Note 6 – Investment in Equity Affiliates

Venezuela – Petrodelta, S.A.

Petrodelta’s reporting and functional currency is the U.S. Dollar. HNR Finance owns a 40 percent interest in Petrodelta. As discussed further in Note 5 – Dispositions, Share Purchase Agreement, on December 16, 2013, Harvest and HNR Energia entered into the Share Purchase Agreement with Petroandina and Pluspetrol, its parent, to sell all of our 80 percent equity interest in Harvest Holding to Petroandina in two closings for an aggregate cash purchase price of $400 million. The first closing occurred on December 16, 2013 contemporaneously with the signing of the Share Purchase Agreement, when we sold a 29 percent equity interest in Harvest Holding for $125 million. This first transaction resulted in a loss on the sale of the interest in Harvest Holding of $23.0 million in the year ended December 31, 2013.

Petrodelta’s financial information is prepared in accordance with International Financial Reporting Standards (“IFRS”) which we have adjusted to conform to U.S. GAAP. The differences between IFRS and U.S. GAAP for which we adjust are:

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Deferred income tax: IFRS allows the inclusion of non-monetary temporary differences impacted by inflationary adjustments, whereas U.S. GAAP does not. In addition, we have adjusted for the impact on deferred income tax of other adjustments to arrive at net income under U.S. GAAP.

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Depletion expense: Oil and gas reserves used by Petrodelta in calculating depletion expense under IFRS are provided by MENPET. MENPET reserves are not prepared using the guidance on extractive activities for oil and gas (ASC 932). At least annually at yearend, we prepare reserve reports for Petrodelta’s oil and gas reserves using ASC 932. On a quarterly basis, we recalculate Petrodelta’s depletion using the most recent reserve report using ASC 932.

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Windfall Profits Tax Credit: The April 2011 Windfall Profits Tax law included a provision wherein it considered that an exemption of the Windfall Profits Tax could be granted for the incremental production of projects and grass root developments until the specific investments are recovered. The projects deemed to qualify for the exemption have to be considered and approved on a case by case basis by MENPET. In March 2013, PDVSA requested from MENPET a Windfall Profits Tax exemption credit under provisions in the April 2011 Windfall Profits Tax law. The exemption was applied to several oil development projects, including Petrodelta. However, MENPET has not defined the projects qualifying for exemption or provided the guidance necessary to calculate the exemption. PDVSA issued to Petrodelta its estimated share of the exemption credit related to 2012 of $55.2 million ($36.4 million net of tax) based on PDVSA’s calculation and projects PDVSA deemed to qualify for the exemption. Petrodelta has not been provided with supporting documentation indicating the properties have been appropriately qualified by MENPET, the specific details for the exemption credit, such as which fields, production period or production, or the supporting calculations. Until MENPET either issues guidance on the exemption provisions in the law or issues payment forms including the exemption credit, or written approval from MENPET for this exemption credit is received by Petrodelta or us, we have and will continue to exclude the exemption credit from our equity earnings in Petrodelta.

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Sports Law Overaccrual: The Organic Law on Sports, Physical Activity and Physical Education (“Sports Law”) was published in the Official Gazette on August 24, 2011. The purpose of the Sports Law is to establish the public service nature of physical education and the promotion, organization and administration of sports and physical activity. Funding of the Sports Law is by contributions made by companies or other public or private organizations that perform economic activities for profit in Venezuela. The contribution is one percent of annual net or accounting profit and is not deductible for income tax purposes. Per the Sports Law, contributions are to be calculated on an after-tax basis. However, in March 2012, CVP has instructed Petrodelta to calculate the contribution on a before-tax basis contrary to the Sports Law. As of December 31, 2013, the cumulative amount of overstatement of the liability by following this calculation method is $1.3 million ($0.3 million net to our 20.4 percent interest as of December 31, 2013). We have adjusted for the overaccrual of the Sports Law in the results reported for net income from equity affiliate during the applicable periods, i.e., the years ended December 31, 2013 and 2012.

In addition to the adjustments to arrive at Petrodelta’s net income under U.S. GAAP, earnings from equity affiliate also reflect the amortization of the excess basis in equity affiliate using the unit-of-production method based on risk adjusted total current estimated reserves.

