Operating & Financial Review

The drilling programme in the Group’s 100%-owned Cheleken Contract Area continued successfully, delivering a 28% increase in the average daily rate of production to 40,992 barrels of oil over the course of 2008. In early 2008, unusually cold weather was experienced in this area of the Caspian Sea, which temporarily affected operations. In particular, production from Dzheitune (Lam) 28/120 well needed to be shut to enable a new coflex alternative pipeline to be installed. In April 2008, the production from this well was restored to full flow.

Production and marketing

Gross production during the year reflected a 28% increase over the previous year. Total 2008 gross field production from the Cheleken Contract Area was 15 million barrels of oil with an average daily gross production rate of 40,992 bopd. This compares to 11.7 million barrels of oil in 2007 and an average daily gross production rate of 31,997 bopd. The Group’s entitlement barrels are dependent amongst other factors on operating and development expenditures and realised crude oil prices. As a result of the fiscal terms of the PSA, the Group’s entitlement barrels in the current period were about 60% (2007: 68%) of the gross field production.

The Group sold 7.5 million barrels (2007: 8.7 million barrels) of oil in 2008 and held a crude oil inventory of 0.7 million barrels at the year-end (2007: 0.2 million barrels). The quantity sold during the year is lower due to change in the lifting positions and inventory movement. At the year-end, the Group was in an underlift position of approximately 0.6 million barrels. The average realised price in 2008 was approximately US$90.8 per barrel (2007: US$70.9 per barrel). The realised oil prices achieved a discount of about 6% to Brent during the year.

The Group continued to market approximately 80% of its crude oil through Neka in Iran during 2008 because it offered higher netback prices as compared to the western route through Baku, Azerbaijan. The Group moved approximately 20% of its crude through Baku in order to maintain marketing flexibility. The Baku route was briefly interrupted for two weeks earlier in 2008 due to the conflict in Georgia. During that time 100% of production was marketed through the Iranian swap agreement at Neka. The marketing team continues to assess the possibility of opening additional routes through Makhachkala in Russia and the BTC pipeline initiating at Baku.

The drilling programme

Nine development wells were completed during 2008: four from Dzheitune (Lam) 22 platform (L22/124, 126, 128 and 130) using the CIS Rig 1, four from Dzheitune (Lam) A platform (LA/125, 127, 129 and 131) using the Iran Khazar, and one from Dzheitune (Lam) 21 Platform (L21/132) also using the Iran Khazar.

The drilled depths of the nine wells varied between 3,000 m and 4,200 m. Except for L21/132, which was completed as a single string completion, the other eight wells were completed as dual completions. Initial tested rates from the nine wells varied between 916 bopd (L21/132) to 4,682 bopd (LA/131).

Further perforations were added to three wells in the fourth quarter of 2008 resulting in an incremental production of approximately 2,000 bopd.

Following refurbishment of the Group’s Rig 40, the Group mobilised the rig to begin drilling the first well in January 2009. This well was targeted at the Southern flank of the field beyond the fault line and was found to be wet. Therefore, we decided to sidetrack it in order to reach the planned depth and complete. We expect to complete three wells using Rig 40 by the year-end.

The Iran Khazar rig underwent planned maintenance and was mobilised to the designated platform to commence drilling. We expect to complete four wells using the Iran Khazar rig by the year-end. The Group has commenced discussions to renew the contract for the Iran Khazar rig, which is due to expire in Q2 2009.

On 6 March 2009, Dragon Oil announced that it had decided not to renew the CIS Rig 1 contract. The management team concluded that a higher specification platform-based rig was more suitable for drilling slanted wells to obtain higher productivity. Subject to contract negotiations, the Group expects to award a contract in Q2 2009 with an intention to complete one well by the end of 2009.

Infrastructure

A number of important infrastructure projects were awarded over the course of 2008.

In July 2008, a US$170 million contract was awarded for the engineering, procurement and installation of a new 30-inch, 40-km oil and gas trunkline. Once commissioned, the trunkline will be capable of transporting all the oil and gas produced offshore in the Cheleken Contract Area to the Group’s onshore Central Processing Facility.

Another project integral to the success of the field development plan is the phase 2 upgrade of the Central Processing Facility to handle up to 100,000 barrels of liquid and 220 mmscfd of gas per day. In October 2008, a contract worth US$37 million for the project was awarded.

Other important projects under way include the phase 2 upgrade of the export facility at the Aladja Jetty to increase loading capability and efficiency and the building of the desalination plant, which is planned to ensure a constant supply of fresh water to the Group’s operations as well as to the local community.

Reserves and Resources as at 30 June 2008

Note: Based on the latest reserves certification by independent petroleum engineers.

Proved and probable remaining recoverable reserves as at 31 December 2008 on working interest and entitlement bases were 636 million barrels and 296 million barrels, respectively.

