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Shareholders of the Calgary-based O&G company, Equal Energy (EQU) have been engaged in a long battle with the Board and management of the company to protect their rights and position the company away from a management-friendly enterprise to a shareholder-friendly one.

In this article, I will attempt to review the history of Equal Energy and assist current and potential investors in better understanding the underpinnings which are motivating the dissident shareholders to act.

Enterra / Equal History

The predecessor to Equal Energy, "Enterra Energy Trust", was formed on November 25th 2003. Between 2004 and 2007 the Trust undertook a series of acquisitions: Rocky Mountain Energy in 2004, Rocky Mountain Gas in 2005, High Point Resources in 2005, Altex Resources in 2006, and Trigger Resources in 2007. Enterra operated as a trust until its formal dissolution on May 31st 2010, and its conversion into a growth oriented E&P company called Equal Energy Ltd.

As a trust, Enterra Energy was established for the purpose of providing a monthly income stream for unit holders while offering a scope for capital appreciation. Between December 2003 and September 2007 Enterra paid a total of $239.8M in distributions:

2003: $2.45M

2004: $40.14

2005: $66.19M

2006: $90.5M

2007: $39.5M

2008: $0

2009: $0

2010: $0

November 2003 and November 2005

Enterra Entergy Trust initially operated under the leadership of Mr. Luc Chartrand, who was shortly succeeded by Mr. Reg Greenslade in early 2004 until approximately November 2005. During this period, the Trust operated smoothly and distributed over $108M in distributions while maintaining prudent leverage parameters ranging between 1.12 debt to cash flow ratio and 1.82 debt to cash flow ratio.

November 2005 to November 2007

During this period, and under the leadership of Mr. Keith Conrad, the company substantially increased its debt levels from $102.1M in 2005 to $279.89M by 2007. This led to a jump in the debt to cash flow multiple from 1.5 in 2005 to 3.64 in 2007. During this period, the company acquired the privately held Trigger Resources for $63.2M, a company that was headed by Mr. Don Klapko, who was subsequently hired as CEO on June 27th 2008. Enterra suspended its annual distribution in September 2007.

Recent History & Reasons to Take Action

On June 30th 2008, Equal announced the appointment of Mr. Don Klapko as President, CEO and a Director of Equal Energy (SEDAR filings indicate the official director date being June 27th 2008). From 2009 to 2011, the next three full years subsequent to Mr. Don Klapko's appointment, saw a sharp deterioration in a number of key metrics: shareholder equity per share, gross reserves per share, and average production per share experienced sharp declines ranging from 55.65% to 16%. Furthermore, during this time there were absolutely no cash distributions paid to the shareholders nor a noticeable reduction in net debt levels despite raising a total of $88.24M in two secondary offerings on July 9th 2009 and May 19th 2010:

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Shareholder Equity per Share

Year

Shareholder Equity Per Share**

2008

$14.32*

2009

$10.37*

2010

$7.71*

2011

$6.35*

Net Increase / Decrease

(55.65%)

*Adjusted for the 1 for 3 reverse split effected in Q2/2010. ** As reported in the company SEDAR filed annual reports for the years 2008, 2009, 2010 and 2011.

Gross Reserves per Share

Year

Barrel Per Share**

2008

1.3*

2009

1.47*

2010

1.15*

2011

1.09*

Net Increase / Decrease

(16%)

*Adjusted for the 1 for 3 reverse split effected in Q2/2010. ** As reported in the company SEDAR filed annual information forms for the years 2008, 2009, 2010 and 2011.

Yearly Average Production per Share

Year

Yearly Average Production Per Share**

2008

0.18*

2009

0.16*

2010

0.12*

2011

0.10*

Net Increase / Decrease

(41.70%)

*Adjusted for the 1 for 3 reverse split effected in Q2/2010. ** As reported in the company SEDAR filed annual reports for the years 2008, 2009, 2010 and 2011.

