Note 8 — Investment in Equity Affiliates

Petrodelta

Petrodelta is governed by its own charter and bylaws and operates a portfolio of properties in eastern Venezuela including large proven oil fields as well as properties with substantial opportunities for both development and exploration. Petrodelta has undertaken its operations in accordance with Petrodelta’s business plan as set forth in its conversion contract. Under its conversion contract, work programs and annual budgets adopted by Petrodelta must be consistent with Petrodelta’s business plan. Petrodelta’s business plan may be modified by a favorable decision of the shareholders owning at least 75 percent of the shares of Petrodelta. Petrodelta’s 2011 capital expenditures are expected to be approximately $200 million. Petrodelta’s shareholders are still reviewing the 2011 final capital budget for updated drilling requirements.

As previously disclosed, PDVSA has failed to pay on a timely basis certain amounts owed to contractors that PDVSA has contracted to do work for Petrodelta. PDVSA purchases all of Petrodelta’s oil production. PDVSA and its affiliates have reported shortfalls in meeting their cash requirements for operations and planned capital expenditures, and PDVSA has fallen behind in certain of its payment obligations to its contractors, including contractors engaged by PDVSA to provide services to Petrodelta. In addition, PDVSA has fallen behind in certain of its payment obligations to Petrodelta, which payments Petrodelta would otherwise use to pay its contractors. As a result, Petrodelta has experienced, and is continuing to experience, difficulty in retaining contractors who provide services for Petrodelta’s operations. We cannot provide any assurance as to whether or when PDVSA will become current on its payment obligations. Inability to retain contractors or to pay them on a timely basis is having an adverse effect on Petrodelta’s operations and on Petrodelta’s ability to carry out its business plan.

In 2008, the Venezuelan government published in the Official Gazette the Law of Special Contribution to Extraordinary Prices at the Hydrocarbons International Market (“original Windfall Profits Tax”). The original Windfall Profits Tax is calculated on the Venezuelan Export Basket (“VEB”) of prices as published by the Ministry of the People’s Power for Energy and Petroleum (“MENPET”). The original Windfall Profits Tax is applied to gross oil production delivered to PDVSA. The original Windfall Profits Tax established a special contribution to the Venezuelan government of (1) a 50 percent tax when the average price of the VEB exceeded $70 per barrel but is less than $100 per barrel, and (2) a 60 percent tax when the average price of the VEB exceeds $100 per barrel. The original Windfall Profits Tax was repealed with the issuance on April 18, 2011 of the Law Creating a Special Contribution on Extraordinary Prices and Exorbitant Prices in the International Hydrocarbons Market (the “amended Windfall Profits Tax”).

The amended Windfall Profits Tax establishes a special contribution for extraordinary prices to the Venezuelan government of 20 percent to be applied to the difference between the price fixed by the Venezuela budget for the relevant fiscal year (set at $40 per barrel for 2011) and $70 per barrel. The amended Windfall Profits Tax also establishes a special contribution for exorbitant prices to the Venezuelan government of (1) 80 percent when the average price of the VEB exceeds $70 per barrel but is less than $90 per barrel; (2) of 90 percent when the average price of the VEB exceeds $90 per barrel but is less that $100 per barrel; and (3) of 95 percent when the average price of the VEB exceeds $100 per barrel. The amended Windfall Profits Tax caps the royalty paid on production at $70 per barrel. It is not clear from the drafting of the amended Windfall Profits Tax how the $70 cap on royalty barrels will be applied to royalties paid in-kind. By placing a cap on the royalty barrels, the amended Windfall Profits Tax reduces the royalties paid to the government and increases payments to the National Development Fund (“FONDEN”). Petrodelta pays royalties in-kind and has not applied the $70 cap to its royalty barrels as doing so may overstate earnings. Until further guidance is issued, Petrodelta will continue applying the current sales price to its royalty barrels.

Also, the amended Windfall Profits Tax considers that an exemption of this tax could be granted by MENPET for the incremental production of projects and grass root developments until the specific investments are recovered. This exemption has to be considered and approved in a case by case basis by MENPET. We believe several of the fields operated by Petrodelta may qualify for the exemption from the amended Windfall Profits Tax. We are waiting for clarification from MENPET on the definitions of incremental production and grass roots development, as well as guidance on the process for applying for the exemption. There are many sections of the amended Windfall Profits Tax which have yet to be clarified.

Both the original and amended Windfall Profits Taxes are deductible for Venezuelan income tax purposes. Petrodelta recorded $65.3 million and $92.5 million for the combined original and amended Windfall Profits Taxes during the three and six months ended June 30, 2011, respectively. We estimate that the amended Windfall Profits Tax increased the expense for windfall profits tax by $15.4 million for the six months ended June 30, 2011. Petrodelta recorded $1.7 million and $2.9 million of expense for the original Windfall Profits Tax during the three and six months ended June 30, 2010, respectively.