All amounts through Net Income under U.S. GAAP represent 100 percent of Petrodelta. Summary financial information has been presented below at December 31, 2013 and 2012, and for the years ended December 31, 2013, 2012 and 2011:


	Year Ended December 31,
	2013			2012			2011
	(in thousands, except percentages)
Results under IFRS:
Revenues:
Oil sales	$	1,326,093		$	1,263,264		$	1,122,191
Gas sales		4,000			3,350			3,497
Royalty *		(440,963	)		(423,069	)		(374,135	)

		889,130			843,545			751,553

Expenses:
Operating expenses		151,661			121,023			77,236
Workovers		29,168			17,302			28,508
Depletion, depreciation and amortization		87,203			86,004			58,376
General and administrative		26,345			31,753			11,297
Windfall profits tax		234,453			291,355			237,632
Windfall profits credit		(55,168	)		0			0

		473,662			547,437			413,049

Income from operations		415,468			296,108			338,504
Gain on exchange rate		169,582			0			0
Investment earnings and other		15			13			610
Interest expense		(21,728	)		(7,017	)		(10,699	)

Income before income tax		563,337			289,104			328,415
Current income tax expense		325,217			127,080			190,577
Deferred income tax expense (benefit)		(17,662	)		76,030			(94,622	)

Net income under IFRS		255,782			85,994			232,460

Adjustments to increase (decrease) net income under IFRS:
Deferred income tax (expense) benefit		9,080			78,968			(49,545	)
Depletion expense		(20,352	)		7,282			1,908
Reversal of windfall profits tax credit		(55,168	)		0			0
Sports law over accrual		1,313			2,536			0

Net income under U.S. GAAP		190,655			174,780			184,823

Equity interest in equity affiliate		40	%		40	%		40	%

Income before amortization of excess basis in equity affiliate		76,262			69,912			73,929
Amortization of excess basis in equity affiliate		(3,684	)		(2,143	)		(1,863	)

Earnings from equity affiliate included in income	$	72,578		$	67,769		$	72,066

*	As discussed below, royalties paid-in-kind have been adjusted to reflect market prices as required under U.S. GAAP.


	As of December 31,
	2013		2012
	(in thousands)
Financial Position under IFRS:
Current assets	$	1,906,595	$	1,425,115
Property and equipment		717,449		538,351
Other assets		181,116		70,468
Current liabilities		1,652,806		1,180,559
Other liabilities		136,298		93,101
Net equity		1,016,056		760,274

Conversion Contract

On October 25, 2007, the Venezuelan Presidential Decree which formally transferred to Petrodelta the rights to the Petrodelta Fields subject to the conditions of the Conversion Contract was published in the Official Gazette. Petrodelta is governed by its own charter and bylaws and will engage in the exploration, production, gathering, transportation and storage of hydrocarbons from the Petrodelta Fields for a maximum of 20 years from that date. Petrodelta 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 is to undertake 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.

Sales Contract

The sale of oil and gas by Petrodelta to the Venezuelan government is pursuant to a Contract for Sale and Purchase of Hydrocarbons with PDVSA Petroleo S.A. (“PPSA”) signed on January 17, 2008. The form of the agreement is set forth in the Conversion Contract. Crude oil delivered from the Petrodelta Fields to PPSA is priced with reference to Merey 16 published prices, weighted for different markets, and adjusted for variations in gravity and sulphur content, commercialization costs and distortions that may occur given the reference price and prevailing market conditions. Merey 16 published prices are quoted and sold in U.S. Dollars. Natural gas delivered from the Petrodelta Fields to PPSA is priced at $1.54 per thousand cubic feet. Natural gas deliveries are paid in Bolivars, but the pricing for natural gas is referenced to the U.S. Dollar. PPSA is obligated to make payment to Petrodelta of each invoice within 60 days of the end of the invoiced production month by wire transfer, in U.S. Dollars in the case of payment for crude oil and natural gas liquids delivered, and in Bolivars in the case of payment for natural gas delivered, in immediately available funds to the bank accounts designated by Petrodelta.

When the Sales Contract was executed, Petrodelta was producing only one type of crude, Merey 16. Beginning in October 2011, the Ministry of the People’s Power for Petroleum and Mining (“MENPET”) determined that Petrodelta’s production flowing through the COMOR transfer point was a heavier type of crude, Boscan. Since Petrodelta was producing only Merey 16 when the Sales Contract was executed, the Boscan gravity and sulphur correction factors and crude pricing formula are not included in the Sales Contract. However, under the Sales Contract, PPSA is obligated to receive all of Petrodelta’s production. All production deliveries for all of Petrodelta’s fields have been certified by MENPET and acknowledged by PPSA. All pricing factors to be used in the Merey 16 and Boscan pricing formulas have been provided by and certified by MENPET to Petrodelta.

