Challenger Energy : Quarterly report 31 December 2015

Appendix 5B - Mining exploration entity and oil and gas exploration entity quarterly report

29th Jan 2016

Board of Directors:

Michael Fry

(Non-executive Chairman)

Robert Willes (Managing Director)

William Bloking

(Non-executive Director)

Issued capital:

352,025,933 fully paid ordinary shares (ASX: CEL)

65,896,502 listed options (ASX: CELO)

26,000,000 unlisted options and rights

Substantial holders:

LQ Super 11.72%

W&M Brown 7.32%

Registered office:

Level 17,

500 Collins St Melbourne VICTORIA 3000

Tel [phone]

Fax [phone]

QUARTERLY ACTIVITIES REPORT FOR THE PERIOD ENDING 31 DECEMBER 2015

HIGHLIGHTS

• Positive industry engagement with government on key legislation - progress on MPRDA Amendment Bill and licence application process anticipated soon.

  
  

• ANC National General Council identifies ongoing power crisis as one of the "specific domestic weaknesses" in the economy undermining growth, investment and confidence, emphasises role of gas and affirms role of Independent Power Producers ("IPPs") to be expanded beyond renewables to include gas.

  
  

• Continuing economic pressure from electricity supply constraints, lower commodity prices and lower confidence levels lead to reduced growth forecasts.

  
  

• State power utility Eskom seeks further substantial electricity tariff increases to claw back R22.8 billion of costs primarily related to diesel consumption and reduced revenue.

  
  

• Farm-out discussions continue pending grant of exploration right.

South Africa

As previously reported, the petroleum industry has continued to engage with government throughout the year to deliver constructive solutions for the legislative framework (the Mineral and Petroleum Resources Development Act, 28 of 2002 - "MPRDA"). Linked to Operation Phakisa (a government programme aimed at fast-tracking the implementation of solutions on critical development issues, particularly oil and gas) the Minister of Mineral Resources established a bilateral process between the Department of Mineral Resources ("DMR") and the industry associations, the Offshore Petroleum Association of South Africa ("OPASA") and the Onshore Petroleum Association of South Africa ("ONPASA"). These bilateral engagements took into account the frontier nature of South Africa's petroleum industry, along with the imperative to achieve the national development goals as outlined in the National Development Plan and related government policies. The engagements have been constructive and productive, with convergence on key principles and a clear desire on the part of government to move the process forward. At this point we anticipate that either a mutually acceptable revision to the MPRDA will be proposed to Parliament soon, or the controversial clauses will be suspended, pending the splitting of the legislation into separate acts covering mining and oil and gas. Either way, it seems this may now be off the critical path and the government can proceed.

The South African Shadow Minister of Mineral Resources, James Lorimer, who represents his party on the parliamentary portfolio committee on mineral resources, echoes this sentiment in recent South African media reporting. Mr Lorimer comments on his expectations of the outcomes of revision of the MPRDA for South Africa's oil and gas industry, including the nascent shale gas sector.

He is reported as saying that the bill is likely to re-emerge on the parliamentary agenda and that the concerns of the oil and gas industry have been largely addressed in the new version, with agreement on the wording of the paragraphs that will govern state participation. He is quoted as saying:

"The 20% free carried interest will go, for example and there will still be a state interest but it will be a more subdued formulation" and

"Exploration and production costs will be covered before the state starts taking its 20% share in profits. This is much more regular across the world and more acceptable."

As previously reported, in late September the inaugural South Africa Gas Options Conference was held in Cape Town, attracting significant interest and pointed commentary from Energy Minister Tina Joemat-Pettersson with regard to the importance of gas in South Africa's future energy mix.

Minister Joemat-Pettersson stressed that gas will be the cornerstone of the country's base load power. The minister stated that it was vital for South Africa to change its energy mix, noting that the target for gas-fired power generation from 2019 to 2025 to widen South Africa's electricity base could be increased.

The government would play a significant role in developing timely, reliable and affordable electricity, while investment was encouraged in exploration and the development of natural gas resources, the minister said.

In October the governing African National Congress ("ANC") held its National General Council ("NGC"). Held midway between party conferences, the NGC is convened to discuss and debate the "strategic organisational and political issues facing the movement".

Delegates to the NGC were reported to have agreed that priority should be given to making clear decisions on future base load power investments, so as to avoid economically debilitating supply instability medium- to long-term. The ongoing power crisis was stated to be one of the "specific domestic weaknesses" in the economy, undermining growth, investment and confidence.

