capital
Requirements
 
 The oil
and gas exploration and development, refining and liquefaction industries are
capital intensive and our business plans necessarily involve raising additional
capital.  The availability and cost of such capital is highly
dependent on market conditions at the time we raise such capital.  No
assurance can be given that we will be successful in obtaining new sources of
capital on terms that are acceptable to us, particularly given continuing market
conditions.
 
 Upstream
 
 We are
required under our $125.0 million Amended and Restated Indirect Participation
Agreement (“IPI Agreement”) of 2005 to drill eight exploration
wells.  We have drilled four wells to date.  As at December
31, 2009, we are committed to spend a further $83.0 million as a condition of
renewal of our petroleum prospecting and retention licenses up to
2014.  Of this $83.0 million commitment, as at December 31, 2009,
management estimates that $46.3 million would satisfy the commitments in
relation to the Amended and Restated IPI Agreement of February
2005..
 
 We will
need to raise additional funds in order for us to complete the programs and meet
our exploration commitments.  Therefore, we must extend or secure
sufficient funding through renewed borrowings, equity raising and or asset sales
to enable the availability of sufficient cash to meet these obligations over
time and complete these long term plans.  No assurances can be given
that we will be successful in obtaining new sources of capital on terms
acceptable to us, particularly given the current market conditions.
 
 In the
event that we establish sufficient gas reserves, we will also be required to
obtain substantial amounts of financing for the development of Elk and Antelope
fields, condensate stripping plant and delivery of gas to the LNG Project and it
would take a number of years to complete these projects.  In the event
that the commercial viability of these projects are established, we plan to use
a combination of debt, equity and the partial sale of capitalized properties to
raise adequate capital.  The availability and cost of various sources
of financing is highly dependent on market conditions at the time and we can
provide no assurances that we will be able to obtain such financing or conduct
such sales on terms that are acceptable.  If the disruption in the
financial and credit markets continue for an extended period of time, this
financing may be more expensive and difficult to obtain.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     23
  
 
 Midstream
- Refining
 
 We
believe that we will have sufficient funds from our operating cash flows to pay
our estimated capital expenditures associated with our Midstream – Refining
segment in 2010.  We also believe cash flows from operations will be
sufficient to cover the costs of operating our refinery and the financing
charges incurred under our crude import facility.  Should there be a
major deterioration in refining margins, our refinery may not generate
sufficient cash flows to cover all of the interest and principal payments under
our secured loan agreements.  As a result, we may be required to raise
additional capital and/or refinance these facilities in the future.
 
 Midstream
- Liquefaction
 
 We and
our current joint venture partner in the LNG Project - Pacific LNG Operations
Limited, are currently in the process of inviting bids from industry majors and
other interested parties to participate in the LNG Project as a joint venture
partner.
 
 Completion
of any liquefaction facility will require substantial amounts of financing and
construction will take a number of years to complete.  As a joint
venture partner in the project, if the project proceeds, we would be required to
fund our share of the development costs.  No assurances can be given
that we will be able to source sufficient gas, successfully construct such a
facility, or as to the timing of such construction.  The availability
and cost of capital is highly dependent on market conditions at the time we
raise such capital.
 
 Downstream
 
 We
believe on the basis of current market conditions and the status of our business
that our cash flows from operations will be sufficient to meet our estimated
capital expenditures for our wholesale and retail distribution business segment
for 2010.
 
 We can
provide no assurances that we will be able to obtain additional capital required
for our development plans, or that our lenders will agree to refinance our
working capital facilities, or, if available, that the terms of any such capital
raising or refinancing will be acceptable to us, particularly given the current
market conditions.
 
 Contractual
Obligations and Commitments
 
 The
following table contains information on payments for contracted obligations due
for each of the next five years and thereafter.  It should be read in
conjunction with our audited financial statements for the year ended December
31, 2009 and the notes thereto:
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     24
  
 
 Payments Due by Period ($
      thousands)Contractual obligations
                                        ($ thousands)
                                      
                                      Total
                                      
                                      Less than
                                        1 year
                                      
                                      1 - 2
                                        years
                                      
                                      2 - 3
                                        years
                                      
                                      3 - 4
                                        years
                                      
                                      4 - 5
                                        years
                                      
                                      More
                                        than 5
                                        yearsSecured loan(3)
                                      
                                      
                                      53,500
                                      
                                      
                                      9,000
                                      
                                      
                                      9,000
                                      
                                      
                                      9,000
                                      
                                      
                                      9,000
                                      
                                      
                                      9,000
                                      
                                      
                                      8,500Indirect participation interest(1)
                                      
                                      
                                      1,384
                                      
                                      
                                      540
                                      
                                      
                                      844
                                      
                                      
                                      -
                                      
                                      
                                      -
                                      
                                      
                                      -
                                      
                                      
                                      -PNG
      LNG Inc. Joint Venture (proportionate share of
commitments)
                                      
                                      
                                      35
                                      
                                      
                                      28
                                      
                                      
                                      7
                                      
                                      
                                      -
                                      
                                      
                                      -
                                      
                                      
                                      -
                                      
                                      
                                      -Petroleum prospecting and retention licenses(2)
                                      
                                      
                                      83,000
                                      
                                      
                                      4,500
                                      
                                      
                                      9,500
                                      
                                      
                                      20,000
                                      
                                      
                                      14,850
                                      
                                      
                                      34,150
                                      
                                      
                                      -Total
                                      
                                      
                                      137,919
                                      
                                      
                                      14,068
                                      
                                      
                                      19,351
                                      
                                      
                                      29,000
                                      
                                      
                                      23,850
                                      
                                      
                                      43,150
                                      
                                      
                                      8,500
 (1)
              These
      amounts represent the estimated cost of completing our commitment to drill
      exploration wells under our indirect participation interest agreement
      entered into in July 2003 (Indirect Participation Interest -
      PNGDV).  See Note 20 to our audited financial statements for the
      year ended December 31, 2009.
 (2)
              The
      amount pertaining to the petroleum prospecting and retention licenses
      represents the amount we have committed as a condition on renewal of these
      licenses.  Of this $83.0 million commitment, as at December 31,
      2009, management estimates that $46.3 million would satisfy the
      commitments in relation to the IPI
investors
 (3)
              This
      excludes the contractual interest payments on the principal amount. The
      effective interest rate on this loan for the year ended December 31, 2009
      was 6.89%.  The annual effective interest rate will be applied
      to the outstanding balance for the contractual interest payment
      calculation.
  Off
Balance Sheet Arrangements
 
 Neither
during the year ended, nor as at December 31, 2009, did we have any off balance
sheet arrangements or any relationships with unconsolidated entities or
financial partnerships.
 
