Headwater Exploration : 2021 Year End MD&A

2021 Management's Discussion and Analysis

The following management's discussion and analysis ("MD&A") as provided by the management of Headwater Exploration Inc. ("Headwater" or the "Company") is dated March 10, 2022 and should be read in conjunction with the audited annual financial statements for the years ended December 31, 2021 and 2020 and the notes thereto. The audited annual financial statements have been prepared in accordance with International Financial Reporting Standards ("IFRS") as issued by the International Accounting Standards Board ("IASB"). All dollar amounts are referenced in Canadian dollars unless otherwise stated. In addition, readers are also directed to the Company's Annual Information Form for the year ended December 31, 2021, dated March 10, 2022, which is available on the Company's website at www.headwaterexp.comand under the Company's profile on the System for Electronic Document Analysis and Retrieval ("SEDAR") at www.sedar.com.

Description of the Company

Headwater is a Canadian junior resource company engaged in the exploration for and development and production of petroleum and natural gas in Canada. Headwater currently has heavy oil production and reserves in the Clearwater formation in the Marten Hills area of Alberta and natural gas production and reserves in the McCully field near Sussex, New Brunswick.

Unless otherwise indicated herein, all production information presented herein has been presented on a gross basis, which is the Company's working interest prior to deduction of royalties and without including any royalty interests.

FOURTH QUARTER 2021 HIGHLIGHTS

• Achieved average production of 10,449 boe/d (consisting of 9,377 bbls/d of heavy oil and 6.4 mmcf/d of natural gas), an increase of over 500% from the fourth quarter of 2020.
• Cash flows provided by operating activities was $47.8 million, $0.23 per share (basic), and adjusted funds flow from operations (1) was $48.7 million, $0.24 per share (basic).
• Achieved an operating netback (2) of $50.36/boe and an adjusted funds flow netback (2) of $50.64/boe.
• Generated net income of $27.9 million, $0.14 per share (basic), and adjusted net income (3) of $32.6 million, $0.16 per share (basic).
• Executed a $49.0 million capital expenditure (3) program in the Marten Hills area including 3 successful exploration wells and 8 multi-lateral development wells at a 100% success rate. In addition to the drilling program, $26.5 million was spent on equipping and facilities primarily for ongoing construction of Headwater's 100% owned 15,000 bbls/d oil processing facility. The oil processing facility was commissioned subsequent to December 31, 2021.
• On December 23, 2021, Cenovus Marten Hills Partnership, a wholly owned subsidiary of Cenovus
  Energy Inc. ("Cenovus"), exercised its 15 million warrants (the "Cenovus Warrants") for 15 million common shares of the Company for total proceeds of $30 million. On exercise of the Cenovus Warrants, Cenovus held approximately 7% of the outstanding common shares of the Company.
• As at December 31, 2021, Headwater had working capital of $89.8 million, adjusted working capital
  (1) of $92.9 million and no outstanding debt.

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YEAR ENDED DECEMBER 31, 2021 HIGHLIGHTS

• Achieved average production of 7,393 boe/d (consisting of 6,665 bbls/d of heavy oil, 4.4 mmcf/d of natural gas and 2 bbls/d of natural gas liquids), an increase of over 700% from 2020 annual production of 882 boe/d.
• Cash flows provided by operating activities was $111.7 million, $0.56 per share (basic), and adjusted funds flow from operations (1) was $117.9 million, $0.59 per share (basic).
• Executed a $140.4 million capital expenditure (3) program in the Marten Hills area including 58 wells (51 crude oil wells, 4 source wells and 3 stratigraphic tests) at 100% success rate.
• The Company's joint gas processing facility, commissioned in the third quarter of 2021, in combination with pipeline infrastructure installed in the first quarter of 2021, has resulted in an approximate 50% reduction in Headwater's CO2e emissions intensity per barrel of oil equivalent over the 2021 calendar year.

1. Refer to "Management of capital" in note 18 of the audited annual financial statements and to "Non-GAAP and Other Financial Measures" within this MD&A.
2. Non-GAAPratio that does not have any standardized meaning under IFRS and therefore may not be comparable with the calculation of similar measures of other entities. Refer to "Non-GAAP and Other Financial Measures" within this
   MD&A.
3. Non-GAAPmeasure that does not have any standardized meaning under IFRS and therefore may not be comparable with the calculation of similar measures of other entities. The most directly comparable GAAP measure for adjusted net income is net income. Refer to "Non-GAAP and Other Financial Measures" within this MD&A.

