Underground Energy Announces Operational and Financial Update Including First Production From New Wells at the Zaca Field Extension Project

SANTA BARBARA, CA, Aug. 22, 2012 /CNW/ - Underground Energy Corporation ("Underground", "UGE" or the "Company") (TSX VENTURE: UGE) (OTCQX: UGGYF) today provided an operational update including initial production test results on its Chamberlin 3-2 and Chamberlin 2-2 wells and details of a resource evaluation report conducted by Netherland, Sewell and Associates, Inc. ("NSAI").

Operational Update

Through seismic and drilling programs at the Zaca Field Extension Project, Underground has significantly expanded the potential of this project and this is reflected in the NSAI report, summarized below. The Company has also produced initial oil from the Chamberlin 3-2 well, validating the Company's discovery of a deeper Monterey sub-thrust formation. Initial testing indicates that this oil is of a lighter gravity than the ultra-heavy oil produced at the existing Zaca oil field and with a water disposal solution (subject to capital availability), UGE will have the ability to complete testing and move this well into production. In addition, the Company has moved its Chamberlin 2-2 well at Zaca into production. Underground has also optimized its Gabriel 1-35 well at Burrel to an increased average production rate, since July 27, 2012, of approximately 70 barrels per day of light gravity oil, providing a source of cash flow for the Company.

Zaca Field Extension Project

The Company acquired the Zaca Field Extension Project in Fall 2011 for its potential to support a number of relatively low-cost, low-risk wells stepping out from the existing Zaca Field, where 61 wells drilled by other industry participants have produced in excess of 32 million barrels of oil to date (with cumulative production in excess of 500,000 barrels per well).  Since purchasing this asset, UGE has acquired and processed more than 50 miles of seismic data and has now drilled three wells, one of which was also re-drilled.  Through this process, the Company has: identified and validated the discovery of a deeper Monterey play in the newly discovered Chamberlin East Fault Block; validated the potential for a number of wells in the shallower Monterey play at the field; and identified the potential for in excess of 100 wells across those structures mapped to date.

Underground has increased its initial acreage from 6,200 net acres to approximately 9,923 net acres at Zaca. The Zaca Field Extension Project surrounds the existing Zaca oil field and a large portion of the acreage is within the State's designated boundary for the Zaca oil field. The Company now has 13 permitted well locations at its Zaca Field Extension Project, of which four have been drilled, with a further 10 locations moving through the permit process. Subject to raising additional capital, Underground will have the ability to implement a water disposal well leading to greatly reduced water disposal costs. The Company commenced its 2012 drilling program in February and is in the process of validating the commercial potential of multi zone production at Zaca. The Chamberlin 2-2 well has validated the commercial potential of the shallower Monterey zone stepping out from the existing Zaca field and we expect the Chamberlin 3-2 well to fully validate the commercial potential of the deeper Monterey sub-thrust zone.

Chamberlin 3-2 Well

The Chamberlin 3-2 well reached a total depth of 7,685 feet and validated the discovery of the Chamberlin East Fault Block with approximately 1,200 feet of oil-saturated Monterey shale in this deeper zone. The Company completed the Chamberlin 3-2 well with a pre-perforated liner set from 6,685 feet to 5,292 feet and subsequently began pumping the well.  While high water cut is relatively common in Monterey heavy oil wells, the Company did not anticipate the significant amount of water encountered in this new block.

The original down-hole pump installed in the Chamberlin 3-2 well was too small to effectively deal with the amount of fluid in the well bore, which resulted in too much back pressure on the formation to allow the oil to flow and a loss of required heat. Despite this, the well did produce some amounts of movable oil and large amounts of heavy oil were observed on the well's tubing and rods. A cement plug was subsequently placed at the bottom of the well to try to slow the flow of water, with only limited success. A higher capacity pump to handle larger than expected amounts of fluid was thereafter installed and a series of initial production tests conducted. The first production test showed oil cut in the fluid at an average of 4% in a 10 hour production test.  The gravity of the oil produced in this test was higher than the 8 degree API found at the nearby Zaca field.  Subsequent tests at different flow rates and pressures have yielded an average oil cut of approximately 1%.

The 4% oil cut is consistent with some of the most productive Monterey wells in the Santa Maria Basin. During the initial ten hour production test, the well pumped at daily rates of approximately 1,100 barrels of fluid, including 42 barrels of oil per day.  With the ability to increase fluid production from the current down-hole pump to up to 3,500 barrels per day, the potential exists to increase the amount of oil produced at this level of oil cut. In addition, the fluid level and pressure remains high in the well bore at 802 PSI. As pumping is increased and the fluid level and pressure fall, the Company believes that additional oil-filled fractures should begin to flow. However, in order to increase fluid production and to reach steady state production on such wells, it is typically necessary to produce the well for several weeks.  Additionally, initial production tests are not necessarily indicative of long-term performance or ultimate recovery.