Since the Sales Contract provides for only one crude pricing formula, the Sales Contract had to be amended to include the Boscan pricing formula to allow Petrodelta to invoice PPSA for El Salto crude oil deliveries. Petrodelta received a draft amendment to the Sales Contract from PDVSA Trade and Supply. The pricing formula in the draft amendment has been used to accrue revenue for El Salto field deliveries from October 1, 2011 through December 31, 2013. Except for the inclusion of the Boscan pricing formula to be used in invoicing El Salto crude oil deliveries, all other terms and conditions of the Sales Contract remain in force. On January 31, 2013, Petrodelta’s board of directors endorsed the amendment to the Sales Contract. The amendment has been approved by CVP’s board of directors. HNR Finance, as shareholder, has agreed to the contract amendment.

CVP’s board of directors reviewed the amendment on April 30, 2013. A certificate of CVP’s final board resolution approving the amendment dated April 30, 2013 was received by Petrodelta on May 23, 2013. The remaining steps for the contract amendment are to (1) inform MENPET of the approval, (2) receive approval from Petrodelta’s shareholders to amend the Sales Contract including the Boscan formula, and (3) sign the contract amendment with PDVSA Trade and Supply. Once the Sales Contract is executed, PPSA will be invoiced for the deliveries. As of December 31, 2013, revenues of $756.7 million ($352.7 million as of December 31, 2012) for El Salto remain uninvoiced to PPSA pending execution of the amendment.

Payments to Contractors

As discussed in previous filings, PDVSA has failed to pay on a timely basis certain amounts owed to contractors that PDVSA has contracted to do work for Petrodelta. PDVSA, through PPSA, 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, including Harvest Vinccler. 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.

Harvest Vinccler has advanced certain costs on behalf of Petrodelta. These costs include consultants in engineering, drilling, operations, seismic interpretation, and employee salaries and related benefits for Harvest Vinccler employees seconded into Petrodelta. Currently, we have three employees seconded into Petrodelta. Costs advanced are invoiced on a monthly basis to Petrodelta. Harvest Vinccler is considered a contractor to Petrodelta,and as such, Harvest Vinccler is also experiencing the slow payment of invoices. During the year ended December 31, 2013, Harvest Vinccler advanced to Petrodelta $0.5 million for continuing operations costs. Petrodelta and Petrodelta’s board have not indicated that the advances are not payable, nor that they will not be paid. At December 31, 2013, we reclassified $0.8 million of the Advances to Affiliate to a long-term receivable due to slow payment and age of the advances. Although payment is slow and the balance is increasing, payments continue to be received.

Windfall Profits Tax

In April 2011, the Venezuelan government published in the Official Gazette the Law Creating a Special Contribution on Extraordinary Prices and Exorbitant Prices in the International Hydrocarbons Market (“Windfall Profits Tax”). In February 2013, the Venezuelan government published in the Official Gazette an amendment to the Windfall Profits Tax. The amended Windfall Profits Tax establishes new levels for contribution of extraordinary and exorbitant prices to the Venezuelan government. Extraordinary prices are considered to be equal to or lower than $80 per barrel, and exorbitant prices are considered to be over $80 per barrel.

Royalty Cap

Royalties are paid at 33.33 percent with the 30 percent royalty paid in kind and the 3.33 percent royalty paid in cash. The amended Windfall Profits Tax also sets a new royalty cap per barrel of $80 ($70 per barrel in 2012). The law does not specify whether the cap on royalties is applicable to royalties paid in-cash, in-kind, or both. Per instructions received from PDVSA, Petrodelta reports royalties, whether paid in-cash or in-kind, at $80 per barrel (royalty barrels x $80). Per our interpretation of the Windfall Profits Tax law and as required under U.S. GAAP, the $80 cap on royalty barrels should only be applied to the 3.33 percent royalty which Petrodelta pays in cash. The revenues and royalties in the table above have been adjusted to report royalties paid in-kind at the oil price applicable for the period. For the year ended December 31, 2013, the reduction to oil sales due to the $80 cap applied to all royalty barrels was $38.4 million ($12.1 million net to our percent interest for the period) ($113.7 million [$36.4 million net to our 32 percent interest] and $85.0 million [$27.2 million net to our 32 percent interest] for the years ended December 31, 2012 and 2011, respectively). While both methods of reporting result in the same amount being reported for net sales, our method results in prices per barrel of oil which are consistent with the prices expected under the Sales Contract.