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Results of Operations

Production and Pricing

	Three months ended				Year ended
	December 31,		Percent		December 31,		Percent
	2021	2020		Change	2021	2020		Change
Average daily production
Heavy oil (bbls/d)	9,377	979	858	6,665	246	2609
Natural gas (mmcf/d)	6.4	4.0	60	4.4	3.8	16
Natural gas liquids (bbls/d)	-	3	(100)	2	3	(33)
Barrels of oil equivalent (boe/d)	10,449	1,646	535	7,393	882	738
Average daily sales (boe/d) (1)
Heavy oil (bbls/d)	9,388	979	859	6,661	246	2608
Natural gas (mmcf/d)	6.4	4.0	60	4.4	3.8	16
Natural gas liquids (bbls/d)	-	3	(100)	2	3	(33)
Barrels of oil equivalent (boe/d)	10,459	1,646	535	7,390	882	738
Headwater average sales price (2)
Heavy oil ($/bbl) (3)	75.12	45.05	67	68.69	45.05	52
Natural gas ($/mcf)	8.46	5.37	58	7.18	3.21	124
Natural gas liquids ($/bbl)	-	56.23	(100)	70.14	57.28	22
Barrels of oil equivalent ($/boe)	72.62	39.90	82	66.18	26.57	149
Average Benchmark Price
WTI (US$/bbl) (4)	77.19	42.66	81	67.91	39.40	72
WCS differential to WTI (US$/bbl)	(14.64)	(9.30)	57	(13.04)	(12.60)	3
WCS (Cdn$/bbl) (5)	78.72	43.42	81	68.73	35.59	93
Condensate at Edmonton (Cdn$/bbl)	99.65	55.37	80	85.47	49.45	73
AGT (US$/mmbtu) (6)	8.09	3.23	150	5.49	2.47	122
AECO 5A (Cdn$/GJ)	4.41	2.50	76	3.44	2.11	63
NYMEX Henry Hub (US$/mmbtu)	5.83	2.66	119	3.84	2.08	85
Exchange rate (US$/Cdn$)	0.79	0.77	3	0.80	0.75	7

1. Includes sales of heavy crude oil excluding the impact of purchased condensate. The Company's heavy oil sales volumes and production volumes differ due to changes in inventory.
2. Average sales prices are calculated using average sales volumes.
3. Realized heavy oil prices are based on sales, net of blending expense.
4. WTI = West Texas Intermediate
5. WCS = Western Canadian Select
6. AGT = Algonquin city-gates. The AGT price is the average for the winter producing months in the McCully field which include January - April, November and December.

Sales

		Three months ended				Year ended
		December 31,		Percent		December 31,		Percent
		2021	2020		Change	2021	2020		Change
		(thousands of dollars)				(thousands of dollars)
Heavy oil sales	70,038	4,400	1492	178,434	4,400	3955
Blending expense	(5,162)	(343)	1405		(11,423)	(343)	3230
Heavy oil, net of blending (1)	64,876	4,057	1499	167,011	4,057	4017
Natural gas	5,005	1,966	155	11,416	4,466	156
Natural gas liquids	-	17	(100)	62	54	15
Gathering, processing and
transportation	244	243	-		1,028	579	78
Total sales, net of blending expense (1)		70,125	6,283	1016		179,517	9,156	1861

1. Non-GAAPmeasure. Refer to "Non-GAAP and Other Financial Measures" within this MD&A.

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Marten Hills

The Company's realized price received for its heavy crude oil is determined by the quality of crude compared to the benchmark price of WCS. Headwater's heavy crude oil production (average 18 - 22˚ API) is blended with diluent in order to meet pipeline transportation specifications.

During the year ended December 31, 2021, Headwater's heavy oil sales, net of blending expense, increased to $167.0 million from $4.1 million in 2020 due to a significant increase in both sales volumes and realized prices.

In 2021, the WTI crude price strengthened significantly as a result of increased demand for crude oil following the global recovery from the COVID-19 pandemic. The WCS differential to WTI remained narrow due to improved market access out of western Canada. The Company's heavy oil realized price for the year ended December 31, 2021, was $68.69/bbl, reflecting a discount to WCS of $0.04/bbl. The negligible discount to WCS realized over the year ended December 31, 2021, is a result of the Company selling more volumes later in the year at higher commodity pricing. Pursuant to the Acquisition (as defined below), Headwater acquired Cenovus' Marten Hills assets with approximately 2,800 bbls/d of heavy crude oil production in December 2020 and commenced its drilling program in January 2021. The Company averaged 2021 production volumes of 6,665 bbls/d and sales volumes of 6,661 bbls/d.

During the three months ended December 31, 2021, Headwater's heavy oil sales, net of blending expense, increased to $64.9 million from $4.1 million in the comparable period of 2020 due to an 859% increase in sales volumes and a 67% increase in realized prices. The Company's heavy oil realized price for the three months ended December 31, 2021, was $75.12/bbl, reflecting a discount to WCS of $3.60/bbl mainly resulting from increased blending costs, apportionment and terminal outages. The cost of condensate increased significantly to $99.65/bbl in the fourth quarter of 2021 from $55.37/bbl in the fourth quarter of 2020 resulting in increased blending costs.