Without on-site water disposal facilities, the Company does not currently have the financial resources to continue trucking water for disposal on a daily basis and as such, has suspended the testing of the Chamberlin 3-2 well, pending the availability of cost effective water disposal. The Company has identified and is permitting several suspended / abandoned wells on its leases which it believes will make good water disposal wells.  Based on the Company's preliminary test results of the Chamberlin 3-2 well, each disposal well has the capacity to handle the fluid from approximately five producing wells as the Company drills additional wells at Zaca. Upon and subject to the receipt of additional capital, the Company will be in a position to drill out one of these wells and commence on-site water disposal within a few weeks. At that time, the Company will also re-commence pumping the Chamberlin 3-2 well, to finalize production testing and we anticipate ultimately moving this well into commercial production.

Chamberlin 2-2 Well

The Chamberlin 2-2 ultimately reached a total depth of 4,650 feet. This well penetrated approximately 1,700 feet of oil saturated Monterey Shale which compares favourably with the typical gross pay of approximately 1,100 feet at the existing nearby Zaca field.  The bottom one-third of the net pay of the Chamberlin 2-2 well was subsequently perforated and after cleaning up, the Chamberlin 2-2 produced oil at a rate of approximately 30 barrels of oil per day ("bopd") with very little water during a 61 hour production test. This test proved the commercial potential of the Chamberlin 2-2 well and since completing the initial test, the Company has perforated the next third of potential pay with the view to further increasing production.

The Chamberlin 2-2 is a 10-acre step-out well offsetting two wells drilled by other industry participants at the existing Zaca field which both produced in excess of 550,000 barrels of oil and targets the same, shallower productive zone of Monterey Shale. Following the application of additional completion operations, the Company expects this well to produce in line with the infill drilling done at Zaca in the 1970's through the 1990's when wells reached optimized production rates of 70 bopd on average and produced 375,000 barrels average cumulative oil recovery.

The Company has made the decision to move the Chamberlin 2-2 well into production. With one third of the pay already providing commercial rates, the Company believes that moving the well into production is also the best way to optimize this well and increase production rates further.

As is common with fractured shale wells, there is the potential that some of the natural fractures in this wellbore are plugged by drilling mud and cement which invaded the wellbore during the drilling and completion process. In the Company's experience, it is usual for wells in this field to need several weeks of production before rates are optimized.  This typically allows formation heat to build and fractures to clear, enabling the heavy oil to flow. Depending on whether or not production increases over the next several weeks and contingent on the availability of capital, the Company may stimulate this well further to clean up the plugged fractures. Underground also has the option to perforate the balance of the potential pay.

Chamberlin 1-2 Well

The Chamberlin 1-2 well was acquired by the Company when it completed its asset purchase in November, 2011. This well was producing oil at approximately 10 bopd, but was suspended by the Company when it made the decision to use the same well pad to drill the Chamberlin 2-2 well. As new production from the Chamberlin 2-2 well comes on line, the Company plans to put the Chamberlin 1-2 well back on production. Subject to the raising of additional capital, Underground will likely also stimulate this well, with a view to optimizing and increasing production further.

Burrel Field Production

The Company acquired 8,525 net acres at Burrel in the San Joaquin Valley in November 2011. As part of that purchase, the Company acquired one producing light oil well Gabriel 1-35. This well has an approximate 99% water cut, but there is a water disposal well on site, enabling low cost water disposal. Following remedial work over the last couple of months, the Company has increased production from approximately 20 bopd to more than 70 bopd. With the strong price received for light oil in California, this well provides positive cash-flow and with planned electrification, the returns from this well should increase further.

Netherland Sewell Resource Evaluation

UGE today announced the results of a resource evaluation conducted by independent petroleum consultants, Dallas, Texas-based Netherland, Sewell and Associates, Inc. ("NSAI"). NSAI is independent of Underground.  In a report dated August 23, 2012, with an effective date of August 1, 2012, NSAI evaluated both discovered and undiscovered petroleum initially-in-place and the prospective and contingent resources.  The report covers the seismically defined structures on the Company's leases adjacent to the East side of the existing Zaca Field. The evaluation was conducted in accordance with the Canadian standards and requirements of National Instrument 51-101 - Standards of Disclosure for Oil and Gas Activities.