 Transactions
with Related Parties
 
 Petroleum
Independent and Exploration Corporation, a company owned by Mr. Mulacek, our
Chairman and Chief Executive Officer, earned management fees of $150,000 during
the year ended December 31, 2009 (December 2008 - $150,000).  This
management fee relates to Petroleum Independent and Exploration Corporation
acting as the General Manager of one of our subsidiaries, S.P. InterOil LDC, in
compliance with OPIC loan requirements.
 
 Share
Capital
 
 Our
authorized share capital consists of an unlimited number of common shares and
unlimited number of preferred shares, of which 1,035,554 series A preferred
shares are authorized.  As of December 31, 2009, we had 43,545,654
common shares (45,957,701 common shares on a fully diluted basis) and no
preferred shares outstanding. The dilutive instruments outstanding as at
December 31, 2009 includes employee stock options in respect of 1,879,900 common
shares, IPI conversion rights to 527,147 common shares, and 5,000 common shares
that can be exchanged by Petroleum Independent and Exploration Corporation at
any time for the remaining 5,000 shares it holds in our subsidiary, S.P.
InterOil LDC.
 
 Derivative
Instruments
 
 Our
revenues are derived from the sale of refined products.  Prices for
refined products and crude feedstocks can be volatile and sometimes experience
large fluctuations over short periods of time as a result of relatively small
changes in supplies, weather conditions, economic conditions and government
actions.  Due to the nature of our business, there is always a time
difference between the purchase of a crude feedstock and its arrival at the
refinery and the supply of finished products to the various
markets.
 
 Generally,
we purchase crude feedstock two months in advance, whereas the supply/export of
finished products will take place after the crude feedstock is discharged and
processed.  Due to the fluctuation in prices during this period, we
use various derivative instruments as a tool to reduce the risks of changes in
the relative prices of our crude feedstocks and refined
products.  These derivatives, which we use to manage our price risk,
effectively enable us to lock-in the refinery margin such that we are protected
in the event that the difference between our sale price of the refined products
and the acquisition price of our crude feedstocks contracts is
reduced.  Conversely, when we have locked-in the refinery margin and
if the difference between our sales price of the refined products and our
acquisition price of crude feedstocks expands or increases, then the benefits
would be limited to the locked-in margin
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     25
  
 
 The
derivative instrument which we generally use is the over-the-counter (OTC)
swap.  The swap transactions are concluded between counterparties in
the derivatives swaps market, unlike futures which are transacted on the
International Petroleum Exchange (“IPE”) and Nymex Exchanges.  We
believe these hedge counterparties to be credit worthy.  However,
given the financial and credit market crisis, the creditworthiness of our hedge
counterparties could change quickly.  It is common place among
refiners and trading companies in the Asia Pacific market to use derivatives
swaps as a tool to hedge their price exposures and margins.  Due to
the wide usage of derivatives tools in the Asia Pacific region, the swaps market
generally provides sufficient liquidity for the hedging and risk management
activities.  The derivatives swap instrument covers commodities or
products such as jet and kerosene, diesel, naphtha, and also bench-mark crudes
such as Tapis and Dubai.  Using these tools, we actively engage in
hedging activities to lock in margins.  Occasionally, there is
insufficient liquidity in the crude swaps market and we then use other
derivative instruments such as Brent futures on the IPE to hedge our crude
costs.
 
 At
December 31, 2009, we had a net receivable of $nil (December 2008 – net
receivable of $31.3 million) relating to commodity hedge
contracts.  The total 2008 net receivable related to $16.3 million of
hedge accounted contracts and $15.1 million of outstanding derivative contracts
for which hedge accounting was not applied or had been discontinued. There were
no commodity hedge contracts outstanding as at December 31, 2009.
 
 The gain
on hedges for which final pricing will be determined in future periods was $nil
(December 2008 - $18.0 million) and has been included in comprehensive
income.  The hedges that have resulted in a gain being included within
comprehensive income at December 31, 2009 were settled in January
2009.  However, these gains have been fully released into the
Statement of Operations as the anticipated transactions that these hedges were
initially taken to cover have occurred.
 
 A profit
of $17.2 million was recognized from the effective portion of priced out hedge
accounted contracts for the year ended December 31, 2009 (December 2008 – profit
of $3.7 million), and a profit of $1.0 million was recognized on the non-hedge
accounted derivative contracts and the ineffective portion of hedge accounted
contracts for the year ended December 31, 2009 (December 2008 – profit of $24.0
million).
 
 INDUSTRY
TRENDS AND KEY EVENTS
 
 Competitive
Environment and Regulated Pricing
 
 We are
currently the sole refiner of hydrocarbons in Papua New Guinea under our 30 year
agreement with the Papua New Guinea Government, which expires in
2035.  The government has undertaken to ensure that all domestic
distributors purchase their refined petroleum products from our refinery, or any
other refinery which is constructed in Papua New Guinea, at an Import Parity
Price (“IPP”).  The IPP is monitored by the Papua New Guinea
Independent Consumer and Competition Commission (“ICCC”).  In general,
the IPP is the price that would be paid in Papua New Guinea for a refined
product being imported.  For all price controlled products (diesel,
unleaded petrol, kerosene and aviation gas) produced and sold locally in Papua
New Guinea, the IPP is calculated by adding the costs that would typically be
incurred to import such product to the posted price for such product in
Singapore.  In November 2007, the IPP was modified by changing the
Singapore benchmark price from the ”Singapore Posted Prices” which is no longer
being updated, to ”Mean of Platts Singapore” (”MOPS”) which is the benchmark
price for refined products in the region in which we operate.  The
revised formula is yet to be formally entrenched by means of necessary amendment
to the Project Agreement governing the Company’s relationship with the
Independent State of Papua New Guinea.  However, it is the current IPP
calculation mechanism being monitored by the ICCC.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     26
  
 
 We are
also a significant participant in the retail and wholesale distribution business
in Papua New Guinea.  The ICCC regulates the maximum prices that may
be charged by the wholesale and retail hydrocarbon distribution industry in
Papua New Guinea.  Our Downstream business may charge less than the
maximum margin set by the ICCC in order to maintain its competitiveness with
other participants in the market.  In June 2009, ICCC commenced a
review into the pricing arrangements for petroleum products in
PNG.  The last such review was undertaken during 2004 and was due to
expire on December 31, 2009.  The purpose of the review is to consider
the extent to which the existing regulation of price setting arrangements at
both wholesale and retail levels should continue or be revised for the next five
year period.  We have provided detailed submissions to the
ICCC.  The ICCC have most recently advised that its final report will
be issued in March 2010.  It is possible that the ICCC may determine
to increase regulation of pricing and reduce the margins able to be obtained by
our distribution business.  Such a decision, if made, may negatively
affect our downstream business and require a review of its
operations.
 
