Pearl Exploration and Production Ltd.



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  Aug 14, 2007 - 09:30 ET
Pearl Announces Financial Results for Interim Period Ended June 30, 2007

  CALGARY, ALBERTA--(Marketwire - Aug. 14, 2007) - Pearl Exploration and Production Ltd. ("Pearl" or the "Company") (TSX Venture:PXX)(FIRST NORTH:PXXS) is pleased to announce the results of the three and nine months ended June 30, 2007.

Financial Highlights and Operational Highlights:



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Three months ended Nine months ended
($000s, except per share data) June 30, 2007 June 30, 2007
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Revenue 23,520 48,260
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Net loss (7,225) (30,116)
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Net loss per share basic (0.05) (0.27)
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Total assets 620,792 620,792
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Three months ended June 30, 2007
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Oil - net production, bopd 5,934
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Gas - net production, mcf/day 11,757
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Total net production, boe/d(i) 7,910
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Oil - average selling price per bbl $41.29
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Gas - average selling price per mcf $ 6.81
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(i)gas production converted at 6:1

 


PRESIDENT'S MESSAGE

The second quarter of calendar 2007 saw the Company continue with its stated goals of building a strong base of production and cash flow from its core properties in western Canada while pursuing high upside potential through steam pilot projects and acquisitions. Despite challenges from extreme cold weather in the first quarter and anomalously high rainfall in the second quarter, the Company was able to increase production levels by 14% (6,966 to 7,910 boepd) and revenues by 21% ($19.4 million to $23.5 million) during the quarter. These gains are expected to increase and continue throughout the remainder of 2007.

At Onion Lake, we are aggressively pushing forward our development project with 30 wells drilled this year and a production increase from approximately 350 at the end of the first calendar quarter to 1,300 barrels of oil equivalent per day at the time of writing of this letter. We are well along the way to implementing a steam flood pilot project which could have a dramatic impact on recoverable reserves. Due to positive results, we have elected to move 30 contingent wells to our firm capital budget and now expect Onion Lake to contribute between 4,000 and 4,400 barrels of oil equivalent per day to our bottom line numbers by the end of 2007. Relations with the Onion Lake First Nations continue to be good, and we look forward to a strong partnership in the future.

The development plan at Mooney has yielded excellent results and will see further acceleration due to the purchase of interest of our minority partner which gives us an approximate 98% working interest in the field. Plans are underway to implement a full field pressure maintenance program using either a water or polymer flood which could dramatically impact the production rates and recoverable reserves in this field. Production has risen from approximately 700 barrels of oil equivalent per day at the beginning of 2007 to a net 2,400 barrels of oil equivalent per day net to the Company today including the acquisition.

We also continue to optimize our other producing fields in western Canada with some more profitable fields like Ear Lake/Salt Lake and Pike's Peak seeing increased development activity while other fields are being earmarked for sale or joint venture. We continue to seek options to divest our Southern Alberta Gas properties but with the state of the gas market, current options do not meet our value expectations.

A large part of our growth strategy is associated with increasing our reserve potential with the introduction of steam projects into our field containing large amounts of oil in place. The two most important of these are San Miguel in South Texas and the Onion Lake field on the Alberta / Saskatchewan border. Steam flood pilot operations started last year in San Miguel and we are now encouraged enough by the results to expand the existing pilot and are making plans to move into production phase by drilling a 16 well development pilot in the northern portion of the field nearby the area where Conoco had highly successful results in their 1981 pilot program. The Onion Lake steam pilot is also progressing well with the permit application in process and a steam generation unit enroute from China. We are hoping to have steam in the ground there during the 4th quarter. Plans are also underway to evaluate the reserves potential of the Druid field in Saskatchewan. A horizontal well has recently been drilled to assess productivity and the results will be incorporated into a full field reservoir simulation model to assist in designing a water cycling scheme for this field.

The acquisition front has been highly active and resulted in two new acquisitions being announced in late July. The first of these saw us buying out our minority partner at Mooney in order to consolidate what we consider our best producing asset and allow us to move aggressively forward with an accelerated development program. The second of these was the acquisition of Watch Resources in an all share transaction. The primary asset of Watch is a heavy oil field at Fishing Lake which will fit well with our strategy to build low risk production and cash flow from Western Canada. An eight well program is planned for the rest of this year to better define the field and confirm the extent of the reservoir and resources. This field is nearby the Onion Lake field and we believe operational synergies will allow for a rapid development. Several additional new venture opportunities are currently in advanced stages of evaluation and negotiation as we consider the acquisition market to still be quite strong in the heavy oil arena.

We believe we are well on our way to meeting the ambitious targets for both production and cash flow growth as well as realizing the high growth rates through reserve growth due to steam projects and acquisitions that Pearl shareholders have come to expect. We still believe that heavy oil assets are highly undervalued and plan to aggressively capitalize on the lack of competition in this arena which we feel will be open for a limited time frame. The need to incorporate heavy oil into the world energy solution is gaining pace and we want to make sure Pearl is well positioned as this potential becomes a reality.

Keith C. Hill

President and CEO

August 9, 2007

PEARL EXPLOPRATION AND PRODUCTION LTD.

MANAGEMENT'S DISCUSSION AND ANALYSIS

(Amounts in Canadian Dollars unless otherwise indicated)

Three and nine months ended June 30, 2007 and 2006

Management's discussion and analysis ("MD&A") of Pearl Exploration and Production Ltd.'s (the "Company" or "Pearl") financial condition and results of operations should be read in conjunction with the unaudited consolidated financial statements for the three and nine months ended June 30, 2007 and 2006 and related notes therein prepared in accordance with Canadian generally accepted accounting principles. The effective date of this MD&A is August 9, 2007. Additional information relating to the Company is available on SEDAR at www.sedar.com and on the Company's web-site at www.pearleandp.com.

OVERVIEW

Pearl is a Canadian-based oil and gas company whose common shares are traded on the TSX Venture Exchange under the symbol "PXX". Pearl's main focus is large, heavy oil projects in Canada and the USA. The Company also holds interests in a number of natural gas properties.

Prior to September 30, 2005, Pearl was a Calgary based mining company known as Newmex Minerals Inc. and traded on the TSX Venture Exchange under the symbol "NMM". During the quarter ended December 31, 2005, the Company began its transition into an oil and gas company, and completed several significant acquisitions which are described more fully in the Company's Annual Report dated September 30, 2006 and filed on SEDAR. In February 2006, the Company changed its name to Pearl.

Pearl's main properties in Canada include:

- Onion Lake, Saskatchewan - heavy oil;

- Mooney, Alberta - heavy oil;

- Druid, Saskatchewan - heavy oil;

- Unity, Saskatchewan - natural gas;

- Pike's Peak, Saskatchewan - heavy oil;

- Salt Lake, Saskatchewan - heavy oil;

- Southern Alberta - natural gas;

- Ear Lake, Saskatchewan - heavy oil; and

- Broad Acres, Saskatchewan - natural gas.

The Company is also involved with two major projects in the USA: the San Miguel heavy oil development project and the Palo Duro Basin shale gas exploration project, both in Texas. The Company is currently conducting a thermal (steam) pilot project at San Miguel.

CHANGE OF FINANCIAL YEAR END

The Company changed its financial year end from September 30 to December 31 effective October 1, 2006. The Company made this change in order that its financial year end would be comparable to its peers in the oil and gas industry. As a result of this change, the Company will have a 15 month transitional financial year ending December 31, 2007.

TRADING ON FIRST NORTH, STOCKHOLM

On June 20, 2007, the Company commenced trading of its Swedish depository receipts ("SDRs") on the First North list of the OMX Nordic Exchange.

Each SDR represents one issued common share of the Company on deposit with a designated depository and is exchangeable into common shares on a one-for-one basis subject to a payment of an exchange fee.

OIL AND GAS ACQUISITIONS AND DISPOSITIONS

On May 8, 2007, the Company announced that the sale of its Gulf of Mexico assets to Bayou Bend Petroleum Ltd. ("Bayou Bend") had closed. In consideration for 10 million common shares of Bayou Bend, Pearl sold its 100% working interest in five Gulf of Mexico offshore exploration blocks, farm-in rights to acquire a 25% working interest in a sixth offshore block and all physical data, work products and files and records associated with these blocks. The Bayou Bend common shares had a value of $27.4 million at the time of closing. In June 2007, the Company sold half of the Bayou Bend shares.

On August 2, 2007, the Company announced that it had closed the acquisition of a 24% working interest in the Mooney oil field from Ravenwood Energy Corp. ("Ravenwood"), a private oil and gas company. The acquisition will bring Pearl's working interest in the Mooney field to over 98% and will add approximately 625 boepd in current production. Pearl purchased Ravenwood's working interest for $20 million, net of standard industry adjustments, effective July 1, 2007. The net purchase price was comprised of $7.6 million in cash and 1,475,108 of Pearl common shares at a deemed value of $5.12 per share.