The expanded role of IPPs was affirmed, together with the desirability of extending the success of the renewables procurement programme to technologies such as coal and gas.

The ANC also emphasised the role of gas in South Africa's future energy mix, arguing gas, including shale gas, could be a "game changer" for the South African economy.

These positive developments take place against a background of continuing economic pressure.

Then Finance Minister Nhlanhla Nene presented his medium-term budget policy statement speech in October, making the point that without economic growth, there is no revenue growth, and without revenue growth, expenditure cannot increase and the nation cannot develop and succeed. The Treasury revised its growth expectations to 1.5% for 2015 and 1.7% for 2016 as compared to February's forecasts of 2% for 2015 and 2.4% for 2016. Nene said that electricity supply constraints, falling commodity prices and lower confidence levels had resulted in South Africa's growth forecasts being revised lower.

In December President Zuma announced that Mr Nene would be replaced as Finance Minister by little-known parliamentarian David van Rooyen. The appointment triggered market reaction and criticism, during which the rand depreciated substantially against the dollar. Within days, President Zuma removed Minister van Rooyen and announced the appointment of Pravin Gordhan as Finance Minister. Mr Gordhan had served as Finance Minister from 2009 to 2014, and was succeeded by his respected deputy, Mr Nene. The reappointment of Mr. Gordhan, to promote "fiscal discipline and prudence," calmed investors and led to a partial recovery of the rand. At a media briefing following his appointment Mr Gordhan emphasised sound fiscal management and sober spending.

The dramatic about-turn in reappointing the well-respected Mr Gordhan is a reflection of the pressure the President's office came under.

The financial pressure on state power utility Eskom has continued. Post the reporting period, the National Energy Regulator of South Africa (NERSA) is to hold hearings on Eskom's application for an electricity tariff increase to claw back R22.8-billion of costs. The utility has submitted an application for the first year, or 2013/14, of the third multiyear price determination (MYPD3), under which Eskom has been granted five yearly tariff increases of 8% until the end of March 2018.

The hearings are likely to centre on whether Eskom should be allowed to recoup various costs, including diesel expenses of R8-billion that were incurred during the financial year.

The other main component relates to a revenue variance of R11.7-billion, owing to lower than anticipated demand during the period.

If approved, the claw-back could result in tariffs rising by nearly 17% from 1 April, 2016, instead of the 8% already sanctioned. This follows a prior grant to Eskom of a 4.69% upward adjustment to the tariff from April 1, 2015, which resulted in a hike of 12.69% in 2015. A further claim for the 2014/15 financial year is also anticipated, and Eskom is reportedly also considering an early MYPD4 application and the possibility of applying for a 10-year tariff path. NERSA is expected to make its determination before the end of February.

Whilst it is difficult to provide precise guidance on the timing of the application determination process, the economic and political fundamentals to resolve the power crisis and grow the economy remain as strong as ever. The potential of natural gas to address these issues is increasingly appreciated and promoted, and the foundations for gas in South Africa's future energy mix are clearly being laid. As described above, Challenger anticipates that there will soon be positive developments with regard to key legislation and progression of the application process.

In the meantime, Challenger continues its discussions with prospective farm-in partners and we will continue to keep shareholders updated and informed as and when there is material progress.

Corporate

Whilst working to progress the licence application, management continues to focus on cost reduction, and this is reflected in the reduced expenditure for the fourth quarter and forecast for the coming quarter.

As part of building the Company's profile in South Africa, Challenger presented at the Investec Oil & Gas Conference in Cape Town in October for the second year running. This event runs concurrently with the annual Africa Oil Week and is a by-invitation-only opportunity to meet with selected funds and institutions. Challenger's presentation was well received.

The Company also ran an investor roadshow in Melbourne, Sydney, Brisbane and Perth in November.

Background

The Karoo Basin, which extends across 600,000 km2, is located in central and southern South Africa and contains organic rich shales of Permian age with combined thickness up to 5,000 feet. The focus for shale gas exploration is in the southern portion of the basin where the shales are at sufficient depth and where five wells, all pre-1970, intersected the shales with significant gas shows. One well, the Cranemere CR1/68 well, flowed more than 8 MMcf/day of natural gas from the Fort Brown shale during testing over a 158 feet interval in 1968. The production was judged to be from fractures and secondary porosity in the shales. As first mover, Bundu selected its application area centred on this well.

The US Energy Information Administration (EIA) updated its 2011 report on World Shale Gas Resources in June 2013. The EIA estimates that the Lower Permian Ecca Group