 Credit
Crisis and Financing Arrangements
 
 During
2008 and 2009 the U.S. and other world economies were in recession and the
financial and credit markets were significantly disrupted.  Many
financial institutions had liquidity concerns prompting intervention from
governments.  These resulted in a reduced capacity of the financial
institutions to finance new projects and renew existing facilities with their
clients.  However, the crisis seems to have bottomed out in the third
quarter of 2009 with most major economies starting to see growth by the end of
2009.  We continue to monitor liquidity risk through our level of
acceptable gearing where we are actively managing the gearing levels as required
to manage risk whilst optimizing shareholder returns.
 
 Our aim
is to maintain our debt-to-capital ratio, or gearing levels, (long term
debt/(shareholders’ equity + long term debt)) at 50% or less, and had achieved
this objective throughout 2009.  Gearing levels were reduced to 11% in
December 2009 from 36% in December 2008.  This reduction in gearing
levels as at December 31, 2009 as compared to December 31, 2008 was mainly due
to the conversion during the period from July 2009 to June 2009 of the remaining
$65 million outstanding of the $95.0 million 8% convertible subordinated
debenture completed in May 2008, plus the registered direct offering completed
in June 2009 for 2,013,815 common shares to a number of institutional investors
at a purchase price of $34.98 per share raising $70.4 million.
 
 In 2008,
we filed a short form base shelf prospectus with the Ontario Securities
Commission and a corresponding registration statement on Form F-10/A with the
SEC pursuant to the multi-jurisdictional disclosure system.  These
filings were made to provide us with financial flexibility in the future and
allow us to issue, from time to time until September 2010, up to an aggregate of
$129.6 million of securities in one or more offerings.  These
securities may be debt securities, common shares, preferred shares, warrants or
a combination thereof.
 
 We have a
short term total working capital facility of $190.0 million for our Midstream –
Refining operation that is renewable annually with BNP Paribas.  As
part of the renewal process completed in the quarter ended December 31, 2009,
the facility was renewed for a period of fifteen months ending December 31,
2010.  The facility is fully secured against trade debtors, inventory
and cash deposits.  The BNP working capital facility is split into two
categories, namely Facility 1 and Facility 2, with their respective sub-limits
and restricted usage for each of these components (refer to note 16 in our
consolidated financial statements for further information on the split between
the two facilities).  Our association with BNP Paribas began in 2004
with the working capital facility and has expanded over time to include certain
other aspects of our business including managing our hedging
trades.  See “Liquidity and Capital Resources – Summary of Debt
Facilities”.
 
 In 2008
we secured a $55.5 million (Papua New Guinea Kina 150.0 million) revolving
working capital facility for our Downstream operations in Papua New Guinea from
Bank of South Pacific Limited and Westpac Bank PNG Limited. The Westpac facility
limit is Papua New Guinea Kina 80.0 million (approximately $29.6 million) and is
for an initial term of three years and is due for renewal in October
2011.  The BSP facility limit is Papua New Guinea Kina 70.0 million
(approximately $25.9 million) is renewable annually and was renewed in October
2009 at a lower limit of Papua New Guinea Kina 50.0 million (approximately $18.5
million).  See “Liquidity and Capital Resources – Summary of Debt
Facilities”.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     27
  
  We had
cash, cash equivalents and cash restricted of $75.8 million as at December 31,
2009, of which $29.3 million was restricted (as governed by BNP working capital
facility utilization requirements and OPIC secured loan
facility).  With regard to our cash and cash equivalents, we invest in
bankers acceptances and money market instruments with major financial
institutions that we believe are creditworthy.  We also had $116.5
million of the combined BNP working capital facility available for use in our
Midstream – Refining operations, and $36.6 million of the Westpac/BSP combined
working capital facility available for use in our Downstream
operations.
 
 Crude
Prices
 
 Crude
prices were less volatile throughout 2009 as compared to 2008, with the price of
Tapis crude oil (as quoted by the Asian Petroleum Price Index (“APPI”)) starting
the year at $39/bbl, and on an increasing trend throughout the year closing at
$79/bbl.  Tapis is the benchmark for setting crude prices within the
region where we operate and is used by us when we purchase crude feedstock for
our refinery.  The price of Tapis during 2009 averaged $66/bbl
compared to $101/bbl during 2008.
 
 The
decrease in average crude prices during the year has reduced our utilization of
our working capital facilities.  As noted above, we had as at year end
$116.5 million of the combined BNP working capital facility available for use in
our Midstream – Refining operations, and approximately $36.6 million of the
Westpac/BSP combined working capital facility available for use in our
Downstream operations.  Any increase in prices will have an impact on
the utilization of our working capital facilities, and related interest and
financing charges on the utilized amounts.
 
 The high
volatility of crude prices in 2008 meant that we faced significant timing and
margin risk on our crude cargos during that year.  A significant
portion of this timing and margin risk was managed by us through short and long
term hedges that were put in place during the year.  We believe our
hedge counterparties to be creditworthy.  The number of hedges in
place declined in 2009 with a reduction in the volatility in
prices.  There were no outstanding hedge accounted contracts or
non-hedged derivative contracts on which final pricing was to be determined in
future periods as at December 31, 2009.
 
 Refining
Margin
 
 The
distillation process used by our refinery to convert crude feedstocks into
refined products is commonly referred to as hydroskimming.  While the
Singapore Tapis hydroskimming margin is a useful indicator of the general margin
available for hydroskimming refineries in the region in which we operate, it
should be noted that the differences in our approach to crude selection,
transportation costs and IPP pricing work to assist our refinery in generally
outperforming the Singapore Tapis hydroskimming margin.  Therefore, our
refinery realizes additional margins due to its niche location when compared to
the benchmark for the region.
 
 The
volatility of Singapore Tapis hydroskimming margins decreased during 2009, and
margins are generally improved in comparison with the previous
year.
 
 Distillate
margins remained weak in 2009 compared with historical levels due to lower
demand and new refining capacity coming on stream in the region.  This
has adversely affected the gross refining margins on finished products achieved
by the refining industry in general.
 
