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Financial Review

Financing

Since Afren’s inception in late 2004, in acquiring and developing the portfolio, Afren has relied on a combination of equity and debt financing. However, in Afren’s first full year of production the Company realised an operating cash flow of US$278 million under a turbulent oil price environment. With forecast 2010 exit production of 35,000 bopd, the Ebok development will add to the existing production base, and will be significantly cash generative for the company in 2011 and beyond to the point where capital expenditure in subsequent development phases will be financed from a combination of operating cash flow and the financial flexibility afforded by the US$450 million Reserve Based Lending facility recently secured on the Ebok project reserves.

Afren recapitalised the balance sheet in May 2009 raising approximately US$126 million of equity funds (before expenses) and subsequently raised a further US$200 million (before expenses) on the move to the Main Board following the successful appraisal of the Ebok area and the signing of the Okwok agreement with Oriental Energy Resources Ltd.

Cash reserves across the Group at the year end amounted to US$321 million. Following repayments relating to the Okoro and Côte d’Ivoire facilities, gross debt at the year end amounted to US$281 million (2008: US$430 million). These are before deducting unamortised costs of issue of US$14 million and US$25 million respectively. It is expected that circa US$118 million will be repayable during 2010. Overall Afren had net cash of circa US$40 million at 31 December 2009 (US$54 million net of debt issue costs).

Production and revenue

Production at Okoro was ahead of pre-production expectation leading to an average gross production rate for the field of 18,800 bopd. Production from CI-11 in Côte d’Ivoire was stable, with average gross rates of 30 mmscfd and 1,230 bopd. Total revenue after royalties came to US$335.8 million (2008: US$42.5 million). The average sales prices before royalties achieved were US$58.7 per barrel for Okoro and US$65.0 per barrel in CI-11. The total contribution to the revenue from gas sales from CI-11 came to US$19.7 million in the year or around 6% (2008: US$1.6 million and 4%). A further US$4.3 million related to sales of butane from the Lion Gas Plant (2008: US$2.4 million).

Operating costs, depreciation and impairments

Total operating costs for the year were US$90.0 million (2008: US$41.0 million, both excluding any stock adjustments), of which US$73.4 million related to Okoro (2008: US$38.7 million). This followed an opex reduction initiative, against expectations at the start of the year of US$85 million. On a per barrel basis, the rates fell considerably, also due to plateau production from Okoro. Operating costs per barrel averaged US$11.6 for the Group, compared with US$29.7 per barrel in 2008. Total oil and gas depreciation for the Group in 2009 was US$152.2 million (2008: US$28.7 million restated). Since Afren funds the full field development cost and recovers out of sales revenues, there is a relatively high depreciation rate on a net barrel – US$20.6 per bbl. The total charge relating to Okoro came to US$134.2 million, compared with US$24.7 million in 2008. The increase reflects the significant step up in production (from 1.2 mmbbls in 2008 to 6.9 mmbbls in 2009 gross). CI-11 depreciation came to US$13.6 million at an average rate of US$16.3 per barrel. The Lion Gas Plant is depreciated over its expected life and a charge of US$4.4 million was booked for 2009.

Barrels produced but not sold as at the end of the period are valued at the lower of cost or net realisable value and the cost of sales adjusted accordingly. In December, the Okoro offtake was switched to a terminal on a nearby field. This has the capacity to offload on to much larger vessels, enabling the Okoro crude to be sold in bigger parcels attaining a higher price. With this new system, there is now a longer period between liftings and consequently at the year end there was over 600,000 barrels of oil in storage compared with less than 200,000 barrels at the start of the year. The end of period stock barrels are valued at cost and this amount is deducted from the cost of sales. In total, the cost of sales were reduced by US$12.8 million (2008: US$5.6 million), relating to the difference between the stock value at the start of the year and the much larger stock value at the end of the year.

Gross profit for the year was US$105.8 million, compared with a loss of US$28.0 million for 2008. Total administrative expenses have decreased from US$32.5 million in 2008 to US$27.2 million in 2009. This decrease reflects the cost control initiatives put in place at the start of the year and the benefit from the relatively stronger US dollar as a significant proportion of the administrative costs are denominated in sterling or Nigerian Naira.

