-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, S9oEidLVYD4mejPSbvrFYW8KLZY9BXk/srNnW0Mcn+yRr7Gmff8CiGfed4/h4SHs eQ0yZUg5r/O5+pJvu9qAyA== 0000899243-00-000577.txt : 20000327 0000899243-00-000577.hdr.sgml : 20000327 ACCESSION NUMBER: 0000899243-00-000577 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000324 FILER: COMPANY DATA: COMPANY CONFORMED NAME: BELLWETHER EXPLORATION CO CENTRAL INDEX KEY: 0000319459 STANDARD INDUSTRIAL CLASSIFICATION: CRUDE PETROLEUM & NATURAL GAS [1311] IRS NUMBER: 760437769 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-09498 FILM NUMBER: 578370 BUSINESS ADDRESS: STREET 1: 1331 LAMAR STREET 2: SUITE 1455 CITY: HOUSTON STATE: TX ZIP: 77010 BUSINESS PHONE: 7136501025 MAIL ADDRESS: STREET 1: 1221 LAMAR STREET 2: STE 1600 CITY: HOUSTON STATE: TX ZIP: 77010-3039 10-K405 1 FORM 10-K405 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 0-9498 BELLWETHER EXPLORATION COMPANY (Exact name of registrant as specified in its charter) Delaware 76-0437769 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 1331 Lamar, Suite 1455, Houston, Texas 77010 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (713) 650-1025 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $0.01 par value NASDAQ/NMS Preferred Stock purchase rights Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant at March 10, 2000 was approximately $92,691,653. As of March 10, 2000, the number of outstanding shares of the registrant's common stock was 13,860,390 Documents Incorporated by Reference: Portions of the registrant's annual proxy statement, to be filed within 120 days after December 31, 1999, are incorporated by reference into Part III. BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES ANNUAL REPORT ON FORM 10-K For the Year Ended December 31, 1999 TABLE OF CONTENTS
PAGE Number ------ PART I Item 1. Business............................................................................. 3 Item 2. Properties........................................................................... 9 Item 3. Legal Proceedings.................................................................... 19 Item 4. Submission of Matters to a Vote of Security Holders.................................. 19 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters............ 20 Item 6. Selected Financial Data.............................................................. 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7a. Quantitative and Qualitative Disclosures About Market Risk........................... 29 Item 8. Financial Statements and Supplementary Data.......................................... 31 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 62 PART III Item 10. Directors and Executive Officers of the Registrant................................... 62 Item 11. Executive Compensation............................................................... 62 Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 62 Item 13. Certain Relationships and Related Transactions....................................... 62 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................... 62 -- Signatures
BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES PART I Item 1. Business Forward Looking Statements This annual report on Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934 ("Exchange Act"). All statements other than statements of historical fact included herein regarding the Company's financial position, estimated quantities and net present values of reserves, business strategy, plans and objectives for future operations and covenant compliance, are forward-looking statements. The Company can give no assurances that the assumptions upon which these statements are based will prove to have been correct. Important factors that could cause actual results to differ materially from the Company's expectations ("cautionary statements") are disclosed under Risk Factors and elsewhere herein. All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified by the cautionary statements. General Bellwether Exploration Company ("Bellwether" or the "Company") is an independent energy company engaged in the acquisition, exploitation, development, exploration and production of oil and gas properties. The Company's core area of activity is southeastern New Mexico, west Texas, the Texas/Louisiana Gulf Coast, both on and offshore, Latin America and the Ukraine. At December 31, 1999, the Company's estimated net proved reserves, using constant prices which were in effect at such date, totaled 14.7 MMBbl of oil, 2.1 MMBbl of natural gas liquids ("NGL"), and 130 Bcf of natural gas for a total of 38.5 million barrels of oil equivalent ("MBOE"). On an equivalency basis, approximately 56% of the Company's estimated net proved reserves were natural gas and 79% were developed at such date. In addition, the Company has interests in natural gas processing plants in California and West Texas. In order to facilitate greater comparability with its peer group by the financial community, the Company changed its fiscal year to the calendar year, beginning January 1, 1998. This resulted in a six-month transition period of July 1, 1997 through December 31, 1997 ("transition period"). Oil and Gas Activities In 1987 and 1988, the Company merged with two independent oil and gas companies owned by institutional investors and managed by Torch Energy Advisors Incorporated ("Torch"). Since those mergers, the Company has operated under agreements, pursuant to which the Company outsources certain administrative functions to Torch. In April 1997, the Company acquired oil and gas properties and $13.9 million of working capital from affiliates of Torch ("Partnership Transactions"), for $141.1 million after purchase price adjustments. The Company financed the Partnership Transactions and related fees, with $34.1 million net proceeds of a Common Stock offering, $97.0 million net proceeds of $100.0 million offering of 10 7/8% Senior Subordinated Notes due 2007 (the "Offerings") and advances under a new credit facility ("New Credit Facility" or "Senior Credit Facility"). In addition, as consideration for advisory services, Torch was issued 150,000 shares of the Company's common stock and a warrant, expiring in April 2002, to purchase 100,000 shares of common stock at $9.90 per share. The warrant and shares were valued at $1.5 million and recorded as a cost of the Partnership Transactions. Subsequent to the Partnership Transactions, the Company identified for divestiture non-core properties including approximately 10% of the estimated net proved reserves attributable to the Partnership Transactions. These properties were primarily small working interests in geographically diverse locations, with generally lower operating margins and limited development potential. Such properties were sold in a series of transactions from May 1997 to December 1997 for aggregate consideration of $24 million. The net proceeds from these divestitures were used to repay indebtedness. 3 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES In December 1998 Bellwether was the successful bidder for the Charapa field in Ecuador. With the successful bid, the Company was awarded with a contract for production and exploration of crude oil in the Charapa field. The contract provides the Company with approximately 50% of the crude oil produced above the base production curve. The base production curve is defined as the production profile of the crude oil projected by the Ecuadorian government hydrocarbons' subsidiary. Bellwether is also entitled to recoup lease operating expenses associated with the base production. Negotiations with the Ecuadorian government took place throughout 1999 with Bellwether officially taking over operations of the field in January of 2000. Bellwether has committed to a $12 million work program over three years. During 1998, in connection with a possible transaction by the Company with Carpatsky Petroleum Company ("Carpatsky"), the Company agreed to guarantee $500,000 of indebtedness of Carpatsky to Torch Energy Advisors Incorporated. ("Torch"). The Carpatsky note to Torch went into default in June 1998. Under an agreement effective October 31, 1999, Bellwether paid Torch $565,700 for the guaranty. The Company received in exchange 4.5 million shares of Carpatsky and a warrant to acquire an additional 967,296 common shares. On December 30, 1999 Bellwether purchased 95.45 million preferred shares of Carpatsky Petroleum, Inc. and warrants to acquire 12.5 million common shares for $4 million. The preferred shares are convertible into 50 million Carpatsky common shares (approximately 43% of the Carpatsky's equity), do not carry a preferential dividend and have majority voting rights over Carpatsky. In connection with this investment, Mr. J.P. Bryan, Chairman and Chief Executive Officer of Bellwether became the Chairman and CEO of Carpatsky and three Carpatsky directors retired and were replaced by three Bellwether appointees, giving Bellwether five of the new eight directorships of Carpatsky. Carpatsky conducts oil and gas exploration and production activities in the Republic of Ukraine. Business Strategy The Company is committed to providing outstanding performance in all categories of financial measurement in order to become a significant international exploration and production company. This vision is dictated by the following business strategy: Acquire, Exploit and lastly, Explore. The Company believes that acquiring oil and gas reserves is the most effective way to increase shareholder value. Once a property has been acquired, the Company immediately employs and aggressive exploitation program to increase production, reduce operating costs and develop low risk exploration opportunities. Emphasize Acquisition of International Properties with Significant Development Upside. The Company focuses on acquisition opportunities in the international arena in an effort to realize significant value in areas that other companies of Bellwether's size are not operating. The Company reviews acquisition opportunities spanning the globe, but focuses particularly in Latin America and Eastern Europe. Focus Activities in Core Areas. The Company will enhance its competitive position by focusing its activities within core geographic areas where it has significant existing assets and infrastructure, superior technical expertise and experience, a technical/operational database and demonstrated business know-how. The Company considers the Texas-Louisiana Gulf Coast, both on and offshore, Latin America and Eastern Europe to be its core areas. The Company may seek to establish additional core areas in the future which are complementary to its strategy. Contain and Reduce Cost. In order to maintain a competitive cost structure and to increase efficiency, the Company will continuously seek to reduce cost, whether operating, capital or overhead. In this regard the Company outsources certain non-strategic functions. Additionally, the Company will regularly review its property base 4 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES aggressively exploiting identified opportunities and divesting non-core or lower margin assets and redeploying capital to a higher use. Concentrate on High Value Operated Properties. The Company will increase efficiency, establish greater control and enhance economic impact with respect to its activities through concentrating its holdings in a fewer number of higher value properties, a majority of which it will seek to operate. Achievement of this objective will be a principal targeting criteria in the execution of its acquisition and divestiture strategies. Toward this end the Company's exploration program will emphasize internal prospect generation as well as strategic relationships with prospect generators having demonstrated expertise within a particular play type or area of interest. Be Technology Driven. The Company will seek to improve its success rates and reduce its finding and operating costs by employing the latest state of the art technology in its exploration, development and operating activities. Its exploration and development program will utilize 3-D seismic evaluation, sophisticated seismic processing and modeling tools and computer aided exploration and development systems. Operationally the Company will employ horizontal drilling, enhanced recovery methods and advanced completion and production techniques. Use an Interdisciplinary Approach. The Company utilizes interdisciplinary teams comprised of geologists, geophysicists and engineers in the generation and evaluation of acquisition, exploration and exploitation investment opportunities. Through this approach the Company will maximize the identification and quantification of opportunities and reduce risk through the application of complementary experience, know-how and technology. The Company will target opportunities which offer multiple application of successful concepts and are on trend with and extensions of existing applications of such concepts. Markets Bellwether's ability to market oil and gas from the Company's wells depends upon numerous domestic and international factors beyond the Company's control, including: 1) the extent of domestic production and imports of oil and gas, 2) the proximity of gas production to gas pipelines, 3) the availability of capacity in such pipelines, 4) the demand for oil and gas by utilities and other end users, 5) the availability of alternate fuel sources, 6) the effects of inclement weather, 7) state, federal and international regulation of oil and gas production and 8) federal regulation of gas sold or transported in interstate commerce. No assurances can be given that Bellwether will be able to market all of the oil or gas produced by the Company or that favorable prices can be obtained for the oil and gas Bellwether produces. In view of the many uncertainties affecting the supply of and demand for oil, gas and refined petroleum products, the Company is unable to predict future oil and gas prices and demand or the overall effect such prices and demand will have on the Company. The marketing of oil and gas by Bellwether can be affected by a number of factors, which are beyond the Company's control, the exact effects of which cannot be accurately predicted. Sales to Torch Co-Energy LLC accounted for approximately 22%, 28% and 22% of fiscal year 1999, 1998 and transition period 1997 revenues, respectively. Sales to Valero Industrial Gas, L.P. accounted for 18.0% of fiscal 1997 revenues. Management of the Company does not believe that the loss of any single customer or contract would materially affect the Company's business. There are no other significant delivery commitments and substantially all of the Company's U.S. oil and gas production is sold at market responsive pricing through a marketing affiliate of Torch. While there is no 1999 production from Bellwether's Ecuadorian or Ukrainian assets, the Ecuador crude oil will be marketed by YPF and the Ukraine crude oil is sold on the spot market into the domestic market. The Company from time to time may enter into crude oil and natural gas price swaps or other similar hedge transactions to reduce its exposure to price fluctuations. 5 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Regulation Federal Regulations Transportation of Gas. The Company's sales of natural gas are affected by the availability, terms and cost of transportation. The rates, terms and conditions applicable to the interstate transportation of gas by pipelines are regulated by the Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, the FERC has implemented regulations intended to increase competition within the gas industry by making gas transportation more accessible to gas buyers and sellers on an open-access, non-discriminatory basis. The FERC has announced several important transportation-related policy statements and rule changes, including a statement of policy and final rule issued February 25, 2000, concerning alternatives to its traditional cost-of- service rate-making methodology to establish the rates interstate pipelines may charge for their services. The final rule revises FERC's pricing policy and current regulatory framework to improve the efficiency of the market and further enhance competition in natural gas markets. Sales and Transportation of Oil. Sales of oil and condensate can be made by the Company at market prices not subject at this time to price controls. The price that the Company receives from the sale of these products will be affected by the cost of transporting the products to market. As required by the Energy Policy Act of 1992, the FERC has revised its regulations governing the rates that may be charged by oil pipelines. The new rules, which were effective January 1, 1995, provide a simplified, generally applicable method of regulating such rates by use of an indexing system for setting transportation rate ceilings. In certain circumstances, the new rules permit oil pipelines to establish rates using traditional cost of service and other methods of rate making. Legislative Proposals. In the past, Congress has been very active in the area of gas regulation. There are legislative proposals pending in the state legislatures of various states, which, if enacted, could significantly affect the petroleum industry. At the present time it is impossible to predict what proposals, if any, might actually be enacted by Congress or the various state legislatures and what effect, if any, such proposals might have on the Company's operations. Federal, State or Indian Leases. In the event the Company conducts operations on federal, state or Indian oil and gas leases, such operations must comply with numerous regulatory restrictions, including various nondiscrimination statutes, and certain of such operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the Bureau of Land Management ("BLM") or, in the case of the Company's Outer Continental Shelf ("OCS") leases in federal waters, Minerals Management Service ("MMS") or other appropriate federal or state agencies. The Company's OCS leases in federal waters are administered by the MMS and require compliance with detailed MMS regulations and orders. The MMS has promulgated regulations implementing restrictions on various production-related activities, including restricting the flaring or venting of natural gas. Under certain circumstances, the MMS may require any Company operations on federal leases to be suspended or terminated. Any such suspension or termination could materially and adversely affect the Company's financial condition and operations. On March 15, 2000, the MMS issued a final rule effective June , 2000, which amends its regulations governing the calculation of royalties and the valuation of crude oil produced from federal leases. Among other matters, this rule amends the valuation procedure for the sale of federal royalty oil by eliminating posted prices as a measure of value and relying instead on arm's length sales prices and spot market prices as market value indicators. Because the Company sells its production in the spot market and, therefore, pays royalties on production from federal leases, it is not anticipated that this final rule will have any substantial impact on the Company. The Mineral Leasing Act of 1920 (the "Mineral Act") prohibits direct or indirect ownership of any interest in federal onshore oil and gas leases by a foreign citizen of a country that denies "similar or like privileges" to citizens of the United States. Such restrictions on citizens of a "non- reciprocal" country include ownership or 6 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES holding or controlling stock in a corporation that holds a federal onshore oil and gas lease. If this restriction is violated, the corporation's lease can be canceled in a proceeding instituted by the United States Attorney General. Although the regulations of the BLM (which administers the Mineral Act) provide for agency designations of non-reciprocal countries, there are presently no such designations in effect. The Company owns interests in numerous federal onshore oil and gas leases. It is possible that the Common Stock will be acquired by citizens of foreign countries, which at some time in the future might be determined to be non-reciprocal under the Mineral Act. State Regulations. Most states regulate the production and sale of oil and gas, including: 1) requirements for obtaining drilling permits, 2)the method of developing new fields, 3) the spacing and operation of wells and 4) the prevention of waste of oil and gas resources. The rate of production may be regulated and the maximum daily production allowable from both oil and gas wells may be established on a market demand or conservation basis or both. The Company owns certain natural gas pipeline facilities that it believes meet the traditional tests the FERC has used to establish a pipeline's status as a gatherer not subject to FERC jurisdiction under the NGA. State regulation of gathering facilities generally includes various safety, environmental, and in some circumstances, nondiscriminatory take requirements, but does not generally entail rate regulation. The Company may enter into agreements relating to the construction or operation of a pipeline system for the transportation of gas. To the extent that such gas is produced, transported and consumed wholly within one state, such operations may, in certain instances, be subject to the jurisdiction of such state's administrative authority charged with the responsibility of regulating intrastate pipelines. In such event, the rates which the Company could charge for gas, the transportation of gas, and the construction and operation of such pipeline would be subject to the rules and regulations governing such matters, if any, of such administrative authority. Environmental Regulations General. The Company's activities are subject to existing federal, state and local laws and regulations governing environmental quality and pollution control. Activities of the Company with respect to gas facilities, including the operation and construction of pipelines, plants and other facilities for transporting, processing, treating or storing gas and other products, are also subject to stringent environmental regulation by state and federal authorities including the Environmental Protection Agency ("EPA"). Risks are inherent in oil and gas exploration and production operations, and no assurance can be given that significant costs and liabilities will not be incurred in connection with environmental compliance issues. The Company cannot predict what effect future regulation or legislation, enforcement policies issued thereunder, and claims for damages to property, employees, other persons and the environment resulting from the Company's operations could have on its activities. Solid and Hazardous Waste. The Company currently owns or leases, and has in the past owned or leased, numerous properties that for many years have been used for the exploration and production of oil and gas. Although the Company believes it has utilized operating and waste disposal practices that were standard in the industry at the time, hydrocarbons or other solid wastes may have been disposed or released on or under the properties owned or leased by the Company or on or under locations where such wastes have been taken for disposal. In addition, many of these properties have been owned or operated by third parties. The Company had no control over such parties' treatment of hydrocarbons or other solid wastes and the manner in which such substances may have been disposed or released. State and federal laws applicable to oil and gas wastes and properties have gradually become stricter over time. Under these new laws, the Company could be required to remove or remediate previously disposed wastes (including wastes disposed or released by prior owners or operators) or property contamination (including groundwater contamination by prior owners or operators) or to perform remedial plugging operations to prevent future contamination. 7 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The Company generates wastes, including hazardous wastes, that are subject to the federal Resource Conservation and Recovery Act ("RCRA") and comparable state statutes. The EPA and various state agencies have limited the approved methods of disposal for certain hazardous and non-hazardous wastes. Furthermore, it is possible that certain wastes generated by the Company's oil and gas operations that are currently exempt from treatment as "hazardous wastes" may in the future be designated as "hazardous wastes" under RCRA or other applicable statutes, and therefore be subject to more rigorous and costly operating and disposal requirements. Superfund. The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), also known as the "Superfund" law, imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons with respect to the release of a "hazardous substance" into the environment. These persons include the owner and operator of a disposal site where a release occurred and any company that disposed or arranged for the disposal of the hazardous substance released at the site. CERCLA also authorizes the EPA and, in some cases, third parties, to take actions in response to threats to the public health or the environment and to seek to recover from the responsible classes of persons the costs of such action. In the course of its operations, the Company has generated and will generate wastes that may fall within CERCLA's definition of "hazardous substances." The Company may also be an owner of sites on which "hazardous substances" have been released. The Company may be responsible under CERCLA for all or part of the costs to clean up sites at which such wastes have been disposed. Oil Pollution Act. The Oil Pollution Act of 1990 (the "OPA") and regulations thereunder impose certain duties and liabilities on "responsible parties" related to the prevention of oil spills and damages resulting from such spills in United States waters. A "responsible party" includes the owner or operator of an onshore facility, vessel or pipeline, or the lessee or permittee of the area in which an offshore facility is located. The OPA assigns liability to each responsible party for oil removal costs and a variety of public and private damages. While liability limits apply in some circumstances, a party cannot take advantage of liability limits if the spill was caused by gross negligence or willful misconduct or resulted from violation of a federal safety, construction or operating regulation. If the party fails to report a spill or to cooperate fully in the cleanup, liability limits also do not apply. Few defenses exist to the liability imposed by the OPA. The failure to comply with OPA requirements may subject a responsible party to civil or even criminal liability. The OPA also imposes ongoing requirements on a responsible party, including proof of financial responsibility to cover at least some costs in a potential spill. Certain amendments to the OPA that were enacted in 1996 require owners and operators of offshore facilities that have a worst case oil spill potential of more than 1,000 barrels to demonstrate financial responsibility in amounts ranging from $10 million in specified state waters and $35 million in federal OCS waters, with higher amounts, up to $150 million based upon worst case oil spill discharge volume calculations. The Company believes that it currently has established adequate proof of financial responsibility for its offshore facilities. Air Emissions. The operations of the Company are subject to local, state and federal laws and regulations for the control of emissions from sources of air pollution. Administrative enforcement actions for failure to comply strictly with air regulations or permits may result in the payment of civil penalties and, in extreme cases, the shutdown of air emission sources. The Company believes it is in compliance with all air emission regulations. OSHA and other Regulations. The Company is subject to the requirements of the federal Occupational Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard communication standard, the EPA community right-to- know regulations under Title III of CERCLA and similar state statutes require the Company to organize and/or disclose information about hazardous materials used or produced in the Company's operations. The Company believes that it is in substantial compliance with these applicable requirements. 8 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Competition The oil and gas industry is highly competitive in all of its phases. Bellwether encounters competition from other oil and gas companies in all areas of the Company's operations, including the acquisition of reserves and producing properties and the marketing of oil and gas. Many of these companies possess greater financial and other resources than Bellwether. Competition for producing properties is affected by the amount of funds available to the Company, information about a producing property available to the Company and any standards established by the Company for the minimum projected return on investment. Competition may also be presented by alternate fuel sources. ITEM 2. PROPERTIES Domestic Properties The Company's domestic exploration, development and acquisition activities are focused in nine core areas: Central Gulf of Mexico; Western Gulf of Mexico; West Texas; South Texas; Northwest Texas; Texas Coast; Southwest Louisiana; Oregon; and New Mexico. Central Gulf of Mexico - The primary fields in this area are East Cameron, Eugene Island, Ship Shoal, South Marsh Island, West Cameron and South Timbalier blocks in the Gulf of Mexico. All of the blocks are operated by others except East Cameron and Eugene Island 307 which are operated by the Company. The Central Gulf of Mexico core area represents approximately 15% of the Company's total present value of reserves discounted at 10% (NPV10%). The area is comprised of approximately 550 wells of which 163 are producing and have an average working interest of about 20%. The average reserve life is six and a half years. Western Gulf of Mexico - The primary fields in this area are Cove, High Island Blocks A-334, A-552 and 71/88 and Matagorda Island Block 605 in the Gulf of Mexico. The Cove field and High Island Block A-552 are Company operated while the other fields are outside operated. The Western Gulf of Mexico core area represents approximately 9% of the Company's NPV10%. The area is comprised of approximately 35 wells of which 14 are producing and have an average working interest of about 40%. The average reserve life is six and a half years. West Texas - The primary fields in this area are Waddell Ranch, Gomez, Happy and Brooks/Zan-Zan. All of the fields are outside operated, except the Happy field which the Company operates. The West Texas core area represents approximately 19% of the Company's NPV10%. The area is comprised of approximately 2,200 wells of which 1,400 are producing and have an average working interest of about 25%. The Waddell Ranch field is primarily under waterflood and represents 97% of total and producing wells in this core area. The average working interest for the Waddell Ranch field is about 10% and the field has a reserve life of 40 years. The average reserve life for all the fields in the West Texas core area thirty-five years. South Texas - The primary fields in this area are Belle Pepper, La Rica and McAllen Ranch. The Company operates all the fields in this area except for the McAllen Ranch field. The South Texas core area represents approximately 1% of the Company's total present value of 10% reserves. The area is comprised of approximately 30 wells of which 27 are producing. The Belle Pepper and La Rica fields have 100% working interest and the McAllen Ranch field has an average working interest of about 20%. The average reserve life for the South Texas core area is ten years. Northwest Texas - The primary fields in this area are Giddings, Rocky Creek, Fort Trinidad and Matterhorn. The Giddings and Matterhorn fields are Company operated while the other fields are outside operated. The Northwest Texas core area represents approximately 6% of the Company's NPV10%. The area is comprised of approximately 200 wells of which 160 are producing and have an average working interest of about 27%. The average reserve life is twenty years. 9 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Texas Coast - The primary fields in this area are Porter's Creek, which is Company operated, and McFarlan, which is outside operated. The Texas Coast core area represents approximately 4% of the Company's NPV10%. The area is comprised of 18 wells of which 17 are producing and have an average working interest of about 50%. The average reserve life is thirteen years. Southwest Louisiana - The primary fields in this area are Second Bayou, which is Company operated, and West Chalkley, which is outside operated. The Southwest Louisiana core area represents approximately 6% of the Company's NPV10%. The area is comprised of 11 wells of which 10 are producing and have an average working interest of about 12%. The average reserve life is nine years. Oregon - The only field in this area is the Mist field which is outside operated and has a 50% working interest. The Oregon core area represents approximately 3% of the Company's NPV10%. The area is comprised of 32 wells of which 11 are producing. The average reserve life is fifteen years. New Mexico - The primary fields in this area are Lusk, Turkey Track, Crow Flats, Burton Flats and Empire. Currently five wells in the Lusk and Turkey Track fields are operated by the Company and all other wells are outside operated. As more wells are drilled in this core area, the Company will increase its operated areas. The New Mexico core area represents approximately 6% of the Company's NPV10%. The area is comprised of approximately 240 wells of which 230 are producing and have an average working interest of about 38%. The average reserve life is thirty-two years. California - The primary field in this area is Point Pedernales which is operated by Nuevo Energy. The California core area represents approximately 2% of the Company's NPV10%. The area is comprised of 22 wells of which 10 are producing and have an average working interest of about 20%. The average reserve life is nine years. International Properties Ecuador - In December 1998 Bellwether was the successful bidder for the Charapa field in Ecuador. Negotiations with the Ecuadorian government took place throughout 1999 with Bellwether officially taking over operations of the field in January of 2000. Bellwether has committed to a $12 million work program over a three year period. Ecuador represents 8% of the Company's NPV 10%. Beginning in 2000, one well will be producing with approximately a 50% interest. Ukraine - Bellwether owns an interest in two projects in the Ukraine through its ownership of Carpatsky Petroleum Inc. Carpatsky is developing a natural gas project in the Rudovsko-Chernozovodsky ("RC") field in central Ukraine, and owns an interest in the Bitkov field in western Ukraine. The RC project includes the acquisition and documentation of ownership rights in the RC field sufficient to support financing for development of the field. In addition, Carpatsky is seeking western purchasers for the gas reserves in the field to reduce exposure to default in payment for reserves experienced when gas was sold to Ukrainian purchasers. Bellwether's interest in reserves in the Ukraine were not material to Bellwether on December 31, 1999. 10 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Reserves Estimated net proved oil and gas reserves at December 31, 1999 increased approximately 34% from December 31, 1998. This increase was primarily caused by the acquisition of properties in New Mexico and the Gulf of Mexico and increased oil and gas prices. The Company has not filed oil or gas reserve information with any foreign government or Federal authority or agency which contain reserves materially different than those set forth herein. The following table sets forth certain information, as of December 31, 1999, which relates to fields which hold approximately 94% of the Company's proved oil and gas reserves:
Net Production Net Proved Reserves ------------------------------------ --------------------------------------------- Oil & NGL Gas Oil & NGL Gas Oil Equivalent FIELD (MBBLS) (MMCF) MBOE (MBBLS) (MMCF) (MBOE) - ----------------------------------------- --------- -------- ------ ---------- -------- -------------- Central Gulf of Mexico 407 3,566 1,002 1,248 25,490 5,496 Western Gulf of Mexico 67 4,138 757 391 14,137 2,747 West Texas 556 1,110 741 6,066 15,419 8,636 South Texas 6 815 142 11 3,615 614 Northwest Texas 232 1,389 464 477 10,255 2,186 Texas Coast 14 961 174 91 7,192 1,290 Southwest Louisiana 64 618 167 394 4,353 1,120 Oregon -- 567 94 -- 4,008 668 New Mexico 2 39 8 310 10,505 2,061 California 44 21 48 3,280 1,995 3,613 Ecuador* -- -- -- 3,884 -- 3,884 Non-Core: Robinsons Bend /Blue Creek field -- 1,106 184 -- 12,627 2,104 Lirette field 10 767 138 17 1,803 318 Morganza field 5 569 100 23 2,620 460 Reddell field 12 435 84 76 3,474 655 Carpenter field -- 291 49 -- 2,745 458 All others 661 2,573 1,089 512 9,841 2,150 ----------------------------------------------------------------------------------- 2,080 18,965 5,241 16,780 130,079 38,460 ===================================================================================
* Such reserves are pursuant to a contract with the Ecuadorian government under which the Company does not own the reserves, but has a contractual right to produce the reserves and receive revenue. In general, estimates of economically recoverable oil and natural gas reserves and of the future net cash flows therefrom are based upon a number of variable factors and assumptions, such as historical production from the properties, assumptions concerning future oil and natural gas prices and future operating costs and the assumed effects of regulation by governmental agencies, all of which may vary considerably from actual results. All such estimates are to some degree speculative, and classifications of reserves are only attempts to define the degree of speculation involved. Estimates of the economically recoverable oil and natural gas reserves attributable to any particular group of properties, classifications of such reserves based on risk of recovery and estimates of future net cash flows expected therefrom, prepared by different engineers or by the same engineers at different times, may vary substantially. The Company's actual production, revenues, severance and excise taxes and development and operating expenditures with respect to its reserves will vary from such estimates, and such variances could be material. Estimates with respect to proved reserves that may be developed and produced in the future are often based upon volumetric calculations and upon analogy to similar types of reserves rather than actual production history. 11 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Estimates based on these methods are generally less reliable than those based on actual production history. Subsequent evaluation of the same reserves based upon production history will result in variations, which may be substantial, in the estimated reserves. In accordance with applicable requirements of the Securities and Exchange Commission ("SEC"), the estimated discounted future net cash flows from estimated proved reserves are based on prices and costs as of the date of the estimate unless such prices or costs are contractually determined at such date. Actual future prices and costs may be materially higher or lower. Actual future net cash flows also will be affected by factors such as actual production, supply and demand for oil and natural gas, curtailments or increases in consumption by natural gas purchasers, changes in governmental regulations or taxation and the impact of inflation on costs. Acreage The following table sets forth the acres of developed and undeveloped oil and gas properties in which the Company held an interest as of December 31, 1999. Undeveloped acreage is considered to be those leased acres on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether or not such acreage contains proved reserves. A gross acre in the following table refers to the number of acres in which a working interest is owned directly by the Company. The number of net acres is the sum of the fractional ownership of working interests owned directly by the Company in the gross acres expressed as a whole number and percentages thereof. A net acre is deemed to exist when the sum of fractional ownership of working interests in gross acres equals one. All of the acreage is domestic. Gross Net --------- ------- Developed Acreage............... 515,493 94,661 Undeveloped Acreage............. 1,138,200 396,847 --------- ------- Total....................... 1,653,693 491,508 ========= ======= Bellwether believes that the title to its oil and gas properties is good and defensible in accordance with standards generally accepted in the oil and gas industry, subject to such exceptions which, in the opinion of the Company, are not so material as to detract substantially from the use or value of such properties. The Company's properties are typically subject, in one degree or another, to one or more of the following: 1) royalties and other burdens and obligations, express or implied, under oil and gas leases; 2) overriding royalties and other burdens created by the Company or its predecessors in title; 3) a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farmout agreements, production sales contracts and other agreements that may affect the properties or their titles; 4) back-ins and reversionary interests arising under purchase agreements and leasehold assignments; 5) liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing obligations to unpaid suppliers and contractors and contractual liens under operating agreements; 6) pooling, unitization and communitization agreements, declarations and orders; and 7) easements, restrictions, rights-of-way and other matters that commonly affect oil and gas producing property. To the extent that such burdens and obligations affect the Company's rights to production revenues, they have been taken into account in calculating the Company's net revenue interests and in estimating the size and value of the Company's reserves. Bellwether believes that the burdens and obligations affecting the Company's properties are conventional in the industry for properties of the kind owned by the Company. 12 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Productive Wells The following table sets forth Bellwether's gross and net interests in productive oil and gas wells as of December 31, 1999. Productive wells are defined as producing wells and wells capable of production. All of the wells listed are domestic. Gross Net ----- --- Oil Wells................. 1,323 211 Gas Wells................. 813 160 ----- --- Total................. 2,136 371 ===== === Production The Company's principal production volumes during the fiscal year ended December 31, 1999 were from the states of Louisiana, Texas, Oregon and Alabama, from federal waters in offshore California and from the Gulf of Mexico in federal and state waters. Data relating to production volumes, average sales prices, average unit production costs and oil and gas reserve information appear in Note 12 of the Notes to Consolidated Financial Statements - Supplemental Information. Drilling Activity and Present Activities During the last three fiscal years and the transition period ended December 31, 1997, the Company's principal drilling activities occurred in the continental United States and offshore Texas, Louisiana and California in federal and state waters. The following table sets forth the results of drilling activity for the last three fiscal years and the transition period. Gross wells, as it applies to wells in the following tables, refers to the number of wells in which a working interest is owned directly by the Company. A "net well" is deemed to exist when the sum of fractional ownership working interests in gross wells equals one. The number of net wells is the sum of the fractional ownership of working interests owned directly by the Company in gross wells expressed as whole numbers and percentages thereof.
Exploratory Wells ----------------- Gross Net -------------------------------- ---------------------------- Dry Dry Productive Holes Total Productive Holes Total -------------------------------- ----------------------------- Fiscal 1997 3 4 7 .75 .74 1.49 Six Month Transition 1997 2 2 4 .28 .78 1.06 Fiscal 1998 14 5 19 4.10 1.52 5.62 Fiscal 1999 8 4 12 3.75 2.04 5.79
13 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
Development Wells ----------------- Gross Net ------------------------------- ---------------------------- Dry Dry Productive Holes Total Productive Holes Total ------------------------------- ----------------------------- Fiscal 1997 52 2 54 5.34 .63 5.97 Six Month Transition 1997 30 5 35 2.40 1.19 3.59 Fiscal 1998 69 4 73 7.53 .52 8.05 Fiscal 1999 13 2 15 4.39 .14 4.53
The Company had 8 wells in progress as of December 31, 1999. Gas Plants As of December 31, 1999 the Company owned interests in the following gas plants:
Fiscal Year 1999 -------------------------------------- Capacity Throughput Ownership Facility State Operator MMCFD MMCFD Interest - -------- ------ -------- -------------------------------------- Nuevo Energy Company Point Pedernales Gas Plant CA 13 4 19.7% Snyder Gas Torch Energy Plant TX Marketing Inc. 60 14 11.9% Diamond M- Sharon Ridge Exxon Company, Gas Plant(1) TX U.S.A. (1) (1) (1) (1) The Company has a 32.0% interest in the operations of the former Diamond M-Sharon Ridge Gas Plant. This plant was dismantled in December 1993 and the gas is being processed by Snyder Gas Plant pursuant to a processing agreement.
Risk Factors Volatility of Oil and Gas Prices and Markets Prices for oil and gas are subject to large fluctuations in response to relatively minor changes in the supply of and demand for oil and gas, market uncertainty and a variety of additional factors beyond the control of the Company. These factors include: 1) weather conditions in the United States, 2) the condition of the United States economy, 3) the actions of the Organization of Petroleum Exporting Countries, 4) governmental regulation, 5) political stability in the Middle East and elsewhere, 6) the foreign supply of oil and gas, 7) the price of foreign imports and 8) the availability of alternate fuel sources. Oil prices were lower in 1998 than in previous years and hit historic lows during the first quarter of 1999, but recovered significantly by year end 1999. Any substantial and extended decline in the price of oil or gas would have an adverse effect on the Company's carrying value of its proved reserves, its borrowing capacity, its ability to obtain additional capital, and its revenues, profitability and cash flows. Volatile oil and gas prices make it difficult to estimate the value of producing properties in connection with acquisitions and often cause disruption in the market for oil and gas producing properties, as buyers and sellers have 14 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES difficulty agreeing on such value. Price volatility also makes it difficult to budget for and project the return on acquisitions and exploitation, development and exploration projects. The availability of a ready market for the Company's oil and natural gas production also depends on a number of factors, including the demand for and supply of oil and natural gas and the proximity of reserves to, and the capacity of, oil and natural gas gathering systems, pipelines or trucking and terminal facilities. Wells may temporarily be shut-in for lack of a market or due to inadequacy or unavailability of pipeline or gathering system capacity. Ability to Replace Reserves The Company's future performance depends upon its ability to find, develop and acquire additional oil and gas reserves that are economically recoverable. The proved reserves of Bellwether will generally decline as reserves are depleted. The Company therefore must locate and develop or acquire new oil and gas reserves to replace those being depleted by production. Because the Company's reserves are characterized by relatively rapid decline rates, without successful exploration, development or acquisition activities, the Company's revenues will decline rapidly. No assurances can be given that the Company will be able to find and develop or acquire additional reserves at an acceptable cost. Acquisition Risks The Company's rapid growth in recent years has been attributable in significant part to domestic and to a less significant part, to international acquisitions of oil and gas properties. The Company expects to continue to evaluate and, where appropriate, pursue acquisition opportunities on terms management considers favorable to the Company. There can be no assurance that suitable acquisition candidates will be identified in the future, or that the Company will be able to finance such acquisitions on favorable terms. In addition, the Company competes against other companies for acquisitions, and there can be no assurances that the Company will be successful in the acquisition of any material property interests. Further, there can be no assurances that any future acquisitions made by the Company will be integrated successfully into the Company's operations or will achieve desired profitability objectives. The successful acquisition of producing properties requires an assessment of: 1) recoverable reserves, 2) exploration and exploitation potential, 3) future oil and natural gas prices, 4) operating costs, 5) potential environmental and other liabilities and 6) other factors beyond the Company's control. In connection with such an assessment, the Company performs a review of the properties that it believes to be generally consistent with industry practices. Nonetheless, the resulting assessments are inexact and their accuracy is inherently uncertain, and such a review may not reveal all existing or potential problems, nor will it necessarily permit the Company to become sufficiently familiar with the properties to fully assess their merits and deficiencies. Inspections may not always be performed on every well, and structural and environmental problems are not necessarily observable even when an inspection is undertaken. In addition, sellers of properties may be unwilling or financially unable to indemnify the Company for known or unknown liabilities at the time of an acquisition. Additionally, significant acquisitions can change the nature of the operations and business of the Company depending upon the character of the acquired properties, which may be substantially different in operating and geologic characteristics or geographic location than existing properties. While the Company's operations are focused in Texas, Louisiana, Alabama, offshore California, the Gulf of Mexico, Latin America and Ukraine there is no assurance that the Company will not pursue acquisitions or properties located in other geographic areas. In connection with the Partnership Transactions, Bellwether assumed or otherwise became liable for all obligations with respect to operations of the properties acquired in such transactions, including environmental and operational liabilities, unknown liabilities, and liabilities arising prior to the closing date. 15 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Drilling Risks Drilling activities are subject to many risks, including the risk that no commercially productive reservoirs will be encountered. There can be no assurance that new wells drilled by the Company will be productive or that the Company will recover all or any portion of its investment. Drilling for oil and natural gas may involve unprofitable efforts, not only from dry wells, but from wells that are productive but do not produce sufficient net revenues to return a profit after drilling, operating and other costs. The cost of drilling, completing and operating wells is often uncertain and cost overruns are common. The Company's drilling operations may be curtailed, delayed or canceled as a result of numerous factors, many of which are beyond the Company's control, including: 1) title problems, 2) weather conditions, 3) compliance with governmental requirements and 4) shortages or delays in the delivery of equipment and services. Substantial Capital Requirements The Company makes, and will continue to make, substantial capital expenditures for the exploitation, exploration, acquisition and production of oil and gas reserves. Historically, the Company has financed these expenditures primarily with the sale of senior subordinated notes, proceeds from bank borrowings, sales of its Common Stock and cash flow from operations. The Company believes that it will have sufficient cash flows provided by operating activities, the proceeds of equity offerings and borrowings under the Senior Credit Facility to fund planned capital expenditures. If revenues or the Company's borrowing base decrease as a result of lower oil and gas prices, operating difficulties or declines in reserves, the Company may have limited ability to expend the capital necessary to undertake or complete future drilling programs. There can be no assurance that additional debt or equity financing or cash generated by operations will be available to meet these requirements. Significant Leverage and Debt Service The Company's level of indebtedness has several important effects on its future operations, including: 1) a substantial portion of the Company's cash flow from operations must be dedicated to the payment of interest on its indebtedness and will not be available for other purposes, 2) covenants contained in the Company's debt obligations require the Company to meet certain financial tests, and other restrictions limit its ability to borrow additional funds or to dispose of assets and may affect the Company's flexibility in planning for, and reacting to, changes in its business, including possible acquisition activities and 3) the Company's ability to obtain financing in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired. The Company's ability to meet its debt service obligations and to reduce its total indebtedness will be dependent upon the Company's future performance, which will be subject to general economic conditions and to financial, business and other factors affecting the operations of the Company, many of which are beyond its control. There can be no assurance that the Company's future performance will not be adversely affected by such economic conditions and financial, business and other factors. Risks of Foreign Operations The Company was the successful bidder for a marginal lease in Ecuador in 1998. Contract negotiations with the Ecuadorian government were completed in late 1999 with operations beginning January 2000. In addition, on December 30, 1999, the Company acquired an interest in Carpatsky, which has operations in Ukraine. Ownership of property interests and production operations in Ecuador, Ukraine and in any other areas outside of the United States in which the Company may choose to do business, are subject to the various risks interest in foreign operations. These risks may include, among other things, currency restrictions and exchange rate fluctuations, loss of revenue, property and equipment as a result of hazards such as expropriations, nationalization, war, insurrection and other political risks, risks of increase in taxes and governmental policies governing operations of foreign-based companies 16 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES and other uncertainties arising out of foreign government sovereignty over the Company's international operations. The Company's international operations may also be adversely affected by laws and policies of the United States affecting foreign trade, taxation and investment. In addition, in the event of a dispute arising from foreign operations, the Company may be subject to the exclusive jurisdiction of foreign courts or may not be successful in subjecting foreign persons to the jurisdiction of the courts of the United States. Carpatsky's activities are focused in the RC field, which has substantial gas reserves. Carpatsky is seeking to acquire and fully document its ownership interests in the RC field. Currently, Carpatsky operates under a joint activities agreement with a state majority owned oil company. The joint activities agreement gives Carpatsky the right to receive proceeds from a portion of the production from the field in exchange for payment of a portion of the costs. The portions of production received and costs paid vary depending on the amount paid by Carpatsky under the joint activities agreement. The joint activities agreement is not currently referred to in the RC field license granted by the government of the Ukraine. In addition, the current license covers only production from a pilot project designed to determine the productive boundaries of the field. Carpatsky is seeking to have the RC field license granted directly to it or to an entity in which it has an ownership interest, and to have the license changed to a development license. No assurances can be made that Carpatsky will be successful in these activities. Administrative Services Agreement; Reliance on Torch The Company currently has 24 employees. The Company is party to a Master Services Agreement ("MSA") with Torch, pursuant to which Torch performs certain administrative functions for the Company, including financial, accounting, marketing, land, legal and technical support (See Note 4 to the Consolidated Financial Statements). The Company believes that its relationship with Torch provides the Company with access to professional, technical and administrative personnel not otherwise available to a company of its size. Bellwether believes that if the MSA were terminated Bellwether could, over time, hire experienced personnel and acquire the accounting and reporting systems and other assets necessary to replace Torch. However, the unanticipated termination of the MSA could have a material adverse effect upon the Company. Conflicts of Interest Director, Mr. J. P. Bryan, was elected Chairman and Chief Executive Officer effective August 2, 1999. Mr. Bryan is Senior Managing Director of and a holder of common stock of the parent corporation of Torch. Mr. Bryan has limited involvement in the day to day operations of Torch. Torch also renders administrative services to other independent oil and gas companies and may manage or render management or administrative services for other energy companies in the future. These services may include the review and recommendation of potential acquisitions. It is possible that conflicts may occur between Bellwether and these other companies in connection with possible acquisitions or otherwise in connection with the services rendered by Torch. Although the Master Services Agreement provides for procedures to reconcile conflicts of interest between these other companies and the Company, no assurances can be made that such procedures will fully protect the Company from losses which may occur if a conflict between the Company and these other companies arises. Estimates of Oil and Gas Reserves This document contains estimates of oil and gas reserves owned by the Company, and the future net cash flows attributable to those reserves. There are numerous uncertainties inherent in estimating quantities of proved reserves and cash flows attributable to such reserves, including factors beyond the control of the Company and the reserve engineers. Reserve engineering is a subjective process of estimating underground accumulations of oil and gas that cannot be measured in an exact manner. The accuracy of an estimate of quantities of reserves, or of cash flows attributable to such reserves, is a function of: 1) the available data, 2) assumptions regarding future oil and gas 17 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES prices and expenditures for future development and exploitation activities, and 3) of engineering and geological interpretation and judgment. Additionally, reserves and future cash flows may be subject to material downward or upward revisions based upon production history, development and exploitation activities and prices of oil and gas. Actual future production, revenue, taxes, development expenditures, operating expenses, quantities of recoverable reserves and the value of cash flows from such reserves may vary significantly from the assumptions and estimates set forth herein. In addition, reserve engineers may make different estimates of reserves and cash flows based on the same available data. In calculating reserves on a gas equivalent basis, oil was converted to gas equivalent at the ratio of one Bbl of oil to six Mcf of gas. While this ratio approximates the energy equivalency of oil to gas on a Btu basis, it may not represent the relative prices received by the Company on the sale of its oil and gas production. The estimated quantities of proved reserves and the discounted present value of future net cash flows attributable to estimated proved reserves set forth herein were prepared in accordance with the rules of the SEC, and are not intended to represent the fair market value of such reserves. Hedging of Production The Company may, from time to time, reduce its exposure to the volatility of oil and gas prices by hedging a portion of its production. In a typical hedge transaction, the Company will have the right to receive from the counterparty to the hedge, the excess of the fixed price specified in the hedge over a floating price based on a market index, multiplied by the quantity hedged. If the floating price exceeds the fixed price, the Company is required to pay the counterparty this difference multiplied by the quantity hedged. In such case, the Company is required to pay the difference regardless of whether the Company has sufficient production to cover the quantities specified in the hedge. Significant reductions in production at times when the floating price exceeds the fixed price could require the Company to make payments under the hedge agreements even though such payments are not offset by sales of production. Hedging will also prevent the Company from receiving the full advantage of increases in oil or gas prices above the fixed amount specified in the hedge. Operating Hazards, Offshore Operations and Uninsured Risks Bellwether's operations are subject to risks inherent in the oil and gas industry, such as: 1) blowouts, 2) cratering, 3) explosions, 4) uncontrollable flows of oil, gas or well fluids, 5) fires, 6) pollution, 7) earthquakes and 8) environmental risks. These risks could result in substantial losses to the Company due to injury and loss of life, severe damage to and destruction of property and equipment, pollution and other environmental damage and suspension of operations. Moreover, a portion of the Company's operations are offshore and therefore are subject to a variety of operating risks peculiar to the marine environment, such as hurricanes or other adverse weather conditions, to more extensive governmental regulation, including regulations that may, in certain circumstances, impose strict liability for pollution damage, and to interruption or termination of operations by governmental authorities based on environmental or other considerations. The Company's operations could result in liability for: 1) personal injuries, 2) property damage, 3) oil spills, 4) discharge of hazardous materials, 5) remediation and clean-up costs and other environmental damages. The Company could be liable for environmental damages caused by previous property owners. As a result, substantial liabilities to third parties or governmental entities may be incurred, the payment of which could have a material adverse effect on the Company's financial condition and results of operations. The Company maintains insurance coverage for its operations, including limited coverage for sudden environmental damages, but does not believe that insurance coverage for all environmental damages that occur over time is available at a reasonable cost. Moreover, the Company does not believe that insurance coverage for the full potential liability that could be caused by sudden environmental damages is available at a reasonable cost. Accordingly, the Company may be subject to liability or may lose substantial portions of its properties in the event of certain environmental damages. 18 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Environmental and Other Regulation The Company's operations are subject to numerous laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. These laws and regulations require: 1) the acquisition of a permit before drilling commences, 2) restrict the types, quantities and concentration of various substances that can be released into the environment in connection with drilling and production activities, 3) limit or prohibit drilling activities on certain lands lying within wilderness, wetlands and other protected areas, and 4) impose substantial liabilities for pollution resulting from the Company's operations. Moreover, the recent trend toward stricter standards in environmental legislation and regulation is likely to continue. For instance, legislation has been proposed in Congress from time to time that would reclassify certain oil and gas exploration and production wastes as "hazardous wastes" which would make the reclassified wastes subject to much more stringent handling, disposal and clean-up requirements. If such legislation were to be enacted, it could have a significant impact on the operating costs of the Company, as well as the oil and gas industry in general. Initiatives to further regulate the disposal of oil and gas wastes are also pending in certain states, and these various initiatives could have a similar impact on the Company. Management believes that the Company is in substantial compliance with current applicable environmental laws and regulations. The Oil Pollution Act of 1990 imposes a variety of regulations on "responsible parties" related to the prevention of oil spills. The implementation of new, or the modification of existing, environmental laws or regulations, including regulations promulgated pursuant to the Oil Pollution Act of 1990, could have a material adverse impact on the Company. Competition The Company operates in the highly competitive areas of oil and gas exploration, development and production. The Company's competitors include major integrated oil and gas companies and substantial independent energy companies, many of which possess greater financial and other resources than the Company. ITEM 3. LEGAL PROCEEDINGS The Company was a defendant in Cause No. C-4417-96-G; A.R. Guerra, et al. v. Eastern Exploration, Inc., et al. in the 370th Judicial District Court of Hidalgo County, Texas. On May 11, 1999, the trial court granted plaintiff's Motion of Summary Judgement and denied defendants' Motion of Summary Judgement. The trial court awarded plaintiffs in excess of $5.8 million in damages plus interest. The Company recently settled the case for the sum of $353,500 net to its interest. The Company has been named as a defendant in certain lawsuits incidental to its own business. Management does not believe that the outcome of such litigation will have a material adverse impact on the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 19 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the NASDAQ National Market (Symbol: BELW). There were approximately 822 stockholders of record as of March 10, 2000. The Company has not paid dividends on its common stock and does not anticipate the payment of cash dividends in the immediate future as it contemplates that cash flows will be used for continued growth in Company operations. In addition, certain covenants contained in the Company's financing arrangements restrict the payment of dividends (See Management's Discussion and Analysis of Financial Condition and Results of Operations - Financing Activities and Note 7 of the Notes to Consolidated Financial Statements). The following table sets forth the range of the high and low sales prices, as reported by the NASDAQ for Bellwether common stock for the periods indicated.
Sales Price ----------- High Low ------ ----- Quarter Ended: September 30, 1996................. $ 6.88 $4.38 December 31, 1996.................. $ 9.00 $5.63 March 31, 1997..................... $11.50 $7.88 June 30, 1997...................... $10.25 $7.25 September 30, 1997................. $15.38 $9.08 December 31, 1997.................. $14.88 $9.75 March 31, 1998..................... $11.13 $7.88 June 30, 1998...................... $ 9.88 $7.81 September 30, 1998................. $ 8.88 $3.81 December 31, 1998.................. $ 7.69 $4.13 March 31,1999....................... $ 5.56 $2.69 June 30, 1999....................... $ 5.75 $3.19 September 30, 1999.................. $ 6.25 $4.00 December 31, 1999................... $ 6.19 $3.88
Treasury Stock Repurchases In September 1998, the Board of Directors of the Company authorized the open market repurchase of up to $5 million of the Company's common stock during 1998, at times and prices deemed attractive by management. As of December 31, 1999, the Company had repurchased 311,000 shares of common stock in open market transactions, at an average purchase price of $6.13 per share. 20 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES ITEM 6. SELECTED FINANCIAL DATA The following selected financial data with respect to the Company should be read in conjunction with the Consolidated Financial Statements and supplementary information included in Item 8 (amounts in thousands, except per share data).
