Corporate Update
KOS Energy
Shareholder Update
December 15, 2008
Our intention is to provide our shareholders with an update every two months so we first would apologize for delaying this into the third month. Our last update was September 15th but it seems like we have seen a lifetime of economic changes in such a short period of time. Oil has since fallen almost 70% and the Canadian dollar 20%… the stock market and overall economy needs no explanation.
Looking ahead to 2009, we believe that the economy and commodity prices will continue to struggle. The good news is that OPEC and Russia are no happier with $45 oil than any of us. Most analysts at this stage (and even feedback we have seen from OPEC members) believe that oil in a range of $60 to $75 is enough to help the economy and at the same time, keep global producers content.
OPEC, which pumps more than 40 percent of the world’s oil, may reduce its output limit by as much as 2.5 million barrels a day. Billionaire hedge-fund manager (and oil tycoon) Boone Pickens said on December 9th that we could see $100 oil in 2009 or 2010 as the economy recovers.
Wild speculation by huge commodity traders and hedge funds pushed oil far beyond $100 and it was the unwinding of those same funds that wreaked havoc across the globe. As credit markets tightened and access to cheap speculative money disappeared, these firms were forced to liquidate positions in massive amounts. This has resulted in the mess we’ve seen for the past two months.
That’s the negative news out of the way, now we can get on with the Positive.
The advantage to being in Kentucky is that our labour and equipment rates for working in the field are probably ½ of what you would see in Canada or in many oil producing regions of the United States. 
We have a small field crew of about 7 that work tremendously hard for extremely competitive rates and our costs of drilling and workovers are a fraction of other producers because our equipment rate is low, our holes are shallow (typically above 1500 ft), and we now own our own truck and equipment for jet drilling laterals off the wellbore
The rural region of Kentucky in particular (where our business is focused) is no stranger to financial hardship. These people have seen their economy struggle for years and have learned to make the best of what they have. They are hard working, dedicated and appreciative… and we are extremely fortunate to have them working for KOS.
As we move into 2009 we are confident that the team we have assembled knows the value of a dollar and will help us achieve our objectives.
Fiscal Responsibility
This global shakeup in the economy is forcing households and businesses to tighten their belt and we are taking a very pro-active approach to this. When the stock markets and oil began to collapse in October, we took immediate action to conserve cash until things stabilized. 
We are obviously not there yet but believe economic stability will begin to surface in Q1/09. From there it may take 12 to 18 months before the economies can show decent signs of life again.
In an effort to reduce our administration costs as low as possible without affecting production, we are closing our small Vancouver office in January. Our CEO will establish a home office along with our two contract support staff who provide accounting and administration. This allows us to focus manpower in the field which has the most direct impact on our bottom line. Phones and email can be answered just as easily and we now have Hyperoffice which is a very inexpensive office collaboration website that is used by leading corporations around the world.
In addition to Head Office changes:
This past summer was spent accumulating our large land position (securing over 30,000 acres in leases). We have now spent the past couple of months cherry picking and rationalizing those leases in order to hold the most promising and avoid fragmentation which would make these leases expensive to maintain and drill. September and October were spent securing the rights to the new Jet Drilling technology (including our own truck) and then working in the field with the developer to perfect the process and test different formations, drilling fluids, etc. – we had just started drilling our first few holes when the current economic meltdown started. A decision was made at the time to preserve cash and focus on workovers and lateral jet drilling (SRS) with the new downhole tool – on existing wells.
The decision to put new drilling on hold until Q1/09 would allow us to preserve cash while the markets, economy, and oil tried to stabilize. We were also overly cautious on new drilling until we secured the contract services of a highly qualified petroleum geologist familiar with our leased regions.
We have been fortunate to find someone with decades of experience from a Kentucky University and he should be starting February 1st under an exciting trial program we will be running from February to May. 