In December 2008 Afren announced that the deep offshore Cuda-1x well on the Keta Block in Ghana had been plugged and abandoned after encountering an unexpectedly severe high pressure zone. The costs of the well were written off as it is unlikely that a significant part of the well will be reused. The total cost to Afren, expensed in 2008, was US$23.8 million. This has been subject to an insurance claim which was recently settled. The net effect of the insurance claim is a credit in the 2009 income statement of US$7.8 million. Following a review of the Ogedeh opportunity in Nigeria and given the near-term focus on the enlarged Ebok development, Afren sees limited potential in the project and has formally agreed with its partner Bicta to relinquish its interest. All remaining costs of approximately US$2.5 million relating to the asset have been written off. The Iris Marin licence in Gabon is due for renewal in May 2010. Following the analysis of the well results on the block from 2008, the operator made a formal recommendation to relinquish the block. Afren reviewed its position in the last quarter of 2009 and expects to formally relinquish its interest in the licence. As the partners are unlikely to go ahead with the Ibekelia TEA if there is no interest in the Iris Marin licence, Afren has written off all costs related to the remaining Gabon licences (US$2.1 million). Following the results of the Tie Tie NE well on the La Noumbi licence in Congo, all costs incurred on the well in 2009 (US$2.1 million) have also been expensed. An additional US$0.6 million of additional costs are expected to be incurred and expensed in 2010 in respect of this well.

Net Income

The Group made a pre-tax profit for the first time in 2009, as the benefits of full production and the recovery of the oil price led to a profitable second half of the year. The profit of US$0.5 million compares with a pre-tax loss in 2008 of US$55.6 million. The normalised profit for the year (after excluding unrealised hedge movements, share related costs, exchange movements and the share of loss from associates) was US$50.7 million, see note 7 to the financial statements for a full reconciliation of this figure (2008: loss of US$96.0 million). The reported loss after tax was US$16.8 million, compared with a loss of US$56.1 million for 2008 and a loss in the first half of 2009 of US$38.5 million, as the Group made a profit in the second half of the year. The loss per share for the year was 2.6c compared with 15.0c in 2008 (restated).

Derivative financial instruments – hedging

In May 2007, as part of the financing arrangements for the Okoro field, Afren entered into a series of swaps and call options to economically protect against exposure to the variability in the price of around 14% of expected Okoro oil production through to the end of 2010. This arrangement partly protects the Group against the risk of a significant fall in the price of crude by establishing a minimum swap price for a proportion of the Okoro crude. However, the Group will receive a set discount from the market price if the oil price is above that minimum. In this way, no up-front costs are payable and the Group enjoys the benefits of the majority of any oil price upside whilst there is only a cost to the Group if the oil price is sufficiently firm. In September 2008, a similar set of instruments was entered into in relation to the oil production from the Côte d’Ivoire assets covering the period from October 2008 to mid-2012. Essentially all the base net CI-11 oil production is hedged in this period (approximately 925,000 barrels) at prices between US$79 and US$85 per barrel. In June 2009 a further set of instruments were entered into related to an additional tranche of Okoro production, covering around a further 10% of production and extending out to the end of 2011.

The value of these derivative instruments are marked to market for each period and the gains and losses arising out of the changes in fair value are accounted for in the income statement. During 2009 the oil price strengthened, reducing the value of these instruments, with Brent moving from circa US$40 per barrel in December 2008 to circa US$80 per barrel in December 2009. The change in fair value of the instruments equates to a loss of US$15.3 million relating to Okoro and a loss of US$18.3 million relating to Côte d’Ivoire net of actual realisations (2008: a gain of US$13.4 million and a gain of US$41.3 million respectively). The actual realisation from these instruments for 2009 was a gain of US$11.4 million, compared with a gain in 2008 of US$3.6 million, as market prices have been consistently below the hedged price for Côte d’Ivoire production and were below the hedged price for Okoro production until the third quarter. These positions are likely to remain volatile as they are marked to market at each balance sheet date and their value will depend on both the spot price and the forward curve.

Net interest and other gains and losses

Net interest, financing costs and other gains and losses for the Group in 2009 amounted to US$45.3 million (2008: US$11.5 million). Total gross interest expense (including facility fees, amortisation of costs and unwinding of discount where applicable) amounted to US$37.7 million (2008: US$33.0 million), of which US$1.8 million was capitalised relating to the Ebok development (2008: US$16.9 million, relating to the Okoro development). 2008 also had a one-off charge relating to the early conversion of a convertible bond (US$9.3 million). The charge relating to the unwinding of discount from the abandonment provisions for the Okoro and CI-11 fields amounted to US$1.1 million (2008: US$0.4 million). Interest income came to US$0.6 million (2008: US$5.3 million), reflecting the significantly lower rates paid on deposits. All Afren’s cash is retained in short-term or immediately available deposits with a selected group of banks and financial institutions. Afren made a loss of US$2.8 million (2008: US$15.4 million) due to foreign exchange differences in the year. This mostly related to sterling funds where the exchange rate fell to the year end. The bulk of the sterling funds have since been transferred
into US dollars removing any significant risk from the rates going forward, as the Group’s costs are largely US dollar denominated. Certain warrants held in Afren shares are not convertible at a fixed price in the Company’s functional currency (due to the fluctuation of the exchange rates from sterling to US Dollar) so are marked to market at each balance sheet date and the increase or decrease in the liability is taken to net income. As Afren shares moved significantly between 1 January 2009 and 31 December 2009 (from 26.5 pence to 85 pence), there was a significant increase in the value of the warrants to the warrant holder and hence the deemed liability to Afren. This led to a US$5.0 million charge in the income statement, compared with a US$26.6 million gain made in 2008. The effect of these warrants is likely to remain volatile, with any further increases in value of the share price creating a charge in the financial statements as the value of the warrants to the warrant holder increases. In 2009, Afren invested a further £1.5 million in Gasol and Afren’s current interest is 20.9%. Since 11 February 2009 when Afren made the initial increased investment it has accounted for Gasol as an associate. Afren’s share of Gasol’s losses over the period amount to US$1.3 million.