Six Month Year Ended Year Ended Transition Period Dec.31, Dec.31, Ended Dec. 31 Fiscal Years Ended June 30, ------------- -------------- ---------------- ---------------------------------------- 1999 1998 1997 1997(1) 1996 1995(2) ------------- ------------- ---------------- ------------ --------- -------------- Gas revenues.......... $ 41,380 $ 46,461 $ 26,755 $ 24,202 $ 9,856 $ 4,864 Oil revenues.......... 26,568 26,756 17,408 14,865 5,810 3,643 Gas plant revenues, net.................. 1,464 1,203 804 3,330 3,534 4,627 Interest and other income............... 1,335 1,347 609 363 116 97 -------- -------- -------- -------- ------- ------- Total revenues....... 70,747 75,767 45,576 42,760 19,316 13,231 Production expenses... 21,532 25,381 13,836 11,437 5,317 2,856 General and administrative expenses............. 7,848 8,459 3,748 4,042 3,013 2,739 Depreciation, depletion and amortization......... 23,863 39,688 16,352 15,574 8,148 5,269 Impairment expenses... --- 73,899 --- --- --- --- Interest expense...... 11,845 11,660 5,978 4,477 1,657 1,245 Provision (benefit) for income taxes (3,154) (6,069) 2,114 2,585 46 9 Other expenses........ --- --- --- --- 153 172 -------- -------- -------- -------- ------- ------- Total expenses....... 61,934 153,018 42,028 38,115 18,334 12,290 -------- --------- -------- -------- ------- ------- Net income (loss) $ 8,813 $ (77,251) $ 3,548 $ 4,645 $ 982 $ 941 ======== ========= ======== ========= ======= ======= Earnings (loss) per commonshare.......... $ .64 $ (5.50) $ 0.26 $ 0.46 $ 0.11 $ 0.12 Earnings (loss) per commonshare-diluted.. $ .63 $ (5.50) $ 0.25 $ 0.45 $ 0.11 $ 0.12 Working capital....... $ 3,770 $ 6,077 $ 13,964 $ 22,783 $ 5,168 $(1,246) Long-term debt, net of current $130,000 $104,400 $100,000 $115,300 $13,048 $18,525 maturities........... Stockholders' equity.. $ 23,314 $ 14,489 $ 91,669 $ 87,924 $46,597 $45,447 Total assets.......... $171,761 $131,196 $214,757 $222,648 $67,225 $74,650
(1) Includes operations from the Partnership Transactions beginning April 1, 1997. (2) Reflects operations from Odyssey and Hampton mergers beginning August 1994 and February 1995, respectively. 21 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Bellwether is an independent energy company primarily engaged in the acquisition, exploitation and development of and exploration for oil and gas properties. Prior to April 1997, the Company had grown and diversified its operations primarily through acquisitions and subsequent development of the acquired properties. Subsequent to April 1997 the Company has employed a more balanced growth strategy combining strategic acquisitions of producing properties with technology driven exploration and development drilling. As a result, the Company's results of operations have been significantly affected by its success in acquiring oil and gas properties and its ability to maintain or increase production through its exploitation activities. In April 1997, the Company purchased oil and gas properties and $13.9 million of working capital from affiliates of Torch for an adjusted purchase price of $141.1 million ("Partnership Transactions"). The acquisition was recorded effective April 1, 1997 and the operations of the Company include the Partnership Transactions from that date. The Partnership Transactions were financed with $34.1 million of net proceeds of a Common Stock offering, $97.0 million net proceeds of 10 7/8% Senior Subordinated Notes due 2007 (the "Offerings") and borrowings under a new credit facility ("New Credit Facility"). In addition as consideration for advisory services Torch was issued 150,000 shares of the Company's common stock and a warrant, expiring in April 2002, to purchase 100,000 shares at $9.90 per share for advisory services rendered in connection with the Partnership Transactions. The warrant and shares were valued at $1.5 million and recorded as a cost of the Partnership Transactions. In order to facilitate greater comparability with its peer group by the financial community, the Company changed its fiscal year to the calendar year, beginning January 1, 1998. This resulted in a six-month transition period of July 1, 1997 through December 31, 1997 ("transition period"). The Company uses the full cost method of accounting for its investment in oil and gas properties. Under the full cost method of accounting, all costs of acquisition, exploration and development of oil and gas reserves are capitalized in a "full cost pool" as incurred. Oil and gas properties in the pool, plus estimated future expenditures to develop proved reserves and future abandonment, site reclamation and dismantlement costs, are depleted and charged to operations using the unit of production method based on the ratio of current production to total proved recoverable oil and gas reserves. To the extent that such capitalized costs (net of depreciation, depletion and amortization) exceed the discounted future net revenues on an after-tax basis of estimated proved oil and gas reserves, such excess costs are charged to operations. Once incurred, the writedown of oil and gas properties is not reversible at a later date even if oil and gas prices increase. Sharp declines in oil and gas prices, including further gas price decline subsequent to year end, and to a lesser extent, downward revision in estimated proved reserves resulted in a $73.9 million pretax impairment charge ($71.6 million after tax), in the fiscal year ended December 31, 1998. February 23, 1999 prices used in computing the impairment were based on a NYMEX oil price of $12.48 per barrel and a NYMEX gas price of $1.71 per MMBTU, adjusted to the wellhead. No such write down was required for the year ended December 31, 1999. The Company periodically uses derivative financial instruments to manage oil and gas price risk. Settlements of gains and losses on price swap contracts are generally based upon the difference between the contract price and the average closing NYMEX or other floating index price and are reported as a component of oil and gas revenue during the period in which the underlying commodity is produced. Gains or losses attributable to the termination of swap contracts are deferred and recognized in revenue when the hedged oil and gas is sold. Financing Activities The Company's outstanding indebtedness totals $130.0 million at December 31, 1999; $100 million is attributable to 10 7/8% Senior Subordinated Notes due in 2007 while $30.0 million is outstanding under a senior revolving unsecured credit facility with an ultimate maturity date of November 2003. In April 1997, the Company entered into a senior revolving unsecured credit facility ("Senior Credit Facility") in an amount up to $90.0 million, with a current borrowing base of $55.0 million, and a maturity date of November 5, 2003. 22 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Bellwether may elect an interest rate based either on a margin plus London Interbank Offered Rate ("LIBOR") or the higher of the prime rate or the sum of 1/2 of 1% plus the Federal Funds Rate. For LIBOR borrowings, the interest rate will vary from LIBOR plus 1.0% to LIBOR plus 1.75% based upon the borrowing base usage. In connection with the acquisition of oil and gas properties, $30 million was drawn under this facility. As of December 31, 1999, $30.0 million was outstanding under the Senior Credit Facility. The Senior Credit Facility contains various covenants including certain required financial measurements for current ratio, consolidated tangible net worth and interest coverage ratio. In addition, the Senior Credit Facility includes certain limitations on restricted payments, dividends, incurrence of additional funded indebtedness and asset sales. In October 1996, the Company entered into a syndicated credit facility in an amount up to $50.0 million with an initial borrowing base of $27.0 million, to be re-determined semi-annually. This credit facility was unsecured and was retired in April 1997. In February 1995, the Company entered into a credit facility with a commercial bank providing an initial borrowing base of $29.8 million. The borrowings under the credit facility were secured by the Company's interest in oil and gas properties, a gathering system and two gas plants. The Credit Facility was retired in October 1996. In April 1997, the Company issued $100.0 million of 10 7/8% senior subordinated notes ("Notes") that mature April 1, 2007 for net proceeds of $97.0 million. Interest on the Notes is payable semi-annually on April 1 and October 1 commencing on October 1, 1997. The Notes contain certain covenants, including limitations on: 1) the incurrence of debt, 2) on other senior subordinated indebtedness, 3) on restricted payments and 4) on liens as well as restrictions 5) on the disposition of proceeds of asset sales and 6) on mergers, and 7) consolidations or sales of assets. Additionally, the notes require the Company to offer to purchase the notes in the event of a change of control. In order to reduce interest costs, effective September 22, 1998, the Company entered into an eight and one half year interest rate swap agreement with a notional value of $80 million. Under the agreement, the Company receives a fixed interest rate and pays a floating interest rate based on the simple average of three foreign LIBOR rates. Floating rates are redetermined for a six month period each April 1 and October 1. The floating rate for the period from October 1, 1999 to April 1, 2000 is 9.64%. Through April 1, 2002, the floating rate is capped at 10.875% and capped at 12.375% thereafter. This interest swap is accounted for as a hedge. In April 1997, the Company issued 4.4 million common shares in a public offering. The net proceeds of the offering were $34.1 million. Liquidity and Capital Resources The Company's principal sources of capital for the last three years and for the six month transition period have been the sale of Notes, borrowings under bank credit facilities, the public sale of common stock and cash flow from operations. The Company sold $100 million in Notes in fiscal 1997. Borrowings from banks were 30.0 million, $4.9 million, $1.5 million and $57.3 million for the fiscal years 1999 and 1998, the transition period 1997 and fiscal year ended June 30, 1997 respectively. The Company issued 4.4 million shares of common stock in a public offering in April 1997 for net proceeds of $34.1 million. Cash flow from operations before change in assets and liabilities totaled $30.8 million, $30.4 million, $21.8 million and $23.3 million for the fiscal years 1999 and 1998, the transition period 1997 and fiscal year 1997, respectively. Cash flow from operations before changes in working capital for the fiscal year 1998 was adversely impacted by a 22% reduction in the average price received for the Company's oil and gas production as compared to the average price received during the transition period 1997. In a series of transactions from May through December 1997, the Company divested non-core assets representing approximately 10% of its estimated net proved reserves for $24.3 million. Also, the Company divested additional non-core assets in September and October 1999 for approximately $4.9 million. The Company's primary uses of capital have been to fund acquisitions and to fund its exploration and development projects. Acquisitions, net of working capital acquired, totaled $25.9 million, $10.3 million, $5.5 million and $140 million for the fiscal years 1999 and 1998, the transition period 1997 and fiscal 1997, respectively. The Company's expenditures for exploration and development of its oil and gas properties totaled $31.3 million, $30.6 million, $13.7 million and $15.6 million for the fiscal years 1999 and 1998, the transition period ended December 31, 1997 and the fiscal year ended June 30, 1997, respectively. 23 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Outlook The Company has adopted a $55.2 million capital budget for the year ending December 31, 2000 primarily for development and exploratory drilling activities. The Company believes its working capital and net cash flows provided by operating activities are sufficient to meet these capital commitments. Additionally, the Company currently has a $55.0 million borrowing base under its Senior Credit Facility with $30.0 million outstanding borrowings at December 31, 1999. The Company is continuously reviewing acquisition opportunities and expects to conclude one or more acquisitions during 2000. Acquisitions are not included in the capital budget and will be funded through additional borrowings and/or the issuance of securities. The Company's results of operations and cash flow are affected by changing oil and gas prices. Changes in oil and gas prices often result in changes in the level of drilling activity, which in turn adjusts the demand for and cost of exploration and development. Thus, increased prices may generate increased revenue without necessarily a corresponding increase in profitability while declining prices almost always have a negative impact on profitability. These industry market conditions have been far more significant determinants of Company earnings than have macroeconomic factors such as general inflation, which has had only minimal impact of Company activities in recent years. It is impossible to predict the precise effect of changing prices and inflation on future Company operations, and no assurance can be given as to the Company's future success at reducing the impact of price changes in the Company's operating results. Year 2000 Issues The Year 2000 problem ("Y2k") refers to the inability of computer and other information technology systems to properly process date and time information. The problem was caused, in part, by the outdated programming practice of using two digits rather than four to represent the year in a date. The consequence of the Y2k problem is that information technology and embedded processing systems are at risk of malfunction, particularly during the transition between 1999 to 2000. The estimated total costs for Y2k readiness were nominal. In addition, there have been no material capital expenditures for Y2k and there is not anticipated to be material capital expenditures because most major critical field operations do not have date sensitive equipment. The Company has experienced no material Y2k failures. 24 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Results of Operations For comparability with annual periods, amounts discussed in this section regarding the six month transition period 1997 have been annualized. These amounts may not be indicative of twelve month's operating results. The table below recaps the major components of financial and operating performance to be discussed (amounts in thousands):
Year-ended December 31, Annualized/(1)/ ---------------------------------- Transition Fiscal 1999 1998 Period 1997 1997 -------------- ------------- ----------------- ---------------- Oil and gas revenues $67,948 $ 73,217 $88,326 $39,067 Gas plant revenues, net 1,464 1,203 1,608 3,330 Interest and other 1,335 1,347 1,218 363 ------- -------- ------- ------- Total revenue 70,747 75,767 91,152 42,760 Production expenses 21,532 25,381 27,672 11,437 Depreciation, depletion and amortization 23,863 39,688 32,704 15,574 Impairment expense --- 73,899 --- --- General and administrative expenses 7,848 8,459 7,496 4,042 Income tax (benefit) and other (3,154) (6,069) 4,228 2,585 Interest expense 11,845 11,660 11,956 4,477 ------- -------- ------- ------- Net income (loss) $ 8,813 $(77,251) $ 7,096 $ 4,645 ======== ======== ======= ======= Production: Oil and 2,080 2,298 2,108 854 condensate(MBBLS) Natural gas (MMCF) 18,965 21,302 22,386 10,552 Gas equivalent (MMCFE) 31,445 35,090 35,034 15,676 Average sales price/(2)/ Oil and condensate (per barrel) $ 12.77 $ 11.64 $ 16.52 $ 17.41 Natural gas (per MCF) $ 2.18 $ 2.18 $ 2.39 $ 2.29 Average unit production costs per equivalent MCF (1 barrel equals 6 MCF) $ .68 $ .72 $ .79 $ .73 Average unit general and administrative expense per equivalent MCF/(3)/ $ .25 $ .24 $ .21 $ .23 Average unit depletion rate per equivalent MCF/(4)/ $ .72 $ 1.10 $ .90 $ .94
(1) Annualized amounts were computed by multiplying Transition Period 1997 components by 2 (2) Average sales price is inclusive of the effect of natural gas and crude oil price hedges (3) Exclusive of general and administrative expenses allocated to gas plants (4) Exclusive of depreciation on gas plants 25 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Operations of the gas plant and the gathering system are summarized as follows:
Annualized Year Ended Year Ended Transition Period Fiscal 1999 1998 1997 1997 -------------- ------------- ------------------- ------------ Plant product sales volume (MBBLS)..................... 241 254 218 319 Average product sales price per barrel............................................... $12.93 $10.19 $14.45 $16.77
Year Ended 1999 Compared to Year Ended 1998: Net income for the year ended December 31, 1999 was $8.8 million or $.63 per share on a diluted basis while the year ended December 31, 1998 resulted in a loss of $77.3 million or $5.50 per share diluted. The loss in 1998 was due to a pre-tax $73.9 million impairment charge resulting from the Company's capitalized cost exceeding the discounted future net revenues on a after-tax basis of estimated proved oil and gas reserves. Oil and gas revenues were $67.9 million for the year ended 1999, as compared to $73.2 million of oil and gas revenues for the year ended 1998. While oil and gas volumes were down approximately 10% in 1999 compared to 1998, oil prices were 10% higher in 1999. Oil prices increased from $11.64 per barrel in 1998 to $12.77 in 1999. Gas prices remained flat at $2.18 for 1999 and 1998. While gas prices were weak in the first few months in 1999, gas prices recovered in the fourth quarter of 1999. As a result of natural gas and crude oil hedging activities, oil and gas revenues were reduced by $4 million in 1999 and were increased by $3.6 million in 1998. The production declines were attributable to normal declines in the Company's Gulf of Mexico properties. This decline was somewhat halted by the acquisition of additional Gulf of Mexico properties in July and the November acquisition of Southeast New Mexico properties. Gas plant net revenues were $1.5 million in 1999, as compared to $1.2 million in 1998. Contributing to this increase were increases in plant liquid prices of 27% over the prior year. Production expenses for fiscal 1999 totaled $21.5 million, as compared to $25.4 million in fiscal 1998. On an MCF basis, production expenses were $.68 per MCF in 1999 as compared to $.72 in 1998. The primary reason for the decreased costs was the sale of $2.9 million of non-core assets. These assets had minimal production, but high lease operating and workover expenses. On an equivalent MCF basis production expenses decreased from $.72 per equivalent MCF in 1998 to $.68 per equivalent MCF in 1999. Depreciation, depletion and amortization decreased 40% to $23.9 million in 1999 versus $39.7 million in 1998. Such decrease was attributable to the lower book basis due to the 1998 impairment mentioned above. General and administrative expenses decreased in 1999 to $7.8 million from $8.5 million in 1998. A decrease in outsourcing costs from $4 million to $2.9 million was the major contribution to this decline. Until October 2000, the Company was charged an outsourcing fee, which was based upon a specified percentage of the average book value of the Company's total assets, excluding cash, plus a percentage of operating cashflows. Due to the $73.9 million impairment charge mentioned above, the Company's total assets and resulting percentage of such assets was reduced. Additionally, the 1998 period included costs related to the closing of the Company's Dallas exploration office in March 1998 and certain transition costs related to the change of the Company's 1997 fiscal year. Partially offsetting such decreases was $1.7 million in severance costs incurred in the third quarter of 1999 due to the Company's recent management change. General and administrative expenses on an equivalent MCF basis increased from $.24 per equivalent MCF in 1998 to $.25 per equivalent MCF in 1999. A refund on 1998 taxes was received in 1999. The refund resulted from higher than anticipated dry hole and expired lease charges in 1998. For the year ended December 31, 1999, due to increased future net reserves, the Company recognized a portion of the deferred tax asset previously offset by a valuation allowance. 26 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Interest expense increased to $11.8 million for the year ended December 31, 1999 from $11.7 million in the year ended December 31, 1998. Year Ended 1998 Compared with Annualized Transition Period 1997: The year ended 1998 reflects a loss of $77.3 million as compared to net income of $7.1 million for the annualized transition period 1997. The loss in 1998 is directly attributable to oil and gas price declines of 31% and 20%, respectively, and the full cost ceiling impairment of $73.9 million. Such impairment resulted from the price declines as well as the downward revision in proved reserves. Oil and gas revenues were $73.2 million for the year ended December 31, 1998, a decrease of 17% over the annualized transition period 1997. This decrease is primarily due to the decline in oil and gas prices mentioned above. Oil prices decreased from $16.52 per barrel in the annualized transition period 1997 to $11.64 in the year ended December 31, 1998. Gas prices decreased from $2.39 per Mcf in the annualized transition period 1997 to $2.18 per Mcf in the year ended December 31, 1998. The Company utilized various hedging transactions to manage a portion of the risks associated with natural gas and crude oil price volatility. As a result of these hedges, oil and gas revenues were increased by $3.6 million in the year ended December 31, 1998 and reduced by $1.6 million in the transition period 1997. Gas plant revenues were $3.2 million in the year ended December 31, 1998, a decrease of 22% from the transition period 1997 gas plant revenues of $4.1 million. The decrease in average liquid prices of 30% is the primary reason gas plant revenues have declined. The average liquid price in the year ended 1998 was $10.19 per barrel while the annualized transition period 1997 average liquid price was $14.45 per barrel. Throughput volumes have remained steady at 14.3 MMcf per day in the year ended 1998 as compared to 14.9 MMcf per day in annualized transition period 1997. Plant shut-in days were less in the year ended 1998 with 8 days downtime in 1998 resulting from an accident in an adjacent plant and the tie-in of new equipment. Downtime in 1997 totaled 24 days (48 days annualized) for installation of an amine unit in September 1997 and repairs to the insulation in the incinerator. Gas plant expenses were $2.0 million in the year ended 1998 and $2.5 million in annualized transition period 1997. Interest and other income increased to $1.3 million in the year ended 1998 from $1.2 million in annualized transition period 1997. Production expenses for the year ended December 31, 1998 were $25.4 million, a decrease of 8% from the transition period amount. On an MCF equivalency basis, production expenses for the year decreased to $.72 per equivalent MCF versus $.79 per equivalent MCF in the transition period 1997. Depreciation, depletion and amortization for the year ended December 31, 1998 increased 21% to $39.7 million. The increase is due to the increase in the depreciation, depletion and amortization rate per MCF to $1.10 per MCF. This represents a 21% increase over the annualized transition period 1997 rate of $.90 per MCF. The rate increase is primarily due to a downward revision to proved reserves of 26 BCFE or 12% of the reserve quantities at the beginning of the year. Weak oil and gas prices were the most significant contributor to the reserve revision. Production performance also contributed to the revision, but to a lesser extent as the weak prices resulted in a shortened economic life for certain of the Company's properties. An impairment expense of $73.9 million was required in the year ended 1998 because the Company's capitalized costs (net of depreciation, depletion and amortization) exceeded the discounted future net reserves on an after-tax basis of estimated proved oil and gas reserves. The decline in oil and gas reserves and discounted future net revenues is due largely to depressed oil and gas prices. General and administrative expenses increased from $7.5 million in annualized transition period 1997 to $8.5 million in the year ended December 31, 1998. The closing of the Company's Dallas exploration office in March 1998 resulted in $.3 million of increased general and administrative expenses and certain transition costs related to the change of the Company's fiscal year also increased such expenses by approximately $.4 million. On 27 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES an equivalent MCF basis, general and administrative cost increased to $.24 per MCF in fiscal 1998 as compared to $.21 per MCF in the transition period 1997. The large impairment mentioned above resulted in an increase in the Company's tax valuation allowance for the benefit for the current period's net loss from operations. Annualized interest expense decreased 2% to $11.7 million from $12.0 million in fiscal 1997. Annualized Transition Period 1997 Compared with Fiscal 1997: Net income for the annualized transition period 1997 was $7.1 million as compared to net income of $4.6 million in the fiscal year 1997. The primary reason for the increase is the full year's production attributable to the Partnership Transactions in the annualized transition period 1997. The fiscal 1997 period reflects only 3 months of such activity. Oil and gas revenues were $88.3 million for the annualized transition period 1997, an increase of 126% over the fiscal year ended June 30, 1997. This increase is due to a full year of production from the properties acquired in the Partnership Transactions, which closed in the fourth quarter of fiscal 1997. Annualized production on an equivalent MCFE basis increased 124% to 35,034 equivalent MCF in the transition period compared to 15,676 equivalent MCF of production in fiscal 1997. During the period, the volatility of oil and gas prices also directly impacted revenues. Most significantly, natural gas prices increased in the transition period 1997 to $2.55 per Mcf from $2.29 per Mcf in fiscal 1997. During the transition period 1997 and fiscal 1997, the Company utilized various hedging transactions to manage a portion of the risks associated with natural gas and crude oil price volatility. As a result of these hedges, oil and gas revenues were reduced by $1.6 million in the transition period 1997 and by $18,000 in fiscal 1997. Gas plant revenues were $4.1 million in the annualized transition period 1997, a decrease of 39% from fiscal 1997 gas plant revenues. The decrease, prior to annualization, was due to a 10 day shut-down of the plant in September to install an amine unit and a two week shut-down in December to repair the insulation in the incinerator (a total of 48 days on a annualized basis). Also, contributing to the decline in the annualized transition period 1997 gas plant revenues was a 14% decline from fiscal 1997 in plant liquids prices. Annualized gas plant expenses were $2.5 million in the transition period 1997 as compared to $3.3 million during fiscal 1997. The decrease in expenses is attributable to the plant shut-downs. Production expenses for the annualized transition period 1997 were $27.7 million, an increase of 142% over the fiscal 1997 amount. The increase is primarily due to inclusion of the Partnership Transactions for all of transition 1997, while fiscal 1997 amounts reflect only one quarter for the Partnership Transactions. On an MCF equivalency basis, production expenses for the annualized transition period increased to $.79 per equivalent MCF versus $.73 per equivalent MCF in fiscal 1997. The increase in the per unit rate results from the suspension of production, but not production expenses, at the Point Pedernales field for most of the last quarter of the transition period and from out of period expenses recorded within the annualized 1997 transition period. Depreciation, depletion and amortization for the annualized transition period 1997 increased 110% to $32.7 million. The impact of increased production in the transition period due to the Partnership Transactions was partially offset by a $.04 per MCF decrease in the depletion rate. Depreciation, depletion and amortization was $.90 per MCF in the annualized transition period 1997 as compared to $.94 per MCF in fiscal 1997. General and administrative expenses increased from $4.0 million in fiscal 1997 to $7.5 million in annualized transition period 1997. The increase is primarily due to increased management fees resulting from the Partnership Transactions. Management fees are based on the Company's net assets and operating cash flows. On an MCF basis, general and administrative expenses decreased to $.21 per MCF in transition 1997 from $.23 per MCF in fiscal 1997. 28 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Annualized interest expense increased 167% to $12 million from $4.5 million in fiscal 1997. The increase is primarily due to interest attributable to the $100 million of 10 7/8% Senior Subordinated Notes issued April 1997 to finance the Partnership Transactions. Other Matters Dividends At present, there is no plan to pay dividends on the Common Stock. Certain restrictions contained in the Company's outstanding Notes and Senior Credit Facility limit the amount of dividends, which may be declared. The Company maintains a policy, which is subject to review from time to time by the Board of Directors, of reinvesting its discretionary cash flows for the continued growth of the Company. Gas Balancing Positions It is customary in the industry for various working interest partners to sell more or less than their entitled share of natural gas production. The Company uses the sales method of accounting for gas imbalances. Under this method, gas sales are recorded when revenue checks are received or are receivable on the accrual basis. The settlement or disposition of gas balancing positions as of December 31, 1999 is not anticipated to adversely impact the financial condition of the Company. Derivative Financial Instruments The Company periodically uses derivative financial instruments to manage oil and gas price risk and interest rate risk. For purposes of its hedging activities, the Company divides product price risks into two categories, fluctuations in the price of oil and gas on the NYMEX and fluctuations in the difference between NYMEX prices and the price actually received by the Company for its production (referred to as "basis differential"). From time to time the Company enters into swap transactions in which the Company agrees to pay a fixed price and the counter party to the swap agrees to pay a NYMEX based price. Effective September 22, 1998, the Company entered into an eight and a half- year interest rate swap agreement with a notational value of $80 million. Under the agreement, the Company receives a fixed interest rate and pays a floating interest rate based on the simple average of three foreign LIBOR rates. Floating rates are redetermined for a six-month period each April 1 and October 1. The floating rate for the period from October 1, 1999 to April 1, 2000 is 9.64%. Through April 2002 the floating rate is capped at 10.875% and capped at 12.375% thereafter. A 10% increase in these floating rates would have the effect of increasing interest costs to the Company by $216,800 per year. New Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards of accounting for and disclosures of derivative instruments and hedging activities. As amended, this statement is effective for fiscal quarters beginning after January 1, 2001. The Company has not yet determined the impact of this statement on the Company's financial condition or results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk, including adverse changes in commodity prices and interest rate. Commodity Price Risk - The Company produces and sells crude oil, natural gas and natural gas liquids. As a result, the Company's operating results can be significantly affected by fluctuations in commodity prices caused by changing market forces. The Company periodically seeks to reduce its exposure to price volatility by hedging its productions through swaps, options and other commodity derivative instruments. The Company uses hedge 29 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES accounting for these instruments, and settlements of gains or losses on these contracts are reported as a component of oil and gas revenues and operating cash flows in the period realized. These agreements expose the Company to counterparty credit risk to the extent that the counterparty is unable to meet its settlement commitments to the Company. The following tables detail the Company's hedges of future production, which were in place at December 31, 1999. OIL HEDGES
NYMEX NYMEX PERIOD BBLS TOTAL BBLS TYPE PRICE PRICE PER DAY FLOOR CEILING - ------------------------------------------------------------------------- Jan 2000-March 2000 2,000 182,000 Collar $19.00 $21.75 - ------------------------------------------------------------------------- Jan 2000-March 2000 2,000 182,000 Collar $21.75 $25.60 - ------------------------------------------------------------------------- April 2000-June 2000 4,000 364,000 Collar* $22.00 $24.63 - -------------------------------------------------------------------------
GAS HEDGES
NYMEX NYMEX PERIOD MCF TOTAL MCF TYPE PRICE PRICE PER DAY FLOOR CEILING - ------------------------------------------------------------------------------- Jan 2000-Mar 2000 15,000 2,280,000 Floor $2.40 N/A - ------------------------------------------------------------------------------- Jan 2000-Mar 2000 15,000 2,280,000 Collar** $3.00 $3.55 - ------------------------------------------------------------------------------- April 2000-Oct 2000 15,000 3,210,000 Collar $2.30 $2.87 - ------------------------------------------------------------------------------- Nov 2000-March 2001 20,000 3,020,000 Collar $2.40 $3.40 - ------------------------------------------------------------------------------- April 2001-Oct 2001 20,000 4,280,000 Collar $2.20 $2.95 - -------------------------------------------------------------------------------
* This agreement includes a put at $17.00 per barrel ** This agreement includes a put at $2.40 per Mcf The fair value at December 31, 2000 of these swap agreements was a gain of $862,000. these energy swap agreements expose the Company to counterparty credit risk to the extent the counterparty is unable to meet its montly settlement commitment to the Company. Interest Rate Risk - The Company may enter into financial instruments such as interest rate swaps to manage the impact of changes in interest rates. Effective September 22, 1998, the Company entered into an eight and a half year interest rate swap agreement with a notional value of $80 million. Under the agreement, the Company receives a fixed interest rate and pays a floating interest rate, subject to a cap, based on the simple average of three foreign LIBOR rates. Floating rates are redetermined for a six month period each April 1 and October 1. This agreement is not held for trading purposes. As the swap provider is a major financial institution, the Company does not anticipate non- performance by the provider. The Company's exposure to changes in interest rates primarily results from short term changes in the LIBOR rates. A 10% increase in the floating LIBOR rates would have the effect of increasing interest costs to the Company by $216,500 per year. 30 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Page Number ----------- Independent Auditors' Report.......................................... 32 Financial Statements: Consolidated Balance Sheets as of December 31, 1999 and 1998,........ 33 Consolidated Statements of Operations for the Periods Ended December 31, 1999, 1998 and 1997, and June 30, 1997................. 35 Consolidated Statements of Changes in Stockholders' Equity for the Periods Ended December 31, 1999, 1998, 1997, and June 30, 1997...... 36 Consolidated Statements of Cash Flows for the Periods Ended December 31, 1999, 1998, 1997, and June 30, 1997.................... 37 Notes to Consolidated Financial Statements........................... 39 31 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders of Bellwether Exploration Company and Subsidiaries: We have audited the accompanying consolidated balance sheets of Bellwether Exploration Company and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years ended December 31, 1999 and 1998, the six month period ended December 31, 1997 and the year ended June 30, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Bellwether Exploration Company and subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for the years ended December 31, 1999, 1998, the six month period ended December 31, 1997, and the year ended June 30, 1997 in conformity with generally accepted accounting principles. KPMG LLP Houston, Texas March 16, 2000 32 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS (Amounts in thousands)
DECEMBER 31, 1999 DECEMBER 31, 1998 ----------------------- ------------------------- CURRENT ASSETS: Cash and cash equivalents...................................... $ 6,101 $ 10 Accounts receivable and accrued revenues................................................ 14,354 15,602 Accounts receivable - related parties.......................... --- 853 Prepaid expenses............................................... 1,562 1,719 ---------------------- ------------------------- Total current assets......................................... 22,017 18,184 ----------------------- ------------------------- PROPERTY, PLANT AND EQUIPMENT, AT COST: Oil and gas properties (full cost): United States - Unproved properties of $16,325 and $8,754 excluded from amortization as of December 31, 1999 and 1998 respectively............................ 344,778 289,040 Latin America - Unproved properties of $404 and $191 excluded from amortization as of December 31, 1999 and 1998, respectively........................... 1,246 191 Gas plant facilities........................................... 17,775 17,406 ----------------------- ------------------------- 363,799 306,637 Less accumulated depreciation, depletion and amortization.............................. (227,226) (198,421) ----------------------- ------------------------- 136,573 108,216 ----------------------- ------------------------- INVESTMENT IN OUTSIDE COMPANIES................................ 4,554 --- DEFERRED INCOME TAXES.......................................... 2,739 --- OTHER ASSETS................................................... 5,878 4,796 ----------------------- ------------------------- $ 171,761 $ 131,196 ======================= =========================
See Notes to Consolidated Financial Statements. 33 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY (Amounts in thousands, except share information)
DECEMBER 31, 1999 DECEMBER 31, 1998 ----------------------- ------------------------- CURRENT LIABILITIES: Accounts payable and accrued liabilities............................................. $ 18,247 $ 11,982 Accounts payable - related parties............................. --- 125 -------- -------- Total current liabilities.................................... 18,247 12,107 -------- -------- LONG-TERM DEBT................................................. 130,000 104,400 OTHER LIABILITIES.............................................. 200 200 CONTINGENCIES.................................................. --- --- STOCKHOLDERS' EQUITY: Preferred stock, $0.01 par value, 1,000,000 shares authorized, none issued or outstanding........................ --- --- Common stock, $0.01 par value, 30,000,000 shares authorized 14,168,791 and 14,164,791 shares issued at December 31, 1999, and 1998, respectively.................................. 142 142 Additional paid-in capital..................................... 80,455 80,442 Retained earnings (deficit).................................... (55,378) (64,191) Treasury stock, at cost, 311,000 and 310,800 shares (1,905) (1,904) at December 31, 1999 and 1998, respectively............. -------- -------- Total stockholders' equity..................................... 23,314 14,489 -------- -------- $171,761 $131,196 ======== ========
See Notes to Consolidated Financial Statements. 34 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands, except per share data)
Six Month Transition Year Ended Year Ended Period Ended Fiscal Year December 31, December 31, December 31, Ended June 30, ------------- ------------- -------------------- -------------- REVENUES: 1999 1998 1997 1997 ------------- ------------- -------------------- -------------- Gas revenues........................ $ 41,380 $ 46,461 $ 26,755 $ 24,202 Oil revenues........................ 26,568 26,756 17,408 14,865 Gas plant revenues, net............. 1,464 1,203 804 3,330 Interest and other income........... 1,335 1,347 609 363 -------- --------- -------- -------- 70,747 75,767 45,576 42,760 -------- --------- -------- -------- COSTS AND EXPENSES: Production expenses................. 21,532 25,381 13,836 11,437 General and administrative expenses.......................... 7,848 8,459 3,748 4,042 Depreciation, depletion and Amortization...................... 23,863 39,688 16,352 15,574 Impairment expense.................. --- 73,899 --- --- Interest expense.................... 11,845 11,660 5,978 4,477 -------- -------- -------- -------- 65,088 159,087 39,914 35,530 -------- -------- -------- -------- Income (loss) before income tax (benefit)...................... 5,659 (83,320) 5,662 7,230 Provision for income tax (benefit).. (3,154) (6,069) 2,114 2,585 -------- -------- -------- -------- Net income (loss)................... $ 8,813 $(77,251) $ 3,548 $ 4,645 ======== ======== ======== ======== Net income (loss) per share......... $ .64 $ (5.50) $ .26 $ 0.46 ======== ======== ======== ======== Net income (loss) per share- diluted............................ $ .63 $ (5.50) $ .25 $ 0.45 ======== ======== ======== ======== Weighted average common shares outstanding........................ 13,854 14,039 13,876 10,201 ======== ======== ======== ======== Weighted average common shares outstanding-diluted................ 13,896 14,039 14,446 10,261 ======== ======== ======== ========
See Notes to Consolidated Financial Statements. 35 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Amounts in thousands)
Common Stock Preferred Stock Additional Retained Treasury Stock -------------- ----------------- Paid-In Earnings --------------- Shares Amount Shares Amount Capital (Deficit) Shares Amount Total ------ ------- ------ ------- ----------- --------- ------- ------- ----- Balance June 30, 1996.......... 9,075 $ 91 --- $ --- $41,639 $ 4,867 --- $ --- $ 46,597 Shares issued in public stock offering, net of offering costs................ 4,687 47 --- --- 36,169 --- --- --- 36,216 Stock options exercised and related tax effect................... 83 1 --- --- 465 --- --- --- 466 Net income.................... --- --- --- --- --- 4,645 --- --- 4,645 ------ ----- ----- ------ ------- ------ ----- ------ -------- Balance June 30, 1997......... 13,845 $139 --- $ --- $78,273 $ 9,512 --- $ --- $ 87,924 ====== ====== ===== ====== ======= ======== ===== ====== ======== Offering costs................ --- --- --- --- (96) --- --- --- (96) Stock options exercised and related tax effects.................. 47 --- --- --- 293 --- --- --- 293 Net income.................... --- --- --- --- --- 3,548 --- --- 3,548 ------ ----- ----- ------ ------- ------ ----- ------ -------- Balance December 31, 1997............ 13,892 $139 --- $ --- $78,470 $ 13,060 --- $ --- $ 91,669 ====== ====== ===== ====== ======= ======== ===== ====== ======== Stock options exercised and related tax effects.................. 273 3 --- --- 1,972 --- --- --- 1,975 Treasury shares purchased.................... --- --- --- --- --- --- (311) (1,904) (1,904) Net loss...................... --- --- --- --- --- (77,251) --- --- (77,251) Balance December 31, 1998........... 14,165 $142 --- $ --- $80,442 $(64,191) (311) $(1,904) $ 14,489 ====== ====== ===== ====== ======= ======== ===== ====== ======== Stock options Exercised and related tax effects .............. 4 --- --- --- 13 --- --- --- 13 Treasury shares purchased................... --- --- --- --- --- --- --- (1) (1) Net income.................... --- $--- --- $ --- $ --- 8,813 --- $ --- $ 8,813 ------ ----- ----- ------ ------- ------ ----- ------ -------- Balance December 31, 1999........... 14,169 $142 --- $ --- $80,455 $(55,378) (311) $(1,905) $ 23,314 ====== ====== ===== ====== ======= ======== ===== ======= ========
See Notes to Consolidated Financial Statements. 36 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in Thousands)
Six Month Transition Period Fiscal Year Ended Year Ended Ended Year Ended December 31, December 31, December 31, June 30, ------------- ------------- ------------------ ------------ 1999 1998 1997 1997 ------------- ------------- ------------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss).............................. $ 8,813 $(77,251) $ 3,548 $ 4,645 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation, depletion and Amortization................................. 24,694 40,544 16,708 16,044 Impairment expense........................... --- 73,899 --- --- Deferred taxes............................... (2,739) (6,820) 1,585 2,562 -------- -------- ------- -------- 30,768 30,372 21,841 23,251 Change in assets and liabilities, net of acquisition effects: Accounts receivable and accrued revenues................................... 2,101 2,691 (1,498) 2,941 Prepaid expenses............................. 157 1,521 (1,481) (638) Accounts payable and accrued expenses........ 6,265 (2,220) 1,502 4,438 Due (to) from affiliates..................... (125) 3,245 (2,346) 5,738 Other........................................ (1,837) (1,908) (57) (6,447) -------- -------- ------- -------- NET CASH FLOWS PROVIDED BY OPERATING ACTIVITIES................................... 37,329 33,701 17,961 29,283 -------- -------- ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisitions of oil and gas properties, including working capital of $13,914 in fiscal year ended June 30, 1997 -Partnership Transactions.................... --- --- --- (147,909) -Other acquisitions.......................... (25,889) (9,596) (5,486) (2,005) Investment in outside companies................ (4,554) --- --- --- Additions to oil and gas properties............ (30,904) (30,583) (13,727) (20,811) Proceeds from sales of properties.............. 5,139 421 5,362 18,775 Additions to gas plant facilities.............. (369) (689) (1,632) (84) Other.......................................... (273) (88) (17) (88) -------- -------- ------- -------- NET CASH FLOWS USED IN INVESTING ACTIVITIES......................... (56,850) (40,535) (15,500) (152,122) ======== ======== ======= ========
See Notes to Consolidated Financial Statements. 37 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (Amounts in Thousands)
Six Month Transition Fiscal Year Year Ended Year Ended Period Ended Ended December 31, December 31, December 31, June 30, ------------- ------------- --------------- ------------ 1999 1998 1997 1997 ------------- ------------- --------------- ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings...................... 42,000 4,900 1,500 157,300 Net proceeds from issuance of common stock................................ 13 1,649 197 35,145 Payments of long-term debt.................... (16,400) (500) (16,800) (55,048) Purchase of treasury shares................... (1) (1,904) --- --- -------- -------- --------- -------- NET CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES.............. 25,612 4,145 (15,103) 137,397 -------- -------- --------- -------- Net increase (decrease) in cash and cash equivalents............................ 6,091 (2,689) (12,642) 14,558 Cash and cash equivalents at beginning of period......................... 10 2,699 15,341 783 -------- -------- --------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD................................... $ 6,101 $ 10 $ 2,699 $ 15,341 ======== ======== ========= ========
See Notes to Consolidated Financial Statements. 38 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES 1. ORGANIZATION Bellwether Exploration Company ("the Company") was formed as a Delaware corporation in 1994 to succeed to the business and properties of its predecessor company pursuant to a merger, the primary purpose of which was to change the predecessor company's state of incorporation from Colorado to Delaware. The predecessor company was formed in 1980 from the consolidation of the business and properties of related oil and gas limited partnerships. References to Bellwether or the Company include the predecessor company, unless the context requires otherwise. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Bellwether Exploration Company and its wholly-owned subsidiaries. Snyder Gas Plant Venture and NGL/Torch Gas Plant Venture and their 11.9% and 32.0% investments in the Snyder and Diamond M-Sharon Ridge Gas Plants have been pro rata consolidated through September 1999 at which time the joint ventures were dissolved. The Company's Ukrainian interests are currently reflected using the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation. Fiscal Year Change In order to facilitate greater comparability with its peer group by the financial community, the Company changed its fiscal year to the calendar year, beginning January 1, 1998. This resulted in a six-month transition period of July 1, 1997 through December 31, 1997 ("transition period"). Oil and Gas Properties The Company utilizes the full cost method to account for its investment in oil and gas properties. Under this method, all costs of acquisition, exploration and development of oil and gas reserves (including such costs as leasehold acquisition costs, geological expenditures, dry hole costs and tangible and intangible development costs and direct internal costs) are capitalized as incurred. The cost of oil and gas properties, the estimated future expenditures to develop proved reserves, and estimated future abandonment, site remediation and dismantlement costs are depleted and charged to operations using the unit-of-production method based on the ratio of current production to proved oil and gas reserves as estimated by independent engineering consultants. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization computation until it is determined whether or not proved reserves can be assigned to the properties or whether impairment has occurred. Depletion expense per equivalent MCF of production was approximately $ .72 in 1999, $1.10 in 1998, $.90 in transition period 1997, and $.94 in fiscal 1997. The following table shows, by category of cost and date incurred, the domestic unproved property costs excluded from amortization (amounts in thousands):
Leasehold Exploration Development Total at Costs Costs Cost December 31, 1999 ---------- ------------ ----------- ------------------- Costs Incurred During Periods Ended: December 31, 1999 $ 9,198 $1,297 $2,641 $13,136 December 31, 1998 3,016 --- --- 3,016 December 31, 1997 173 --- --- 173 Prior --- --- --- --- ------- ------ ------ ------- $12,387 $1,297 $2,641 $16,325 ======= ====== ====== =======
39 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The Latin American unproved property costs of $404,000 excluded from amortization was incurred in 1999 and was for acquisition costs. Significant land and seismic costs have been incurred in the current and prior years by the Company and are still in the evaluation stage. While approximately $1.2 million has been evaluated and moved to the full cost pool in 1999, $16.3 million of such domestic costs remain to be evaluated. Such costs fall into four broad categories: 1) Material projects which are in the last one to two years of seismic evaluation; 2) Material projects currently being marketed to third parties; 3) Leasehold and seismic costs for projects not yet evaluated at all; and 4) Drilling and completion costs for projects in progress at year end which have not resulted in the recognition of reserves at December 1999. This category of costs will transfer into the full cost pool in 2000. Dispositions of oil and gas properties are recorded as adjustments to capitalized costs, with no gain or loss recognized unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas. To the extent that capitalized costs of oil and gas properties, net of accumulated depreciation, depletion and amortization, exceed the discounted future net revenues of proved oil and gas reserves net of deferred taxes, such excess capitalized costs would be charged to operations. Oil and gas prices declined in 1998, with continued declines in early 1999. As a result of such declines, the Company's capitalized costs were in excess of future net revenues calculated using prices in effect in late February 1999. The Company recorded an oil and gas property impairment of $73.9 million in 1998. No such impairment in book value was required at December 1999, 1997 or June 1997. Any reference to oil and gas reserve information in the Notes to Consolidated Financial Statements is unaudited. Gas Plants and Gas Gathering System Gas plant facilities include the costs to acquire certain gas plants and to secure rights-of-way. Capitalized costs associated with gas plants facilities are amortized primarily over the estimated useful lives of the various components of the facilities utilizing the straight-line method. The estimated useful lives of such assets range from four to fifteen years. Effective September 1, 1999, NGL Associates, the Company's partner in Diamond M - NGL - Torch Gas Plant Venture, backed-in for a 16.5% working interest in the Diamond M and Snyder gas plants. This resulted in the dissolution of the joint venture and the Company's reduced interest in the Diamond M and Snyder gas plants. The Company sold its gas gathering subsidiary for $40,000 on March 1, 1999. Gas Imbalances The Company uses the sales method of accounting for gas imbalances. Under this method, gas sales are recorded when revenue checks are received or are receivable on the accrual basis. The Company had a net imbalance liability, at fair value, of $1.2 million and $.5 million, at December 31, 1999 and 1998, respectively. A certain portion of the gas balancing liability is related to properties approaching depletion; therefore; cash settlement may be likely. The Company has taken steps to extend the productive life of such reserves. 40 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Natural Gas and Crude Oil Hedging Commodity derivatives utilized as hedges include swap contracts. In order to qualify as a hedge, price movements in the underlying commodity derivative must be sufficiently correlated with the hedged commodity. When a commodity derivative ceases to qualify as a hedge, the change in its fair value is recognized in income currently. Settlement of gains and losses on price swap contracts are realized monthly, generally based upon the difference between the contract price and the average closing New York Mercantile Exchange ("NYMEX") price and are reported as a component of oil and gas revenues and operating cash flows in the period realized. Gains and losses attributable to the termination of a swap contract are deferred on the balance sheet and recognized in revenue when the hedged crude oil and natural gas is sold. There were no such deferred gains or losses at December 31, 1999 or 1998. Oil and gas revenues were decreased by $4.0 million in the year ended December 31, 1999, increased by $3.6 million in the year ended December 31, 1998, decreased by $1.6 million in the six month transition period ended December 1997 and decreased by $18,000 in the fiscal year ended June 1997, as a result of such hedging activity. Income Taxes Deferred taxes are accounted for under the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized in income in the period the change occurs. Statements of Cash Flows For cash flow presentation purposes, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Interest paid in cash for the years ended December 31, 1999 and 1998, the six month transition period ended December 31, 1997, and the fiscal year ended June 30, 1997, was $ 11.1 million, $11.1 million, $5.4 million and $1.5 million, respectively. Income tax refunds received in cash for December 31, 1999, were $437,000. Income taxes paid in cash for the year ended December 31, 1998, the transition period ended December 31, 1997 and the fiscal year ended June 30, 1997, were $1,408,000, $41,000 and $198,000, respectively. In April 1997, a portion of the purchase price of the Partnership Transactions included the issuance to Torch Energy Advisors Inc. ("Torch"), as consideration for advisory services, 150,000 shares of the Company's common stock valued at $1.2 million and a warrant to purchase 100,000 shares of common stock at $9.90 per share valued at $300,000. New Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards of accounting for and disclosures of derivative instruments and hedging activities. As amended, this statement is effective for fiscal quarters beginning after January 1, 2001. The Company has not yet determined the impact of this statement on the Company's financial condition or results of operations. Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities as well as reserve information which affects the depletion calculation and the computation of the full cost ceiling limitation to prepare these financial 41 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES statements in conformity with generally accepted accounting principles. Actual results could differ from these estimates. Reclassifications Certain reclassifications of prior period statements have been made to conform to current reporting practices. 3. ACQUISITIONS AND MERGERS During the last three fiscal years, the Company has completed the following mergers and acquisitions, all of which were recorded using the purchase method of accounting: During 1998, in connection with a possible transaction by the Company with Carpatsky Petroleum Company ("Carpatsky"), the Company agreed to guarantee $500,000 of indebtedness of Carpatsky to Torch. The Carpatsky note to Torch went into default in June 1998. Under an agreement effective October 31, 1999, Bellwether paid Torch $565,700 for the guaranty. The Company received in exchange 4.5 million shares of Carpatsky and a warrant to acquire an additional 967,296 common shares. On December 30, 1999 Bellwether purchased 95.45 million preferred shares of Carpatsky Petroleum, Inc. and warrants to acquire 12.5 million common shares for $4 million. The preferred shares are convertible into 50 million Carpatsky common shares (approximately 43% of the Carpatsky's equity), do not carry a preferential dividend and have majority voting rights over Carpatsky. In connection with this investment, Mr. J.P. Bryan, Chairman and Chief Executive Officer of Bellwether became the Chairman and CEO of Carpatsky and three Carpatsky directors retired and were replaced by three Bellwether appointees, giving Bellwether five of the new eight directorships of Carpatsky. Carpatsky conducts oil and gas exploration and production activities in the Republic of Ukraine. In December 1998 Bellwether was the successful bidder for the Charapa field in Ecuador. With the successful bid, the Company was awarded with a contract for production and exploration of crude oil in the Charapa field. The contract provides the Company with approximately 50% of the crude oil produced above the base production curve. The base production curve is defined as the production profile of the crude oil projected by the Ecuadorian government hydrocarbons subsidiary. Bellwether is also entitled to recoup lease operating expenses associated with the base productions. Negotiations with the Ecuadorian government took place throughout 1999 with Bellwether officially taking over operations of the field in January of 2000. Bellwether has committed to a $12 million work program over three years. In April 1997, the Company closed acquisitions of oil and gas properties, totaling $141.1 million, after purchase price adjustments, including working capital of $13.9 million, from certain partnerships and other entities managed or sponsored by Torch. The acquisitions were financed by the sale of 4.4 million shares of common stock, the sale of $100.0 million of 10-7/8% senior subordinated notes due in 2007 and the use of $33.3 million of a new $90.0 million senior unsecured credit facility (including the repayment of $22.0 million on a then existing credit facility). 4. RELATED PARTY TRANSACTIONS The Company is a party to a master services agreement and six specific contracts which requires Torch to administer certain business activities of the Company. The various contracts have terms from two years to five years in length and annual fees ranging from fixed amounts of $.4 million to $2.8 million plus fees based upon percentages of production ranging from 1/2% to 2% depending on the product. Prior to October 1999, the Company was party to an administrative services agreement which required Torch to administer certain activities of the Company for monthly fees equal to the sum of one-twelfth of 2% of the average of the book value of the Company's total assets, excluding cash, plus 2% of annual operating cash flows (as defined) during the period in which the services are rendered plus reimbursement of certain costs incurred on behalf of the Company. For the periods ended 42 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES December 31, 1999, 1998 and 1997, and June 30, 1997, related fees paid to Torch amounted to $2.9 million, $4.0 million, $2.4 million and $2.3 million, respectively. In April, 1997, Torch was issued 150,000 shares of the Company's common stock and a warrant, expiring in April 2002, to purchase 100,000 shares at $9.90 per share for advisory services rendered in connection with the Partnership Transactions. The Company's stock was valued at $1.2 million, and the warrant was valued at $300,000. In December 1993, Torch was issued a warrant to purchase 187,500 shares of the Company's common stock at a price of $6.40 per share for its advisory services in identifying and negotiating a merger; such warrants were exercised in connection with the Partnership Transactions with total proceeds to the Company of $684,000. Torch was also a selling partner in the Partnership Transactions through its ownership of general partnership and working interests in the partnerships programs. As a result, Torch was paid $18.4 million for such interests. On August 2, 1999, Mr. J. Darby Sere, previously Chairman and CEO, and Mr. William C. Rankin, previously Senior Vice President and Chief Financial Officer, left the Company to pursue other opportunities. Director, Mr. J. P. Bryan was elected Chairman and CEO effective August 2, 1999. Mr. Bryan is Senior Managing Director of and a holder of common stock of the parent corporation of Torch. Mr. Bryan has limited involvement in the day to day operations of Torch. Approximately $1.7 million of severance cost attributable to this management change were incurred in August 1999. A subsidiary of Torch markets oil and natural gas production from certain oil and gas properties in which the Company owns an interest. The Company generally pays fees of 1/2% to 2% of revenues for such marketing services. Such charges were $947,500, $1,143,000, $757,000 and $646,000 in periods ended December 1999, 1998 and 1997, June 1997, respectively. Costs of the evaluation of potential property acquisitions and due diligence conducted in conjunction with acquisitions closed are incurred by Torch at the Company's request. The Company was charged $357,800, $379,000, $217,000 and $650,000, for these costs in periods ended December 1999, 1998, 1997 and June 1997, respectively. Torch operates certain oil and gas interests owned by the Company. The Company is charged, on the same basis as other third parties, for all customary expenses and cost reimbursements associated with these activities. Operator's overhead charged for these activities for the periods ended December 31, 1999, 1998, 1997, and June 30, 1997 was $1,153,000, $1,349,000, $698,000 and $729,000, respectively. Torch became the operator of the Snyder Gas Plant on December 1, 1993. In periods ended December 1999, 1998, 1997 and June 1997, the fees paid by the Company to Torch were $73,000, $72,000, $42,000 and $49,000, respectively. 5. STOCKHOLDERS' EQUITY Common and Preferred Stock The Certificate of Incorporation of the Company authorizes the issuance of up to 30,000,000 shares of common stock and 1,000,000 shares of preferred stock, the terms, preferences, rights and restrictions of which are established by the Board of Directors of the Company. Certain restrictions contained in the Company's loan agreements limit the amount of dividends which may be declared. There is no present plan to pay cash dividends on common stock as the Company intends to reinvest its cash flows for continued growth of the Company. In April 1997, the Company issued 4.4 million shares of common stock for net proceeds to the Company of $34.1 million. Such proceeds were used in financing the Partnership Transactions. Also included in the April Offering were 719,264 shares sold by certain shareholders. Additional shares issued during fiscal 1997 included 43 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES 125,000 shares issued upon exercise of a warrant and 150,000 shares issued to Torch for advisory services rendered in connection with the Partnership Transactions. On September 12, 1997, the Company authorized and declared a dividend of one preferred stock purchase right for each share of common stock, par value $.01 per share, of the Company. The dividend was payable on September 26, 1997 to the holders of record of Common Shares as of the close of business on such date. In addition to stock options outstanding, the Company has 100,000 warrants outstanding at an exercise price of $9.90 per share. The expiration date for 100,000 warrants is April 2002. A tax benefit related to the exercise at employee stock options was immaterial in 1999 and approximately $324,000 was allocated directly to additional paid in capital in 1998. Such benefit was not material in prior periods. 44 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Earnings Per Share SFAS No. 128 requires the reconciliation of the numerator (income) and denominator (shares) of the earnings per share computation to the numerator and denominator of the diluted earnings per share computation. The Company's reconciliation is as follows (amounts in thousands):
Year Ended Year Ended December 31, 1999 December 31, 1998 ---------------------------------------------- ------------------------------------------------- Income Shares Per Share Income Shares Per Share ---------------------------------------------- ------------------------------------------------- Net income (loss) $8,813 $(77,251) ------ ------ ---- -------- ------ ------ Earnings (loss) per $8,813 13,854 $.64 $(77,251) 14,039 $(5.50) Common share Effect of Dilutive Securities: Options & Warrants --- 42 --- --- --- ------ ------ ---- -------- ------ ------ Earnings (loss) per Common share-diluted $8,813 13,896 $.63 $(77,251) 14,039 $(5.50) ====== ====== ===== ======== ====== ======
Six Month Transition Period Ended Fiscal Year Ended December 31, 1997 June 30, 1997 ---------------------------------------------- ------------------------------------------------- Income Shares Per Share Income Shares Per Share ---------------------------------------------- ------------------------------------------------- Net Income $3,548 $4,645 ------ ------ ----- ------ ------ ----- Earnings per Common share $3,548 13,876 $0.26 $4,645 10,201 $0.46 Effect of Dilutive Securities: Options & Warrants --- 570 --- 60 ------ ------ ----- ------ ------ ----- Earnings per common Share - diluted $3,548 14,446 $0.25 $4,645 10,261 $0.45 ====== ====== ===== ====== ====== =====
Options and warrants on 203,000 of shares of common stock were not included in computing diluted earnings per share for 1998 because their effects were antidilutive. 45 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Treasury Stock In September 1998, the Company's Board of Directors authorized the repurchase of up to $5 million of the Company's common stock. As of December 31, 1999, 311,000 shares had been acquired at an aggregate price of $1,905,000. These treasury shares are reported at cost as a reduction to Stockholders' Equity. Stock Incentive Plans The Company has stock option plans that provide for granting of options for the purchase of common stock to directors, officers and key employees of the Company and Torch. These stock options may be granted subject to terms ranging from 6 to 10 years at a price equal to the fair market value of the stock at the date of grant. The plans currently allow the Company 1,825,000 options; therefore, the remainder are subject to Shareholder approval of an amendment to the Company's plan. A summary of activity in the stock option plans is set forth below:
Number Option Of shares Price Range ------------------------- ------------------------------- Balance at June 30, 1996................................. 908,325 $3.00 - $7.00 Granted................................................ 378,500 $6.25 - $10.19 Surrendered............................................ (12,000) $7.63 Exercised.............................................. (82,500) $5.63 $5.75 ------------------------- ------------------------------- Balance at June 30, 1997................................. 1,192,325 $3.00 - $10.19 Granted................................................ 242,000 $1.31 - $12.38 Exercised.............................................. (46,500) $3.00 - $10.00 ------------------------- ------------------------------- Balance at December 31, 1997............................. 1,387,825 $3.00 - $12.38 Granted................................................ 300,000 $6.25 - $10.94 Surrendered............................................ (146,000) $5.62 - $12.38 Exercised.............................................. (273,325) $3.00 - $ 7.75 ------------------------- ------------------------------- Balance at December 31, 1998............................. 1,268,500 $4.38 - $12.38 Granted................................................ 653,500 $3.34 - $ 6.22 Surrendered............................................ (390,000) $3.34 - $10.19 Exercised.............................................. (4,000) $3.34 ------------------------- ------------------------------- Balance at December 31, 1999............................. 1,528,000 $3.34 - $12.38 ========================= =============================== Exercisable at December 31, 1999......................... 1,210,000 $3.34 - $12.38 ========================= ===============================
46 Detail of stock options outstanding and options exercisable at December 31, 1999 follows:
Outstanding Exercisable ---------------------------------------------------- ---------------------------------- Weighted Weighted Weighted Average Average Average Remaining Exercise Exercise Range of Exercise Prices Number Life (Years) Price Number Price - --------------------------------------------------------------------------------------------------------------------------------- 1994 Plan $3.34 to $ 7.63 463,000 5.7 $5.27 362,000 $5.47 1996 Plan $3.34 to $12.38 1,065,000 8.6 $7.03 848,000 $7.37 --------- --------- Total 1,528,000 1,210,000 ========= =========
The estimated weighted average fair value per share of options granted during 1999, 1998, transition period 1997 and fiscal 1997 was $11.68, $2.34, $1.78 and $2.34, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: For 1999: expected stock price volatility of 93%; a risk free interest rate of 6.5%; and an average expected option life of 10 years. For 1998, transition period 1997 and fiscal 1997: expected stock price volatility of 40%; and risk free interest rate of 5.5% and an average expected option life of 5 years. Had compensation expense for stock- based compensation been determined based on the fair value at the date of grant, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands except share information):
Six Month Transition Year Ended Year Ended Period Ended Fiscal Year December 31, December 31, December 31, Ended June 30, 1999 1998 1997 1997 ------------------ -------------------- ----------------------- ------------------ Net income (loss) As Reported.......... $ 8,813 $(77,251) $3,548 $4,645 Pro forma............ $(19,516) $(78,321) $2,524 $3,853 Earnings (loss) per share As reported.......... $ .64 $ (5.50) $ 0.26 $ 0.46 Pro forma............ $ (1.41) $ (5.58) $ 0.18 $ 0.38 Diluted earnings (loss) per share As reported.......... $ .63 $ (5.42) $ 0.25 $ 0.45 Pro forma............ $ (1.40) $ (5.50) $ 0.17 $ 0.38
6. DERIVATIVE FINANCIAL INSTRUMENTS The Company periodically uses derivative financial instruments to manage oil and gas price risk; generally commodity price swap agreements which provide for the Company to receive or make counterparty payments on the differential between a fixed price and a variable indexed price for natural gas or crude oil. Gains and losses from these hedging activities are included in oil and gas sales at the time the related production is delivered. Hedging activities decreased returns by $4 million for the year 1999, increased returns by $3.6 million for the year 1998 and reduced revenues by $1.6 million and $18,000 for the transition period 1997 and for the fiscal years ended June 30, 1997, respectively. At December 31, 1999 the Company had unrealized net hedging gains of $862,000. 47 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The following tables detail the Company's hedges of future production, which were in place at December 31, 1999. OIL HEDGES
NYMEX NYMEX PERIOD BBLS TOTAL BBLS TYPE PRICE PRICE PER DAY FLOOR CEILING - ----------------------------------------------------------------------------------------------------------------------------- Jan 2000-March 2000 2,000 182,000 Collar $19.00 $21.75 - ----------------------------------------------------------------------------------------------------------------------------- Jan 2000-March 2000 2,000 182,000 Collar $21.75 $25.60 - ----------------------------------------------------------------------------------------------------------------------------- April 2000-June 2000 4,000 364,000 Collar* $22.00 $24.63 - -----------------------------------------------------------------------------------------------------------------------------
GAS HEDGES
NYMEX NYMEX Period MCF TOTAL MCF Type PRICE PRICE PER DAY FLOOR CEILING - ------------------------------------------------------------------------------------------------------------------------------ Jan 2000-Mar 2000 15,000 2,280,000 Floor $2.40 N/A - ------------------------------------------------------------------------------------------------------------------------------ Jan 2000-Mar 2000 15,000 2,280,000 Collar** $3.00 $3.55 - ------------------------------------------------------------------------------------------------------------------------------ April 2000-Oct 2000 15,000 3,210,000 Collar $2.30 $2.87 - ------------------------------------------------------------------------------------------------------------------------------ Nov 2000-March 2001 20,000 3,020,000 Collar $2.40 $3.40 - ------------------------------------------------------------------------------------------------------------------------------ April 2001-Oct 2001 20,000 4,280,000 Collar $2.20 $2.95 - ------------------------------------------------------------------------------------------------------------------------------
* This agreement includes a put at $17.00 per barrel ** This agreement includes a put at $2.40 per Mcf The fair value at December 31, 1999 of these swap agreements was a gain of $862,000. These energy swap agreements expose the Company to counterparty credit risk to the extent the counterparty is unable to meet its monthly settlement commitment to the Company. In order to reduce interest costs, effective September 22, 1998, the Company entered into an eight and one-half year's interest rate swap agreement with a notional value of $80 million. Under the agreement, the Company receives a fixed interest rate and pays a floating interest rate based on the simple average of three foreign LIBOR rates. Floating rates are redetermined for a six-month period each April 1 and October 1. The floating rate for the period from October 1, 1999 to April 1, 2000 is 9.64%. Through April 1, 2002 the floating rate is capped at 10.875% and capped at 12.375% thereafter. This interest swap is accounted for as a hedge. 48 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES DETERMINATION OF FAIR VALUES OF FINANCIAL INSTRUMENTS Fair value for cash, short-term investments, receivables and payables approximates carrying value. The following table details the carrying values and approximate fair values of the Company's other investments, derivative financial instruments and long-term debt at December 31, 1999 and 1998 (in thousands).
December 31, 1999 December 31, 1998 ------------------------------------------------- -------------------------------------- Approximate Fair Approximate Fair Carrying Value Value Carrying Value Value ---------------------- --------------------- -------------------- ---------------- Assets/ (Liabilities): Derivative instruments other than trading: Interest swap agreements $ --- $ 3,045 $ --- $ 1,392 Production swap agreements $ --- $ 862 $ --- $ --- Long-term debt (See Note 7) $(130,000) $(125,485) $(104,400) $(107,001)
7. LONG-TERM DEBT Long-term debt is comprised of the following at December 31, 1999 and 1998 (in thousands):
December 31, December 31, 1999 1998 --------------------- --------------------- Bank credit facility.................................... $ 30,000 $ 4,400 10-7/8% Senior Subordinated Notes....................... 100,000 100,000 --------------------- --------------------- Long-term debt.......................................... $130,000 $104,400 ===================== =====================
Debt maturities by fiscal year are as follows (amounts in thousands): 1999 $ --- 2000 --- 2001 --- 2002 --- 2003 30,000 Thereafter 100,000 -------- $130,000 ======== In October 1996, the Company entered into a syndicated credit facility ("Syndicated Credit Facility") in an amount up to $50.0 million with an initial borrowing base of $27.0 million, to be re-determined semi-annually. At Bellwether's option, the interest rate varied, based upon borrowing base usage, from London Interbank Offered Rate ("LIBOR") plus 7/8% to LIBOR plus 1-1/4%, or the greater of the prime rate or Federal Funds rate plus 1/2%. The Syndicated Credit Facility was unsecured and was retired in April 1997. In April 1997, the Company entered into a senior revolving unsecured credit facility ("Senior Credit Facility") in an amount up to $90.0 million, with a borrowing base to be re-determined semi-annually, and a maturity date of November 5, 2003. On May 20, 1999 the borrowing base was re-determined to be $55.0 million. Bellwether may elect an interest rate based either on a margin plus LIBOR or the higher of the prime rate or the sum of 1/2 of 1% plus the Federal Funds Rate. For LIBOR borrowings, the interest rate will vary from LIBOR plus 0.875% to LIBOR 49 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES plus 1.25% based upon borrowing base usage. In connection with the acquisition of oil and gas properties, $33.3 million was drawn under this facility, including $22 million used to retire outstandings under the Syndicated Credit facility. At December 31, 1999, there were $30.0 million borrowings outstanding. The Senior Credit Facility contains various covenants including certain required financial measurements for a current ratio, consolidated tangible net worth and interest coverage ratio. In addition, the Senior Credit Facility includes certain limitations on restricted payments, dividends, incurrence of additional funded indebtedness and asset sales. In April 1997, the Company issued $100.0 million of 10-7/8% senior subordinated notes ("Notes") that mature April 1, 2007. Interest on the Notes is payable semi-annually on April 1 and October 1. The Notes will be redeemable, in whole or in part, at the option of the Company at any time on or after April 1, 2002 at 105.44% which decreases annually to 100.00% on April 1, 2005 and thereafter, plus accrued and unpaid interest. In the event of Change of Control of the Company, each holder of the Notes will have the right to require the Company to repurchase all or part of such holder's Notes at an offer price in cash equal to 101.0% of the aggregate principal amount thereof, plus accrued and unpaid interest to the date of purchase. The Notes contain certain covenants, including limitations on indebtedness, restricted payments, transactions with affiliates, liens, guarantees of indebtedness by subsidiaries, dividends and other payment restrictions affecting restricted subsidiaries, issuance and sales of restricted subsidiary stock, disposition of proceeds of asset sales, and restrictions on mergers, and consolidations or sales of assets. 8. INCOME TAXES Income tax expense (benefit) is summarized as follows (in thousands):
Six Month Year Ended Year Ended Transition Period Year Ended December 31, December 31, Ended December 31, June 30, 1999 1998 1997 1997 ------------- -------------- ------------------ ----------- Current Federal........................... $ (425) $ 658 $ 400 $ (12) State............................. 10 93 129 35 ------ ------- ------ ------ Deferred - Federal and State........ (2,739) (6,820) 1,585 2,562 ------ ------- ------ ------ Total income tax expense (benefit)................. $(3,154) $(6,069) $2,114 2,585 ======= ======= ====== ======
50 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1999 and 1998 is as follows:
December 31, December 31, 1999 1998 -------------------------- ------------------------ Net operating loss Carryforwards......................................... $ 10,296 $ 11,085 Percentage depletion Carryforwards......................................... 271 271 Alternative minimum tax credit carryforwards............................. 725 1,150 Property, plant and equipment............................................. 9,551 10,646 State income taxes...................................... 1,732 1,901 -------------------------- ------------------------ Total deferred income tax assets............................................... 22,575 25,053 -------------------------- ------------------------ Valuation allowances.................................... (19,836) (25,053) -------------------------- ------------------------ Net deferred income tax asset (liability)........................................... $ 2,739 $ --- ========================== ========================
At December 31, 1999, the Company determined that it is more likely than not that a portion of the deferred tax assets will not be realized and the valuation allowance was adjusted by $5.2 million to a total valuation allowance of $19.8 million. A tax benefit related to the exercise of employee stock options of approximately $324,000 was allocated directly to additional paid-in capital in 1998. Such benefit was not material in 1999 and prior periods. 51 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Total income tax differs from the amount computed by applying the Federal income tax rate to income before income taxes and minority interest. The reasons for the differences are as follows:
Six Month Transition Year Ended Year Ended Period Ended Fiscal Year December 31, December 31, December 31, Ended June 30 1999 1998 1997 1997 ----------- ----------- ------------- ------------- Statutory Federal income tax rate....................... 34.0% (34.0%) 34.0% 34.0% Increase (decrease) in tax rate resulting from: State income taxes, net of federal benefit....................................... 3.1% (3.1%) 3.2% 1.3% Non-deductible travel and entertainment......................................... .2% 0.1% 0.1% 0.5% Other................................................... (.8%) --- --- --- Change in valuation allowance........................... (92.2%) 29.7% --- --- ------ ---- ----- ---- (55.7%) (7.3%) 37.3% 35.8% ====== ==== ===== ====
The Company issued 3,400,000 shares of its common stock on July 20, 1994. As a result of the common stock issuance, the Company has undergone an ownership change. Therefore, the Company's ability to use a portion of its net operating loss ("NOL") carryforwards for federal income tax purposes is subject to limitations. Section 382 of the Internal Revenue Code significantly limits the amount of NOL and investment tax credit carryforwards that are available to offset future taxable income and related tax liability when a change in ownership occurs. At December 31, 1999, the Company had net operating loss carryforwards of approximately $30.2 million, which will expire in future years beginning in 2000. 9. COMMITMENTS AND CONTINGENCIES Lease Commitments The minimum future payments under the terms of the Company's office space operating lease is as follows: YEAR ENDED DECEMBER 31 ($ IN THOUSANDS) ---------------------- ---------------- 2000 382 2001 403 2002 415 2003 426 2004 430 Rent expense was $16,023 in 1999 and zero in prior years. Prior to October 1999, the Company was not responsible for office rental as the administration services contract with Torch at the time included office space. Upon the new Torch Master Service Agreement in October 1999, Bellwether began paying office rent. 52 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Other Commitments Under the Company's contract for production of oil in the Charapa field of Ecuador, the Company is required to execute a three year $11.8 million minimum investment program. In 2000, the first year of the commitment, the Company is budgeted to spend approximately $7.1 million in the Charapa field. Contingencies The Company has been named as a defendant in certain lawsuits incidental to its business. Management does not believe that the outcome of such litigation will have a material adverse impact on the Company. The Company was defendant in Cause No. C-4417-96-G;A.R. Guerra, et al. v. Eastern Exploration, Inc., et al. in the 370th Judicial District Court of Hidalgo County, Texas. On May 11, 1999, the trial court granted plaintiff's Motion of Summary Judgement and denied defendants' Motion of Summary Judgement. The trial court awarded plaintiffs in excess of $5.8 million on damages plus interest. The Company recently settled the case for the sum of $353,500 net to its interest. 10. Select Quarterly Financial Data (amounts in thousands, except per share data) (Unaudited):
Quarter Ended ----------------------------------------------------------------- December 31, September 30, June 30, March 31, 1999 1999 1999 1999 ------------------------------------------------------------------ Revenues $24,556 $17,696 $15,264 $13,231 Operating income (loss) $ 7,283 $ (463) $ 123 $(1,284) Net income (loss) $ 9,972 $ 2 $ 123 $(1,284) Earnings (loss) per common share $ 0.72 $ 0.00 $ 0.01 $ (0.09) Earnings (loss) per common shares - diluted $ 0.71 $ 0.00 $ 0.01 $ (0.09)
Quarter Ended ------------------------------------------------------------------ December 31, September 30, June 30, March 31, 1998 1998 1998 1998 ------------------------------------------------------------------ Revenues $ 15,943 $19,034 $20,953 $19,837 Operating income (loss) $(82,812) $ (283) $ 399 $ (624) Net income (loss) $(76,919) $ (187) $ 247 $ (392) Earnings (loss) per common share $ (5.55) $ (0.01) $ 0.02 $ (0.03) Earnings (loss) per common share common share- diluted $ (5.55) $ (0.01) $ 0.02 $ (0.03)
The quarter ended December 31, 1998 reflects a $73.9 million full cost ceiling impairment, which resulted from low oil and gas prices at December 31, 1998. 53 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The quarter ended December 31, 1999 reflects increased oil and gas prices and increased production levels as result of increased drilling activities and the acquisition of Gulf of Mexico and New Mexico properties in the last half of 1999. In addition, the Company recognized a $2.7 million tax asset based upon increased future net reserves. 11. SEGMENT REPORTING The Company has recently acquired interests in Ecuador and the Ukraine. (See Note) Relative to the Charapa field in Ecuador, capital expenditures as of December 31, 1999 totaled $843,000 primarily incurred for contract negotiation, development planning and accumulation of necessary tools, supplies and equipment. Field operations commenced in January of 2000. A loss of $172,000 for the year ended December 31, 1999 is attributable to Ecuadorian operations due to the recognition of start up costs and other administrative expenses. The Company's Ukrainian interests were acquired December 30, 1999 through an acquisition of a controlling interest in the preferred stock of Carpatsky Petroleum Inc. At December 31, 1999 Bellwether's consolidated financial statements reflected $4.6 million in Investment in Outside Companies identified to the Ukrainian interests. No revenues or expenses related to the Ukrainian operations were recognized by the Company for the year ended December 31, 1999. 12. SUPPLEMENTAL INFORMATION - (Unaudited) OIL AND GAS PRODUCING ACTIVITIES: Included herein is information with respect to oil and gas acquisition, exploration, development and production activities, which is based on estimates of year-end oil and gas reserve quantities and estimates of future development costs and production schedules. Reserve quantities and future production are based primarily upon reserve reports prepared by the independent petroleum engineering firm Ryder Scott Company for fiscal 1999 and 1998 and the transition period 1997 and the year ended June 30, 1997. These estimates are inherently imprecise and subject to substantial revision. Estimates of future net cash flows from proved reserves of gas, oil, condensate and natural gas liquids were made in accordance with Statement of Financial Accounting Standards No. 69, "Disclosures about Oil and Gas Producing Activities." The estimates are based on prices at year-end. Estimated future cash inflows are reduced by estimated future development and production costs based on year-end cost levels, assuming continuation of existing economic conditions, and by estimated future income tax expense. Tax expense is calculated by applying the existing statutory tax rates, including any known future changes, to the pre-tax net cash flows, less depreciation of the tax basis of the properties and depletion allowances applicable to the gas, oil, condensate and NGL production. The impact of the net operating loss is considered in calculation of tax expense. The results of these disclosures should not be construed to represent the fair market value of the Company's oil and gas properties. A market value determination would include many additional factors including: 1) anticipated future increases or decreases in oil and gas prices and production and development costs; 2) an allowance for return on investment; 3) the value of additional reserves, not considered proved at the present, which may be recovered as a result of further exploration and development activities; and 4) other business risks. There are no reserves associated with the Company's Ukrainian investments as such amounts were immaterial at December 31, 1999. 54 COSTS INCURRED (IN THOUSANDS)
Six Month Year Ended December 31, Transition --------------------------------------------------- Period Ended December 31, Fiscal Year Ended 1999 1998 1997 Junne 30, 1997 ------------------------- ---------------------- ---------------------- -------------------- United States: - -------------- Property acquisition:..... Proved properties....... $22,428 $ 617 $ 3,281 $138,984 Unproved properties..... 2,406 52 326 1,002 Exploration............... 7,264 16,186 3,274 1,576 Unproved properties..... 6,788 8,736 1,879 --- Development............... 16,852 14,397 10,453 14,032 ------- ------- ------- -------- $55,738 $39,988 $19,213 $155,594 ------- ------- ------- -------- Latin America: - --------------- Property acquisition:..... Proved properties....... $ 651 $ --- $ --- $ --- Unproved properties..... 404 191 --- --- Exploration............... --- --- --- --- Development............... --- --- --- --- ------- ------- ------- ------- $ 1,055 $ 191 $ --- $ --- ------- ------- ------- ------- Worldwide: - ---------- Property acquisition: Proved properties....... $23,079 $ 617 $ 3,281 $138,984 Unproved properties..... 2,810 243 326 1,002 Exploration............... 7,264 16,186 3,274 1,576 Unproved properties..... 6,788 8,736 1,879 1,002 ------- ------- ------- -------- Development............... 16,852 14,397 10,453 14,032 ------- ------- ------- -------- $56,793 $40,179 $19,213 $155,594 ======= ======= ======= ========
55 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES CAPITALIZED COSTS (IN THOUSANDS):
Year Ended December 31, ---------------------------------------------------------------- 1999 1998 ----------------------------- ----------------------------- United States: - -------------- Proved properties................................... $ 328,453 $ 280,286 Unproved properties................................. 16,325 8,754 ----------------------------- ----------------------------- Total capitalized costs............................. 344,778 289,040 Accumulated depreciation, depletion, amortization and impairment......................... (221,092) (193,445) Net capitalized costs............................... $ 123,686 $ 95,595 ----------------------------- ----------------------------- Latin America: - -------------- Proved properties................................... $ 842 $ --- Unproved properties................................. 404 191 ----------------------------- ----------------------------- Total capitalized costs............................. 1,246 191 Accumulated depreciation, depletion, amortization and impairment......................... --- --- Net capitalized costs............................... $ 1,246 $ 191 ----------------------------- ----------------------------- Worldwide: - ---------- Proved properties................................... $ 329,295 $ 280,286 Unproved properties................................. 16,729 8,945 ----------------------------- ----------------------------- Total capitalized costs............................. 346,024 289,231 Accumulated depreciation, depletion, amortization and impairment......................... (221,092) (193,445) Net capitalized costs............................... $ 124,932 $ 95,786 ============================= =============================
56 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Results of operations for producing activities (in thousands):
Six Month Fiscal Year Ended Year Ended Transition Period Year Ended December 31, December 31, Ended December 31, June 30, ----------------------- ------------------- ---------------------- ----------------- 1999 (1) 1998 1997 1997 ------------------------ ------------------- ---------------------- ----------------- Revenues from oil and gas producing activities.................... $ 67,948 $ 73,217 $44,163 $39,067 Production costs.......................... 21,532 25,381 13,836 11,437 Income tax................................ 8,820 --- 5,379 4,529 Impairment expense........................ --- 73,899 --- --- Depreciation, depletion and amortization............................. 22,643 38,548 15,831 14,691 --------- --------- -------- -------- Results of operations from producing activities (excluding corporate overhead and interest costs)............ $ 14,953 $(64,611) $ 9,117 $ 8,410 ======== ======== ======= =======
1) Ecuador and Ukraine activities did not commence production until 2000; therefore, no information for International operations is disclosed.