The Company expects the weighted average annual discount to WCS, as a result of diluent blending, to be approximately $2.50/bbl in 2022.

The Company commissioned its Marten Hills joint gas processing facility and started generating sales from its associated natural gas production in the third quarter of 2021. The natural gas sales transaction price is based on the AECO 5A daily benchmark price adjusted for delivery location and heat content. Headwater's natural gas sales volumes averaged 2.5 mmcf/d with natural gas sales of $1.0 million during the three months ended December 31, 2021, while its natural gas sales volumes averaged 0.7 mmcf/d with natural gas sales of $1.1 million during the year ended December 31, 2021.

McCully

The Company sells its natural gas production daily from the McCully field in New Brunswick. The transaction price is based on the AGT daily benchmark price adjusted for the delivery location and heat content. The Company shut-in production effective May 1, 2021, and May 1, 2020, to take advantage of higher natural gas pricing during the winter months. The Company resumed operations at the end of November 2021 and at the end of October 2020.

Natural gas sales for the three months ended December 31, 2021, increased to $4.0 million from $2.0 million in the corresponding period of 2020, due primarily to a 109% increase in Headwater's average realized natural gas sales price as production remained consistent over the periods at 3.9 mmcf/d during the three months ended December 31, 2021, compared to 4.0 mmcf/d during the three months ended December 31, 2020. The increase in Headwater's average realized natural gas sales price was consistent with the increase in the AGT benchmark over the period.

Natural gas sales for the year ended December 31, 2021, increased to $10.3 million from $4.5 million in the corresponding period of 2020, due primarily to a 142% increase in Headwater's average realized natural

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gas sales price as production remained consistent over the periods at 3.7 mmcf/d during the twelve months ended December 31, 2021, compared to 3.8 mmcf/d during the twelve months ended December 31, 2020. The increase in Headwater's average realized natural gas sales price was consistent with the increase in the AGT benchmark price over the period.

In 2021, AGT benchmark pricing increased as a result of lower than average natural gas storage levels and colder North American east coast temperatures as compared to 2020.

Headwater owns the midstream facilities which process and transport gas from the McCully field to the Maritimes & Northeast Pipeline ("M&NP"). Gathering, processing and transportation revenue primarily relates to income earned on third party gas flowing through these facilities. This revenue will vary quarter over quarter depending on the amount of third-party volumes processed.

Financial Derivatives Gains (Losses)

Realized financial derivative gains Unrealized financial derivative gains (losses) Financial derivative gains (losses)

Per boe

Three months ended				Year ended
December 31,		Percent		December 31,		Percent
2021	2020		Change	2021	2020		Change
(thousands of dollars)				(thousands of dollars)
1,360	1,578	(14)	955	5,515	(83)
5,830	205	2744		(3,228)	(1,407)	129
7,190	1,783	303		(2,273)	4,108	(155)
7.47	11.77	(37)	(0.84)	12.73	(107)

Natural gas and crude oil commodity contracts

The realized financial derivative gains and losses during the three and twelve months ended December 31, 2021, represent both the natural gas contracts referenced to the AGT price and the crude oil contracts referenced to the WCS price.

A realized financial derivative gain was recorded during the three and twelve months ended December 31, 2021 of $1.0 million and $0.6 million, respectively, compared to a realized gain of $1.6 million and $5.5 million in the same periods of 2020 for the Company's natural gas contracts settled. The Company recognized gains on its natural gas contracts in 2021 as the commodity contracts to fix the AGT price were higher when compared to the AGT settlement price in the period. North American east coast temperatures and natural gas storage levels are the main variables impacting the AGT settlement price.

A realized financial derivative gain of $0.4 million was recorded for both the three and twelve months ended December 31, 2021, for the Company's oil contracts settled. The Company recognized gains on its oil contracts in 2021 as the commodity contracts to fix the WCS price were higher when compared to the WCS settlement price in the period. US Gulf Coast heavy oil demand and market access are the main variables impacting the WCS settlement price.

As at December 31, 2021, the fair value of Headwater's outstanding financial derivative contracts was a net unrealized liability of $3.2 million as reflected in the audited annual financial statements. The fair value or mark to market value of these contracts is based upon the estimated amount that would have been payable as at December 31, 2021, had the contracts been monetized or terminated. Subsequent changes in the fair value of the contracts are recognized in each reporting period and could be materially different than what is recorded as at December 31, 2021. For the three and twelve months ended December 31, 2021, Headwater recognized unrealized gains of $5.8 million and unrealized losses of $3.2 million, respectively, compared to unrealized gains of $0.2 million and unrealized losses of $1.4 million in the corresponding periods of 2020.

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