 Domestic
Demand
 
 Sales
results for our refinery for 2009 indicate that Papua New Guinea’s domestic
demand for middle distillates (which includes diesel and jet fuels) from the
refinery has stayed fairly constant compared to 2008.  The total
volume of all products sold by us in the Papua New Guinea was 6.5 million
barrels for fiscal year 2009 compared with 6.6 million barrels in
2008.
 
 The
refinery on average sold 10,933 bbls/day of refined petroleum products to the
domestic market during fiscal year 2009 compared with 10,888 bbls/day in
2008.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     28
  
 
 Interest
Rates
 
 The LIBOR
USD overnight rate is the benchmark floating rate used in our midstream working
capital facility and therefore accounts for a significant proportion of our
interest rate exposure.  The LIBOR USD overnight rate has decreased
from around 0.6% in early 2009 to 0.2% by the end of 2009, which was in line
with underlying U.S. Federal Reserve rate cuts.  Any rate increases
would add additional cost to financing our crude cargoes and vice versa as our
BNP Paribas working capital facility is linked to LIBOR rates.  See
“Liquidity and Capital Resources – Summary of Debt Facilities”.
 
 Exchange
Rates
 
 Changes
in the Papua New Guinea Kina (“PGK”) to USD exchange rate can affect our
Midstream Refinery results as there is a timing difference between the foreign
exchange rates utilized when setting the monthly IPP, which is set in PGK, and
the foreign exchange rate used to convert the subsequent receipt of PGK proceeds
to USD to repay our crude cargo borrowings.  The PGK weakened against
the USD during the three months ended March 31, 2009 (from 0.3735 to
0.3400).  However, it has since strengthened against the USD during
the nine months ended December 31, 2009 (from 0.3400 to 0.3700).
 
 RISK
FACTORS
 
 Our
business operations and financial position are subject to a range of
risks.  A summary of the key risks that may impact upon the matters
addressed in this document have been included under section “Legal Notice – Risk
Factors and Forward Looking Statements” above.  Detailed risk factors
can be found under the heading “Risk Factors” in our 2009
Annual Information Form available at www.sedar.com.
 
 CRITICAL
ACCOUNTING ESTIMATES
 
 The
preparation of financial statements in accordance with GAAP requires our
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes.  Actual
results could differ from those estimates.  The following accounting
policies involve estimates that are considered critical due to the level of
sensitivity and judgment involved, as well as the impact on our consolidated
financial position and results of operations.  The information about
our critical accounting estimates should be read in conjunction with Note 2
of the notes to our consolidated financial statements for the year ended
December 31, 2009, available at www.sedar.com which
summarizes our significant accounting policies.
 
 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 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.  A valuation allowance is provided against any portion of a
future tax asset which will more than likely not be recovered.  In
considering the recoverability of future tax assets and liabilities, we consider
a number of factors, including the consistency of profits generated from the
refinery, likelihood of production from Upstream operations to utilize the
carried forward exploration costs, etc.  If actual results differ from
the estimates or we adjust the estimates in future periods, we may need to
record a valuation allowance.  The net deferred income tax assets as
of December 31, 2009 and 2008 were $16.9 million and $3.1 million,
respectively.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     29
  
 
 Oil
and Gas Properties
 
 We use
the successful-efforts method to account for our 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 using the units-of-production method.  Geological
and geophysical costs are expensed as incurred.  If our plans change
or we adjust our estimates in future periods, a reduction in our oil and gas
properties asset will result in a corresponding increase in the amount of our
exploration expenses.
 
 Asset
Retirement Obligations
 
 Estimated
costs of future dismantlement, site restoration and abandonment of properties
are provided based upon current regulations and economic circumstances at year
end.  Management estimates there are no material obligations
associated with the retirement of the refinery or with its normal operations
relating to future restoration and closure costs.  The refinery is
located on land leased from the Independent State of Papua New
Guinea.  The lease expires on July 26, 2097.  Future
legislative action and regulatory initiatives could result in changes to our
operating permits which may result in increased capital expenditures and
operating costs.
 
 Environmental
Remediation
 
 Remediation
costs are accrued based on estimates of known environmental remediation
exposure.  Ongoing environmental compliance costs, including
maintenance and monitoring costs, are expensed as
incurred.  Provisions are determined on an assessment of current
costs, current legal requirements and current technology.  Changes in
estimates are dealt with on a prospective basis.  We currently do not
have any amounts accrued for environmental remediation
obligations.  Future legislative action and regulatory initiatives
could result in changes to our operating permits which may result in increased
capital expenditures and operating costs.
 
 Impairment
of Long-Lived Assets
 
 We are
required to review the carrying value of all property, plant and equipment,
including the carrying value of oil and gas assets, and goodwill for potential
impairment.  We test long-lived assets for recoverability whenever
events or changes in circumstances indicate that its carrying amount may not be
recoverable by the future undiscounted cash flows.  If impairment is
indicated, the amount by which the carrying value exceeds the estimated fair
value of the long-lived asset is charged to earnings.  In order to
determine fair value, our management must make certain estimates and assumptions
including, among other things, an assessment of market conditions (including
estimation of gross refining margins, crude price environments and its impact on
IPP, etc), projected cash flows, investment rates, interest/equity rates and
growth rates, that could significantly impact the fair value of the asset being
tested for impairment.  Due to the significant subjectivity of the
assumptions used to test for recoverability and to determine fair value, changes
in market conditions could result in significant impairment charges in the
future, thus affecting our earnings.  Our impairment evaluations are
based on assumptions that are consistent with our business plans.
 
 Legal
and Other Contingent Matters
 
 We are
required to determine whether a loss is probable based on judgment and
interpretation of laws and regulations and whether the loss can reasonably be
estimated.  When the amount of a contingent loss is determined it is
charged to earnings.  Our management continually monitors known and
potential contingent matters and makes appropriate provisions by charges to
earnings when warranted by circumstances.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     30
  
 
 NEW
ACCOUNTING STANDARDS
 
 Standards
adopted effective January 1, 2009
 
 Effective
year ended December 31, 2009, the Company adopted the revisions to CICA 3862 –
Financial Instruments – Disclosures which was amended to include additional
disclosure requirements about fair value measurements of financial instruments
and to enhance liquidity risk disclosure requirements for publicly accountable
enterprises.  The revisions require the disclosure of maturity
analysis for derivative and non-derivative financial assets and liabilities, and
additional information on liquidity risk.  The Company has made these
additional disclosures within notes 3(b) Liquidity risk, and note 3(g) Fair
values.
 