In the report, NSAI provides their "best" estimate of total petroleum initially-in-place at 493.2 million barrels, of which 15.4 million barrels (12.3 million barrels net to UGE) is categorized as contingent resources. NSAI's "best" estimate of the portion of the undiscovered oil initially-in-place that is categorized as prospective resources is 46.2 million barrels (37.0 million barrels net to UGE).

Findings of the report are summarized in the tables below:

Notes:
(1) Contingent resources are those quantities of petroleum estimated, as of a given date, to be potentially recoverable from known accumulations.  There is no certainty that it will be commercially viable to produce any portion of the resources.  The economic status of the contingent resources set forth above is "economic status undetermined".
(2) Underground owns an 80 percent working interest in these properties.
(3) Prospective resources are those quantities of petroleum estimated, as of a given date, to be potentially recoverable from undiscovered accumulations by application of future development projects.  Prospective resources have both an associated chance of discovery and a chance of development.  There is no certainty that any portion of the prospective resources will be discovered and, if discovered, there is no certainty that it will be commercially viable to produce any portion of those resources.
(4) Total petroleum initially-in-place ("TPIIP") is that quantity of petroleum that is estimated to exist originally in naturally occurring accumulations.  It includes that quantity of petroleum that is estimated, as of a given date, to be contained in known accumulations, prior to production, plus those estimated quantities in accumulations yet to be discovered.  There is no certainty that it will be economically viable or technically feasible to produce any portion of this TPIIP except to the extent that it may subsequently be identified as proved or probable reserves. Resources do not constitute, and should not be confused with, reserves.
(5)  The contingent resources shown in the report are contingent upon demonstration of commercially productive rates and a financial commitment from the Company to develop the resources.
(6)  The most significant positive factors with respect to the estimate of contingent resources include that the formation of interest is extensive in the Zaca Field Extension Project, that there is extensive offset well data and that there is extensive seismic data.  Negative factors include that the Company current has no economic method to dispose of produced water.

Financial Update

The process of testing and moving wells into production has taken longer than anticipated. This is due in large part to high water cut in the Chamberlin 3-2 well which has stretched the Company's temporary facilities at Zaca, impacting the process of testing the Chamberlin 3-2 and Chamberlin 2-2 wells. As a result, Underground has experienced unanticipated extended testing costs without the benefit of cash flow from production. As such, the Company is in the position where it needs to raise additional capital in order to continue to develop the Zaca Field Extension Project. In that regard, the Company is currently exploring potential financing alternatives.

The Company has initial production.  It also possesses a diverse portfolio of quality, prospective assets and is in the process of selling a non-core asset, with the closing of that sale anticipated shortly. Certain other assets of the Company are also being considered for sale. Management has also significantly reduced operational and administrative overheads as it looks to focus its resources on bringing on and expanding production at its Zaca Field Extension Project.  The Company expects to release its detailed financial results for the three and six months ended June 30^th during the week of August 27, 2012.

CEO Comment

"While the process of completing and bringing the Chamberlin 3-2 well on to production has taken considerably longer than anticipated and has put financial strain on the Company, this is a brand new heavy oil discovery with significant potential for the Company," said Mike Kobler President and CEO. "We now have a better understanding of the characteristics of this new zone and how to test and produce the 3-2 well. We know the well has great pressure, permeability and natural fracture conductivity and we continue to believe that it has the potential to achieve optimized production rates in line with the average of over 200 bopd seen in wells drilled by other industry participants at the existing Zaca field. The fact that this zone has to date produced some higher gravity oil also increases the potential returns further."

"We are pleased that the Chamberlin 2-2 well is now moving into production and we believe that we will see continued production increases as we start to produce this well. We intend to continue to optimize and stimulate oil production as necessary. We also intend to put the Chamberlin 1-2 well back onto production and to increase its production."

"While production from the upper Monterey zone is somewhat pressure depleted, we believe that the Chamberlin 2-2 well validates the potential to drill additional, low risk, step out wells which have the potential for long life and, with the strong pricing of California heavy oil, the potential for robust returns especially as we start to commission permanent facilities. The NSAI report supports our view of the ultimate potential of the Zaca Field Extension Project, including the potential for a field in excess of 100 wells."

"I am also pleased that our work at Burrel has resulted in significantly increased production at our light oil well which provides another source of cash flow and demonstrates that with permanent water disposal in place, wells with very high water cut have the potential for strong returns. Our initial production at Zaca, combined with Burrel production, provides a good base from which to grow. With additional capital, we will be able to optimize production further from our existing wells and install water disposal which is key to moving the Chamberlin 3-2 well into production and will greatly reduce our production costs."

Options Grant

As part of the process of reducing overhead, the management team has agreed to significant reductions in salary over the next 3 months and by way of recognition, the Company is issuing to members of management options to acquire a total of 800,000 common shares in the Company at an exercise price to be set after the release of the second quarter financial results.