SELECTED QUARTERLY INFORMATION

The following is a summary of selected financial information for the Company for the periods indicated:



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(000s, Jun Mar Dec Sep Jun Mar Dec Sep
except per 30 31 31 30 30 31 31 30
share data) 2007 2007 2006 2006 2006 2006 2005 2005
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Revenue 23,520 19,422 5,318 1,924 1,422 425 28 5
Net loss (7,225)(17,628) (5,263) (1,990) (3,742) (2,486) (735) (143)
Net loss per
share basic
and diluted (0.05) (0.13) (0.08) (0.04) (0.09) (0.07) (0.03) (0.01)
Total
assets 620,792 586,276 640,195 129,067 97,982 26,068 24,307 3,191

 


The increase in revenue for the quarter ended June 30, 2007 is mainly due to an increase in oil production volumes and oil selling prices compared to the prior quarter. Development drilling activities at Onion Lake and Mooney fields are the main reason for the increase in production volumes.

The significant increase in revenue for the quarter ended March 31, 2007 is a result of the Company's acquisition of Atlas Energy Ltd. ("Atlas") which closed on December 22, 2006. The Atlas acquisition added approximately 5,300 boepd to the Company's production for the quarter ended March 31, 2007.

Prior to September 30, 2005, the Company was a mineral company and had limited operational activities. Subsequent to September 30, 2005, the Company changed its strategic direction to become an oil and gas exploration and development company by acquiring a variety of oil and gas interests in the USA and Canada. Beginning with the quarter ended March 31, 2006, revenues include oil and gas sales. The amount of revenues has increased each quarter as the Company has added additional production through oil and gas acquisitions and development activities.

The increase in total assets in the quarter ended December 31, 2006 is due to the Atlas acquisition. The increase in total assets in the prior quarters is mainly the result of the Company's acquisition activities. Some of the Company's oil and gas properties are in the exploration or development stages therefore there is currently no production nor associated revenue from these properties.

OPERATIONS UPDATE

Onion Lake Heavy Oil Project - Saskatchewan

The Company resumed its multi-well development drilling program of this heavy oil trend in July 2007. Of the 31 wells drilled thus far in 2007, 23 wells have been placed on production. A well down-spacing application has been submitted to regulatory authorities and is expected to be approved before the end of August 2007. This will result in approximately 35 to 45 additional near-term drilling locations in the current producing area. A 3-D seismic survey is being designed and permitted to further evaluate the Company's southern acreage and prioritize 2007 and 2008 development drilling locations. At the end of June 2007, production was approximately 1,300 boepd net to the Company. A thermal recovery pilot site has been chosen and applications submitted to regulatory authorities. In order to enable an operational start-up in late 2007, pilot facilities design has been completed and procurement is now underway. The Company has also continued with the engineering design of centralized production facilities for sand and oil handling which are scheduled for construction in September 2007. Based on the positive results of the drilling campaign in the first half of 2007, the Company has elected to shift 30 wells from the contingent budget to the firm budget which will result in the drilling of 120 wells in the 2007 drilling season subject to regulatory approvals and weather conditions.

Mooney Heavy Oil Project - Alberta

Development drilling continued at the Mooney Bluesky "A" oil pool throughout the spring break-up period. As of the end of June 2007, a total of 16 new horizontal oil wells had been drilled in the current year. Twelve of these wells are currently on production. The remaining wells will be brought on production in September 2007. With the acquisition of Ravenwood's 24% working interest, the field production net to the Company will increase to approximately, 2,400 boepd and development projects including water injection and potential polymer injection will be accelerated.

San Miguel Heavy Oil Project - Maverick Basin, South Texas

The Company is continuing with the San Miguel Heavy Oil Project's steam injection pilot operations to determine the technical and economic feasibility of cyclic steam injection to enhance oil recovery. Both pilot wells are presently on a second cycle of injection and production, and additional cycles will occur throughout 2007. Following discussions with our partners, a decision has been made to expand the current pilot prior to the end of 2007. Initial planning and procurement is therefore underway for the drilling of additional wells and the procurement of long-lead items for facility modifications. Discussions and planning are also underway for a second, 16 well production pilot project to the north of the existing steam injection pilot facility. The production pilot is presently projected to be operational in the second quarter of 2008.

Palo Duro Shale Gas Exploration Project - North Texas

No additional drilling was undertaken during the quarter ended June 30, 2007 on the Palo Duro Shale Gas Project. Efforts were concentrated on building the required pipeline and facilities to tie-in and test the long term performance of the two existing MacIntosh wells. The Company will continue to monitor the results of the extended production testing as well as the results of other operators in the basin in order to evaluate the long term economic viability of the Palo Duro Shale Gas Project.

Other Area Properties - Alberta, Saskatchewan

Drilling and other production enhancement projects continued on the Company's heavy oil producing properties in Alberta and Saskatchewan. The greatest efforts were placed on the Ear Lake/Salt Lake area where the largest short term production additions are expected. The Company has also completed the drilling of a horizontal production well on the Druid field to test the reserves potential of this field which has a significant amount of oil-in-place, and has the potential for a water cycling project in the first half of 2008.

RESULTS OF OPERATIONS



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
----------------------------------------------------------
Net loss $ (7,225) $(17,628) $ (5,263) $ (3,742) $(30,116) $ (6,963)
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The Company had a net loss of approximately $7.2 million for the three months ended June 30, 2007. The Company has incurred losses in both the current and prior quarters as a result of additional expenses relating to its oil and gas operations including production costs, depletion and higher general and administrative costs. As further production volumes are added from the Company's development activities in 2007, oil and gas revenues will continue to increase.

An in-depth analysis of revenues and expenses follows.

Oil and Gas Sales and Production



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Oil & gas ----------------------------------------------------------
sales $ 29,801 $ 24,464 $ 6,223 $ 1,362 $ 60,488 $ 1,758
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Oil (net bopd) 5,934 4,622 1,238 112 3,919 46
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Natural gas
(net mcf/d) 11,757 13,923 2,620 950 9,392 416
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NGLs (net bbls/d) 17 23 - - 13 -
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Total (net
boe/d)(i) 7,910 6,966 1,674 270 5,498 115
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Oil -
average selling
price per bbl $ 41.29 $ 35.89 $ 34.28 $ 46.90 $ 37.15 $ 46.90
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Gas -
average selling
price per mcf $ 6.81 $ 7.32 $ 6.62 $ 6.99 $ 6.92 $ 7.60
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(i) gas production converted at 6:1

 


The Company's oil and gas sales have increased approximately 22% over the prior quarter mainly as a result of higher oil production volumes and higher oil prices. The average oil price realized by the Company in the most recent quarter was 15% higher than the prior quarter, and oil production volumes were 28% higher. These increases were partially offset by a reduction in both gas volumes and gas prices compared to the prior quarter.

For the prior year three and nine month periods, the Company's oil and gas sales were much lower. The Company acquired Onion Lake in late April 2006 therefore there is only two months production from Onion Lake reflected above for these periods.

As of the date of this report, production was approximately 8,600 boepd, net to the Company.

Royalties



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
----------------------------------------------------------
Royalties $ 6,322 $ 5,285 $ 1,171 $ 192 $ 12,778 $ 217
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As a percent
of sales 21% 22% 19% 14% 21% 12%
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Royalties include Crown, freehold and gross overriding royalties. As a percentage of sales, royalties have decreased slightly from 22% in the prior quarter to 21%.

In the prior year periods, low royalties on the production from Pearl's Texas Queen City wells has impacted the overall royalty rate. The US royalty rates that pertain to this production averaged 6%.

Production Costs



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Production ----------------------------------------------------------
costs $ 10,949 $ 10,132 $ 2,370 $ 302 $ 23,451 $ 320
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Per boe $ 15.21 $ 16.16 $ 15.38 $ 12.27 $ 15.63 $ 10.19
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Operating costs on a per boe basis averaged $15.21 for the most recent quarter. As production continues to increase from drilling and development activities, per barrel operating costs are expected to decline.

For the prior year periods, operating costs relate only to Onion Lake and the Texas Queen City gas wells. The Texas gas wells have a very low operating cost on a per boe basis. Due to the lower volumes in the prior year quarters, the Texas operating costs had a more pronounced impact on reducing the total operating cost per boe.

Transportation Costs



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Transportation ----------------------------------------------------------
costs $ 1,074 $ 999 $ 168 $ - $ 2,241 $ -
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Per boe $ 1.49 $ 1.59 $ 1.09 $ - $ 1.49 $ -
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Transportation costs are incurred to move marketable crude oil and natural gas to their selling points. Transportation costs are currently averaging $1.49 per boe for the Company. For the three and nine months ended June 30, 2006, the Company had minimal oil and gas revenues from its operations. Transportation costs were minimal and were therefore netted against revenue by the operator.

Interest Income



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Interest ----------------------------------------------------------
income $ 40 $ 243 $ 266 $ 252 $ 550 $ 333
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Interest income represents bank interest earned on excess cash. In the prior quarters, the Company had higher excess cash balances as a result of its equity issues through private placements.