Per unit sales prices and costs: Six Month Transition Period Fiscal Year Ended Year Ended Ended Year Ended December 31, December 31, December 31, June 30, ------------------ ----------------- ------------------ ------------- 1999 (2) 1998 1997 1997 ------------------ ----------------- ------------------- -------------- Average sales price: (1) Oil (per barrel)........................ $ 12.77 $11.64 $16.52 $17.41 Gas (per MCF)........................... $ 2.18 $ 2.18 $ 2.39 $ 2.29 Average production cost per equivalent MCF.......................... $ .68 $ .72 $ .79 $ .73 Average unit depletion rate per equivalent MCF...................... $ .72 $ 1.10 $ .90 $ .94
1) Average sales price is inclusive of the effect of natural gas and crude oil price swaps, which decreased revenues $4 million in 1999, increased revenues $3.6 million in 1998, decreased revenues $1.6 million in transition period 1997 and decreased revenues $18,000 in fiscal year ended June 30, 1997. 2) Ecuador and Ukraine activities commenced production in 2000; therefore, price and cost information is not disclosed. 57 The Company's estimated total proved and proved developed reserves of oil and gas as follows:
Year Ended Year Ended Description December 31, 1999 December 31, 1998 - --------------------- ----------------------------------------- ---------------------------------- Oil NGL Gas Oil NGL Gas (MBBL) (MBBL) (MMCF) (MBBL) (MBBL) (MMCF) ----------------------------------------- ---------------------------------- United States - ------------- Proved reserves at Beginning of period. 8,489 1,573 111,585 12,238 2,571 125,960 Revisions of previous estimates........... 2,671 798 (767) (2,473) (1,032) (5,944) Extensions and 499 --- 11,636 813 225 9,416 discoveries........... Production............. (1,831) (249) (18,965) (2,106) (191) (21,302) Sales of reserves in-place.............. (262) (60) (6,754) (4) --- (167) Purchase of reserves in-place.............. 1,261 7 33,344 21 --- 3,622 ------ ----- ------ ------ ----- ------- Proved reserves at end of period............. 10,827 2,069 130,079 8,489 1,573 111,585 ====== ===== ======= ====== ===== ======= Proved developed reserves - Beginning of period.. 8,021 1,554 106,253 11,153 2,460 119,270 ====== ===== ======= ====== ===== ======= End of period........ 9,990 2,032 108,491 8,021 1,554 106,253 ====== ===== ======= ====== ===== ======= Latin America (1) - ----------------- Purchase of reserves in-place............... 3,884 --- --- --- --- --- ------ ----- ------ ------ ---- ------ Proved developed reserves - Beginning of period... --- --- --- --- --- --- ====== ===== ====== ====== ==== ====== End of period......... 245 --- --- --- --- --- ====== ===== ====== ====== ==== ====== Worldwide: ---------- Proved reserves at beginning of period............. 8,489 1,573 111,585 12,238 2,571 125,960 Revisions of previous estimates............. 2,671 798 (767) (2,473) (1,032) (5,944) Extensions and discoveries.......... 499 --- 11,636 813 225 9,416 Production............ (1,831) (249) (18,965) (2,106) (191) (21,302) Sales of reserves in-place............. (262) (60) (6,754) (4) --- (167) Purchase of reserves in-place............. 5,145 7 33,344 21 --- 3,622 ------- ------ ------- ------ ------ ------- Proved reserves at end of year................. 14,711 2,069 130,079 8,489 1,573 111,585 ======= ====== ======= ====== ===== ======= Proved developed reserves- Beginning of year.. 8,021 1,554 106,253 11,153 2,460 119.270 ======= ====== ======= ====== ===== ======= End of year........ 10,235 2,032 108,491 8,021 1,554 106,253 ======= ====== ======= ====== ===== =======
(1) The Company's Latin American reserves are pursuant to a contract with the Ecuadorian government under which the Company does not own the reserves but has a contractual right to produce the reserves and receive revenues. 58 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Reserves continued:
Six Month Transition Period Ended December 31, Fiscal Year Ended June 30, - ----------------------- ----------------------------------------- --------------------------------------- Description 1997 1997 - ----------------------- ----------------------------------------- --------------------------------------- Oil NGL Gas Oil NGL Gas (MBBL) (MBBL) (MMCF) (MBBL) (MBBL) (MMCF) ------------------------------------------ ---------------------------------------- Worldwide: - ----------- Proved reserves at beginning of period.................. 12,007 4,023 127,940 1,808 --- 33,194 Revisions of previous estimates.................. 1,246 (1,417) 1,599 (1,187) 2,435 (2,773) Extensions and discoveries.. 641 52 4,869 658 52 4,202 Production.................. (967) (87) (11,193) (854) --- (10,552) Sales of reserves in-place................... (694) --- (642) (1,260) --- (16,194) Purchase of reserves in-place................... 5 --- 3,387 12,842 1,536 120,063 ------- ------ ------- ------ ------ ------- Proved reserves at end of period.................. 12,238 2,571 125,960 12,007 4,023 127,940 ======= ====== ======= ====== ====== ======= Proved developed reserves- Beginning of year......... 10,162 3,705 117,914 1,494 --- 22,696 ======= ====== ======= ====== ====== ======= End of year............... 11,153 2,460 119,270 10,162 3,705 117,914 ======= ====== ======= ====== ====== =======
59 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Discounted future net cash flows (in thousands) The standardized measure of discounted future net cash flows and changes therein related to proved oil and gas reserves shown below:
Six Month Transition Period Fiscal Year Ended Year Ended Ended Year Ended June December 31, December 31, December 31, 30, ---------------- ---------------- -------------------- -------------------- 1999 1998 1997 1997 ----------------- ---------------- -------------------- --------------------- United States - ------------- Future Cash Flow....................... $ 535,605 $ 328,285 $ 517,323 $ 529,928 Future Future production costs......... (202,800) (132,108) (191,988) (183,479) Future income taxes.................... (23,234) --- (48,594) (59,419) Future development costs............... (54,034) (29,609) (33,197) (32,237) --------- --------- --------- --------- Future net cash flows.................. 255,537 166,568 243,544 254,793 10% discount factor.................... (63,933) (50,588) (57,829) (67,300) --------- --------- --------- --------- Standardized future net cash flows..... $ 191,604 $ 115,980 $ 185,715 $ 187,493 ========= ========= ========= ========= Latin America - ------------- Future Cash Flow....................... $ 88,089 $ --- $ --- $ --- Future production costs................ (34,534) --- --- --- Future income taxes.................... (9,860) --- --- --- Future development costs............... (13,273) --- --- --- --------- --------- --------- --------- Future net cash flows.................. 30,422 --- --- --- 10% discount factor.................... (17,138) --- --- --- --------- --------- --------- ---------- Standardized future net cash flows..... $ 13,284 $ --- $ --- $ --- ========= ========= ========== ========== Worldwide: - ---------- Future Cash Flow....................... $ 623,694 $ 328,285 $ 517,323 $ 529,928 Future production costs................ (237,334) (132,108) (191,988) (183,479) Future income taxes.................... (33,094) --- (48,594) (59,419) Future development costs............... (67,307) (29,609) (33,197) (32,237) --------- --------- -------- --------- Future net cash flows.................. 285,959 166,568 243,544 254,793 10% discount factor.................... (81,071) (50,588) (57,829) (67,300) --------- --------- --------- --------- Standardized future net cash flows..... $ 204,888 $ 115,980 $ 185,715 $ 187,493 ========= ========= ========= =========
60 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES The following are the principal sources of change in the standardized measure of discounted future net cash flows:
Year Ended December 31, 1999 ----------------------------------------------------------------------- Latin United World America States Wide ----------------------- ----------------------- --------------- Standardized measure - beginning of year................ $ --- $115,980 $115,980 Sales, net of production costs.......................... --- (50,430) (50,430) Purchases of reserves in-place.......................... 17,431 40,488 57,919 Net change in prices and production costs............... --- 40,736 40,736 Net change in income taxes.............................. (4,147) --- (4,147) Extensions, discoveries and improved recovery, net of future production and development costs..................................... --- 23,497 23,497 Changes in estimated future development costs................................................. --- (3,304) (3,304) Development costs incurred during the period................................................ --- 8,930 8,930 Revisions of quantity estimates......................... --- 20,565 20,565 Accretion of discount................................... --- 11,598 11,598 Sales of reserves in-place.............................. --- (6,575) (6,575) Changes in production rates and other................... --- (9,881) (9,881) ------- -------- -------- Standardized measure - end of year...................... $13,284 $191,604 $204,888 ======= ======== ========
Six Month Transition Period Year Ended December Ended 31 December 31 ---------------------- -------------------- 1998 1997 1997 --------------------- ---------------------- -------------------- Standardized measure - beginning of year........ $185,715 $187,493 $ 45,188 Sales, net of production costs.................. (44,264) (30,327) (27,630) Purchases of reserves in-place.................. 3,379 4,117 151,836 Net change in prices and production costs....... (55,408) (3,922) 22,599 Net change in income taxes...................... 14,517 8,706 (20,265) Extensions, discoveries and improved recovery, net of future production and development costs............................. 8,255 10,769 12,555 Changes in estimated future development costs......................................... 4,542 (3,588) (3,034) Development costs incurred during the period........................................ 11,244 6,662 9,124 Revisions of quantity estimates................. (20,520) 569 27,102 Accretion of discount........................... 18,572 18,749 4,518 Sales of reserves in-place...................... (260) (4,602) (16,140) Changes in production rates and other........... (9,792) (8,911) (18,360) -------- -------- -------- Standardized measure - end of year.............. $115,980 $185,715 $187,493 ======== ======== ========
The discounted future cash flows above were calculated using NYMEX equivalent prices of $25.60, $12.05, $18.32 and $19.80 per barrel and $2.33, $2.15, $2.58 and $2.35 per MMBTU, for December 31, 1999, 1998 and 1997 and June 30, 1997, respectively, adjusted to the wellhead to reflect adjustments for transportation, quality and heating content. 61 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On or about June 18, 1997 the Company replaced the firm of Deloitte and Touche, LLP as its principal independent accountant and auditors to audit all the Company's financial statements with the firm of KPMG LLP. The decision to make this change was influenced by the acquisition of Partnership properties and interests, which were previously audited by KPMG LLP. The Company does not and has not during the past three years had disagreements with Deloitte and Touche LLP or KPMG LLP concerning their audit or application of accounting principles according to GAAP. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 1999. Such information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 1999. Such information is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 1999. Such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after December 31, 1999. Such information is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. and 2. Financial Statements. See index to Consolidated Financial Statements and Supplemental Information in Item 8, which information is incorporated herein by reference. 3. Exhibits 3.1 Certificate of Incorporation of Bellwether Exploration Company (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement No. 33-76570) 3.2 Certificate of Amendment to Certificate of Incorporation (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1997) 3.3 Certificate of Designation, Preferences and Rights of Series A Preferred Stock (incorporated by reference to Exhibit 1 to the Company's Registration Statement on Form 8-A dated September 19, 1997.) 62 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES 3.4 By-laws of Bellwether Exploration Company (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement No. 33-76570) 3.5 Amendment to Article II, Section 2.2 of Bellwether Exploration Company's Bylaws (incorporated by reference to Exhibit 3.5 to the Company's Annual Report on Form 10-K for the transition period ended December 31, 1997). 3.6 Amendment to Bellwether Exploration Company's bylaws adopted on March 27, 1998 (incorporated by reference to Exhibit 3.6 to the Company's Annual Report on Form 10-K for the transition period ended December 31, 1997). 4.1 Specimen Stock Certificate (incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1, File No. 33-76570) 4.2 The Company's 1996 Stock Incentive Plan (incorporated by reference to Exhibit 10.20 to the Company's Registration Statement on Form S-1, File No. 33-21813) 4.3 Indenture dated April 9, 1997 among the Company, a Subsidiary Guarantor and Bank of Montreal Trust Company (incorporated herein by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-1, Registration No. 33-21813) 4.4 First Supplemental Indenture dated April 21, 1997 among the Company, Odyssey Petroleum Company, Black Hawk Oil Company, 1989-I TEAI Limited Partnership and Bank of Montreal Trust Company, as Trustee (incorporated by reference to Exhibit 99.2 on the Company's Form 8-K Current Report filed on April 23, 1997) 4.5 Shareholders Rights Agreement between the Company and American Stock Transfer & Trust Company (incorporated herein by reference to the Company's Registration Statement on Form 8-A as filed with the Securities and Exchange Commission on September 19, 1997) 4.6 Warrant to Torch Energy Dated April 9. 1997 (incorporated by reference to Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1997) 10.1 Administrative Services Agreement with Torch Energy Advisors Incorporated commencing January 1, 1994 (incorporated by reference to Exhibit 94-10-3 to the Company's Report on Form 10-Q for the quarter ended March 31, 1994) 10.2 1994 Stock Incentive Plan (incorporated by reference to Exhibit 10.9 to the Company's Registration Statement No. 33-76570) 10.3 Registration Rights Agreement among the Company, Allstate Insurance Company and the former owners of Odyssey Partners, Ltd. (incorporated by reference to Exhibit 10.4 to the Company's Registration Statement No. 33-76570) 10.4 Assignment of gas purchase contract from Texas Gas Transmission Corporation to Bellwether (incorporated by reference to Exhibit 96-10-4 to the Company's Report on Form 10-Q for the quarter ended March 31, 1997) 10.5 Acquisition Agreement dated March 31, 1997 among Bellwether Exploration Company, Program Acquisition Company and the other parties thereto. (incorporated by reference to Exhibit 2.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-21813) filed on April 3, 1997) 10.6 Credit Agreement dated April 21, 1997 among the Company, Odyssey Petroleum Company, Black Hawk Oil Company, 1989-I TEAI Limited Partnership, Morgan Guarantee Trust Company of New York, as administrative Agent, and certain banking institutions (incorporated by reference to the Company's Form 8-K Current Report as filed with the Commission on April 23, 1997) 63 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES 10.7 Purchase and Sale Agreement dated June 9, 1997 among Bellwether Exploration Company, Black Hawk Oil Company, 1988-II TEAI Limited Partnership, 1989-I TEAI Limited Partnership, TEAI Oil and Gas Company, and the other parties thereto as Sellers, and Jay Resources Corporation as Buyer (incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1997). 10.8 Employment contract dated June 1, 1998 between the Company and J. Darby Sere' (incorporated by reference to Exhibit 10.1 to the Company's 10-Q for the quarter ended June 30, 1998). 10.9 Employment contract dated June 1, 1998 between the Company and William C. Rankin (incorporated by reference to Exhibit 10.2 to the Company's Report on Form 10-Q for the quarter ended June 30, 1998). 11.10 Purchase and Sale Agreement dated June 11, 1999 between Bellwether Exploration Company as Buyer and Energen Resources MAQ, Inc. as Seller (incorporated by reference to Exhibit 10.15 to the Company's Report on Form 10-Q for the quarter ended June 30, 1999.) 11.11 Separation contract dated August 9, 1999 between the Company and J. Darby Sere' (incorporated by reference to Exhibit 10.16 to the Company's Report on 10Q for the quarter ended June 30, 1999. 11.12 Separation contract dated August 9, 1999 between the Company and William C. Rankin (incorporated herein by reference to Exhibit 10.17 to the Company's Report on 10-Q for the quarter ended June 30, 1999. 11.13 Employment Contract dated August 1, 1999 between the Company and J.P. Bryan (incorporated herein by reference to Exhibit 10.18 to the Company's Report on 10-Q for the quarter ended September 30, 1999). 11.14 Securities Purchase Agreement dated December 29, 1999 by and between the Company and Carpatsky Petroleum, Inc. - included herewith. 11.15 Master Services Agreement dated October 1, 1999 between the Company and Torch Operating Company, Torch Energy Marketing, Inc., Torch Energy Advisors, Inc. and Novistar, Inc., - included herewith. 11.16 Contract for the Production of Crude Oil and Additional Hydrocarbon Exploration in the Charapa Marginal Field of Petroecuador between the Company in Consortium with Tecnipetrol, Inc. and the Ecuadorian State Oil Company, Petroecuador - included herewith. 11.17 Master Service Agreement between the Company and Tecnie S.A.C. dated November 1, 1999 - included herewith. 64 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES 16.1 Letter from predecessor auditors regarding change in certifying accountant (incorporated by reference to Exhibit 16-1 to the Company's Form 8K/A-1 dated July 8, 1997) 21.1 Subsidiaries of Bellwether Exploration Company - Included herewith. 23 Consents of experts: 23.2 Consent of Ryder Scott Company 23.3 Consent of KPMG LLP 27 Financial Data Schedule 65 BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company and in the capacities and on the dates indicated. BELLWETHER EXPLORATION COMPANY /s/ J. P. Bryan ------------------- J. P. BRYAN Chairman of Board of Directors and Chief Executive Officer Dated March 24, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company and in the capacities and on the dates indicated. SIGNATURES TITLE DATE /s/ J. P. Bryan Chairman of Board of March 24, 2000 - -------------------- Directors and Chief J. P. Bryan Executive Officer /s/ Robert Bensh Senior Vice President - March 24, 2000 - -------------------- Finance Robert Bensh /s/ Dr. Jack Birks - -------------------- Director March 24, 2000 Dr. Jack Birks /s/ Judith Allen - -------------------- Director March 24, 2000 Judith Allen /s/ Vincent H. Buckley - ----------------------- Director March 24, 2000 Vincent H. Buckley /s/ Habib Kairouz - -------------------- Director March 24, 2000 Habib Kairouz /s/ A. K. McLanahan - -------------------- Director March 24, 2000 A. K. McLanahan /s/ Townes G. Pressler - ---------------------- Director March 24, 2000 Townes G. Pressler 66 EX-11.14 2 SECURITIES PURCHASE AGREEMENT Execution Copy ================================================================================ SECURITIES PURCHASE AGREEMENT by and between CARPATSKY PETROLEUM INC. an Alberta corporation (the "Company") and BELLWETHER EXPLORATION COMPANY a Delaware corporation ("Purchaser") Concerning the purchase of convertible preferred shares and warrants to purchase common shares December 29, 1999 ================================================================================ H- TABLE OF CONTENTS Page ---- ARTICLE I. DEFINITIONS..................................................... 1 Section 1.1 Definitions.................................................. 1 ARTICLE II. PURCHASE AND SALE OF SECURITIES................................ 4 Section 2.1 Sale and Issuance Purchase Shares........................... 4 Section 2.2 Sale and Issuance of Warrants............................... 5 Section 2.3 Legend...................................................... 5 Section 2.4 Purchase; Purchase Price.................................... 5 ARTICLE III. CLOSING DATE; DELIVERY........................................ 5 Section 3.1 Closing Date................................................. 5 Section 3.2 Payment; Delivery............................................ 5 ARTICLE IV. REPRESENTATIONS AND WARRANTIES................................. 6 Section 4.1 Representations and Warranties of the Company............... 6 (a) Organization and Standing; Articles and By Laws.................... 6 (b) Corporate Power; Authority......................................... 6 (c) Purchase Shares and Warrants....................................... 6 (d) Capitalization..................................................... 7 (e) Subsidiaries....................................................... 7 (f) No Conflicts or Consents........................................... 7 (g) Corporate Documents................................................ 8 (h) ASC Documents; Financial Statements; Liabilities................... 8 (i) Oil and Gas Properties............................................. 9 (j) Investment Company................................................. 10 (k) Public Utility Company............................................. 10 (l) Environmental Matters.............................................. 11 (m) Tax Matters........................................................ 13 (n) Litigation......................................................... 15 (o) Broker's and Finder's Fee.......................................... 15 (p) Absence of Sensitive Payments...................................... 15 (q) Compliance with Law................................................ 15 (r) Contracts.......................................................... 16 (s) Employment Plans/Employment Agreements............................. 17 (t) Absence of Certain Changes or Events............................... 17 (u) The Company's Assets............................................... 18 (v) Registration Rights................................................ 18 Section 4.2 Representations and Warranties of Purchaser................. 18 (a) Investment Intent.................................................. 18 H- (i) (b) Accredited Investor................................................ 21 (c) Corporate Power; Authority......................................... 21 Section 4.3 Acknowledgments of the Purchaser............................. 21 ARTICLE V. CONDITIONS TO CLOSING........................................... 22 Section 5.1 Purchaser's Conditions....................................... 22 (a) Representations and Warranties Correct............................. 22 (b) Covenants.......................................................... 22 (c) Compliance Certificate............................................. 22 (d) No Material Adverse Change......................................... 23 (e) Consents........................................................... 23 (f) Registration Rights Agreement...................................... 23 (g) Opinion of Company's Counsel....................................... 23 (h) Pease Merger Agreement............................................. 23 (i) Due Diligence...................................................... 23 Section 5.2 Company's Conditions........................................ 23 (a) Representations.................................................... 23 (b) Consents........................................................... 23 (c) Pease Merger Agreement............................................. 23 ARTICLE VI. AFFIRMATIVE COVENANTS OF THE COMPANY........................... 24 Section 6.1 Financial Information........................................ 24 (a) ASC Reports........................................................ 24 (b) Other Reports...................................................... 24 Section 6.2 Access....................................................... 24 Section 6.3 Rule 144 Reporting........................................... 24 Section 6.4 Shareholder Approval......................................... 25 Section 6.5 Conduct of Business by the Company Pending the Closing....... 25 Section 6.6 Stock Exchange Listing....................................... 26 Section 6.7 Additional Agreements........................................ 26 Section 6.8 No Shop...................................................... 27 Section 6.9 Advice of Changes............................................ 27 Section 6.10 Pease Merger................................................ 27 Section 6.11 Board Nominees.............................................. 28 Section 6.12 Use of Proceeds............................................. 28 ARTICLE VII. MISCELLANEOUS................................................. 29 Section 7.1 Governing Law............................................... 29 Section 7.2 Survival.................................................... 29 Section 7.3 Successors and Assigns...................................... 29 Section 7.4 Entire Agreement, Amendment................................. 29 Section 7.5 Notices, etc................................................ 29 Section 7.6 Delays or Omissions......................................... 29 H- (ii) Section 7.7 Counterparts................................................. 30 Section 7.8 Severability................................................. 30 Section 7.9 Titles and Subtitles......................................... 30 Section 7.10 Specific Performance........................................ 30 Articles of Amendment Exhibit A Warrant Exhibit B First Amendment to Registration Rights Agreement Exhibit C Form of Legal Opinion Exhibit D Amendment to the Pease Merger Agreement Exhibit E Company's Articles of Incorporation and By Laws Schedule 4.1(a) Company's Capitalization Schedule 4.1(d) Company's Subsidiaries Schedule 4.1(e) Required Consents Schedule 4.1(f) Material Adverse Changes Schedule 4.1(h) Changes to Reserves Schedule 4.1(i)(ii) Environmental and Safety Matters Schedule 4.1(l) Taxes Schedule 4.1(m) Litigation Schedule 4.1(n) Sensitive Payments Schedule 4.1(p) Contracts Schedule 4.1(r) Registration Rights Schedule 4.1(v) H- (iii) SECURITIES PURCHASE AGREEMENT This Securities Purchase Agreement (the "Agreement") is made and entered into as of December 29, 1999 by and between Carpatsky Petroleum Inc., an Alberta corporation (the "Company"), and Bellwether Exploration Company, a Delaware corporation ("Purchaser"). W I T N E S S E T H: WHEREAS, Purchaser desires to purchase 95,450,000 million Preferred Shares, and Warrants to purchase 12,500,000 Common Shares, and the Company desires to issue and sell to Purchaser the Preferred Shares and the Warrants, for an aggregate consideration of U.S.$4,000,000, all on the terms and conditions described herein. NOW, THEREFORE, for and in consideration of the mutual covenants and promises herein contained, as well as for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties, intending to be legally bound, contract and agree as follows: ARTICLE I. DEFINITIONS Section 1.1 Definitions. As used in this Agreement, the following terms when capitalized have the meanings indicated. "Affiliate" shall have the meaning ascribed by the Business Corporations Act (Alberta). "Agreement" shall mean this Agreement, including the Schedules and Exhibits hereto, all as amended or otherwise modified from time to time. "Alternative Proposal" has the meaning set forth in Section 6.8. "Amendment to the Pease Merger Agreement" means the amendment to the Pease Merger Agreement described in Exhibit F. "Ancillary Agreements" means, collectively, the First Amendment to Registration Rights Agreement and the Amendment to the Pease Merger Agreement. "Articles" has the meaning set forth in Section 2.1. "Articles of Amendment" means the articles of amendment with respect to the Preferred Shares in the form attached as Exhibit A. "ASC" means the Alberta Securities Commission. "ASC Documents" has the meaning set forth in Section 4.1 (h) (i). H- "Audited Financial Statements" shall mean the audited balance sheets, and the related statements of earnings, shareholders' equity and cash flows, and the related notes thereto of Company as of and for the years ended December 31, 1998. "CDNX" means the Canadian Venture Exchange. "Closing" shall have the meaning ascribed to it in Section 3.1. "Closing Date" has the meaning provided for in Section 3.1. "Code" shall mean the Internal Revenue Code of 1986, as amended. "Common Shares" has the meaning set forth in Section 2.1. "Company" has the meaning set forth in the introductory paragraph. "Environmental Laws" has the meaning set forth in Section 4.1(1)(xi). "Environmental Liability" has the meaning set forth in Section 4.1(1) (xiii). "ERISA" has the meaning provided for in Section 4.1(s). "Exchange Act" shall mean the Securities Exchange Act of 1934, as amended. "Financial Statements" shall mean the Audited Financial Statements and the Interim Financial Statements. "First Amendment to Registration Rights Agreement" means the agreement set forth in Exhibit C. "Governmental Authority" means the government of any nation, state or other political subdivision thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, and any corporation or other entity owned or controlled, through stock or capital ownership or otherwise, by any of the foregoing (including, without limitation, a government controlled oil company). "Hazardous Materials" has the meaning set forth in Section 4.1(1) (xii). "Holder" means the Purchaser and any subsequent direct or indirect transferee of the Purchase Shares, Warrants, Shares or Warrant Shares, other than a transferee, (i) who has acquired the Purchase Shares, Warrants, Shares or Warrant Shares that have been the subject of a distribution registered under the Securities Act or (ii) in the case of Shares or Warrant Shares, who has acquired such Common Shares after such shares have been the subject of a distribution 2 H- to the public pursuant to Rule 144 under the Securities Act or otherwise distributed under circumstances not requiring a legend as described in Section 2.3. "Interim Financial Statements" shall mean the unaudited balance sheet, and the related unaudited statements of earnings and cash flows of the Company as of and for the nine months ended September 30, 1999. "Latest Balance Sheet" shall mean the balance sheet included in the Interim Financial Statements. "Liens" shall mean pledges, liens, defects, leases, licenses, equities, conditional sales contracts, charges, claims, encumbrances, security interests, easements, restrictions, chattel mortgages, mortgages or deeds of trust, of any kind or nature whatsoever. "Material Adverse Change" is a change which had or is reasonably likely to have a Material Adverse Effect. "Material Adverse Effect" shall mean with respect to any Person, a material adverse effect on the financial condition, results of operations, business or prospects of such Person and, in the case of the Company, its consolidated subsidiaries taken as a whole. "Other Securities" has the meaning provided for in the Articles of Amendment or the Warrant. "Payment" has the meaning set forth in Section 4.1(p). "Pease" means Pease Oil and Gas Company, a Nevada corporation. "Pease Merger Agreement" means the Agreement and Plan of Merger between the Company and Pease, dated September 1, 1999. "Person" shall mean an individual, firm, corporation, general or limited partnership, limited liability company, limited liability partnership, joint venture, trust, Governmental Authority or body, association, unincorporated organization or other entity. "Preferred Shares" has the meaning set forth in Section 2.1. "Purchase Price" has the meaning set forth in Section 2.4. "Purchase Shares" has the meaning set forth in Section 2.1. "Purchaser" has the meaning set forth in the introductory paragraph. 3 H- "Reserve Engineer" has the meaning set forth in Section 4.1 (i) (ii). "Reserve Report" has the meaning set forth in Section 4.1(i) (ii). "Returns" shall mean all returns, reports, estimates, declarations and statements of any nature regarding Taxes for periods required to be filed by the taxpayer relating to its income, properties or operations. "SEC" means the U.S. Securities and Exchange Commission or any similar agency then having jurisdiction to enforce the Securities Act. "Securities Act" means the U.S. Securities Act of 1933, as amended, and the rules and regulations of the SEC thereunder, and shall include any replacement statute and rules and regulations thereunder. "Securities Act (Alberta)" means the Securities Act (Alberta), as amended, and the rules, regulations, policy statements, notices and other requirements promulgated thereunder. "Shareholder Consent" means the consent to private placement in the form of Exhibit E. "Shares" has the meaning set forth in Section 2.1. "Securities Laws" has the meaning set forth in Section 4.1(c). "Taxes" shall mean any taxes imposed by any government or entity empowered with taxing authority by a government, including, without limitation, national, federal, provincial, state, regional, local or other taxes (including, without limitation, income, value-added, alternative minimum, franchise, property, sales, use, lease, excise, premium, payroll, wage, employment or withholding taxes), fees, duties, assessments, withholdings or governmental charges of any kind whatsoever (including interest, penalties and additions to tax). "Warrants" means the warrants in the form of Exhibit B. "Warrant Shares" has the meaning set forth in Section 2.2. ARTICLE II. PURCHASE AND SALE OF SECURITIES Section 2.1 Sale and Issuance Purchase Shares. The Company shall issue and sell to Purchaser at the Closing (as hereinafter defined) 94,450,000 shares (the "Purchase Shares") of its convertible preferred shares ("Preferred Shares"), initially convertible into 50,000,000 common shares ("Common Shares") of the Company, representing, as of the date hereof, 31.66% of the Common Shares on a fully diluted basis. The Purchase Shares have the characteristics set forth in the Articles of Amendment. The Purchase Shares and the Shares (as hereinafter defined) 4 H- issuable upon conversion of the Purchase Shares shall be entitled to all of the rights, privileges and preferences provided therein and in the Company's Articles of Incorporation, as amended by the Articles of Amendment, included in Schedule 4.1 (a) ("Articles"). The Common Shares or Other Securities to be received upon conversion of the Purchase Shares are referred to herein as the "Shares." Section 2.2 Sale and Issuance of Warrants. The Company shall issue and sell to Purchaser at the Closing (as hereinafter defined) Warrants to purchase 12,500,000 Common Shares, representing, as of the date hereof, 7.91 % of the Common Shares on a fully diluted basis. All Warrant Shares (as hereinafter defined) to be purchased pursuant to the Warrants shall have the rights, privileges and preferences as set forth in the Articles. The Common Shares or Other Securities for which the Warrants shall be exercisable upon payment of the exercise price set forth in the Warrant are referred to herein as the "Warrant Shares." Section 2.3 Legend. The Purchase Shares, Warrants, any Shares issued upon conversion of the Purchase Shares, and any Warrant Shares issued upon exercise of the Warrants will not be registered under the Securities Act, and will bear a restrictive legend as set forth in Section 4.2 (a) (vii). Section 2.4 Purchase; Purchase Price. Subject to the terms and conditions set forth herein, for and in consideration of the sale and issuance of the Purchase Shares and Warrants, Purchaser hereby agrees to pay to the Company at the Closing U.S.$4,000,000 in cash ("Purchase Price"). ARTICLE III. CLOSING DATE; DELIVERY Section 3.1 Closing Date. The closing ("Closing") of the purchase and sale of the Purchase Shares and Warrants hereunder shall be held at 10:00 A.M. Houston, Texas time, on December 29, 1999 ("Closing Date"), at the offices of Haynes & Boone L.L.P., 1000 Louisiana, Suite 4300, Houston, Texas 77002. Section 3.2 Payment; Delivery. At the Closing, the Company will deliver to Purchaser duly executed certificates representing the Purchase Shares registered in the name of Purchaser, against payment of the Purchase Price therefor, by wire transfer of immediately available funds per the Company's instructions, together with delivery by the Company of such other documents, certificates and opinions of counsel as may be required to be delivered by the Company to Purchaser as a condition to Purchaser's consummation of this Agreement, including, without limitation, the Ancillary Agreements. 5 H- ARTICLE IV. REPRESENTATIONS AND WARRANTIES Section 4.1 Representations and Warranties of the Company. In order to induce Purchaser to enter into this Agreement, the Company hereby represents and warrants to Purchaser, as follows: (a) Organization and Standing; Articles and By Laws. The Company is a corporation legally incorporated, duly organized, validly existing and in good standing under the laws of the province of Alberta, Canada, has full corporate power and authority and all necessary licenses and permits to own, lease, produce and operate the properties used in its business and to carry on its business as now being conducted. The Company is duly qualified to do business and is in good standing as a foreign corporation in each jurisdiction where the character of the properties owned, leased or produced by it or the nature of the businesses transacted by it requires it to be so qualified. Schedule 4.1 (a) is a true, correct and complete copy of the Company's Articles and By Laws, containing all amendments through the date hereof. (b) Corporate Power; Authority. The Company has full corporate power and authority to enter into this Agreement and each of the Ancillary Agreements and to perform its obligations hereunder and thereunder. The execution, delivery and performance of this Agreement, and the Ancillary Agreements, the issuance of the Purchase Shares and Warrants, the issuance upon conversion of the Purchase Shares of the Shares, the issuance upon exercise of the Warrants of the Warrant Shares, and the consummation of the transactions contemplated hereby and thereby have been duly authorized and approved by the Board of Directors of the Company and, subject to the receipt of approval of the Company's shareholders as contemplated by Section 6.4, no other corporate proceeding on the part of the Company is necessary to authorize and approve this Agreement and the Ancillary Agreements and the transactions contemplated hereby and thereby. This Agreement has been, and at the Closing each Ancillary Agreement will be, duly executed and delivered by, and constitutes or will constitute a valid and binding obligation of, the Company, enforceable against the Company in accordance with its terms (except as enforceability may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws affecting creditors' rights generally or by the principles governing the availability of equitable remedies). (c) Purchase Shares and Warrants. The Purchase Shares and Warrants, when issued in accordance with this Agreement, will be validly issued, fully paid and nonassessable and will have the rights, preferences and privileges set forth in the Articles of Amendment or Warrant (as the case may be). The Shares and Warrant Shares have been duly and validly reserved and, when issued in compliance with the provisions of this Agreement and the Articles of Amendment or Warrant (as the case may be), will be validly issued, fully paid and non-assessable and will have the rights, preferences and privileges set forth in the Articles. Upon issuance upon conversion of the Purchase Shares 6 H- or upon exercise of the Warrants, the Shares or Warrant Shares (as the case may be) will be free of any Liens created by the Company; provided, however, that the Shares and Warrant Shares will be subject to restrictions on transfer under the Securities Act or any applicable United States or Canadian state and provincial securities laws and rules of the ASC (collectively, "Securities Laws"). The Shares and Warrant Shares are not subject to any preemptive rights or rights of first refusal. (d) Capitalization. The authorized capital stock of the Company consists of unlimited number of Common Shares, of which 77,778,263 shares are issued and outstanding as of the date of the hereof. The outstanding shares have been duly authorized and validly issued, and are fully paid and nonassessable. All outstanding securities of the Company were issued in compliance with applicable Securities Laws. The Company has reserved 50,000,000 and 12,500,000 Common Shares for issuance upon conversion of the Preferred Shares and exercise of the Warrants, respectively. Other than the Common Shares and except as specifically described on Schedule 4.1(d), the Company does not have any outstanding capital stock or securities convertible into or exchangeable for any shares of its capital stock, or any outstanding rights (either preemptive or other) to subscribe for or to purchase, or any outstanding rights or options for the purchase of, or any agreements providing for the issuance (contingent or otherwise) of, or any outstanding calls, commitments or claims of any character relating to, any capital stock or any stock or securities convertible into or exchangeable for any capital stock of the Company. The Company is not subject to any obligation (contingent or otherwise) to repurchase or otherwise acquire or retire any shares of its capital stock or any convertible securities, rights or options of the type described in the preceding sentence. The Company is not a party to any agreement (except as contemplated by this Agreement) restricting the transfer of any shares of the Company's capital stock. (e) Subsidiaries. Except as listed on Schedule 4.1(e), the Company has no subsidiaries and does not otherwise own or control, directly or indirectly, any equity interest in any corporation, association, business entity or other Person. Each such subsidiary is a corporation legally incorporated, duly organized, validly existing and in good standing under the laws of the jurisdiction of its incorporation, has full corporate power and authority and all necessary licenses and permits to own, lease, produce and operate the properties used in its business and to carry on its business as now being conducted. Each subsidiary is duly qualified to do business and is in good standing as a foreign corporation in each jurisdiction where the character of the properties owned or leased by it or the nature of the businesses transacted by it requires it to be so qualified except where the failure to be so qualified would not have a Material Adverse Effect. (f) No Conflicts or Consents. (i) Neither the execution, delivery or performance of this Agreement nor the Ancillary Agreements by the Company nor the 7 H- consummation of the transactions contemplated hereby or thereby will (1) violate, conflict with, or result in a breach of any provision of, constitute a material default (or an event that, with notice or lapse of time or both, would constitute a material default) under, result in the termination of, or accelerate the performance required by, or result in the creation of any material adverse claim against any of the material properties or assets of the Company or its subsidiaries under, (A) the Articles, by laws or any other organizational documents of the Company or its subsidiaries, or (B) any material note, bond, mortgage, indenture, deed of trust, lease, license, agreement, production sharing contract, concession or other instrument or obligation to which the Company or any of its subsidiaries is a party, or by which the Company or any of its subsidiaries or any of their respective assets are bound, or (2) violate any order, writ, injunction, decree, judgment, statute, rule or regulation of any Governmental Authority to which the Company or any subsidiary is subject or by which the Company or any of its subsidiaries or any of their respective assets are bound in any material respect. (ii) Except as set forth on Schedule 4.1(f), no consent, approval, order, permit or authorization of, or registration, declaration or filing with, any Person or of any Governmental Authority is required for the execution, delivery and performance by the Company of this Agreement and the Ancillary Agreements and the covenants and transactions contemplated hereby or thereby. (g) Corporate Documents. The minute books of the Company and its subsidiaries contain reasonably complete and accurate required records of all corporate actions of the equity owners of the various entities and of the boards of directors or other governing bodies, including committees of such boards or governing bodies. The share transfer records of the Company are maintained by its transfer agent and registrar and, to the knowledge of the Company, contain complete and accurate records of all issuances and redemptions of shares by the Company. (h) ASC Documents; Financial Statements; Liabilities. (i) Since January 1, 1997, the Company has filed all reports, forms, statements and other documents required under the Securities Act (Alberta) to be filed with the ASC (the "ASC Documents") other than annual audited financial statements for the year ended June 30, 1999 and unaudited interim financial statements for the three months ended September 30, 1999. The ASC Documents, and any such reports, forms and documents filed by the Company with the ASC after the date hereof, as amended, complied, or will comply, as to form in all material respects with 8 H- the requirements of the Securities Act (Alberta), as the case may be, applicable to such ASC Documents, and none of the ASC Documents contained, any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. (ii) The Financial Statements included in the ASC Documents have been audited by Garrett Power, Chartered Accountants (in the case of the Audited Financial Statements) in accordance with Canadian generally accepted auditing standards, have been prepared in accordance with Canadian generally accepted accounting principles applied on a basis consistent with prior periods, and present fairly the consolidated financial position of the Company at such dates and the results of operations and cash flows for the periods then ended, except, in the case of the Interim Financial Statements, as permitted by the Securities Act (Alberta). The Interim Financial Statements reflect all adjustments (consisting only of normal, recurring adjustments) that are necessary for a fair statement of the results for the interim periods presented therein. Except as set forth on Schedule 4.1(h), or in the Latest Balance Sheet and the notes thereto, there has not been any Material Adverse Change in the consolidated financial condition of the Company since December 31, 1998. (iii) The Latest Balance Sheet includes appropriate reserves for all Taxes and other liabilities incurred as of such date but not yet payable. (iv) Since the date of the Latest Balance Sheet, there has been no change that has had or is likely to have a Material Adverse Effect on the Company. (i) Oil and Gas Properties. (i) Except for Liens arising in the ordinary course of business after the date of the Latest Balance Sheet and assets disposed of in the ordinary course of business after the date of the Latest Balance Sheet, each of the Company and its subsidiaries has good and marketable title, free and clear of all Liens which would have a Material Adverse Effect on the Company and its subsidiaries on a consolidated basis, to the all their material properties and assets, whether tangible or intangible, real, personal or mixed, reflected in the Latest Balance Sheet as being owned by the Company and its subsidiaries as of the date thereof or purported to be owned on the date thereof, including without limitation, the oil and gas interests reported upon in the Reserve Report. All buildings, and all fixtures, equipment and other property and assets which are material to its business on a 9 H- consolidated basis, held under leases by the Company and its subsidiaries are held under valid instruments enforceable by each of them in accordance with their respective terms. Substantially all of the Company's and its subsidiaries' equipment in regular use has been reasonably well maintained and is generally in good and serviceable condition, reasonable wear and tear excepted. (ii) The Company has delivered to the Purchaser a copy of the reserve report ("Reserve Report") dated as of December 31, 1998, prepared by Ryder Scott Company Petroleum Engineers, independent reserve engineers ("Reserve Engineers") relating to the oil and gas reserves of the Company. The factual information underlying the estimates of the reserves of the Company, which was supplied by the Company to the Reserve Engineers for the purpose of preparing the Reserve Report, including, without limitation, production, volumes, sales prices for production, contractual pricing provisions under oil or gas sales or marketing contracts under hedging arrangements, costs of operations and development, and working interest and net revenue information relating to the Company's ownership interests in properties, was true and correct in all material respects on the date of such Reserve Report; the estimates of future capital expenditures and other future exploration and development costs supplied to the Reserve Engineers were prepared in good faith and with a reasonable basis; the information provided to the Reserve Engineers for purposes of preparing the Reserve Reports were prepared in accordance with customary industry practices; each of the Reserve Engineers were, as of the date of any Reserve Report prepared by it, and are, as of the date hereof, independent petroleum engineers with respect to the Company; other than normal production of the reserves and intervening oil and gas price fluctuations set forth in Schedule 4.1(i) (ii), the Company is not, as of the date hereof, aware of any facts or circumstances that would result in a materially adverse change in the reserves in the aggregate, or the aggregate present value of future net cash flows therefrom, as described in the Reserve Reports; estimates of such reserves and the present value of the future net cash flows therefrom in the Reserve Report comply in all material respects to the applicable requirements of Regulation S-X under the Securities Act; (j) Investment Company. Neither the Company nor any of its subsidiaries is an "investment company" within the meaning of the Investment Company Act of 1940, as amended. (k) Public Utility Company. Neither the Company nor any of its subsidiaries is a "public utility," a "holding company" or a subsidiary or "affiliate" of a public utility within the meaning of the Public Utility Holding Company Act of 1935, as amended. 10 H- (L) Environmental Matters. Except as set forth on Schedule 4.1(1), and except for matters that would not result individually in liability to the Company or any of its subsidiaries in excess of (a) $10,000 in the case of matters known to the Company or, in the aggregate with all other such matters, in liability to the Company or any of its subsidiaries in excess of $25,000, or (b) $25,000 in the case of matters not known to the Company or, in the aggregate with all other such matters, in liability to the Company or any of its subsidiaries in excess of $50,000, to the best knowledge of the Company: (i) the properties, operations and activities of the Company or any of its subsidiaries are in compliance in all material respects with all applicable Environmental Laws and there are no circumstances which could reasonably be expected to prevent or interfere with their continued compliance with applicable Environmental Laws; (ii) each of the Company and its subsidiaries and the properties and operations of the Company and its subsidiaries (including, without limitation, properties located in the Ukraine) are not subject to any existing, pending, or, to the Company's knowledge, threatened civil, criminal or administrative action, suit, claim, notice of violation, investigation, notice of potential liability, request for information, inquiry, demand or proceeding under applicable Environmental Laws; (iii) neither the Company nor any of its subsidiaries has agreed, whether by contract or by consent agreement with Governmental Authorities or private persons, to undertake any environmental investigation, clean up, or remedial activities; (iv) all notices, permits, licenses, or similar authorizations required to be obtained or filed by the Company or its subsidiaries under any Environmental Law in connection with any aspect of the business of the Company or its subsidiaries, including without limitation those relating to the treatment, storage, disposal or discharge of Hazardous Materials, have been duly obtained or filed, and the Company and its subsidiaries are in compliance with the terms and conditions of all such notices, permits, licenses and similar authorizations. (v) the Company and each of its subsidiaries has satisfied and is currently in compliance with all financial responsibility requirements applicable to their operations and imposed by any Governmental Authority under Environmental Laws, and the Company has not received any notice of noncompliance with respect to any such financial responsibility requirements; (vi) there are no physical or environmental conditions existing on any property of the Company or any of its subsidiaries or resulting from the Company's or any of its subsidiaries' operations or activities, past or present, at any location, 11 H- including, without limitation, releases and disposal of Hazardous Materials, that would give rise to any on-site or off site investigation, reporting, or remedial obligations or other Environmental Liability; (vii) to the extent required by applicable Environmental Laws, all Hazardous Materials generated by the Company and its subsidiaries have been transported only by persons authorized under applicable Environmental Laws to transport such materials, and disposed of only at treatment, storage and disposal facilities authorized under applicable Environmental Laws to treat, store or dispose of such Hazardous materials; (viii) there has been no exposure of any person or property to Hazardous Materials or any release of Hazardous Materials into the environment by the Company and its subsidiaries or in connection with their present or prior properties or operations that could reasonably by expected to give rise to any Environmental Liability; (ix) no release or clean up of Hazardous Materials has occurred at the Company's and its subsidiaries' properties which could reasonably be expected to result in the assertion or creation of any Lien on the properties by any Governmental Authority with respect thereto, nor has any such lien been asserted or made by any Governmental Authority with respect thereto; and (x) the operations of each third party operator of any of the Company's and its subsidiaries' properties are in compliance with the terms of this Section. The Company has made available to the Purchaser all material internal and external environmental audits, studies, documents and correspondence on environmental matters in the possession of the Company relating to any of the present or prior properties or operations of the Company and its subsidiaries. In this Section, (xi) "Environmental Laws" shall mean any and all laws, statutes, ordinances, rules, regulations or orders of any Governmental Authority pertaining to pollution, health, safety, or the environment, including, without limitation, the laws of the Ukraine on Environmental Protection (VVR (Visnyk Verkhovnoi Rady (Herald of the Supreme Rada]) 1991, #41. p. 5546), the Clean Air Act, the Comprehensive Environmental, Response, Compensation, and Liability Act, the Clean Water Act, the Occupational Safety and Health Act, the Resource Conservation and Recovery Act, the Solid Waste Disposal Act, the Emergency Planning and Community Right-To-Know Act, the Safe Drinking Water Act, the Toxic Substances Control Act, the Hazardous Materials Transportation Act, the Oil 12 H- Pollution Act, all as amended, any state laws implementing the foregoing federal laws, any state laws pertaining to, health, safety and waste management including, without limitation, the handling of asbestos, medical waste or disposable products, hydrocarbon products, PCBs or other Hazardous Materials or processing or disposing of wastes or the use, maintenance and closure of pits and impoundments, all other federal, provincial, state or local environmental conservation or protection and health and safety laws, domestic and foreign, and any common law creating liability for environmental conditions. Environmental Laws shall include, without limitation, all restrictions, conditions, standards, limitations, prohibitions, requirements, guidelines, obligations, schedules and timetables contained in Environmental Laws or contained in any regulation, plan, code, order, decree, judgment, injunction, notice or demand letter issued, entered, promulgated or approved thereunder. (xii) "Hazardous Materials" shall mean any materials that are regulated by or form the basis or liability under Environmental Laws, and include, without limitation, asbestos, wastes, including, without limitation, medical wastes or disposable products, hazardous substances, pollutants or contaminants, hazardous or solid wastes, hazardous constituents, hazardous materials, toxic substances, petroleum, including crude oil or any fraction thereof, natural gas, natural gas liquids, liquefied natural gas or synthetic gas usable for fuel (or mixtures of natural gas and such synthetic gas). (xiii) "Environmental Liability" shall mean liabilities, fines, penalties, obligations, consequential damages, responsibilities, response costs, natural resource damages, corrective action costs, reclamation costs, and costs and expenses, known or unknown, absolute or contingent, past, present or future, resulting from any requirement, claim or demand under Environmental Laws or contract. (m) Tax Matters. (i) Each of the following is true with respect to each of the Company and its subsidiaries to the extent applicable to such member: (1) all Returns that are or were required to be filed by or with respect to the Company and its subsidiaries have been or will be timely filed by each of the Company and its subsidiaries when due in accordance with all applicable laws; all Taxes shown on the Returns have been or will be timely paid when due; the Returns have been properly completed in compliance with all applicable laws and regulations and completely and accurately reflect the facts regarding the income, expenses, properties, business and operations 13 H- required to be shown thereon; the Returns are not subject to penalties under Section 6662 of the Code (or any corresponding provision of state, local or foreign tax law); (2) except as set forth on Schedule 4.1(m), each member of the Company and its subsidiaries has paid all Taxes required to be paid by it (whether or not shown on a Return) or for which it could be liable (provided that it shall not be considered a breach of this representation if it is ultimately determined that additional tax payments are due but such assessment is based on an adjustment to a Return or position, if such member has a reasonable basis for the position taken with respect to such Taxes), whether to taxing authorities or to other Persons under tax allocation agreements or otherwise, and the charges, accruals, and reserves for Taxes due, or accrued but not yet due, relating to its income, properties, transactions or operations for any period as reflected on its books (including, without limitation, the Latest Balance Sheet) are adequate to cover such Taxes; (3) there are no ongoing or scheduled audits, agreements or consents currently in effect for the extension or waiver of the time (A) to file any Return or (B) for assessment or collection of any Taxes relating to the income, properties or operations of any of the Company and its subsidiaries for any period, and neither the Company nor any subsidiary has been requested to enter into any such agreement or consent; (4) there are no Liens for Taxes (other than for current Taxes not yet due and payable and Taxes set forth on Schedule 4.1 (m) upon the assets of any of the Company nor its subsidiaries; (5) the Company and its subsidiaries have not received notice of any Tax deficiency outstanding, proposed or assessed against or allocable to the Company or its subsidiaries or their assets (other than for Taxes set forth on Schedule 4.1 (m); (6) to the knowledge of the Company, each of the Company and its subsidiaries has complied in all material respects with all applicable tax laws (other than for Taxes set forth on Schedule 4.1(m); and 14 H- (7) all Taxes that the Company and its subsidiaries are or were required by applicable law to withhold or collect have been duly withheld, collected and paid. (n) Litigation. Except as disclosed on Schedule 4.1(n), there are no actions, suits, proceedings, arbitrations or investigations pending or, to the knowledge of the Company, threatened before any court, any Governmental Authority, governmental instrumentality or any arbitration panel, against or affecting any of the Company or its subsidiaries. To the knowledge of the Company, no facts or circumstances exist that would be reasonably likely to result in the filing of any such action that would have a Material Adverse Effect on the Company. Except as disclosed on Schedule 4.1(n), neither the Company nor its subsidiaries is subject to any currently pending judgment, order or decree entered in any lawsuit or proceeding. (o) Broker's and Finder's Fee. No agent, broker, Person or firm acting on behalf of the Company is or will be entitled to any commission or broker's or finder's fee from the Company or its subsidiaries in connection with any of the transactions contemplated herein. (p) Absence of Sensitive Payments. Except as disclosed to Purchaser, neither the Company, any subsidiary nor any Affiliate thereof nor any officer or director of any of them acting alone or together, has performed any of the following acts: (i) the making of any contribution, payment, remuneration, gift or other form of economic benefit (a "Payment") to or for the private use of any governmental official, employee or agent where the Payment or the purpose of the Payment was illegal under the laws of the United States, Canada or the Ukraine or the jurisdiction in which such payment was made, (ii) the establishment or maintenance of any unrecorded fund, asset or liability for any purpose or the making of any false or artificial entries on its books, (iii) the making of any Payment or the receipt of any Payment with the intention or understanding that any part of the Payment was to be used for any purpose other than that described in the documents supporting the Payment, or (iv) the giving of any Payment to, or the receipt of any Payment from, any person who was or could have been in a position to help or hinder the business of the Company and its subsidiaries (or assist any of the Company or its subsidiaries in connection with any actual or proposed transaction) which (A) would reasonably have been expected to subject any of the Company or its subsidiaries to any damage or penalty in any civil, criminal or governmental litigation or proceeding, (B) if not given in the past, would have had a Material Adverse Effect on the Company or (C) if not continued in the future, would have a Material Adverse Effect on the Company. (q) Compliance with Law. Neither the Company nor any subsidiary is in violation of any statute, law, ordinance, regulation, rule or order of any foreign, United States, Canadian or Ukranian federal, state, provincial or local Governmental Authority or any judgment, decree or order of any court, except where any such violation would not, 15 H- individually or in the aggregate, have a Material Adverse Effect on the Company. Each of the Company and its subsidiaries has all permits, approvals, licenses and franchises from Governmental Authorities required to conduct its business as now being conducted, except for such permits, approvals, licenses and franchises the absence of which would not, individually or in the aggregate, have a Material Adverse Effect on the Company. (r) Contracts. (i) Schedule 4.1 (r) sets forth, as of the date hereof, a list of all of the following material contracts and other agreements to which the Company or its subsidiaries is a party or by which any of them or any material portion of their properties or assets are bound or subject (other than those set forth on any other Schedule): (1) contracts, severance agreements and other agreements with any current or former officer, director, employee, consultant, agent or other representative; (2) contracts and other agreements with any labor union or association representing any employee of the Company and its subsidiaries; (3) contracts, agreements or other agreements relating to the Company and its subsidiaries between the Company and its subsidiaries, on the one hand, and any shareholder or any of his, her or its Affiliates on the other hand; (4) joint venture agreements, concessions, licenses or production sharing contracts; (5) contracts and other agreements under which the Company or any of its subsidiaries agrees to indemnify any party; (6) contracts and other agreements relating to the borrowing of money; or (7) any other material contract or other agreement whether or not made in the ordinary course of business. There have been delivered or made available to the Purchaser true and complete copies of all such contracts and other agreements set forth on Schedule 4.1(r). (ii) All contracts, agreements and understandings set forth on Schedule 4.1 (r) are valid and binding and are in full force and effect and enforceable in accordance with their respective terms other than contracts, agreements or understandings which are by their terms no longer in force or effect. Except as set forth on Schedule 4.1 (r) (or on another Schedule), (1) no approval or consent of, or notice to, any Person is needed in order that such contract, agreement or understanding shall continue in full force and effect in accordance with its terms without penalty, acceleration or rights of early termination following the consummation of the transactions contemplated by this Agreement, and (2) neither the Company nor any of its subsidiaries is in violation or breach of or default under any such contract, agreement or understanding nor to the knowledge of the Company is any other party to any such contract, agreement or understanding. 16 H- (s) Employment Plans/Employment Agreements (i) Neither the Company nor its subsidiaries has sponsored, maintained or contributed to or for the benefit of the current or former employees, officers or directors of the Company or its subsidiaries or has been so sponsored, maintained or contributed to within six years prior to the Closing Date: (1) any "employee benefit plan," as such term is defined in Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") (including, but not limited to, employee benefit plans, such as foreign plans, which are not subject to the provisions of ERISA); and (2) any personnel policy, option plan, collective bargaining agreement, bonus plan or arrangement, incentive award plan or arrangement, vacation policy, severance pay plan, policy or agreement, deferred compensation agreement or arrangement, executive compensation or supplemental income arrangement, consulting agreement, employment agreement and each other employee benefit plan, agreement, arrangement, program, practice or understanding. (ii) Neither the Company nor its subsidiaries contributes to or has an obligation to contribute to, and has not at any time within six years prior to the Closing Date contributed to or had an obligation to contribute to or any liability with respect to (a) a multiemployer plan within the meaning of Section 3(37) of ERISA or (b) a plan subject to Title IV of ERISA, Section 302 of ERISA or Section 412 of the Code. No Plan is funded through a trust that is intended to be exempt from federal income taxation pursuant to Section 501 (c) (9) of the Code. (iii) the Company does not have a 401 (k) Plan or any health benefit plans. (t) Absence of Certain Changes or Events. Since the date of the Latest Balance Sheet, each of the Company and its subsidiaries has conducted its business only in the ordinary course, and has not: (i) amended its articles of incorporation, bylaws or similar organizational documents; (ii) merged or consolidated with another entity (other than a subsidiary) or acquired or agreed to acquire any business or any corporation, partnership or other business organization, or sold, leased, 17 H- transferred or otherwise disposed of any material portion of its assets except for fair value in the ordinary course of business; (iii) suffered any damage, destruction or loss (whether or not covered by insurance) which has had or could have a Material Adverse Effect on the Company; (iv) suffered the termination, suspension or revocation of any license or permit necessary for the operation of its business; (v) entered into any transaction other than on an arm's-length basis; (vi) declared or paid any dividend or made any distribution with respect to any of its equity interests, or redeemed, purchased or otherwise acquired any of its equity interests, or issued, sold or granted any option, warrant or other right to purchase or acquire any equity interest; or (vii) agreed, whether or not in writing, to do any of the foregoing (other than as contemplated by the Pease Merger Agreement). (u) The Company's Assets. The assets of the Company and of its subsidiaries consist solely of (i) reserves of oil, rights to reserves of oil and associated exploration and production assets with a fair market value not exceeding $500 million and (ii) other assets with a fair market value not exceeding $15 million. For purposes of this Section 4.1(u), the term "associated exploration and production assets" shall have the meaning ascribed thereto in Section 802.3 of the Rules promulgated pursuant to the Hart-Scott-Rodino Antitrust Improvements Act of 1976 ("HSR Act"). (v) Registration Rights. The Company is not under any obligation to register (as defined in the First Amendment to Registration Rights Agreement) any of its presently outstanding securities or any of its securities which may hereafter be issued, except as described on Schedule 4.1(v). Section 4.2 Representations and Warranties of Purchaser. Purchaser hereby represents and warrants to the Company as follows: (a) Investment Intent. Purchaser: (i) is acquiring the Purchase Shares, the Warrants, the Shares and the Warrant Shares for investment for its own account, not as a nominee or agent, and not with the view to, or for resale in connection with, any distribution thereof except pursuant to the First Amendment to Registration Rights Agreement; 18 H- (ii) understands and acknowledges that the Purchase Shares, the Warrants, the Shares and the Warrant Shares have not been and will not be registered under any applicable Securities Laws, and that the issuance contemplated hereby is being made in reliance on a private placement exemption to "accredited investors" as defined in Regulation D under the Securities Act and similar exemptions under state law and applicable exemptions under the Securities Act (Alberta); (iii) has had access to such information concerning the Company as it has considered necessary in connection with its investment decision to invest in the Purchase Shares, the Warrants, the Shares and the Warrant Shares, including an opportunity to meet with members of management of the Company and to ask and receive answers to questions regarding the Company, its business, financial condition, prospects and the terms of this offering; (iv) has such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risks of its investment in the Purchase Shares, Warrants, Shares and Warrant Shares and is able to bear the economic risks of such investment; (v) acknowledges that it has not purchased the Purchase Shares, the Warrants, the Shares and the Warrant Shares as a result of any general solicitation or general advertising, including advertisements, articles, notices or other communications published in any newspaper, magazine or similar media or broadcast over the internet, radio or television, or any seminar or meeting whose attendees have been invited by general solicitation or general advertising; (vi) agrees that if it decides to offer, sell or otherwise transfer any of the Purchase Shares, the Warrants, the Shares or the Warrant Shares, it will not offer, sell or otherwise transfer any of such Purchase Shares, Warrants, Shares or Warrant Shares, directly or indirectly, unless: A. the sale is to the Company or registered under applicable Securities Laws; or B. the sale is made outside the United States in a transaction meeting the requirements of Rule 904 of Regulation S (or such successor rule or regulation as then in effect); C. the sale is made pursuant to the exemption from the registration requirements under the Securities Act provided by Rule 144 thereunder, if available, and in accordance with any applicable state securities laws; or 19 H- D. the sale is made in a transaction that otherwise does not require registration under applicable Securities Laws governing the offer and sale of the Purchase Shares, Warrants, Shares and Warrant Shares; (vii) understands and acknowledges that upon issuance thereof and until such time as is no longer required under requirements of the applicable Securities Laws, all certificates representing the Purchase Shares, the Warrants, the Shares and the Warrant Shares (and all certificates issued in exchange therefor or in substitution thereof), shall bear, in addition to any legend (s) required by applicable Securities Laws and policies, the following legend: THE SECURITIES REPRESENTED HEREBY HAVE NOT BEEN AND WILL NOT BE REGISTERED UNDER THE UNITED STATES SECURITIES ACT OF 1933, AS AMENDED (THE "1933 ACT"). THE HOLDER HEREOF, BY PURCHASING SUCH SECURITIES, AGREES FOR THE BENEFIT OF THE COMPANY THAT SUCH SECURITIES MAY BE OFFERED, SOLD, PLEDGED OR OTHERWISE TRANSFERRED ONLY (A) TO THE COMPANY, (B) OUTSIDE THE UNITED STATES IN ACCORDANCE WITH REGULATION S UNDER THE 1933 ACT, IF APPLICABLE (OR SUCH SUCCESSOR RULE OR REGULATION AS THEN IN EFFECT), (C) INSIDE THE UNITED STATES (1) PURSUANT TO REGISTRATION UNDER THE 1933 ACT AND APPLICABLE STATE LAWS, OR (2) PURSUANT TO THE EXEMPTION FROM REGISTRATION UNDER THE 1933 ACT PROVIDED BY RULE 144 THEREUNDER, IF AVAILABLE, AND IN ACCORDANCE WITH APPLICABLE STATE SECURITIES LAWS, OR (3) IN A TRANSACTION THAT DOES NOT REQUIRE REGISTRATION UNDER THE 1933 ACT OR ANY APPLICABLE STATE SECURITIES LAWS, AND THE HOLDER HAS PRIOR TO SUCH SALE FURNISHED TO THE COMPANY AN OPINION OF COUNSEL OF RECOGNIZED STANDING, REASONABLY SATISFACTORY TO THE COMPANY, TO THE EFFECT THAT NO SUCH REGISTRATION IS REQUIRED. DELIVERY OF THIS CERTIFICATE MAY NOT CONSTITUTE "GOOD DELIVERY" IN SETTLEMENT OF TRANSACTIONS ON STOCK EXCHANGES IN CANADA. and understands that the certificate representing the Purchase Shares, Warrants, Shares and Warrant Shares will bear the following additional legend: THE SECURITIES REPRESENTED BY THIS CERTIFICATE MAY NOT BE SOLD UNLESS (A) A PERIOD OF AT LEAST 12 MONTHS HAS ELAPSED FROM THE DATE OF ORIGINAL ISSUE, (B) NO UNUSUAL EFFORT IS MADE TO PREPARE THE MARKET OR TO CREATE A DEMAND FOR THE SECURITIES MAKING UP THE DISTRIBUTION, (C) NO EXTRAORDINARY COMMISSION OR CONSIDERATION IS PAID TO A PERSON OR 20 H- COMPANY OTHER THAN THE VENDOR OF THE SECURITIES IN RESPECT OF THE TRADE, AND (D) THE FIRST TRADE IS NOT FROM THE HOLDINGS OF A CONTROL PERSON. ("UNUSUAL EFFORT," "EXTRAORDINARY COMMISSION" AND "CONTROL PERSON" HAVE THE MEANINGS SET OUT IN THE SECURITIES ACT (ALBERTA) AND THE RULES THEREUNDER.) (viii) consents to the Company making a notation on its records or giving instructions to any transfer agent of the Purchase Shares, the Warrants, the Shares and the Warrant Shares in order to implement the restrictions on transfer set forth and described herein; and (ix) will not sell all or any of the Purchase Shares, the Warrants, the Shares and the Warrant Shares except in compliance with applicable Securities Laws. (b) Accredited Investor. The Purchaser is an "accredited investor" as such term is defined in Regulation D under the Securities Act. (c) Corporate Power; Authority. The Purchaser has full corporate power and authority to enter into this Agreement and the Ancillary Agreements and to perform its obligations hereunder and thereunder. The execution, delivery and performance of this Agreement, and the Ancillary Agreements and the consummation of the transactions contemplated hereby and thereby have been duly authorized and approved by the Board of Directors of the Purchaser and no other corporate proceeding on the part of the Purchaser is necessary to authorize and approve this Agreement and the Ancillary Agreements and the transactions contemplated hereby and thereby. This Agreement has been, and at the Closing, each Ancillary Agreement will be, duly executed and delivered by, and constitutes or will constitute a valid and binding obligation of the Purchaser enforceable against the Purchaser in accordance with its terms (except as enforceability may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws affecting creditors' rights generally or by the principles governing the availability of equitable remedies). Section 4.3 Acknowledgments of the Purchaser. In connection with the issuance of the Purchase Shares and the Warrants, Purchaser certifies that it is not a resident of Alberta and hereby acknowledges to the Company as follows: (a) Purchaser understands that no securities commission or similar regulatory authority has reviewed or passed on the merits of the Purchase Shares or the Warrants, (b) there is no government or other insurance covering the Purchase Shares or the Warrants, 21 H- (c) there are risks associated with the purchase of the Purchase Shares and the Warrants, (d) there are restrictions on the Purchaser's ability to resell the Purchase Shares and the Warrants (and the Shares and Warrant Shares) and it is the responsibility of the Purchaser to find out what those restrictions are and to comply with them before selling the Purchase Shares Warrants (and the Shares and Warrant Shares), and (e) the Company has advised the Purchaser that the Company is relying on an exemption from the requirements to provide the Purchaser with a prospectus and to sell the Purchase Shares and Warrants through a person or company registered to sell securities under the Securities Act (Alberta) and, as a consequence of acquiring the Purchase Shares and the Warrants pursuant to this exemption, certain protections, rights and remedies provided by the Securities Act (Alberta), including statutory rights of rescission or damages, will not be available to the Purchaser. ARTICLE V. CONDITIONS TO CLOSING Section 5.1 Purchaser's Conditions. Purchaser's obligations to purchase the Purchase Shares and the Warrants at the Closing are subject to the fulfillment of the following conditions, the waiver of which shall not be effective against Purchaser unless specifically consented to in writing: (a) Representations and Warranties Correct. The representations and warranties made by the Company in Section 4.1 hereof shall be true and correct when made, and shall be true and correct on the Closing Date except to the extent such representations and warranties specifically relate to an earlier date, in which case such representations and warranties shall be true and correct as of such earlier date. (b) Covenants. All covenants, agreements and conditions contained in this Agreement to be performed by the Company on or prior to the Closing Date shall have been performed or complied with in all respects. (c) Compliance Certificate. The Company shall have delivered to Purchaser a certificate of the Company, executed by the President and Secretary of the Company, dated the Closing Date, and certifying, that all representations and warranties of the Company contained in the Agreement are true and correct on the Closing Date as if made on such date, that all conditions to the obligations of Purchaser to close the transactions contemplated by this Agreement have been satisfied or waived in writing by Purchaser and that the Company has complied with all covenants or obligations set forth in this Agreement. 