The Science and Technology Law (referred to as “LOCTI” in Venezuela) requires major corporations engaged in activities covered by the Hydrocarbon and Gaseous Hydrocarbon Law (“OHL”) to contribute two percent of their gross revenue generated in Venezuela from activities specified in the OHL on projects to promote inventions or investigate technology in areas deemed critical to Venezuela. The contribution is based on the previous year’s gross revenue and is due the following year. LOCTI requires that each company file a separate declaration stating how much has been contributed; however, waivers have been granted in the past to allow PDVSA to file a declaration on a consolidated basis covering all of its and its consolidating entities liabilities. Since Petrodelta expected PDVSA to continue requesting and receiving waivers, Petrodelta did not accrue a liability to LOCTI for the year ended December 31, 2009. For filing years 2007 and 2008, PDVSA provided Petrodelta with a copy of the waiver acceptance letter from LOCTI. PDVSA has stated that a waiver was granted for filing year 2009; however, LOCTI has not yet issued the acceptance letter to PDVSA for the 2009 filing year. The potential exposure to LOCTI for the year ended December 31, 2009 after devaluation is $4.8 million, $2.4 million net of tax ($0.8 million net to our 32 percent interest). In January 2011, PDVSA informed its consolidating entities, including Petrodelta, that effective with the 2010 reporting year it would no longer be requesting waivers to file the LOCTI declaration on a consolidated basis. Based on this information, Petrodelta accrued the 2010 liability to LOCTI in the fourth quarter of 2010. However, in April 2011, Petrodelta received a copy of the waiver acceptance letter issued by LOCTI to PDVSA for the 2010 filing year. Petrodelta reversed the 2010 LOCTI accrual of $4.6 million, $2.3 million net of tax ($0.7 million net to our 32 percent interest) in the three months ended March 31, 2011. Petrodelta is accruing the 2011 liability to LOCTI on a current basis.

In December 2010, LOCTI was modified to reduce the amount of contributions beginning January 2011 to one percent of gross revenues for companies owned by individuals or corporations and 0.5 percent for companies owned by Venezuela. Petrodelta’s rate of contribution starting in 2011 will be 0.5 percent. LOCTI was also modified to require all contributions to be paid in cash directly to the National Fund for Science, Technology and Innovation (“FONDACIT”), the entity responsible for the administration of LOCTI contributions. Self-funded programs and direct contributions to projects performed by other institutions are no longer allowed.

In November 2010, Petrodelta’s board of directors declared a dividend of $30.6 million, $12.2 million net to HNR Finance ($9.8 million net to our 32 percent interest). Petrodelta shareholder approval of the dividend was received on March 14, 2011. As of July 29, 2011, this dividend has not been received, and the timing of the receipt of this dividend is uncertain.

Petrodelta does not have currency exchange risk other than the official prevailing exchange rate that applies to its operating costs denominated in Bolivars (4.30 Bolivars per U.S. Dollar). Petrodelta does not have, and has not had, any Bolivars pending government approval for settlement for U.S. Dollars at the official exchange rate or the SITME rate. The monetary assets that are exposed to exchange rate fluctuations are cash, accounts receivable, prepaid expenses and other current assets. The monetary liabilities that are exposed to exchange rate fluctuations are accounts payable, accruals and other current liabilities. All monetary assets and liabilities incurred at the official Bolivar exchange rate are settled at the official Bolivar exchange rate. At June 30, 2011, the balances in Petrodelta’s Bolivar denominated monetary assets and liabilities accounts that are exposed to exchange rate changes are 97.3 million Bolivars and 2,542.6 million Bolivars, respectively.

Petrodelta’s reporting and functional currency is the U.S. Dollar. Petrodelta’s financial information is prepared in accordance with International Financial Reporting Standards (“IFRS”) which we have adjusted to conform to GAAP. All amounts through Net Income Equity Affiliate represent 100 percent of Petrodelta. Summary financial information has been presented below at June 30, 2011 and December 31, 2010 and for the three and six months ended June 30, 2011 and 2010:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
	(in thousands)
Revenues:
Oil sales	$	282,975		$	135,964		$	509,588		$	277,466
Gas sales		679			1,022			1,405			2,040
Royalty		(96,214	)		(46,391	)		(173,529	)		(94,377	)

		187,440			90,595			337,464			185,129
Expenses:
Operating expenses		18,684			10,632			32,966			20,675
Workovers		7,021			—			13,496			—
Depletion, depreciation and amortization		13,231			9,770			25,718			18,377
General and administrative		3,782			2,641			2,852			6,058
Windfall profits tax		65,345			1,664			92,471			2,915

		108,063			24,707			167,503			48,025

Income from operations		79,377			65,888			169,961			137,104

Gain on exchange rate		—			1,938			—			120,654
Investment earnings and other		185			(13	)		352			2,881
Interest expense		(3,146	)		(1,328	)		(4,418	)		(2,223	)


Income before income tax		76,416			66,485			165,895			258,416

Current income tax expense		31,618			52,656			84,961			138,076
Deferred income tax (benefit) expense		(2,513	)		5,118			(28,275	)		47,582

Net income		47,311			8,711			109,209			72,758
Adjustment to reconcile to reported net income from unconsolidated equity affiliate:
Deferred income tax (benefit) expense		1,176			(14,499	)		19,739			(47,488	)

Net income equity affiliate		46,135			23,210			89,470			120,246
Equity interest in unconsolidated equity affiliate		40	%		40	%		40	%		40	%

Income before amortization of excess basis in equity affiliate		18,454			9,284			35,788			48,098
Amortization of excess basis in equity affiliate		(452	)		(322	)		(873	)		(656	)
Conform depletion expense to GAAP		(216	)		(47	)		(297	)		(160	)

Net income from unconsolidated equity affiliate	$	17,786		$	8,915		$	34,618		$	47,282


	June 30,		December 31,
	2011		2010
	(in thousands)
Current assets	$	905,004	$	535,225
Property and equipment		365,998		321,816
Other assets		87,013		67,755
Current liabilities		756,916		406,339
Other liabilities		43,207		39,224
Net equity		557,892		479,233