Between June 2004 and April 2005, the Group acquired 3-D seismic data over an area of 652 kms² across both the Dzheitune (Lam) and Dzhygalybeg (Zhdanov) fields. This set of data was then processed and made available for interpretation in the Q4 2005.

A preliminary interpretation of the time-migrated data set was initiated at that time and the resultant maps were used to position the new Dzheitune (Lam) A platform and to identify the potential for hydrocarbons in the Dzheitune (Lam) West structure. Dzheitune (Lam) West was successfully appraised with the well Dzheitune (Lam) 28/120 and the Group has since drilled eight successful wells from the Dzheitune (Lam) A platform.

Dragon Oil recognised that due to the structural complexity of the fields, the quality of the imaging could be improved with further processing of the seismic data. A full depth migration of the data (Pre-Stack Depth Migration) was conducted, which resulted in a significant improvement in the structural and stratigraphic imaging further improving our understanding of the fields.

This latest reserves update incorporates the results of full field re-mapping, based on this improved dataset.

Following completion of the gas facilities and a gas sales agreement in the future it is expected that Dragon Oil will be able to confirm the proportion of contingent gas resources that can be transferred to reserves.

Yemen operations update

In April 2008, Dragon Oil announced non-commercial findings of crude oil from Block 49 of its three non-operated acreage in the Republic of Yemen. Studies for a possible commercialisation in conjunction with two existing small discoveries on Block 49 are ongoing. Geological and geophysical analysis is continuing on Block 35 in order to identify prospects to be drilled during the current exploration period. Block R2 has been relinquished after two dry holes were drilled in 2007–08.

Commercialisation of the gas resources

Significant strides were made in 2008 towards commercialising Dragon Oil’s gas resources in the Cheleken Contract Area. This included award of the contracts for the 40-km trunkline project and the phase 2 upgrade of the Central Processing Facility. The Group is looking to award the six-month front end engineering and design contract shortly, following which the engineering, procurement and construction contract for the gas processing facility will be tendered.

Our people

In 2008 Dragon Oil increased its Group headcount by 10% over the previous year taking the average number of staff to 913 during 2008. The Group continues to maintain a very diverse culture in its approach to recruitment and to develop its human resources in line with our growth and diversification strategy.

The Group is increasingly sourcing candidates from within Turkmenistan and this is expected to increase over time as we aim to nurture and encourage skilled local candidates for key roles in a growing Dragon Oil.

One of the focuses in 2008 was recruitment of additional staff into the contracts and purchasing department as well as the engineering and construction department — both are crucial for the proper implementation of the field development strategy and oversight of the extensive infrastructure expenditure programme for 2009. The majority of this recruitment took place in the second half of 2008 and Dragon Oil expects the benefit of this to filter through in 2009 as the major infrastructure projects begin to progress.

The former employees involved in the irregularities identified by the Group’s IAD have been replaced. The Group’s operations are now driven by a high-calibre, motivated team of managers.

Outlook for 2009–11

We intend to complete eight wells by the end of 2009. Drilling will take place from the Dzheitune (Lam) A platform and from the refurbished Dzheitune (Lam) 28 and 13 platforms. The Group intends to complete up to 35 development wells in total during the years 2009–11.

The average daily production in 2008 was 40,992 bopd and the exit rate reached at the end of the year was 45,600 bopd. Following the changes to the drilling programme, the Group expects to be able to achieve the annual production growth of up to 15% on average during 2009–11.

The Group has an estimated capital expenditure programme for 2009 of up to US$300 million for infrastructure (including platforms, trunkline, upgrades to the Central Processing Facility and the export facilities). These expenditures will be internally funded. For the planning period of 2009–11, the total spending on infrastructure projects is expected to be around US$700–800 million. The level of capital expenditure is subject to approval of projects under the PSA and the availability of contractors in the Caspian Sea region. The amount of capital expenditure for drilling is mainly determined by the number of wells drilled. The progress of the drilling programme is dependent on availability of rigs.

For gas development, we envisage capital expenditure in the range of US$200–250 million for the onshore Gas Treatment Plant including facilities.

Financial summary

An 18% growth in revenue and a 30% growth in operating profit were generated largely on the back of increased realised prices in 2008. Earnings per share was 21% higher than 2007 and net operating cash flow was up 24% over 2007. The year 2008 saw an increase of 36% in capital employed represented by higher expenditure in oil and gas interests and an increased cash balance at the year-end.

Key Financial Highlights

Income statement

Revenue

Production levels in 2008 averaged 40,992 bopd (2007: 31,997 bopd) on a working interest basis and 24,490 bopd (2007: 21,739 bopd) on an entitlement basis. The Group’s share of entitlement production is determined by reference to cost oil and profit oil in accordance with the terms of the PSA. Due to the fact that the Group fully recovered its historic costs in 2007, the entitlement barrels have been and continue to be determined by, amongst other factors, the level of development expenditure and the realised oil prices.