Functional Currency

Petrodelta’s functional and reporting currency is the U.S. Dollar. PPSA is obligated to make payment to Petrodelta in U.S. Dollars in the case of payment for crude oil and natural gas liquids delivered. In addition, major contracts for capital expenditures and lease operating expenditures are denominated in U.S. Dollars. Any dividend paid by Petrodelta will be made in U.S. Dollars.

Petrodelta has currency exchange risk from fluctuations of the official prevailing exchange rate that applies to their operating costs denominated in Venezuela Bolivars (“Bolivars”). 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, current and deferred income tax and other tax obligations and other current liabilities. All monetary assets and liabilities incurred at the official Bolivar exchange rate are settled at the official Bolivar exchange rate. The official prevailing currency exchange rate was increased from 4.3 Bolivars per U.S. Dollar to 6.3 Bolivars per U.S. Dollar in February 2013. Petrodelta reflected a gain of approximately $169.6 million on revaluation of its non-income tax related assets and liabilities during the year ended December 31, 2013 primarily related to the February 2013 devaluation.

As a result of legislation enacted in December 2013 and January and February of 2014, Venezuela now has a multiple exchange rate system. Most of Petrodelta’s transactions are subject to a fixed official exchange rate of 6.3. In addition, there is a variable official exchange rate system in which the exchange rate is determined through auctions (11.3 rate as of December 31, 2013). The third system is not yet available as the government has not yet specified the scope of application and mechanics. The financial information is prepared using the official fixed exchange rate (6.3 from February 2013 through December 2013). At December 31, 2013, the balances in Petrodelta’s Bolivar denominated monetary assets and liabilities accounts that are exposed to exchange rate changes are 1,011 million Bolivars and 6,683 million Bolivars, respectively.

Petrodelta’s results were also impacted by PDVSA changing its policy with respect to invoicing for disbursements made in Bolivars on behalf of Petrodelta to require that such invoices be denominated in U.S. dollars rather than Bolivars. This change was implemented in the fourth quarter of 2013 with retroactive application to certain transactions occurring in 2011 and thereafter. As a result of this change, Petrodelta recorded a $14.2 million foreign currency loss in the three months ended December 31, 2013.

Collective Labor Agreement

On February 11, 2014, the Collective Labor Agreement for the period from October 1, 2013 thru October 1, 2015, between the employees of the oil industry represented by the Venezuelan Unitary Federation of workers of the oil, gas, and derivatives (FUTPV) and PDVSA was signed. The Collective Labor Agreement establishes a salary raise and payroll and retirement benefits which has a significant impact on Petrodelta’s payroll cost. The most significant impact is a step increase of salary around 90%, where 59% is to be retroactive from October 1, 2013, then a 23% raise from May 1, 2014 and finally the remaining portion to be adjusted on January 1, 2015.

Dividends

On November 12, 2010, Petrodelta’s board of directors declared a dividend of $30.6 million, $12.2 million net to HNR Finance. Petrodelta shareholder approval of the dividend was received on March 14, 2011. Due to Petrodelta’s liquidity constraints caused by PDVSA’s insufficient monetary support and contractual adherence, as of May 2, 2012, this dividend has not been received, although it is due and payable. Petrodelta’s board of directors declared this dividend and has never indicated that the dividend is not payable, nor that it will not be paid. The dividend receivable is classified as a long-term receivable at December 31, 2013 and 2012 due to the uncertainty in the timing of payment. There is uncertainty with respect to the timing of the receipt of this dividend and whether future dividends will be declared and/or paid. During the term of the Share Purchase Agreement, Harvest Holding may not pay any dividends to HNR Energia, and therefore would not benefit from any dividends paid by Petrodelta during this period. Should this receivable be paid and subsequently distributed to Harvest Holding’s shareholders prior to the second closing sale to Petroandina, we would not receive any portion of the dividend.

Fusion Geophysical, LLC (“Fusion”)

On January 28, 2011, Fusion Geophysical, LLC’s (“Fusion”) 69 percent owned subsidiary, FusionGeo, Inc., was acquired by a private purchaser pursuant to an Agreement and Plan of Merger. We received $1.4 million for our equity investment.