22 H- (d) No Material Adverse Change. There shall have been no Material Adverse Change with respect to the Company since the date of the Interim Financial Statements. (e) Consents. The shareholders of the Company shall have approved the issuance of the Purchase Shares and Warrants as contemplated by Section 6.4. Any consent, approval, authorization or order of any court, Governmental Authority or administrative body required for the consummation of the transactions contemplated by this Agreement, shall have been obtained and shall be in effect on the Closing Date. (f) Registration Rights Agreement. The Company shall have executed the First Amendment to Registration Rights Agreement. (g) Opinion of Company's Counsel. Purchaser shall have received from McManus Thompson a favorable opinion dated the Closing Date, in form and substance satisfactory to Purchaser, in the form of Exhibit D. (h) Pease Merger Agreement. The Pease Merger Agreement shall have been amended as contemplated by Section 6.10 and the form and substance of such amendment shall be satisfactory to the Purchaser, acting reasonably. (i) Due Diligence. The Purchaser shall have completed its due diligence investigation of the Company, its subsidiaries and their respective assets, operations and prospects, and the Company shall be satisfied in its sole and absolute discretion with the results of that investigation. Such due diligence shall include, without limitation, receipt of such opinions and certificates regarding the operations, properties and prospects of the Company from Ukranian counsel to Purchaser as purchaser shall request. Section 5.2 Company's Conditions. The Company's obligation to sell and issue the Purchase Shares and Warrants at the Closing is, at the option of the Company, subject to the fulfillment as of the Closing Date of the following conditions: (a) Representations. The representations made by Purchaser in Sections 4.2 and 4.3 hereof shall be true and correct when made, and shall be true and correct on the Closing Date. (b) Consents. The shareholders of the Company shall have approved the issuance of the Purchase Shares and Warrants as contemplated by Section 6.4. Any other consent, approval, authorization or order of any court, Governmental Authority or administrative body required for the consummation of the transactions contemplated by this Agreement, shall have been obtained and shall be in effect on the Closing Date. (c) Pease Merger Agreement. The Pease Merger Agreement shall have been amended as contemplated by Section 6.10. 23 H- ARTICLE VI. AFFIRMATIVE COVENANTS OF THE COMPANY Section 6.1 Financial Information. The Company will mail to each Holder of any of the Purchase Shares, Warrants, Shares or Warrant Shares the following: (a) ASC Reports. The Company shall promptly mail copies of all quarterly and annual reports and of the information, documents and other reports which the Company is required to file with the ASC or the SEC, exclusive of any exhibits to such reports and exclusive of registration statements on Form S-8. (b) Other Reports. If the Company is not required to file reports with the ASC or the SEC, the Company shall mail within five days after it would have been required to file with the SEC, financial statements, including notes thereto (and with respect to annual financial statements, an auditor's report by a firm of established national reputation), and a "Management's Discussion and Analysis of Financial Condition and Results of Operations" both comparable to that which the Company would have been required to include in such annual or quarterly reports, information, documents or other reports if the Company were subject to the requirements of Section 13 or 15(d) of the Exchange Act. Section 6.2 Access. The Company will allow, and will cause its subsidiaries to allow, any Holder of Purchase Shares, Warrants, Shares or Warrant Shares or proposed assignee of Purchase Shares, Warrants, Shares or Warrant Shares designated by such Holder, and their respective representatives, upon two Business Days prior telephonic notice, to visit and inspect any of its property, to examine its books of record and account, and to discuss its affairs, finances and accounts with its officers, provided, (i) the Holder of Purchase Shares, Warrants, Shares or Warrant Shares, proposed assignee or representative signs a customary confidentiality agreement if requested by the Company and (ii) the examination will not unreasonably disrupt, in any material manner, the operations of the Company. Section 6.3 Rule 144 Reporting. The Company agrees that from and after the date it registers any class of its securities under Section 12 (b) or 12 (g) of the Exchange Act, it shall: (a) Make and keep "adequate public information" available, as those terms are understood and defined in Rule 144 under the Securities Act, at all times from and after the date hereof; (b) File with the SEC in a timely manner all reports and other documents required of the Company under the Securities Act and the Exchange Act; and (c) So long as Purchaser owns any Purchase Shares or Common Shares, furnish to Purchaser promptly upon request a written statement by the Company as 24 H- to its compliance with the reporting requirements (i) necessary to cause "adequate public information" to be available under Rule 144, and (ii) of the Securities Act and Exchange Act. Section 6.4 Shareholder Approval. The Company will take all action necessary to obtain the approval of the shareholders of the Company in accordance with the requirements of the CDNX by obtaining Shareholder Consents from holders of a majority of its Common Shares, excluding the Purchaser and Torch Energy Advisors Incorporated, with respect to the transactions contemplated hereby. The Board of Directors of the Company shall recommend such approval and shall each take all lawful action to solicit such approval; provided, however, that such recommendation is subject to any action required by the fiduciary duties of the Board of Directors of the Company under applicable law. Section 6.5 Conduct of Business by the Company Pending the Closing. Prior to the Closing, unless Purchaser shall otherwise agree in writing or except as otherwise required by this Agreement: (i) the Company shall, and shall cause its subsidiaries to, carry on their respective businesses in the usual, regular and ordinary course in substantially the same manner as heretofore conducted, and shall, and shall cause its subsidiaries to, use their reasonable efforts to preserve intact their present business organizations and preserve their relationships with customers, suppliers and others having business dealings with them to the end that their goodwill and on-going businesses shall be unimpaired at the Closing. The Company shall, and shall cause its subsidiaries to, (a) maintain insurance coverages and its books, accounts and records in the usual manner consistent with past practice; (b) comply in all material respects with all laws, ordinances and regulations of Governmental Authorities applicable to the Company and its subsidiaries; (c) maintain and keep its material properties and equipment in good repair, working order and condition, ordinary wear and tear excepted; (d) maintain its material concessions in full force and effect and not take any action or fail to take any action which would constitute a material breach or default thereunder; and (e) perform in all material respects its obligations under all material contracts and commitments to which it is a party or by which it is bound; (ii) the Company shall not, and shall not propose or agree to, nor shall it permit any of its subsidiaries to, or propose or agree to, (a) sell or pledge or agree to sell or pledge any capital stock owned by it in any of their respective subsidiaries, (b) amend their respective articles or by-laws, (c) split, combine or reclassify their outstanding stock or issue or authorize or propose the issuance of any other securities in respect of, in lieu of or in substitution for such shares of stock, or declare, set aside, authorize or pay any dividend or other distribution payable in cash, stock or property, or (d) directly or indirectly redeem, purchase or otherwise acquire or agree to redeem, purchase or otherwise acquire any shares of stock; 25 H- (iii) the Company shall not, nor shall it permit any of its subsidiaries to, (A) issue, deliver or sell or agree to issue, deliver or sell any additional shares of, or rights of any kind to acquire any shares of, its respective stock of any class, any indebtedness having the right to vote on any matter on which the Company's shareholders may vote or any option, rights or warrants to acquire, or securities convertible into, exercisable for or exchangeable for, shares of stock other than issuances, deliveries or sales of securities pursuant to obligations outstanding as of the date of this Agreement; (B) acquire, lease or dispose or agree to acquire, lease or dispose of any capital assets or any other assets other than in the ordinary course of business; (C) incur additional indebtedness or encumber or grant a security interest in any asset or enter into any other material transaction other than in each case in the ordinary course of business; (D) acquire or agree to acquire by merging or consolidating with, or by purchasing a substantial equity interest in, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof; or (E) enter into any contract, agreement, commitment or arrangement with respect to any of the foregoing; (iv) the Company shall not, nor shall it permit any of its subsidiaries to, except as required to comply with applicable law, enter into any new (or amend any existing) employment, severance or consulting agreement, grant any general increase in the compensation of current or former directors, officers or employees (including any such increase pursuant to any bonus, pension, profit-sharing or other plan or commitment) or grant any increase in the compensation payable or to become payable to any director, officer or employee, except in any of the foregoing cases in accordance with pre-existing contractual provisions or in the ordinary course of business consistent with past practice; and (v) the Company shall not, nor shall it permit any of its subsidiaries to, amend, modify, terminate, waive or permit to lapse any material right of first refusal, preferential right, right of first offer, or any other material right of the Company or any of its subsidiaries. Section 6.6 Stock Exchange Listing. The Company shall use its best efforts to list on the CDNX, the Shares and Warrant Shares, to be issued pursuant to the Purchase Shares and Warrants. Section 6.7 Additional Agreements. Subject to the terms and conditions herein provided, each of the parties hereto agrees to use all commercially reasonable efforts to take, or cause to be taken, all actions and to do, or cause to be done, all things necessary, proper or advisable under applicable laws and regulations to consummate and make effective the transactions contemplated by this Agreement, including using all commercially reasonable efforts to obtain all necessary waivers, consents and approvals, to effect all necessary registrations and filings and to lift any injunction to the transactions contemplated hereby (and, in such case, to proceed with such transactions as expeditiously as possible). 26 H- Section 6.8 No Shop. The Company agrees (a) that neither it nor any of its subsidiaries shall, and it shall direct and use its best efforts to cause its officers, directors, employees, agents and representatives (including, without limitation, any investment banker, attorney or accountant retained by it or any of its subsidiaries) not to, initiate, solicit or encourage, directly or indirectly, any inquiries or the making or implementation of any proposal or offer (including, without limitation, any proposal or offer to its shareholders) with respect to a merger, stock or asset acquisition, consolidation or similar transaction, involving, or any purchase of all or any significant portion of the assets or any equity securities of, the Company or its subsidiaries, taken as a whole (any such proposal or offer being hereinafter referred to as an "Alternative Proposal"), or engage in any negotiations concerning, or provide any confidential information or data to, or have any discussions with, any Person relating to an Alternative Proposal, or release any third party from any obligations under any existing standstill agreement or arrangement, or enter into any agreement with respect to an Alternative Proposal, or otherwise facilitate any effort or attempt to, make or implement an Alternative Proposal; (b) that it will immediately cease and cause to be terminated any existing activities, discussions or negotiations with any parties conducted heretofore with respect to any of the foregoing, and it will take the necessary steps to inform the individuals or entities referred to above of the obligations undertaken in this Section 6.8; and (c) that it will notify the Purchaser immediately if any such inquiries or proposals are received by, any such information is requested from, or any such negotiations or discussions are sought to be initiated or continued with, it. Notwithstanding the foregoing, the Company may, directly or indirectly, furnish information and access to, and may participate in discussions and negotiate with, any Person, if such Person has submitted a written proposal to its Board of Directors relating to an Alternative Proposal which the Board of Directors believes is superior from a financial point of view to the transactions contemplated hereby and is reasonably likely to be consummated and the Company's Board of Directors, having received a written opinion of legal counsel relating thereto, determines in its good faith judgment that failing to take such action would constitute a breach of the Board of Directors' fiduciary duty to its shareholders imposed by law. The Board of Directors shall provide a copy of any such written proposal to the Purchaser immediately after receipt thereof and thereafter keep the other party promptly advised of any development with respect thereto and any revision of the terms of such Alternative Proposal. Section 6.9 Advice of Changes. The Company shall confer on a regular basis with Purchaser on operational matters. The Company shall promptly advise the Purchaser orally and in writing of any change or event that has had, or could reasonably be expected to have, a Material Adverse Effect. The Company shall promptly provide the Purchaser (or their respective counsel) copies of all filings made by such party with the CDNX or any other Governmental Authority in connection with this Agreement and the transactions contemplated hereby. Section 6.10 Pease Merger. The Company is currently party to the Pease Merger Agreement. Contemporaneously with the execution of this Agreement, Pease and the Company have amended the Pease Merger Agreement as contemplated by Exhibit E. Purchaser agrees to vote all Common Shares which it owns or controls and all of the Preferred Shares in favor of the Pease Merger Agreement (as amended as contemplated by Exhibit E), including the approval and 27 H- adoption of the Redomestication (as defined in the Pease Merger Agreement) and the Merger (as defined in the Pease Merger Agreement); provided however, Purchaser shall not be required to vote or cause the voting of Common Shares or Preferred Shares unless: (i) The conditions to consummation of the Redomestication and the Merger set forth in Section 7.01 (a) and (c) of the Pease Merger Agreement shall have been satisfied as of the date of the vote of shareholders or waived by Purchaser. (ii) The conditions to the consummation of the Redomestication and Merger set forth in Section 7.02 (a) through 7.02 (j) of the Pease Merger Agreement shall have been satisfied as of the date of the vote of shareholders or waived by Purchaser, except that (A) the certificates of the President and Chief Financial Officer of Pease described in Section 7.02 (a), 7.02 (b) and 7.02 (c) of the Pease Merger Agreement shall be delivered and addressed to Purchaser and shall be dated the date of the shareholder vote; (B) the "reasonable business judgement of Carpatsky" set forth in Section 7.02 (d) of the Pease Merger Agreement shall be the "reasonable business judgement of Bellwether Exploration Company"; (C) Purchaser shall have been advised orally that the requirements of the second sentence of clause (iii) below are anticipated to be satisfied at the closing. (iii) Purchaser shall have received drafts of the opinions set forth in Section 7.02(e) and (f) of the Pease Merger Agreement, and such opinion shall be in form and substance acceptable to Purchaser, acting reasonably. Each of the opinions described in Section 7.02 (e) and (f) of the Pease Merger Agreement shall be addressed and delivered to Purchaser at the Closing. (iv) The Company will not waive the conditions in Section 7.02(i) or (j) of the Pease Merger Agreement without the prior written consent of Purchaser. Section 6.11 Board Nominees. At or prior to the Closing, the company shall cause J.P. Bryan to be appointed as Chief Executive Officer of the Company, and shall cause [ ], [ ], [ ] and [ ] to resign as directors, and Mr. Bryan, Dr. Jack Birks and Mr. Dennis Martin to be appointed as directors of the Company. Section 6.12 Use of Proceeds. The Company shall pay $1.0 million of the net proceeds of the issuance of the Preferred Shares and Warrants to the joint activity account created pursuant to the Joint Activity Agreement, dated September 14, 1995, between Poltavanaftogaz and the Company, as amended. 28 H- ARTICLE VII. MISCELLANEOUS Section 7.1 Governing Law. THIS AGREEMENT SHALL BE GOVERNED IN ALL RESPECTS BY THE INTERNAL LAWS OF THE STATE OF TEXAS. Section 7.2 Survival. The representations, warranties, covenants and agreements made herein shall survive any investigation made by Purchaser and the closing of the transactions contemplated hereby. Section 7.3 Successors and Assigns. Except as otherwise provided herein, the provisions hereof shall inure to the benefit of, and be binding upon, the successors, assigns, heirs, executors and administrators of the parties hereto. Section 7.4 Entire Agreement, Amendment. This Agreement and the other documents delivered pursuant hereto at the Closing constitute the full and entire understanding and agreement between the parties with regard to the subjects hereof and thereof, and no party shall be liable or bound to any other party in any manner by any warranties, representations or covenants except as specifically set forth herein or therein. Except as expressly provided herein, neither this Agreement nor any term hereof may be amended, waived, discharged or terminated other than by a written instrument signed by the party against whom enforcement of any such amendment, waiver, discharge or termination is sought. Section 7.5 Notices, etc. All notices and other communications required or permitted hereunder shall be in writing and shall be mailed by registered or certified mail, postage prepaid, or otherwise delivered by hand or by messenger, addressed (a) if to Purchaser, at: Bellwether Exploration Company, 1331 Lamar, Suite 1450, Houston, Texas 77010, Attn: Roland E. Sledge, Esq. with a copy to Haynes and Boone, LLP, 1000 Louisiana, Suite 4300, Houston, Texas 77002, Attention: Guy Young, or at such other address as Purchaser shall have furnished to the Company in writing, or (b) if to any other Holder of any Purchase Shares, Warrants, Shares or Warrant Shares, at such address as such Holder shall have furnished the Company in writing, or, until any such Holder so furnishes an address to the Company, then to and at the address of the last Holder of such Purchase Shares, Warrants, Shares or Warrant Shares who has so furnished an address to the Company, or (c) if to the Company, to its address set forth on the signature page of this Agreement and addressed to the attention of the Corporate Secretary, or at such other address as the Company shall have furnished to Purchaser, with a copy to McManus Thomson, 1210, 6064th Street S.W., Calgary, Alberta T2P 1T1, Attention: James D. Thomson. Section 7.6 Delays or Omissions. Except as expressly provided herein, no delay or omission to exercise any right, power or remedy accruing to any Holder of any Purchase Shares, Warrants, Warrant Shares or Shares, upon any breach or default of the Company under this Agreement, shall impair any such right, power or remedy of such Holder nor shall it be construed to be a waiver of any such breach or default, or an acquiescence therein, or of or in any similar breach or default thereafter occurring; nor shall any waiver of any single breach or default be 29 H- deemed a waiver of any other breach or default theretofore or thereafter occurring. Any waiver, permit, consent or approval of any kind or character on the part of any Holder of any breach or default under this Agreement, or any waiver on the part of any Holder of any provisions or conditions of this agreement, must be in writing and shall be effective only to the extent specifically set forth in such writing. All remedies, either under this Agreement or by law or otherwise afforded to any Holder, shall be cumulative and not alternative. Section 7.7 Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be an original, and all of which together shall constitute one agreement. Section 7.8 Severability. In the event that any provision of this Agreement becomes or is declared by a court of competent jurisdiction to be illegal, unenforceable or void, this Agreement shall continue in full force and effect without said provision; provided that no such severability shall be effective if it materially changes the economic benefit of this Agreement to any party. Section 7.9 Titles and Subtitles. The titles and subtitles used in this Agreement are used for convenience only and are not considered in construing or interpreting this Agreement. Section 7.10 Specific Performance. The Company acknowledges that any breaches of the agreements and covenants contained in of this Agreement would cause irreparable injury to Purchaser for which Purchaser would have no adequate remedy at law. In addition to any other remedy that Purchaser may be entitled to, the parties agree that Purchaser shall be entitled to the remedy of specific performance. [SIGNATURES ON THE FOLLOWING PAGE] 30 H- The foregoing Agreement is hereby executed as of the date first above written. "COMPANY" Address: 6671 Southwest Freeway, Suite 303 CARPATSKY PETROLEUM INC. Houston, Texas 77074 Fax: (713) 981-8670 By ________________________________________ David A. Melman, Chief Corporate Officer "PURCHASER" BELLWETHER EXPLORATION COMPANY By ________________________________________ J.P. Bryan, Chief Executive Officer 31 H- Schedule 4.1 (d) to Securities Purchase Agreement dated December 29, 1999 Common Stock Outstanding 77,778,263(1) Stock Options Outstanding -0- Stock Purchase Warrants 17,665,4042(2) Offers Outstanding to Convert: Calaway Debt - approximately $275,000 @ 12.5(Cents) per share RLF Debt - approximately $365,000 @ 12.5(Cents) per share No other securities with equity component. - --------------------- (1) Inclusive of stock option repurchases. (2) All at $.20 US expiring December 31, 2000. 32 H- Schedule 4.1(f) to Securities Purchase Agreement dated December 29, 1999 Consent of the CDNX. 33 H- Schedule 4.1(i) (i) (1) to Securities Purchase Agreement dated December 29, 1999 Common to the oil and gas industry in foreign countries, Carpatsky does not own an interest in real property; its rights and obligations are governed by joint agreements with its Ukrainian partners. Carpatsky's oil and gas assets consist of interests in the following two fields in the Republic of Ukraine: (1) Rudovsko-Chervonozavodskoye natural gas and gas condensate field (the "RC" field) located in the Poltava District of Eastern Ukraine; and (2) the Bitkov- Babchensky oil field (the "Bitkov field") located in the Ivano-Frankovsk District of southwest Ukraine. The RC field is governed by the Joint Activity Agreement No. 410/95 dated September 15, 1995, revised on October 15, 1996 and amended on December 25, 1997 and again on August 26, 1998. This Joint Activity Agreement was established for the purpose of investment, exploration and operation of the RC field. All of Carpatsky's rights and obligations are subject to all terms and conditions of the Joint Activity Agreement as amended. The Bitkov field is governed by a Joint Venture Agreement dated April 18, 1995, which establishes Carpatsky's rights and obligations in UkrCarpatoil, Ltd., a Ukrainian joint venture. UkrCarpatoil was created for the purpose of production, exploitation and exploration of the Bitkov field. As outlined in the License Agreement dated July 25, 1995, Carpatsky's rights are limited to the incremental hydrocarbon production above the "baseline" production as defined in the License Agreement. The "organizational period" as defined in the license agreement dated April 18, 1995 has been extended through August 13, 2000 by amendments executed on August 13, 1999. Carpatsky's rights and obligations are subject to all of the terms and conditions of the Joint Venture Agreement and License Agreement as amended. 34 H- Schedule 4.1(i) (ii) to Securities Purchase Agreement dated December 29, 1999 a) The Reserve Report dated June 30, 1999, prepared by Ryder Scott Company Petroleum Engineers and entitled, "Carpatsky Petroleum Estimated Future Reserves and Income Attributable to Certain Leasehold Interests in Ukraine, SEC Perimeters Full Contractual Interest Case", is subject to all the limitations, contingencies, uncertainties and estimates that are described in the Discussion Letter dated June 23, 1999 included in the aforementioned Reserve Report. This Discussion Letter is incorporated in this document by reference in its entirety. b) The Development Schedule (or Drilling Plan) that was contemplated in the aforementioned Reserve Report has not been adhered to principally because the capital necessary to fund the drilling activity has not been available. c) The aforementioned Reserve Report contemplated that all of the natural gas in the RC field would be sold to Unocal beginning October 1, 1999 on an exported basis. That event did not occur and the natural gas from the RC field is currently being sold domestically in Ukraine. Historically, Carpatsky has not received payment for the majority of its natural gas sales in Ukraine and there can be assurance payment will be received in the future. d) The sales price used in the Reserve Report for natural gas is $1.50 per Mcf and is held constant throughout the life of the reserves. The actual selling price for 1999 (through September 30th) has averaged $0.87 per Mcf. 35 H- Schedule 4.1 (m) to Securities Purchase Agreement dated December 29, 1999 As of September 30, 1999, the Carpatsky Poltavanaftagas, Joint Activity in the RC field has incurred a corporate profits liability in UAH of 2,899,558 (U.S. equivalent is $648,714 using September 30, 1999 exchange rate). This liability is past due and incurring interest and penalties at an annual rate of 45% (the discount rate in UAH of the National Bank of Ukraine). Carpatsky's properties are subject to a lien to the extent of unpaid taxes. 36 H- Schedule 4.1 (r) to Securities Purchase Agreement dated December 29, 1999 The terms of the Stock Subscription Agreement for the 1999 Private Placement stated David A. Melman will be appointed as a member of Senior Management and a member of the Company's Board of Directors. The following debts are past due as of September 30, 1999: 1) Series 1 Debenture dated August 15, 1998 in favor of James C. Calaway, principal amount $220,000 plus accrued interest of $55,973. 2) Promissory Note in favor of RLG International, Inc.; principal amount of $328,914 plus accrued interest of $30,277. 37 H- EX-11.15 3 MASTER SERVICE AGREEMENT EXHIBIT 10.15 Master Services Agreement between Bellwether Exploration Company and Torch Operating Company, Torch Energy Marketing, Inc., Torch Energy Advisors Incorporated and Novistar, Inc. Effective as of October 1, 1999 - CONFIDENTIAL - MASTER SERVICES AGREEMENT ------------------------- This Master Services Agreement (this "Master Agreement") is entered into among Bellwether Exploration Company ("Customer"), and Torch Operating Company ("TOC"), Torch Energy Marketing, Inc. ("TEMI"), Torch Energy Advisors Incorporated ("TEAI") and Novistar, Inc. ("Novistar") (TOC, TEMI, TEAI and Novistar are herein referred to individually as a Torch Party and collectively as "Torch" and Each Torch Party and Customer are herein individually referred to as a Party and collectively referred to as the "Parties"), effective as of October 1, 1999 (the "Effective Date"). For and in consideration of the mutual promises and covenants contained herein, the receipt, sufficiency, and adequacy of which are hereby acknowledged, the Parties agree as follows: BACKGROUND AND PURPOSE TEAI and other Torch Parties currently provide certain administrative, operations, and marketing services to Customer pursuant to the Management Agreement between TEAI and Customer dated January 1, 1994, as amended, the Contract Operations Agreement between TOC and Customer dated November 11, 1991 and the Marketing Letter Agreement between TEMI and Customer dated May 1, 1997. This Master Agreement sets forth the general terms and conditions applicable to each Service Agreement. The Parties may, from time to time, enter into one or more additional Service Agreements setting forth the specific terms and conditions applicable to specific services to be contracted for by Customer and one or more Torch Parties. ARTICLE 1 DEFINITIONS Section 1.1 Certain Definitions In this Master Agreement, the following terms shall have the indicated meanings: "Affiliate" means, with respect to any specified person or entity, any other person or entity that directly, or indirectly through one or more intermediaries, Controls or is Controlled by, or is under common Control with, the specified person or entity. "Business Day" means any day during which the New York Stock Exchange is generally conducting business. "Business Records and Data" means a Party's contracts, leases, accounting documents, invoices, checks, statements, invoices, receipts, correspondence, vouchers and all files, records, data, information, and maps related to such leases and contracts, including, without limitation, computer-readable copies of all computer records pertaining to the leases, files, contracts, division order files, title opinions and other title information (including abstracts, evidence of rental payments, land maps, surveys, and data sheets), production records and other technical data, geological and geophysical information and maps, well logs and related data, or seismic data, including basic field tapes, observers' logs, survey notes, base maps and all other business records relating to the business operations of such Party, but in any event excluding documents that constitute another Party's contracts, leases, accounting documents, invoices, checks, statements, invoices, receipts, correspondence, vouchers and including all files, records, data, information, and maps related to such leases and contracts, including, without limitation, computer-readable copies of all computer records pertaining to the leases, files, contracts, division order files, title opinions and other title information (including abstracts, evidence of rental payments, land maps, surveys, and data sheets), production records and other technical data, geological and geophysical information and maps, well logs and related data, or seismic data, including basic field tapes, observers' logs, survey notes, base maps and all other business records relating to the business operations of such Party. "Change Order" has the meaning ascribed to it in Section 4.3(a). "Confidential Information" means information designated as confidential or which ought to be considered as confidential from its nature or from the circumstances surrounding its disclosure. Confidential Information includes, without limiting the generality of the foregoing, work product, the terms of each Service Agreement (other than its term and general scope), and information: (a) relating to the Disclosing Party's software or hardware products or services, or to its research and development projects or plans; (b) relating to the Disclosing Party's business, policies, strategies, operations, finances, plans or opportunities, including the identity of, or particulars about, the Disclosing Party's clients or customers; (c) marked or otherwise identified as confidential, restricted, secret or proprietary, including, without limiting the generality of the foregoing, information acquired by inspection or oral disclosure provided such information was identified as confidential at the time of disclosure or inspection; and (d) that the Receiving Party should have, without any exercise of due diligence, known was obtained as a result of or subject to a confidentiality agreement between Disclosing Party and a third party. Notwithstanding the foregoing, Confidential Information does not include information that the Receiving Party can establish: -2- (w) has become generally available to the public or commonly known in either Party's industry other than as a result of a breach by the Receiving Party of any obligation to the Disclosing Party; (x) was known to the Receiving Party prior to disclosure to the Receiving Party by the Disclosing Party by reason other than having been previously disclosed to the Receiving Party: (A) in confidence by the Disclosing Party, or (B) in the course of the Receiving Party acting as agent of the Disclosing Party; (y) was disclosed to the Receiving Party by a third party who did not owe an obligation of confidence to the Disclosing Party with respect to the disclosed information; or (z) was independently developed by the Receiving Party without any reference to any part of the Confidential Information. "Confidential Materials" means the part of any tangible media upon or within which any part of the Confidential Information is recorded or reproduced in any form, excluding any storage device which forms a part of computer hardware. "Contract Executive" means the individual representatives of Torch Parties and Customer who are assigned the primary responsibility of managing a Service Agreement. "Contract Year" with respect to a Service Agreement, means each annual period beginning on the Service Agreement Effective Date unless defined otherwise within a Service Agreement. "Control" and its derivatives means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person or entity, whether through the ownership of voting securities, by contract, or otherwise. "Disclosing Party" means the Party furnishing Confidential Information or Confidential Materials (or having beneficial ownership of, Confidential Information or Confidential Materials in the possession of another Party). "Effective Date" means the date of this Master Agreement. "Indemnitees" shall mean, with respect to a Party entitled to indemnification hereunder, such Party and its Affiliates, officers, directors, employees, agents, successors, and assigns. "Insurance Policy Limit" shall mean (i) the amount ultimately paid by an insurer of a Party with respect to a covered claim; but if such claim is not ultimately paid, then (ii) zero. -3- "Master Agreement" means this Master Agreement, all Schedules, Exhibits and Appendices hereto and, when the meaning so requires, all Service Agreements. "Pass-Through Expenses" means the actual invoiced amounts (excluding any Torch Party's profit, administrative fee or overhead charges) charged to the Torch Party by third parties that Customer has agreed to pay directly or for which Customer has agreed to reimburse the Torch Party. "Performance Deposit" means a payment by Customer to each Torch Party in an amount equal to the sum of the two highest months' fees earned by such Torch Party under an agreement being terminated under Article 16, within the 12-month period ending at the time termination notice is given. "Receiving Party" means a Party other than the Disclosing Party. "Schedules" means any schedule attached to this Master Agreement or a Service Agreement, if such document is initialed by Customer and the applicable Torch Party(ies) and states that it is a schedule to such agreement. "Service Agreement" means any Service Agreement entered into between Customer and a Torch Party(ies) pursuant to Section 2.1. "Service Agreement Effective Date" means the date indicated in the Service Agreement as the date upon which such agreement becomes effective. "Service Agreement Term" means the term of the applicable Service Agreement, as defined in each Service Agreement. "Service Credits" means any Service Level Credits issued pursuant to a Service Level provision of a Service Agreement or Change Order. "Service Level" shall mean a performance metric related to the Services. "Services" means the services provided by Torch Party(ies) to Customer pursuant to Section 4.1. "Term" means the Term of this Master Agreement as provided in Article 3. When used herein in the context of a Service Agreement, "Term" refers to the applicable Service Agreement Term. -4- Section 1.2 Other Definitions Other terms used in this Master Agreement, the Schedules, Exhibits and Appendices hereto and the Service Agreements are defined where they first appear and have the respective meanings there indicated. ARTICLE 2 MASTER AGREEMENT Section 2.1 Master Agreement This Master Agreement contains general contractual terms for Services to be provided to Customer. Services will be provided by Torch Party(ies) pursuant to Service Agreements and Change Orders (as defined) entered into by Customer and Torch Party(ies). Separate Service Agreements may be entered into for discrete Services. Each Service Agreement shall describe the Services covered by the Service Agreement, the provisions for payment, the term for performance, any applicable Service Levels and other provisions that are specific to the Service Agreement. No Service Agreement Term shall extend beyond the Term of this Master Agreement. Except as otherwise expressly set forth in this Master Agreement, the obligations of a Party under this Master Agreement, except (i) unsatisfied obligations under Article 7 and/or (ii) other obligations covered by Section 18.10, shall be suspended during any period in which no Service Agreement is in effect with respect to such Party. Section 2.2 Interpretation and Precedence This Master Agreement, the Schedules, Exhibits and Appendices hereto, the Service Agreements, any Schedules that may be added to the Service Agreements, and any Change Orders, are to be interpreted so that all of the provisions are given as full effect as possible. In the event of a conflict among this Master Agreement or a Schedule, Exhibit or Appendix hereto and any Service Agreement or Change Order, the order of precedence shall be: first, Sections 2.2, 5.1, 6.4, and 7.5 of this Master Agreement, and Articles 8, 9, and 14 through 18 of this Master Agreement, next, the Change Order, next, the Service Agreement, next, any exhibit or Schedule to the Service Agreement; next, the remaining sections of this Master Agreement; and last, any other Exhibits, Schedules or appendices to this Master Agreement. Otherwise, the terms of this Master Agreement shall apply to each Service Agreement and Change Order. Section 2.3 No Implied Agreement Except as expressly set forth in a Service Agreement or Change Order, nothing in this Master Agreement requires Customer to purchase products or services from a Torch Party or requires a Torch Party to provide products or services to Customer. Customer may request -5- information, proposals, or competitive bids from third parties on the same or different terms than provided in this Master Agreement. Section 2.4 Agreed Termination of Prior Agreements The Parties hereby agree that the Contract Operations Agreement dated November 11, 1991 and the Management Agreement dated January 1, 1994 and the Marketing Letter Agreement dated May 1, 1997 (collectively the "Prior Agreements") are terminated as of the Effective Date and the Parties further agree that no termination fees shall be due as a result of such terminations. The Parties further agree that all of the indemnification provisions contained in the Prior Agreements shall survive the termination of the Prior Agreements and shall apply to any and all claims for indemnification based upon events occurring prior to the Effective Date. All indemnification claims among the Parties based upon events occurring on or after the Effective Date shall be governed by the indemnification provisions of this Agreement. ARTICLE 3 TERM Section 3.1 Term The term of this Master Agreement (the "Term") shall begin as of the Effective Date and shall continue with respect to a Party, for so long as any Service Agreement is in effect with respect to such Party unless earlier terminated or renewed in accordance with the provisions of this Master Agreement. Each Service Agreement shall set forth the applicable Service Agreement Term. A Change Order shall terminate, except with respect to any payment obligation thereunder, if no Service Agreement is in effect among the parties to the Change Order. ARTICLE 4 SERVICES Section 4.1 General; Service Agreements Throughout each Service Agreement Term, each Party shall perform such obligations as it may have under the Services Agreements and Change Orders, as such Service Agreements and Change Orders may be amended and supplemented from time to time by written amendments thereto or pursuant to the Change Order Procedures (collectively, the "Services"). Each Party shall perform its obligations in accordance with the terms of this Master Agreement, the Schedules, Exhibits and Appendices hereto, the Service Agreements to which it is a party and Change Orders to which it is a party. -6- The specific Services to be supplied by a Torch Party to Customer, the compensation to be paid and other related matters shall be expressed in Service Agreements and Change Orders. Each Service Agreement shall be subject to the terms and conditions of this Master Agreement. No Torch Party shall have an obligation to provide any Services, and no amounts will become due from Customer, unless and until the appropriate Service Agreement has been duly signed and delivered by authorized officers of Customer and any applicable Torch Parties. The Parties further agree that, while the applicable Service Agreement is in effect, any service (other than those services identified in Schedule 4.1, which may be amended if and when a Service Agreement is terminated) that was customarily and routinely performed by a Torch Party for Customer at no additional charge during the year prior to the Effective Date and is related to the Services under in-effect Services Agreement(s), but is neither listed as an included Service nor listed as an excluded Service or separately charged Service in the Services Schedules to the applicable Service Agreement, shall be performed by the Torch Party at no additional charge. With respect to assets Customer acquires after the Effective Date: (i) Customer may, before closing the acquisition, make an election to exclude such assets from the scope of any Service Agreement; (ii) Customer may, upon reasonable notice to the Torch Party, revoke such election under (i), which revocation shall be permanent and effective on a date as mutually agreed (iii) a Torch Party may elect to exclude such assets from the scope of such Service Agreement if Customer has on at least one occasion made an election that remains in effect under (i); (iv) a Torch Party may elect to exclude such assets from the scope of this Agreement if the Torch Party in its sole discretion determines (in good faith) that it has a non- trivial environmental, health or safety issue with respect to such assets. Customer and various Torch Parties contemplate entering into the following Service Agreements: Service Agreement - ----------------- Oil and Gas Administration Field Operating Corporate Administration Crude Oil and Natural Gas Marketing Midstream Asset Management Land Leasing The Service Agreements will be entered into among Customer and the individual Torch Parties; no Torch Party shall be responsible for the obligations of another Torch Party under this Master Agreement, any Service Agreement or any Change Order, except that if at any time an Affiliate of TEAI fails to perform obligations including payment obligations the Affiliate has under this Master Agreement or any Service Agreement or any Change Order, then TEAI shall be responsible for performance of such obligations. Except as expressly provided in the preceding sentence, notwithstanding any other provision of this Agreement, a Torch Party shall have no liability to Customer with respect to (i) any Service Agreement (unless the Torch Party is a party -7- thereto); (ii) any Change Order (unless the Torch Party is a party thereto); (iii) any act (or failure to act) other than an act (or failure to act) on the part of such Torch Party. Section 4.2 Performance of Out-Of-Scope Services Notwithstanding any request made to a Torch Party or the submission of any proposal by a Torch Party pursuant to Section 4.3, Customer shall have the right to contract with a third party to perform any services which are in addition to, or outside the scope of, the Services. If Customer makes a decision to perform for itself or to contract with a third party to perform any such service, the Torch Parties shall cooperate with Customer and such third party to the extent reasonably required for the provision of services by Customer or such third party, at Customer's expense and only to the extent specified in a Change Order, except to the extent included specifically in the scope of the Services. The Parties acknowledge and agree that this Master Agreement and the Service Agreements shall not apply to properties located outside the United States and its territorial waters and owned or operated by Customer, except to the extent provided in a Change Order. Section 4.3 Change Order Procedure (a) From time to time during the Term, Customer or Torch Party(ies) may propose changes in or additions to or deletions from the Services or other aspects of this Master Agreement or a Service Agreement. No such changes, additions or deletions shall be effective or binding on the Parties unless a written change order (a "Change Order") is signed by authorized representatives of both Customer and the Torch Party(ies) to be bound thereby. Subject to clause (e) below, all such Change Orders shall be implemented pursuant to the procedures set forth in this Section (the "Change Order Procedures"). (b) Any change to any of Article 1 through 18 of this Master Agreement must be approved by a majority of each Party's Management Board members and memorialized in a written amendment to this Master Agreement. (c) If Customer desires to propose a change in or addition to or deletion from the Services under a Service Agreement, it shall deliver at Customer's expense a written notice to the Torch Contract Executive describing the proposal. A Torch Party, in a timely manner, may decline such a proposal or may respond to such a proposal at the Torch Party's expense (except as otherwise agreed) by delivering to the Customer Contract Executive a written proposal ("Change Order Proposal"). If a Torch Party desires to propose a change in or addition to or deletion from the Services or other aspects of this Master Agreement or a Service Agreement, it may do so by preparing at its expense and delivering a Change Order Proposal to the Customer Contract Executive. A Change Order Proposal shall not constitute an offer but shall instead be deemed to be a proposal given for discussion purposes. -8- (d) No change in or addition to or deletion from the Services or any other aspect of a Service Agreement shall become effective without the written approval (which may be withheld or delayed in a Party's sole and absolute discretion) of the affected Parties' Contract Executive(s). If Customer and the applicable Torch Party approve a Torch Party's Change Order Proposal, as evidenced by the written approval of the Contract Executives, any changes in or additions to or deletions from the Services described in the Change Order Proposal shall thereafter be deemed "Services," any other changes described in the Change Order Proposal shall be deemed to have amended the applicable Service Agreement, and the Parties thereto shall agree on any further modifications to the applicable Service Agreement required to reflect the Change Control Proposal. (e) Changes made by a Torch Party in the ordinary course of providing the Services, that are performed within the then-existing resources used to provide the Services and that do not cause non-compliance with Service Levels (such as changes to operating procedures, schedules and equipment configurations) need not comply with the procedures set forth in this Section 4.3, provided that they do not involve any additional unreimbursed cost to a Party. Section 4.4 Resources Except as otherwise expressly provided in a Service Agreement or Change Order, each Party shall provide, at its expense, all of the facilities, personnel, equipment, software, services and other resources necessary for it to perform its obligations under this Agreement. Section 4.5 Licenses and Permits Each Party shall be responsible for obtaining all applicable licenses, authorizations, and permits required for such Party to carry out its obligations under this Master Agreement, and each Service Agreement (or Change Order) to which it is a party, and shall have financial responsibility for, and shall pay, all fees and taxes associated with such licenses, authorizations, and permits, except as otherwise expressly provided in this Master Agreement or a Service Agreement or Change Order. ARTICLE 5 SERVICE LEVELS Section 5.1 Failure to Meet Service Levels (a) If a Torch Party fails to meet a Service Level for reasons other than those specified in Section 5.1(b) below, Customer shall, as its sole remedy for any such failure, have the right to credits in the applicable amount as specified, or other Service Level remedy as specified, in the applicable Service Agreement ("Service Level Remedy") as liquidated damages. -9- The Parties acknowledge that actual damage to Customer from such a failure would be impracticable to determine and that each Service Level Remedy is reasonable under the circumstances existing as of the date of this Master Agreement and any Service Agreement's effective date. If an applicable Service Level Remedy is a credit then the Torch Party shall deduct the Service Level Remedy from its next succeeding invoice or other amount due to it. (b) To the extent any failure to meet a Service Level is attributable to (i) a Force Majeure Event, or (ii) a failure of Customer to satisfy its obligations under this Master Agreement or a Service Agreement, such Service Level shall be deemed not to have been failed. Section 5.2 Baseline Customer Satisfaction Survey Upon the request of Customer, not more than once each year and as part of the Services, Torch (or if Customer elects, a third party selected by Customer but then at Customer's expense) shall, if requested by Customer, conduct a baseline Customer satisfaction survey as approved by the Parties for affected end-users of the Services as designated by Customer. This survey shall be of the content and scope reasonably determined by the Parties, administered in accordance with the procedures agreed upon by the Parties. ARTICLE 6 CHARGES FOR SERVICES Section 6.1 Charges in General Customer shall pay to the Torch Parties thereto the amounts due as set forth in each Service Agreement and each Change Order as well as amounts due in connection with any matters identified as at Customer's expense under this Agreement, or Service Agreement(s) or Change Order(s). Except for costs and expenses that this Master Agreement, or a Service Agreement or a Change Order, states are Customer's responsibility, a Torch Party shall be solely responsible for, and shall indemnify Customer against, all third-party claims for costs and expenses incurred by such Torch Party to perform its obligations under this Master Agreement and the Service Agreements and Change Orders. Except as otherwise expressly provided in this Master Agreement or a Service Agreement or Change Order, or as otherwise mutually agreed in writing by the Parties, Customer will not pay the Torch Parties any additional fees, charges, assessments, or reimbursements. Section 6.2 Taxes Payment of federal, state, local, foreign, and other taxes based on the Services shall be the responsibility of Customer, which will reimburse the applicable Torch Party for any federal, state, local, or foreign excise, sales, use, business privilege, gross receipts, value-added, single business, or other similar tax (excluding federal, state, or local taxes based on income or profits of a Torch Party, or any franchise taxes assessed against a Torch Party) based on the Services. Each Party shall reasonably cooperate with the other in minimizing any applicable tax and, in -10- connection therewith, Customer shall provide the Torch Parties any resale certificates, information regarding out-of-state use of materials, services or sales, or other exemption certificates or information reasonably requested by a Torch Party. Section 6.3 Benchmarking Customer may, not more frequently than annually, at its expense, engage an independent qualified consultant for the purpose of performing a review of the costs to Customer of the Services, the Torch Parties' performance of the Services, and use by Customer and Torch of new technologies and techniques, as measured by industry norms. The Torch Parties shall reasonably cooperate with Customer and Customer's consultant but as "out-of-scope services" (as defined) except to the extent specified in a Change Order and/or to the extent involving tasks included in the scope of the Services. Section 6.4 Out-of-Scope Services Customer shall pay for any "out-of-scope services" (i.e., ancillary services that are not a part of Services), in accordance with the terms and conditions stated in a written Change Order signed by an authorized Customer representative. Customer shall reimburse Torch Parties for reasonable out-of- pocket expenses incurred by Torch Parties in the performance of out-of-scope services, such as reasonable travel and living expenses, provided such expenses are invoiced with reasonable supporting documentation. Section 6.5 Recordkeeping Torch Parties shall maintain commercially reasonable records for the amounts billed to and payments made by Customer under this Master Agreement and all Service Agreements and Change Orders. Such records shall include data and documentation of third party charges invoiced to and paid by Torch Parties. Torch Parties shall retain such records for at least three years (including any records received by a Torch Party maintained by Customer prior to the applicable Service Agreement Effective Date). Torch Parties shall provide Customer, at Customer's request, with paper and electronic copies of documents and information reasonably necessary to verify Torch Parties' compliance with this Master Agreement. Customer and its authorized agents and representatives shall have reasonable access to such records for inspection purposes during normal business hours for the period during which the Torch Parties are required to maintain such records. Upon termination or expiration of this Master Agreement, the Torch Parties, in any event and notwithstanding the provisions of Sections 9.2, 9.4, and 16.5, may retain, subject to other applicable confidentiality obligations under this agreement, an archive copy of any record. -11- ARTICLE 7 INVOICING AND PAYMENT Section 7.1 Invoices A Torch Party shall issue to Customer, on a monthly basis: (i) a consolidated invoice billing in advance for base charges due, (ii) a consolidated invoice billing in arrears for variable amounts due other than time and materials charges, and (iii) a consolidated invoice billing in arrears for time and materials charges (which shall include detail for each Service Agreement and remaining balance information for time and materials services included as part of base charges, substantially in the form of Schedule 7.1 hereto), all with respect to each Service Agreement. If out-of-scope Services are provided under one or more Change Orders, Torch Party(ies) will invoice the applicable charges in a separate, composite invoice for such services. Each Torch Party agrees to waive any charges that it fails to invoice within six months of the time such charges were due to be invoiced to Customer under this Master Agreement, each Service Agreement and any Change Order. Section 7.2 Payment (a) Subject to Section 7.5, each invoice for variable amounts delivered pursuant to Section 7.1 shall be due and payable within thirty (30) days after the date such invoice is delivered to Customer; provided, however, that each invoice for variable amounts with respect to Termination/Expiration Assistance under Section 16.5 shall be due and payable within ten (10) days after such invoice is delivered to Customer. Subject to Section 7.5, fifty percent (50%) of each invoice for base amounts delivered pursuant to Section 7.1 shall be due and payable on the later of five (5) days after the date such invoice is delivered to Customer or the first of the month in which the Services covered by such invoice are to be provided and the remaining fifty percent (50%) of each invoice for base amounts delivered pursuant to Section 7.1 shall be due and payable on the later of five (5) days after the date such invoice is delivered to Customer or the fifteenth of the month in which the Services covered by such invoice are to be provided. (b) To the extent Customer is entitled to a credit from a Torch Party pursuant to this Master Agreement or any Service Agreement, the Torch Party shall provide Customer with such credit on the first invoice delivered after such credit is earned. If the amount of any credits on an invoice exceeds the amount owing to the Torch Party reflected on such invoice, the Torch Party shall pay the balance of the credit to Customer within ten (10) days after the invoice date. Section 7.3 Proration All periodic charges under this Master Agreement or the Service Agreements (excluding charges based upon actual usage or consumption of Services) shall be computed on a calendar month basis and shall be prorated for any partial month. -12- Section 7.4 Refunds If either Party receives from a third party a credit or refund or other rebate for goods or services paid for by another Party, such other Party shall be entitled to receive the same, and if it is in an amount that exceeds $25,000, the recipient of a payment of such refund, credit or rebate shall promptly notify the other Party and shall promptly pay to it the amount it receives therefor (and if such amount is not so paid within 45 days of its receipt then the recipient shall also pay interest, from the date of receipt, at the then- current prime rate of Citibank of New York (or its successor), to the other Party. Section 7.5 Setoff and Withholding (a) Notwithstanding any other provision of this Master Agreement, a Party who is owed any undisputed amount by the other Party may, at its option, set off that amount as a credit against any undisputed amounts it otherwise owes to the other Party. (b) If Customer reasonably disputes in good faith any portion of an invoice delivered pursuant to Section 7.1, Customer shall nevertheless pay the full dollar amount of such invoice when due. If Customer reasonably disputes in good faith any other claim by a Torch Party for reimbursement of any amount, Customer shall pay the dollar amount due that is not so disputed and may, at its option, withhold such disputed portion pending resolution of the dispute by mutual agreement or pursuant to Article 17 of this Master Agreement. If Customer withholds any amount pursuant to the preceding sentence, Customer shall notify the Torch Party of the basis for such withholding in accordance with Section 18.9. Upon resolution of the dispute, Customer shall pay to the Torch Party such portion, if any, of such disputed amount determined to be owing to the Torch Party. If the dispute with respect to a disputed item is not resolved within 90 days and the amount reasonably in dispute exceeds $50,000 then the reasonably disputed amounts will, upon request, be deposited by the Parties into an escrow account within five business days. If the invoice amounts reasonably in dispute aggregate more than $250,000 then the reasonably disputed amounts will, on request, be deposited by the Parties into an escrow account within five business days. In either case the escrow account shall be with a third party escrow agent that shall be a United States National Bank selected by the Party making the escrow deposit, pending resolution of the dispute by mutual agreement or pursuant to Article 17 of this Master Agreement. (c) If a Torch Party reasonably disputes in good faith any request for issuance of a credit or other claim by Customer for reimbursement of any amount, the Torch Party shall pay or credit the dollar amount due that is not so disputed and may, at its option, withhold such disputed portion pending resolution of the dispute by mutual agreement or pursuant to Article 17 of this Master Agreement. If the Torch Party withholds any payment or credit pursuant to this Section 7.5(c), the Torch Party shall notify Customer of the basis for such withholding in accordance with Section 18.9. Upon resolution of the dispute, the Torch Party shall pay (in the case of a payment dispute) or credit (in the case of a credit dispute) to Customer such portion, if any, of such disputed amount determined to be owing to Customer. If the dispute with respect to a -13- disputed item is not resolved within 90 days and the amount reasonably in dispute exceeds $50,000 then the reasonably disputed amounts will, upon request, be deposited by the Torch Party into an escrow account within five business days. If the amounts reasonably in dispute withheld by the Torch Party aggregate more than $250,000, then the reasonably disputed amounts will, upon request, be deposited by the Torch Party into an escrow account within five business days. In either case the escrow account shall be with a third party escrow agent that shall be a United States National Bank selected by the Party making the escrow deposit, pending resolution of the dispute. (d) The phrase "reasonably in dispute" shall mean that the parties to the dispute are in compliance with Section 18.14. ARTICLE 8 INTELLECTUAL PROPERTY RIGHTS AND OBLIGATIONS Section 8.1 Non-Infringement Each Party agrees that it shall perform its obligations under this Master Agreement and all Service Agreements and Change Orders in a manner that does not constitute an infringement or misappropriation of any United States patent, copyright, trademark, trade secret or other intellectual property right of any third party. ARTICLE 9 CONFIDENTIALITY AND COMPETITION Section 9.1 Rights, Restrictions and Obligations of the Receiving Party (a) During the Term, the Receiving Party may: (i) disclose Confidential Information received from the Disclosing Party to its employees, officers and directors and Affiliates who have a need to know such information exclusively for the purpose of executing obligations or exercising rights under this Master Agreement or any Service Agreement or Change Order; (ii) reproduce the Confidential Information received from the Disclosing Party as required to perform its obligations or exercise its rights under this Master Agreement or any Service Agreement; (iii) disclose Confidential Information as required by law, provided the Receiving Party, to the extent practicable, gives the Disclosing Party reasonable notice prior to -14- such disclosure to allow the Disclosing Party to make an effort to obtain a protective order or otherwise protect the confidentiality of such information; and (iv) disclose the terms of a Service Agreement to a third party who is not a competitor of the Disclosing Party, but only if: (A) such third party agrees in writing that it shall comply with the confidentiality obligations applicable to the Receiving Party under this Article 9 and (B) such writing provides that the Disclosing Party is an intended third party beneficiary thereof. (b) Except as otherwise specifically provided in this Master Agreement or any Service Agreement, the Receiving Party shall not: (i) disclose, in whole or in part, any Confidential Information received directly or indirectly from the Disclosing Party; or (ii) sell, rent, lease, transfer, encumber, pledge, reproduce, publish, transmit, translate, modify, reverse engineer, decompile, disassemble or otherwise use the Confidential Information in whole or in part. (c) The Receiving Party shall exercise the same care in preventing unauthorized disclosure or use of the Confidential Information that it takes to protect its own information of a similar nature, but in no event less than reasonable care. Reasonable care includes, without limiting the generality of the foregoing: (i) informing its directors, officers, employees and Affiliates and, where applicable, their respective directors, officers and employees (and agents and subcontractors, who have access to Disclosing Party's Confidential Information), of the confidential nature of the Confidential Information and the terms of this Master Agreement, directing them to comply with these terms, and obtaining their written acknowledgment that they have been so informed and directed, and their written agreement to abide by reasonable terms and that the Disclosing Party is an intended third party beneficiary of such agreement; and (ii) notifying the Disclosing Party promptly upon discovery of any loss, unauthorized disclosure or use of Confidential Information, or any other breach of this Article by the Receiving Party, and assisting the Disclosing Party in every reasonable way to help the Disclosing Party regain possession of the Confidential Information and to prevent further unauthorized disclosure or use. (d) The Receiving Party acknowledges that: (i) the Disclosing Party possesses and will continue to possess Confidential Information that has been created, discovered or developed by or on behalf of the Disclosing Party, or otherwise provided to the Disclosing Party by third parties, which information has commercial value and is not in the public domain; -15- (ii) unauthorized use or disclosure of Confidential Information is likely to cause injury not readily measurable in monetary damages, and therefore irreparable; (iii) in the event of an unauthorized use or disclosure of Confidential Information, the Disclosing Party shall be entitled, without waiving any other rights or remedies, to such injunctive or equitable relief as may be deemed proper by a court of competent jurisdiction; (iv) subject to the rights expressly granted to the Receiving Party in this Master Agreement or in any Service Agreement, the Disclosing Party and its licensors retain all right, title and interest in and to the Confidential Information, including without limiting the generality of the foregoing, title to all Confidential Materials regardless of whether provided by or on behalf of the Disclosing Party or created by the Receiving Party; and Section 9.2 Rights and Remedies of the Disclosing Party (a) At the expiration or earlier termination of this Master Agreement or any applicable Service Agreement, the Receiving Party shall: (i) return all Confidential Materials (other than those covered by Section 9.2(a)(ii), including, without limitation, all originals, copies, reproductions and summaries of Confidential Information; and (ii) destroy all copies of Confidential Information in its possession, power or control, which are present on magnetic media, optical disk, volatile memory or other storage device, in a manner that assures the Confidential Information is rendered unrecoverable. Upon completion of those tasks an officer of the Receiving Party shall provide written confirmation to the Disclosing Party that the requirements of this Section have been complied with. (b) The Disclosing Party may visit the Receiving Party's premises, upon reasonable prior notice and during normal business hours, to review the Receiving Party's compliance with the terms of this Section. (c) In the event of an unauthorized disclosure of Confidential Information by the Receiving Party, the Disclosing Party shall have the right to: (i) seek appropriate injunctive