Energy (and Oil in particular) is something we cannot live without. And fortunately, so long as you can find and produce it, there is someone there to buy it. We may see slowdowns that affect pricing but as previously indicated OPEC will do what is necessary to stabilize pricing. With our very low exploration and production costs, we can still make excellent money at $40 or $50 per barrel of oil.
As a shareholder in KOS you can rest assured we are doing everything possible to ensure the long term success of your company. Without question we face challenges much greater than what we faced in the summer of 2008 but the fundamental strengths of what we formed this company around are still there. Our administration costs are being kept as low as possible and our field costs are amongst the lowest you will find anywhere.
In addition, our Field Supervisor (Tom) is one of the hardest working individuals you can find. This is the same fellow who salvaged an old pumpjack with a tree stump growing through it!!
An odd example but typical of what they are doing to try and save money (without jeopardizing safety, the environment, or production).
Share Structure & Financing
We have been able to avoid financing since the initial round we did during the summer so everyone’s ownership interest remains relatively the same. It would be great to have millions sitting in the bank but at the same time, we have made significant progress with the small amount we raised. Our structure as a result is just slightly over 9 million shares outstanding - yet we have:
- a large land position with many potential drill targets and over 100 old wells suitable for workovers and application of our lateral jet drilling (SRS)
- license in Kentucky for the SRS technology along with our own truck, field crew and associated pumps and equipment. In addition, a subsidiary service company has been setup in Kentucky to start taking advantage of contract drilling in 2009
- we have almost 20 wells awaiting SRS that should be on production in Q1/09. Four are 20% joint ventures, one is 38% and the balance are 100% KOS
- a tremendous number of inquiries developing for us to lease land and also to contract SRS drilling on old wells. This is all work we will follow up on in 2009
In January we will likely do a 2nd (small) financing but will give existing shareholders first option. These funds will be used to bring the 15 or 20 wells we have awaiting SRS, onstream. Obviously the more money we raise, the more aggressive we can be on drilling and workovers. 
However, we do not want to put the cart before the horse. We want to first target lateral jet drilling of 50 to 100 feet (horizontal from the well bore) *. This ensures we have the best shot at hitting oil pools or reservoirs that otherwise could be missed. In the last trial program that we ran two weeks ago on a 700ft well, we were able to drill 60 laterals (approx. 30 feet each) in 1 day. The optimum situation would be ½ that number 50 to 100 feet. In doing so, we open up huge opportunities for increasing oil production from a well.
* [It should still be noted however, that a lot of the jet drill’s ability to go out further is dependant upon the porosity of the rock.]
Although we would like to go out further at this early stage, we are still seeing impressive results. December 9th we brought a well onstream that was previously producing 2 bopd. Following our SRS program (which drilled approx. twenty - 20 foot laterals), that same well now appears capable of producing about 15 barrels of oil per day (bopd).
Once our objective of 50 to 100 feet is achieved, we can look at a larger financing as we are then in a position to aggressively drill our own wells and work over existing old wells (our only cost being labour, fuel and drilling fluids or acid).
Unexpected Delays
This summer and fall when we secured the right to use the SRS in Kentucky, it was hoped we would gain immediate access to the equipment. This didn’t occur because the developer’s test unit was continually busy. If we were to build another unit it would have taken 4 months and more than $1/2 million for us to have our own truck. In September (as mentioned in our last shareholder update) we were able to negotiate the purchase of the developer’s yellow rig - well below replacement value.
The unit required some modifications which took us into early October but we were able to work with the test unit in the field. During this phase our own crew trained and learned a tremendous amount about the technology and the overall jet drilling process. What we found was that the process is as much an art as it is a science. We also soon discovered that the size of the coiled tubing on our yellow truck should be increased to accommodate greater downhole pressure.
This now took us into November as testing in the field continued with the developer and his crew – forcing delays on our own wells which we desperately wanted to run the SRS on (so we could get production online). Because the coiled tubing required for our yellow rig was still on order, we were at the mercy of the testing unit and its limited availability – which was understandable but frustrating none-the-less.