General and Administrative Expenses



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
----------------------------------------------------------
G&A $ 3,953 $ 2,559 $ 2,006 $ 1,176 $ 8,518 $ 1,708
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Per boe $ 5.49 $ 4.08 $ 13.02 $ 47.85 $ 5.68 $ 54.33
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General and administrative expenses have increased on a per boe basis compared to the prior quarter as a result of some one-time costs. These one-time costs relate to the $1.2 million write-down of old accounts receivable balances that were assumed from an acquired company in the prior year. The Company does expect general and administrative costs on a per boe basis to decrease as efficiencies are realized, certain costs reduced and production volumes increase.

General and administrative expenses were very high on a per boe basis for the prior year periods as a result of minimal production volumes. The Company had minimal production volumes from Onion Lake and the Texas Queen City wells during those periods.

Depletion, Depreciation and Amortization



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
----------------------------------------------------------
DD&A $ 22,076 $ 17,238 $ 6,475 $ 2,858 $ 45,788 $ 3,525
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Per boe $ 30.67 $ 27.49 $ 42.03 $ 116.25 $ 30.51 $ 111.37
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The DD&A amount is predominantly depletion of the oil and gas producing assets. The Company follows the full cost method of accounting for its oil and gas interests, whereby capitalized costs along with estimated future costs to develop proved reserves, are depleted on a unit-of-production basis using estimated proved oil and gas reserves. The current year depletion expense has been calculated using the capitalized and future costs relating to the producing properties the Company previously acquired: the Onion Lake lands, the Nevarro, Atlas and Cipher oil and gas interests and the Texas Queen City gas wells. Depletion for the prior year periods was quite high as at that time the Company had only a few properties that had minimal proved reserves over which to deplete the costs. The depletion rate on a per boe basis has declined significantly as the Company added proved reserves from further acquisitions.

Costs of acquiring and evaluating unproved properties are excluded from costs subject to depletion until it is determined whether proved reserves are attributable to the properties or impairment occurs. Certain of the Company's assets have been excluded from depletion as they are considered unproved properties at this time.

Stock-Based Compensation



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(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Stock-based ----------------------------------------------------------
compensation $ 918 $ 958 $ 563 $ 687 $ 2,439 $ 2,891
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The Company uses the fair value method of accounting for stock options granted to directors, officers, employees and consultants whereby the fair value of all stock options granted is recorded as a charge to operations. The fair value of common share options granted is estimated on the date of grant using the Black-Scholes option pricing model. For the three months ended June 30, 2007, the Company issued 144,000 options at prices ranging from $4.86 to $5.64.

Interest Expense



--------------------------------------------------------------------------
(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Interest ----------------------------------------------------------
expense $ 1,240 $ 399 $ 116 $ - $ 1,754 $ 114
--------------------------------------------------------------------------
Per boe $ 1.72 $ 0.64 $ 0.79 $ - $ 1.17 $ 3.62
--------------------------------------------------------------------------

 


Included in interest expense is $221,000 of interest accrued on the Company's unspent flow-through share obligation. The remaining $1,019,000 of interest expense relates to the Company's bank debt. For the quarter ended June 30, 2007, the Company had an average debt level of $63.4 million and an effective interest rate of 6.44% .

Accretion of Asset Retirement Obligation ("ARO")



--------------------------------------------------------------------------
(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
ARO ----------------------------------------------------------
accretion $ 247 $ 299 $ 64 $ 10 $ 610 $ 12
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The accretion of ARO relates to the estimated future costs for reclamation and abandonment of oil and gas properties. The increase in the accretion of ARO in the last two quarters is the result of the additional ARO related to the Atlas properties acquired in December 2006.

Change in Fair Market Value of Gas Pricing Contracts



--------------------------------------------------------------------------
(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Change in ----------------------------------------------------------
FMV of gas
contracts $ - $ 488 $ 48 $ - $ 536 $ -
--------------------------------------------------------------------------

 


The Company acquired the gas contracts as part of the Atlas acquisition which closed on December 22, 2006. For the quarter ended March 31, 2007, the change in the fair market value of the gas pricing contracts represents the change in fair market value from December 31, 2006 to March 31, 2007. For the quarter ended December 31, 2006, the change in the fair market value represents the change in fair market value from December 22, 2006 to December 31, 2006. All gas contracts expired at the end of March 2007.

Foreign Currency Exchange Loss



--------------------------------------------------------------------------
(000's) Three months ended Nine months ended
----------------------------------------------------------
Jun 30, Mar 31, Dec 31, Jun 30, Jun 30, Jun 30,
2007 2007 2006 2006 2007 2006
Foreign ----------------------------------------------------------
currency
exchange
loss $ 97 $ 172 $ 54 $ 133 $ 322 $ 270
--------------------------------------------------------------------------

 


The foreign currency exchange loss relates to the revaluation of the US dollar bank balances into Canadian dollars for financial reporting purposes.

FINANCIAL CONDITION

As at June 30, 2007, the Company had total assets of $620.8 million compared to $129.1 million at September 30, 2006.

Accounts receivable were $24.8 million at June 30, 2007 compared to $4.4 million at September 30, 2006. The June 30, 2007 accounts receivable balance includes approximately $11 million relating to oil and gas revenue receivables and accruals for the period, and approximately $13 million for joint interest receivables relating to capital and operating costs owed by partners.

Investments at June 30, 2007 were $17.3 million compared to $3.0 million at September 30, 2006. The investments include shares in Serrano Energy Ltd. ("Serrano") and Bayou Bend. The Company holds common shares of Serrano, a private oil and gas exploration and development company, which is in the initial stages of acquiring and drilling oil and gas exploration and development prospects. These shares represent an ownership of 28.67% in Serrano. Initially, the Company subscribed for six million shares in Serrano in conjunction with the acquisition of Nevarro Energy Ltd. in September 2006. In June 2007, the Company subscribed for an additional 2,074,689 shares of Serrano. Subsequent to the end of the quarter, Serrano consolidated the shares on a 2:1 basis.

The Company also owns five million shares of Bayou Bend. The Company received ten million common shares of Bayou Bend in consideration for the sale of its Gulf of Mexico leases (described more fully above in the section Oil and Gas Acquisitions and Dispositions) and in June 2007, sold five million of these shares. At June 30, 2007, the market value of the Bayou Bend shares was $2.35 per share.

Long-term accounts receivable were $nil at June 30, 2007 compared to $1.1 million at September 30, 2006. Prior to the Company's acquisition of Pan-Global in April 2006, Pan-Global had advanced $3 million to the Onion Lake First Nation ("OLFN"). The total receivable amount was being set-off against the OLFN's share of net revenue from production from the pre-existing Onion Lake oil and gas producing wells. As a result of the new joint venture operating agreement entered into with OLFN, the Company has assumed the remaining receivable balance and reclassified the capital and operating portions accordingly.

Prepaid expenses and deposits were $3.4 million at June 30, 2007 compared to $0.8 million at September 30, 2006. Approximately $0.9 million of the balance relates to office rent deposits, $0.5 million to Crown royalty deposits and approximately $0.8 million relates to prepaid insurance and interest. The remaining $0.4 million includes cash call advances to partners, lease rentals and other prepayments.

Accounts payable and accruals were $49.7 million at June 30, 2007 compared to $12.6 million at September 30, 2006. Included in the balance is $24.6 million of trade payables (operating and capital), $0.5 million for royalties and $24 million for operating and capital accruals.

The Company has a credit facility with a Canadian chartered bank in the amount of $75 million of which $74 million was drawn at June 30, 2007. Subsequent to the end of the quarter, the Company raised $60.6 million gross from the issuance of 12 million shares at a price of $5.05 per share. The proceeds were applied against the revolving credit facility. The bank also completed its semi-annual review of the credit facility and reduced the facility to $60 million.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2007, the Company had a working capital deficit of $98.5 million compared to a working capital deficit of $3.8 million at September 30, 2006. The significant increase in the working capital deficit is mainly the result of the Company's drawings on its credit facility. On June 27, 2007, the Company announced that it had agreed to sell on a non-brokered, private placement basis up to an aggregate of 12 million common shares at a price of $5.05 per share for gross proceeds of up to $60.6 million. A finder's fee of 4% was paid on a portion of the private placement. The private placement was fully subscribed and closed on July 12, 2007. Net proceeds were used to reduce the outstanding bank debt.

Funds from operations were $1.0 million for the three months ended June 30, 2007 compared to funds from operations of $35,000 for the prior year three month period. Funds from operations for the nine months ended June 30, 2007 were $6.6 million compared to funds used in operations of $0.3 million for the prior year nine month period. The increase in funds from operations for the nine months ended June 30, 2007 compared to the prior year period is mainly the result of increased oil and gas sales. The addition of the Atlas properties has significantly increased the Company's production volumes and revenues.

Net cash from financing activities for the three months ended June 30, 2007 was $45.5 million compared to net cash from financing activities of $37.6 million for the prior year three month period. During the current quarter, the Company received bank loan advances of $35.4 million, and received cash proceeds of $10.0 million from the sale of five million of its Bayou Bend shares.