 Based on
the detailed review conducted by the Company of the new CICA sections, or
revisions to current sections, no other items have been identified as having any
material impact on the Company’s financial statements.
 
 New
Accounting standards not yet applicable as at December 31, 2009
 
 Based on
the detailed review conducted by the Company of the new CICA sections, or
revisions to current sections, that are effective for the year beginning January
1, 2010, no items have been identified as having any material impact on the
Company’s financial statements.
 
 The
Accounting Standards Board (“AcSB”) has announced its intention to adopt
International Financial Reporting Standards (“IFRS”) as Canadian GAAP, effective
January 1, 2011.  In anticipation of the change, the AcSB
is   revising certain Canadian accounting standards to conform to
IFRS in advance of the 2011 implementation date.  The required change
to IFRS is mandatory for all Canadian publicly accountable entities, which
includes those with public debt.
 
 The SEC
currently allows foreign private issuers using IFRS as their primary GAAP to not
provide reconciliation to U.S. GAAP in their financial statements.
 
 We will
adopt IFRS as per the guidelines issued by AcSB and report under IFRS effective
January 1, 2011 with comparative IFRS numbers for 2010.
 
 We have
an IFRS Steering Committee working under the oversight of the Audit Committee
monitoring the IFRS transition plan.  Based on the work performed on
evaluating key differences between Canadian GAAP and IFRS as applicable to us,
no major differences have yet been noted that would have any significant effect
on transition to IFRS.  As a result of this assessment, we do not
expect that there will be a significant impact on us in relation to our systems
and internal controls.
 
 We will
continue to monitor the revisions being made by AcSB to the Canadian accounting
standards to conform to IFRS in advance of the 2011 implementation
date.  Any revisions that will result in a change in the accounting
policy of InterOil, on adoption of IFRS effective January 1, 2011, will be
disclosed as policy changes in the financial statements.
 
 The areas
in which we anticipate revisions to accounting standards prior to the IFRS
adoption date of January 1, 2011 that may affect InterOil’s accounting policies
are:
 
 -
              Oil
      and Gas industry specific accounting under IFRS or Canadian GAAP is
      currently not as comprehensive as the guidance provided under U.S. GAAP
      accounting for industry specific oil and gas transactions. International
      Accounting Standards Board (“IASB”) has commenced a project to publish
      guidelines on accounting for oil and gas transactions, which may be
      different from the current guidelines under U.S.
  GAAP.
 
 -
              Section
      3055 - Joint Venture Interests under Canadian GAAP differs from similar
      guidance under IAS 31 as IAS 31 permits the use of either the
      proportionate consolidation method or the equity method to account for
      joint ventures.  IASB has commenced a project to remove the
      option for accounting for interests in jointly controlled entities using
      the proportionate consolidation method.  InterOil currently uses
      proportionate consolidation for accounting for the LNG joint venture under
      Canadian GAAP, and equity accounting for the same under U.S.
      GAAP.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     31
  
 
 -
              Other
      areas that are being monitored include property plant and equipment
      measurement and impairment, measurement and recognition of provisions,
      enterprises in development stage, and the optional exemptions available
      under IFRS 1 which provides a mandatory framework for first time adopters
      which supersedes the transitional provisions of individual
      standards.
  NON-GAAP
MEASURES AND RECONCILIATION
 
 Gross
Margin is a non-GAAP measure and is “sales and operating revenues” less “cost of
sales and operating expenses”.  The following table reconciles sales
and operating revenues, a GAAP measure, to Gross Margin:
 
 Year ended December 31,Consolidated
      – Operating results
                        ($ thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      2007Midstream
      – Refining
                      
                      
                      574,409
                      
                      
                      
                      786,114
                      
                      
                      
                      523,817Downstream
                      
                      
                      388,991
                      
                      
                      
                      556,868
                      
                      
                      
                      391,738Corporate
                      
                      
                      21,194
                      
                      
                      
                      24,567
                      
                      
                      
                      9,482Consolidation
      Entries
                      
                      
                      (296,115
                      )
                      
                      
                      (451,970
                      )
                      
                      
                      (299,511
                      )Sales
      and operating revenues
                      
                      
                      688,479
                      
                      
                      
                      915,579
                      
                      
                      
                      625,526Midstream
      – Refining
                      
                      
                      (516,349
                      )
                      
                      
                      (779,832
                      )
                      
                      
                      (495,059
                      )Downstream
                      
                      
                      (359,623
                      )
                      
                      
                      (536,920
                      )
                      
                      
                      (368,803
                      )Corporate
      (1)
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Consolidation
      Entries
                      
                      
                      273,989
                      
                      
                      
                      428,129
                      
                      
                      
                      290,253Cost
      of sales and operating expenses
                      
                      
                      (601,983
                      )
                      
                      
                      (888,623
                      )
                      
                      
                      (573,609
                      )Midstream
      – Refining
                      
                      
                      58,060
                      
                      
                      
                      6,282
                      
                      
                      
                      28,758Downstream
                      
                      
                      29,368
                      
                      
                      
                      19,948
                      
                      
                      
                      22,935Corporate
      (1)
                      
                      
                      21,194
                      
                      
                      
                      24,567
                      
                      
                      
                      9,482Consolidation
      Entries
                      
                      
                      (22,126
                      )
                      
                      
                      (23,841
                      )
                      
                      
                      (9,258
                      )Gross
      Margin
                      
                      
                      86,496
                      
                      
                      
                      26,956
                      
                      
                      
                      51,917
 
 (1)
Corporate expenses are classified below the gross margin line and mainly relates
to ‘Office and admin and other expenses’ and ‘Interest expense’.
 
 EBITDA
represents our net income/(loss) plus total interest expense (excluding
amortization of debt issuance costs), income tax expense, depreciation and
amortization expense.  EBITDA is used by us to analyze operating
performance.  EBITDA does not have a standardized meaning prescribed
by United States or Canadian generally accepted accounting principles and,
therefore, may not be comparable with the calculation of similar measures for
other companies.  The items excluded from EBITDA are significant in
assessing our operating results.  Therefore, EBITDA should not be
considered in isolation or as an alternative to net earnings, operating profit,
net cash provided from operating activities and other measures of financial
performance prepared in accordance with GAAP.  Further, EBITDA is not
a measure of cash flow under GAAP and should not be considered as
such.  For reconciliation of EBITDA to the net income (loss) under
GAAP, refer to the following table.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     32
  
 
 The
following table reconciles net income (loss), a GAAP measure, to EBITDA, a
non-GAAP measure for each of the last eight quarters.
 
