The Rotliegend in Poland Regional Setting

We are focused on the Polish portion of the gas bearing Rotliegend fairway of the Northwest European Permian Basin.  This fairway begins in the west in the UK sector of the Southern North Sea ("SNS"), extends through the Netherlands and Germany, and culminates in Poland.  Similar aeolian Rotliegend sandstone reservoirs, formed by structural and/or stratigraphic traps, with gas sourced by Carboniferous coals and sealed by Zechstein evaporates, extend across the Basin.

Steady advances in geophysical techniques in these Permian basins have led to the discovery and development of over 200 trillion cubic feet (Tcf) of gas in the Rotliegend of the SNS Gas Basin and the Dutch onshore.  In contrast, only 5 Tcf of gas has been discovered by PGNiG to date in the Rotliegend in Poland since the mid-sixties, mostly in shallow plays to the south of the Wolsztyn High.  Between 1976 and 1985 however, 500 bcf of gas reserves was discovered by PGNiG in a deeper Rotliegend play, to the north of the Wolsztyn High.  This Radlin trend bisects our Fences concession.  There was little or no activity targeted towards the Rotliegend by PGNiG since these discoveries in the early eighties.  During the past dozen years PGNiG’s attention has focused on the Main Dolomite and Basal Limestone plays in the Zechstein.

We have concluded that there are likely to be substantial additional gas reserves in the Rotliegend (and in the Main Dolomite and Basal Limestone) that can be identified through the application of geophysical techniques that have not previously been applied in this area in Poland.

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Exploration History

While many wells have been drilled "Soviet-style" in the region, effective exploration drilling density is relatively low at the Rotliegend horizon.  The quality of seismic data in this area has been poor until recently.  Furthermore, interpretation is subject to the well-known complexities affecting the Rotliegend throughout the Northwest European Permian Basin.  Interpretation lessons from the SNS were generally not applied.  It is only in the last few years, with the entry of western companies, the computer enhancement of vintage seismic and the acquisition of good quality new seismic data, that the substantial additional exploration potential within the Rotliegend in Western Poland has been recognized.

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Geological Setting

The Rotliegend sandstone, our main target reservoir, is present throughout the Fences and Northwest concession project areas at depths of between approximately 2,500 to 4,000 meters (approximately 1,200 to 1,500 meters in Block 287).  The Rotliegend dips gently towards the northeast, into the Foresudetic Monocline.  To the southwest, the Rotliegend pinches out up dip onto the Wolsztyn High, with stratigraphic play potential.

Reservoir quality deteriorates somewhat as depth of burial increases.  However, a down dip well at a depth of 3,750 meters, and our own commercial successes at Zaniemysl 3 (2,850 meters), Sroda 4 (3,600 meters), Winna Gora (3,550 meters), Roszkow (3,000 meters), Kromolice-1 (3,500 meters) and Kromolice-2 (3,550 meters) support good reservoir characteristics over virtually the entire Fences area.  The top Rotliegend horizon is quite heavily faulted, most frequently by normal faults.  The dominant trend of these faults is northwest to southeast, with most tending to downthrow to the northeast.  However, a number of potential traps, and the Radlin field itself, are set up by down thrown faults against the regional dip.

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Rotliegend Reservoir Presence and Quality

In the Upper Rotliegend, desert sandstones, mainly aeolian with minor fluvial and sabkha deposits, are the dominant facies in the Fences areas.  The Fences concession area is favorably located for aeolian facies sands with good porosity and permeability characteristics.  Some of the best reservoir rock is found in the Fences area as the Rotliegend climbs up the Foresudetic Monocline around the Radlin field.

Reservoir quality in many wells in the area is extremely good in the top 40-65 meters of the Rotliegend, which is usually predominantly clean aeolian dune facies.  Volumetrically, this interval would form at least 90% of the expected closure in all but the very biggest anticipated structural cases.

Based on offset well data and regional models, porosities in this upper interval generally range between 14% and 20%.  Permeabilities are harder to predict and more variable, as they are dramatically affected by grain-size, which varies independently of facies and porosity.  Nevertheless, core permeabilities show an average of 25 mD, generally within a range of 10 mD to 100 mD, with individual layers from less than 1 mD to several Darcies.  Average permeabilities from well tests in the Radlin field are 185 mD.

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The Zechstein in Poland

The Zechstein has two proven productive carbonate horizons in Poland’s Permian Basin: the Basal Limestone or Ca1 and the Main Dolomite or Ca2.  The Ca1 is gas productive and has been the target of extensive exploration since the early 1980’s. The Ca2 has more recently been proved to be oil as well as gas bearing in subtle stratigraphic plays apparent on 3-D seismic.