Net cash from financing activities for the nine months ended June 30, 2007 was $98.1 million compared to $55.5 million for the prior year nine month period. During the current year nine month period, the Company received approximately $106.6 million net proceeds pursuant to an equity financing agreement with GMP Securities L.P. The Company issued 22,444,444 common shares at a price of $4.50 per share and issued 1,709,401 flow-through common shares at $5.85 per share. The Company repaid bank loans of $94.7 million from these proceeds, predominantly debt assumed as part of the Atlas acquisition in December 2006. The Company also received bank loan advances totaling $75.5 million, $10 million from the sale of Bayou Bend shares and $0.6 million from the exercise of stock options during this nine month period.

Net cash used in investing activities was $45.2 million for the three months ended June 30, 2007 compared to $2.3 million for the prior year three month period. During the current quarter, the Company used cash of $51.3 million to add to its oil and gas interests through exploration, development and lease acquisition activities, and used $2.5 million of cash to acquire additional shares in Serrano, a privately held oil and gas exploration and development company, in which the Company has an ownership of 28.67% . Net cash used in investing activities for the nine months ended June 30, 2007 was $96.5 million compared to $16.6 million for the prior year nine month period. During the current year nine month period, the Company's exploration, development and lease acquisition activities totaled $108.9 million and corporate acquisition costs totaled $11.7 million.

Contributed surplus at June 30, 2007 has increased $1.9 million over the balance at September 30, 2006. The increase is due to the stock-based compensation for the nine month period ended June 30, 2007. When options are granted, the Black-Scholes option value method is used to calculate a value for the stock options. The offset to the amount that is recorded as stock compensation expense is a credit to contributed surplus. When stock options are exercised, a proportionate amount of the value recorded on the granting of options is moved from contributed surplus to share capital. If any unvested stock options are cancelled, the amount previously credited to contributed surplus is reversed and stock-based compensation expense is reduced in the period of the cancellation. For the nine months ended June 30, 2007, contributed surplus was debited for $750,000 for stock options that were exercised and for unvested stock options that were cancelled. During the nine months ended June 30, 2007, 165,000 stock options were exercised and 224,833 unvested stock options were cancelled.

The Company does not currently generate sufficient cash flow from its oil and gas operations to fund its entire oil and gas exploration, development and acquisition activities. The Company has relied upon the issuance of common shares and debt financing to provide additional funding. The Company may consider additional issuances of common shares or debt instruments to assist with financing its ongoing oil and gas exploration, development and acquisition activities to the extent that sufficient cash flow from operations is unavailable in the future. In addition, the Company may consider divesting of non-core oil and gas assets or farming out interests in oil and gas properties to finance its operations. Accordingly, the Company's consolidated financial statements are presented on a going-concern basis.

FINANCIAL INSTRUMENTS

The carrying amounts of financial instruments comprising cash, accounts receivable, investments, accounts payable and loans payable approximate their fair value due to the immediate or short-term nature of these financial instruments. Long-term receivables approximate their present value.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has no off-balance sheet arrangements.

OUTSTANDING SHARE DATA

As at August 9, 2007, the Company had 147,434,697 common shares outstanding and 4,248,667 stock options outstanding under its stock-based compensation plan.

RELATED PARTY TRANSACTIONS

Tanganyika Oil Company Ltd. ("Tanganyika") provides management services to the Company based upon time and expenses incurred by Tanganyika. For the nine months ended June 30, 2007, Tanganyika charged the Company $169,000. Tanganyika and Pearl have certain directors and officers in common.

ACCOUNTING POLICIES AND CRITICAL ACCOUNTING ESTIMATES

Other than the adoption as of October 1, 2006 of Section 3855 - Financial Instruments Recognition and Measurement, the accounting policies utilized in the preparation of the Company's June 30, 2007 unaudited interim consolidated financial statements are unchanged from those as set out in note 2 to the audited consolidated financial statements in the Company's Annual Report for the period ended September 30, 2006. The adoption of Section 3855 is described in note 3 of the June 30, 2007 unaudited interim consolidated financial statements.

RISKS AND UNCERTAINTIES

The Company is exposed to a number of risks and uncertainties inherent in exploring for, developing and producing crude oil and natural gas. These risks and uncertainties include, but are not limited to, the following: economic risk of finding and producing reserves at a reasonable cost; cost of capital risk associated with securing the needed capital to carry out the Company's operations; risk of fluctuating foreign currency exchange rates; risk of carrying out operations with minimal environmental impact; risk of governmental policies, social instability or other political, economic or diplomatic developments in its operations; market risks associated with investing the Company's cash reserves in interest bearing depository instruments; and environmental risks related to its oil and gas properties. Many of the previously mentioned risks are beyond the Company's control, and it is impossible to ensure that any exploration drilling program will result in commercial operations. The Company does not utilize derivative instruments to hedge its foreign currency exchange or interest rate risks.

INTERNAL CONTROLS OVER FINANCIAL REPORTING

The discussion and conclusion with respect to the Company's internal controls over financial reporting included in the September 30, 2006 MD&A disclosed in the Company's Annual Report remain unchanged as at June 30, 2007.

OUTLOOK

The Company plans to continue pursuing North American oil and gas opportunities to add to its portfolio of exploration and development properties, and to focus on the development of its existing interests in the USA and Canada.

FORWARD-LOOKING STATEMENTS

Certain information regarding the Company contained herein may constitute forward-looking statements. Forward-looking statements may include estimates, plans, expectations, opinions, forecasts, projections, guidance or other statements that are not statements of fact. By their nature, forward-looking statements and information involve assumptions, inherent risks and uncertainties, many of which are difficult to predict, and are usually beyond the control of management, that could cause actual results to be materially different from those expressed by these forward-looking statements and information. The Company does not undertake to update or re-issue the forward-looking statements and information that may be contained herein, whether as a result of new information, future events or otherwise. The Company's forward-looking statements are expressly qualified in their entirety by this cautionary statement.

NON-GAAP MEASURES

Certain measures in this MD&A do not have any standardized meaning as prescribed by Canadian GAAP such as "funds from operations" and "cash flows" and therefore are considered non-GAAP measures. These measures may not be comparable to similar measures presented by other issuers. These measures have been described and presented in this MD&A in order to provide shareholders and potential investors with additional information regarding the Company's liquidity and its ability to generate funds to finance its operations. Management's use of these measures has been disclosed further in this MD&A as these measures are discussed and presented.

BOES

Throughout this MD&A the calculation of barrels of oil equivalent (boe) is calculated at a conversion rate of six thousand cubic feet (mcf) of natural gas for one barrel of oil and is based on an energy equivalence conversion method. BOEs may be misleading, particularly if used in isolation. A boe conversion ratio of 6 mcf:1 bbl is based on an energy equivalence conversion method primarily applicable at the burner tip and does not represent a value equivalence at the wellhead.



--------------------------------------------------------------------------
Consolidated Balance Sheet
(unaudited)
--------------------------------------------------------------------------
September
June 30,2007 30,2006

--------------------------------------------------------------------------

Assets
Current assets
Cash $ 4,465,393 $ 8,717,568
Accounts receivable 24,786,205 4,417,816
Prepaid expenses and deposits 3,415,722 788,394
-------------- --------------
32,667,320 13,923,778


Investments (note 5) 17,250,000 3,000,000
Long-term accounts receivable - 1,144,136
Petroleum and natural gas properties
(note 6) 411,010,694 92,069,058
Goodwill (note 4) 159,863,578 18,930,509
-------------- --------------
$ 620,791,592 $ 129,067,481
-------------- --------------

Liabilities
Current liabilities
Accounts payable and accrued liabilities $ 49,706,235 $ 12,559,545
Bank loan (note 4 and 7) 74,000,000 4,976,200
Income taxes and capital taxes payable 7,471,571 145,372
-------------- --------------
131,177,806 17,681,117
-------------- --------------

Long-term liabilities
Asset retirement obligation (note 13) 15,902,183 3,772,479
Future income tax 20,576,172 5,523,339
-------------- --------------
167,656,161 26,976,935

Shareholders' equity
Share capital (note 9) 491,144,375 112,613,584
Contributed surplus (note 9) 6,671,640 4,791,060
Cumulative other comprehensive income
(note 3 ) 750,000 -
Deficit (45,430,584) (15,314,097)
-------------- --------------
453,135,431 102,090,546
-------------- --------------
$ 620,791,592 $ 129,067,481
-------------- --------------
-------------- --------------
Commitments (note 10)
Contingencies (note 14)

See accompanying notes to financial statements


--------------------------------------------------------------------------
Consolidated Statement of Operations and Deficit
(unaudited)
--------------------------------------------------------------------------
For the For the
three months ended June 30 nine months ended June 30
-----------------------------------------------------------
2007 2006 2007 2006
------------- ------------- ------------- -------------
Revenue
Oil and gas
sales $ 29,801,464 $ 1,361,537 $ 60,488,133 $ 1,758,412
Interest
income 40,057 251,912 549,506 333,311
Royalties (6,321,753) (191,654) (12,777,829) (217,041)
------------- ------------- ------------- -------------
23,519,768 1,421,795 48,259,810 1,874,682
------------- ------------- ------------- -------------