relief to prevent any further disclosure where there exists reasonable grounds to believe that the unauthorized disclosure may continue; and/or (ii) pursue the dispute resolution procedure pursuant to Article 17 to recover damages related to the disclosure. A material breach of the confidentiality provisions of this Article 9 that is not fully cured within 30 days after notice to the breaching party shall then give rise to a right of the non-breaching party(ies) to terminate immediately this Master Agreement and/or each Service Agreement for cause. In the event of a -16- termination for cause resulting from a breach of confidentiality obligations owed to a Torch Party, Torch shall not be required to provide the Termination/Expiration Assistance specified in Section 16.7. Section 9.3 Ownership of Business Records and Data Each Party's Business Records and Data shall remain its property. A Party's Business Records and Data shall not without its consent (which may be withheld or delayed in such Party's sole and absolute discretion) be: (i) used by another Party other than in connection with obligations hereunder, (ii) disclosed, sold, assigned, leased or otherwise provided to third parties by another Party, or (iii) commercially exploited by or on behalf of another Party. All Business Records and Data obtained solely for Customer's benefit and separately paid for by Customer shall be acquired in Customer's name. Section 9.4 Return of Business Records and Data A Party shall upon request by another Party at any time (if such requesting Party reimburses related out-of-pocket costs and, in the case of a request by Customer, pays related data processing charges at the Torch Party's published rates) promptly return to such other Party such other Party's Business Records and Data. Section 9.5 Security (a) Each Party will establish and comply with commercially reasonable security procedures during the Term of this Master Agreement and any Service Agreement for the security of each other Party's Business Records, Confidential Information and Data. Each Party may periodically, at reasonable frequencies and times, inspect other Parties' facilities to ensure compliance with this Section. (b) Since a Party's personnel may have access to another Party's financial information and other information that, if utilized or disclosed could lead to violations of the applicable securities laws, each Party covenants that it (i) will not trade in securities of another Party in violation of applicable securities laws and (ii) will maintain a policy that its employees will not trade in securities of another Party in violation of any applicable securities laws. Section 9.6 Destroyed or Lost Business Records or Data No Party will delete or destroy another Party's Business Records or Data without prior written authorization except in accordance with a records retention policy agreed by the Parties. In the event any Party's Business Records or Data are lost or destroyed due to any act or omission of another Party in breach of the security procedures described in this Article 9 and/or any Service Agreement, such other Party shall use all commercially reasonable efforts to regenerate or replace such Business Records or Data and the Parties agree to cooperate to provide -17- any available information, files or raw data needed for the regeneration of the Business Records or Data. Section 9.7 Non-Competition and Business Opportunities (a) Customer agrees that it shall not compete with Novistar for the provision of services, in Novistar's lines of business (as operated on the Effective Date), to third parties, during the term of any Service Agreement to which Novistar is a party, and for three years after such term; provided, however, that Customer may: (i) provide services to third parties in the ordinary course of its business as an operator to Customer's Affiliates and to Customer's venture partners; and (ii) provide services that are merely incidental to good practice and efficient management of the services Customer provides in the ordinary course of business otherwise conducted in compliance with this Section 9.7. (b) Each Torch Party agrees, that, during the term of any Service Agreement to which it is a party and for three years after such term, the Torch Party shall act in good faith to determine which business opportunities arising during such term rightfully belong to Customer and shall refrain from usurping such business opportunities. ARTICLE 10 MANAGEMENT AND SUBCONTRACTING Section 10.1 Contract Executives and Personnel Section 10.1.1 Contract Executives Each of the Service Agreements shall identify a Contract Executive for each Party thereto, which such Party may change from time to time by written notice to the other Parties. The Customer Contract Executive shall have the authority to act on behalf of Customer with respect to all matters relating to the services included in the applicable Service Agreement, and the Contract Executive for any Torch Party shall have the authority to act on behalf of such Torch Party with respect to all matters relating to the services included in the applicable Service Agreement. Section 10.1.2 Workplace Rules All personnel of another Party while at any Party's facility shall abide by the workplace rules and regulations applicable to such Party's own employees. -18- Section 10.1.3 Torch Services to Third Parties Customer recognizes that Torch personnel providing Services to Customer under this Master Agreement may perform similar services from time to time for other persons, including competitors of Customer. This Master Agreement shall not prevent Torch from using such personnel (or any Torch equipment) for the purpose of performing such similar services for such other persons provided that: Torch complies with its obligations concerning Customer's Confidential Information. Section 10.2 Management Board The Parties shall establish and maintain a Management Board, which shall be composed of three representatives of each Party including at least one senior executive of each Party. The initial representatives and their positions with Customer and Torch Parties are set forth in Schedule 10.2. The Management Board will meet at least quarterly. The general responsibilities of the Management Board shall be: (i) to monitor the general progress of the performance of this Master Agreement and the Service Agreements; (ii) to analyze and attempt to resolve problems referred by the Contract Executives; (iii) subject to the last sentence of this Section, to approve and implement Change Orders (including material changes in the Services); and (iv) resolve disputed invoice amounts where possible. No Change Order resulting in charges in excess of $50,000.00 will be binding without the express written consent (which may be withheld or delayed in a Party's sole and absolute discretion) of a majority of each affected Party's Management Board members. Section 10.3 Subcontracting Except as provided herein or in a Service Agreement or Change Order, each Torch Party shall be solely responsible for paying any subcontractors it uses to provide Services under this Master Agreement or any Service Agreement. Subcontracting shall not relieve a Torch Party of its obligations under this Master Agreement or any Service Agreement. Section 10.4 Hiring of Employees Customer shall not (without the written consent of the affected Torch Party which the Torch Party may withhold or delay in its sole and absolute discretion), during the term of any Service Agreement and for a period of twelve (12) months thereafter, solicit or hire any person who is an employee of a Torch Party, except that upon termination of a Service Agreement (i) Customer may extend offers to "Dedicated Employees" (as defined) who are not "Restricted Employees" (as defined), and (ii) Customer may extend offers to employees whom the Torch Party has identified in an officer's certificate delivered pursuant to the provisions of this Section 10.4 and/or Section 16.2. A "Dedicated Employee" is any employee of a Torch Party to the terminating Service Agreement who has worked on Customer matters for more than three-fourths of that person's reported time in the Torch Parties' timekeeping system(s) during the previous six (6) months (or during the period since the Effective Date, if such period is less than six (6) -19- months). A "Restricted Employee" is an employee, other than an hourly field employee, that a Torch Party designates as such not to exceed thirty percent of its "Dedicated Employees" but not to be less than three (3) employees for each Service Agreement. In connection with each termination of this Agreement or any Service Agreement, each affected Torch Party shall as soon as practicable provide notice in writing to Customer identifying (i) each affected employee who is a Dedicated Employee for purposes of such agreement and (ii) whether the employee is a Restricted Employee. As soon as practicable thereafter Customer shall provide written notice to the appropriate Torch Party specifying by name each Dedicated non-Restricted employee that Customer intends in good faith to hire as its own permanent employee under the provisions of this Section 10.4. As soon as practicable thereafter the Torch Party shall deliver an officer's certificate attesting to the identity of persons whose employment is being terminated as a result of such agreement's termination (and that the agreement's termination was the predominant reason for the employee's termination) with respect to whom the Torch Party intends to require reimbursement from Customer of severance costs pursuant to Section 16.2. Customer shall not, in any event, assist another service provider in recruiting employees of a Torch Party; provided, however, that merely providing a reference or other similar routine information shall not be treated as assistance for purposes of this sentence. Section 10.5 Key Personnel Up to six persons may be designated as Key Personnel in Schedule 10.5. The applicable Torch Party shall consult with Customer on any removal of any such person from the person's position (or any substantial change in such person's duties in providing Service to Customer) and on the selection of any replacement for any such person, who shall in any event be appropriately qualified. Customer may amend Schedule 10.5 from time to time; provided, however, that: (i) any such amendment may only designate Dedicated Employees or replacements for persons designated as Key Personnel who have left the employ of the Torch Party (except with the applicable Torch Party's consent which may be withheld or delayed in the Torch Party's sole and absolute discretion); and (ii) the number of Key Persons shall not exceed six at any time; and (iii) any such amendment shall have only prospective effect. ARTICLE 11 AUDITS Section 11.1 Audit Rights The applicable Torch Party shall maintain records and supporting documentation of all financial and non-financial transactions under this Master Agreement and all Service Agreements and all Change Orders, sufficient to reasonably permit an audit thereof in accordance with this Section 11.1. Each Torch Party shall at no charge provide reasonable access for one audit each calendar year to Customer's contract and financial statement auditors, who have signed confidentiality agreements reasonably satisfactory to the applicable Torch Party, to examine the Torch Parties' charges and performance of the Services under this Master Agreement and any -20- Service Agreement and to perform audits and inspections of Customer and its business and of the systems that process, store, support and transmit Customer's Data, solely so that its financial statement auditors can verify the integrity of Customer's Business Records and Data. Each Torch Party shall, at Customer's expense in accordance with a Change Order, provide access at reasonable times agreed by the Parties: (i) to all such records and supporting documentation relating to the Services to Customer necessary for its joint venture auditors or regulatory auditors solely to perform audits and inspections of Customer and its business and (ii) to Customer's financial statement auditors to the systems that process, store, support and transmit Customer's Data solely so that its auditors can verify the integrity of Customer's Business Records and Data. Torch Parties shall provide reasonable cooperation to such auditors, inspectors, regulators and representatives, including the installation and operation of audit software. The applicable Torch Parties shall, at their own expense, provide Customer with an annual SAS 70 (type II) audit regarding the Torch Party; provided, however, Customer shall be given the opportunity to participate in determining the scope of the audit. Section 11.2 Payments If an audit reveals that a Torch Party has overcharged Customer for Services during either of the two (2) then-preceding calendar years, the Torch Party promptly shall reimburse the undisputed amount of any overcharges. Section 11.3 Survival Sections 11.1 through 11.3 shall (i) apply with respect to a Torch Party while a Service Agreement to which the Torch Party is a party and (ii) continue to the third (3d) anniversary thereafter, after which time Sections 11.1 through 11.3 shall no longer apply to the Torch Party. Section 11.4 TEAI Financial Statements While a Service Agreement to which a Torch Party is a party remains in effect, TEAI shall make available to Customer at no additional charge TEAI's annual audited financial statements, within ninety (90) days after the end of the year that the statements cover, as well as its quarterly unaudited financial statements, within forty-five (45) days after the end of the quarter that the statements cover. TEAI shall make available its appropriate personnel to answer reasonable questions related to the financial condition of TEAI. -21- ARTICLE 12 INSURANCE; RISK OF LOSS Section 12.1 Required Insurance Coverages Throughout the Term, each Party (except with respect to a coverage identified as Torch only) shall maintain in force, at minimum, the insurance coverages described below. Additional insurance coverage(s) may be required under a Service Agreement. Each Torch Party may satisfy its insurance requirements as a named insured on a policy that covers other parties within the same policy limit, which limit shall conform to the requirements set forth below. (a) Commercial General Liability Insurance with a minimum combined single limit of $3 million per occurrence and minimum general aggregate limit of $5 million; (b) Umbrella Liability Insurance with a minimum limit of $50 million per occurrence and minimum aggregate amount of $50 million; (c) Worker's Compensation Insurance or any alternative plan or coverage as permitted or required by applicable law and employers liability insurance with a minimum occurrence limit of $500,000; (d) Except with respect to Customer, Comprehensive Errors and Omissions Insurance, for Torch only, covering the liability for financial loss due to error, omission or negligence, by Torch, with a minimum amount of $5 million; (e) Automotive Liability Insurance covering use of all owned, non-owned and hired automobiles with a minimum combined single limit of $3 million per occurrence for bodily injury and property damage liability; (f) "All Risk" Property Insurance, for Torch only, in an amount equal to the replacement value of the equipment used to provide the Services; (g) Employee Dishonesty and Computer Fraud Insurance for loss arising out of or in connection with fraudulent or dishonest acts committed by the employees of a Party, acting alone or in collusion with others, in a minimum amount of $5 million per occurrence. (h) Employment Practice Liability Insurance in a minimum amount of $5 million. Section 12.2 General Insurance Requirements All insurance policies a Party is required to carry pursuant to this Article shall: (i) be primary as to its negligence and non-contributing with respect to any other insurance or self-insurance another Party may maintain; (ii) name the other Parties, its Affiliates, subsidiaries and their respective officers, directors and employees as additional insureds, as such parties' interests -22- may appear with respect to this Master Agreement; (iii) be provided by reputable and financially responsible insurance carriers with a Best's minimum rating of "A-" (or any future equivalent) and minimum Best's financial performance rating of "6" (or any future equivalent); (iv) require the insurer to notify the other Parties in writing at least forty-five (45) days in advance of cancellation or modification; and (v) include a waiver of all rights of subrogation against each other Party and its Affiliates. Each Party shall cause its insurers to issue to the other Parties on or before the Effective Date and each policy renewal date certificates of insurance evidencing that the coverages and policy endorsements required by this Article are in effect. ARTICLE 13 CERTAIN REPRESENTATIONS AND WARRANTIES Section 13.1 Mutual Representations and Warranties Each Party represents and warrants that, as of the Effective Date and continuing throughout the Term: (a) It is a corporation duly incorporated, validly existing and is in good standing under the laws of the state in which it is incorporated, and is qualified as a foreign corporation and in good standing in each other jurisdiction where the failure to be so would have a material adverse effect on its business or its ability to perform its obligations under this Master Agreement or any Service Agreement to which it is a party. (b) It has all necessary corporate power and authority to own, lease and operate its assets and to carry on its business as presently conducted and as it will be conducted pursuant to this Master Agreement and each Service Agreement to which it is a party. (c) It has all necessary corporate power and authority to enter into this Master Agreement and each Service Agreement to which it is a party and to perform its obligations hereunder and thereunder, and the execution and delivery of this Master Agreement and each Service Agreement to which it is a party, and the consummation of the transactions contemplated hereby and thereby have been duly authorized by all necessary corporate actions on its part. (d) This Master Agreement and each Service Agreement to which it is a party constitutes a legal, valid and binding obligation of such Party, enforceable against it in accordance with its terms. (e) It has not violated and it will not violate any applicable laws or regulation regarding the offering of unlawful inducement in connection with this Master Agreement or any Service Agreement. (f) It has and shall have the right and authority to use any software or other intellectual property provided by it in connection with the Services. -23- (g) It is not a party to, and is not bound or affected by or subject to, any instrument, agreement, charter or by-law provision, law, rule, regulation, judgment or order which would be contravened or breached as a result of the execution of this Master Agreement, consummation of the transactions contemplated by this Master Agreement, or execution of, and consummation of the transaction contemplated by, any fully executed Service Agreement. ARTICLE 14 INDEMNIFICATION Section 14.1 Indemnification by Customer. (a) Customer hereby agrees to indemnify, defend and hold harmless each Torch Party's Indemnitees from and against all liability, expense (including without limitation court costs, attorneys' fees and related expenses) and claims for damage of any nature whatsoever, whether known or unknown and whether direct or indirect, as though expressly set forth and described herein, which the indemnified party may incur, suffer, become liable for or which may be asserted or claimed against the indemnified party to the extent resulting from the negligent acts, willful misconduct or statutory violations of Customer. (b) Customer shall, except to the extent a Torch Party acts in a non- operator capacity or with gross negligence or willful misconduct, indemnify, defend and hold harmless each Torch Party's Indemnitees from and against all liability, expense (including without limitation court costs, attorneys' fees and related expenses) and claims for damage of any nature whatsoever, whether known or unknown and whether direct or indirect, as though expressly set forth and described herein, which the indemnified party may incur, suffer, become liable for or which may be asserted or claimed against the indemnified party, to the extent arising from or in connection with the performance (or non- performance) of obligations, under this Master Agreement, the Service Agreements and the Change Orders, by a Torch Party. Section 14.2 Indemnification by Torch. Except to the extent a Torch Party is entitled to indemnification by Customer under Section 14.1(b) for such claim or has merely followed Customer's instructions, each Torch Party hereby agrees to indemnify, defend and hold harmless the Customer's Indemnitees from and against all liability, expense (including without limitation court costs, attorneys' fees and related expenses) and claims for damage of any nature whatsoever, whether known or unknown and whether direct or indirect, as though expressly set forth and described herein, which the indemnified party may incur, suffer, become liable for or which may be asserted or claimed against the indemnified party to the extent resulting from the negligent acts, willful misconduct or statutory violations of the Torch Party. -24- Section 14.3 Joint and Concurrent Negligence. Customer and the Torch Parties expressly agree that the provisions of this Article 14 shall not be limited to the sole negligence, willful misconduct or statutory violation of one of them, but shall also apply to matters in which more than one of them has committed: (i) negligent acts, (ii) acts of willful misconduct and/or (iii) statutory violations. In such event(s), if any of them advances funds, in connection with such a matter that is otherwise subject to this Article 14, in excess of its pro rata share, with due regard for the allocation of risks and responsibilities and duties of indemnification to it set forth in this Article 14, such party shall be indemnified by each other committing party not to exceed such other committing party's pro rata share, with due regard for the allocation of risks and responsibilities and duties of indemnification to it set forth in this Article 14. Section 14.4 Intellectual Property Indemnification Each Party agrees to defend the other Parties against any action to the extent that such action is based on a claim that any software or other intellectual property provided by the indemnitor or the Confidential Information provided by the indemnitor: (a) infringes a copyright perfected under applicable law, (b) infringes a United States patent granted under applicable law or (c) constitutes an unlawful disclosure, use or misappropriation of another party's trade secret. The indemnitor will bear the expense of such defense and pay any damages and attorneys' fees that are attributable to such claim finally awarded by a court of competent jurisdiction. If any software, other intellectual property or Confidential Information becomes the subject of a claim under this Section, or in the indemnitor's opinion is likely to become the subject of such a claim, then the indemnitor may, at its option, (a) modify the software, other intellectual property or Confidential Information to make it noninfringing or cure any claimed misuse of another's trade secret, provided such modification does not adversely affect functionality used by the indemnitee, or (b) procure for the indemnitee the right to continue using the software, other intellectual property or Confidential Information, pursuant to the applicable Service Agreement, or (c) replace the software or other intellectual property or Confidential Information with a substantial equivalent that is noninfringing or that is free of claimed misuse of another's trade secret. Any costs associated with implementing any of the above alternatives shall be borne by the indemnitor. Section 14.5 Indemnification Procedures (a) Promptly after receipt by an indemnitee of any written claim or notice of any action giving rise to a claim for indemnification by the indemnitee, the indemnitee shall so notify the indemnitor and shall provide copies of such claim or any documents relating to the action. No failure to so notify an indemnitor shall relieve the indemnitor of its obligations under this Master Agreement except to the extent that the failure or delay is prejudicial. Within thirty (30) days following receipt of such written notice, but in any event no later than ten (10) days before the deadline for any responsive pleading, the indemnitor shall notify the indemnitee in writing (a -25- "Notice of Assumption of Defense") if the indemnitor elects to assume control of the defense and settlement of such claim or action (and in the event of such election shall be deemed to have waived any right it may have to later assert that the claim or action is not subject to indemnification hereunder). (b) If the indemnitor delivers a Notice of Assumption of Defense with respect to a claim within the required period, the indemnitor shall have sole control over the defense and settlement of such claim; provided, however, that (i) the indemnitee shall be entitled to participate in the defense of such claim and to employ counsel at its own expense to assist in the handling of such claim and (ii) the indemnitor shall obtain the prior written approval (which may be withheld or delayed in indemnitee's sole and absolute discretion) of the indemnitee before entering into any settlement of such claim or ceasing to defend against such claim. After the indemnitor has delivered a timely Notice of Assumption of Defense relating to any claim, the indemnitor shall not be liable to the indemnitee for any legal expenses incurred by such indemnitee in connection with the defense of such claim; provided, that the indemnitor shall pay for separate counsel for the indemnitee to the extent that conflicts or potential conflicts of interest between the Parties so require. In addition, the indemnitor shall not be required to indemnify the indemnitee for any amount paid by such indemnitee in the settlement of any claim for which the indemnitor has delivered a timely Notice of Assumption of Defense if such amount was agreed to without prior written consent of the indemnitor, which shall not be unreasonably withheld or delayed in the case of monetary claims. An indemnitor may withhold or delay consent to settlement of claims of infringement affecting its proprietary rights in its sole and absolute discretion. (c) If the indemnitor does not deliver a Notice of Assumption of Defense relating to a claim within the required notice period, the indemnitee shall have the right to defend the claim in such a manner as it may deem appropriate, at the cost and expense of the indemnitor. The indemnitor shall promptly reimburse the indemnitee for all such costs and expenses upon written request therefor. Section 14.6 Subrogation In the event an indemnitor indemnifies an indemnitee pursuant to this Article, the indemnitor shall, upon payment in full of such indemnity, be subrogated to all of the rights of the indemnitee with respect to the claim to which such indemnity relates. Section 14.7 Express Negligence THE INDEMNIFICATION PROVISIONS IN THIS AGREEMENT SHALL BE APPLICABLE WHETHER OR NOT THE LOSSES, COSTS, EXPENSES AND DAMAGES IN QUESTION AROSE SOLELY OR IN PART FROM THE NEGLIGENCE OF ANY INDEMNIFIED PARTY, OTHER THAN THOSE LOSSES, COSTS, EXPENSES AND DAMAGES ATTRIBUTABLE TO THE GROSS NEGLIGENCE AND/OR WILLFUL MISCONDUCT OF A PARTY. CUSTOMER AND THE TORCH PARTIES -26- ACKNOWLEDGE THAT THIS STATEMENT COMPLIES WITH THE EXPRESS NEGLIGENCE RULE AND IS CONSPICUOUS. ARTICLE 15 LIABILITY AND FORCE MAJEURE Section 15.1 Liability Subject to the limitations set forth in this Article, a Party that breaches any obligation under this Master Agreement or a Service Agreement or Change Order (except for any obligation to which a Service Level Credit or other liquidated damages provision applies, under this Master Agreement or a Service Agreement or a Change Order) shall be liable to each other Party except that with respect to TOC or Novistar in performance of operator responsibilities: (a) if under any joint operating agreement, TOC or Novistar, as the case may be, shall only be liable for damages attributable to gross negligence or willful misconduct in the performance of such responsibilities; and (b) if not under any joint operating agreement, Customer shall be deemed to have entered into a joint operating agreement having the provisions set forth on the attached Exhibit 15.1 (1). Section 15.2 Limit on Types and Amounts of Damages Recoverable (a) EXCEPT AS SET FORTH IN CLAUSE (b) BELOW, NO PARTY SHALL BE LIABLE FOR CONSEQUENTIAL DAMAGES (INCLUDING WITHOUT LIMITATION DAMAGES FOR LOST REVENUE AND/OR PROFITS) OR ANY EXEMPLARY OR PUNITIVE DAMAGES, REGARDLESS OF THE FORM OF ACTION, WHETHER IN CONTRACT, TORT OR OTHERWISE, AND EVEN IF SUCH PARTY HAS BEEN ADVISED OF THE POSSIBILITY OF SUCH DAMAGES. (b) The exclusion set forth in clause (a) shall not apply to (i) Losses otherwise recoverable by an indemnitee pursuant to Article 14 (Indemnification), (ii) breach by a Party of its obligations for intentional acts with respect to Confidential Information, or (iii) damages caused by a Party's willful misconduct. (c) The total liability under this Master Agreement, Service Agreements and Change Orders, of each Torch Party shall be limited to six (6) months' fees under the Service Agreements to which it is a party; provided, however, that the total liability (including without limitation liability under indemnification provisions under this Agreement) of the Torch Parties (aggregated) for gross negligence or willful misconduct shall be limited to $5.0 million. -27- Section 15.3 Force Majeure (a) Subject to clause (b) below, neither Party shall be liable for any failure or delay in the performance of its obligations, other than payment obligations, under this Master Agreement or any Service Agreement or Change Order, to the extent such failure or delay is caused, directly or indirectly, without fault by such Party, by any cause beyond the reasonable control of such Party. Events meeting the criteria set forth in the next preceding paragraph are referred to collectively as "Force Majeure Events." The Parties expressly acknowledge that, except as otherwise expressly provided in a Service Agreement, Force Majeure Events do not include third party non-performance except to the extent caused by an event that would be a Force Majeure Event with respect to a Party; provided, however, that Force Majeure Events shall include disruptions caused by third party failures of public utilities, building facilities, communications facilities or public safety functions. (b) Upon the occurrence of a Force Majeure Event, the non-performing Party shall be excused from any further performance or observance of the affected obligation(s) for as long as such circumstances prevail and such Party continues to attempt to recommence performance or observance whenever and to whatever extent possible without delay. Any Party so delayed in its performance will immediately notify the other by telephone or by the most timely means otherwise available (to be confirmed in writing within two (2) Business Days of the inception of such delay) and describe in reasonable detail the circumstances causing such delay. Section 15.4 Actions of Other Party Neither Party shall be liable for any failure or delay in the performance of its obligations under this Master Agreement or any Service Agreement if and to the extent such failure or delay is caused by the actions or omissions of the other Party or breaches of this Master Agreement, or a Service Agreement or Change Order, by the other Party, provided that the Party which is unable to perform has provided the other Party with reasonable notice of such non- performance. ARTICLE 16 TERMINATION Section 16.1 Termination for Cause (a) A party to a Service Agreement shall have the option, but not the obligation, to terminate any Service Agreement for cause for a material breach of such Service Agreement by another party thereto that is not cured by the other party within thirty (30) days of the date on which such Party was provided written notice of such breach; (b) A Party shall exercise its termination option under this Section 16.1 by delivering to the affected Party(ies) written notice of such termination identifying the termination date. -28- (c) Each Torch Party shall have the option, but not the obligation, to terminate for cause any or all Service Agreements and/or this Master Agreement, if Customer fails to pay when due amounts Customer owes to a Torch Party under a Change Order and/or a Service Agreement and/or this Master Agreement, if Customer fails to cure such failure within ten (10) days after delivery to Customer of written notice of exercise of rights under this Section 16.1(c). Section 16.2 Termination for Convenience (a) Customer shall have the option, but not the obligation, to terminate for convenience this Master Agreement (together with all Service Agreements) or, from time to time, one or more Service Agreements. Customer shall exercise its termination option by delivering to the applicable Torch Party written notice of such termination identifying the agreement(s) being terminated and identifying the termination date (which, except as provided in a Service Agreement, shall be at least ninety (90) days after the delivery to the Torch Party of such notice). (b) Customer shall pay the Torch Party thereto a termination fee, with respect to each Service Agreement terminated under this Section 16.2, equal to the greater of: (i) 0.50 multiplied by the number of months remaining in the agreement's term multiplied by the previous calendar year's fees and incentives earned divided by 12 or (ii) 0.50 multiplied by the number of months remaining in the agreement's term multiplied by the current calendar year's fees earned (together with estimated incentive fees) annualized to 12 months equivalent divided by 12 ("current" and "previous" to be determined with reference to such notice delivery date); provided, however, that in no event shall such termination fee, if with respect to a Service Agreement being terminated under this Section 16.2 after the end of the first third of its initial term, exceed the greater of: (i) the previous calendar year's fees and incentives earned or (ii) the current calendar year's fees earned (together with estimated incentive fees) annualized to 12 months equivalent. (c) In connection with each termination of an agreement pursuant to this Section 16.2, Customer shall be responsible, upon delivery of an officer's certificate pursuant to Section 10.4, for the severance costs incurred pursuant to the applicable Torch Party's then-current severance policies in connection with the termination of each employee identified on such certificate, except for each employee who (i) Customer offers a comparable position at Customer that the employee does not accept; or (ii) Customer employs in a comparable position for at least 12 months after such termination; or (iii) Customer employs in a comparable position until such person's voluntary termination or termination for cause. Customer may seek to withdraw certain assets or services from a Service Agreement, not to exceed an aggregate over the term of such agreement of twenty percent (20%) of the annualized base and variable fees (based on the most recent three months billings under such agreement), by Change Order delivered to the related Torch Party, whereupon the Torch Party shall propose a reasonable credit or reduction in charges for the withdrawn assets or services, which credit or reduction shall bear a reasonable relation to the Torch Party's costs associated -29- with the assets or services. As soon as practicable thereafter, Customer shall advise the Torch Party whether Customer will proceed with such withdrawal. As soon as practicable thereafter the Torch Party shall deliver an officer's certificate attesting to the identity of persons whose employment is being terminated as a result of such withdrawal (and that the withdrawal is the predominant reason for the employee's termination) with respect to whom the Torch Party intends to require reimbursement from Customer of severance costs pursuant to this Section 16.2. In connection with each such withdrawal, Customer shall be responsible, upon delivery of such officer's certificate, for the severance costs incurred pursuant to the applicable Torch Party's then-current severance policies in connection with the termination of each employee identified on such certificate, except for each employee who (i) Customer offers a comparable position at Customer that the employee does not accept; or (ii) Customer employs in a comparable position for at least 12 months after such termination; or (iii) Customer employs in a comparable position until such person's voluntary termination or termination for cause. Section 16.3 Termination for Insolvency A Party shall have the option, but not the obligation, to terminate this Master Agreement in its entirety (including all Service Agreements) without payment of any applicable termination fees if a Party (i) becomes insolvent or is unable to meet its debts as they mature, (ii) files a voluntary petition in bankruptcy or seeks reorganization or to effect a plan or other arrangement with creditors, (iii) files an answer or other pleading admitting, or fails to deny or contest, the material allegations of an involuntary petition filed against it pursuant to any applicable statute relating to bankruptcy, arrangement or reorganization, (iv) shall be adjudicated a bankrupt or shall make an assignment for the benefit of its creditors generally, (v) shall apply for, consent to or acquiesce in the appointment of any receiver or trustee for all or a substantial part of its property, or (vi) any such receiver or trustee shall be appointed and shall not be discharged within thirty (30) days after the date of such appointment; provided, however, that in the event of a termination under Section 16.3(i) by reason of Customer's insolvency, the Customer shall have the right to purchase the terminated Services on a prepaid basis on otherwise substantially the same terms as applicable under this Agreement, but only if it has previously satisfied all of its payment obligations under this Agreement. Section 16.4 Limitation on Effect of Termination Termination of this Master Agreement or any Service Agreement or categories of Services for any reason under this Article shall not affect (i) any liabilities or obligations of a Party arising before such termination or out of the events causing such termination, or (ii) any damages or other remedies to which a Party may be entitled under this Master Agreement or any Service Agreement or any Change Order, at law or in equity, arising from any breaches of such liabilities or obligations. -30- Section 16.5 Termination/Expiration Assistance Concurrently with the expiration or termination of the Master Agreement or any Service Agreement hereunder for any reason other than by reason of a failure by Customer to satisfy a payment obligation, at the request of Customer, Torch shall provide at Customer's expense, on a time and materials basis in accordance with Torch's then-current published pricing, the Termination/Expiration Assistance described in this Section 16.5. Such Termination/Expiration Assistance may not be withheld by Torch provided that Customer has satisfied and continues to satisfy all of its payment obligations to each Torch Party and provided that Customer has paid to each Torch Party a "Performance Deposit": (a) Torch shall deliver to Customer all Business Records and Data, Customer Confidential Information and Customer Confidential Materials, in Torch's possession, and shall, at Customer's request, destroy all electronic copies thereof not turned over to Customer; provided that Torch shall have no obligation to provide or destroy any of its intellectual property, Business Records and Data, Confidential Information, Confidential Materials, or any other of its property; (b) Torch shall take such additional actions and perform such additional tasks as may be reasonably necessary to facilitate a timely disengagement in compliance with the provisions of this Section 16.5, including performance on or before the date of expiration or termination of the Term of all of Torch's obligations under this Section 16.5. ARTICLE 17 DISPUTE RESOLUTION Section 17.1 General Any dispute or controversy between the Parties with respect to the interpretation or application of any provision of this Master Agreement, and/or any Service Agreement(s) and/or any Change Order(s) or the performance by Torch or Customer of their respective obligations hereunder or findings of any audit or any other dispute in connection with this Master Agreement or the Service Agreements or Change Orders, shall be resolved as provided in this Article. Section 17.2 Informal Dispute Resolution The Parties may, by mutual agreement, attempt to resolve their dispute informally in the following manner: (a) Either Party may submit the dispute to the Management Board, which shall meet as often as the Parties reasonably deem necessary to gather and analyze any information relevant -31- to the resolution of the dispute. The Management Board shall negotiate in good faith in an effort to resolve the dispute. (b) If the Management Board determines in good faith that resolution through continued discussions by such Management Board does not appear likely, the matter shall be referred to binding arbitration. (c) During the course of negotiations, all reasonable requests made by one Party to the other for non-privileged information, reasonably related to the dispute, shall be honored in order that each of the Parties may be fully advised of the other's position. (d) The specific format for the discussions shall be determined at the discretion of the Management Board, but may include the preparation of agreed upon statements of fact or written statements of position. (e) Proposals and information exchanged during the informal proceedings described in this Article between the Parties shall be privileged, confidential and without prejudice to a Party's legal position in any subsequent proceedings. All such proposals and information, as well as any conduct during such proceedings, shall be considered settlement discussions and proposals, and shall be inadmissible in any subsequent proceedings. Section 17.3 Arbitration (a) Except as set forth in clause (b) below, any controversy or claim arising out of or relating to this Master Agreement or any Service Agreement, or any alleged breach hereof, including any controversy regarding the arbitrability of any dispute, shall be settled at the request of either Party by binding arbitration in Houston, Texas before and in accordance with the then existing Commercial Arbitration Rules of the American Arbitration Association (the "Rules"). In any dispute in which the amount in controversy is less than Two Hundred Fifty Thousand Dollars ($250,000), there shall be one (1) arbitrator agreed to by the Parties or, if the Parties are unable to agree within thirty (30) days after demand for arbitration is made, selected in accordance with the Rules. In all other cases there shall be three (3) arbitrators, one (1) of whom shall be selected by Customer within thirty (30) days after demand for arbitration is made, one (1) of whom shall be selected by Torch within thirty (30) days after demand for arbitration is made, and one (1) of whom shall be selected by the two Party-appointed arbitrators within thirty (30) days after their selection. If one or more arbitrator(s) is not selected within the time period stated in the preceding sentence, such arbitrator(s) shall be selected pursuant to Rule 13 of the Rules. Any arbitrator(s) proposed by the American Arbitration Association shall have at least ten (10) years of experience in complex, commercial matters in the area that is generally the same as the matter that is the subject of the dispute. Each Party shall pay its own attorneys' fees and one-half (1/2) of the other arbitration costs, subject to final apportionment by the arbitrators. The arbitrators shall apply the law set forth herein to govern this Master Agreement and any Service Agreement and shall have the power to award any remedy available at law or in equity; provided, however, that the arbitrators shall have no power to amend this Master Agreement or -32- any Service Agreement. The Party prevailing in arbitration shall be entitled to recover its reasonable and necessary attorneys' fees and expenses incurred in the arbitration proceeding. Any award rendered pursuant to such arbitration shall be final and binding on the Parties, and judgment on such award may be entered in any court having jurisdiction thereof. A Party may recover its attorneys' fees incurred in any such enforcement action. (b) Notwithstanding clause (a) above, a Party may request a court of competent jurisdiction to grant provisional injunctive relief to such Party until an arbitrator can render an award on the matter in question and such award can be confirmed by a court having jurisdiction thereof. Section 17.4 Continued Performance Subject to Section 7.5, both Parties shall continue performing their respective obligations and responsibilities under this Master Agreement and any Service Agreements and any Change Orders while any dispute, other than a dispute or dispute(s) with respect to breach of confidentiality obligations. Section 17.5 Applicable Law All questions concerning the validity, interpretation and performance of this Master Agreement and any Service Agreement shall be governed by and decided in accordance with the laws of the State of Texas, as such laws are applied to contracts between Texas residents and without regard to the choice of law rules of the State of Texas. Section 17.6 Jurisdiction and Venue The Parties hereby submit and consent to the exclusive jurisdiction of any state or federal court located within Harris County of the State of Texas and irrevocably agree that all actions or proceedings relating to this Master Agreement and any Service Agreement, other than any action or proceeding required by this Article to be submitted to arbitration, shall be litigated in such courts, and each of the Parties waives any objection which it may have based on improper venue or forum non conveniens to the conduct of any such action or proceeding in such court. Nothing in this Section shall affect the obligation of the Parties with respect to the arbitration of disputes pursuant to Section 17.3. -33- Section 17.7 Equitable Remedies The Parties agree that in the event of any breach or threatened breach of any provision of this Master Agreement or any Service Agreement concerning (i) Confidential Information, (ii) intellectual property rights or (iii) other matters for which equitable rights may be granted, money damages would be an inadequate remedy. Accordingly, such provisions may be enforced by the preliminary or permanent, mandatory or prohibitory injunction or other order of a court of competent jurisdiction. ARTICLE 18 MISCELLANEOUS Section 18.1 Interpretation (a) In this Master Agreement and in any Service Agreement or Change Order, words importing the singular number include the plural and vice versa and words importing gender include all genders. The word "person" includes, subject to the context in which it appears, an individual, partnership, association, corporation, other legal entity, trustee, executor, administrator or legal representative. (b) The division of this Master Agreement, any Appendix hereto and any Service Agreement or Change Order into Articles, Sections, subsections and Schedules and the insertion of any captions or headings are for convenience of reference only and shall not affect its construction or interpretation. (c) In this Master Agreement and in any Service Agreement or Change Order, unless otherwise specifically provided: (i) In the computation of a period of time from a specified date to a later specified date, the word "from" means "from and including" and the words "to" and "until" each mean "to but excluding." (ii) References to a specified Article, Section, subsection, Schedule or other subdivision shall be construed as references to that specified Article, Section, subsection, Schedule or other subdivision of this Master Agreement or the applicable Service Agreement or Change Order, unless the context otherwise requires. (iii) The word "dollar" and the symbol "$" refer to United States dollars. (iv) References to "days" means calendar days unless "business days" are specified. -34- (v) The term "including" means "including, without limitation," or "including, but not limited to." (d) The Parties are sophisticated and have been represented by counsel during the negotiation of this Master Agreement and each Service Agreement. As a result, the Parties agree that the presumption of any laws or rules relating to the interpretation of contracts against the drafter thereof should not apply, and hereby waive any such presumption. Section 18.2 Binding Nature and Assignment Except as otherwise provided in this Master Agreement, neither Party may assign (other than by operation of law) any of its rights or obligations under this Master Agreement without the other Parties' consent. Subject to the foregoing, this Master Agreement and each Service Agreement shall be binding on the Parties and their respective successors and assigns. Section 18.3 Expenses In this Master Agreement and each Service Agreement or Change Order, unless otherwise specifically provided, all costs and expenses (including the fees and disbursements of legal counsel) incurred in connection with this Master Agreement or the applicable Service Agreement or Change Order, and the completion of the transactions contemplated by this Master Agreement or the applicable Service Agreement shall be paid by the Party incurring such expenses. Section 18.4 Amendment and Waiver Without limiting Section 4.3(b), this Master Agreement may not be modified, amended, or in any way altered except by written document duly executed by the affected Parties hereto. No waiver of any provision of this Master Agreement, nor of any rights or obligations of any Party hereunder, will be effective unless in writing and signed by the Party waiving compliance, and such waiver will be effective only in the specific instance, and for the specific purpose, stated in such writing. No waiver of breach of, or default under, any provision of this Master Agreement will be deemed a waiver of any other provision, or of any subsequent breach or default of the same provision, of this Master Agreement. Section 18.5 Further Assurances; Consents and Approvals Each Party shall provide such further documents or instruments required by the other Party as may be reasonably necessary or desirable to give effect to this Master Agreement and to carry out its provisions. Section 18.6 Publicity All media releases, public announcements and other disclosures by either Party relating to this Master Agreement or any Service Agreement or Change Order or the subject matter hereof -35- or thereof, including promotional or marketing materials, but excluding announcements intended solely for internal distribution or to meet legal or regulatory requirements, shall be coordinated with and approved by the other Party prior to release. Section 18.7 Severability Any provision in this Master Agreement which is prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions or affecting the validity or enforceability of such provision in any other jurisdiction. Section 18.8 Entire Agreement This Master Agreement and each of the Service Agreements and Change Orders, including the Appendices, Exhibits and Schedules hereto and thereto, constitute the entire agreement among the Parties pertaining to the subject matter hereof and supersede all prior and contemporaneous agreements, understandings, negotiations and discussions, whether oral or written, of the Parties pertaining to the subject matter hereof. Section 18.9 Notices Except as expressly otherwise stated herein, all notices, requests, consents, approvals, or other communications provided for, or given under, this Master Agreement, shall be in writing, and shall be deemed to have been duly given to a Party if delivered personally, or transmitted by facsimile to such Party at its telecopier number set forth below, or sent by first class mail or overnight courier to such Party at its address set forth below, or at such other telecopier number or address, as the case may be, as shall have been communicated in writing by such Party to the other Party in accordance with this Section. All notices will be deemed given when received in the case of personal delivery or delivery by mail or overnight courier, or when sent in the case of transmission by facsimile upon electronic confirmation of receipt. Notices to Customer shall be addressed as follows: Attention: Robert J. Bensh Bellwether Exploration Company 1331 Lamar St. Suite 1455 Houston, TX 77010-3039 Telephone No.: (713) 652-1025 -36- with a copy to: Attention: Corporate Secretary Bellwether Exploration Company 1331 Lamar St., Suite 1455 Houston, TX 77010-3039 Telephone No.: (713) 652-1025 Notices to a Torch Party shall be addressed as follows: Attention: President [Torch Party Name] c/o Torch Energy Advisors Incorporated 1221 Lamar St. Suite 1600 Houston, TX 77010-3039 Telephone No.: (800) 324-8672 with a copy to the attention of the Torch Party's general counsel at: Attention: General Counsel [Torch Party Name] c/o Torch Energy Advisors Incorporated 1221 Lamar St. Suite 1600 Houston, TX 77010-3039 Telephone No.: (800) 324-8672 Section 18.10 Survival Any provision of this Master Agreement or of any Service Agreement which contemplates performance or observance subsequent to any termination or expiration of this Master Agreement or of any Service Agreement shall survive expiration or termination of this Master Agreement or any Service Agreement. Section 18.11 Independent Contractors This Master Agreement will not be construed to (nor shall any Service Agreement or Change Order be construed to) constitute either Party as a representative, agent, employee, partner, or joint venturer of the other. The Parties will be independent contractors for the performance under this Master Agreement. Section 18.12 Third Party Beneficiaries Except as set forth in Article 16 (Indemnification) of this Master Agreement, nothing in this Master Agreement or in any Service Agreement, express or implied, is intended to confer on rights, benefits, remedies, obligations or liabilities on any person (including, without limitation, -37- any employees of the Parties) other than the Parties or their respective successors or permitted assigns. Section 18.13 Counterparts This Master Agreement and each Service Agreement may be executed in one or more counterparts, each of which shall be deemed an original but all of which taken together shall constitute one and the same instrument. Section 18.14 Duty to Act Reasonably Whenever a provision of this Master Agreement or any Service Agreement or Change Order hereunder requires or contemplates any action, consent, or approval, the Parties shall act reasonably and in good faith and (unless the provision expressly allows exercise of a Party's sole, or sole and absolute discretion) may not unreasonably withhold or delay such action, consent, or approval. Section 18.15 Year 2000 Compliance As of the Effective Date and continuing throughout the Term, each Torch Party agrees that all assets and information systems owned or leased by such Torch Party and used to provide the Services from and after December 31, 1999 will be and shall remain Year 2000 Compliant; provided, however, that Torch Parties shall not be required to bear the cost of replacing or repairing any of Customer's assets to correct any Year 2000 problems. In the event that a Torch Party fails to achieve Year 2000 compliance for any assets or information systems owned or leased by the Torch Party and used to provide Services to Customer, and such failure materially harms Customer and continues to do so for a period of ninety (90) days after written notice is provided by Customer, then Customer may terminate any and all Service Agreements with such Torch Party that are materially affected by such failure. Upon any such termination hereunder, Customer shall pay to the Torch Party a termination fee equal to one-half of the termination for convenience fee that is applicable to such Service Agreement. IN WITNESS WHEREOF the Parties have executed this Master Agreement as of the date first above written. BELLWETHER EXPLORATION COMPANY By:----------------------------- Robert J. Bensh Sr. Vice President, Finance -38- TORCH ENERGY ADVISORS INCORPORATED By:------------------------------------- Michael Smith, Managing Director and Chief Financial Officer TORCH OPERATING COMPANY By:------------------------------------- Michael B. Smith, Vice President TORCH ENERGY MARKETING, INC. By:--------------------------------------- Douglas B. Chapman, President NOVISTAR, INC. By:--------------------------------------- Thomas M. Ray, III, President -39- SCHEDULE 4.1 EXCLUDED SERVICES MASTER SERVICES AGREEMENT 1. Acquisition services, including deal generation, screening, analysis, evaluation, due diligence, negotiation, closing and final accounting. 2. Divestiture services, including preparation of sales package and/or data room, bid analysis and screening, sale negotiation, closing and final accounting. 3. Scientific (engineering, geological and geophysical) information technology, including all hardware, software and systems support. 4. Geological and geophysical interpretation and analysis. 5. Reservoir and exploitation engineering. 6. Office space, lease negotiation and lease management. 7. Phone systems and related maintenance. 8. Office security systems and related maintenance. 9. The cost of the following items and related maintenance will no longer be borne by Torch, though Torch Parties will continue to provide services related to selecting, purchasing and arranging for maintenance of such items: (a) Desktop computer systems and related software; (b) Office supplies, equipment and furniture; (c) Kitchen equipment and supplies; and (d) Office services, such as pest control, plant maintenance, coffee service, water filter replacement and similar items. SCHEDULE 10.2 MANAGEMENT BOARD REPRESENTATIVES MASTER SERVICES AGREEMENT Torch Parties 1. Douglas B. Chapman President, TEMI and Managing Director, TEAI 2. Michael B. Smith Chief Financial Officer and Managing Director, TEAI 3. Thomas M. Ray III Chief Executive Officer and President, Novistar Bellwether Exploration Company 1. J.P. Bryan Chief Executive Officer 2. Robert J. Bensh Sr. Vice President-Finance 3. Cliff M. West, Jr. Sr. Vice President-Exploration and Explotation SCHEDULE 10.5 KEY PERSONNEL MASTER SERVICES AGREEMENT 1. Ann Kaeserman: Controller, TEAI 2. Carol Cooley: Landman, TEAI 3. Randy A. Bailey: Senior Vice President, TOC 4. Wayne Penello: Vice President, Risk Management, TEMI 5. Kim Yates: Senior Financial Analyst, TEAI 6. Jim Abney: Director, Land, TEAI EX-11.16 4 CONTRACT FOR THE PRODUCTION OF CRUDE OIL EXHIBIT 10.16 TRANSLATOR NOTE: The following additions (in bold) were included in the changes in the file "cambios 10sep," but did not appear in the final Spanish version, so I have deleted them from this final English version. 25.2.2 - The Parties agree that the Arbitration shall take place in the city of Quito, Ecuador and, if it considers it appropriate, the Center may designate the Arbitration Center of the Quito Chamber of Commerce as the place and the facilities for the development of the arbitration proceeding. 25.3.1 If the disagreement or controversy is of a nature such that it cannot be resolved by the Consultant as stipulated in Clause 25.1, or if one or both of the Parties is not satisfied with the decision rendered by the Consultant, unless it has been agreed that the opinion of the Consultant be binding, PETROECUADOR and the Contractor agree to submit such a disagreement or controversy to the arbitration of the International Center for the Settlement of Investment Disputes (ICSID). (The Center) Page 1 of 56 CONTRACT FOR THE PRODUCTION OF CRUDE OIL AND ADDITIONAL HYDROCARBON EXPLORATION IN THE CHARAPA MARGINAL FIELD OF PETROECUADOR Dear Mr. Notary: Within the registry of public instruments under your supervision, and using the formalities of said style, please incorporate one which shows the Contract for the Production of Crude Oil and Additional Hydrocarbon Exploration in Charapa Marginal Field, to be signed by the Ecuadorian State Oil Company PETROECUADOR, on the one hand; and the Consortium composed of the companies TECNIPETROL, INC. and BELLWETHER INTERNATIONAL INC., on the other, containing the following clauses: FIRST -- PARTIES APPEARING: The parties appearing for the signing of this contract are on the one hand the Ecuadorian State through the intercession of the Ecuadorian State Oil Company, PETROECUADOR, and its affiliate, the State Company for the Oil Development and Exploration, PETROPRODUCCION, represented by economist Jorge Pareja Cucalon and engineer Carlos Quiroz Soria in their roles as Executive President and manager, respectively, duly authorized by the Administrative Council of PETROECUADOR and the Board of PETROPRODUCCION, in that order, as shown in the attached documents, hereinafter to be known as PETROECUADOR, and on the other, the Companies TECNIPETROL, INC. y BELLWETHER INTERNATIONAL, INC., affiliates of TECNOLOGIA INVERSIONES ECUADOR - TECNIE CIA. LTDA and BELLWETHER EXPLORATION COMPANY who constitute the Consortium referred to as BELLWETHER - TECNIPETROL CONSORTIUM represented legally and jointly by Eng. Carlos Paz y Mino and Dr. Jorge Paz Durini respectively, as accredited by the documentation which shall also be attached, and hereinafter known as the Contractor. SECOND--BACKGROUND: 2.1 - Through Law Number 44, published in Official Record No. 326 of November 29, 1993, reformed by means of Law no. 49, published in the Official Record No. 346 of December 28 of the same year, the reforms to the Hydrocarbons Law were issued, incorporating the modality of Contract for the Development of Crude Oil and Additional Hydrocarbon Exploration in Marginal Fields, by means of which PETROECUADOR delegates to the Contractor the ability to undertake the additional development and exploration activities in marginal production fields currently under development by its Ecuador Oil Exploration and Production Affiliate, PETROPRODUCCION. Page 2 of 56 2.2 - According to what has been set forth in Article 2, reformed, of the Hydrocarbons Law, the Ministry of Energy and Mines, through Ministerial Agreement No 090 dated published in Official Registry Number 255 dated February 11, of the same year, qualified the Charapa Field as Marginal, subject Special Bid No. 003-UCCM, based on the Technical, Economic and Legal Study for Deposits Management, for the Qualification of Marginal Fields presented by PETROECUADOR with official letter number 256-PEP-UCP-PPR-97/116805 of December 22, 1997, and on the reports of the National Office of Hydrocarbons and the Office of Legal Affairs of the Ministry of Energy and Mines, shown in the Memorandums Nos. 980091_DNH-CO-PT -Y-008-98 and 008-DAJ-JE-98, of January 8 and 9 of 1998, which are respectively appended. 2.3 - The Special Bidding Committee, CEL, convoked in the month of April 1998 the First Round of the Special Bids for the Production of Crude Oil and the Additional Exploration of Hydrocarbons in Marginal Fields on national territory, for which purpose the said Committee approved the corresponding pre-contract documents, and also issued the Basic Contracting Conditions, by means of Executive Decree No. 1327-A, published in the Supplement of the Official Register No. 305 dated April 27, 1998. 2.4 - For the purposes of presenting their Bid, the Companies TECNOLOGIA INVERSIONES ECUADOR - TECNIE CIA. LTDA. and BELLWETHER EXPLORATION COMPANY constituted the Consortium referred to as TECHNIE - BELLWETHER by means of the Public Document made before he Third Notary of Quito Canton, Metropolitan District on June 25, 1998, a certified copy of which is attached. XX Following the qualification and selection process of the companies that presented their offer in the bids for the Charapa Field, the CEL by means of Resolution no. 579-CEL-99 of January 4, 1999 determined the first place in the preference to be the offer presented by presented by the Companies composing the TECHNIE - BELLWETHER Consortium. 2.5 TECNIPETROL, INC. is a company constituted within the scope of the laws of the Republic of Panama, domiciled in Ecuador and inscribed in the Business Register on the first of June of nineteen ninety-nine, affiliate of TECNOLOGIA INVERSIONES ECUADOR- TECNIE CIA. LTDA; and the Company BELLWETHER INTERNATIONAL, INC. is a Company constituted under the laws of the United States of America domiciled in Ecuador and inscribed in the Business Register on the fourth of June nineteen ninety-nine, affiliate of BELLWETHER EXPLORATION COMPANY. By means of the Public Document made before the Thirty-Second Notary of the Quito Canton, Metropolitan District on September 13, 1999, a certified copy of which is appended, the Affiliated Companies that sign this Contract for the execution thereof have constituted the Consortium referred to as the BELLWETHER- TECNIPETROL CONSORTIUM. Page 3 of 56 2.6 - The Executive President of PETROECUADOR, with Official Letters Nos. 201- UCP-99 2659 of July 19, 1999 and 199-UCP-99 2655 of July 19, 1999 respectively, requested the report from the Attorney General of the State as to this contracting and the opinion of the Armed Forces, whose favorable report and opinion are recorded in the Official Letters Nos. 07331 of September 3, 1999 and 990148-DIN-4 of July 20, 1999, respectively, which are appended. 2.7 - The Special Bidding Committee, CEL, by means of Resolution No. 609-CEL-99 of September 12, 1999, which is appended awarded the present Contract to the Consortium composed of the Companies TECNIPETROL, INC and BELLWETHER INTERNATIONAL, INC. for the Development of Crude Oil and the Additional Exploration of Hydrocarbons in the Charapa Marginal Field. 2.8 - The Administrative Council of PETROECUADOR and the Board of Directors of PETROPRODUCCION, by means of Resolutions Nos. 367-CAD-99-10-28 of October 28, 1999 and 10.-110-PPR-99-10-22 of October 22, 1999, respectively, which are appended, authorized the Executive President of PETROECUADOR and the Manager of PETROPRODUCCION to enter into the present Contract. THIRD -- INTERPRETATIONS AND DEFINITIONS 3.1 Interpretation 3.1.1 - Contractual interpretation: If the interpretation of one or more clauses of this Contract is necessary, the Parties shall interpret them as per the dispositions of Title XIII, Book IV of the Ecuadorian Civil Code, setting forth that the titles and the order of the clauses and sub-clauses are only for purposes of identification and reference, but not preeminence or preference. 3.1.2 - Any tolerance by the Parties regarding non-fulfillment of the obligations set forth in this Contract under no circumstances shall imply a change or alteration of these stipulations, and such a fact shall not constitute a precedent for the interpretation of this Contract, nor a renunciation, nor a source of rights in favor of the Party that did not meet its obligations. 3.1.3 - The stipulations appearing in this Contract shall prevail, in the event of any discrepancy, over those appearing in the subcontracts with third parties, additional agreements between the Parties, and in other documents which by their legal, technical or economic nature, may be considered secondary in nature. 3.1.4 - The Parties leave express evidence of their acceptance that, in the event of contradictions between this Contract and the legal, regulatory, or Basic Contracting provisions, these latter dispositions shall prevail over this Contract. Page 4 of 56 3.1.5 - Language: This Contract has been written by the Parties in the Spanish language;. the said version shall be considered for all its effects as the only valid version. In spite of this, the Contractor may notarize a version of this Contract in another language under the proviso that if there is any difference between both versions, the Spanish text shall prevail. 3.1.6 - For the best interpretation of this Contract, PETROECUADOR and the Contractor agree to grant the meanings that are assigned later on to the technical or specialized terms employed with the greatest frequency in this instrument, indistinctly from the fact that they may be written in singular or plural. 3.2 - Definitions: 3.2.1 - Fiscal Year: Refers to the twelve month period running between January 1 and December 31, both inclusive, for each year. 3.2.2 - Contract Area: Refers to the surface and its projection into the subsurface the boundaries and specifications of which appear in Annex I/ii/. 3.2.3. Environmental Audit: Refers to the study that determines the conditions affecting the environment, for a certain area, resulting from oil development and exploration activities in the said area. 3.2.4 - Barrel: Refers to the Crude Oil production unit equal in volume to forty-two gallons of the United States of America, measured at Standard Conditions (STP), that is a temperature of sixty degrees (60 degrees) Fahrenheit and a barometric pressure of fourteen point six nine five nine (14.6959) pounds per square inch. 3.2.5 - Charapa Field: Refers to the one qualified as a Marginal Field by the Ministry of Energy and Mines and is located in the Contract Area. It includes the deposits and their surface projection, four drilled wells, flow lines and central production station. 3.2.6 - Inspection and Delivery Center: Refers to the site where the Inspected Crude Oil Production from the Charapa Field is measured and delivered, which is located in the Charapa Central Station. PETROECUADOR shall receive the volumes of Crude Oil corresponding to the Base Curve and to its participation in the Incremental Production at the Inspection and Delivery Center. The Contractor shall likewise receive the volume corresponding to its participation in the incremental production at this Center. If operatively appropriate, the Parties shall agree on new Inspection and Delivery Centers, which shall be approved by the MEM. Page 5 of 56 3.2.7 Standard Conditions (STP): Refers to the normal conditions of a temperature of sixty degrees (60 degrees) Fahrenheit and a barometric pressure of fourteen point six nine five nine (14.6959) pounds per square inch. 3.2.8. Contract: Refers to the present instrument, including its qualifying documents and annexes, which in their aggregate shall be referred to as the "Contract for the Development of Crude Oil and Additional Exploration for Hydrocarbons of the Charapa Field of PETROECUADOR." 3.2.9 - Contractor: Refers to the Consortium composed of the Companies TECNIPETROL, INC and BELLWHETHER INTERNATIONAL, INC. 3.2.10 - Operating Costs: These are the production costs of the Contractor, minus the amortization and depreciation. If the cost of operation for a given period is divided by the inspected production of that same period, the unit operation cost can be derived for that period. 3.2.11 - Base Curve Cost: This is the value of 1.70 U.S. dollars per barrel of Crude Oil, applicable to the 1999 Fiscal Year, that PETROECUADOR will pay to the Contractor to produce the volume of the Base Production Curve. This value shall be updated annually at the start of each fiscal year, according to the variation of the price index to the Producer Price Index- Series ID:wpssop3510 Seasonally Adjusted Item: Finished Energy Goods Commodities of the United States of America. 3.2.12 - Related Companies Parent Company: Refers to the company or entity that directly or indirectly controls the Affiliate or the Subsidiary, respectively. Affiliate: Refers to a company or entity that is directly controlled by its Parent Company. Subsidiary: Refers to a company or entity that is directly controlled by the Affiliate and indirectly by the Parent Company. The term "control" for the above mentioned relationships shall be understood to conform to that indicated in the Regulation on the Special Bidding System for Additional Development and Exploration Contracts for Marginal Fields. 3.2.13 - Base Production Curve: This is the production profile of the Crude Oil projected by PETROPRODUCCION for the Charapa Field, that appears in this Contract as Annex II" 3.2.14 - DNH: National Office of Hydrocarbons Page 6 of 56 3.2.15 - Dollar: Refers to the monetary unit of the United States of America (U.S. dollars) 3.2.16 - Main Conduits: Refers, in general, to the pipelines and other equipment and facilities for the transportation and storage necessary to evacuate Crude Oil, from its Intake Stations, to the exportation terminals or industrial centers of the country. 3.2.17 - Secondary Conduits: Refers in general to the pipelines and other transportation and storage equipment and installations necessary for the evacuation of Crude Oil from the storage tanks in the Inspection and Delivery Centers of the Contract Area to the Intake Station of the Main Conduits. 3.2.18 - EIA: (Environmental Impact Study) - This is the document by means of which the Contractor makes known, from descriptive, analytical and predictive multidisciplinary studies, the potential risks as well as the positive and negative effects that may be caused to nature, to the ecosystems and to the social organizations, by hydrocarbon operations, as well as the measures that will be taken to prevent and to control and mitigate the risks and negatives effects, as well as the actions necessary for rehabilitating the affected areas. 3.2.19 - Head Station for Main Conduits: Refers to the site where the set of facilities for storing, measurement (inspection) and pumping of Crude Oil is located, from where a Main Conduit starts. Currently, this station is located in Lago Agrio; in the future other Head Stations can be built for new Main Conduits. 3.2.20 - Effective Date: Refers to the date of registration of this Contract in the Hydrocarbons Register of the DNH, from which its deadlines are counted. 