Revenue for the year was US$706 million compared with US$597 million in 2007. The increase of 18% over the previous year is primarily attributable to a higher average realised price of US$90.8 per barrel (2007: US$70.9 per barrel), despite a 14% decrease in the sales volumes during 2008. The realised oil prices achieved a discount of about 6% to Brent during the year. The decrease in sales volumes is attributable to change in lifting position and higher inventory sold after the year-end.

The PSA includes provisions such that parties to the agreement may not lift their respective crude oil entitlements in full and as such underlifts or overlifts of crude oil may occur at period ends. The underlift and overlift positions are dependent on factors similar to those affecting determination of the entitlement barrels. At the year end, the Group was in an underlift position of 0.6 million barrels that is recognised as revenue and measured at market value.

Operating profit

The Group generated an operating profit of US$474 million (2007: US$365 million).

Cost of sales comprises operating and production costs and depletion charge. The Group’s cost of sales was US$193 million in 2008 compared to US$199 million in 2007, a decrease of about 3%. The decrease is primarily due to a reversal of a 2007 overlift charge of US$24 million and a higher crude oil inventory at the year-end, offset by an increase in depletion charge.

The average rate for depletion has increased by 30% to US$16.7 per barrel (2007: US$12.8 per barrel), mainly as a result of the upward revision of the long-term oil price assumption and the increased field development costs. Depletion and depreciation charges during the year were US$150 million (2007: US$102 million). The Group’s view on long-term oil price until the end of the PSA was revised to US$70 per barrel for 2008 (2007: US$50 per barrel).

Operating profit for 2008 was 30% higher than in the previous year despite an increase in other losses of US$5 million on account of derivative financial instruments. These instruments put in place for managing crude oil price exposure using zero-cost collars resulted in a net fair value charge of US$21 million at the year-end (2007: US$15 million). A write-off of US$0.4 million (2007: US$4 million) for exploration and evaluation expenditure in Yemen was made to the extent that the efforts did not result in commercial discoveries.

Profit for the year

Profit for the year was US$369 million (2007: US$304 million).

The profit included finance income and a higher taxation charge. Finance income increased to US$25 million (2007: US$19 million) on the back of higher cash and cash equivalents and term deposits maintained during the year.

During the year the tax rate applicable to the Group’s operations in Turkmenistan was increased to 25% by the Hydrocarbon Resources Law of 2008. The Group has applied this new rate in determining its tax liabilities as at 31 December 2008. The Group is in discussions with the authorities in Turkmenistan about the applicability of the new rate to prior periods, but it does not believe that prior periods are affected by the new rate. Consequently, no provision has been made in respect of any additional tax that could become payable if the increased tax rate were applied to prior periods.

Balance sheet

Investments in oil and gas interests were higher by US$138 million due to capital expenditure of US$287 million (2007: US$228 million) incurred, offset by the depletion and depreciation charge during the year. The expenditure during the year was primarily on drilling and infrastructure projects in Turkmenistan. Of the total capital expenditure for 2008, 60% was attributable to drilling. The balance of the capital expenditure was spent on infrastructure projects including the refurbishment of Dzheitune (Lam) 13 and 28 platforms, the new Dzheitune (Lam) B platform, construction of tanks at the Central Processing Facility and the 40-km trunkline. Included in exploration and evaluation assets was the acquisition of a minority working interest in three exploration blocks in the Republic of Yemen. These assets are carried as intangible assets net of write-off due to lack of commercial success.

Current assets and liabilities

Current assets rose by US$313 million mainly as result of a US$327 million increase in cash at bank due to increased cash from operations. The cash and cash equivalents and term deposits at the year-end were US$876 million, including interest receivable of US$9 million and deposits of US$91.5 million held for abandonment and decommissioning activities. The increase in cash over the previous year reflects strong realised oil prices, despite a 14% decrease in sale volumes and a 32% increase in investing activities.

Current liabilities rose by US$41 million primarily due to an increase of US$63 million in provision for abandonment and decommissioning on increased production and an increase of US$16 million in tax payable, offset by a US$11 million decrease in the fair value provision on derivative financial instruments and a movement of US$24 million in overlift creditors.

Cash flows

Net cash generated from operations during the year improved by approximately US$111 million to US$579 million (2007: US$467 million). The increase was primarily attributable to higher sales prices realised during the year for the sale of crude oil. Cash used in investing activities was US$516 million (2007: US$391 million), mainly comprising capital expenditure of US$288 million (2007: US$232 million) and placement of term deposits amounting to US$253 million (2007: US$173 million). Cash generated by financing activities was US$12 million (2007: US$1 million) on account of an increase in share capital resulting from exercise of share options.

The Group’s robust cash position secures funding for organic growth in Turkmenistan and its diversification plan over the next few years.