Expenses
Production
costs 10,948,973 301,615 23,451,065 320,273
Transportation
costs 1,074,032 - 2,240,718 -
General and
administrative 3,952,930 1,176,441 8,517,603 1,707,512
Depletion,
depreciation
and
amortization 22,075,786 2,858,191 45,788,147 3,525,307
Stock-based
compensation 917,621 687,359 2,438,743 2,891,297
Interest 1,239,918 - 1,754,317 113,817
Change in
unrealized
loss of gas
pricing
contracts
(note 3) - - 536,000 -
Foreign
currency
exchange loss 96,673 133,160 322,152 270,409
Accretion of
asset
retirement
obligation 246,500 10,223 609,886 12,043
------------- ------------- ------------- -------------
40,552,433 5,166,989 85,658,631 8,840,658
------------- ------------- ------------- -------------

Other items
Gain on sale
of assets (13,270,044) (3,374) (13,270,044) (3,374)
------------- ------------- ------------- -------------
(13,270,044) (3,374) (13,270,044) (3,374)
------------- ------------- ------------- -------------

Loss before
income taxes (3,762,621) (3,741,820) (24,128,777) (6,962,602)
------------- ------------- ------------- -------------

Income taxes
Future income
taxes
(recovery) (3,120,243) - (979,279) -
Income taxes
and capital
taxes 6,582,979 - 6,966,989 -
------------- ------------- ------------- -------------
3,462,736 - 5,987,710 -
------------- ------------- ------------- -------------

------------- ------------- ------------- -------------
Net loss for
the period (7,225,357) (3,741,820) (30,116,487) (6,962,602)
------------- ------------- ------------- -------------

Deficit,
beginning of
period (38,205,227) (9,582,006) (15,314,097) (6,361,224)
------------- ------------- ------------- -------------

Deficit, end
of period $ (45,430,584) $ (13,323,826) $ (45,430,584) $ (13,323,826)
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------

Basic loss per
share $ (0.05) $ (0.09) $ (0.27) $ (0.20)
Diluted loss
per share $ (0.05) $ (0.09) $ (0.27) $ (0.20)
Weighted
average number
of common
shares
used in
computing
earnings per
share:
basic and
diluted 133,935,248 43,758,784 109,527,508 34,599,177

See accompanying notes to financial statements


--------------------------------------------------------------------------
Consolidated Statement of Comprehensive Loss and Cumulative Other
Comprehensive Income
(unaudited)
--------------------------------------------------------------------------
For the For the
three months ended June 30 nine months ended June 30
----------------------------------------------------------
2007 2006 2007 2006
------------ ------------ ------------- ------------

Net loss $ (7,225,357) $ (3,741,820) $ (30,116,487) $ (6,962,602)
Other
comprehensive
income, net of
tax
Mark-to-market
gain on
available-for-
sale financial
asset 750,000 - 750,000 -

------------ ------------ ------------- ------------
Comprehensive
loss $ (6,475,357) $ (3,741,820) $ (29,366,487) $ (6,962,602)
------------ ------------ ------------- ------------
------------ ------------ ------------- ------------

Cumulative
other
comprehensive
income,
beginning of
period $ - $ - $ - $ -
Other
comprehensive
income, net of
taxes 750,000 - 750,000 -

------------ ------------ ------------- ------------
Cumulative
other
comprehensive
income, end
of period $ 750,000 $ - $ 750,000 $ -
------------ ------------ ------------- ------------
------------ ------------ ------------- ------------

See accompanying notes to financial statements


--------------------------------------------------------------------------
Consolidated Statements of Cash Flows
(unaudited)
--------------------------------------------------------------------------
For the For the
three months ended June 30 nine months ended June 30
-----------------------------------------------------------
2007 2006 2007 2006
------------- ------------- -------------- -------------
Operating
activities
Comprehensive
loss $ (6,475,357) $ (3,741,820) $ (29,366,487) $ (6,962,602)
Items not
involving
cash:
Mark to
market
gain on
available-
for-sale
financial
asset (750,000) (750,000)
Depletion,
depreciation
and
amortization 22,075,786 2,858,191 45,788,147 3,525,307
Writedown of
accounts
receivable 1,252,000 1,252,000
Gain on sale
of assets (13,270,044) (3,374) (13,270,044) (3,374)
Stock-based
compensation 917,621 687,359 2,438,743 2,891,297
Accretion of
asset
retirement
obligation 246,500 10,223 609,886 12,043
Future income
tax (recovery) (3,120,243) - (979,279) -
Change in
unrealized
loss of gas
pricing
contracts
(note 3) - - 536,000 -
Foreign
exchange
loss 96,673 224,909 322,152 270,409
------------- ------------- -------------- -------------
972,936 35,488 6,581,118 (266,920)
------------- ------------- -------------- -------------

Changes in
non-cash
working
capital
balances
related to
operations (1,283,202) (2,770,348) (12,771,621) (2,173,702)
Abandonment
costs (811,338) - (811,338) -
Long term
accounts
receivable - - 1,144,136 -
------------- ------------- -------------- -------------
(1,121,604) (2,734,860) (5,857,705) (2,440,622)
------------- ------------- -------------- -------------

Financing
activities
Advances of
bank loan 35,400,000 - 75,532,316 -
Repayments of
bank loan - - (94,670,719) -
Repayments of
debenture - (14,123,433) - (14,123,433)
Proceeds from
equity
financings,
net of issue
costs - 40,936,004 106,630,074 57,173,576
Proceeds from
sale of
investments 10,000,000 - 10,000,000 -
Exercise of
stock options 119,100 154,751 571,225 154,751
Exercise of
warrants - 10,616,008 12,316,008
------------- ------------- -------------- -------------
45,519,100 37,583,330 98,062,896 55,520,902
------------- ------------- -------------- -------------

Investing
activities
Acquisition of
Atlas Energy
Ltd. - - (2,926,017) -
Acquisition of
Cipher
Exploration
Inc. - - (8,809,049) -
Acquisition of
Pan-Global
Energy Ltd. - 238,929 - 238,929
Acquisition of
Serrano shares (2,500,000) - (2,500,000) -
Additions to
petroleum and
natural gas
properties (51,309,538) (3,327,739) (108,095,249) (16,836,625)
Changes in
non-cash
working
capital from
investing 8,566,025 831,640 25,872,949 -
------------- ------------- -------------- -------------
(45,243,513) (2,257,170) (96,457,366) (16,597,696)
------------- ------------- -------------- -------------

Net increase
(decrease) in
cash (846,017) 32,591,300 (4,252,175) 36,482,584
Cash,
beginning of
period 5,311,410 5,499,596 8,717,568 1,608,312
------------- ------------- -------------- -------------
Cash, end of
period $ 4,465,393 $ 38,090,896 $ 4,465,393 $ 38,090,896
------------- ------------- -------------- -------------
------------- ------------- -------------- -------------

Supplementary
Information
Interest
paid $ 1,185,719 $ - $ 1,700,118 $ -
Capital
taxes
paid $ - $ - $ 80,460 $ -

See accompanying notes to financial statements

 


PEARL EXPLORATION AND PRODUCTION LTD.

Notes to the Consolidated Financial Statements

(unaudited)

1. NATURE OF OPERATIONS

Pearl Exploration and Production Ltd. (collectively with its subsidiaries, the "Company" or "Pearl") is listed and traded on the TSX Venture Exchange under the trading symbol "PXX". The Company is engaged in the business of oil and gas exploration and development in North America. The Company was formerly named Newmex Minerals Inc.; the name change was effective February 28, 2006.

2. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries: Pearl E&P Canada Ltd., Pearl Exploration and Production USA Ltd., Newmex Energy (USA) Inc., Valkyries Texas Corp., Valkyries Texas Gas Ltd. and Cipher Exploration Inc.

The interim consolidated financial statements for the Company have been prepared in accordance with accounting principles generally accepted in Canada, using the same accounting policies and methods of computation as set out in note 2 to the audited consolidated financial statements in the Company's Annual Report for the period ended September 30, 2006. The disclosures provided herein are incremental to those included with the audited consolidated financial statements. The interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the period ended September 30, 2006.

3. CHANGES IN ACCOUNTING POLICIES

As of October 1, 2006, the Company adopted Section 3855 - Financial Instruments Recognition and Measurement, and Section 1530 - Comprehensive Income. In accordance with these standards, the Company adopted the following accounting policies:

(a) Derivatives that are not designated as hedges continue to be carried at market values. Changes in these market values are recorded in net income of the Company. In the event that the Company chooses to designate derivative instruments as cash flow hedges, changes in market values for the effective portion of the hedge will be recorded in Other Comprehensive Income. Changes in the market value for the ineffective portion of the hedges will be recorded in Net Income.

(b) Investments in private companies are recorded at cost. Investments in public companies are recorded at fair value. Changes in the fair value of public companies that are available-for-sale are recognized in Other Comprehensive Income while changes in the fair value of public company investments that are held-for-trading are recognized in Net Income.