3.2.21 - Act of God or Unavoidable Accident: Refers to the events which can neither be resisted nor controlled by one or both Parties. This definition covers, but is not limited to: earthquakes, seaquakes, floods, landslides, storms, fires, explosions, work stoppages, strikes, social disturbances, acts of war (whether declared or not), acts of sabotage, acts of terrorism, actions or omissions on the part of any state authority, dependency or entity, any other circumstance not mentioned in this Clause 3.2.21, which may be equally impossible to resist and which is beyond the reasonable control of the Party that invokes the occurrence of the fact and which causes the total or partial obstruction or delay of compliance with the obligations of the Party in question, under the stipulations of this Contract, and the concept defined in Article 30 of the Ecuadorian Civil Code. 3.2.22 - Associated Gas: Refers to the mixture of hydrocarbons coming from Crude Oil Deposits located in solution in the deposit and which are transformed into the gaseous state at surface pressure and temperature conditions. 3.2.23 - Free Natural Gas: Refers to the mix of hydrocarbons coming from Gas deposits, which remain in a gaseous state at the deposit and surface pressure and temperature conditions Page 7 of 56 3.2.24 - MEM: Ministry of the Sector, or Ministry of Energy and Mines. 3.2.25 Parties: Refers to the Ecuadorian State through PETROECUADOR and PETROPRODUCCION, on the one part and the Contractor on the other. 3.2.26 - PETROECUADOR: Is the State Oil Company of Ecuador, with legal personality, its own equity, administrative, economic, financial and operating autonomy, domiciled in the city of Quito. When PETROECUADOR is mentioned, it shall be understood that reference is made to this company and its Affiliates, as far as applicable. 3.2.27 PETROPRODUCCION: Refers to the State Company for Exploration and Production of Oil of Ecuador, affiliate of PETROECUADOR with a legal personality, its own equity, administrative, and operating autonomy, domiciled in the city of Quito, which shall be responsible for the administration, follow- up and coordination of the Contract. 3.2.28 - Crude Oil: Refers to the mix of hydrocarbons that exists in the liquid phase in deposits and that remains in a liquid state on the surface under Standard Conditions. 3.2.29 - Development Plan: Refers to the set of activities and their corresponding estimated investments that the Contractor undertakes to make and in the event that Commercially Viable Crude Oil deposits are discovered as a result of the execution of the additional exploration activities, it will be submitted to the approval of the MEM. 3.2.30 - Minimal Plan for Additional Exploration and Investments: Refers to the collection of activities offered by the Contractor and that it is obligated to execute, for its account and risk, in the Contract Area during the first three years of validity, for the purpose of defining structures for new discoveries of reserves which are indicated in Annex III with their respective estimated investments. 3.2.31 - Five Year Plan: Refers to the document containing the collection of projected activities and estimated investments, proposed by the Contractor during the Contract, for the five fiscal years subsequent to the date of submission of the said plan. This plan must be updated annually. 3.2.32 - Term and Deadlines: Term: refers to the period running between one date and another, including both weekends and holidays, at the national level and in the city of Quito. Deadline: is the period running between one date and another, in which only working days are taken into account. Page 8 of 56 3.2.33. Horizontal Well: Refers to a well drilled from the surface with directional control and intentionally detoured from vertical for the purpose of intersecting the objective geological zone or zones, at a detour angle greater than sixty (60) degrees from vertical and in order to penetrate a portion of the geological section in a horizontal or quasi horizontal plane, within the said section at a distance of more than 300 feet. 3.2.34 - Reference Price (Pi/t/): Refers to the final weighted average monthly price corresponding to the immediately preceding month for direct external cash sales of Crude Oil made by PETROECUADOR, including incidental or "spot" and long term sales, adjusted in quality equivalent to the Crude Oil produced in the Contract Area. These prices shall be expressed in the terms FOB Ecuadorian port (main export terminal) and in Dollars per Barrel. In the event that PETROECUADOR does not realize external sales in the respective period, the Reference Price shall be established based on a basket of crudes, agreed upon by the Parties, whose prices shall be obtained from specialized publications of recognized prestige. 3.2.35 - Average Sales Price from PETROECUADOR (PM): Refers to the latest average monthly price corresponding to the immediately preceding month, for direct external sales of Crude Oil, realized by PETROECUADOR in cash, including incidental or "spot" sales and long term sales. These prices shall be expressed in FOB Ecuadorian port terms (main export terminal) and in dollars per barrel. 3.2.36 - Inspected Production: Refers to the Crude Oil of the Contract Area, measured in barrels at the Inspection and Delivery Center, subtracting the volume of water and sediments (BS&W), duly certified by the DNH. 3.2.37 - Incremental Production: Refers to the volume of Inspected Crude Oil that exceeds the Base Production Curve. 3.2.38 - Annual Budget and Activities Program: Refers to the Collection of activities and estimated investments that the Contractor must present annually by October 31 of each Fiscal Year and that it proposes to realize in the following Fiscal Year. The said Annual Programs and Budgets must be presented in conformity with the Minimum Production Activities and Investments Plan and the Minimum Plan for Additional Exploration and Investments for the respective periods. 3.2.39 - Minimum Production Activities and Investments Plan: Refers to the collection of activities offered by the Contractor and that it is obligated to execute in the Charapa Field, within the first three (3) years of validity of the Contract, and that is included in Annex IV, with its respective estimated investments. Page 9 of 56 3.2.40 - Reconditioning: Refers to the operation performed on a well to assure, restore or improve the Crude Oil production of an open (drilled) deposit for production of the well. It also refers to the closing or abandonment operation of a completion in a deposit in order to attempt a new completion in the same or another deposit, from the said well. These operations include, but are not limited to, stimulations (acidifications, fracturing), installation or recovery of a pumping system, repairs or maintenance works, opening of windows, deepening, recompletion or plugging of the well. 3.2.41 - Possible Reserves: Refers to the hydrocarbon volumes which may originate from formations identified as suitable for the accumulation of hydrocarbons, but which have still not been drilled. 3.2.42 - Probable Reserves: Refers to the hydrocarbon volumes which through geological interpretation, geophysics and deposit engineering studies are presumed to exist in areas adjacent to the proven zones of the same deposit, and which may be recovered. 3.2.43 - Developed Proven Reserves: Refers to the volumes of Crude Oil which can be recovered through the available wells with the existing equipment and operating conditions. 3.2.44 - Undeveloped Proven Reserves: Refers to the proven reserves which are expected to be recovered through new wells or by means of the existing wells, which for this purpose must be completed in areas which are currently not in production or have not been drained. 3.2.45 - Total Proven Reserves: Are constituted by the total of the developed proven reserves and the undeveloped proven reserves. 3.2.46 - Emergency Situations: Are those extraordinary circumstances qualified as such by the Ministry of Energy and Mines and which occur or are envisioned as occurring, within or outside the Country, and which lead to the adoption of necessary and immediate actions to avoid detriments that affect or may affect the normal operating conditions envisioned in this Contract or the persons who render services to any of the Parties or the goods owned by these or third parties, and the goods owned by them or by third parties, without prejudice to that set forth in the Hydrocarbons Law and the National Security Law. 3.2.47 - Sucre: Refers to the monetary unit of the Republic of Ecuador. 3.2.48 - Production Rate: Shall have the highest efficiency fixed by the DNH on the base of the characteristics and individual size of the deposits, production characteristics and number of wells and facilities in a way that can be preserved for a given period under principles of balanced relationships between reserves and production. The procedure for fixing the Production Rate is included as Annex 5. Page 10 of 56 3.2.49 - Calendar Quarter: The period of three (3) consecutive months starting on the first of January, the first of April, the first of July and the first of October of each fiscal year, respectively. 3.2.50 - Production Unit: Barrel 3.2.51 - Condensed Gas deposits: Refers to those Gas deposits that, upon being developed, will produce gas and liquids in a ratio not exceeding one hundred thousand standard cubic feet of gas for each Barrel of liquids, according to measurements made on the surface under normal conditions of pressure and temperature. 3.2.52 - Gas deposits: Refers to those deposits of hydrocarbons that, in deposit conditions of pressure and temperature, contain only hydrocarbons in the gaseous state. 3.2.53 - Commercially Viable Crude Oil Deposits: Refers to those deposits of Crude Oil that, in the judgment of the Contractor are commercially viable and are included in the Development Plan or Plans. For the definitions not included in this Contract or within the legal framework composing it, the Parties shall refer to the definitions contained in the law, regulations relating hereto, the Basic Contract Conditions and definitions generally accepted in the international oil industry. FOURTH - PURPOSE: 4.1 - The purpose of this contract is the Production of Crude Oil and the Additional Exploration of Hydrocarbons in Contract Area of the Charapa Field in order to increase current production and integrate new reserves. 4.2 - To meet the purpose of this Contract, the Contractor, under its exclusive responsibility and risk, must carry out the activities and make the investments required with the use of adequate technology. FIFTH - RIGHTS OF THE PARTIES: 5.1 - The hydrocarbon deposits located within Ecuadorian territory represent national resources owned and controlled by the State. Therefore, the Ecuadorian State is the sole and unconditional owner of all hydrocarbon deposits and substances that accompany them, in any physical condition in which they may be found. Page 11 of 56 5.2 - This Contract does not grant the Contractor any right of ownership over the surface, subsurface or over any type of resource, whether natural or not, which may exist in the Contract Area, nor over any areas to be expropriated in favor of PETROECUADOR for the execution of this Contract, nor over its rights of way, nor over the works performed therein. As a consequence, the boundaries of the Contract Area have the sole end or purpose of determining surface space and its projection down to the subsurface in which the Contractor must operate. 5.3 - PETROECUADOR shall have the right to receive from the Contractor the volumes of Crude Oil corresponding to it both from the Base Production Curve and for its percentage share in the Incremental Production. 5.4 - The Contractor shall have the right to its share in the Crude Oil production and to freely dispose of it in conformity with this Contract, with the exception of that set forth in Article 33 of the Hydrocarbons Law; and to receive the recompense for the Cost of the Base Production Curve. The rights of the Contractor arising from this Contract do not include ownership rights over the underground hydrocarbon reserves resulting from the additional exploration and production works. 5.5 - The Contractor has the exclusive right to develop the activities under this Contract within the Contract Area. 5.6 - The Contractor has the right, free of charge, to make use of the infrastructure and assets which PETROECUADOR currently owns in the Contract Area, with the Contractor being responsible for their care, proper use, maintenance, and restoration of the infrastructure and assets in question in such a way that upon the expiration of the Contract, it may restore the field to PETROECUADOR with all of its infrastructure and assets in conditions similar to how they were delivered, except for natural wear and tear due to normal use. 5.7 - In the execution of its activities and works, the Contractor shall have full autonomy for its administration or management. SIXTH - OBLIGATIONS OF THE PARTIES: 6.1 - The Contractor undertakes the following: 6.1.1. - To carry out the technical, administrative and economic operations under its responsibility as well as meeting with all of the obligations arising from the Law, Regulations, Contract Conditions and this Contract, assuming all of the risks inherent in the production and additional exploration operations in the Contract Area. As a result, failures of a technical nature and their consequences, arising from an action of the Contractor or its subcontractors shall be its exclusive responsibility. 6.1.2. - To execute the Minimum Program for Production Activities and Investments committed to for the first three (3) years, in order to increase the Crude Oil production over the Base Production Curve in the Charapa Field 6.1.3 - To execute, during the first three (3) years of effectiveness of this Contract, the Minimum Plan for Additional Exploration and Investments which will enable the realization of new Crude Oil discoveries and the resulting increase of the reserves of the Contract Area. 6.1.4. - In order to increase Crude Oil production, the Contractor shall utilize modern techniques which represent a greater level of technical and economic efficiency in the operation. 6.1.5. - To provide the capital or financial resources necessary for fully complying with the Minimum Program for Production Activities and Investments and with the Minimum Plan for Additional Exploration and Investments in accordance with the annual Programs and Budgets. 6.1.6 - To preserve the environment, during the execution of its activities and works, applying the most advisable techniques used in international oil practices and in compliance of the legal, regulatory and administrative provisions, as well as valid international agreements ratified by Ecuador regarding the prevention and control of environmental pollution and the conservation of icthyological and agropecuary resources. 6.1.7 - To immediately undertake the decontamination efforts in the event of environmental pollution caused during the performance of its activities without detriment to other responsibilities to third parties or authorities having competence. For this purpose, the Contractor shall acquire the respective insurance policies covering the hazards pursuant to environmental protection. In all cases, the Contractor shall take all necessary precautions, since it shall be solely responsible for any impact caused by it on the environment. 6.1.8 - To meet and develop, in a permanent and uninterrupted manner, the activities set forth in the Minimum Program for Production Activities and Investments, in the Minimum Plan for Additional Exploration and Investments, and in the Annual Activity and Investment Budget Programs presented by the Contractor and approved by the MEM, unless these must be suspended or interrupted due to Acts of God, Unavoidable Accident, or Emergency Situations. Page 13 of 56 6.1.9 - When for technical reasons, the Contractor determines it is appropriate to undertake Reconditioning involving the opening of windows for directional or horizontal drilling in the well subject to the said works, it shall be understood that such Reconditioning shall be equivalent to two (2) of those offered by the Contractor. 6.1.10 - When as a result of the execution of Reconditioning or treatment works on the Charapa 1 well, the Contractor affects the formation and consequently loses or lessens the current production of Crude Oil from the well in a considerable amount, the Contractor shall have the obligation, at its cost, to drill a replacement well to the same depth of the affected well. If the volume of reserves to be recovered by the said well does not justify its drilling, the Contractor must agree with PETROECUADOR on another location for the replacement well. 6.1.11 - To keep PETROECUADOR constantly informed by means of its PETROPRODUCCION affiliate and the Oil Contracting Unit of the progress of all activities undertaken during the term of this Contract, for which it must present periodic reports as set forth by the Hydrocarbon Operation Regulations. It must further provide copies or originals, as required of electrical, sonic, radioactive and other profiles, seismic tapes and streamers, well samples, cores, formation samples, maps, sections, topographical, geological, geochemical and drilling reports, geological and geophysical interpretations, evaluation reports on the deposits found in the Contract Area, and in general, any other information of a scientific, technical, economic, environmental or legal nature obtained through its work. 6.1.12 - To provide to authorized functionaries of the Ecuadorian State or from PETROECUADOR, as well as the members of the Armed Forces, responsible for the safety of the oil installations, in accordance with the covenant made for this purpose, the facilities necessary for the performance of their duties and obligations regarding this Contract, including, in field operations, transportation, lodging, food and other services, in conditions equal to those provided by the Contractor to its own personnel, taking into consideration the facilities available for the efficient compliance and execution of said obligations. The costs incurred by the Contractor in providing said facilities shall be posted, as necessary, according to the Accounting Regulations. State or PETROECUADOR functionaries must abide by the Contractor's rules for industrial safety and environmental protection. 6.1.13 - To preserve complete records of all the technical and environmental operations conducted under this Contract. Page 14 of 56 6.1.14 - Respect the rights related to industrial property, holding PETROECUADOR harmless from claims or payments of indemnities resulting from non- compliance or non-observance by the Contractor regarding said obligations. 6.1.15 - Take the necessary measures, in its operations, for preserving the health, conservation and safety of life, property, vegetation, fishing, navigation, disposal of water and effluents, as well as the health and safety of the personnel under its responsibility. 6.1.16 - The Contractor shall deliver to PETROECUADOR, during the first three years of effect of the Contract, by March 31 of each year, the annual contribution that was offered for training. 6.1.17 - To receive students or graduates from technical or higher education institutions related to the hydrocarbon industry, in the number, time and dates agreed with PETROECUADOR, so that they may engage in practicums and studies in the working fields of the Contract Area and at the Contractor's Offices in Ecuador. During performance of the practicums, students shall be covered by the accident policy that the Contractor has for its own employees. The Contractor shall be responsible for the transportation, lodging, feeding, minor medical and emergency services which shall be provided under the same conditions as to the Contractor's personnel in Ecuador. The time for said practicums and study, and the number of persons conducting them, shall be established in such a manner that they do not interfere with the efficient performance of the Contractor's activities. The Contractor shall further provide monthly economic assistance for each student no smaller than two minimum vital salaries. It shall be understood that no dependent relationship whatsoever shall exist between those who carry out said practices and study, neither with the Contractor nor PETROECUADOR. The students or graduates shall prepare the corresponding reports on the said practicums and studies and shall furnish a copy to the Contractor. During their stay in the Contractor's facilities, the students must abide by its industrial safety and environmental protection regulations. 6.1.18 - To take those actions it considers most suitable or pertinent in Emergency Situations, notifying their occurrence to PETROECUADOR within the following three days. 6.1.19 - To protect and hold PETROECUADOR free of any judicial action or claim resulting from the non-observance or non-compliance with any of its obligations arising from this Contract, whether with its workers, subcontractors, suppliers or third parties whether or not related to the Contract. Page 15 of 56 6.1.20 - To pay the taxes, levies and contributions in conformity with the corresponding laws and regulations in effect in Ecuador on the date of the signing of the Contract, with the exceptions established under the laws and regulations. 6.1.21 - To register this Contract in the Hydrocarbons Registry of the DNH within the first thirty (30) days counted from its signing. 6.1.22 - To maintain and conserve, in a good state, the existing access roads in the Contract Area, that the Contractor uses for its operations. Likewise, maintain and conserve in a good state, the roads that the Contractor will construct for this purpose in the future. In the case of the sections of the access roads shared by the Contractor with other users, the maintenance costs required for this shall be shared with the other contractors and organizations that operate in the affected area, during the validity of this Contract. 6.1.23 - To provide, renew and keep in effect the guarantees and contract the insurance provided under the law, in regulations and in this Contract. 6.1.24 - To deliver to PETROECUADOR the volumes of Crude Oil, both of the Base Production Curve and those corresponding to PETROECUADOR in the Incremental Production, in accordance with their percentage share in this Contract . Due to the fact that the current production of the Charapa Field comes from a sole well and as of the date of the signing of the Contract was below the volume projected by PETROECUADOR for the Base Production Curve corresponding to the first year of validity of the Contract, the Contractor shall have a maximum period of thirty (30) days reckoned from the date of the assumption of operations to raise the production volume to the level of the Base Production Curve; until this level is achieved, the Contractor shall deliver the actual production of the Field. 6.1.25 - To present the corresponding Development Plan for the approval of the MEM, upon informing PETROECUADOR, and in case commercially exploitable Crude Oil deposits are found as a result of the additional exploration. 6.1.26 - To comply with the legal and regulatory provisions in effect, and with the contractual stipulations, relating to the Development Plan, the Annual Programs and Budgets and to the Five Year Plan. 6.2 PETROECUADOR undertakes the following: Page 16 of 56 6.2.1 - To pay the stipulated compensation to the Contractor in the manner, terms, amount and other conditions set forth in the Ninth Clause of this Contract. 6.2.2. - To furnish the Contractor for its use, for the purposes of this Contract, the goods, equipment, machinery and facilities according to Annex VI "Inventory, Inventory, Technical Inspection and Asset Valuation." 6.2.3 - To respond in a timely manner to the requests, proposals and requirements of the Contractor and make the corresponding remarks or approvals within the terms and deadlines set forth in this Contract. 6.2.4 - To make available to the Contractor all communications and transportation routes, whether extant or under construction. 6.2.5 - To provide the fuel required and requested by the Contractor for its operations, by means of PETROCOMERCIAL, at national market prices. 6.2.6 - To notify the Contractor, as soon as it is made aware, of any claim or legal proceeding that may affect the Contractor's rights under this Contract in such a way that the latter may adopt the measures it considers most suitable to defend its interests. 6.2.7 - To protect and keep the Contractor free of any judicial action or claim that results from the non-observance or non-fulfillment of any of its obligations arising from activities performed for PETROECUADOR, either with its workers, its subcontractors, suppliers or third parties, whether or not related to the Contract Area, prior to the Effective Date of the present Contract. 6.2.8 To assume the environmental responsibility for damages caused prior to the Effective Date of this Contract and reimburse the Contractor for all the costs that are required for their remedy, as set forth in Clause Eleven 6.2.9 - To request from MEM, at the request of the Contractor, the declaration of public utility in conformity with Article 91 of the Hydrocarbons Law. 6.2.10 - To grant a favorable report for the import of equipment, machinery and tools and other materials necessary for fulfillment of the objective of this Contract, in conformity with Article 87 of the Hydrocarbons Law and other applicable laws. 6.2.11 - To provide to the Contractor the available technical information related to the Contract Area and, without cost other than that established by the Board of PETROPRODUCCION, the available technical information of other areas. 6.3 - The Parties shall have the following obligations in common: Page 17 of 56 6.3.1 - If, as a result of the execution of the Minimum Program for Production Activities and Investments and/or of the Minimum Plan for Additional Exploration and Investments for the Charapa Field, the proven reserves increase significantly and the total production of Crude Oil of the Charapa Marginal Field exceeds three hundred percent (300%) of the production of the Base Curve, the Parties agree that the X3 participation factor of the Contractor shall be equal to fifty point nine percent (50.9%) of the production exceeding three hundred percent (300%). 6.3.2 - To interpret and execute this Contract in good faith. 6.3.3 - To meet with the requirements set forth by the MEM and other state dependencies regarding the performance of this Contract. 6.3.4 - To enter into additional and modifying Contracts, as well as others that suit their interests. 6.3.5 - As incumbent upon them, the Parties shall comply with that set forth in Article 31 of the Hydrocarbons Law in the execution of this Contract. 6.3.6 - If the Parties so agree, upon the making of a written agreement, they may delegate to the other Party the marketing of the volume of Crude Oil belonging to them under this Contract. The said agreement must specify the mutual obligations, among others it shall mention the place of physical delivery of the respective volume share of Crude Oil, sales conditions and payment periods. In addition, the agreement shall establish the corrections for API quality for determination of price and volume compensations, in conformity with Clause 9.6, as well as the adjustment for the fee for transport through the Main Conduit, if applicable. 6.3.7 - All others indicated in the Law, Regulations, Contracting Conditions and this Contract. 6.4 - Responsibilities: 6.4.1 - The Contractor assumes full responsibility before the State and PETROECUADOR regarding the obligations acquired by virtue of this Contract, from its Effective Date. The Contractor assumes similar responsibility regarding the obligations of its subcontractors and of its related companies in activities linked with the performance of this Contract. Likewise, the Ecuadorian State and PETROECUADOR assume full responsibility for their contractual obligations. SEVENTH - TERM: Page 18 of 56 7.1 - This Contract shall have a duration of 20 years, counted from its Effective Date. 7.2 - The production operations of the Contractor must begin and continue without interruption in the Contract Area within the first eight (8) days counted from the Effective Date of this Contract. Nevertheless, in order to guard against interruption of the operations and to increase the production from the assumption of the operations by the Contractor, PETROPRODUCCION and the Contractor shall coordinate the transfer of the operations, extending the term if necessary. The Additional Exploration Activities shall be developed within an non- extendible term of three (3) years counted from the official date of approval of the Environmental Impact Study, which must be prepared by the Contractor within the first six (6) months counted from the Effective Date of the Contract. Nevertheless, the said term shall be extended only in the event that the Contractor is performing the drilling or tests for an exploratory well, until the completion of the said works. EIGHTH - ACT OF GOD OR UNAVOIDABLE ACCIDENT: 8.1 - None of the Parties shall be answerable for noncompliance, suspension or delay in the performance of the obligations set forth in this Contract, nor will it be obligated to indemnify the other Party for any losses caused when the non- compliance, suspension or delay are due to Acts of God or Unavoidable Accident duly corroborated as stipulated in the Eighth Clause herein. In this case, the Party alleging the said situation must notify the other within the maximum period of ten days of the occurrence of the said fact with indication of the estimated time of suspension and shall present the corresponding justifications. The Act of God or Unavoidable Accident, shall extend over the number of days that are justified and shall apply to the rights and obligations affected by such an event. However, the mutual obligations set forth in this Contract shall not be considered extinguished due to the occurrence of the Act of God or Unavoidable Accident, rather only suspended. Once either of the Parties has invoked the Act of God or Unavoidable Accident, it will take effect even though it does not imply tacit acceptance by the other Party, which shall have the right to impugn it using the resources provided in this Contract and pertinent legislation. 8.2 - The burden of proof of the Act of God or Unavoidable Accident shall fall on the party invoking it. 8.3 - Even in the event of Acts of God or Unavoidable Accidents, should there be any production in the Contract Area, the Parties shall have the right to participate in it as per Page 19 of 56 the Ninth Clause of this Contract, except in the case envisioned in Article 180 and numeral 2 of Article 181 of the Political Constitution of the Republic of Ecuador. 8.4 - The occurrence of Acts of God or Unavoidable Accidents may give rise to the revision of the work schedule proposed by the Contractor, without detriment to restarting the compliance of its obligations as soon as possible after the impediment has been removed. The obligations not affected by the Act of God or Unavoidable Accident shall be met in a timely manner, as per the specifications of this Contract. In the event that due to lack of transport capacity in the Main Conduits, the Contractor cannot transport more than 50% of the volume of the Crude Oil corresponding to his Participation, calculated in relation to the Production Rate of the Field, the suspension of the delay in the execution of the Minimum Program for Production Activities and Investments shall not be considered as non-fulfillment of the contract. Once the problem of lack of transport capacity has been resolved, the Contractor shall have the right to recover the loss sustained due to this reduction. The Parties shall agree on the most adequate manner for the Contractor to recover such loss. 8.5 - In circumstances of the Act of God or Unavoidable Accident, the Contractor shall inform the MEM as to the event, within a maximum period of ten days and shall take the corresponding actions for renewing the activities as soon as possible. 8.6 - If Act of God, Unavoidable Accident or other Emergency Situations arise, which in the Contractor's opinion require immediate attention, the Contractor shall take all actions and shall make all the expenditures it deems necessary or advisable to safeguard its interests and those of PETROECUADOR, as well as those of their respective workers, although said expenditures have not been included in the Annual Schedule and Budget in effect for the corresponding fiscal year. The actions undertaken must be notified to PETROECUADOR and the MEM within the term of ten (10) days following the taking of the action. 8.7 - The duration of the suspension of activities due to Acts of God or Unavoidable Accident shall not be imputed to the term of the production period or the additional exploration period, as applicable. As a consequence of this, the expiration dates for both periods shall be postponed in a time span equal to the duration of the Acts of God or Unavoidable Accident. If the Contractor has been producing in the production period, the extension of said period shall be applicable only when the Act of God or Unavoidable Accident diminishes the production or evacuation of Crude Oil by more than fifty per cent (50%) with regard to the daily average of the thirty (30) days prior to the occurrence of the Act of God or Unavoidable Accident, in which case the Contractor shall maintain its right to the corresponding share in the Crude Oil that it was unable to produce or evacuate during the Act of God or Unavoidable Accident. Page 20 of 56 When the reduction of production or evacuation of Crude Oil does not exceed fifty percent (50%) with respect to the daily average over the thirty (30) days prior to the occurrence of Act of God or Unavoidable Accident, the Parties may recover the loss sustained for the reduction, by increasing production. NINTH--INCOME FROM THE CONTRACTOR 9.1 The percentages of participation offered by the Contractor (Annex VII) were the following: X1=52.9% X2=51.9% X3=50.9% (to be negotiated in the range of +/- 1%) As a result of the negotiation, the details of which are recorded in the Summary Minutes thereof appearing as Annex VIII, it was agreed to keep X3 at 50.9%; and to reduce the share of the Contractor for X2, by one percentage point, to 50.9%. Consequently, only two shares shall apply for this Contract: X1= 52.9%; and X2=X3=50.9% 9.2 The Contractor, for the execution of this Contract, shall receive: The Base Cost Curve in United States of America Dollars in conformity with Clause 3.2.11: and, The volume of Crude Oil corresponding to its share in the Incremental Production over the Base Curve, in accordance with the percentages X1 and X2 stipulated in Clause 9.1. Consequently, for the present Contract only two shares shall apply: X1 for an initial increase (delta)Q1 of up to 310 barrels per day and X2 (equal to X3) for any increase in production achieved by the Contractor above (delta)Q1. 9.3 The following formulas shall be applied to determine the amounts that the Contractor must receive according to Clauses 9.1 and 9.2. 9.3.1 Income by Base Curve Cost: ICBt = CB (Ipt / Ipt-1) QBt (1) where Page 21 of 56 ICBt = Income by Base Curve Cost (US$) CB = Base Curve Cost (US$/ bbl) Ip t = Consumer price index of the United States of America published by the Bureau of Labor Statistics, Producer Price Index - Commodities series ID: wpssop3510 Seasonally Adjusted, Item: Finished energy goods, for the year 1 Ipt-1 = Consumer price index of the United States of America published by the Bureau of Labor Statistics, ....... Price Index - Commodities series ......... Seasonally Adjusted, corresponding to the preceding year and during the contract period. QBt = Value in Barrels, of the volume of production of the Base Curve for a period t; specified in Annex II of this Contract. 9.3.2 Share of the Contractor in the Incremental Production.- The determination of the Volume of Crude Oil in the Incremental Production over the Base Curve, is given by the following expression: PCt = Xt (delta) QTt - QBt) (2) where PCt = Participation of the Contractor, in volume of the Incremental Production (bbls); Xt = Participation of the Contractor in the Inspected Incremental Production (delta)QTt -QBt) in decimal fraction, corresponding to the period t; QTt = Value in Barrels of the total Inspected production volume of the Contract Area, corresponding to the period t; QBt = Value in Barrels of the production volume in accordance with the Base Curve, corresponding to the period t; The participation of the Contractor, Xt is given by the following expression: X t = X 1* (delta)Q1t + X3 * (delta)Q3\\t\\ (3) ---------------------------------------- QTt - QBt Page 22 of 56 where: (delta)Q1t corresponds to a first increase of production given by the expression: (delta)Q1t = QTt - QBt where QTt * (QBt + 310) (delta)Q1t = 310 where QT t ** (QB t + 310) (delta)Q3t = (delta)Q2t corresponds to any additional increase in production over Q1t given by the expression: (delta)Q3t = (delta)Q2 t = 0 where QT t * (QBt + 310) (delta)Q3t = (delta)Q2 t = QTt - QBt - (delta)Q1t where QT t > (QB t + 310) Consequently the total production, for any period t, is given by the expression: QTt = QB t + (delta)Q1 t + (delta)Q3 t (4) Consequently, the share values for the Contractor will be: X1= 52.9% for the first production increase (delta)Q1, of up to 310 bppd average during the period t and; X2= X3 = 50.9% for any additional increase over (delta)Q1 9.4 Application Example The example presented here following will serve to illustrate the correct form of application of the formulas established in the preceding Clauses 9.1, 9.2 and 9.3. Considering the first year of the contract, when the value of the Base Curve is QB=210 BPD and supposing that Base Curve CB (Ip\\t\\Ip\\t\\-/1/) = US$1.80/ barrel, and one period t = 90 days in which the total inspected production of the Contract Area reaches 75,600 barrels, the following values are obtained for the Contractor's share: . Base Curve Value ............. QB = 210 BPD . Total Production Value ....... QB = 840 BPD (QT=75,600/90) . (delta)Q1 = 310 BPD and (delta)Q2 = (delta)Q3 = QT- QB- (delta)Q1 = 840 - 210 - 310 = 320 BPD * Greater than ** Less than Page 23 of 56 hence meeting the condition that QT ** (QB + 310) Consequently, during the period t = 90 days: . Income of the Contractor by Base Curve Cost ICB\\t\\ = CB (Ip\\t\\/Ip\\t\\-1) QB\\t\\ = $1.80 x 210 = US$ 387/day or US$ 34,020 in 90 days . Share of the Contractor in the Incremental Production over the Base Curve, and inasmuch as X1 = 52.9%, and X3 = X2 = 50.9%, it is: X\\t\\ = (X1*(delta)Q1 + X3*(delta)Q3) / (QT-QB) = (0.529*310 + 0.509*320) / (840 - 210 ) = 0.5188 PC\\t\\ = X\\t\\ (QT\\t\\ - QB\\t\\ ) = 0.5188 (840 - 210) = 327 BPD or that which is equivalent, during the period t = 90 days, at a total oil volume to be received by the Contractor of: 327 x 90 = 29,430 barrels The volume of PETROECUADOR is: 75,600 - 29,430 = 46,170 barrels, that include the production corresponding to the Base Curve and its share in the Incremental Production. 9.5 Based on that established in the Clauses 9.2 and 9.3, the determination of the income of the Contractor in any time period, t, is given by the following formula: I t = ICBt + PC t * PVt (5) where It = Total income of the Contractor in any period t, in US Dollars PVt = Sales price in US$/ bbl. It is clarified that for tax purposes, the Contractor may in no case declare a PVt value less than the Reference Price. When the sale is done in a location other than Balao, the corresponding transport rate must be discounted from the Reference Price. 9.6 DETERMINATION OF THE REFERENCE PRICE OF THE CRUDE OIL OF THE CONTRACT AREA ** Greater than Page 24 of 56 The parties shall adjust the price of the Crude Oil coming from the Contract Area, for its quality (degrees API), in relation to the Average Sales Price, applying the following formula: Pi\\t\\ = PM (1 + KDC/ 100) (6) where: Pi\\t\\ = Price adjusted for quality in a certain period t, in dollars per Barrel PM = Average Sales Price of PETROECUADOR in dollars per Barrel. DC = Difference between the quality of Crude Oil originating from the Contract Area (CC) and the average quality corresponding to the crude exported by PETROECUADOR (CM). Measured in degrees API. DC = CC - CM K = Correction coefficient for the quality (degrees API) K = 1.1, if 25(degrees) API * CC * 35 (degrees) API K = 1.3, if 15(degrees) API * CC *** 25 (degrees) API K = 1.1 and DC = 10 if CC ** 35 (degrees) API CC = Quality of the crude oil produced in the Contract Area. CM = Average quality of the Crude Oil exported by PETROECUADOR. The coefficient K may be revised by agreement of the Parities, if after an unbroken period of at least twelve (12) months it does not reflect market realities. In the event that disagreements arise over this point, such disagreements shall be submitted for resolution by a consultant, who must render a verdict within the term granted for such. 9.7 PAYMENT PROCEDURE FOR THE BASE CURVE COST The Base Curve Cost shall be paid provisionally by PETROECUADOR to the Contractor on a quarterly basis and settled annually. The said payments shall be made in dollars or, if agreeable to the Parties, in kind upon equivalency in dollars in the manner stipulated in Clause 9.6; nevertheless, if the payments are not made in dollars within the period of forty-five (45) days subsequent to the end of each quarter, the Contractor shall receive the Page 25 of 56 amount of the Base Curve Cost, in Crude Oil, coming from the share corresponding to PETROECUADOR in this Contract. 9.8 SETTLEMENT OF SHARES The settlement of the share in the Incremental Production of Crude Oil of the Parties, in the Contract Area shall be done quarterly in a provisional manner and annually in a definitive manner. 9.9 - CONTRACTOR TAX BASE: The contractor's tax base for any period "t" is provided by the following expression: BIt = It - COSTSt (7) where: It = Contractor's earnings during the period (t) given by expression. COSTSt = Costs incurred by the Contractor during period t. 9.10 - TAXES AND LABOR SHARE The labor share for the Contractor's employees is given by the following expression: PLABt = 0.15 BLt (8) And the taxes paid by the Contractor are given by: TAXt = 0.25 (Blt - PLABt) (9) 9.11 - CONTRACTOR'S NET PROFIT The contractor's net profits for the year (t) are given by the following expression: UNt = Blt - PLABt - TAXt (10) 9.12 - GENERAL DISPOSITIONS OF THE ECONOMIC MODEL: Page 26 of 56 9.12.1 - The Contractor may freely dispose of its share in the Crude Oil, except for that set forth in Article 33 of the Hydrocarbons Law. 9.12.2 - In application of what has been stated in Article 33 of the Hydrocarbons Law, the Ministry of Energy and Mines may require the contractors to supply a part of their crude oil for the supply of the internal market and national petrochemical plants. In this event, the crude oil shall be valued at the Reference Price adjusted for quality and transportation. 9.12.3 - Without prejudice to that stipulated in Clause 6.1.24, the volume of Crude Oil received by the State shall under no circumstances be lower than that being received while the field was under PETROPRODUCCION operation; consequently volume less than the Base Production Curve cannot be received. 9.12.4 - The investments made by the Contractor in the execution of its activities in compliance with the Minimum Exploitation and Investment Program and the Additional Exploration and Investment Plan shall be made for its own account and risk. In the event that the production is not increased or that no commercially viable deposits are found, PETROECUADOR shall not pay anything to the Contractors for these reasons. 9.12.5 - The Contractor have the right to maintain, control and operate bank accounts in any currency, both within the country and outside its borders, as well as make free use of the funds in said accounts. 9.12.6 - If PETROECUADOR makes no external oil sales during the respective period, the Reference Price shall be established based on a basket of crude oils, as agreed by the Parties, whose prices shall be obtained from specialized, prestigious publications. TENTH - TAX SYSTEM, LABOR SHARE AND CONTRIBUTIONS 10.1 - For tax purposes, labor share and contributions, the Contractor shall be governed by that established in the Internal Tax System Law, the Law Reordering Economic Matters in the Tax - Financial Area, the Law for the Reform of Public Finances, the Labor Code, the Hydrocarbons Law, the Municipal System Law, the Company Law and other applicable laws and regulations. 10.2 - The Contractor's total income - shall represent Base Curve Cost paid by PETROECUADOR, plus the Contractor's share in the Incremental Production computed at the sale price, however, for tax purposes this cannot be less than the Reference Price adjusted in conformity with Clause 9.6 as applicable. 10.3 - Calculation method: The tax base, labor share and income taxes shall be obtained as follows, subject to the Laws in effect relating thereto: Page 27 of 56 10.3.1 - For the Contractor's Gross Income, it shall make the deductions envisioned in the applicable laws, mentioned in Clause 10.1. Among others, the deductions mentioned in Title I of the Internal Tax Law and in the Cost Accounting Regulations applicable to Contracts for Marginal Fields (Annex IX). 10.3.2 - The fifteen percent (15%) which constitutes the labor share shall be applied on the result indicated in Clause 10.3.1, and the balance shall represent the tax base. 10.3.3 - Finally, the twenty-five percent (25%) corresponding to income tax shall be imposed on this final value, indicated in Clause 10.3.2, which is the tax base, the payment of which shall be done as set forth in the Law Reordering Economic Affairs in the Tax-Financial Area and the Law for Reform of Public Finances. 10.4 - Contribution for the Use of Water and Construction Materials: The Contractor shall pay, according to Article 52 of the Hydrocarbons Law, for preferential use of water and construction materials found in the Contract Area and belonging to the State, the amount of sixty thousand Dollars (US$ 60,000) a year during the production period. Said contributions shall be paid in advance during the month of January, each Fiscal Year, by means of a deposit in the Banco Central del Ecuador to be credited to the account of PETROECUADOR. The deposits shall be made in Sucres at the exchange rate applicable at the time of the transaction. In case the Contractor must pay additional values to third parties for the use of materials or water, it may deduct these values from the established contribution. 10.5 - Contribution to the Superintendency of Companies: The Contractor shall pay the annual contribution of up to one per thousand (1/1,000) on the total assets provided in Article 455 of the Corporate Law in conformity with the standards dictated by the Superintendent of Companies. 10.6 - Tax on Total Assets: The Contractor shall pay the tax of one point five per thousand (1.5/ 1,000) on the total assets, intended for the municipalities as set forth in Chapter III of Law No. 006 of the Tax and Financial Control. 10.7 - Proportional Payment: If the first or last payment year for the contributions determined in this Tenth Clause do not correspond to an entire Fiscal Year, these shall be paid in proportion to the number of months corresponding to said Fiscal Year. When the exploration period or the production period do not begin on January one, the first payments shall be made within thirty (30) days from the start of the respective period. When the Contractor does not pay the given contributions in this Tenth Clause on the given dates, the corresponding legal interest will be charged. Page 28 of 56 10.8 - Fund for Amazon Regional Eco-development and for Strengthening its Sectional Organizations: The Contractor shall pay on its share in the Crude Oil produced in the Contract Area, the tax established under Law No. 10, published in the Official Register No. 39 of September 21, 1992, and its amendment incorporated into Law No. 20, published in the Official Register No. 152 of September 15, 1997. 10.9 - The Law Creating Substitute Income for the Napo, Esmeraldas and Sucumbios Provinces: The Contractor shall pay on its share in the Crude Oil that is transported by the Trans-ecuadorian Oil Pipeline the tax stipulated under Law No. 40, published in the Supplement of the Official Register No. 248 of August 7, 1989. 10.10 - Exemptions: As per reformed Article 54 of the Hydrocarbons Law, the Contractor shall be exempt from paying exploration fees, surface rights, royalties and compensatory project contributions, as well as contributions for technological research. It will also have a right to other exemptions contemplated in other pertinent legal bodies, applicable under this Contract. 10.11 - Modifications of the Tax Code: In the event of any modification to the tax code, in effect on the date of the signing of this Contract, including the creation of new taxes or labor shares, or the interpretation of said code having economic consequences on this Contract, a factor corresponding to the percentages of participation that absorbs the increase or reduction of the tax burden or of the labor share mentioned earlier shall be included. This correction factor shall be calculated between the Parties and approved by the MEM. 10.12 - Notary Fees: The Contractor shall be responsible for paying the notary fees and expenses incurred by the formalization of this Contract and of the ten (10) certified copies of the instrument which it shall furnish to PETROECUADOR. ELEVEN - ENVIRONMENT 11.1 - The Contractor must make in a manner parallel to the execution of the production operations in the Charapa Field, but prior to starting the additional exploration activities: a) Within the first three months from the Effective Date of the Contact, an Environmental Audit of the Charapa Field and; b) Within the first six (6) months from the Effective Date of the Contract, an Environmental Impact study (EIA), in accordance with the Reference Terms established in the Environmental Regulations for Hydrocarbon Activities in Ecuador, issued under Executive Decree No. 2982, published in the Official Register No. 766 of August 24, 1995. 11.1.1 - Environmental Audit Page 29 of 56 The Contractor undertakes to perform, at its cost, and in a period of no more the ninety (90) days reckoned from the Effective Date of this Contract an Environmental Audit of the Charapa Field, which shall be supervised by PETROECUADOR and must be approved by the Subsecretary for Environmental Protection. This Audit shall contain an Inventory and Diagnostic (Baseline) to determine the environmental situation and pollution level existing as of the date in which the Contractor assumes the operations in the Charapa Field This Audit shall include the description of the existing natural resources, particularly forests, flora and wildlife, geographic, social, economic and cultural aspects of the populations or communities existing within the area of influence of the Charapa Field, as well as the recommendations for necessary environmental remedies that must be executed by the Contractor at the cost of PETROECUADOR and paid against the presentation of the corresponding invoices. The payment to the Contractor may be done in Crude Oil, at its equivalent value in dollars, to be charged to the share of PETROECUADOR in the production of the Charapa Field. As a requirement for starting the remedial works, the Contractor shall present the corresponding budget that must be approved by PETROECUADOR within a maximum period of fifteen (15) days; once this period has expired, the silence of PETROECUADOR shall be understood as acceptance of the Budget presented by the Contractor, which may then proceed with the execution of the corresponding works. During the execution of the remedial works the Environmental Production Unit of PETROECUADOR shall perform the corresponding follow-up. 11.1.2 - Environmental Impact Study (EIA) This study constitutes a prior requirement to the Additional Exploration operations in the Contract Area, shall be performed in conformity with the reference terms approved by the MEM and the INEFAN and, among others shall contain: - A description and technical evaluation of the direct and indirect effects which are liable to be caused in the physical, biotic and social environment, over the short and long term, for the operations that are scheduled to be developed in the Contract Area. - A detailed environmental management plan whose performance avoids exceeding the maximum tolerable levels and reduces to an acceptable level the foreseeable negative effects indicated in the previous paragraph. This plan shall include contingency and emergency programs, and, Page 30 of 56 - An abandonment plan for the Contract Area. 11.2 - Once the Contractor has presented the Audit as well as the EIA, the MEM must approve or reject them within a term of sixty (60) days. If no pronouncements are made, the Study is understood to have been approved. 11.3 - Said studies referred to in Clause 11.2 shall serve as the basis for future Socio-environmental audits to be conducted twice a year by the Undersecretary of the Environment of the MEM in order to insure that the Contractor's operations are conducted without affecting human settlements and the environment. 11.4 - The Contractor shall conduct at its own expense any environmental mitigation work related to its intervention in the Contract Area, within the terms and other conditions set forth in the reports of the Socio-environmental Audits performed by the Undersecretary of Environmental Protection. 11.5 - Two (2) years prior to the expiration of the Contract for the reason stipulated in letter b) of Clause 27.1, the parties must contract an Integral Environmental Audit of the Contract Area, which must be completed prior to the six (6) months immediately before the expiration of the Contract. The execution costs of this last audit shall be paid by the Parties in equal proportions. 11.6 - The companies conducting the audits and EIA referred to in this Clause Eleven must be previously qualified by the MEM. 11.7 - The Contractor shall not be responsible for environmental damage existing prior to the Effective Date of this Contract, which if present shall be the exclusive responsibility of PETROECUADOR. TWELFTH - PLANS, PROGRAMS AND BUDGETS: 12.1 - The activities, both of the Minimum Exploration and Investment Activities Schedule and of the Minimum Plan for Additional Exploration Activities and Investments, which must compulsorily be met by the Contractor and that correspond to the firm bid, shall be included as Annexes III and IV of this Contract, it being understood that the corresponding investments are estimates. 12.2 - During the first Effective Year of the Contract, or fraction of the year, the Annual Activities and Budget Schedule shall be approved by MEM within the term of thirty (30) days reckoned from the Effective Date of the Contract. If the validity of the Contract commences after October 31, the annual budget shall be added to the immediately following Fiscal year. Page 31 of 56 12.3 - For the Fiscal Years subsequent to the year of the signing of this Contract, the Contractor shall present, by October 31st of each year and during the term of this Contract, for the knowledge of PETROECUADOR and approval of the MEM, the Annual Activities and Budget Schedule that it intends to make for the following year within the Contract Area, setting forth the activities to be carried out, the estimated costs, the possible production and the Crude Oil reserves it hopes to obtain. The MEM shall approve or observe the Annual Activities and Budget Program submitted within thirty (30) days of its presentation. Remarks, should there be any, shall be communicated to the Contractor, which shall present the document anew within the following thirty (30) days after having received notification from the MEM. If the Ministry of Mines and Energy does not make any pronouncements during the thirty (30) days following the Contractor's presentation of the Annual Activities and Budget Program, it shall be understood to have been approved. 12.4 - Furthermore, the Contractor shall present annually, for the approval of the MEM, the updated five-year program of the activities to be undertaken, including the investment programs and budgets. 12.5 - The Development Plans resulting from the Additional Exploration works shall include the following aspects, among others: a) Estimates of recoverable Crude Oil reserves and the recovery factor; b) Results of initial production tests conducted in the drilled well or wells; c) Number and description of the development wells to be drilled; d) Prediction of production and behavior of the wells of the field; e) Necessary production facilities and additional infrastructure work; f) Estimated production investments; g) Costs of production, transport and sales; h) Programs and investments for protection and preservation of the environment; i) Activity schedule; and, j) Other activities discussed, agreed and approved by the Parties. Page 32 of 56 12.6 - With prior approval from the MEM, the Contractor may reform the yearly programs and budgets that have previously been approved, provided these reforms do not reduce the total activities committed to in Annexes III and IV of this Contract. THIRTEENTH -- PRODUCTION RATE: 13.1 - Before the starting date of production for a new deposit, the Contractor shall propose to the MEM for its approval, the production rate based on conventional studies or deposit simulation studies in agreement with what has been stipulated in Executive Decree No. 543, published in the Official Register No. 135 of March 1, 1985, and with the "Technical Criteria for the Calculation of Production Rates" set forth by the National Hydrocarbons Office, and the Hydrocarbon Operations Regulations. 13.2 - The Ministry of Energy and Mines shall proceed to fix the Production Rate. Until the Ministry of Energy and Mines determines this Rate, the Contractor shall provisionally apply the rate proposed by it as established in Clause 13.1. 13.3 - At any time, the Contractor may propose to the Minister of Energy and Mines a review of the Production Rate according to the procedure established in Clause 13.1. 13.4 - If the ministry of Energy and Mines should impose, for any reason whatsoever, a restriction on Ecuador's total production rate, said restriction would be proportionally applied to the production rate of all the producers of crude oil in Ecuador. 13.5 - The volume of Crude Oil production affected by the reduction of the Production Rate in conformity with the preceding Clause 13.4 shall be recovered by the Contractor in a period equal to the time during which the restriction persisted. 13.6 - The Contractor may request from the National Hydrocarbons Office an extended period for well production tests, so as to establish the technical parameters that substantiate its request for the fixing of the Production Rate. 13.7 - The volume of Crude Oil coming from any type of well production test that can be Inspected, shall be distributed among the parties in conformity with the Ninth Clause of this Contract. 13.8 - In the event of any disagreements concerning the fixing of the Production Rate, the Contractor may request that the DNH select an independent technical expert to issue a technical opinion with respect to the disagreement. The expert's report shall provide a reference for the Minister of Energy and Mines to ratify or rectify the opinion of the DNH. The costs of the expert appraisal shall be covered by the Contractor. Page 33 of 56 FOURTEENTH -- UNIFIED PRODUCTION: 14.1 - If during the performance of this Contract deposits common to two (2) or more areas of the Contract should appear, the Contractor shall be under obligation, by virtue of what has been set forth in Articles 85 of the Hydrocarbons Law and 58 of the Hydrocarbon Operations Regulations, to enter into unified production operating contracts in order to achieve greater efficiency and economy in the operation. 14.2 - Should no agreement be reached in the designation of the operator of the shared deposit, the MEM shall be responsible of making a provisional ruling in regard to the operator of the unified field. 14.3 - The Parties agree that for the appointment of the operator they shall request that the MEM take the following into consideration: a) Who made the discovery; b) The location of a significant part of the recoverable reserves of the commercial deposit in common within the Contract Area, and; c) Whoever shows the greatest efficiency and economy in the operation. 14.4 - All agreements for the unified development of shared deposits agreed between the Parties shall be approved by the MEM. FIFTEENTH -- INSPECTION AND DELIVERY CENTER 15.1 - The Inspection and Delivery Center is that which is defined in Clause 3.2.6. 15.2 - The costs and expenses as well as the losses produced as a consequence of transportation from the center of collection of the production of the Contract Area to the Inspection and Delivery Center shall be assumed by the Contractor. 15.3 - The delivery, reception and payment of the volumes of Crude Oil originating from the Contract Area shall be done according to the procedures set forth by the DNH. 15.4 - The Parties shall fix the location for the physical delivery of the volumes of Crude Oil corresponding to each one of them, commensurate with operating convenience, SIXTEENTH - TRANSPORTATION Page 34 of 56 16.1 - If necessary, the Contractor may employ the existing storage and transportation facilities belonging to PETROPRODUCCION from the Contract Area to the Inspection and Delivery Centers once it has effected the treatment and separation of the Crude Oil. 16.2 - PETROECUADOR shall provide, subject to payment of the corresponding rates, the storage and transportation facilities it has available from the Inspection and Delivery Center to the initial station of a Main Duct or its interconnection to the same. For operation and cost reasons, the parties may agree that the Charapa Station - North Lago Agrio Station transfer line be operated by the Contractor. In this case, the responsibility for the maintenance shall be under the responsibility of the Contractor and there shall be no need for the payment of any transport rate between the Parties. 16.3 - If required, the Contractor shall build, at its own cost, the separation, treatment and storage facilities for Crude Oil, and if the production conditions so require it, the construction of transportation conduits and Inspection and Delivery Centers. 16.4 - Without prejudice to that set forth in Article 64 of the Hydrocarbons Law, PETROECUADOR shall assure to the Contractor the same rights possessed by other producers for the evacuation of their Crude Oil. Therefore, the evacuation volume shall be in proportion to the Production Rate fixed for the Contractor with respect to the total for the Production Rates fixed for the other producers who use the Main Pipelines. 16.5 - The transportation rate for Main and Secondary Oil Pipelines belonging to PETROECUADOR shall be determined by the MEM. 16.6 - The transportation rate for Main or Secondary Oil Pipelines not owned by PETROECUADOR shall be agreed to between the Contractor and the operator of the transportation system in question. Should there not be an agreement, it shall be fixed by the MEM. SEVENTEENTH - GUARANTEES 17.1 - The Contractor shall provide PETROECUADOR with the bank guarantee for fulfillment of the investments, the guarantee of the Parent Company, and the guarantee for the Proper use of the Goods and Equipment, as established in this clause. Subsequently, the Contractor shall provide the corresponding guarantees in conformity with the Hydrocarbons Law and other applicable legal norms. 17.2 - INVESTMENT COMPLIANCE GUARANTEE. In order to guarantee the fulfillment of the activities and works that it is obligated to perform during the first three (3) years in the Contract Area, in conformity with the Minimum Program for Production Activities and Investments and the Minimum Plan for Additional Exploration and Page 35 of 56 Investments, the Contractor shall provide an irrevocable and unconditional guarantee for immediate collection and payment, written according to the guideline approved by the CEL, in U.S. Dollars, for 20% of the total estimated value as appears in Annexes III and IV, which shall be for the sum of TWO MILLION THREE HUNDRED FORTY THOUSAND DOLLARS (US$ 2,340,000.00), a certified copy of which appears as Annex X of this Contract. If the bank guarantee is granted by a bank that is not domiciled in the country, it must have the backing of a bank legitimately authorized to operate in Ecuador. This guarantee shall be reduced by April 1 every year in direct proportion of the fulfillment of the activities of the Minimum Program for Production Activities and Investments and of the Minimum Plan for Additional Exploration and Investments. 17.3 - JOINT AND SEVERAL GUARANTEE. As set forth in the Regulation on the Special Tendering System for the Contracts for Production and Additional Exploration of Marginal Fields, the joint and several guarantee of the Parent Company of the companies signing this Contract shall be attached as Annex XI. 17.4 - GUARANTEE FOR PROPER USE OF THE GOODS AND EQUIPMENT The Contractor shall provide in favor of PETROECUADOR and its Affiliated Company PETROPRODUCCION the guarantee indicated in Annex XII of this Contract, which shall assure the proper use of the goods, equipment machinery, installations, infrastructure and other assets according to the inventory appearing in Annex VI. EIGHTEENTH -- INSURANCE 18.1 - For its own benefit and for safeguarding of PETROECUADOR, for the protection of its personnel, machinery, equipment and other assets under its administration in the Contract Area, the Contractor shall contract the necessary insurance policies, having the limits, deductibles, modalities and other conditions required by the law and by this Contract. The terms of these policies must be accepted by PETROECUADOR. 18.2 - The Contractor shall likewise be obligated to contract and maintain insurance policies covering civil liability for personal or material damage caused directly or indirectly to third parties, including functionaries and State employees and those of PETROECUADOR as a result of its obligations in the Contract Area, as well as to hold PETROECUADOR harmless against any recovery, claim or lawsuit that could be brought against it as a claim for damages and losses by the Contractor or its subcontractors during the execution of this Contract. Page 36 of 56 18.3 - The indemnifications paid under insurance policies contracted under this Contract, shall serve to immediately repair or to replace the goods, installations, equipment and other damaged, destroyed or subtracted assets. If there is insufficient insurance, the Contractor shall cover the difference. 18.4 - If the insurer fails to pay any claim for loss and damages to goods, installations, equipment and other insured assets, alleging that such damages were caused or committed deliberately or by inexcusable faults or omissions by the executive or supervisory personnel of the Contractor, the cost for repair or replacement shall be for the account of the latter. 18.5 - In the insurance policies that it contracts, the Contractor shall include coverage for material responsibilities caused by deliberately committed acts, omissions or inexcusable faults, by the personnel, executive or not, or supervisory personnel of the Contractor. 18.6 - The Contractor shall require its insurers to include in all the policies an express clause by virtue of which they waive their right of subrogation against PETROECUADOR. 18.7 - All the insurance policies necessary for the complete execution of this Contract must be subject to the provisions of Ecuadorian law and, in addition, be based on the practices generally accepted by the international petroleum industry. 18.8 - It shall be the exclusive responsibility of the Contractor to require of all its subcontractors or suppliers of goods and services that they must contract the insurance policies that the Contractor considers necessary to comply with their respective obligations arising from this Contract. 18.9 - To cover the goods located in the country, the Contractor shall take out the insurance policies in the Ecuadorian insurance market, with the exception of those risks for which there is no coverage in the country, in which case they are to be contracted overseas. 18.10 - The Contractor shall deliver to PETROECUADOR authentic copies of the insurance policies contracted in Ecuador; and in the case of policies contracted overseas it shall deliver to the entire satisfaction of PETROECUADOR, coverage notes or certificates for each and every one of these contracted policies, duly granted and signed by the respective insurance companies. 18.11 - In the case where for reasons imputable to the Contractor or its subcontractors, the necessary insurance policies were not contracted in a timely manner; or the Contractor has not made the payment of the premiums corresponding to such policies, the damages, and losses that occur, as well as the risks, shall be the exclusive responsibility of the Page 37 of 56 Contractor who must cover them immediately, and shall not be permitted to allege the right to claim any type of reimbursement from PETROECUADOR. 18.12 - The Contractor shall require from the national and foreign insurers who grant the respective insurance policies, sufficient accreditation to the satisfaction of PETROECUADOR so that these are sufficiently backed with the corresponding reinsurances. 18.13 - The Contractor shall maintain the contracted insurance policies in effect, at the annually updated values. 18.14 - Under the terms contained in the preceding clauses, the Contractor shall contract insurance policies that cover, at least the following risks: - Breakage of the machinery - Civil responsibility - Fire and annexed lines - Robbery - All Contractor risk - All risk of construction and mounting, including the drilling, completion and reconditioning of the wells; electronic equipment; and, transport. - Blowout, fire and well blowout and fire, covering the normal and extraordinary costs of: - Control of fire and/or blowout - Redrilling - Recompletion - Well reconditioning - Cleaning and removal of debris - Decontamination of the affected area 18.15 - The Contractor shall also acquire to the satisfaction of PETROECUADOR, the insurance policies needed to cover the hazards of environmental pollution and impact on ecosystems. These policies shall be valid from the start of the operations of the Contractor until the termination of the Contract. 18.16 - The Contractor may additionally have, at its own discretion, other insurance policies that it considers suitable for the performance of its activities. NINETEENTH: ACCOUNTING 19.1 - The Contractor shall keep accounting records of its investments, costs and expenses related or originating from its activities under this Contract, and shall be subject to the hierarchy and order of the following laws, regulations and procedures. Page 38 of 56 . Laws governing the Internal Tax Code and Economic Reorganization, in the Tax- Finance Area; and Rationalization of Public Finances; . General Regulations Applicable under Laws governing the Internal Tax Code in the Tax-Finance Area; . Cost Accounting Regulations, as applicable to this type of Contract, issued by Decree Number 1322, published in the Official Register No. 299, of April 17, 1998; . The present Contract; and . Accounting principles generally accepted in the international petroleum industry. 19.2 - The accounting records to be kept by the Contractor shall be in Spanish and bimonetary; accounting ledgers shall use the Sucre and the Dollar, as appropriate. TWENTIETH: SUPERVISION AND CONTROL 20.1 - During the term of this Contract and in order to insure faithful compliance with the obligations, PETROECUADOR shall have the right to inspect the activities of the Contractor as well as those of its subcontractors, for which it shall have access to the technical information generated. 20.2 - Without detriment to the terms set forth in Article 56 of the revised Hydrocarbons Law, the audits for each Fiscal Year shall be initiated no later than three (3) months following the termination of the Fiscal Year to be audited. For the purpose of these audits, the Contractor shall place at the disposal of the MEM all documentation related to this Contract. These Audits shall be conducted by the DNH in accordance with the terms established in Article 11 of the Hydrocarbons Law. 20.3 - The MEM, through the Undersecretary of the Environment, shall carry out the socio-environmental control of operations for which the Contractor is responsible under the terms of this Contract. 20.4 - The DNH shall carry out the technical-economic control of the operations for which the Contractor is responsible. TWENTY-FIRST: SUBCONTRACTS 21.1 - Without affecting the terms established in Articles 50 and 51 of the Law of National Security, the Contractor may chose its own subcontractors and may negotiate and subcontract, at its own risk and responsibility, any works or services necessary to carry out this Contract. Page 39 of 56 21.2 - The Contractor shall choose subcontractors from suitable companies and shall give preference to Ecuadorian firms in order to stimulate the provision of services by domestic companies, providing that these domestic companies offer quality goods and services at internationally competitive prices and availability. 21.3 - The Contractor may not employ the services of subcontractors to which PETROECUADOR has objected. 21.4 - The Contractor shall include in its subcontracts stipulations obliging the subcontractors to abide by all of the legal provisions and terms of this Contract that are applicable to them. 21.5 - The subcontractors, in Ecuador, shall be subject to the laws of the Republic of Ecuador. 21.6 - In the event that the Contractor subcontracts with foreign companies to perform works or provide services that by their very nature must be carried out in Ecuador, the said companies must establish legal residence in the country or appoint a legal representative in those cases where the law so requires it. TWENTY-SECOND: CONTRACTOR PERSONNEL AND LABOR RELATIONS 22.1 - The Contractor shall contract national personnel subject to that prescribed in subparagraph a) of Article 31 of the Hydrocarbons Law; and the minimum number of foreign personnel necessary for the complete and efficient fulfillment of the purpose of this Contract. 22.2 - If the Contractor feels it is necessary, it may contract PETROPRODUCCION workers who have not been relocated to other fields by this branch. In the event that the Contractor contracts these workers, the labor relationship with PETROPRODUCCION shall be extinguished and the Contractor shall not assume the labor responsibility incumbent on PETROPRODUCCION. 