Based on this 3-D work, two significant oil prone stratigraphic plays have been recognized in the Ca2 in lowstand fan features down slope from structural highs. The potential of these plays is illustrated by two PGNiG discoveries: the BMB field discovered in 1993 with a reported 90 million barrels of oil plus 350 bcf of gas and the Lubiatow-Miedychod-Grotow (LMG) complex with a reported 38 million barrels of oil plus 160 bcf of gas. These two fields together have recoverable oil and gas reserves reportedly in excess of a TCF equivalent. These main Dolomite or (Ca2) fields are located in Western Poland.

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Polish Exploration Rights

As of December 31, 2010, we held oil and gas exploration rights in Poland in a number of separately designated project areas encompassing approximately 4.6 million gross acres.  We are currently the operator in all areas, except our 852,000 gross-acre core Fences project area, in which we hold a 49% interest in approximately 807,000 acres and a 24.5% interest in the remaining 45,000 acres.  PGNiG is the operator in the Fences project area.  We hold interests in approximately 4.0 million net acres throughout Poland. 

As we build revenues in our core area and further explore and evaluate our acreage in Poland, we expect to increase the operational and financial efforts we expend outside our core area.  As we do so, we may add new concessions that we believe have high potential and relinquish acreage that we believe has lower potential.

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Exploratory Activities in Poland

Our ongoing activities in Poland are conducted in several project areas: Fences, Block 287, Warsaw South, Kutno, Northwest, Edge, Block 229, and Block 246.  Our drilling activities have been focused primarily on the core Fences area.  We have focused on this core area because substantial gas reserves have already been discovered and developed by PGNiG.  We and PGNiG have discovered proved gas reserves of over 137 Bcf gross (59 Bcf net to our interest) in eight commercial wells in the Fences area as of the date of this report.  We have concluded that there is likely to be substantial additional natural gas in the same geologic horizon in this area.  We are selling gas from wells located in the Fences area and Block 287. 

We plan to begin drilling on the Warsaw South and Kutno concessions in 2011.  These wells will be targeting greater resources, but will be higher risk than our Fences wells.  To help mitigate the financial risk from drilling these wells, we have executed farm-out agreements with industry participants.

We are developing longer-term exploration prospects in the remaining project areas.

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Fences Area

The Fences concession area is 852,000 gross acres (3,450 sq. km.) in western Poland's Permian Basin. surrounding PGNiG's Radlin gas field. PGNiG gas fields located in the Fences area are "fenced off" or excluded from our exploration acreage. These fields, discovered by PGNiG between 1974 and 1985, produce from structural traps in the Rotliegend sandstone. We hold a 49% interest in approximately 807,000 acres and a 24.5% interest in the remaining 45,000 acres in the Fences area for 406,000 total net acres.

The Rotliegend is the primary target horizon throughout most of the Fences concession area, at depths from approximately 2,500 to 4,000 meters. Both structural traps and stratigraphic ("pinch-out") traps are known to produce gas from the Rotliegend in the region. In addition, we have identified what appear to be carbonates in the Zechstein formation, a third type of trap that is known to produce both oil and gas in the region.

Fences Area: Structural Traps

Based on our drilling experience since 2000 in the Fences area, we have emphasized the use of seismic acquisition, processing, and interpretation techniques that have been used successfully in the Rotliegend gas fields of the United Kingdom's offshore Southern Gas Basin.  With Rotliegend structures as our target and using improved seismic data processing and acquisition techniques, we have drilled 11 wells targeting Rotliegend structures through the date of this filing.  Eight of these wells are commercial, with aggregate remaining proved gas reserves of over 112 Bcf gross (51 Bcf net to our interest) as of December 31, 2010, including proved reserves from the Lisewo-1 well, which was completed subsequent to year-end 2010.

Three of these wells have been in production from 2009 or earlier.  A newly constructed production facility has been completed for the Kromolice-1, Sroda-4, and Kromolice-2, or KSK, wells.  One of the KSK wells began production during late December 2010.  We expect production from the other two KSK wells to begin during the second quarter of 2011.  By the second half of this year, we expect the KSK wells to collectively produce approximately 14 MMcfd of gas (6.9 MMcfd net to us).  Our Winna Gora well is expected to begin producing in the first half of 2012.  Our recent Lisewo-1 discovery should begin production in mid-2013.  Those wells that are currently in production are producing under the required production licenses obtained by PGNiG in its capacity as operator or under the two-year period of test production that is permitted under the exploration concession. 