4. ACQUISITIONS

Property Acquisitions

(i) Atlas Acquisition -- On December 22, 2006 the Company acquired all of the issued and outstanding shares of Atlas Energy Ltd. ("Atlas") on the basis of 0.82 of a Pearl share for each Atlas share and Atlas became a wholly-owned subsidiary of the Company. The Company issued 55,670,226 common shares and paid $157,000 in cash to the Atlas shareholders upon closing of the Atlas Arrangement. On January 1, 2007 Atlas was amalgamated with Pearl E&P Canada Ltd.

The deemed consideration, including transaction costs, for the Atlas acquisition totaled $267,011,172. The allocation of the purchase price for Atlas is as follows:



Petroleum and natural gas properties $ 243,001,173
Working capital deficiency (92,046,077)
Asset retirement obligation (9,389,295)
Future income tax (12,745,082)
Goodwill 138,190,453
---------------------------------------------------------
$ 267,011,172
---------------------------------------------------------

 


The purchase price for Atlas was adjusted from the amounts disclosed in the December 31, 2006 quarterly financial statements. The adjustments were made as a result of an updated internal oil and gas reserves assessment. The adjustments resulted in a decrease to petroleum and natural gas properties of $65,128,918, a decrease to future income tax of $19,613,899 and an increase to goodwill of $45,515,019.

(ii) Cipher Acquisition - On March 1, 2007, the Company acquired all the issued and outstanding shares of Cipher Exploration Inc. ("Cipher") for a gross purchase price of $20,000,000 in common shares of the Company reduced by an amount equal to the aggregate of all outstanding long and short term debt of Cipher. At closing, the Company issued 2,047,502 common shares to the Cipher shareholders and assumed $10,675,724 of debt.

The deemed consideration, including transaction costs, for the Cipher acquisition totaled $10,307,319. The allocation of the purchase price for Cipher is as follows:



Petroleum and natural gas properties $ 20,000,000
Working capital deficiency (10,675,724)
Asset retirement obligation (1,578,543)
Future income tax (181,030)
Goodwill 2,742,616
---------------------------------------------------------
$ 10,307,319
---------------------------------------------------------


Goodwill Continuity

September 30,
June 30, 2007 2006
--------------------------------------------------------------------------
Opening balance $ 18,930,509 $ -
Acquired during period 140,933,069 18,930,509
--------------------------------------------------------------------------
Closing balance $ 159,863,578 $ 18,930,509
--------------------------------------------------------------------------

 


5. INVESTMENTS



----------------------------------
September 30,
June 30, 2007 2006
----------------------------------
Investment in Serrano Energy Ltd. $ 5,500,000 $ 3,000,000
Investment in Bayou Bend Petroleum Ltd. 11,750,000 -
----------------------------------
$ 17,250,000 $ 3,000,000
----------------------------------

 


On June 13, 2007 the Company acquired an additional 2,074,689 shares of Serrano Energy Ltd. ("Serrano") at a price of $1.205 per share, bringing the total shares to 8,074,689 shares representing 28.267% of Serrano. Subsequent to quarter end, Serrano consolidated its shares on a 2:1 basis.

On May 8, 2007 the Company closed the sale of its Gulf of Mexico assets to Bayou Bend Petroleum Ltd. ("Bayou Bend") as announced on January 18, 2007. In consideration for ten million common shares of Bayou Bend, the Company sold to Bayou Bend a 100% working interest in five Gulf of Mexico offshore exploration blocks, farm-in rights to acquire a 25% working interest in a sixth offshore block and all material contracts, physical data, work products and files and records associated with these blocks. On June 8, 2007 the Company sold five million of its shares of Bayou Bend . At June 30, 2007, the market value of the Bayou Bend shares was $2.35 per share.

6. PETROLEUM AND NATURAL GAS PROPERTIES



-------------------------------------------
June 30, 2007
-------------------------------------------
Accumulated
deprec-
iation and Net
Cost depletion book value

Petroleum and natural gas
properties $ 461,125,448 $ 51,276,087 $ 409,849,361
Office equipment 1,305,599 144,266 1,161,333
-------------------------------------------
$ 462,431,047 $ 51,420,353 $ 411,010,694
-------------------------------------------

-------------------------------------------
September 30, 2006
-------------------------------------------
Accumulated
deprec-
iation and Net
Cost depletion book value

Petroleum and natural gas
properties $ 97,669,414 $ 5,626,440 $ 92,042,974
Office equipment 31,840 5,756 26,084
-------------------------------------------
$ 97,701,254 $ 5,632,196 $ 92,069,058
-------------------------------------------

 


The depletion and ceiling test calculations have excluded the cost of unproved properties of $120.3 million (September 30, 2006 - $6.9 million) and included the cost of future development costs of $53.2 million (September 30, 2006 - $1.6 million).

7. BANK CREDIT FACILITY

The Company has a credit facility with a Canadian chartered bank which, as of June 30, is comprised of a $65 million revolving 364 day extendible term facility, and a $10 million demand revolving operating facility. Subsequent to the semi-annual review, the facility as of August 3, 2007, is comprised of a $50 million revolving 364 day extendible term facility, and a $10 million demand revolving operating facility. The Company may borrow, repay or re-borrow advances with the aggregated outstanding not to exceed the total credit facility. The facility bears interest at the bank prime rate payable monthly and is secured by a general securities agreement.

The facility is subject to semi-annual reviews. The next scheduled review will take place on October 31, 2007.

During the nine months ended June 30, 2007 the Company repaid and cancelled two credit facilities that were acquired through the Nevarro Energy Ltd. and the Atlas acquisitions.

8. RELATED PARTY TRANSACTIONS

Other than as described herein, the Company has entered into transactions with related parties in the normal course of business, which were valued at the exchange amount established and agreed to by the related parties. During the nine months ended June 30, 2007 the related party transactions were as follows:

(a) the Company paid $168,778 (2006 - $38,171) to Tanganyika Oil Company Ltd. ("Tanganyika") for administrative and other services. The Company and Tanganyika have certain officers and directors in common.

(b) the Company borrowed $3,000,000 on October 27, 2006 from Tanganyika which was repayable on or before November 30, 2006. Interest was charged at a rate equal to prime plus 2% per annum. The Company repaid the loan in full on November 22, 2006 plus accrued interest of $18,195.

9. SHARE CAPITAL

(a) Authorized:

The Company is authorized to issue an unlimited number of common shares.

(b) Common Shares Issued:



Attributed
Number of Shares Value
---------------- -------------
Balance as at September 30, 2006 51,913,016 $ 112,613,584
Shares issued through equity financing (i) 24,153,845 110,999,994
Shares issued for Atlas acquisition (ii) 55,670,226 264,085,155
Shares issued for Cipher acquisition (iii) 2,047,502 9,792,174
Shares issued upon exercise of options 165,000 1,129,388
Tax effect of December 2006 flow-through (iv) (3,106,000)
Equity financing share issue costs (4,369,920)
---------------- -------------
Balance as at June 30, 2007 133,949,589 $ 491,144,375
---------------- -------------

(i) On November 15, 2006, the Company completed an equity financing of
common shares, and flow-through shares for gross proceeds of $111
million. 22,444,444 common shares were issued at a price of $4.50 each
and 1,709,401 of flow-through common shares were issued at a price of
$5.85 each. A 3.9 percent underwriters fee was paid to qualified
persons in respect of a portion of the equity financing.

(ii) The Company issued 55,670,226 common shares to Atlas shareholders
pursuant to the Atlas Arrangement which provided for the acquisition
by the Company of all the issued and outstanding Atlas shares
(see note 4).

(iii) The Company issued 2,047,502 common shares to Cipher shareholders for
the acquisition of all the issued and outstanding shares of Cipher
(see note 4).

(iv) Pursuant to the flow-through Common Share offering, the Company
renounced $10.0 million of qualifying oil and natural gas expenditures
effective December 31, 2006. The future income tax effect and
reduction to share capital has been recorded in the first quarter of
2007, the period in which the Company filed the renouncement documents
with the tax authorities.

 


(c) Warrants Outstanding:



--------------------------------------------------------------------------
Weighted
average
Number of exercise price
whole warrants per share
--------------------------------------------------------------------------
Balance as at June 30, 2007 and
September 30, 2006 4,091,800 $ 0.98
--------------------------------------------------------------------------

 


(i) Four million warrants were issued pursuant to the San Miguel acquisition in November 2005. Each warrant entitles the holder thereof to purchase an additional common share of the Company at a price of $1.00, exercisable from the date the San Miguel heavy oil project achieves an average daily producing rate of 5,000 barrels of oil per day, averaged over 30 consecutive days, until November 18, 2008.

(ii) Initially 270,000 warrants were issued pursuant to the Palo Duro acquisition. This number was subsequently reduced by 66% to 91,800 when the vendor exercised a back-in right on March 3, 2006. Each warrant provides the warrant holder with the right to receive an additional 91,800 common shares of the Company, within 75 days of the third anniversary of the memorandum of understanding, for no additional consideration, if the average production rate per well drilled in the Palo Duro shale gas project is at least 1.5 million cubic feet equivalent per day, based on the initial 60 days of production. The number of warrants issued will be reduced pro rata to the actual average production rate if the actual average production rate per well drilled by September 15, 2008 is less than 1.5 million cubic feet equivalent per day.