Tax

The tax charge for the year of US$17.3 million arises from the Group operations in Nigeria and Côte d’Ivoire. The charge reflects the current and deferred tax expense for the Okoro field and the current tax expense for the CI-11 operations. This represents the charge for a full year of operations for both assets and the use of tax losses applicable to the Okoro project.

Reallocation of acquisition costs on Côte d’Ivoire assets

The 2008 annual report reflected our provisional estimates of the fair values of the assets acquired from Devon in September 2008. Following the receipt in March 2009 of the full data set relating to these assets, Afren has been able to reassess the reasonableness of these initial calculations. The technical analysis to date on the full data set has now been reviewed by NSAI, and the analysis indicates that CI-01 has significantly greater reserves potential than originally envisaged but that CI-11 has less. Therefore, in accordance with the one year window allowed by IFRS to finalise fair value estimates, at 30 June 2009 Afren reallocated the value of the assets acquired between CI-11, the Lion Gas Plant and CI-01, resulting in a reclassification between intangible assets and PP&E in the 2008 balance sheet, and a consequent immaterial adjustment to the 2008 full year results in accordance with IFRS 3.

Balance Sheet

Total net assets at 31 December 2009 amounted to US$658.2 million (2008: US$350.9 million) with the increase principally due to the share placings in May and December 2009. Total non-current assets stood at US$684.0 million at the year end compared with US$710.7 million at the end of 2008 (restated). This reflects the expenditure on Ebok where the carried value has grown from US$47.0 million to US$158.6 million offset by depreciation on the producing fields (US$152.2 million). Intangible oil and gas assets have fallen in value from US$213.9 million to US$184.2 million, reflecting the transfer of Ebok from an intangible asset to Property, Plant and Equipment. Following government and partner approval for the Ebok development at the end of August, the balance was transferred to tangible assets. In total around US$24 million was spent in 2009 on exploration and evaluation (excluding Ebok expenditure), spread across Afren’s assets. Current assets have grown from US$211.4 million to US$416.0 million in the year. The largest component of this is the cash balance of US$321.3 million (2008: US$117.7 million) referred to above.

Total current liabilities were US$257.6 million at the year end, marginally higher than at the end of 2008 (US$257.0 million). Non-current liabilities stood at US$184.1 million at the year end compared with US$314.2 million at 31 December 2008, the decrease of US$130.1 million in the last 12 months being primarily due to significant repayments of debt made from the Okoro and Côte d’Ivoire cash flows, partially offset by the provision for a deferred tax liability in relation to Okoro of US$12.5 million.

Cash flow

Net cash generated from operating activities totalled US$278.3 million (2008: cash used of US$26.8 million) reflecting a full year of production. Once more there was significant investment in oil and gas assets (US$197.9 million including inventory; 2008: US$289.4 million) as Afren continues to develop its portfolio. Net cash used in investing activities fell from US$459.4 million to US$209.1 million year on year. However, 2009 saw the start of significant repayments of the outstanding loans as the field revenues were received, with a total repayment of US$148.4 million, compared with a draw-down in 2008 of US$321.9 million after costs and repayments later in the year.

Principal risks to 2010 performance

In common with other companies in the oil and gas sector, Afren is exposed to commodity price risk, the delivery of major projects and ensuring safe operations in all locations. The Board determines key risks for the Company and required mitigation plans and reviews delivery on a regular basis. Key specific risks for 2010 include the successful execution of the phased Ebok development.

Outlook

With the first full year of production behind Afren, a recapitalised balance sheet, the financial flexibility from the recently secured (post year-end) US$450 million Reserve Based Lending facility and a significant forecast increase in production from the Ebok field, Afren has an appropriate capital structure
to fund its forward growth strategy.