Acquisition of Certain Minority Interests in Petroleum Leases

The Company will not pursue purchase and sale agreements for the acquisition of certain minority interests in petroleum leases at its Zaca Field Extension Project as well as at its Burrel, Buttonwillow and Devil's Den properties and minority interests in small additional prospects in the San Joaquin Basin, California, which was announced on May 31, 2012.

About Underground Energy Corporation

Underground is focused on developing its Zaca Field Extension Project in Santa Barbara County, California. In total, Underground currently holds mineral rights on approximately 70,000 net acres of prospective lands in California and Nevada with an initial focus on the Monterey Shale in California. Underground is listed on the TSX Venture Exchange under the ticker symbol "UGE" and quoted on the OTCQX trading platform under the ticker symbol "UGGYF". For more information on Underground, including a copy of the Company's latest corporate presentation, please visit www.ugenergy.com. Underground's regulatory filings are available under the Company's profile at www.sedar.com.

Cautionary Statements

Statements in this press release contain forward-looking information and forward-looking statements within the meaning of applicable securities laws (collectively, "forward-looking information").  Forward-looking information is frequently characterized by words such as "plan", "expect", "project", "intend", "believe", "anticipate", "estimate" and other similar words, or statements that certain events or conditions "may" or "will" occur.  In particular, forward-looking information in this press release includes, without limitation, statements with respect to: (i) the potential future production of the Chamberlin 1-2 well, 2-2 well and the 3-2 well; (ii) future completion and stimulation operations to potentially be conducted on the Chamberlin 1-2, 2-2 well and the 3-2 well; and (iii) the commissioning of abandoned wells as water disposal wells.

Initial production test results should be considered preliminary data and such data is not necessarily indicative of long-term performance or of ultimate recovery.

Although we believe that the expectations and assumptions reflected in the forward-looking information are reasonable, there can be no assurance that such expectations or assumptions will prove to be correct. In particular, assumptions have been made that: (i) Underground will be able to obtain equipment, qualified staff and regulatory approvals in a timely manner to carry out its planned exploration and development activities; (ii) Underground will have sufficient financial resources with which to conduct its planned capital expenditures; and (iii) the current regulatory and tax regime will remain substantially unchanged. Certain or all of the forgoing assumptions may prove to be untrue.

Forward-looking information is based on the opinions and estimates of management at the date the statements are made, and is subject to a variety of risks and uncertainties and other factors (many of which are beyond the control of Underground) that could cause actual events or results to differ materially from those anticipated in the forward-looking information.  Some of the risks and other factors could cause results to differ materially from those expressed in the forward-looking information include, but are not limited to: operational risks in exploration, development and production; delays or changes in plans; competition for and/or inability to retain drilling rigs and other services; competition for, among other things, capital, acquisitions of reserves, undeveloped lands, skilled personnel and supplies; risks associated to the uncertainty of reserve and resource estimates; governmental regulation of the oil and gas industry, including environmental regulation; geological, technical, drilling and processing  problems and other difficulties in producing reserves; the uncertainty of estimates and projections of production, costs and expenses; unanticipated operating events or performance which can reduce production or cause production to be shut in or delayed; incorrect assessments of the value of acquisitions; the need to obtain required approvals from regulatory authorities; stock market volatility; volatility in market prices for oil and  natural gas; liabilities inherent in oil and natural gas operations; access to capital; and other factors.  Readers are cautioned that this list of risk factors should not be construed as exhaustive. 

The forward-looking information contained in this news release is expressly qualified by this cautionary statement.  Underground does not undertake any obligation to update or revise any forward-looking statements to conform such information to actual results or to changes in our expectations except as otherwise required by applicable securities legislation.  Readers are cautioned not to place undue reliance on forward-looking information.

Certain information contained herein is considered "analogous information" as defined in National Instrument 51-101 including the information concerning wells drilled by other industry participants at Zaca, the production rates therefrom and the cumulative production therefrom.  Underground is unable to verify whether such information has been prepared in accordance with NI 51-101 and the Canadian Oil and Gas Evaluation Handbook and Underground is unable to confirm whether such estimates have been prepared by a qualified reserves evaluator. The information on the historic production of wells drilled by other industry participants on the Zaca Field was obtained from California Division of Oil, Gas and Geothermal Resources on August 24, 2011. The information has been provided to demonstrate the potential for similar aggregate production for certain wells drilled by or to be drilled by Underground at the Zaca Field.

Neither the TSX Venture Exchange nor its Regulation Services Provider (as that term is defined in the policies of the TSX Venture Exchange) accepts responsibility for the adequacy or accuracy of this release.