(d) Stock Options

The Company has a stock option plan (the "plan") for directors, officers, consultants and employees of the Company and its subsidiaries. A total of 13,394,959 stock options are authorized to be issued under the plan. The plan is administered by the Board of Directors. In accordance with the policies of the TSX Venture Exchange, the option exercise price, when granted, reflects current trading values of the Company's shares and all of the options are subject to a four-month "hold" period. The exercise period of the options is fixed by the Board of Directors and is not to exceed the maximum period permitted by the TSX Venture Exchange. Vesting rights are determined at the discretion of the Board of Directors.

The continuity of incentive stock options issued and outstanding is as follows:

Stock option continuity



Weighted Average
Number of Options Exercise Price $
--------------------------------------
Outstanding September 30, 2006 1,752,500 4.11
Granted 2,916,000 5.13
Exercised (165,000) 3.46
Cancelled (224,833) 4.54
----------------- ----------------
Outstanding at June 30, 2007 4,278,667 4.79
----------------- ----------------

 


Stock-based compensation

Compensation expense for the nine month period of $2,438,743, net of recovery of $192,086 for cancelled stock options, has been recorded in the Consolidated Statements of Operations and Deficit for the period ended June 30, 2007 (2006 -- $2,891,297). The fair value of common share options granted is estimated on the date of grant using the Black-Scholes option pricing model. The weighted average fair value of options granted during 2007 and the assumptions used in their determination are as noted below:



Nine Months
Ended June 30,
2007
-------------

Weighted average fair value of stock options granted
(per option) $ 2.385
Expected life of stock options (years) 3.06
Volatility (weighted average) 67%
Risk free rate of return (weighted average) 3.93%
Expected dividend yield 0%


September 30,
Contributed surplus continuity June 30, 2007 2006
----------------------------
Balance, beginning of the period $ 4,791,060 $ 816,444
Stock-based compensation 2,630,829 3,411,784
Stock-based compensation allocated to
contributed surplus as part of Pan-Global
acquisition - 800,957
Recovery of expense on cancelled stock options (192,086)
Transfer to share capital on exercise of options (558,163) (238,125)
------------- -------------
Balance, end of period $ 6,671,640 $ 4,791,060
------------- -------------

 


10. COMMITMENTS AND CONTRACTUAL OBLIGATIONS

The Company enters into commitments and contractual obligations in the normal course of business, including the purchase of services, farm-in agreements, royalty agreements, operating agreements, transportation agreements, processing agreements, right of way agreements and lease agreements for vehicles.

(a) On January 1, 2006, the Company entered into a consulting agreement with Rincon Energy, LLC ("Rincon") whereby Rincon will provide consulting services for the purpose of generating oil and gas prospects in the Gulf of Mexico and California and any other areas as mutually agreed upon by the Company and Rincon. The consulting agreement is for an initial term of two years, with the ability of the Company to extend the agreement for an additional two years. The consulting fee payable is US $60,000 per month plus certain overriding royalty interests, back-in rights and participation rights. Under the agreement, the Company is committed to spend US $7.5 million per year for the initial two year term of the contract for general administration and overhead, licensing seismic data, obtaining leases and drilling wells in pursuit of prospects as defined in the agreement. For the 2006 calendar, the Company met its obligations under the agreement. In May 2007, the Company closed the sale of its interests in all of its Gulf of Mexico assets, including the Rincon consulting agreement, to Bayou Bend Petroleum Ltd. and the Company has no further commitments under the Rincon consulting agreement.

(b) The Company has a ten year operating lease for leased space. The estimated future commitments are as follows:



-------------------------------------------------------------------------
Subsequent
2007 2008 2009 2010 2011 to 2011
-------------------------------------------------------------------------
Office rent $ 360,918 $ 745,229 $ 761,938 $ 785,331 $ 802,040 $3,702,751
-------------------------------------------------------------------------

 


(c) The Company renounced $10.0 million of qualifying oil and natural gas expenditures effective December 31, 2006 pursuant to the flow-through share offering which closed on November 15, 2006. By June 30, 2007, the Company had incurred $2.5 million of qualifying expenditures and has an additional commitment to expend $7.5 million on qualifying expenditures by December 31, 2007.

11. FINANCIAL INSTRUMENTS

The Company does not utilize derivative instruments to manage risks. The Company is exposed to the following risks related to financial assets and liabilities:

(a) Foreign currency exchange risk

The Company is exposed to risks arising from fluctuations in foreign currency exchange rates and the volatility of those rates. This exposure primarily relates to: (i) certain expenditure commitments, deposits, accounts receivable, and accounts payable which are denominated in US dollars, and (ii) its operations in the United States.

(b) Fair values

The carrying amounts of financial instruments comprising cash, accounts receivable, advances and loans receivable, investments and accounts payable approximate their fair value due to the immediate or short-term nature of these financial instruments.

12. SEGMENTED INFORMATION

The Company presently has one reportable business segment, that being oil and gas exploration and development. The Company's operations are carried on in the following geographic locations:



Three Months Ended June 30, 2007
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of
royalties $ 23,330,845 $ 188,923 $ 23,519,768

Expenses 40,214,337 241,423 40,455,760
Foreign currency loss 96,673 - 96,673
Gain on sale of assets - (13,270,044) (13,270,044)
------------- ------------- --------------
Net income (loss) before
income taxes (16,980,165) 13,217,544 (3,762,621)
Income taxes (2,988,890) 6,451,626 3,462,736
------------- ------------- --------------
Net income (loss) $ (13,991,275) $ 6,765,918 $ (7,225,357)
------------- ------------- --------------
------------- ------------- --------------

Segment assets $ 581,178,300 $ 39,613,292 $ 620,791,592
------------- ------------- --------------
Goodwill $ 159,863,578 $ - $ 159,863,578
------------- ------------- --------------
Segment petroleum and
natural gas properties $ 384,617,319 $ 26,393,375 $ 411,010,694
------------- ------------- --------------
Capital additions, net of
disposals $ 49,607,206 $ (5,771,479) $ 43,835,727
------------- ------------- --------------


Nine Months Ended June 30, 2007
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of
royalties $ 47,210,489 $ 1,049,321 $ 48,259,810

Expenses 83,503,028 1,833,451 85,336,479
Foreign currency loss 322,152 - 322,152
Gain on sale of assets - (13,270,044 (13,270,044)
------------- ------------- --------------
Net income (loss) before
income taxes (36,614,691) 12,485,914 (24,128,777)
Income taxes (463,916) 6,451,626 5,987,710
------------- ------------- --------------
Net income (loss) $ (36,150,775) $ 6,034,288 $ (30,116,487)
------------- ------------- --------------
------------- ------------- --------------

Segment assets $ 581,178,300 $ 39,613,292 $ 620,791,592
------------- ------------- --------------
Goodwill $ 159,863,578 $ - $ 159,863,578
------------- ------------- --------------
Segment petroleum and natural
gas properties $ 384,617,319 $ 26,393,375 $ 411,010,694
------------- ------------- --------------
Capital additions $ 359,280,435 $ 5,449,358 $ 364,729,793
------------- ------------- --------------


Three Months Ended June 30, 2006
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of
royalties $ 748,083 $ 673,712 $ 1,421,795

Expenses 4,121,267 912,562 5,033,829
Foreign currency loss 133,160 - 133,160
Gain on sale (3,374) - (3,374)
------------- ------------- --------------
Loss before income taxes (3,502,970) (238,850) (3,741,820)
Income taxes - - -
------------- ------------- --------------
Net loss $ (3,502,970) $ (238,850) $ (3,741,820)
------------- ------------- --------------
------------- ------------- --------------

Segment assets $ 77,851,340 $ 20,130,611 $ 97,981,951
------------- ------------- --------------
Segment petroleum and natural
gas properties $ 37,638,781 $ 19,410,347 $ 57,049,128
------------- ------------- --------------
Capital additions $ 38,588,083 $ 2,906,448 $ 41,494,531
------------- ------------- --------------


Nine Months Ended June 30, 2006
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Canada USA Consolidated
--------------------------------------------------------------------------
Total revenues, net of
royalties $ 829,482 $ 1,045,200 $ 1,874,682

Expenses 6,465,842 2,104,407 8,570,249
Foreign currency loss 270,409 - 270,409
Gain on sale (3,374) - (3,374)
------------- ------------- --------------
Loss before income taxes (5,903,395) (1,059,207) (6,962,602)
Income taxes - - -
------------- ------------- --------------
Net loss $ (5,903,395) $ (1,059,207) $ (6,962,602)
------------- ------------- --------------
------------- ------------- --------------

Segment assets $ 77,851,340 $ 20,130,611 $ 97,981,951
------------- ------------- --------------
Segment petroleum and natural
gas properties $ 37,638,781 $ 19,410,347 $ 57,049,128
------------- ------------- --------------
Capital additions $ 39,491,072 $ 20,933,363 $ 60,424,435
------------- ------------- --------------

 


13. ASSET RETIREMENT OBLIGATION

The total future asset retirement obligation was estimated based on the Company's net ownership interest in all wells and facilities, the estimated costs to abandon and reclaim the wells and facilities and the estimated timing of the costs to be incurred in future periods. The total undiscounted amount of the estimated cash flows required to settle the asset retirement obligations is approximately $26.8 million which will be incurred over the next 47 years with the majority of costs incurred between 2008 and 2025. A credit adjusted risk-free rate of 8 percent and an inflation factor of 1.5 percent was used to calculate the fair value of the asset retirement obligation.