22.3 - The Contractor and subcontractors are autonomous companies and, as such, their personnel shall be contracted at their exclusive risk and they shall be solely responsible for any labor or employer obligations arising from or related to the Work Code, the Law of Compulsory Social Security, or from the individual or collective contracts they have entered into with their personnel. Therefore, PETROECUADOR shall not be liable, even jointly, for any labor claim that may arise as a result of trials or lawsuits, whether individual or collective, on behalf of the workers of the Contractor or its subcontractors. Page 40 of 56 22.4 - The Contractor and subcontractors shall submit information that contains data on all of the domestic and foreign personnel for whom they are responsible to the Joint Command of the Armed Forces, and shall not hire any persons that are later vetoed by this Command. TWENTY-THIRD: GOODS AND IMPORTS 23.1 - The Contractor shall furnish the goods, materials, equipment and other fixed assets or goods required for the execution of this Contract, according to the Minimum Program for Production Activities and Investments, the Minimum Plan of Additional Exploration and Investments, and the Annual Activities Programs and Budgets. 23.2 - When acquiring goods, the Contractor shall give preference to domestic products, providing they are similar in technical quality, price and availability. 23.3 - Regarding imports: the importation and temporary clearing through customs of goods needed to execute this Contract shall be carried out according to the Hydrocarbons Law, the Organic Customs Law and other pertinent legal dispositions. 23.4 - The goods, machinery and equipment to be temporarily employed may enter and leave Ecuador by applying the Temporary Importation Regimen or similar methods established in related legislation. In these cases, the Contractor shall only account in its books the value of the use of these goods in the appropriate proportion related to the amount of time the goods spend in the country, as well as expenses related to importing, transporting and insuring the goods. These costs shall be reasonable in relation to the value of similar expenditures in the international market. 23.5 - During the term of this Contract, the Contractor shall not alienate, encumber or withdraw, any part of the goods, machinery or equipment acquired for the purposes of this Contract, without the prior notification of PETROECUADOR and authorization from the MEM. 23.6 - The Contractor shall keep all goods, machinery, equipment, tools, installations and other movable and immovable objects acquired for purposes of this Contract in good operating conditions. To this end, two (2) years prior to the expiration of this Contract, or earlier if necessary, the Contractor shall carry out, at its own expense, a technical inspection of all the facilities within the Contract Area. The Contractor shall hire a specialized firm to conduct this inspection and shall be obligated to make all of the repairs or replacements determined or resulting from said technical inspection, with the exception of the normal wear resulting from use during the term of this Contract. 23.7 - In accordance with Article 29 of the Hydrocarbons Law, upon the expiration of the Contract all goods, machinery, equipment and other assets and infrastructure that the Contractor may have acquired or developed for the fulfillment and execution of this Page 41 of 56 Contract shall be returned, at no cost and in good condition, to the State through PETROECUADOR or its subsidiary, PETROPRODUCCION. Commercial renting or leasing shall not be allowable during the last five (5) years of the Contract, unless those instruments stipulate the compulsory acquisition of goods by the Contractor within said time frame. The goods imported under the temporary Importation Regimen shall not be subject to the terms established in Article 29 of the Hydrocarbons Law. TWENTY-FOURTH: INFORMATION AND CONFIDENTIALITY 24.1 - The Ecuadorian State is the owner of all the technical information generated during the execution of the Contract and shall have access to all economic information. 24.2 - The Contractor shall submit the original of all technical information and information related to investments, cost, and charges incurred in the execution of this Contract as it is generated to the MEM through the Oil Contracting Unit, and shall forward a copy to PETROPRODUCCION. The Parties shall expressly and mutually notify each other of any documents that are confidential in nature. 24.3 - The blueprints, designs, drawings, data, technical and scientific reports and any other information related to contracted operations and services shall be treated as confidential by the Parties. Therefore, their content, in whole or in part, shall not be disclosed to third parties in any way whatsoever, without a prior written agreement between the Parties. The documents of a confidential or reserved nature shall conserve that quality until five (5) years after the conclusion of the Contract. 24.4 - The stipulations of Clause 24.3 shall not apply to the information that the Parties are under obligation to furnish, according to the law and the terms of this Contract, nor to the information that the Contractor must supply to its related companies, auditors, legal advisors, financial institutions or due to the requirement of domestic or foreign regulating authorities. However, the Contractor must notify PETROECUADOR in advance. 24.5 - The Contractor and PETROECUADOR may supply the confidential information referred to in Clause 24.3 to their functionaries, workers, agents, representatives, directors, arbiters, consultants and subcontractors. However, they shall take all necessary measures to insure that these parties comply with the same obligations of confidentiality with respect to the confidential documents to which they may have access. TWENTY-FIFTH: CONSULTING AND ARBITRATION 25.1 Consulting: Page 42 of 56 25.1.1 - Disagreements between the parties concerning matters of a technical nature that involve economic aspects and vice versa, arising from the application of this Contract, except for those matters that, that by reason of this Contract or the law, must be decided through arbitration, shall be referred to the legal representatives of the Parties for resolution. 25.1.2 - If within ten (10) days of having referred the disagreement to the legal representatives of the Parties, the said disagreement has not been resolved, the Parties shall submit the said disagreement as well as those themes mutually agreed upon, to a Consultant. 25.1.3 - The Consultant must be appointed by agreement between the parties within a period of ten (10) days counted from the date on which the legal representatives of the Parties should have resolved the dispute. If the parties cannot come to an agreement regarding the nomination, the Consultant shall be appointed by the Arbitration Center of the Quito Chamber of Commerce, which must select an expert in the matter under dispute, who is not related to either of the Parties. 25.1.4 - The Parties shall furnish the Consultant with all verbal or written information and other evidence required to reach a solution to the disagreement. The opinion of the Consultant shall have the effect that the Parties have mutually agreed upon prior to the appointment of the Consultant. In the event that the Parties agreed that the opinion is to be binding, they shall request the opinion of the Attorney General of the State in conformity with subparagraph three of Article 4 of the Law on Arbitration and Mediation; in this case the resolution shall have the character of an arbitration finding. If the Parties do not so agree, the opinion shall only serve as a reference and shall not be binding on the Parties, in accordance with Number 9.16 of the Basic Contracting Conditions for Contracts for the Production of Crude Oil and Additional Hydrocarbon Exploration carried out in the marginal fields of PETROECUADOR. In all cases, the expenses arising from the Consultant's participation shall be mutually borne by both Parties. 25.1.5 - The appointed Consultant shall prepare and present its report in writing on the matter submitted to its consideration, within the period of forty-five (45) days reckoned from its acceptance. The Parties may extend this period by mutual agreement, if the Consultant so requests. 25.2 Rules for International Arbitration. - In the event that a disagreement or controversy is submitted to arbitration as stipulated in Clauses 25.3 the parties agreed that the said arbitration proceeding shall be subjected to the following rules, in addition to the specific rules for each respective case. 25.2.1 - Waiver of ordinary jurisdiction. - As provided in Article 4 of the Law on Arbitration and Mediation, the Parties freely and voluntarily resolve to waive the ordinary Page 43 of 56 jurisdiction for carrying out the arbitration agreed upon herein, therefore undertaking to respect the content of the finding. 25.2.2 - The Parties agree that the Arbitration shall take place in the city of Quito, Ecuador. 25.2.3 - Any Arbitration Tribunal constituted in conformity with this agreement shall be composed of three (3) arbiters. Each party shall appoint one (1) arbiter and these two (2) arbiters shall by common accord appoint a third arbiter who shall be the President of the Tribunal. If one of the parties does not appoint an arbiter within the thirty (30) days following the appointment of the first arbiter, or if the two (2) arbiters appointed by the parties do not name the third arbiter within the thirty (30) days following the appointment of the second arbiter, the respective appointment or appointments shall be made in accordance with the Rules of the Center. The three (3) arbiters must be Ecuadorian citizens or citizens of countries maintaining diplomatic relations with the Republic of Ecuador and with the countries where the parties composing the Contractor are constituted, they must be citizens of signatory countries of the Convention, not have any interest or economic relationship with the Parties and the President of the Tribunal may not be of the nationality of either of the Parties. 25.2.4 - Any Arbitration Tribunal constituted in conformity with this Contract shall apply the Ecuadorian legislation in effect on the date of the making of the present Contract and apply the arbitration rights. 25.2.5 - The Spanish language shall be the language used in any arbitration proceeding. All the materials used in the hearings, complaint, response to the complaint, arbitration finding and their grounds must be in Spanish. 25.2.6 - It is hereby agreed that the right of the Parties to submit any dispute to the Arbitration Center in accordance with this Contract shall not be affected by the fact that a total or partial indemnification has been received from a third person with respect to any loss or damage that is an object of the dispute. 25.2.7 - The absence or recalcitrance of either of the Parties in the arbitration shall not be cause for preventing or obstruction of the arbitration proceeding in any manner or at any of its stages. 25.2.8 - Any arbitration finding pronounced in accordance with any arbitration proceeding carried out in conformity with this Contract shall have the effect of a final judgment. It shall be definitive and binding for the Parties, without right of appeal of any type, shall be executed by an ordinary judge, in conformity with Article 32 of the Law on Arbitration and Mediation and the international covenants and treaties in effect in Ecuador. 25.2.9 - Any arbitration finding that requires the payment of money, must be paid in dollars of the United States of America, free of any deduction, or in Sucres at the exchange rate at Page 44 of 56 the time of payment. Furthermore, in the event that any finding that requires one of the Parties to pay an amount of money, that Party must recognize the corresponding late interest from the date of noncompliance or violation of this Contract, if the arbitration finding so determines, and in addition, pay the late interest from the date of the ruling until the date on which payment is made in full. 25.2.10 - The arbiters shall be authorized to prescribe precautionary measures. The Arbitration Tribunal shall be authorized to request the aid of public, judicial, police and administrative functionaries for the execution of the precautionary measures, without the need to appeal to any ordinary judge. 25.2.11 - The standards of the Law on Arbitration and Mediation, Civil Code and Civil Procedures Code of the Republic of Ecuador shall be applied supplementary to all that provided in the norms and regulations of the respective Arbitration Center. 25.2.12 - All Arbitration proceedings shall be confidential. 25.2.13 - The Parties indicate as their domiciles those that are indicated in this Contract in the city of Quito for all summons and notifications of the arbitration. 25.2.14 - The fees and expenses of the members of the Arbitration Tribunal, as well as the charges applicable for the use of the services of the Center shall be borne equally by the Parties in any arbitration proceeding carried out under this Contract. 25.2.15 - The parties agree that that stipulated in Clause 25 shall be kept in effect and shall be binding on the Parties, even in the event that this Contract becomes null and void. 25.3 - International Arbitration 25.3.1 If the disagreement or controversy is of a nature such that it cannot be resolved by the Consultant as stipulated in Clause 25.1, or if one or both of the Parties is not satisfied with the decision rendered by the Consultant, unless it has been agreed that the opinion of the Consultant be binding, PETROECUADOR and the Contractor agree to submit such a disagreement or controversy to the arbitration of the International Center for the Settlement of Investment Disputes (ICSID). The arbitration shall be carried out as stipulated in the Agreement on the Settlement of Differences Relative to Investments between States and Nationals of Other States, published in the Official Record No. 386 of March 3, 1986 provided that this Agreement are kept in effect for Ecuador. 25.3.2 - PETROECUADOR has been registered at the ICSID since the year 1988, as a party appointed by the Republic of Ecuador, as inferred from the Certificate granted on the day of Page 45 of 56 April 27, 1999 by the General Secretary for Foreign Relations of the Ministry of Foreign Relations, what appears as Annex XIII. 25.3.3 - The Contractor is composed of companies of United States and Panamanian nationality. 25.3.4 - Any arbitration proceeding that is initiated in accordance pursuant to this Clause 25.3 shall tried subject to the ICSID Rules in effect on the date in which the arbitration proceeding is initiated and shall observe the common rules stipulated in Clause 25.2. TWENTY-SIXTH: TRANSFER OR CESSION The Contractor may not cede or transfer the rights and obligations of this Contract without the prior knowledge of PETROECUADOR and the authorization of the MEM. Therefore, any cession or transfer made without the fulfillment of this essential requirement shall be null and void, without detriment to the MEM declaring the Contract void. In any case, the transfer or cession shall be subject to the terms established in Article 79 of the Hydrocarbons Law and in Executive Decree Number 809 and its revisions. TWENTY-SEVENTH: CAUSES FOR TERMINATION AND NULLITY 27.1 - This Contract shall be terminated for the following reasons: a) The failure to fulfill the purpose of this Contract. b) The expiration of the established period. c) At any time before expiration of the contract period by mutual agreement between the Parties. d) In the event that the economic conditions of the Contract are not profitable, the Contractor shall request the approval of PETROECUADOR to declare this Contract terminated, provided it has faithfully performed all the obligations undertaken in this Contract. e) By a declaration of nullity issued by the MEM for the reasons and under the procedures set forth in Articles 74, 75 and 76 of the Hydrocarbons Law. f) If, after the third year of this Contract, the Contractor does not achieve a 50% increase in production over the Base Production Curve. Page 46 0f 56 g) Due to filing for bankruptcy by any of the corporate entities composing the consortium. h) Due to the extinction of the legal entity of any of the corporate entities composing the consortium. i) Due to a final ruling made by a competent judge or arbiter; and j) Due to any other cause provided in the law. 27.2 - In cases of non-fulfillment that may constitute a cause for termination and nullity in conformity with the provisions of the Hydrocarbons Law, the following procedures must be followed: 27.2.1 - PETROECUADOR shall notify the non-fulfillment to the Contractor, so that it may respond with the period of ten (10) days. Nevertheless, the Contractor shall take actions tending to remedy, correct or rectify the failure or non-fulfillment that gave rise to the claim within the period of thirty (30) days. If such actions have been taken and this period proves insufficient for the Contractor to be able to remedy, correct or rectify the said failure or non- fulfillment and it so demonstrates, PETROECUADOR shall concede to it a period additional to that granted, at the petition of the Contractor. 27.2.2 - The following procedure shall be required to declare nullity: a) If within the periods mentioned in number 27.2.1 the Contractor does not resolve such failures or non-fulfillment, PETROECUADOR shall request the Ministry of Energy and Mines to declare this Contract null and void. b) Prior to the declaration of the nullity of the Contract, the MEM shall notify the Contractor so that, within a period of no less than thirty (30) days nor more than sixty (60) days from the date of the notification, it complies with the obligations not met or dispels the charges that have been brought. c) Once nullity has been declared, the Contractor shall immediately return the contracted area to the State and shall deliver all the equipment, machinery and other production and exploration elements, and industrial and transport installations, free of any charge to PETROECUADOR and, in addition, the surety bonds and guarantees provided under the Law and the Contract shall automatically be lost, which shall revert in favor of the State. 27.2.3 - The procedures established in the pertinent laws and regulations and in absence of these, those agreed upon by the parties shall be followed in the other causes of termination. Page 47 of 56 TWENTY-EIGHTH: APPLICABLE LAW, DOMICILE, JURISDICTION AND NEGOTIATION 28.1 - Applicable Legislation: This Contract shall be governed exclusively by Ecuadorian legislation and the laws in effect at the time the making of this Contract shall be considered to be incorporated within it. The Contractor expressly declares to have a complete understanding of all Ecuadorian legislation applicable to Contracts for the Production of Crude Oil and Additional Exploration for Hydrocarbons in Marginal Fields. 28.1.1 - Legal Framework: Includes, without being limited to, the legal standards established in Annex XIV, which are applicable to this Contract: 28.2 - Domicile, Jurisdiction and Competence: The Parties submit to the laws of Ecuador and establish their residence in the City of Quito as set forth in Article 3 of Law No. 44 published in the Official Register 326 of November 29, 1993. This provision shall prevail even after this Contract has expired, up to the moment in which the operating permit of Contractor in Ecuador has been legally canceled, without taking the causes for termination into consideration. 28.2.1 - In the event of disputes that may arise due to the application of this Contract, the Contractor, pursuant to Ecuadorian legislation, expressly renounces the right to use diplomatic or consular resources, or to resort to any domestic or foreign jurisdictional mechanism not provided in this Contract, or to an arbitration that is not recognized by Ecuadorian law or provided in this Contract. 28.2.2 - The Parties agree to use the means established in this Contract for settling doubts or controversies that may arise during its validity. The Parties also agree to observe and comply with any rulings made by authorized consultants, arbiters, judges, or courts, in related cases, according to the stipulations of the Contract. TWENTY-NINTH- COMMUNICATIONS AND NOTIFICATIONS 29.1 - COMMUNICATIONS All the communications or notifications that contain requests, suggestions, opinions, acceptances, authorizations, reports, studies, balances, inventories and other documents that the Parties interchange between themselves or that they present to the MEM and/or PETROECUADOR, for purposes of this Contract shall be written in the Spanish language. If there are technical reports, which due to their nature require presentation in another language, these must be translated into Spanish. Page 48 of 56 29.2 - The documents presented by the Contractor to PETROECUADOR or to the MEM by virtue of this Contract shall be subject to that set forth in Article 82 of the Hydrocarbons Law. 29.3 - Written notification between the Parties shall be conducted in Spanish and shall be forwarded to the following addresses: MEM Santa Prisca No. 221 y Av. 10 de Agosto FAX: 580724 Telephone: 570-877 Quito, Ecuador PETROECUADOR Edificio Matriz Alpallana y 6 de Diciembre FAX: 593-2-569738 Telex: 022213 Telephone: 563-060 Apartado Postal 17.11.5007 Quito, Ecuador UCP Unidad de Contratacion Petrolera Av. Amazonas 4600 y Pereira Edif. Casa Vivanco 6to. Piso FAX 593-2-262375 Telephone: 265246-265247 Quito, Ecuador PETROPRODUCCION Av. 6 de Diciembre 4226 y Gaspar Canero FAX: 449000 Telephone: 440333 to 342 Quito, Ecuador CONTRACTOR: TECNIPETROL, INC. Av. Republica de El Salvador 970, Piso 7 Telefonos: 466770 - 466802 FAX: (593-2) 466802 Quito, Ecuador. Page 49 of 56 BELLWETHER INTERNATIONAL, INC. Whymper 1105 y Diego de Almagro Telefonos: 222057 - 508123 - 501354 FAX: (593-2) 501902 Quito, Ecuador. THIRTIETH: QUANTITY AND NOTARY EXPENSES 30.1 - Given its nature, this Contract is not liable to quantification on the date that it is granted. Therefore, the present Public Instrument is of an indeterminate quantity. 30.2 - The expenses required for the making of this Contract, including the cost for ten (10) certified copies to be delivered to the Oil Contracting Unit, shall be paid by the Contractor and the respective procedures shall be for his account. THIRTY-FIRST: QUALIFYING DOCUMENTS The following documents are qualifying documents of the present Contract: a) Certified copies of the appointment and formal investiture of the executive president of PETROECUADOR and appointment of the manager of PETROPRODUCCION; b) Certified copy of the instrument constituting the Bellwether-Tecnipetrol Consortium made before the Thirty-Second Notary on September 13, 1999. c) Certified copy appointment or powers of attorney of the Legal Representatives of the companies composing the Contractor, who appear in the document mentioned in clause 2.4; d) Certified copy of the documents listed in the numerals 2.2, 2.4, 2.5, 2.6, 2.7 and 2.8 of the Second Clause. e) Certificates from the Superintendency of Companies accrediting the legal existence of the companies composing the Contractor and their residence in Ecuador. f) Certified copy of the Resolution of the Special Bid Committee accrediting the approval of this Contract, its awarding in favor of the Contractor and the approval for its signing; g) Certified copies of the Resolutions of Administrative Council of PETROECUADOR and the Board of PETROPRODUCCION authorizing the Page 50 of 56 Executive President of Petroecuador and the Manager of that Affiliate to sign this Contract; and h) Certified copies of the official letters that request the favorable report of the Attorney General of the State and the opinion of the Joint Command of the Armed Forces regarding this Contract in the aspects set forth by law, contained in clause 2.6. THIRTY-SECOND: ANNEXES The following are an integral part of this Contract and are appended as ANNEXES: Delimitation of the Contract Area and Ecuadorian Oil Cadastral Map, certified by the Military Geographic Institute and the National Office of Hydrocarbons; Base Production Curve of the Charapa Field; Minimum Plan for Additional Exploration and Investments; Minimum Program for Production Activities and Investments; Procedure for fixing the Production Rate; Inventory, Technical Inspection and Valuation of Assets Contractor's Offer, (Envelope 2) Negotiation Record (the Minutes) Cost Accounting Regulations applicable to Marginal Fields; Investment Guarantee; Joint Guarantees of the Parent Company Guarantee of Proper Use of Goods and Equipment Certificate granted on April 27, 1999 by the General Secretary of Foreign Relations of the Ministry of Foreign Relations. Legal Framework Page 51 of 56 You, Mr. Notary Public shall please add any other stylistic formalities necessary to make this Contract perfectly valid. Dr. Jorge Paz Durini, and Dr. Jaqueline Silva inscribed in the Bar Association of Pichincha under Matriculation Nos. 2582 and 3154, respectively. Page 52 of 56 ANNEX XIV. Legal Framework Hydrocarbon Legislation Codification of the Hydrocarbons Law (DS 2967. RO 711: 78.11.15.) Law No. 101, reforming the Hydrocarbons Law (RO 306: 82.08.13.) Law No. 08, reforming the Hydrocarbons Law (RO 277: 85.09.23.) Law Decree No. 24, reforming the Hydrocarbons Law (RO 446: 86.05.29.) Special Law No. 45, of the State Oil Company of Ecuador (PETROECUADOR) and its Subsidiary Companies (RO 283: 89.09.26.), its reforms and pertinent regulations. Law No. 44, reforming the Hydrocarbons Law (RO 326: 93.11.29.) List of errata published in the RO 344: 93-12-24 Law No. 49, reforming the Hydrocarbons Law (RO 346: 93.12.28.) Law Reforming the Hydrocarbons Law (Supplement RO 523: 94.09.09.) Law Reforming the Hydrocarbons Law No. 98-09 (RO 12: 98.08.26) Regulation of the Law No. 101 (DE 1491. RO 427: 83.02.07.) and its reforms (DE 1770. RO 509: 83.06.08.) and (DE 3136-A. RO 753: 87.08.20.) Regulation for application of the Law No. 44 (DE 1417. RO 364: 94.01.21.), and its reforms (DE 2360. RO 595: 94.12.22.) Regulation of the Special Bidding System for Contracts for Production and Additional Exploration of Marginal Fields (RO 419: 94-04-13). Basic contracting conditions for the Special Bidding for Contracts for Crude Oil Exploration and Additional Hydrocarbon Production in Marginal Fields (RO S 305: 98-04-27). Cost Accounting Regulation applicable to Contracts for Exploration for Crude Oil and Additional Hydrocarbon Production in Marginal Fields (RO 299: 98-04-17). Regulation on Hydrocarbon Operations (AM 1311. RO 681: 87.05.08.), and its reform (AM 189. RO 123: 89.02.03.) Page 53 of 56 Procedure for Fixing Production Rates (DE 543. RO 135: 85.03.01.), and its reform. Regulation to Article 79 of the Hydrocarbons Law on Cession of the Rights and Obligations of Hydrocarbon Exploration and Production Contracts (DE 809. RO 197: 85.05.31.), and its reforms. Executive Decree No. 976, RO 274: 82-06-29 Regulation for the scheduling of Crude Oil Shipments (RO 257: 98-02-13) Tax Legislation: Law for the Reform of Public Finances (RO S 181: 99.04.30.). Law Reordering Economic Matters for the Tax-Finance Area (Law 98-17) (RO S 78: 98.12.01.). Tax Code (DS 1016-A. RO - Supplement 958: 75.12.23.). Law No. 006, on Tax and Financial Control (RO 97: 88.12.29.) and its Regulation (DE 393. RO S 118: 89.01.27.) Law No. 56, on the Domestic Tax System (RO - Supplement 341: 89.12.22.) and its Regulation. Law No. 63, Reform of the Law No. 006 (RO 366: 90.01.30.) Law No. 72 (RO 441: 90.05.21.). Law No. 40, that creates Substituting Revenue for the Provinces of Napo, Esmeraldas y Sucumbios (RO 248 S 89.08.07.). Law No. 122, that creates the Development Fund of the Provinces of the Amazon Region (RO 676: 91.05.03.). Law No. 51, Reform of the Law the Domestic Tax System (RO 349: 93.12.31.). Decree - Law No. 05, Reform of the Laws No. 51, No. 56 and Tax Code (RO 396: 94.03.10.) Law No. 10, of the Fund for Regional Amazon Eco-development and Reinforcement of its Sectional Bodies (RO 30: 92.09.21.), its reform Law No.20 (RO 152: 97.09.15.) and Page 54 of 56 its Regulation (DE 461. RO: 121:93.02.03.) Legislation on the Environment: Roads Law (DS 1351. RO 285: 64.07.07.) and its Regulation (AM 0282. RO 378: 71.12.24.). Health Code (DS 188. RO 158: 71.02.08.). Law for the Preservation of Reserve Zones and National Parks (DS 1306. RO 301:71.09.02.) Environmental Regulation for the Hydrocarbon Operations in Ecuador (DE 2982. RO 766: 95.08.24.) Law on Waters (DS 369. RO 69: 72.05.30.) and its Regulation (DS 40. RO 233: 73.01.26.). Reform to the Maritime Police Code (DS 945. RO 643: 74.09.20.). Law on Prevention and Control of Environmental Contamination (DS 374. RO 097: 76.05.31.). Instruction for the Preparation of Environmental Impact Reports and Studies (AM 764. RO 330: 85.12.09.) Law No. 74, on Forestry and on conservation of Natural Areas and Wild Life (RO 64: 81.08.24.), reformed, and its Regulation (DE 1529. RO 436: 83.02.22.), reformed. Norms for the Prevention, Control and Rehabilitation of the Environment in the Hydrocarbon Exploration and Production Activities in the National Parks or equivalents (AM 1743. RO OO4: 88.08.16.) Regulation for the Prevention and Control of Environmental Contamination, relative to water resources (AM 2144. RO 204: 89.06.05.) Regulation for the Prevention and Control of Environmental Contamination caused due to emission of noises (AM 7789. RO 560: 90.11.12.). Regulation for the Prevention and Control of Environmental Contamination relating to ground resources (AM 14629. RO 989: 92.07.30.). Regulation for the handling of solid wastes (AM 14630. RO 991: 92.08.03.). Page 55 of 56 Various Legal Provisions: Political Constitution of the Republic of Ecuador. Law on Arbitration and Mediation, (RO 145: 97.09.04.). Law No. 147, on the Facilitation of Exports and Aquatic Transport (RO 901: 92.03.25.). Law No. 99, Organic Customs Law (RO 359: 98.07.13.) Law on the Status of Aliens (DS 1897. RO 382: 71.12.30.) and its Regulation (DE 1991. RO 473: 86.07.07.). Law No. 50, on Modernization of the State, Privatizations and Providing of Public Services by Private Initiative (RO 349: 93.12.31.) and its Regulation. General Insurance Law (Law No. 74 RO 290: 98.04.03.) Codification of the National Security Law (DS 275. RO 892: 79.08.09) and its Regulation (DE 2264. RO 642: 91.03.14.). Regulation for the application of Articles 18 and 57 of the Industrial Promotion Law, 50 and 51 of the Law for Promoting Small Industry, 87 and 88 of the Law for Promoting the Automotive Industry (DE 976. RO 274: 82.06.29.). Codified Regulation for the Determination and Collection of Contributions that companies subject to the control and supervision of the Superintendency of Companies must pay annually to the latter (ADM 90154. RO 442: 90.05.22.). Ministerial Accord that fixes the minimum wage for workers working in the production of crude oil and natural gas, its processing, packing and marketing. Page 56 of 56 EX-11.17 5 MASTER SERVICE AGREEMENT EXHIBIT 10.17 MASTER SERVICE AGREEMENT FOR PROJECT MANAGEMENT SERVICES BETWEEN BELLWETHER INTERNATIONAL, INC. AND TECNIE S.A.C. November 1, 1999 ---------------------------------- CHARAPA FIELD ---------------------------------- TABLE OF CONTENTS
ARTICLE PAGE 1.0 Purpose.......................................... 1 2.0 Effective Date & Term............................ 6 3.0 Contractor's Obligations......................... 7 4.0 Payments & Audit Rights.......................... 9 5.0 Independent Contractor........................... 10 6.0 Taxes & Social Obligations....................... 11 7.0 Insurance........................................ 12 8.0 Indemnity........................................ 13 9.0 Termination...................................... 14 10.0 Confidentiality.................................. 16 11.0 Force Majeure.................................... 16 12.0 Applicable Law................................... 17 13.0 Dispute Resolution............................... 17 14.0 Assignment....................................... 18 15.0 Warranty as to Illegal Payments.................. 18 16.0 Miscellaneous.................................... 19 Signature Page................................... 19
ANNEXES ------- ANNEX A...........Scope of Service ANNEX B...........Compensation Schedule ANNEX C...........First Year Budget ANNEX D...........Insurance Requirements MASTER SERVICE AGREEMENT This Master Service Agreement (the "Agreement") is made this 21st day of October 1999, but effective as November 1, 1999, by and between Bellwether International, Inc. (hereinafter called "Bellwether" or "Operator") and Tecnie S.A.C. (hereinafter called "Contractor"). WHEREAS, Petroecuador, Petroproduccion, on the one hand and Bellwether and Tecnipetrol, Inc. ("Tecnipetrol"), on the other hand, initialed on June 29, 1999 and later shall enter into that certain contract for exploration and exploitation of the Charapa Marginal Field (the "Chapara Contract"); and WHEREAS, Bellwether is designated "Operator" under the "JOA" (defined below) for operations to be undertaken pursuant to the Charapa Contract and Bellwether, as Operator, requires the "Services" (defined below) be performed for the benefit of Operator and Tecnipetrol. NOW THEREFORE, Operator and Contractor desire to enter into this Agreement to govern the performance of the Services and the respective right and duties of Operator and Contractor and based on such premises and the mutual covenants set forth below, do hereby agree as follows: 1.0 PURPOSE 1.1 This Agreement is a master service agreement which shall be the underlying document controlling all Services described in the Annexes and performed by Contractor for the duration of this Agreement, and shall be specifically applicable to and shall control all Services undertaken by Contractor. 1.2 This Agreement is an exclusive service agreement and Contractor shall not render the same Services or any services similar to the Services to any Third Party which conflict with Operator's interests or which would use the same Contractor Personnel without the express written approval of the Operator. If Contractor, with Operator's approval, renders such services to a Third Party, appropriate adjustments shall be made to the rates of compensation set forth on Annex B. If Operator and Contractor are unable to agree on such adjustments to the rates of compensation, either party shall have the right to terminate this Agreement pursuant to Article 9.1. 1.3 Subject to Article 14.0, Operator shall have the right to contract with a Third Party to perform the same Services or any services which are in addition to or outside the scope of the Services. 1.4 This Agreement includes Annexes A through D, which are attached to and incorporated into this Agreement for all purposes. 1.5 For purposes of this Agreement and the Annexes the following defined terms shall have the meanings given them below: -1- "AD-HOC SERVICES" means those certain services, including the supply of personnel, material, equipment or products, that are not included in the Services, and that are specifically described in the applicable Ad-Hoc Service Commitment for the respective Ad-Hoc Services. "AD-HOC SERVICE COMMITMENT" means a contract, purchase order, service order or other agreement or commitment between Operator and an Affiliate of Contractor or a Third Party or between Contractor and a Third Party for the performance of Ad-Hoc Services. AFFILIATE: means a company, partnership or other legal entity, which controls, or is controlled by or which is controlled by an entity which controls, a Party. In this definition, the term "control" and derivatives thereof means the ownership directly or indirectly of fifty (50) percent or more of the voting rights in a company, partnership or legal entity. "ANNUAL BUDGET" shall have the meaning given in Article 2.3. "APPLICABLE LAW" means the Hydrocarbons Law (as defined to in the Charapa Contract) and any other statute, decree, order, directives, regulation, or rule (of whatever nature) including without limitation tax legislation, regulations and decrees incorporated by the terms of the Contract or as may be validly issued by the Government and in effect from time to time. "BASE CHARGES" means the Contractor's Personnel Costs and the Ecuador Operations Overhead Costs, as both such terms are described in Section 1.1 of Annex B. "B&B" means the burdens and benefits applicable to salary paid to each of Contractor Personnel under Applicable Law as described in Section 1.1.2 d of Annex B. "BUSINESS RECORDS AND DATA" means Operator's contracts, accounting documents, invoices, checks, statements, receipts, correspondence, vouchers and includes all files, records, data, information, and maps related to such information and the Contract Area, including, without limitation, computer-readable copies of all computer records pertaining to the files, contracts, production records and other technical data, geological and geophysical information and maps, well logs and related data, or seismic data, including basic field tapes, observers' logs, survey notes, base maps and all other business records relating to Operator's business operations. "CALENDAR QUARTER" means a period of three (3) months commencing with January 1 and ending on the following March 31, a period of three (3) months commencing with April 1 and ending on the following June 30, a period of three (3) months commencing with July 1 and ending on the following September 30, or a period of three (3) months commencing with October 1 and ending on the following December 31. "CALENDAR YEAR" means a period of twelve (12) months commencing on the 1st of January and ending on the 31st of December. -2- "CHANGE ORDER" means the written agreement between Operator and Contractor covering the terms and provisions to govern a revision of the Services. "CHARAPA CONTRACT" means the instrument initialed by and to be concluded between Petroecuador, Petroproduccion, Bellwether and Tecnipetrol and referred to in the first recital paragraph of this Agreement and any extension, renewal or amendment thereof agreed to in writing by the Parties. "CHARAPA FACILITIES" means the wells, facilities and surface and subsurface equipment located within the Contract Area and used in Operations and the pipeline, facilities and equipment located outside the Contract Area used to transport hydrocarbons from the Contract Area to storage facilities at the Lago Agrio Norte storage facility or other storage facility as designated by Operator. "COMPETITIVE TENDER" means an invitation or request for a proposal or an offer for an Ad-Hoc Service Commitment with a value estimated to be $50,000 USD (or equivalent in Sucre) or greater in respect of which Contractor shall: (i) prepare and deliver to Operator a list of the entities whom Contractor proposes to invite to tender for the Ad-Hoc Service Commitment; (ii) submit written invitations to tender to all entities determined by Contractor and Operator to be qualified to perform under the Ad-Hoc Service Commitment; (iii) complete the tendering process within a reasonable period of time; (iv) deliver to Operator a competitive bid analysis recommending the entity to award the Ad-Hoc Service Commitment; and (v) obtain Operator's prior approval before awarding the Ad-Hoc Service Commitment for such tender and before incurring any commitments or expenditures in respect of same. "CONTRACT AREA" means the surface area covered by the Charapa Contract and described in Annex I to the Charapa Contract and as such area may vary from time to time during the term of validity of the Contract. "CONTRACTOR GROUP" means (i) the Contractor and its parent, subsidiary and Affiliates; (ii) the Contractor's contractors and subcontractors; and (iii) the Contractor Personnel, and all other agents, consultants, underwriters, and employees, directors and/or officers of both (i) and (ii) above; but excluding any member of the Operator Group. "CONTRACTOR PERSONNEL" means the personnel described in and provided under this Agreement in accordance with Section 2.1 of Annex A and any other officers, employees, agents and consultants and other individuals employed, hired, contracted or otherwise engaged by Contractor or an Affiliate of Contractor in connection with the performance of the Services and any Ad- Hoc Services. "CONTRACTOR'S BASE MARK-UP" shall have the meaning given in Section 4.1.1 of Annex B. "CONTRACTOR'S ADDITIONAL MARK-UP" shall have the meaning given in Section 4.1.2 of Annex B. -3- "CTT" means the Capital Transfer Tax, being the Impuesto a la Circulacion de Capitales. "DNH" means the Direcion Nacional de Hidrocarburos. "ECUADOR OPERATIONS OVERHEAD" means the office space, furniture, fixtures, supplies and materials to be provided by Contractor, all as more particularly described in Section 2.7 of Annex A. "EFFECTIVE DATE" means the date this Agreement comes into effect as stated in Article 2.1. "EXTERNAL SERVICES" means legal, accounting, tax and other professional counsel or advisory services. "FORCE MAJEURE" means an event or cause which is beyond the reasonable control of the party claiming force majeure and which could not have been avoided or prevented by reasonable foresight, planning and implementation. Such causes shall include, without limitation, acts of God, natural disasters, extreme adverse climate conditions such as violent storms, war (declared or undeclared), insurrections, hostilities, strikes, work stoppages or delays, labor disputes, boycotts or lockouts (other than when such labor matters involve Contractor's employees, which shall be deemed not to be a force majeure event), civil unrest, riots, fire, storm, expropriation and interference or hindrance of governmental authority (including any political subdivision thereof). "GOVERNMENT" means the government of the Republic of Ecuador and any political subdivision, agency, entity or instrumentality thereof, including without limitation the Ministry of Energy and Mines (Ministro del Energia y Minas) Petroecuador, Petroproduccion and the DNH. "INITIAL TERM" shall have the meaning given in Article 2.1. "I.V.A." means the value added tax, being the Impuesto al Valor Agregado. "JOA" means the Joint Operating Agreement by and between Bellwether and Tecnipetrol entered into on October 21,1999, but effective as of the date provided therein, covering the conduct of exploration and exploitation operations on the Contract Area. "OPERATIONS" means all work conducted under the Charapa Contract, including, without limitation, work to increase the production of hydrocarbons from existing wellbores on the Contract Area; drilling, deepening or sidetracking development wells to previously discovered reservoirs; the recompletion, workover, plug back, or installation of equipment or pumps in or on a well or wells; fracturing or stimulating wells with chemicals or pressure; and exploration to discover new reservoirs or additional reserves of hydrocarbons including by geophysical data acquisition or reprocessing and by drilling, deepening or sidetracking of a well or wells. "OPERATOR GROUP" means (i) the Operator and its parent, subsidiary and Affiliates; (ii) the Operator's co-venturers (including Tecnipetrol), contractors, and subcontractors; and (iii) the -4- agents, underwriters and employees, directors and/or officers of both (i) and (ii) above; but excluding any member of the Contractor Group. "OPERATOR'S REPRESENTATIVE" means the person or persons designated in writing from time to time with authority to represent the Operator under the terms of this Agreement. "PARTICIPATION AGREEMENT" means that certain Participation Agreement dated August 25, 1999, entered into by and between Bellwether and Tecnipetrol covering rights, benefits, duties and obligations of the Parties under the Charapa Contract. "PETROECUADOR" means the state oil company of Ecuador, being "la Empresa Estatal Petroleos del Ecuador." "PETROPRODUCCION" means the affiliate of Petroecuador responsible for exploitation and production, being "la Empresa Estatal de Exploracion y Produccion de Petroleos del Ecuador." "REIMBURSABLE COSTS" means the actual amounts (excluding any Contractor's Additional Mark-Up) paid by Contractor to Third Parties for which Operator is obligated to reimburse Contractor under the terms of this Agreement. "SCHEDULED HOURS" means the number of hours in a calendar month a member of Contractor Personnel are required under Applicable Law to be paid for regular time (not overtime); which in the case of Full Time employees is 160 hours per calendar month and in the case of Part Time employees is 80 hours per calendar month. "SERVICES" means (i) the supply of Contractor's Personnel to perform the operational, reporting, clerical and financial duties to be conducted by the Contractor under this Agreement, and (ii) the provision of Ecuador Operations Overhead; all as more particularly described in Annex A. "TASK SCHEDULE" means a general itemization of on-going or routine work in the conduct of Operations that Contractor is to perform on a regular basis as a part of the Services. "TENDER" means an invitation or request for a proposal or an offer for an Ad-Hoc Service Commitment with a value estimated to be greater than $10,000 USD and less than $50,000 USD (or equivalent in Sucre), either verbally or in writing, made to two (2) or more entities determined to be qualified to render the proposed service or supply requirement in connection with Operations, for such entities to make a firm written offer to conduct or provide such supply or service obligation. "THIRD PARTY" means any person or entity that is not an Affiliate of either Contractor or Operator; provided, such person or entity may be a member of either the Operator Group or the Contractor Group. "USD" means United States Dollar. -5- "WORK HOUR" means the number of hours in a calendar month a member of Contractor Personnel is actually engaged in the performance of the Services. 2.0 EFFECTIVE DATE & TERM 2.1 This Agreement is and shall be in effect from November 1, 1999; provided, however, the commencement of the Services and payment of the rates of compensation shall gradually occur as provided in Annex A and Annex B. Subject to Article 9.0, the term of this Agreement shall be for a period of three (3) years from the Effective Date (referred to as the "Initial Term") and may be continued for subsequent periods of one (1) year each upon written agreement of the Parties. 2.2 The rates of compensation and costs set forth on Annex B are fixed until 31 December 2000; provided, however, if at any time during a Calendar Year, Contractor desires to revise such rates and costs, Contractor shall deliver to Operator its Contractor's proposed amendment to Annex B for the remainder of the then current Calendar Year and detailing with justification the reasons for such adjustment. Operator and Contractor shall endeavor in good faith to mutually agree on the amended Annex B. If the parties are unable to agree on the amended Annex B proposed by Contractor, the existing Annex B shall not be amended; however Contractor shall have the right to propose an amended Annex B at such time as it submits the next proposed Annual Budget to Operator. 2.3 Attached to this Agreement as Annex C is the first Annual Budget (defined below) to cover costs of the Base Charges and certain Reimbursable Costs from the commencement of the Services until 31 December 2000. Not later than September 1st, of each Calendar Year, Contractor shall deliver to Operator a proposed budget itemizing the costs of the Base Charges and certain Reimbursable Costs to be incurred in performing the Services during the following Calendar Year ("Annual Budget"). Operator and Contractor shall endeavor to agree on the Annual Budget for such following Calendar Year. If by October 31, Operator and Contractor are unable to agree on the Annual Budget or on certain line items within the Annual Budget for the Calendar Year, the Annual Budget for the following Calendar Year shall be comprised of (i) all line items on which the Parties can agree and (ii) the line items from the then current Annual Budget covering the same line item matters on which the parties cannot agree plus ten percent (10%) of such current Annual Budget line items. If the Parties are unable to agree upon at least eighty percent (80%) of the total value of the Annual Budget of any Calendar Year by March 31 of such Calendar Year, either party shall have the right to terminate this Agreement pursuant to Article 9.1. 2.4 For expenditures on any line item of an approved Annual Budget, Contractor shall be entitled to incur an overexpenditure for such line item up to ten percent (10%) of the amount for such line item; provided that the cumulative total of all overexpenditures for a Calendar Year shall not exceed five percent (5%) of the total Annual Budget in question without Operator's prior written approval and Operator shall have no obligation to pay any compensation or Reimbursable Costs in excess of such amounts. -6- 3.0 CONTRACTOR'S OBLIGATIONS 3.1 Contractor shall perform all Services with due diligence and in a good, competent, professional and safe manner in accordance with the highest standards of petroleum industry practices and the specifications and/or instructions of Operator and this Agreement. Contractor shall fully comply with the Scope of Service attached as Annex A. 3.2 Contractor shall provide the Contractor Personnel described on Annex A and represents and warrants that Contractor Personnel shall at all times be competent and qualified to perform the Services contemplated by this Agreement. Contractor shall not reassign or substitute Contractor Personnel without written consent of Operator; provided, however, Operator shall have the continuing right to request that Contractor remove or substitute any or all such personnel, and on such request, Contractor shall promptly substitute such personnel. This right shall not be exercised unreasonably. All costs of any such removal or substitution shall be paid by Contractor; provided, if Operator unreasonably requires or causes the termination of employment of any Contractor Personnel, Operator shall pay the costs of severance compensation to terminate such person. If Contractor Personnel are engaged in other activities in addition to the Services under this Agreement, the cost of such personnel shall be allocated on an equitable basis as set forth in Annex A and Annex B or as may be otherwise mutually agreed between Operator and Contractor. 3.3 The Operator may order any variation to the Services by altering, adding to or deducting from the same. No departure from the Services as specified in the Annexes shall be made by Contractor and no additional Services or Ad- Hoc Services shall be performed and no alterations or reduction in the Services shall be made by Contractor unless specifically authorized by Operator. Whenever Operator orders a variation to the Services, the Contractor shall submit a proposal and estimate of the cost of the proposed variation. The Parties' agreement to this variation will be evidenced by the issuance of a Change Order by Operator. No variations to the Services shall be allowed without a duly signed Change Order; and no Ad-Hoc Services shall be allowed without a duly signed Ad-Hoc Service Commitment. 3.4 Contractor shall cause an Affiliate of Contractor or a Third Party to perform any Ad-Hoc Services in accordance with the terms and conditions stated in a written Ad-Hoc Service Commitment. 3.5 Contractor is subject to and shall comply with Applicable Law, which now or in the future may pertain to its business, material, equipment and Contractor Personnel engaged in, or in any manner connected with, Contractor's performance of Services under this Agreement, including without limitation, the "Ley de Regimen Tributario Interno", the "Codigo del Trabajo", the "Ley de Seguro Social Obligatorio" and the "Ley de Ejercicio Profesional de la Ingenieria" and those applicable to safeguarding the environment, safeguarding of indigenous people, safety, health, cleanliness, industrial security, medical requirements and accident prevention. Contractor warrants that it has knowledge of Operator's obligations under the Charapa Contract and that Contractor shall strictly comply with, and Contractor shall cause Contractor Group to strictly comply with all obligations, provisions and conditions of such Charapa Contract within the Scope of Service and other provisions of -7- this Agreement. Operator shall notify Contractor of such non-compliance and Contractor shall have fifteen (15) days (unless a shorter period of time is required under the Charapa Contract) from receipt of such notice to remedy such non-compliance, failing which Operator shall have the right to pursue other remedies under his Agreement. 3.6 Contractor shall promptly disclose to Operator the work product and/or any data or information received, made or otherwise obtained during the Services and such product shall be deemed to be owned exclusively by Operator. All intellectual property prepared or supplied by Operator in respect of the Services shall remain in Operator and the Contractor shall ensure that the originals and all copies (if any) shall be returned to the Operator on completion of the Services. 3.7 Contractor shall be responsible for and shall pay all claims for personnel and labor, equipment, materials, services and supplies furnished by Contractor Group under this Agreement and shall protect, defend and indemnify and hold Operator harmless from any such claims. Contractor shall remove any lien or charge fixed upon the Operator Group's interest in the Charapa Contract, any well, the Contract Area or other property of Operator as a result of Contractor Group's failure to pay the above described claims. Contractor shall not have authority to incur any debt, liability or obligation on behalf of Operator without the prior written permission of Operator. 3.8 Contractor Group shall comply with Operator's drug and alcohol use policies including, without limitation, testing for drug, alcohol or illegal substance use, and inspection for possession of drugs, alcohol or illegal substances and/or weapons in compliance with Applicable Law. Contractor shall ensure that no drugs, alcohol, illegal substances or weapons are permitted on the Contract Area by Contractor Personnel except for weapons required for security purposes. 3.9 Contractor, at its expense, will obtain all permits, licenses, registrations, certificates, or other administrative authorizations as may be required by the Government or any other governmental authority (including any political subdivision thereof) from time to time or as may be necessary or incident to Contractor's performance of the Services including, without limitation, the operation of Contractor's business in Ecuador. Contractor shall, at its sole cost and expense, cause such registration, domicile, permits and license to continue in full force and effect during the term of this Contract. 3.10 Contractor warrants that all equipment and products provided by Contractor Group and used in the Services are "Year 2000 Compliant." Any such equipment is deemed to be Year 2000 Compliant if: (A) the functions, calculations, and other computing processes of the equipment (collectively "Processes") perform in a consistent manner regardless of the date in time on which the Processes are actually performed and regardless of the date on which data was input into the equipment, whether before, on, or after January 1, 2000 and whether or not the dates are affected by leap years; (B) the equipment accepts, calculates, compares, sorts, extracts, sequences, and otherwise processes date inputs and date values, and returns and displays date values -8- in a consistent manner regardless of the dates used, whether before, on, or after January 1, 2000; (C) the equipment will function without interruptions caused by the date in time on which the Processes are actually performed or by the date input to the system, whether before, on or after January 1, 2000; (D) the equipment accepts and responds to year input in a manner that resolves any ambiguities as to century in a defined and predetermined and appropriate manner; and (E) the equipment stores and displays date information in ways that are unambiguous as to the determination of the century. If Year 2000 Compliance of any such equipment is dependent in any manner on the associated use of a specific operating system, interface, hardware, software, or the like, or is otherwise restricted in any manner, Contractor shall notify the Operator in writing of such restriction without delay. If any such equipment is not Year 2000 Compliant, Contractor shall notify Operator in writing without delay and Contractor shall work diligently to correct such deficiency at no cost to Operator and to a schedule satisfactory to Operator. Notwithstanding anything in this Agreement to the contrary, if Contractor is unable to comply with any provisions of this Article 3.10, Operator may deem Contractor to have materially breached this Agreement. Operator shall notify Contractor that it is in breach of this Agreement and Contractor shall have forty-five (45) days from receipt of such notice to comply with this Article 3.10 and remedy the equipment or products not Year 2000 Compliant, and if Contractor does not remedy such default within such forty-five (45) days Operator shall have the right to terminate this Agreement with thirty (30) days notice. 4.0 PAYMENTS & AUDIT RIGHTS 4.1 Contractor shall be compensated for Services performed under this Agreement in accordance with the Compensation Schedule attached as Annex B. The Compensation Schedule attached to this Agreement shall not be revised except in accordance with Article 2.2 and Article 2.3. 4.2 As soon as possible after the end of each calendar month, Contractor shall prepare its invoice for Services rendered during such month in U.S. Dollars and shall deliver such invoice to Operator at the address set forth on the last page. Contractor shall issue to Operator, on a monthly basis: (i) a consolidated invoice billing in advance for Base Charges due plus Contractor's Base Mark-Up; and (ii) a consolidated invoice billing in arrears for Reimbursable Costs plus Contractor's Additional Mark-Up Calculation. If Ad-Hoc Services have been provided during such month under an Ad-Hoc Service Commitment between Contractor and a Third Party or Operator, Contractor will invoice the applicable charges in a separate, consolidated invoice billing for such Ad-Hoc Services. All invoices will be prepared on a line item basis with supporting documentation (including Third Party receipts, if applicable and time sheets) and in accordance with the current Government Invoicing Regulations. 4.3 Without prejudice to Paragraph 4.7, Operator will pay (i) the Base Charges plus Contractor's Base Mark-Up within five (5) days of receipt of each invoice for the Base Charges; and (ii) -9- the Reimbursable Costs plus Contractor's Additional Mark-Up within thirty (30) days of receipt of each invoice for Reimbursable Costs; provided, Operator may withhold from any payment to Contractor all amounts reasonably disputed by Operator, and if Operator disputes any amount, the parties shall use all reasonable efforts to resolve such dispute as promptly as possible. Contractor's Base Mark-Up and Contractor's Additional Mark-Up is payable in accordance with Section 4.1 of Annex B. 4.4 If Contractor receives from any person or entity a credit or refund or other rebate for goods or services paid for by Operator, Operator shall be entitled to receive the same and or apply it to payments otherwise made hereunder in accordance with Section 2.6.3 of Annex A. 4.5 To the extent that Operator is required to withhold taxes from payments due Contractor under this Agreement, Operator is authorized to do so and shall notify Contractor promptly of such withholding. 4.6 Upon written request from Contractor, Operator may agree that certain amounts properly payable by Operator to Contractor (and which are not in dispute) under this Agreement may be credited against invoice costs, expenses, Cash Calls or other obligations owed or payable to Operator by Tecnipetrol under the JOA (referred to as an "MSA Credit"), in which event, Operator's payment obligations to Contractor in respect of such amounts shall be deemed to have been paid in full under this Agreement by an amount equal to the MSA Credit. 4.7 Contractor shall maintain books and records in accordance with generally accepted accounting principles applied on a consistent basis and shall retain such books and records for a period of not less than the three (3) year period as required under Applicable Law, but in any event not less than two (2) years after completion of the Services. Operator and its duly authorized representatives shall have access at all reasonable times to the books and records maintained by Contractor relating to the Services performed under this Agreement and shall have the right to audit such books and records at any reasonable time or times during such three (3) year period for the purpose of determining the correctness of the charges made to Operator and of compliance with this Agreement. For the purposes of audit, Operator shall have the right to examine, in Contractor's offices, during business hours and for a reasonable length of time, books, records, accounts, correspondence, instructions, specifications, plans, drawings, receipts and memoranda insofar as they are pertinent to this Agreement or for verifying invoices and shall be entitled to copies (free of charge) of all such data, documentation and supporting information. Contractor shall reconcile its books and records in accordance with the results of any such audit, and Operator or Contractor, as the case may be, shall promptly pay any adjustments necessary to give effect to such reconciliation. The provisions of this Article 4.7 shall continue in force notwithstanding the expiration or prior termination of this Agreement. 5.0 INDEPENDENT CONTRACTOR Contractor and all Contractor Personnel shall render Services as an independent contractor and neither Contractor nor any member of Contractor Group shall be considered an agent, servant, or employee of Operator for any purpose. It is expressly understood that Contractor -10- Personnel shall not in any manner be nor be deemed to be an employee of Operator nor entitled to any benefits Operator makes available for its employees. Accordingly, Operator shall not: (i) pay any B&B in Contractor's behalf; (ii) provide workers' compensation insurance; or (iii) withhold income taxes in respect of Contractor Personnel. Neither Contractor nor any Contractor Personnel will be entitled to participate in any programs or plans, including insurance, maintained by Operator for the benefit of Operator's employees. Except as expressly provided in this Agreement, Contractor Personnel shall not have the right or authority to commit Operator to any work or financial obligation without Operator's prior written approval. Operator shall not provide any insurance for Contractor's property or Contractor Personnel. Operator shall not interfere with the methods used by Contractor to compensate Contractor Personnel. 6.0 TAXES & SOCIAL OBLIGATIONS 6.1 Contractor shall promptly pay directly to the appropriate Government authority, and shall indemnify and hold Operator harmless from, any liability for all taxes, levies and assessments imposed on Contractor Group by any Government authority arising out of or in connection with Contractor's performance under this Agreement, excluding any such taxes, levies and assessments paid by Contractor on behalf of Operator, including, without limitation, corporate and personal income taxes, employment taxes, sales taxes, excise taxes, and social insurance taxes or payments and any fines, penalties or late fees on any of such taxes. Further, Contractor shall be responsible for, indemnify, defend and hold harmless the Operator against any claims whatsoever arising in connection with all taxes assessed or levied against Contractor or on account of wages, salaries, benefits paid, or benefits deemed payable to Contractor Personnel. 6.2 Contractor shall comply, and shall cause Contractor Group to comply, with Applicable Law, including without limitation, all resolutions and regulations issued by the Ministry of Labor, Ministry of Social Welfare, Ministry of Health and the Social Security Institute (i.e. "IESS"). Contractor shall be solely responsible, at its sole cost and expense, for: (i) all wages, salaries, taxes and expenses, of any nature, arising out of or in connection with the employment, support, administration and maintenance of Contractor Group, including, but not limited to, food, lodging, provision of the required safety equipment, medical attention, and all transportation required for Contractor Group; (ii) all costs, expenses, contributions and charges for all benefits, of any nature, which accrue to Contractor Group, which include, without limitation, overtime, vacation, severance, rest and holiday pay, as well as compensation due to accidents, sickness, disability and death of any member of Contractor Group; and (iii) all taxes, fines and penalties in respect of (i) and (ii); and without prejudice to Article 8.2, Contractor shall indemnify, defend and hold harmless Operator Group from and against all liabilities, demands, claims and expenses, of any nature, described or referred to above or related thereto. Except as otherwise expressly provided in this Agreement, it is understood and agreed that Operator shall pay to Contractor only the compensation as set forth on Annex B and such compensation covers and includes all of Contractor's costs and expenses in relation to such of Contractor's Personnel. -11- 7.0 INSURANCE 7.1 Contractor shall procure, carry and maintain, at Contractor's sole expense, and at all times while this Agreement is in effect, insurance coverages as set forth on Annex D. 7.2 Should insurance maintained by Contractor be less than such minimum requirements, Operator may purchase insurance necessary to provide such minimum coverage and deduct the amount of such premiums for such coverage from amounts otherwise payable to Contractor. 7.3 The insurance coverages set forth in this Article 7.0 and on Annex D are minimum requirements to be maintained by Contractor and do not (and shall not be construed to): (a) void or limit the indemnity obligations or other liabilities undertaken by Contractor under this Agreement; or (b) represent in any manner a determination or recommendation of the insurance coverage Contractor or any subcontractor should maintain for its own responsibilities and protection. 7.4 All insurance policies required of Contractor under this Agreement, as provided above and on Annex D, shall be issued by insurance carriers satisfactory to Operator. However, the insolvency, reorganization, bankruptcy, or failure of any such insurance carrier, the loss of license or other authority to do business or the failure of any such carrier to pay claims as they accrue for any reason, shall not affect, diminish, negate or waive any indemnity or other liability obligation of Contractor (or any member of Contractor Group) under this Agreement nor shall it be deemed a release by Operator of Contractor of any obligation to pay such claims or obligations as they accrue. Each insurance policy shall contain endorsements that the carriers or underwriters issuing such policies: (i) shall not cancel or materially change the respective policy without furnishing at least thirty (30) days prior written notice to Operator; (ii) waive all rights of subrogation and any other rights of recourse or recovery against Operator Group, but only to the extent of indemnities given by Contractor hereunder; (iii) name Operator Group as a Named Insured; (iv) name Petroecuador as an Additional Insured and waive all rights of subrogation and any other rights of recourse or recovery against Petroecuador; and (v) stipulate that the insurance covered by such policy shall be primary to and shall receive no contribution from any insurance policies or coverages maintained by or on behalf of Operator Group. 7.5 Contractor shall furnish to Operator the Certificates of Insurance for itself (and each of its subcontractors) evidencing the coverages, limits, endorsements and extensions required above and on Annex D before being allowed to commence the Services; provided, however, commencement of the Services without furnishing such Certificates shall not be deemed a waiver of Operator's rights under this Article 7.0. At least thirty (30) days before the expiration of any coverage Contractor shall provide to Operator a Certificate of Insurance reflecting that such coverage has been renewed or that new coverage has been obtained from a carrier previously approved by Operator, together with proof satisfactory to Operator of -12- Contractor's payment of all insurance premiums for such coverages. Upon request, Contractor shall provide to Operator certified and complete copies of all insurance policies reflecting the coverages that Contractor is required to procure, carry and maintain under this Agreement. 7.6 All deductibles, co-insurance penalties, defense costs or self-insured retention set forth in such policies shall be assumed by, and be for the account of and at the expense of Contractor. Operator Group shall not be responsible or liable for and is hereby released from the payment of any such costs. 7.7 Operator shall cause insurance policies it carries in respect of the Operations and the Services to name Contractor as a Named Insured on Operator's insurance coverage and provide that insurance companies and underwriters waive all rights of subrogation against Contractor, to the extent of indemnities given by Operator under this Agreement. 8.0 INDEMNITY 8.1 Operator shall defend, indemnify and hold harmless Contractor Group, from any and all costs, expenses (including reasonable attorneys' fees) and liabilities incidental to claims, demands or causes of action of every kind and character, brought by any person or entity, for injury to, illness or death of any member of Operator Group or for damage to or loss of the property of Operator Group which injury, illness, death, damage or loss arises out of or is incidental to the Services performed under this Agreement, regardless of whether caused by pre-existing conditions or defect, strict liability, the negligence or other legal fault of Operator Group, unless caused by the gross negligence or willful misconduct of Contractor or any member of Contractor Group. Operator shall fully hold harmless Contractor Group against any such claims, demands or actions at Operator's sole expense, even if the same are groundless. 8.2 Contractor shall defend, indemnify and hold harmless Operator Group from any and all costs, expenses (including reasonable attorneys' fees) and liabilities incidental to claims, demands or causes of action of every kind and character, brought by any person or entity, for injury to, illness or death of any member of Contractor Group or for damage to or loss of the property of Contractor Group, which injury, illness, death, damage or loss arises out of or is incidental to the Services performed under this Agreement, regardless of whether caused by pre-existing conditions or defect, strict liability, the negligence or other legal fault of Contractor Group, unless caused by the gross negligence or willful misconduct of Operator or any member of Operator Group. Contractor shall fully hold harmless Operator Group against any such claims, demands or actions at Contractor's sole expense, even if the same is groundless. 8.3 Except as otherwise provided in this Article 8, Contractor shall be liable for, and shall indemnify and hold harmless Operator Group from any and all costs, expenses (including reasonable attorneys' fees) and liabilities incidental to claims, demands or causes of action of every kind and character, brought by any person or entity, for injury to, illness or death of any Third Party (which under this Article 8.3 shall exclude a member of Contractor Group or -13- Operator Group) or for damage to or loss of any Third Party property (which under this Article 8.3 shall exclude the property of the Contractor Group or Operator Group), which injury, illness, death, damage or loss arises out of or is incidental to the Services performed under this Agreement, regardless of whether caused by pre-existing conditions or defect, strict liability, the negligence or other legal fault of Contractor Group, except to the extent that any such injury, illness, death, damage or loss is caused by the sole negligence, gross negligence, or willful misconduct of Operator or any member of Operator Group. 8.4 Contractor shall be responsible for, indemnify, defend and hold harmless the Operator from and against any and all claims which arise out of or in any way relate to, any patent, registered design, copyright, trademark or trade name or any patent application or other propriety right asserted by any member of Contractor Group or any Third Party in respect of performing the Services. 8.5 Notwithstanding any other provision in this Agreement: (A) Neither party (nor any member of the Operator Group or Contractor Group, as the case may be) shall be liable to the other for exemplary, indirect, consequential or punitive damages including, without limitation, those arising from business interruption or loss of profits, regardless of the negligence or other legal fault of either party, and each party hereby releases the other in this regard. (B) Each party shall notify the other party promptly of any claim, demand, or action that may be presented to or served upon it by any party arising out of or as a result of Services performed pursuant to this Agreement, and shall afford such other party full opportunity to assume the defense of such claim, demand, or action and to protect itself under the obligations of this Article 8. (C) Neither party shall make any form of admission of liability in respect of any claim for which the other party is or might be liable to indemnify such party hereunder, or take any action to settle or compromise any such claims, without the prior written approval of the other party. (D) The obligations and responsibilities contained in this Article 8 are continuing obligations and responsibilities and shall survive the expiration or prior termination of this Agreement. 9.0 TERMINATION 9.1 Without prejudice to Article 1.2 and Article 2.3, at any time after the end of the second year of the Initial Term, this Agreement may be terminated by either party upon ninety (90) days written notice to the other party. 