Total Net Debt

Year

Net debt / working capital deficit*

Convertible Debentures*

Total

2008

$52.38M

$113.42M

$165.8M

2009

$35.95M

$114.86M

$150.81M

2010

$36.74M

$119.90M

$156.60M

2011

$123.72M

$41.3M

$165.046M

Net Increase / Decrease

(0.0046%)

*As reported in the company SEDAR filed reports under net debt, working capital and convertible debentures for the years 2008, 2009, 2010 and 2011.

This dismal performance came at a very high cost. Close to a quarter of a billion dollars ($243.59M) of shareholder money has been squandered during this period; consisting of $104.76M in net cash capital spending, $90.94M in capital spending through share issuance, and a total of $47.89M in G&A spending during this period.

It is also important to note that those inadequate results were delivered despite a sharp rebound in energy prices between the years 2009 and 2011; a period during which WTI crude, Conway Propane and NYMEX Natural Gas increased by 54%, 68% and 4.5% respectively*:

(click to enlarge)

*As reported in the company SEDAR filed annual reports for the years 2009, 2010 and 2011.

During the first full three years of Mr. Klapko's management, the debt to cash flow ratio increased from 1.81 to 2.93 (a 162% increase). Meanwhile, the D/CF ratio peaked at 4.55 in 2010 and was even higher than the D/CF ratio peak of 4.32 in 2006 reached under the previous management, despite paying $0 in distributions:

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In addition to this management team's failure to enhance shareholder value through the drill bit or through acquisitions, management has maintained an average G&A per BOE that is significantly higher than its peers; averaging $4.59 per BOE vs. $3.98 per BOE** for comparable junior and intermediate Canadian O&G companies:

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**Based on available sample comparison tables from BMIR IQ Quarterly for Q1, Q2, Q3-2009, Q2,Q3-2010, Q1,Q2-2011.

Disastrous Transformation into a growth E&P

On January 18th 2010, under Mr. Klapko's leadership, Enterra announced its intention to convert into a non-dividend paying growth oriented E&P company named Equal Energy. On top of its failure to deliver growth as evident in the prior graphs, the company also significantly underperformed its peers since the official day of conversion on June 1st 2010 by declining by over 55% against a 9.5% decline in the S&P TSX Capped Energy Index presented here by the index tracker (XEG) ETF:

(click to enlarge)

While it is true that the elimination of the former trust structure may have compelled the company to convert into an E&P, it was by no means necessary to convert into a non-dividend paying entity: many of the company peers successfully converted into dividend paying corporations and have generated substantially better returns for their shareholders as captured in the S&P TSX Capped Energy index. It was the company's decision to fully eliminate its dividend payments and focus on organic and inorganic growth under the leadership of its CEO Mr. Don Klapko which largely contributed to the dismal returns experienced since that doomed conversion.

Failure of the Strategic Review in Achieving Its Primary Objective

On May 3rd 2012, after years of underperformance and at the shareholders urging, the company announced a strategic review to unlock the significant embedded value in Equal Energy stock, as highlighted in the company's May 10th 2012 press release:

On May 3rd, Equal's board of directors announced the initiation of a strategic review process to be managed by a special committee of independent board members with the assistance of Scotiabank as strategic advisors. The board and management are responding to a perceived significant gap between the value of the Company's underlying assets, and the value being recognized in the Company's stock price. The objective of the strategic review is to explore ways to potentially close this gap and improve the valuation of the Company.

On November 27th 2012, the company concluded the strategic review without closing that gap, as evident from the current discount between the company trading price and its net asset value:

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(NAV calculations can be obtained from the fact sheet at saveequalenergy.com)

The company's conclusion to the strategic review also widened the valuation gap vs. its peers on all key metrics:

(click to enlarge)

We believe the failure of the strategic review in achieving its objective stems from the company failure to deliver a proper shareholder friendly strategy at the conclusion of the strategic review; a strategy which would have entailed: the initiation of a substantial buyback, the introduction of a proper annual dividend, the establishment of a prudent capital spending budget in light of the low prices of natural gas and NGLs, and the transformation into a tax advantaged cross border Trust.