Changes to asset retirement obligation were as follows:



June 30, 2007 Sept. 30, 2006
--------------------------------------------------------------------------
Asset retirement obligation at beginning
of period $ 3,772,479 $ -
Liabilities acquired through
acquisitions 10,967,837 3,490,224
Liabilities incurred during the period 1,363,317 240,462
Liabilities settled during the period (811,338) -
Accretion 609,888 41,793
--------------------------------------------------------------------------
Asset retirement obligation at end of
period $ 15,902,183 $ 3,772,479
--------------------------------------------------------------------------

 


On January 20, 2006, the Company acquired certain US assets from Valkyries Petroleum Corp. ("Valkyries"). Pursuant to the acquisition agreement, the Company may be required to pay additional consideration to Valkyries if three selected properties, referred to in the acquisition agreement as the Topanga, Amber and Mustang Island prospects, have additional net proved reserves within two years of the closing of the transaction. The additional consideration would be calculated as US $1.00 per barrel of additional reserves to be calculated by deducting the net proved reserves from the reserve report date September 1, 2005 prepared by Ryder Scott, from a reserve report to be prepared by a reserves evaluator acceptable to Valkyries and the Company.

The Amber prospect resulted in the drilling of a dry hole thereby eliminating the contingency for additional consideration. The contingency for additional consideration for Mustang Island has been transferred to Bayou Bend Petroleum Ltd. as part of the sale of the Company's Gulf of Mexico assets as described in note 5. Therefore the only remaining contingency for the Company is related to the Topanga prospect.

15. SUBSEQUENT EVENTS

On July 12, 2007 the Company closed its recently announced private placement. The Company sold on a non-brokered, private placement basis an aggregate of twelve (12) million common shares of the Company at a price of $5.05 per share for gross proceeds of $60.6 million. A 4% finder's fee is payable on a portion of the private placement. The shares issued pursuant to the private placement are subject to a four-month hold period expiring on November 12, 2007.

On August 2, 2007, the Company announced that it had closed the acquisition of a 24% working interest in the Mooney oil field from Ravenwood Energy Corp. ("Ravenwood"), a private oil and gas company. The acquisition will bring Pearl's working interest in the Mooney field to over 98% and will add approximately 625 boepd in current production. Pearl purchased Ravenwood's working interest for $20 million, net of standard industry adjustments, effective July 1, 2007. The net purchase price was comprised of $7.6 million in cash and 1,475,108 of Pearl common shares at a deemed value of $5.12 per share. On August 2, 2007, the Company announced that it had signed an agreement to acquire all of the issued and outstanding shares of Watch Resources Ltd. ("Watch"). Subject to necessary approvals, Pearl will acquire Watch in an all-share transaction at an exchange ratio of 0.23 common shares of Pearl for each common share of Watch pursuant to a plan of arrangement. The key producing asset of Watch is its Fishing Lake conventional heavy oil field in north-central Alberta. Based on the closing price of Pearl shares of $4.71 on August 1, 2007, the total transaction is valued at approximately $55 million.

16. SUMMARY OF SIGNIFICANT DIFFERENCES BETWEEN CANADIAN GAAP AND INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

The Company's consolidated financial statements have been prepared in accordance with Canadian GAAP, which differ in certain material respects from International Financial Reporting Standards ("IFRS"). The principal difference between Canadian GAAP and IFRS from a measurement perspective, as applied to the Company's consolidated financial statements, is asset impairment.

(a) Impairment of petroleum and natural gas properties

Under Canadian GAAP, each cost centre should be assessed for impairment as at each annual balance sheet date or whenever events or changes in circumstances indicate that its carrying amount of a cost centre is not recoverable and exceeds its fair value. The carrying amount is not recoverable if the carrying amount exceeds the sum of the undiscounted cash flows expected to result from its use and eventual disposition. Unproved properties and major development projects are included in this recoverability test. A cost centre impairment loss should be measured as the amount by which the carrying amount of assets capitalized in a cost centre exceeds the sum of: the fair value of proved and probable reserves; and the costs (less any impairment) of unproved properties that have been subject to a separate test for impairment and contain no probable reserves. IFRS requires (i) an impairment to be recognized when the recoverable amount of an asset (cash generating unit) is less than the carrying amount; (ii) the impairment loss is determined as the excess of the carrying amount above the recoverable amount ( the higher of fair value less costs to sell and value in use, calculated as the present value of future cash flows from the asst); and (iii) the reversal of an impairment loss when the recoverable amount changes. The differences in accounting policy described above had no impact on these consolidated financial statements.

(b) Petroleum and natural gas properties

The Company follows the full cost method of accounting for petroleum and natural gas properties, as set out in AcG 16 issued by the CICA. Under this method, all costs related to exploration and development of oil and gas reserves are capitalized and accumulated in country- by-country cost centres. For purposes of reporting in accordance with IFRS, the Company has early adopted IFRS 6, Exploration For and Evaluation of Mineral Resources, which permits an entity to continue applying its existing policy in respect of exploration and evaluation costs. Under IFRS, once commercial reserves are established and technically feasibility for extraction is demonstrated, the related capitalized costs are allocated to cash generating units. This difference in accounting policy had no significant impact on the Company's consolidated financial statements.

(c) Impairment of long lived assets

Under Canadian GAAP, a long lived asset should be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. An impairment loss should be recognized when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. Under IFRS, the carrying amounts of the Company's assets, other than petroleum and natural gas properties, are reviewed at each balance sheet date to determine whether there is any indication of impairment. If any such indication exists, the assets' recoverable amounts are estimated. An impairment loss is recognized when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from its use and eventual disposition. This assessment is based on the carrying amount of the asset at the date it is tested for recoverability, whether it is in use or under development. Under IFRS, the recoverable amount of the Company's assets, other than petroleum and natural gas properties, is the greater of their net selling price and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. For an asset that does not generate cash inflows largely independent of those from other assets, the recoverable amount is determined for the cash generating unit to which the asset belongs. In respect of impairment of assets other than petroleum and natural gas properties, under Canadian GAAP, an impairment loss is not reversed if the fair value subsequently increases. For IFRS, an impairment loss may be reversed if there has been a change in the estimates used to determine the recoverable value. An impairment loss, on assets other than petroleum and natural gas properties, is only reversed to the extent that the asset's carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortization, if no impairment loss had been recognized. The differences in accounting policy described above had no impact on these consolidated financial statements.



DIRECTORS CORPORATE INFORMATION

Lloyd Arnason
Director
Calgary, Alberta CORPORATE OFFICE
Suite 2500, 111 -- 5th Avenue S.W.
Brian D. Edgar Calgary, Alberta
Director T2P 3Y6 Canada
Vancouver, British Columbia Telephone: (403) 215-8313
Facsimile: (403) 265-8324
Gary S. Guidry Website: www.pearleandp.com
Director
Calgary, Alberta
BANKER
Gordon D. Harris CIBC
Director ATB Financial
Calgary, Alberta Calgary, Alberta

Keith C. Hill
Director
Vancouver, British Columbia AUDITOR
PricewaterhouseCoopers LLP
John W. Ladd 111-5th Avenue S.W.
Director Calgary, Alberta
Houston, Texas

Lukas Lundin TRANSFER AGENT
Director Computershare Trust Company of Canada
Vancouver, British Columbia 600, 530-8th Avenue S.W.
Calgary, Alberta
A. Murray Sinclair
Director
Vancouver, British Columbia STOCK EXCHANGE LISTING
TSX Venture Exchange
Trading Symbol: PXX
OFFICERS
COMPANY REGISTRATION NUMBER
Gary S. Guidry 409596-1
Chairman
Calgary, Alberta
The report for the fourth quarter 2007
Keith C. Hill will be published on November 14,
President & Chief Executive Officer 2007.
Vancouver, British Columbia

Gary G. Hyde
Chief Operating Officer
Calgary, Alberta

Arlene E. Weatherdon
Chief Financial Officer
Calgary, Alberta

Diane Phillips
Corporate Secretary
Calgary, Alberta

 


FOR FURTHER INFORMATION PLEASE CONTACT:


Pearl Exploration and Production Ltd.
Sophia Shane
Corporate Development
(604) 689-7842
(604) 689-4250 (FAX)
Email: sophias@namdo.com
Website: www.pearleandp.com
 
 

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