 2009
                              
                              
                              2008Quarters
      ended
                                ($
      thousands)
                              
                              Dec-31
                              
                              
                              Sep-30
                              
                              
                              Jun-30
                              
                              
                              Mar-31
                              
                              
                              Dec-31
                              
                              
                              Sep-30
                              
                              
                              Jun-30
                              
                              
                              Mar-31Upstream
                              
                              
                              574
                              
                              
                              
                              (29,097
                              )
                              
                              
                              (669
                              )
                              
                              
                              (469
                              )
                              
                              
                              (2,483
                              )
                              
                              
                              231
                              
                              
                              
                              10,164
                              
                              
                              
                              (1,135
                              )Midstream
      – Refining
                              
                              
                              8,492
                              
                              
                              
                              8,199
                              
                              
                              
                              14,134
                              
                              
                              
                              14,747
                              
                              
                              
                              (13,976
                              )
                              
                              
                              17,516
                              
                              
                              
                              16,329
                              
                              
                              
                              5,724Midstream
      – Liquefaction
                              
                              
                              (1,200
                              )
                              
                              
                              (2,119
                              )
                              
                              
                              (1,379
                              )
                              
                              
                              (2,361
                              )
                              
                              
                              (2,501
                              )
                              
                              
                              (1,570
                              )
                              
                              
                              (1,784
                              )
                              
                              
                              (1,636
                              )Downstream
                              
                              
                              4,391
                              
                              
                              
                              6,542
                              
                              
                              
                              4,150
                              
                              
                              
                              3,241
                              
                              
                              
                              (7,244
                              )
                              
                              
                              610
                              
                              
                              
                              7,893
                              
                              
                              
                              4,529Corporate
                              
                              
                              1,765
                              
                              
                              
                              1,980
                              
                              
                              
                              1,897
                              
                              
                              
                              3,051
                              
                              
                              
                              226
                              
                              
                              
                              764
                              
                              
                              
                              (2,155
                              )
                              
                              
                              1,796Consolidation
      Entries
                              
                              
                              (4,884
                              )
                              
                              
                              (4,092
                              )
                              
                              
                              (278
                              )
                              
                              
                              (7,285
                              )
                              
                              
                              (2,866
                              )
                              
                              
                              (736
                              )
                              
                              
                              (3,092
                              )
                              
                              
                              (2,143
                              )Earnings
      before interest, taxes, depreciation and amortization
                              
                              
                              9,138
                              
                              
                              
                              (18,587
                              )
                              
                              
                              17,855
                              
                              
                              
                              10,924
                              
                              
                              
                              (28,844
                              )
                              
                              
                              16,815
                              
                              
                              
                              27,355
                              
                              
                              
                              7,135Subtract:Upstream
                              
                              
                              (4,056
                              )
                              
                              
                              (2,164
                              )
                              
                              
                              (1,563
                              )
                              
                              
                              (1,552
                              )
                              
                              
                              (1,345
                              )
                              
                              
                              (1,137
                              )
                              
                              
                              (841
                              )
                              
                              
                              (704
                              )Midstream
      – Refining
                              
                              
                              (1,973
                              )
                              
                              
                              (1,682
                              )
                              
                              
                              (1,709
                              )
                              
                              
                              (1,786
                              )
                              
                              
                              (2,771
                              )
                              
                              
                              (2,113
                              )
                              
                              
                              (2,263
                              )
                              
                              
                              (2,761
                              )Midstream
      – Liquefaction
                              
                              
                              (379
                              )
                              
                              
                              (348
                              )
                              
                              
                              (333
                              )
                              
                              
                              (158
                              )
                              
                              
                              (65
                              )
                              
                              
                              (63
                              )
                              
                              
                              (60
                              )
                              
                              
                              (53
                              )Downstream
                              
                              
                              (930
                              )
                              
                              
                              (1,045
                              )
                              
                              
                              (1,013
                              )
                              
                              
                              (1,142
                              )
                              
                              
                              (2,232
                              )
                              
                              
                              (885
                              )
                              
                              
                              (715
                              )
                              
                              
                              (1,005
                              )Corporate
                              
                              
                              (27
                              )
                              
                              
                              0
                              
                              
                              
                              (1,600
                              )
                              
                              
                              (2,325
                              )
                              
                              
                              (2,320
                              )
                              
                              
                              (2,484
                              )
                              
                              
                              (2,871
                              )
                              
                              
                              (3,091
                              )Consolidation
      Entries
                              
                              
                              5,905
                              
                              
                              
                              3,823
                              
                              
                              
                              3,141
                              
                              
                              
                              2,923
                              
                              
                              
                              2,866
                              
                              
                              
                              2,633
                              
                              
                              
                              1,824
                              
                              
                              
                              2,424Interest
      expense
                              
                              
                              (1,460
                              )
                              
                              
                              (1,416
                              )
                              
                              
                              (3,077
                              )
                              
                              
                              (4,040
                              )
                              
                              
                              (5,867
                              )
                              
                              
                              (4,049
                              )
                              
                              
                              (4,926
                              )
                              
                              
                              (5,190
                              )Upstream
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Midstream
      – Refining
                              
                              
                              14,316
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Midstream
      – Liquefaction
                              
                              
                              (8
                              )
                              
                              
                              (3
                              )
                              
                              
                              (32
                              )
                              
                              
                              (12
                              )
                              
                              
                              (12
                              )
                              
                              
                              (25
                              )
                              
                              
                              (49
                              )
                              
                              
                              (24
                              )Downstream
                              
                              
                              (411
                              )
                              
                              
                              (1,398
                              )
                              
                              
                              (733
                              )
                              
                              
                              (485
                              )
                              
                              
                              4,297
                              
                              
                              
                              83
                              
                              
                              
                              (3,212
                              )
                              
                              
                              (753
                              )Corporate
                              
                              
                              1,340
                              
                              
                              
                              (339
                              )
                              
                              
                              (800
                              )
                              
                              
                              (359
                              )
                              
                              
                              (163
                              )
                              
                              
                              (21
                              )
                              
                              
                              (122
                              )
                              
                              
                              (81
                              )Consolidation
      Entries
                              
                              
                              (3
                              )
                              
                              
                              (1
                              )
                              
                              
                              (2
                              )
                              
                              
                              (2
                              )
                              
                              
                              4
                              
                              
                              
                              (3
                              )
                              