Furthermore, and in addition to the company failure in returning cash to its shareholders, the company announced upon the review conclusion that it is considering undertaking significant so-called accretive acquisitions. Mr. Klapko added:

We are now in a position to consider significant accretive acquisitions providing additional growth opportunities.

The market immediately punished the stock in the aftermath of the review's erroneous conclusion and the company's reiterated "failed" growth strategy, causing the stock to decline $3.54 in the last trading day prior to the conclusion of the review to $3.01 as of January 4th 2013, or a decline of 15% in just over a month.

Having failed to deliver shareholder value over the last 5 years either through the drill bit or through acquisitions, it is incomprehensible why a supposedly independent board of directors would hand a demonstrably incompetent management team a blank check to pursue the same failed strategy that caused the implosion in Equal's market value and the initiation of the strategic review in the first place.

Breach of Fiduciary Responsibility

We believe the current board of directors has failed in its role as a guardian of shareholder wealth and shareholders' interest.

Members of this board of directors, notably Mr. Peter Carpenter (Chairman from 2007 to April 2012), have presided over a 93%* destruction in shareholder value since joining Equal's board of directors on May 18, 2006; likewise for Mr. Roger Giovanetto. As Equal shareholders, we fail to see why those individuals continue to serve on the board of directors after such a dismal and shameful performance. The remaining board members (Mr. Michael Doyle, Mr. Victor Dusik, Mr. Dan Botterill, Mr. Robert Wilkinson and Mr. Don Klapko) have not fared much better, with Equal's share price declining by between 8%* and 76%* since each joined the board of directors. No director on this Board has ever created or enhanced shareholder value throughout their tenure:

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* Stock performance table for each director since they joined Equal can be found on the CEO and Board trackrecord section on saveequalenergy.com

Most importantly, this ineffective and misaligned board of directors has permitted a Chief Executive Officer (Mr. Don Klapko) to follow a disastrous business strategy that led to a decline in the value of Equal's shares in excess of 76% since joining the company on June 27 2008, while collecting total compensation in excess of $10.3M during this period (excluding 2012). This board has failed in its most basic and primary fiduciary responsibility, which is preserving and enhancing shareholder value by holding the executive team accountable for its underperformance.

We believe this failure to preserve shareholder value stems in part from the fact that most of the current board members have token ownership interest in the corporation, representing only 1.6% of the outstanding shares.

Excessive Compensation and Lack of Alignment

The misalignment between shareholders and management couldn't be more evident as per the following graphs which clearly indicate a growing divergence between the enrichment of management and the impoverishment of the shareholder, both in terms of share price and per share shareholder equity (up to 2011; 2012 compensation numbers yet to be published):

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(click to enlarge)

Mr. Don Klapko total annual compensation:

2008

2009

2010

2011

$6,586,222.00

$854,000.00

$554,000.00

$2,352,212.00

For the year 2011, Mr. Klapko received a 424% increase in total compensation. Likewise for the company's top executives, who received total compensation increases ranging from 45% to 84% during a year in which the stock price declined by 23.5% and per shareholder equity diminished by 17.7%.

TOP 50 Best Paid CEOs in Alberta

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(Source: Alberta Venture Magazine)

Excluding his $2.3M share based compensation, Don Klapko was the 16th highest paid CEO in Alberta in 2008, earning more than the CEOs of Canadian Natural Resources & Canadian Oil Sands Trust, companies that are 100 to 300 times larger than Equal!.

Conclusion

The board of directors, under the leadership of the ex-Chairman Mr. Peter Carpenter and the new Chairman Mr. Dan Botterill, has demonstrated a total impotence in holding this management team accountable for multiple years of underperformance. It remains a big mystery to us why this supposedly independent board of directors feels so beholden to a CEO that clearly destroyed value and is disdained by a large segment of the shareholder base.

The Board's lack of action leaves shareholders no choice but to take their activism to the next level in order to preserve and protect the value of their investment in Equal Energy.

For those interested in learning more about Equal's shareholders activism please visit www.saveequalenergy.com

Source: Equal Energy: Broken Management And A Broken Board