9.2 If a condition of Force Majeure is declared by either party and continues for a period of at least forty-five (45) consecutive days, then either party may terminate this Agreement on fifteen (15) days prior written notice to the other. In such event, Operator shall pay Contractor all compensation earned by Contractor under this Agreement up to the date of termination and not previously paid. 9.3 If any of the following events occur: -14- (A) Contractor files a petition in bankruptcy, appoints a receiver over any portion of its assets, makes an involuntary assignment for the benefit of creditors, begins dissolving its business, authorizes the sale of all or substantially all of its assets, is named as a debtor in an involuntary bankruptcy which is not dismissed within thirty (30) days or otherwise represents or it becomes evident that Contractor is unable to perform the Services for financial reasons; (B) for reasons other than those in Operator's control, but without prejudice to Article 3.10, Contractor Personnel or Contractor's performance or equipment are not in compliance with the requirements of this Agreement or Contractor's performance is otherwise unsatisfactory under this Agreement and Contractor is notified in writing by Operator of such non-compliance or unsatisfactory performance and Operator describes in detail such non-compliance or unsatisfactory performance in such notice and Contractor does not remedy such non-compliance or unsatisfactory performance to Operator's satisfaction within fifteen (15) days of receipt of Operator's notice; (C) for reasons other than those in Operator's control, Contractor's performance of the Services is not conducted in a safe manner and causes an unsafe condition which is an immediate threat to life, property or the environment; (D) the performance in an unprofessional manner or improper behavior of any officer, director or senior manager of Contractor Group is detrimental to or jeopardizes Operator's relationship with the Government or any agency thereof (including without limitation, Petroecuador or Petroproduccion); or (E) any member of Contractor Group commits any illegal act associated with the performance of this Agreement which is detrimental to or jeopardizes Operator, the Charapa Contract or the performance of this Agreement; then Operator shall have the right to terminate this Agreement immediately on written notice to Contractor stating in detail the reasons for such termination. Any such cancellation shall conclude all obligations; and, subject to Article 4.0, Operator shall pay Contractor the amount of compensation earned up to the time of the termination; provided, however, Operator shall be entitled to deduct from such compensation any expenses or damages incurred by Operator by reason of such termination. 9.4 If (i) Tecnipetrol sells, transfers or assigns all of its interest in the Charapa Contract and JOA; (ii) Tecnipetrol withdraws from or forfeits its interest under the Charapa Contract or the JOA; or (iii) if the ownership or management and control of Contractor or Tecnipetrol is sold, transferred or assigned to a Third Party, Operator shall have right to terminate this Agreement on sixty (60) days written notice to Contractor. If Operator terminates this Agreement under this Article 9.4, Operator shall pay Contractor all compensation earned by Contractor under this Agreement up to the date of termination and not previously paid. 9.5 Upon termination of this Agreement, Contractor shall return to Operator: (A) all data, information, documents and other materials referred to or relating to or concerning that referred to in Article 10.0; and (B) all notes, memoranda, work product and other information concerning the information referred to in Article 10.0 or made or received by Contractor Group during the performance of the Services and all materials supplied by Operator. -15- 10.0 CONFIDENTIALITY 10.1 Contractor acknowledges that all information or data obtained by Contractor Group in the performance of the Services or otherwise under this Agreement including, without limitation, Business Records and Data, is the property of the Operator and/or the Government or was obtained pursuant to an undertaking to hold such information and data confidential. Contractor warrants that Contractor Group shall hold such data and information strictly confidential and shall not disclose such information or data to anyone other than members of Operator Group without the prior written consent of Operator. Moreover, Contractor warrants that Contractor Group shall not in any manner use such information or data in a manner injurious to Operator or its business interests or opportunities or detrimental to the achievement of Operator's objectives. 10.2 All Business Records and Data and all data, logs, charts, drawings, tracings, documents, calculations, computer printouts and items of a similar nature, produced or developed exclusively as part of the Services performed under this Agreement shall be Operator's property, and shall be furnished to Operator at any time at Operator's request and not later than completion of Services. Operator shall thereafter have the unrestricted right to use such items. 10.3 Contractor shall establish and comply with commercially reasonable security procedures during the term of this Agreement for the security of the Business Records and Data. Operator may periodically, at reasonable frequencies and time, inspect Contractor's facilities to ensure compliance with this Article. As Contractor Personnel may have access to Operator's financial information and other information that, if utilized or disclosed could lead to violations of United States securities laws, Contractor covenants that it (i) will not trade in securities of Operator in violation of applicable securities laws; and (ii) will maintain a policy that Contractor Personnel will not trade (buy or sell) in securities of Operator in violation of any applicable securities laws. 10.4 The provisions of this Article 10.0 are continuing obligations and responsibilities and shall survive the expiration or prior termination of this Agreement 11.0 FORCE MAJEURE 11.1 Neither Contractor nor Operator shall be responsible for failure to perform under this Agreement when performance is hindered or prevented by causes of Force Majeure. 11.2 Any party which is unable, in whole or in part, to perform its obligations under this Agreement shall give written notice to that effect to the other party within twenty four (24) hours from the time of occurrence of the Force Majeure event stating in reasonable detail the circumstances underlying such Force Majeure and the estimated time to remedy such event. 11.3 Any party claiming Force Majeure shall diligently use all reasonable efforts to remove the cause of such Force Majeure, shall promptly give written notice to the other party of the -16- termination of such Force Majeure, and shall resume performance of any suspended obligations as soon as reasonably possible after termination of such Force Majeure. 12.0 APPLICABLE LAW THIS AGREEMENT SHALL BE CONSTRUED UNDER AND IN ACCORDANCE WITH THE SUBSTANTIVE LAWS OF THE REPUBLIC OF ECUADOR, EXCEPTING ANY LAWS WHICH WOULD REFER THE DISPUTE TO THE LAWS OF ANOTHER JURISDICTION. 13.0 DISPUTE RESOLUTION 13.1. Any dispute, controversy or claim arising out of or relating to this Agreement, including without limitation, a dispute related to breach, termination or invalidity of this Agreement between Operator and Contractor which cannot be amicably resolved by the parties shall be finally and exclusively settled by binding arbitration conducted in accordance with the Rules of the Ecuador American Chamber of Commerce of Quito, Ecuador ("EACC Rules"). The award of the arbitrators shall be final, binding on the parties and not subject to appeal. 13.2 The arbitration tribunal shall be composed of three (3) arbitrators. Each party shall appoint one (1) arbitrator. If, within thirty (30) days after receipt of the claimant's notification of the appointment of an arbitrator, the respondent has not notified the claimant in writing of the name of the arbitrator it appoints, the claimant may request the Ecuador American Chamber of Commerce of Quito, Ecuador ("EACC ") to appoint the second arbitrator. The arbitrators thus appointed shall choose the third arbitrator who will act as the presiding arbitrator of the tribunal. If within thirty (30) days after the appointment of the second arbitrator, the two arbitrators have not agreed upon the choice of the presiding arbitrator, then either party may request the EACC to appoint the presiding arbitrator. In no event shall the presiding arbitrator be a citizen or resident of either the United States of America or the Republic of Ecuador. 13.3 The language of the arbitration shall be English. The arbitral tribunal shall not award special, indirect, consequential, exemplary or punitive damages. The arbitral tribunal may grant interim or injunctive relief or demand specific performance. The arbitration proceedings, including the making of the award, shall take place in Quito, Ecuador and shall be administered by the EACC. 13.4 The award may be entered in any court having jurisdiction and application may be made in such court for a judicial acceptance of the award or an order of enforcement, as the case may be. 13.5 The above terms and provisions governing arbitration of disputes under this Agreement shall not be deemed to or in any way amend, modify or otherwise affect in any manner whatsoever the dispute resolution mechanism set forth in the JOA or the Participation Agreement. -17- 13.6 If for whatever reason the EACC cannot conduct the arbitration, the parties agree the Quito Chamber of Commerce shall administer the arbitration in accordance with the Rules of the Quito Chamber of Commerce and the provisions of Article 13.0 mutatis mutandis. 13.7 The provisions of this Article 13.0 shall continue in force notwithstanding the expiration or prior termination of this Agreement. 14.0 ASSIGNMENT 14.1 The Operator shall be permitted to assign and re-assign (whether on one or several occasions) all or any of the provisions of this Agreement to any Affiliate and/or any co-venturer member of Operator Group with notice only to Contractor; or to any other entity with prior written consent of Contractor. However, the Operator shall be permitted to freely assign this Agreement to any person or entity designated as "Operator" under the JOA, on notice to but without the consent of Contractor, unless the Contractor can demonstrate on reasonable grounds that such assignee is unable to meet the financial obligations hereunder. 14.2 Contractor shall not assign this Agreement in whole or in part without the prior written consent of Operator. Contractor shall not have the right to subcontract the performance of the Services contained within the Base Charges exceeding sixty percent (60%) of the value of the Base Charges in a Calendar Year or any single subcontract with an estimated value of more than USD$100,000 without the consent of Operator. Except as provided herein, in a Change Order or a Ad-Hoc Service Commitment, Contractor shall be solely responsible for paying any subcontractors it uses to provide Services under this Agreement. Subcontracting shall not relieve Contractor of obligations under this Agreement. 14.3 Subject to the above in Article 14.0, this Agreement shall transfer to and be binding on the transferees, successors and assigns of such party. 15.0 WARRANTY AS TO ILLEGAL PAYMENTS Contractor warrants that neither it nor any member of the Contractor Group has made or will make, with respect to the matters provided for hereunder, any offer, payment, promise to pay or authorization of the payment of any money, or any offer, gift, promise to give or authorization of the giving of anything of value, directly or indirectly, to or for the use or benefit of any official or employee of the Government or to or for the use or benefit of any Ecuadorian political party, official, or candidate for the purpose of (i) influencing an official act or decision of that person; (ii) inducing that person to do or omit to do any act in violation of his or her lawful duty; or (iii) inducing that person to use his or her influence within the Government to affect any Government decision unless such offer, payment, gift, promise or authorization is authorized by written laws or regulations of Ecuador. Contractor further warrants that neither it nor any member of Contractor Group has made or will make any such offer, payment, gift, promise or authorization to or for the use or benefit of any other person if the Contractor or any member of Contractor Group knows, has a firm belief, -18- or is aware that there is a high probability that the other person would use such offer, payment, gift, promise or authorization for any of the purposes described in the preceding sentence. The foregoing warranties do not apply to any facilitating or expediting payment to secure the performance of routine Government action. Routine Government action, for purposes of this Article 15.0, shall not include, among other things, Government action regarding the terms, award, amendment, or continuation of the Charapa Contract. Contractor shall respond promptly, and in reasonable detail, to any notice from Operator or its auditors pertaining to the above stated warranty and representation and shall furnish documentary support for such response upon request from Operator. 16.0 MISCELLANEOUS 16.1 If any portion of this Agreement is held to be invalid or unenforceable for any reason by a court of competent jurisdiction, then such portion will be deemed to be stricken and the remainder of this Agreement shall continue in full force and effect. 16.2 A waiver by either party to this Agreement of any of the terms and conditions of this Agreement in any instance shall not be deemed or construed to be a waiver of such term and condition for the future, or of any subsequent breach thereof, or of any other term and condition of the Agreement. 16.3 Headings are for ease of reference only and have no effect on the interpretation or construction of this Agreement. 16.4 This Agreement is the entire agreement of the parties, supersedes any prior communications relating to the text of this Agreement, and this Agreement may not be modified except by written amendment signed by the authorized representatives of both parties. 16.5 Notice may be given by hand, fax (when confirmed by return fax), or registered mail to the addresses set forth below and will be effective upon receipt. In witness whereof, each party has caused it authorized representative to sign in the space provided below as of the day and year hereinabove first written. CONTRACTOR: OPERATOR: TECNIE S.A.C. BELLWETHER INTERNATIONAL INC. By: _______________________________ By: _________________________ Name: _____________________________ Name: _______________________ Title: ____________________________ Title: ______________________ Av. Republica de El Salvador 970 1331 Lamar Street Suite 1455 Ed. El Quilate - Piso 7 Quito, Ecuador Houston, Texas 77010 USA Fax: 593.2.466803 Fax: 713.652.2916 -19- ANNEX A =================================== SCOPE OF SERVICE =================================== ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- ATTACHED TO AND MADE A PART OF THE MASTER SERVICE AGREEMENT, EFFECTIVE AS OF NOVEMBER 1, 1999 BETWEEN BELLWETHER INTERNATIONAL, INC. ("OPERATOR") AND TECNIE S.A.C. ("CONTRACTOR"). 1. GENERAL PROVISIONS 1.1 This Scope of Service describes the Services to be performed by Contractor and includes Contractor's provision of Contractor Personnel to perform certain local operational, planning, lease operations, logistics, accounting, clerical, administrative, communications, Government reporting and liaison, office space, and other duties for the Operations, performance of the Services and requirements of Operator, as set forth below. 1.2 Contractor shall appoint a Country Manager who will report to Operator's Representative. Any delegation of authority to Contractor and to the Country Manager will be given as is deemed appropriate by Operator. Operator and Contractor shall agree upon two (2) other persons acceptable to Operator for delegation and assignment of the Country Manager's duties and authorities in the event of the absence or incapacity of the Country Manager. The Country Manager's duties and authorities may be delegated to such other persons upon prior written notice to Operator. 1.3 Contractor shall ensure the Services are conducted in full compliance with Applicable Law. 1.4 Capitalized terms not defined in this or any Annex shall have the same meaning given them in the Agreement. 1.5 Contractor shall begin preparations for the commencement of the Services after the final and unconditional award of the Charapa Contract by the "CEL" (Comite Especial de Licitaciones ), such that Contractor shall be able to commence the Services when operations under the Charapa Contract are transferred from Petroecuador or Petroproduccion to "Contractor" (as defined in the Charapa Contract). 2. CONTRACTOR'S DUTIES Unless otherwise expressly indicated below, the duties and obligations described in Section 2 of this Annex A shall be performed by Contractor at its expense as part of and comprising the Services; and the costs and expenses incurred by Contractor shall be included in the Base Charges or reimbursed by Operator as Reimbursable Costs, as the case may be. 2.1 Contractor Personnel 2.1.1 Upon commencement of the Services Contractor shall provide the following fully qualified personnel on a full-time basis ("FT") and others shown below on a part-time basis ("PT") as follows: A-1 a) Quito Office: ----------------- (i) Country Manager (PT) (ii) Operations Coordinator (FT) (iii) Head Accountant (FT) (iv) Senior Petroleum Engineer (FT) (v) Systems Technician (PT) b) Field Operations (All Full Time): --------------------------------------- (i) Field Superintendent (ii) Two (2) Drivers (iii) Four (4) Field or Lease Operators 2.1.2 At some time after commencement of the Services, if the need arises for additional Contractor Personnel, Contractor is authorized to and shall, if required, provide the following fully qualified personnel on a full- time basis ("FT") and others shown below on a part-time basis ("PT") as follows: a) Quito Office: ----------------- (i) Finance Manager (PT) (ii) Accounting Assistant (PT) (iii) Junior Petroleum Engineer (FT) (iv) Secretary (Bilingual) (PT) (v) Receptionist (PT) b) Field Operations (All Full Time): --------------------------------------- (i) Field Coordinator 2.1.3 The compensation for all Contractor Personnel (all salary and B&B) shall be included in and be a part of the Base Charges. 2.1.4 All personnel required by Contractor to perform the Services that are in addition to the Contractor Personnel set forth in Section 2.1.1 and Section 2.1.2 above, shall require the Operator's prior written approval. Such additional personnel approved by Operator shall also require amendment of the applicable Annual Budget. Any personnel furnished by Contractor in addition to those set forth in Section 2.1.1 and 2.1.2 in exigent circumstances or an emergency and not approved or requested in writing by Operator shall be immediately notified to Operator along with the rate of compensation (salary and B&B) for such personnel. In such notice to Operator, Contractor shall justify such additional personnel and, if not justified, Operator shall have the right to refuse same. 2.1.5 Payment for all Contractor Personnel shall be made by Operator as part of the Base Charges only for time actually spent in the conduct of the Services (i.e. Work Hours). Contractor shall only be compensated for Contractor Personnel actually engaged in the performance of the Services and to the extent any Contractor Personnel are engaged in activities other than A-2 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- the Services, the rates of compensation (as set forth in Section 1.1 of Annex "B") for such personnel shall be allocated through the use of time sheets in accordance with Annex B. 2.1.6 Prior to hiring Contractor Personnel whose functions are set forth in Section 2.1.1 a) (ii)-(iv) and 2.1.1 b)(i) and Section 2.1.2 a)(i)-(iii) and 2.1.2 b)(i) above, Contractor shall provide Operator with full resumes and work experience of proposed personnel including copies of safety certifications (if applicable), diplomas from universities (if applicable) and industry references. In recruiting personnel for this Agreement, Contractor shall use its best efforts to effectively control costs to ensure that they are not in excess of the "going market rate." 2.2 Operator Liaison & Reporting 2.2.1 Contractor shall provide full coordination and communication with Operator's Representative. 2.2.2 In the conduct of Operations, Operator and Contractor shall agree in advance (or from time to time as the need arises) regarding whether a party, an Affiliate of a party or a Third Party shall provide reporting during all phases of the Services, including: a) Competitive Tendering, Tendering and contracting progress reports; b) accident reports; c) environmental incident reports; d) daily drilling reports; e) timely cost estimate reports - during drilling, reconditioning, workover and other Operations with a drilling or workover rig on the Contract Area; f) bottom hole pressure and flowrate reports; g) well report; h) well recap of consumables and assets and their reconciliation to reports; i) copies of all logs or surveys; j) copies of all tests and core analysis reports; k) copies of all plugging reports; and l) other reports as frequently as is justified by the activities or Operations or as reasonably requested by Operator. 2.2.3 All reports and all communications sent to Operator shall be in the English language or, if not in English, shall be accompanied by a quality translation (at Contractor's expense as a Reimbursable Cost) in English, unless otherwise agreed by Operator's Representative; provided, all reports submitted to the Government by Contractor as a part of the Services shall be photocopied and delivered to Operator in the same form as delivered to the Government. 2.3 Government Liaison & Reporting 2.3.1 Contractor shall coordinate all meetings and liaisons with Government authorities to ensure all Operations are carried out in full compliance with the terms of the Charapa Contract and A-3 ANNEX 'A' SCOPE OF SERVICE ________________________________________________________________________________ Applicable Law and all reporting requirements under the Charapa Contract are completely and timely fulfilled. Contractor shall notify Operator as soon as possible of any meetings with the Government and shall, if requested by Operator, provide written reports of such meetings if Operator is unable to attend, as promptly as possible after such meetings. 2.3.2 Contractor shall prepare and deliver to the Government all reports, records and information required to be furnished by "Contractor" under the Charapa Contract and Applicable Law (other than reports Operator is required to provide in respect of its own interests - e.g. income taxes). 2.4. General Duties In performance of and as a part of the Services and included in the Base Charges (unless expressly designated as a Reimbursable Cost), Contractor shall at all times: a) perform the Services in accordance with the provisions of the Charapa Contract, Applicable Law and this Agreement; b) obtain all permits, consents, approvals, or other rights that may be required for or in connection with the conduct of Services (provided that out-of-pocket costs paid by Contractor to the Government to obtain such permits shall be a Reimbursable Cost); c) pay and discharge all liabilities and expenses arising under all commitments made by Contractor incurred in connection with the Operations and the Services; and use its reasonable efforts to keep and maintain the Contract Area and all Joint Property and Exclusive Property (as such terms are defined in the JOA) free from all liens, charges and encumbrances arising out of the Services; d) take all necessary and proper measures for the protection of life, health, the environment and property, to the extent it is reasonably able to do so, and in the case of an emergency, immediately notify the Operator of the details of any such emergency and measures recommended by Contractor; e) in respect of all Ad-Hoc Services with a value estimated in excess of $10,000 USD and less than $50,000 USD, Contractor shall Tender for such supply or service; and f) in respect of all Ad-Hoc Services with a value estimated in excess of $50,000 USD, Contractor shall Competitive Tender for such supply or service. 2.5 Operational Duties 2.5.1 Contractor Personnel Manpower Services: --------------------------------------- In performance of and as a part of the Services, and included in the Base Charges (unless expressly designated as a Reimbursable Cost), and subject to the other provisions of this Agreement, Contractor shall provide Contractor Personnel set forth in Section 2.1.1 and Section 2.1.2 (and additional Contractor Personnel pursuant to Section 2.1.4) to supervise, administer, coordinate, manage, account for, pay invoices in respect of and otherwise ensure the performance of the duties and obligations set forth below: A-4 ANNEX 'A' SCOPE OF SERVICE ________________________________________________________________________________ a) Perform all reporting to and liaison with the Government as required and as requested by Operator. b) Timely prepare and deliver to the Government all reports, applications, permits and other requests as required by the Government or Applicable Law for execution of the Operations (e.g. drilling or workover permits, permits or consents for storage, allocation, transportation and sale of Hydrocarbons). c) Competitive Tender or Tender (as applicable) for and contract (either for itself or on behalf of Operator) with a Third Party for the initial environmental assessment (i.e. baseline) and the environmental impact study for Operations, and any environmental reporting work required by the Government or Applicable Law and as requested by Operator. d) Competitive Tender or Tender (as applicable) for and contract (either for itself or on behalf of Operator) with a Third Party for a level of security appropriate under the circumstances existing from time to time on the Contract Area, required or as necessary during Operations and as requested by Operator and, in particular, for the personnel, equipment and other assets located on the Contract Area during Operations while a drilling or workover rig or other Third Party service contractor is on the Contract Area. e) To the extent not provided by a Third Party service contractor (e.g. drilling contractor), Competitively Tender or Tender (as applicable) and contract (either for itself or on behalf of Operator) with a Third Party or an Affiliate for the supply of locally obtained equipment, consumables, materials, supplies and services as required or as necessary and applicable to the Operations being conducted or as required by Operator for use in Operations, including, without limitation, ad-hoc fixed wing air charter, ad-hoc medevac rotary aircraft charter, fresh water, fuel, security or additional security, power generation, drilling fluids, roustabouts or laborers; access road, drilling pad and location design, preparation, construction and/or maintenance, catering, lodging or accommodations and vehicles. f) Coordinate, administer and control the logistics procurement, supply, transportation and storage of property of all types in connection with Operations and to the extent not provided by a Third Party service contractor (e.g. drilling contractor), including, without limitation, the administration, documentation and supervision of the Tender or Competitive Tender (as applicable) and contract (either for itself or on behalf of Operator) with a Third Party or an Affiliate for the procurement, and importation of equipment, consumables and materials for use in Operations and the transportation of such equipment, consumables and materials in Ecuador. g) Prepare and deliver all documentation required by the Government or Applicable Law for importation, transportation and storage (referred to in Article 2.5.1 f), and for exemption from customs fees, duties and I.V.A., and import taxes or other levies. h) Comply with Operator's written policies and procedures for handling, storing and inventorying all such equipment, consumables and materials (including use of Operator's Materials Transfer System). i) Maintain the communications system between Contract Area and Quito office to mitigate or prevent interruptions in communication and obtain and maintain all A-5 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- licenses and permits required by the Government or Applicable Law for such communication equipment (unless provided by a Third Party service contractor to Operator or Contractor). j) Manage and oversee daily production of hydrocarbons in the Contract Area, including metering or measuring daily production of hydrocarbons. k) Manage, maintain and oversee all hydrocarbons flowlines, treatment facilities and storage facilities and all other Charapa Facilities on the surface related to production, treatment, transportation and storage of hydrocarbons. l) Coordinate and communicate as required with the purchaser of hydrocarbons in respect of meter calibration, tank measurements, deliveries, volume adjustments and storage requirements and perform other duties required under the contract or agreement with such Third Parties for the purchase and sale of hydrocarbons. m) Conduct, with regular frequency, routine inspection and routine maintenance (excluding major repairs or overhauls) on all Charapa Facilities located above the surface. n) Prepare and submit to the Government all environmental reports, notices and all other data or information regarding the environment as required by the Government or Applicable Law. o) Immediately notify Operator of any damage, loss, spill, pollution or other degradation of the natural environment or sociological impact on the Contract Area or elsewhere caused during or in connection with Operations and/or the Services. p) Ensure all Contractor Personnel in the Contract Area have adequate clothing, shoes and equipment necessary for the Services being performed by such Contractor Personnel. q) Competitive Tender or Tender (as applicable) for and contract with a Third Party to provide environmental studies, surveys, remediation, reporting or other environmental services as needed, requested by Operator or required by the Government or Applicable Law. r) Manage and coordinate all community relations in and around the Contract Area as necessary, required by the circumstances and as required by Operator. s) Act as liaison with community leaders in the Contract Area or other Third Parties or persons (other than the Government or Petroecuador) that make requests or demands upon Operator or Contractor. t) Incur expenditures to maintain good relations with the community surrounding the Contract Area in accordance with the Annual Budget; provided, Contractor shall obtain Operator's prior written approval for any single expenditure under this Section 2.5.1 t) in excess of $5,000. u) Comply with all Government requirements and Applicable Law regarding community relations, sociological studies and programs and other matters, including all reporting to and liaison with the Government as required. v) Endeavor to settle, negotiate or compromise the best position or result for Operator Group regarding all demands or claims made by any member of the community surrounding the Contract Area; provided, Contractor shall not settle or compromise any such claim or demand in excess of $2,500 USD without the prior written consent of Operator. A-6 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- w) Locate, Competitive Tender or Tender (as applicable) for the hire, rental or sublet of and maintain and provide staff for a warehouse or storage yard for Operator's movable property (whether owned, leased or rented); such warehouse or storage yard to be located on or off the Contract Area. x) Comply with Operator's Material Transfer System and Operator's procedures regarding warehouse and inventory control. y) Provide security appropriate under the circumstances existing from time to time for the warehouse and/or storage yard to prevent loss or theft of Operator's property. z) Provide other manpower Services as may be required and requested in writing by Operator. Except as may be expressly provided otherwise, the phrase "Contract (either for itself or on behalf of Operator)" used above, refers to the use of an Ad-Hoc Service Commitment. 2.5.2 Operations in General & Task Schedule: -------------------------------------- a) Consistent with the above, it is the intent of the Parties that Contractor shall conduct normal, routine and on-going lease operations on the Contract Area and in connection with the Charapa Contract. b) Contractor shall be under the general direction of Operator's Representative and Operator shall provide a general schedule of on- going or routine tasks (as part of the Services) for Contractor to perform on a continuing basis ("Task Schedule"). All Contractor Personnel time in fulfillment of the Task Schedule shall be included in the Base Charges (unless expressly designated a Reimbursable Cost) and any reasonable and necessary out-of-pocket expenses incurred by Contractor (other than Base Charges) to comply with the Task Schedule shall be a Reimbursable Cost. 2.5.3 Safety: ------ Within sixty (60) days after the effective date of the Charapa Contract, Contractor shall propose for Operator's written approval a written health and safety policy and procedure for the Operations and performance of the Services based on the procedures, rules and manuals provided by the Operator under Section 3 of Annex A and as may be otherwise agreed by Contractor and Operator. Contractor shall conduct the Operations and perform Services in accordance with such health and safety policy. 2.6 Finance & Accounting Responsibilities 2.6.1 Accounting Functions: -------------------- In performance of and as a part of the Services, and included in the Base Charges (unless expressly designated a Reimbursable Cost), and subject to the other provisions of this Agreement, Contractor shall provide Contractor Personnel set forth in Section 2.1.1 and Section 2.1.2 (and additional Contractor Personnel pursuant to Section 2.1.4) to supervise, A-7 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- administer, coordinate, manage, account for, pay invoices in respect of and otherwise ensure the performance of the duties and obligations set forth below: a) Pay all Third Party and Affiliate invoices submitted to Operator in Ecuador (other than those Operator requires to be paid from its office in Houston, Texas) and all Third Party and Affiliate invoices submitted to Contractor in connection with the Operations and/or the Services in accordance with Government Invoicing Regulations and Applicable Law. Contractor shall obtain Operator's approval prior to paying any invoices for Services performed by an Affiliate of Contractor in excess of $3,000.00. b) Fax to Operator all invoices submitted to Operator in excess of $5,000 USD (or $5,000 USD equivalent) for prior written approval before payment from either of Operator's bank accounts in Quito can be made (unless otherwise specifically agreed by Operator). c) Send Operator an itemization of all invoices submitted to Operator and paid from both of Operator's bank accounts in Quito along with an original of all invoices and a copy of Operator's bank accounts checkbook registers once each month. (Operator will return the original invoices to Contractor after they have been registered in the Operator's books and photocopied). d) Supply to Operator, on a monthly basis, a sufficiently detailed schedule containing an itemization of all charges incurred under this Agreement, including without limitation, Base Charges, Reimbursable Costs and all Third Party invoices paid, along with all necessary supporting documentation. e) Prepare all production accounting, including, tracking of the volumes of hydrocarbons produced, in storage and delivered for sale in accordance with Operator's policies and procedures. f) Maintain current records of allocation of hydrocarbons under the Charapa Contract with Petroecuador. g) Prepare and submit to the hydrocarbons purchaser by the tenth (10/th/) of the month following the month of production (or as otherwise may be provided in the applicable hydrocarbons purchase and sale agreement) an invoice covering the sale of "Contractor's" (as defined in the Charapa Contract) share of the hydrocarbons saved and sold; h) If required by the Government or Applicable Law, prepare and submit all invoices to Petroecuador for the "Base Curve Costs" (as defined in the Charapa Contract), environmental costs and other costs to be reimbursed by Petroecuador under the Charapa Contract. i) Manage, report and pay all administrative and accounting issues and payments unique to Ecuador, including I.V.A. and C.T.T., filings and compliance which are required to be paid by "Contractor" (as defined in the Charapa Contract). j) Send "Vendor Set Up" form to Operator by fax for all new vendors as soon as possible. k) Prepare and fax to Operator the Material Transfer forms after completion of such forms in accordance with Operator's Material Transfer System. A-8 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- l) Invoice Operator for Services provided under this Agreement in accordance with Article 4.0 of this Agreement. m) Provide by the twentieth (20/th/) of each month a cash requirements forecast to Operator with a estimate of Contractor's US Dollar cash requirements for the following month and the "USD Fix Amount" (defined below) for each Sucre invoice. This forecast shall include all Base Charges and Reimbursable Costs anticipated to be paid by Contractor in the following month. n) Promptly forward to Operator all USD invoices erroneously received in Quito which Operator will pay from Houston. o) Maintain and keep true and correct records of the production and disposition of all liquid and gaseous hydrocarbons and of all costs and expenditures under this Agreement. p) Maintain accounting records pertaining to the Services and Operations in accordance with all applicable statutory obligations of Ecuador as well as the provisions of the Charapa Contract and this Agreement, using software, chart of accounts and nomenclature as may be required by the Operator; provided, Operator shall be responsible for the input of all accounting data and information (payables, receivables, etc.) in the Operator's books and chart of accounts in Houston, Texas and such information will be transmitted to Contractor on a regular basis, not less than once each month. q) Maintain accounting records and reports in both the English and Spanish language and in dual U.S. and Ecuador currency. The daily rates of Sucre to US Dollar (and vice-versa) exchange published in el Comercio shall be sent weekly to Operator covering the daily rates for such week. r) Engage, liase with and report to Operator regarding the firm of public accountants acceptable to Operator to provide all statutory accounting and financial reporting requirements in accordance with Applicable Law and, subject to the provisions herein, compensation payable to such firm for advice to or work on behalf of Operator shall be a Reimbursable Cost. 2.6.2 Banking and Payment Authority: ------------------------------ a) As part of the Services and included in the Base Charges, Contractor shall open and maintain in the name of Operator one bank account in Sucres ("Sucre Bank Account") and one bank account in US Dollars ("USD Bank Account") in a bank in Quito, Ecuador acceptable to Operator. Authorization for withdrawals, checks, drafts, transfers and other activity in each of such bank accounts shall be in accordance with the signature authority limitations as set forth in Section 2.6.2 c) below. Contractor shall pay all Third Party invoices (and invoices from an Affiliate of Contractor for performing Services) from either of such accounts (as applicable, depending on the currency payment requirement of the payee and Applicable Law). By the twentieth (20/th/) of each month Contractor shall notify Operator in writing with a request to electronically transfer funds to the USD Bank Account in Ecuador in an amount sufficient to pay all Third Party USD and Sucre invoices received by Contractor at that time and payable within thirty (30) days. Such notice from A-9 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- Contractor requesting USD funds shall include a schedule of all invoices to be paid and shall contain at least the following information for each invoice to be paid: . Payee; . Services rendered; . Amount in USD if a USD invoice; and . Amount in Sucres if a Sucre invoice, and the "USD Fix Amount" (defined in Section 2.6.4 below) for each Sucre invoice. If Operator approves the payment request, it shall immediately transfer the USD funds to the USD Bank Account. The amount of USD funds transferred by Operator to the USD Bank Account to pay the Sucre invoices received in each month shall establish the "Monthly USD Requirement" (as defined in Section 2.6.4 below). Operator shall promptly consult with Contractor if Operator finds errors or questions invoices on such schedule. In accordance with Section 2.6.1 b) above, Contractor shall not pay any invoice in the amount of $5,000 USD or more (or equivalent in Sucre) without prior written approval from Operator (unless otherwise specifically agreed by Operator). b) The USD Bank Account and the Sucre Bank Account are to be used for Operator's payment (by Contractor as part of the Services) of all invoices submitted to Operator in Ecuador and all other commitments or obligations of Operator which Operator elects not to make payment from Houston, Texas. Unless specifically agreed by Operator, Contractor's own costs to provide the Services (i.e. Base Charges) shall be paid from Contractor's own bank accounts and not from Operator's bank accounts. c) Both the USD Bank Account and the Sucre Bank Account shall have limitations of signature authority as follows: USD or USD Equivalent Amount of Payment Signatory ----------------- --------- Up to $5,000 Single Signature - One of: Country Manager, Head Accountant, Contractor's General Manager, or Operator's Representative $5,000 or More Dual Signature - Two of: Country Manager, Head Accountant, Contractor's General Manager, Operator's Representative or Operator's Legal Representative d) Operator shall have the right from time to time to revise or revoke the above signature authority levels or to grant other persons with signature authority on the USD Bank Account and the Sucre Bank Account on written notice to the bank. Such accounts and all other accounts maintained by Contractor on behalf of Operator shall be reconciled by the twentieth (20/th/) day of the following month and such reconciliation shall be delivered to Operator not later than the thirtieth (30/th/) day of such following month. A-10 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- e) Other than the USD Bank Account and the Sucre Bank Account opened with the permission of Operator, Contractor shall have no authority to open any other bank account in the name of Operator nor to establish any line of credit or to create indebtedness in the name or on behalf of Operator. f) Pursuant to Article 4.6 of the Agreement, Contractor may request an MSA Credit for any Base Charges and Reimbursable Costs. 2.6.3 Receipt of Funds or Refunds: ---------------------------- If on behalf of Operator or otherwise, Contractor receives any sum of money, refunds or rebates owing to Operator, Contractor shall immediately deposit such funds in the Sucre Bank Account or USD Bank Account, (based on the currency in which the refund was made), and immediately notify Operator. Operator shall have the right to have all or a part of such funds paid immediately to Operator in any account designated by Operator in the United States or to apply such funds to invoices payable to third parties by Operator or to payment of Contractor's compensation under this Agreement. 2.6.4 Currency Exchange Gains or Losses: ---------------------------------- a) Contractor shall request the transfer of USD funds and Operator shall transfer all USD funds for payment of Sucre invoices received by Contractor in performance of the Services in accordance with Section 2.6.2 a) of Annex A. Contractor shall have the right to transfer from the USD Bank Account to the Sucre Bank Account or vice-versa (or otherwise exchange US Dollars received from Operator to Sucre or vice-versa) based on US Dollars to Sucre exchange rates at that time. Contractor shall receive certain compensation for a "Quarterly Currency Gain" (defined below) as further described in Section 2.6.4 d); provided a "Quarterly Currency Loss" (defined below) shall be borne by certain members of the Operator Group. b) Contractor shall notify Operator by fax of any Quarterly Currency Loss in excess of $1,000 USD within two (2) days after the occurrence of such loss. c) Notwithstanding anything in the Agreement or the Annexes to the contrary, Operator shall have the right, in its discretion, to revoke the Contractor's right to exchange currency and receive compensation for Currency Gain as set forth in this Section 2.6.4 at any time on one (1) day notice in writing to Contractor. In such event, Contractor shall be compensated for Quarterly Currency Gain, if any, occurring during the Quarter such termination notice was sent to Contractor. d) The determination of currency gain or currency loss and Contractor's compensation on Quarterly Currency Gain shall be as set forth below: 1. Definitions: A. "Fix Date" means the day on which Contractor receives a Sucre invoice and stamps the date of receipt on the face of such invoice. B. "Exchange Rate" means the US Dollar buying (i.e. "compra") rate as established by the free market for Quito on the applicable Fix Date, as published in El Comercio newspaper under the heading "Mercado Libre de A-11 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- Cambios" on such applicable date; provided, if not published in El Comercio, then the parties shall mutually agree on another publication. C. "USD Fix Amount" means the amount of a Sucre invoice translated into US Dollars using the Exchange Rate on the Fix Date for such Sucre invoice. D. "Monthly USD Requirement" means the total of the USD funds transferred to the USD Bank Account by Operator for the purpose of paying the sum of the USD Fix Amount of all Sucre invoices received by Contractor in the applicable calendar month (as requested under Section 2.6.2 a) of Annex A). E. "Quarterly USD Requirement" means the sum of the three Monthly USD Requirements in the applicable Calendar Quarter. F. "Quarterly USD Payments" means the total amount of USD transferred from the USD Bank Account to the Sucre Bank Account in the applicable Calendar Quarter for the purpose of paying the Sucre invoices received during such Calendar Quarter and included in the Quarterly USD Requirement. G. "Quarterly Currency Gain" means the positive difference, if any, resulting from subtracting the Quarterly USD Payments from the Quarterly USD Requirement. H. "Quarterly Currency Loss" means the negative difference, if any, resulting from subtracting the Quarterly USD Payments from the Quarterly USD Requirement. 2. Procedure: A. Contractor shall stamp each Sucre invoice on receipt with the date on which Contractor receives such invoice, being the Fix Date. Using the Exchange Rate on the Fix Date shall determine the USD Fix Amount of such Sucre invoice. In accordance with Section 2.6.2 a) of Annex A, Contractor shall request the USD funds to pay the total amount of Sucre invoices received each calendar month calculated on the total of USD Fix Amount of all such invoices. Operator shall transfer the Monthly USD Requirement in accordance with Section 2.6.2 a) of Annex A. After receipt of the Monthly USD Requirement, Contractor shall use its reasonable and prudent discretion and knowledge of US Dollar to Sucre currency exchange fluctuations to determine the proper time or time period in which to exchange all or part of the Monthly USD Requirement at any time or from time to time, but shall not have the right to incur interest or any penalty for late payment or otherwise fail to comply with payment terms covering such invoice. Subject to the foregoing, Contractor shall transfer the appropriate amount of USD from the USD Bank Account to the Sucre Bank Account and the sum of the USD funds transferred to the Sucre Bank Account, for the purpose of paying Sucre invoices received in such Calendar Quarter, shall establish the Quarterly USD Payments. Unless expressly authorized in writing by Operator, other than the Monthly USD Requirement, Contractor shall not have the right to use any other USD funds received from Operator for payment of USD invoices for purposes of currency exchange or trading in Sucres. A-12 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- B. Not later than ten (10) days after the end of each Calendar Quarter, Contractor shall submit a written report to Operator containing all USD-Sucre exchange transactions in respect of the Monthly USD Requirement for each calendar month during such Calendar Quarter and summarized for the entire Calendar Quarter. The report shall also contain an itemization of each Sucre invoice paid, and if known, the currency gain or currency loss for each such paid Sucre invoice and shall summarize the Quarterly Currency Gain, if any or the Quarterly Currency Loss, if any. C. If a Quarterly Currency Gain occurs in a Calendar Quarter, Contractor shall be entitled to twenty-five percent (25%) of such Quarterly Currency Gain. In such event, Contractor shall invoice Operator after the end of the applicable Calendar Quarter in which a Quarterly Currency Gain occurred along with a copy of the written report referred to in B. above. Operator shall pay all undisputed amounts of such invoice within fifteen (15) days of receipt. D. If a Quarterly Currency Loss occurs in a Calendar Quarter, Bellwether and Tecnipetrol, shall bear all such loss. 2.7 Ecuador Operations Overhead In performance of and as a part of the Services and included in the Base Charges (unless expressly designated a Reimbursable Cost), Contractor shall provide: 2.7.1 Quito Operations Overhead -------------------------- a) Suitable office space in Quito for the required number of Contractor Personnel (as set forth in Section 2.1) to perform the Services. Initially, Contractor shall provide approximately 2,000 sq. ft. of office space allocated exclusively to the Services. b) Office supplies, sundries and computer software, for the required number of Contractor Personnel in Quito to be able to perform the Services. c) Office furnishings, fixtures and equipment (e.g. desks, chairs, computers, telephone systems, facsimile, copiers, etc.) for an office sufficient for the required number of Contractor Personnel to be able to perform the Services. d) All utilities (gas, water and power). e) Security services for the Quito office. f) Maintenance, janitorial services and insurance, property insurance on the Quito office and all furnishings, equipment and supplies. g) General Administration and overhead 2.7.2 Field Operations Overhead ------------------------- a) Suitable office space in Lago Agrio with space for a minimum of three (3) Contractor Personnel. b) Storage yard and warehouse facility of sufficient size for safe and secure storage and warehousing of Operator's property (whether owned, leased or rented). A-13 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- c) Office supplies, sundries and computer software for the required number of Contractor Personnel in Lago Agrio to be able to perform the Services. d) Office furnishings, fixtures and equipment (e.g. desks, chairs, computers, telephone systems, facsimile, copiers, etc.) for an office sufficient for the required number of Contractor Personnel to be able to perform the Services. e) Security for the office, warehouse and storage yard and the accommodations in Lago Agrio. f) Maintenance and fuel for two 4x4 vehicles dedicated to Contract Area use. g) All utilities (gas, water and power). h) Maintenance and insurance for the office, warehouse and storage yard and the accommodations in Lago Agrio. i) Accommodations for three (3) persons in Lago Agrio, including regular housekeeping services. 2.8 Contract Tendering and Awards 2.8.1 In performance of and as a part of the Services, and included in the Base Charges, Contractor shall provide Contractor Personnel set forth in Section 2.1.1 and Section 2.1.2 (and additional Contractor Personnel pursuant to Section 2.1.4) to supervise, administer, coordinate, manage, otherwise ensure that Contractor shall (i) Competitive Tender prior to awarding all Ad-Hoc Service Commitments with a value estimated greater than $50,000 USD (or equivalent in Sucre) and (ii) Tender prior to awarding all Ad-Hoc Service Commitments less than $50,000 USD but greater than $10,000 USD (or equivalent in Sucre). Subject to the above and to the Charapa Contract and Applicable Law, Contractor shall award each Ad-Hoc Service Commitment with a value less than $10,000 USD to the best- qualified Third Party without the obligation to Tender or Competitive Tender and without seeking the prior written approval of the Operator; provided, however, Contractor shall not award an Ad-Hoc Service Commitment to an Affiliate of Contractor if the value exceeds $3,000 USD (or equivalent in Sucres), without Operator's prior written consent. Contractor shall maintain a complete file on all Competitive Tenders and Tenders and all such files shall be available for inspection by Operator pursuant to Article 4.7 of the Agreement. 2.8.2 All Ad-Hoc Service Commitments shall be prepared on the applicable contract, service order, purchase order or other forms furnished by Operator and issued in the name of Contractor or in the name of Operator and signed by the Country Manager or the Operator's Representative. All Ad-Hoc Service Commitments shall be prepared in accordance with the respective Tender or Competitive Tender document or as required by Operator. The Country Manager shall not have the right or authority to sign any Ad-Hoc Service Commitments with a Third Party if the value exceeds $50,000USD (or equivalent in Sucres) or with an Affiliate of Contractor if the value exceeds $3,000 USD (or equivalent in Sucres), without Operator's prior written consent. Operator shall have the right from time to time to revise the A-14 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- Country Manager's signature authority or to grant other persons the right to sign Ad-Hoc Service Commitments in the name of Operator. 2.8.3 Operator shall have the right to withhold payments to Contractor in respect of any Ad-Hoc Service Commitment awarded in violation of Section 2.8.1 or Section 2.8.2. 2.8.4 Contractor shall have written contracts, purchase orders or service orders for all Ad-Hoc Service Commitments regardless of the value (unless Operator otherwise agrees in writing). Contractor shall retain one original of all such contracts, purchase orders or service orders in its offices in Quito and promptly send one original to Operator. Contractor shall maintain a proper filing and retrieval system for all such documents and all correspondence and other information pertaining to such documents. 2.9 Ad-Hoc Services 2.9.1 As provided in and subject to this Agreement, Contractor shall, and Operator shall have the right to request from time to time that Contractor provide, or contract with a Third Party to provide, Ad-Hoc Services. Unless the value of the Ad-Hoc Services is estimated to be less than $10,000, Contractor shall conduct a Tender or Competitive Tender (as applicable) for such Ad-Hoc Services and shall notify Operator of the results of same. Contractor or an Affiliate of Contractor shall have the right to conduct the Ad-Hoc Services provided Contractor or such Affiliate participates in the Tender or Competitive Tender (as applicable) for such Ad-Hoc Services. 2.9.2 If Contractor or an Affiliate is selected to perform the Ad-Hoc Services, then prior to incurring any commitment or expenditure, Operator and Contractor or Operator and such Affiliate of Contractor shall enter into an Ad-Hoc Service Commitment to govern the performance of the Ad-Hoc Services. The Ad-Hoc Service Commitment shall cover all information relevant to the Ad-Hoc Services, including: . description of services or deliverables; . rates or lump sum cost; . proposed completion or delivery date; and . required resource(s) to complete the Ad-Hoc Services. Compensation properly payable to Contractor or an Affiliate of Contractor under an Ad-Hoc Service Commitment shall be made as a payment for Ad-Hoc Services and not as a Base Charge or a Reimbursable Cost and thus shall not be subject to the Contractor's Additional Mark-Up. 2.9.3 If a Third Party is selected to perform the Ad-Hoc Services, Operator shall have the option of entering into an Ad-Hoc Service Commitment with such Third Party or requiring Contractor to enter into an Ad-Hoc Service Commitment with such Third Party. If Operator so requires and Contractor and such Third Party enter into an Ad-Hoc Service Commitment, Contractor shall invoice Operator in accordance with the relevant Ad-Hoc Service Commitment and all costs properly payable under the Ad-Hoc Service Commitment shall be a Reimbursable Cost. If Operator and a Third Party enter into an Ad-Hoc Service A-15 ANNEX 'A' SCOPE OF SERVICE - -------------------------------------------------------------------------------- Commitment, such Third Party shall invoice Operator directly and such amounts shall not be a Reimbursable Cost. If Operator and an Affiliate of Contractor enter into an Ad-Hoc Service Commitment, such Affiliate shall invoice Operator directly and such amounts shall not be a Reimbursable Cost. (Upon execution of an Ad-Hoc Service Commitment between Contractor and a Third Party, if not already a member of the Contractor Group, such Third Party shall thereupon be a member of Contractor Group. Likewise, upon execution of an Ad-Hoc Service Commitment between Operator and a Third Party, if not already a member of the Operator Group, such Third Party shall thereupon be a member of Contractor Group.) 3. OPERATOR'S DUTIES: 3.1 Provision of Documents: Operator shall provide the following: a). Model Contracts and Tender Forms b). All policies and procedures referenced in this Agreement c). Vendor Set-up Form d). Material Transfer Forms and procedures e). General oversight and directions 3.2 Safety Operator shall conduct periodic health safety audits at least two times per Calendar Year to verify Contractor's compliance with the health and safety manual promulgated by Contractor (and approved by Operator) in Section 2.5.3 of Annex A. A-16 ANNEX B ============================ COMPENSATION SCHEDULE ============================ ANNEX B COMPENSATION SCHEDULE _______________________________________________________________________________ ATTACHED TO AND MADE A PART OF THE MASTER SERVICE AGREEMENT, EFFECTIVE AS OF NOVEMBER 1, 1999 BETWEEN BELLWETHER INTERNATIONAL, INC. ("OPERATOR") AND TECNIE S.A.C. ("CONTRACTOR"). RATES OF COMPENSATION & CALCULATIONS Contractor's compensation shall be divided into four (4) categories as set forth below: 1.1 BASE CHARGES 1.1.1 Contractor Personnel Costs -------------------------- (All amounts shown in Section 1.1.1 below are in US Dollars)
POSITION MONTHLY RATE B&B TOTAL MONTHLY RATE ---------------- ------------- ---- ------------------ EXEMPT: - --------- (i) Country Manager (PT) $8,000 (ii) Operations Coordinator (FT) $2,500 (iii) Finance Manager (PT) $2,000 (iv) Head Accountant (FT) $2,500 (v) Senior Petroleum Engineer (FT) $4,000 (vi) Junior Petroleum Engineer (FT) $1,500 (vii) Field Superintendent (FT) $3,500 (viii) Field Coordinator (FT) $ 800 NON-EXEMPT: - ---------------- (i) Accounting Assistant (PT) $ 500
B-1 ANNEX B COMPENSATION SCHEDULE ______________________________________________________________________________ (ii) Systems Technician (PT) $ 500 (iii) Receptionist (PT) $ 300 (iv) Secretary (Bilingual) (PT) $ 600 (v) Four (4) Field or Lease Operators (FT) $2,000 ($500 each) (vi) Two (2) Drivers in Contract Area (FT) $1,200 ($600 each) 1.1.2 Miscellaneous Personnel Provisions ---------------------------------- a) The above "Total Monthly Rate" includes both Salary and proportionate B&B for each Contractor Personnel. The Monthly Rate salary shall include vacations under Contractor's employee policies and procedures. "Part Time" shall be defined as eighty (80) Scheduled Hours per calendar month. "Full Time" shall be defined as one hundred sixty (160) Scheduled Hours per calendar month. b) Contractor shall receive compensation in respect of Contractor's Personnel only to the extent that such personnel are engaged in performance of the Services and not engaged in other activities not related to or a part of the Services. All Contractor Personnel shall record their respective time engaged in performance of the Services (i.e. Work Hours) on time sheets. Contractor shall receive compensation (as part of the Base Charges) only for the actual Work Hours each calendar month out of the total Part Time Scheduled Hours or Full Time Scheduled Hours in a calendar month, as applicable as to each of Contractor Personnel; provided, Contractor Personnel have recorded their respective Work Hours on time sheets. Accordingly, Contractor shall be entitled to a percentage of the Contractor Personnel Costs based on the pro rata part of the total number of Work Hours (Part Time or Full Time) versus the Scheduled Hours (Part Time or Full Time) during the applicable calendar month, depending on Exempt or Non-Exempt nature of Contractor Personnel. c) Contractor Personnel designated as "Exempt" above are not entitled to overtime pay and the compensation payable by Operator for such Contractor Personnel as part of the Base Charges shall not exceed the Total Monthly Rate set forth in Section 1.1.1 above. Contractor Personnel designated above as "Non-Exempt" shall be entitled to overtime pay for Work Hours in excess of their applicable Scheduled Hours (i.e. Full Time or Part Time) in accordance with Applicable Law. If the overtime for any Non-Exempt Contractor Personnel exceeds twenty percent (20%) of the applicable Scheduled Hours for such Non-Exempt Contractor Personnel, Operator and Contractor shall discuss possible increased personnel needs or other methods to B-2 ANNEX B COMPENSATION SCHEDULE ______________________________________________________________________________ mitigate the overtime and overtime compensation. Contractor shall not have right to allow Non-Exempt Contractor Personnel to exceed twenty- five percent (25%) of their applicable Scheduled Hours without prior approval of the Operator. Contractor shall report overtime properly payable by Operator (in accordance with the above) as part of and in addition to the Base Charges. d) "B&B" shall include the following benefits and burdens Contractor Personnel are entitled under Applicable Law: . Supplementary Bonus (Bonif Comple) . Cost of Living Compensation (Compen Cost Vida) . 13th, 14th, 15th & 16th Salaries (Sueldos) . Medical and Insurance Benefit (Salud y Vida) . IESS Employer Contribution (IESS Patronal) . Vacations (Vacaciones) . Reserve Funds (Fondos de Reserva) . Sick Leave . Severance Pay (Indemnizacion por Despido) e) Pursuant to Section 2.1.2 of Annex A, only certain of the above Contractor Personnel will be on payroll on the Effective Date; others will be added as required. 1.1.3 Ecuador Operations Overhead Costs: ---------------------------------- Covering Contractor's cost and expenses to provide the items described in Section 2.7.1 and 2.7.2 of Annex A. a) Quito Operations (described in Section. 2.7.1 of Annex A): The compensation for the fixed overhead charges for items described in Section 2.7.1of Annex A and provided by Contractor shall be: (i) For the period from the Effective Date until 31 December 2000 (subject to Article 2.2 and Article 2.3 of the Agreement) the sum of USD$14,141.00 per month. (ii) For the period of time after 31 December 2000 (subject to Article 2.2 and Article 2.3 of the Agreement) the amount mutually agreed by the parties in the Annual Budget. b) Field Operations (described in Section 2.7.2 of Annex A) The compensation for the fixed overhead charges for items described in Section 2.7.2 of Annex A shall be: (i) For the period from the Effective Date until 31 December 2000 (subject to B-3 ANNEX B COMPENSATION SCHEDULE ______________________________________________________________________________ Article 2.2 and Article 2.3 of the Agreement) the sum of USD$12,076.00 per month. (ii) For the period of time after 31 December 2000 (subject to Article 2.2 of the Agreement) the amount mutually agreed by the parties in the Annual Budget. c) Notwithstanding the above in Sections 1.1.3 a) and 1.1.3 b) above, the compensation for the Ecuador Operations Overhead shall only be due and payable by Operator as and when such costs and expenses are incurred by Contractor as and when the Services described in Sections 2.7.1 and 2.7.2 of Annex A are provided by Contractor; and a deduction from the above amounts or agreed amounts shall be made to the extent that Ecuador Operations Overhead is not provided by Contractor. 2.1 REIMBURSABLE COSTS: 2.1.1 Reimbursable Costs are certain pass-through costs and expenses specifically designated in this Agreement paid by Contractor and to be reimbursed by Operator, including, without limitation: . Third Party charges to perform the Services, excluding however, such costs and expenses covered by or included in the Base Charges; . out-of-pocket costs paid by Contractor for permits, customs fees or other Government fees; . Transfer Tax, but only if not deducted from or credit to Contractor's tax liability (and excluding income and all other taxes specifically applicable to Contractor or an Affiliate); . Ad-Hoc Services performed by a Third Party pursuant to an Ad-Hoc Service Commitment between Contractor and such Third Party; . External Services (as defined in and in accordance with the Annual Budget); . Quito Office Expenses (as defined in and in accordance with the Annual Budget); and . Field Expenses (as defined in and in accordance with the Annual Budget). 2.1.2 Contractor shall obtain prior written approval of Operator for any External Services estimated to be in excess of $3,500. 3.1 Ad-Hoc Services: Compensation for Ad-Hoc Services will be made on the basis of and in accordance with the applicable Ad-Hoc Service Commitment governing the respective Ad-Hoc Services, in accordance with Section 2.9.3 of Annex A. 4.1 CONTRACTOR'S MARK-UP: Contractor's Mark-Up is comprised of: (i) Contractor's Base Mark-Up and (ii) Contractor's B-4 ANNEX B COMPENSATION SCHEDULE ______________________________________________________________________________ Additional Mark-Up, as set forth below. 4.1.1 Contractor's Base Mark-Up Calculation: ------------------------------------- Contractor's Base Mark-Up shall be calculated by reference to a sliding scale percentage of the sum of the Base Charges (described in Section 1.1 above) paid (or deemed paid under an MSA Credit) by the Operator to Contractor per Calendar Year under this Agreement as set forth below: BASE CHARGES PER CALENDAR YEAR MARK-UP PERCENTAGE ------------------------------ ------------------ (USD or USD/Sucre Equivalent) On the amounts from $0 to $350,000 30% On the excess above $350,000 and up to $1,000,000 25% On the excess above $1,000,000 and up to $2,000,000 15% On the excess above $2,000,000 To be Negotiated 4.1.2 Contractor's Additional Mark-Up Calculation: -------------------------------------------- Contractor's Additional Mark-Up shall be fifteen percent (15%) of the Reimbursable Costs payable by the Operator under this Agreement. 4.1.3 Contractor's Mark-Up - Additional Provisions ---------------------------------------------- a) Contractor's Base Mark-Up shall be payable in accordance with the percentages set forth in Section 4.1.1 on a monthly basis, in accordance with the percentage applicable to the cumulative total amount of the Base Charges paid by Operator to Contractor from the beginning of the Calendar Year to the end of the applicable month and in accordance with Article 4.2 and Article 4.3 of the Agreement. b) Contractor's Additional Mark-Up shall be payable monthly based on the percentage applicable to Reimbursable Costs under Section 4.1.2 for the Reimbursable Costs payable by Operator to Contractor each month in accordance with Article 4.2 and Article 4.3 of the Agreement. c) Payments made by Operator to Contractor or an Affiliate of Contractor for rendering Ad-Hoc Services pursuant to an Ad-Hoc Service Commitment between Operator and Contractor or between Operator and an Affiliate of Contractor are deemed to include the Contractor's Additional Mark-Up for the entity rendering the Ad- Hoc Services and shall be as agreed in the applicable Ad-Hoc Service Commitment and shall not be a Reimbursable Cost subject to Contractor's Additional Mark-Up. Contractor shall be entitled to Contractor's Additional Mark-Up on Ad-Hoc Services (as a Reimbursable Cost) only when the Ad-Hoc Services are performed by a Third Party under a Ad-Hoc Service Commitment between such Third Party B-5 ANNEX B COMPENSATION SCHEDULE ______________________________________________________________________________ and Contractor and the amounts paid under such Ad-Hoc Service Commitment shall be added to the "Reimbursable Costs Per Calendar Year" (above) for purposes of determining Contractor's Additional Mark-Up. d) I.V.A. tax will be added to invoices submitted to Operator by Contractor. B-6 ANNEX C ================================ FIRST YEAR ANNUAL BUDGET ================================ ANNEX 'C' FIRST YEAR ANNUAL BUDGET ================================================================================ ATTACHED TO AND MADE A PART OF THE MASTER SERVICE AGREEMENT, EFFECTIVE AS OF NOVEMBER 1, 1999 BETWEEN BELLWETHER INTERNATIONAL, INC. ("OPERATOR") AND TECNIE S.A.C. ("CONTRACTOR"). [INSERT 1/st/ YEAR BUDGET] C-1 ANNEX D ============================== INSURANCE REQUIREMENTS ============================== ANNEX `D' INSURANCE REQUIREMENTS - -------------------------------------------------------------------------------- ATTACHED TO AND MADE A PART OF THE MASTER SERVICE AGREEMENT, EFFECTIVE AS OF NOVEMBER 1, 1999 BETWEEN BELLWETHER INTERNATIONAL, INC. ("OPERATOR") AND TECNIE S.A.C. ("CONTRACTOR"). The types and minimum insurance coverages that Contractor is required to procure, carry and maintain are as follows: 1. Worker's Compensation Insurance or similar insurance covering persons employed by or a member of Contractor Group, during any period while Services are being performed by a member of the Contractor Group as required by and in amounts sufficient to comply with Applicable Law. This insurance shall be extended to include an "Alternate Employer" endorsement designating the Operator on such endorsement. 2. Employer's Liability Insurance with limits of not less than USD $1,000,000 (or Sucre equivalent thereof) for each person and USD $1,000,000 (or Sucre equivalent thereof) for each occurrence for Bodily Injury by Accident and USD $1,000,000 (or Sucre equivalent thereof) policy limit for Bodily Injury by Disease. The insurance shall be extended to include an "Alternate Employer" endorsement designating the Operator on such endorsement. 3. Commercial General Liability Insurance with a combined single limit for Bodily Injury and Property Damage of not less than USD $1,000,000 (or Sucre equivalent thereof) per occurrence, and such coverage shall be written on an "occurrence" form and shall include broad form comprehensive general liability coverage, broad form Contractual liability coverage (contemplating and insuring the indemnity obligations of Contractor under the Agreement), products and completed operations liability coverage, premises/operations liability coverage, and such other coverage as may be necessary to cover all the Services and all risk and liabilities assumed by Contractor under this Agreement. 4. Business Automobile Liability Insurance covering all owned, non-owned, hired and leased vehicles used by Contractor Group in connection with the Services with a combined single limit of not less than USD $1,000,000 (or the foreign currency equivalent thereof) for Bodily Injury and Property Damage. 5. Umbrella or Excess Liability Insurance with limits of not less than USD $5,000,000 (or Sucre equivalent thereof) per occurrence in excess of all coverage and limits in the policies listed in Articles 2, 3, and 4 above. Provide, upon Operator's approval, Contractor shall have the right to reduce the limits on the coverages shown above if Contractor can demonstrate such limits are excessive in the Ecuador insurance market or are significantly more expensive than lower limits and, further, that such lower limits adequately protect the parties under the circumstances. D-1 EX-21.1 6 SUBSIDIARIES BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES Exhibit 21.1 Subsidiaries of Bellwether Exploration Company Incorporation State of - ------------- -------- Snyder Gas Plant Venture Texas NGL-Torch Gas Plant Venture Texas Black Hawk Oil Company Delaware Bellwether International Delaware Pan American Energy Finance Corp. Delaware Carpatsky Petroleum Inc. Alberta Carpatsky Petroleum Corp. Delaware Bellwether Cayman Delaware EX-23.2 7 CONSENT OF RYDER SCOTT [RYDER SCOTT COMPANY LETTERHEAD APPEARS HERE] CONSENT OF INDEPENDENT PETROLEUM ENGINEERS We hereby consent to the use of this Annual Report on Form 10-K of our reserve report dated February 18, 2000 relating to the oil and gas reserves of Bellwether Exploration Company at January 1, 2000. We also consent to the references to us under the heading "Reserves" in the Notes to the Consolidated Financial Statements of Bellwether Exploration Company in such report. /s/Ryder Scott Company L.P. --------------------------- RYDER SCOTT COMPANY, L.P. Houston, Texas March 24, 2000 EX-23.3 8 CONSENT OF KPMG LLP Exhibit 23.3 Independent Accountants' Consent The Board of Directors Bellwether Exploration Company: We consent to incorporation by reference in the registration statement (No. 33-91320) on Form S-8, registration statement (No. 33-91326) on Form S-8, registration statement (No. 333-27707) on Form S-8 and registration statement (No. 333-16231) on Form S-8 of Bellwether Exploration Company of our report dated March 16, 2000, relating to the consolidated balance sheets of Bellwether Exploration Company and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the year ended December 31, 1999, 1998 and the six month period ended December 31, 1997, and the years ended June 30, 1997, which report appears in the December 31, 1999 annual report on Form 10-K of Bellwether Exploration Company. KPMG LLP Houston, Texas March 24, 2000 EX-27 9 FINANCIAL DATA SCHEDULE
5 1,000 12-MOS DEC-31-1999 JAN-01-1999 DEC-31-1999 6,101 0 14,354 0 0 22,017 368,353 (141,127) 171,761 18,247 100,000 0 0 142 23,172 171,761 67,948 70,747 45,395 65,088 7,848 0 11,845 5,659 (3,154) 8,813 0 0 0 8,813 $0.64 $0.63
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