                              
                              (2
                              )
                              
                              
                              0Income
      taxes and non-controlling interest
                              
                              
                              15,234
                              
                              
                              
                              (1,741
                              )
                              
                              
                              (1,567
                              )
                              
                              
                              (858
                              )
                              
                              
                              4,126
                              
                              
                              
                              34
                              
                              
                              
                              (3,385
                              )
                              
                              
                              (858
                              )Upstream
                              
                              
                              (144
                              )
                              
                              
                              (132
                              )
                              
                              
                              (150
                              )
                              
                              
                              (112
                              )
                              
                              
                              (175
                              )
                              
                              
                              (134
                              )
                              
                              
                              (135
                              )
                              
                              
                              (154
                              )Midstream
      – Refining
                              
                              
                              (2,765
                              )
                              
                              
                              (2,755
                              )
                              
                              
                              (2,801
                              )
                              
                              
                              (2,611
                              )
                              
                              
                              (2,742
                              )
                              
                              
                              (2,742
                              )
                              
                              
                              (2,723
                              )
                              
                              
                              (2,760
                              )Midstream
      – Liquefaction
                              
                              
                              (7
                              )
                              
                              
                              (10
                              )
                              
                              
                              (20
                              )
                              
                              
                              (20
                              )
                              
                              
                              (19
                              )
                              
                              
                              (19
                              )
                              
                              
                              (16
                              )
                              
                              
                              (15
                              )Downstream
                              
                              
                              (679
                              )
                              
                              
                              (658
                              )
                              
                              
                              (662
                              )
                              
                              
                              (651
                              )
                              
                              
                              (722
                              )
                              
                              
                              (693
                              )
                              
                              
                              (582
                              )
                              
                              
                              (573
                              )Corporate
                              
                              
                              (43
                              )
                              
                              
                              (40
                              )
                              
                              
                              (174
                              )
                              
                              
                              (18
                              )
                              
                              
                              (19
                              )
                              
                              
                              (18
                              )
                              
                              
                              (16
                              )
                              
                              
                              (15
                              )Consolidation
      Entries
                              
                              
                              33
                              
                              
                              
                              33
                              
                              
                              
                              32
                              
                              
                              
                              32
                              
                              
                              
                              32
                              
                              
                              
                              33
                              
                              
                              
                              32
                              
                              
                              
                              32Depreciation
      and amortisation
                              
                              
                              (3,605
                              )
                              
                              
                              (3,562
                              )
                              
                              
                              (3,775
                              )
                              
                              
                              (3,380
                              )
                              
                              
                              (3,645
                              )
                              
                              
                              (3,573
                              )
                              
                              
                              (3,440
                              )
                              
                              
                              (3,485
                              )Upstream
                              
                              
                              (3,626
                              )
                              
                              
                              (31,392
                              )
                              
                              
                              (2,382
                              )
                              
                              
                              (2,134
                              )
                              
                              
                              (4,003
                              )
                              
                              
                              (1,039
                              )
                              
                              
                              9,188
                              
                              
                              
                              (1,993
                              )Midstream
      – Refining
                              
                              
                              18,071
                              
                              
                              
                              3,762
                              
                              
                              
                              9,624
                              
                              
                              
                              10,349
                              
                              
                              
                              (19,490
                              )
                              
                              
                              12,660
                              
                              
                              
                              11,345
                              
                              
                              
                              201Midstream
      – Liquefaction
                              
                              
                              (1,593
                              )
                              
                              
                              (2,481
                              )
                              
                              
                              (1,764
                              )
                              
                              
                              (2,551
                              )
                              
                              
                              (2,596
                              )
                              
                              
                              (1,677
                              )
                              
                              
                              (1,910
                              )
                              
                              
                              (1,727
                              )Downstream
                              
                              
                              2,371
                              
                              
                              
                              3,440
                              
                              
                              
                              1,742
                              
                              
                              
                              964
                              
                              
                              
                              (5,900
                              )
                              
                              
                              (886
                              )
                              
                              
                              3,384
                              
                              
                              
                              2,197Corporate
                              
                              
                              3,034
                              
                              
                              
                              1,601
                              
                              
                              
                              (677
                              )
                              
                              
                              350
                              
                              
                              
                              (2,276
                              )
                              
                              
                              (1,759
                              )
                              
                              
                              (5,164
                              )
                              
                              
                              (1,390
                              )Consolidation
      Entries
                              
                              
                              1,050
                              
                              
                              
                              (236
                              )
                              
                              
                              2,893
                              
                              
                              
                              (4,332
                              )
                              
                              
                              35
                              
                              
                              
                              1,928
                              
                              
                              
                              (1,239
                              )
                              
                              
                              314Net
      profit/(loss) per segment
                              
                              
                              19,307
                              
                              
                              
                              (25,306
                              )
                              
                              
                              9,436
                              
                              
                              
                              2,646
                              
                              
                              
                              (34,230
                              )
                              
                              
                              9,227
                              
                              
                              
                              15,604
                              
                              
                              
                              (2,398
                              )
 (1)
              The
      inter-company interest charges have been restated for quarter ended March
      31, 2008 and June 30, 2008 to reflect transfer of certain inter-company
      loan balances to inter-company
investments.
 (2)
              During
      the year, the Company has transferred notional interest cost from
      Corporate segment to the Upstream and Midstream – Liquefaction segments to
      reflect a more accurate view of its segment results.  The prior
      year comparatives have been reclassified to conform to the current
      classification.
  Management
Discussion and Analysis   INTEROIL
CORPORATION     33
  
 
 PUBLIC
SECURITIES FILINGS
 
 You may
access additional information about us, including our Annual Information Form
for the year ended December 31, 2009, in documents filed with the Canadian
Securities Administrators at www.sedar.com, and in
documents, including our Form 40-F, filed with the U.S. Securities and Exchange
Commission at www.sec.gov.  Additional information is also available
on our website www.interoil.com.
 
 DISCLOSURE
CONTROLS AND PROCEDURES
 
 The
Company has implemented disclosure controls and procedures, as defined in
National Instrument 52-109-Certification of Disclosure in Issuer’s Annual and
Interim Filings (“NI 52-109”), to ensure that information required to be
disclosed by the Company is accumulated and communicated to the Company’s
management, as appropriate, to allow timely decisions regarding required
disclosures. Management is also responsible for establishing and maintaining
adequate internal control over the Company’s financial reporting.
 