Finally, in the northernmost part of our Fences concession and lying within the area covered by our recently acquired 3-D seismic data, we have identified a very large upthrown block, or horst, of Rotliegend sandstone that encompasses approximately 50 square kilometers, or 12,000 acres.  One well, the 1984 Plawce-1, was drilled by PGNiG on this Rotliegend block within what is now our Fences concession.  Six other wells have been drilled by others (four of these more than 20 years ago) in this horst block north of our concession boundary.  All six of these wells had substantial gas columns, and all but the most recent two wells were plugged due to relatively tight reservoir rocks.  The newest well, the Trzek-2, located about 12 kilometers north of our concession, was drilled by another firm in 2010 and 2011 and reportedly tested gas at a rate 17 MMcfd on a short-term test, after high-pressure, hydraulic fracturing along a 1,350 meter horizontal wellbore.  Prior to that, the Trzek-1 well, located about six kilometers north of our concession and drilled by the same firm, reportedly tested gas at rates between 2.5 and 7.5 MMcfd after high-pressure, hydraulic fracturing from a vertical wellbore.  We are continuing to evaluate our data and are working with PGNiG on a plan to appraise and explore the gas resource in the Plawce area.  We expect to start drilling a well here in the second quarter of 2011.

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Block 287 Concession Area

The Block 287 concession area is 13,000 acres (52 sq. km.) located approximately 25 miles south of the Fences concession area.  We own 100% of the exploration rights.  We retained this small portion of Block 287 when we relinquished larger portions in 2007 and 2008.

Within our retained acreage in Block 287, there are three Rotliegend gas wells known as the Grabowka wells.  Originally drilled by PGNiG in 1983-85, these three wells tested gas but never produced commercially.  In early 2007, we entered into a joint venture agreement with an unrelated party, PL Energia S.A., headquartered in Krzywoploty, Poland, under which all costs of reentering and completing the three Grabowka wells and building production facilities would be paid by our joint venture partner in exchange for discounted pricing on gas.  To date, we have reentered only the Grabowka-12 well, which has been producing since July 2009 at an average daily rate of approximately 0.5 MMcfd.

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Northwest Concession Area

Kutno Concession Area

 We hold a 100% interest in 706,000 gross acres (2,856 sq. km.) acquired in 2007 and 2008.  The area encompasses a Rotliegend mega-structure ("Kutno") with projected four-way dip closure.  Depth of the structure is estimated at approximately 6,500 meters (21,000 feet).  In view of the depth and cost, we determined to seek industry participation to bear initial exploration costs.  In 2011, PGNiG and FX Energy signed a joint operating agreement under which PGNiG will earn 50% interest in the concession.  A test well on the Kutno structure began drilling in mid 2011.   

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Warsaw South Concession Area

We hold a 100% interest in a total of 638,000 acres (2,581 sq. km.) in east-central Poland that we acquired in 2007.  We also hold an 82% interest in 236,000 acres in the same project area.  The Warsaw South concession has several exploration leads, including carboniferous sands and shales with structural or truncation trapping and possibly Zechstein reefs trapped by overlying evaporites and salt.  Our technical group has reviewed the geological and geophysical data from the area and identified a dozen carboniferous leads and two possible Zechstein reef targets.  We are currently acquiring two-dimensional, or 2-D, seismic data over some of these leads and plan to drill two wells in the Warsaw South concession area in 2011. 

In December 2010, we entered into a letter of intent with PGNiG under which it may acquire a 49% interest in the Warsaw South concession area in exchange for paying for some of the early-stage exploration work.  We will continue as operator.

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Edge Concession Area

In 2008, we acquired a 100% interest in four concessions in north-central Poland covering approximately 881,000 acres (3,567 sq. km.).  Having reprocessed existing 2-D seismic data, we identified a number of leads, including several Permian age Ca2 reefs and a large Devonian structure.  We plan to acquire additional 2-D seismic data this year over two of these leads to select possible drilling locations.  We may seek industry participation in the drilling of wells in this concession area.  

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Block 246 Concession Area

In 2008, we acquired a 100% interest in a concession south of our Fences project area covering approximately 241,000 acres (975 sq. km.).  We have identified an area with potential for Rotliegend gas and a different area with potential for calcium-rich, Ca1 reef build-ups where the Koscian field trend may extend into Block 246.  We plan to seek industry participation while continuing to carry out early-stage exploration work on our own.

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Block 229 Concession Area

In 2008, we acquired a 100% interest in a concession east of our Fences project area covering approximately 233,000 acres (941 sq. km.).  We have identified a possible Rotliegend prospect and a number of possible Ca2 reef build-ups on 2-D seismic data in Block 229.  We plan to seek industry participation while continuing to carry out early-stage exploration work on our own.