Note: In the image to your right, you can see the impact of using the SRS to jet drill through a rock formation. This is rock with no oil in it. In situations where you have oil or gas associated, the jet cutting tool should create a similar cavernous hole but in the shape of a star-fish that will actually fracture the formation even larger. Oil or Gas would move through into the well bore. If the jet drilled hole passes through an oil pool or dozens of these radiate from the well, you can see where the potential exists to increase production dramatically.
Moving Forward
As we head into December, our field crew has learned a tremendous amount about the entire process and they have become very efficient at drilling. Our tests have been limited to approx. 30 feet (so far) but during Q1/09 our goal as discussed is to see 50 to 100 feet attained.
Once we achieve our target distance on lateral jet drilling, the entire process becomes extremely valuable to the company – in particular for regions of Kentucky where more than 10,000 old wells exist that are doing 1 or 2 barrels per day. The same situation exists for thousands of old shallow wells across North America, but for Kentucky alone, the potential is huge. The state of Kentucky has estimated that less than 30% of the oil in the state has been recovered to date. If we can take old wells in proven producing regions and drill dozens of laterals off them, the field takes on an entirely new life. Even at $40 or $50 oil, the producer would start generating significant cashflow again – and a services division of KOS would grow dramatically.
While we have been frustrated by the delay in getting our own production online, it has allowed us to set the company up to focus on the following for 2009:
- developing our own leases with new drilling and workovers (SRS) of existing wells
- establishing an oil & gas Services division in Kentucky that contracts SRS work externally
- establishing joint ventures on our leases for natural gas drilling (we hold 50%, they fund 100%)
- continual research & testing on the SRS technology to expand capability and oil recovery
Conclusion
We believe that the outlook for the economy and commodity prices will continue to be challenging for 2009 but oil is (and will remain) critical to every country. Energy is the driver behind any economy and with oil we are not just dependant upon gasoline, but diesel for heavy machinery, chemicals and lubricants. Rapid economic growth drives demand, but massive quantities of oil are required around the world just to sustain a standard of living. OPEC and Russia will be just as happy to cut production, slow reservoir depletion, and hold prices in a range of $60 to $75.
KOS Energy will work aggressively to keep costs low, minimize share dilution, and get wells on production to generate internal cashflow that will be reinvested in old well workovers (using the SRS) and carefully targeted new drilling. We also have a very promising proposal to joint venture natural gas drilling on some of our leases. If this closes in Q1/09, it will allow us to generate cashflow through 50% ownership of gas wells that will be funded 100% by the development partner.
Between February and May we will be running a test program with the geologist from the University who has exciting new exploration models and applications. We will be shooting seismic in proven fields where modern exploration has never been done before. We will incorporate seismic, satellite and ground geophysics and geochemistry to initially target 3 high impact oil wells (potential 50/50 joint ventures). If this process proves as successful as we hope, it will generate additional cashflow that will then allow us to cookie-cut the process across several of our 100% owned leases.
At the same time, we will continue to focus on development of the SRS and establishing an oil & gas service company for Kentucky (built around the SRS technology). Whether oil is $30 bbl or $100 bbl, we believe that strong demand will exist for the thousands of shallow wells across this state. Our field supervisor is continually approached about new leasing opportunities and contract SRS drilling so our plan is to capitalize on these areas as our working capital will allow.
On a final note, our goal is to still take the company public, but for obvious reasons this has been delayed. The last thing we want to do is jump into a public process in a very poor market environment. This would also result in additional costs. We will follow through on a listing once the markets stabilize or if a very attractive situation surfaced that brought significant cash to the table.
Should you have any questions, please do not hesitate to contact Barry Bergstrom (CEO) by phone
(1-877-278-6430) or email bbergstrom@kosenergy.com
Barry Bergstrom
CEO – KOS Energy