 The
Company’s internal control system was designed to provide reasonable assurance
that all transactions are accurately recorded, that transactions are recorded as
necessary to permit preparation of financial statements in accordance with GAAP,
and that the Company’s assets are safeguarded. Internal control systems, no
matter how well designed, have inherent limitations. Therefore, even those
systems determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that
the degree of compliance with policies or procedure may
deteriorate.
 
 The CEO
and CFO are required to certify on the effectiveness of the Company’s disclosure
controls and procedures and internal controls over financial reporting
concurrent with filing its financial statements for the year ended December 31,
2009 in accordance with NI 52-109.  The Company’s CEO and CFO,
together with management, have concluded, based on their evaluation of the
effectiveness of the Company’s disclosure controls and procedures as of December
31, 2009, that information required to be disclosed by the Company is (i)
recorded, processed, summarized and reported within the time periods specified
in Canadian securities legislation and (ii) accumulated and communicated to the
Company’s management, including its CEO and CFO, to allow timely decisions
regarding required disclosure.
  Internal
Control Over Financial Reporting
 
 The CEO
and the CFO have also evaluated the effectiveness of InterOil's internal
controls over financial reporting ("ICFR") as at December 31,
2009.  During the year ended December 31, 2009, there were no material
changes in the Company’s disclosure controls and procedures or
ICFR.  InterOil's ICFR are designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
GAAP.  However, because of its inherent limitations, ICFR may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.  In making
their evaluation, the CEO and CFO used the criteria set forth in the framework
established by the Committee of Sponsoring Organizations (“COSO”) entitled –
Internals Controls – Integrated Framework.  Based on their evaluation,
the CEO and CFO concluded that our ICFR are effective to provide reasonable
assurance with respect to the objectives of our ICFR.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     34
  
  GLOSSARY
OF TERMS
 
 Barrel, Bbl  Unit
volume measurement used for petroleum and its products, equivalent to 42 U.S.
gallons.
 
 BNP Paribas  BNP
Paribas Capital (Singapore) Limited.
 
 BP  BP Singapore Pte
Limited.
 
 Condensate  A
component of natural gas which is a liquid at surface conditions.
 
 Crack spread  The
simultaneous purchase or sale of crude against the sale or purchase of refined
petroleum products. These spread differentials which represent refining margins
are normally quoted in dollars per barrel by converting the product prices into
dollars per barrel and subtracting the crude price.
 
 Crude OilA mixture consisting
mainly of pentanes and heavier hydrocarbons that exists in the liquid phase in
reservoirs and remains liquid at atmospheric pressure and temperature. Crude oil
may contain small amounts of sulphur and other non-hydrocarbons but does not
include liquids obtained from the processing of natural gas.
 
 EBITDA  Earnings
before interest, taxes, depreciation and amortization. EBITDA represents net
income/(loss) plus total interest expense (excluding amortization of debt
issuance costs), income tax expense, depreciation and amortization
expense.  EBITDA is used to analyze operating
performance.
 
 Feedstock  Raw
material used in a processing plant.
 
 GAAP  Generally
accepted accounting principles.
 
 Gas  A mixture of
lighter hydrocarbons that exist either in the gaseous phase or in solution in
crude oil in reservoirs but are gaseous at atmospheric conditions. Natural gas
may contain sulphur or other non-hydrocarbon compounds.
 
 ICCCIndependent
Consumer and Competition Commission.  The statutory competition
authority in Papua New Guinea.
 
 IPP  Import Parity
Price. For each refined product produced and sold locally in Papua New Guinea,
IPP is calculated by adding the costs that would typically be incurred to import
such product to the average posted price for such product in Singapore as
reported by Platts.  The costs that are added to the reported Platts
price include freight costs, insurance costs, landing charges, losses incurred
in the transportation of refined products, demurrage and taxes.
 
 IPIIndirect Participation
Interest.  These interests are held by various investors pursuant to
pareticipation interest agreements entered into in 2003, 2004 and 2005 and
identified more fully in our Annual Information Form.
 
 Joint Venture Company or PNG LNG means PNG LNG, Inc., a
joint venture company established in 2007 by InterOil LNG Holdings Inc., an
affiliate of InterOil, MLPLC, an affiliate of Merrill Lynch, and PacLNG to
construct the proposed LNG plant. Under an agreement reached in February 2009,
MLPLC no longer holds any interest in PNG LNG.
 
 LIBOR  Daily
reference rate based on the interest rates at which banks borrow unsecured funds
from banks in the London wholesale money market.
 
 LNG  Liquefied
natural gas.  Natural gas converted to a liquid state by pressure and
severe cooling, and then returned to a gaseous state to be used as
fuel.  LNG is moved in tankers, not via pipelines.  LNG,
which is predominantly artificially liquefied methane, is not to be confused
with NGLs, natural gas liquids, which are heavier fractions that occur naturally
as liquids
  Management
Discussion and Analysis   INTEROIL
CORPORATION     35
  
 
 LNG Project  The
potential development by us of a liquefied natural gas processing facility in
Papua New Guinea described as our Midstream Liquefaction business segment and
being undertaken as a joint venture with Pacific LNG Operations Ltd through a
joint venture company PNG LNG Inc.
 
 LSWR  Low Sulphur
Waxy Residue.
 
 NaphthaThat portion of the
distillate obtained in the refinement of petroleum which is an intermediate
between the lighter gasoline and the heavier benzene, has a specific gravity of
about 0.7, and is used as a solvent for varnishes, illuminant, and other similar
products.
 
 Natural gas  A
naturally occurring mixture of hydrocarbon and non-hydrocarbon gases found in
porous geological formations beneath the earth's surface, often in association
with petroleum.  The principal constituent is methane.
 
 PGKthe Kina, Currency of
Papua New Guinea.
 
 PPL  Petroleum
Prospecting License.  The tenement given by the State to explore for
oil and gas.
 
 PRL  Petroleum
Retention License.  The tenement given by the Independent State of
Papua New Guinea to allow the licensee holder to evaluate the commercial and
technical options for the potential development of an oil and/or gas
field.
 
 State or PNGmeans the Independent
State of Papua New Guinea.
 
 USD  United States
Dollars.
 
 Working interest  An
interest in a mineral property that entitles the owner of such interest to a
share of the mineral productions from the property with the share based on such
owner’s relative interest.
 
 Mcf  Standard
abbreviation for 1,000 cubic feet.
 
 Bil cu ft  Billion
cubic feet. Also abbreviated to bcf.
 
 TcfTrillion cubic
feet.
 
 Management
Discussion and Analysis   INTEROIL
CORPORATION     36