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Additional Concession Acreage

We may apply for more concession blocks in Poland in 2011. If we acquire more concession blocks, we will allocate modest technical and financial resources to these areas during 2011, primarily in the form of data collection and seismic reprocessing, with a view to ascertaining relative hydrocarbon potential and exploration risk.

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Activities and Assets in the United States

We produce oil from approximately 10,732 gross (10,418 net) acres in Montana and 400 gross (128 net) acres in Nevada.

Montana

We did not drill any wells in Montana during 2010.  We are evaluating plans for drilling in Montana during 2011.  During 2011, we plan to deepen several wells in our 10,000 acre Cut Bank field to take core samples from the Bakken and related formations for laboratory testing.  We sell all of our Montana production, which constitutes over 94% of our total oil production, to Cenex, a regional refiner and marketer.  We are in discussions with other oil and gas companies with a view to possibly investigating the Bakken potential over a broader area.

Nevada

We did not drill any wells in Nevada during 2010 and have no plans for drilling there during 2011

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Oil and Gas Terms

The following terms have the indicated meaning when used in this report:

"Bbl" means oilfield barrel.

"Bcf" means billion cubic feet of natural gas.

"Bcfe" means billion cubic feet of natural gas equivalent using a ratio of one barrel of oil to 6,000 cubic feet of natural gas.

"BTU" means British thermal unit.

"Ca1" and "Ca2" refers to specific calcium-rich geological formations, typically a dolomitic reef.

"Deterministic" means a method of estimating reserves in which a simple value for each parameter of geoscience, engineering, or economic data in the reserves calculation is used in the reserves estimation.

"Development well" means a well drilled within the proved area of a gas or oil reservoir to the depth of a stratigraphic horizon known to be productive.

"Exploratory well" means a well drilled to find and produce gas or oil in an unproved area, to find a new reservoir in a field previously found to be productive of gas or oil in another reservoir, or to extend a known reservoir.

"Field" means an area consisting of a single reservoir or multiple reservoirs all grouped on or related to the same individual geological structural feature and/or stratigraphic conditions.

"Gross" acres and "gross" wells mean the total number of acres or wells, as the case may be, in which an interest is owned, either directly or through a subsidiary or other Polish enterprise in which we have an interest.

"Horizon" means an underground geological formation that is the portion of the larger formation that has sufficient porosity and permeability to constitute a reservoir.
"MBbls" means thousand oilfield barrels.

"Mcf"means thousand cubic feet of natural gas.

"Mcfe"means thousand cubic feet of natural gas equivalent using a ratio of one barrel of oil to 6,000 cubic feet of natural gas.

"MMcf" means million cubic feet of natural gas.

"MMcfd" means million cubic feet of natural gas per day.

"MMcfe" means million cubic feet of natural gas equivalent using a ratio of one barrel of oil to 6,000 cubic feet of natural gas.

"MMcfed" means million cubic feet of natural gas equivalent (using a ratio of one barrel of oil to 6,000 cubic feet of natural gas) per day.

"Net" means, when referring to wells or acres, the fractional ownership interests held by us, either directly or through a subsidiary or other Polish enterprise in which we have an interest, multiplied by the gross wells or acres.

"P50 reserves" means proved reserves plus probable reserves.

"Probablistic" means a method of estimating reserves using the full range of values that could reasonably occur for each unknown from the geoscience and engineering data to generate a full range of possible outcomes and their associated probablilities of occurrence.

"Probable reserves" means those reserves determined by probabilistic methods that are less certain than proved reserves but which, together with proved reserves, are as likely as not to be recovered.

"Proved reserves" means the estimated quantities of crude oil, gas and gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. “Proved reserves” may be developed or undeveloped.

"PV-10 Value" means the estimated future net revenue to be generated from the production of proved or probable reserves discounted to present value using an annual discount rate of 10.0%, the Standardized Measure of Future Net Cash Flows ("SMOG").  These amounts are calculated net of estimated production costs, future development costs, and future income taxes, using prices and costs determined using guidelines established by the SEC, without escalation and without giving effect to non property-related expenses, such general and administrative costs, debt service, and depreciation, depletion and amortization.

"Reservoir" means a porous and permeable underground formation containing a natural accumulation of producible oil and/or gas that is confined by impermeable rock or water barriers and that is distinct and separate from other reservoirs.

"Tcf"means trillion cubic feet of natrual gas.

"Usufruct"means the Polish equivalent of a U.S. oil and gas lease.

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