Written by Michael Waring

What has changed in the past quarter? Not much in our view. The industry continues to be challenged to replace reserves, whether oil or natural gas on an economic basis.

First, our thought on oil markets. From a demand perspective, China is without peers. The country's almost insatiable rising consumption of oil weighs heavily on global energy markets. As evidenced by the strong growth in first quarter demand, there seems to be no let up in sight. For example, in January, China produced more cars then the U.S. As stated by Marshall Atkins, the energy analyst at Raymond James, "Given that we are expecting global oil supply to increase by only 1.0 to 1.5 MMbpd per year over the next three years, maintaining even a 10% growth rate (in China) would mean that about half the incremental supply would go to China, with the rest of the world (including the entire OECD, India, Southeast Asia, Brazil, etc.) left to fight over the other half. This is neither economically nor politically feasible on a sustained basis although we would point out that China accounted for 45% of the world's incremental demand in 2006." (See Chart One and Two)

Chart One: As the Chinese Economy Grows, its Oil Demand Ramps Up

Chart Two: Chinese Oil Demand Growth (Year-Over-Year)

Evidence of this demand need is the aggressiveness of Chinese oil companies to seek exploration concessions or purchase existing oil fields in politically unstable parts of the world. Since we expect no meaningful slowdown in Chinese GDP growth for the next few years, oil demand growth will likely continue to show strong growth as industrialization, urbanization and the rise of the middle class presses on. It is estimated China will require 15mm boepd by 2030 while only producing 4.2mm boepd at this point.

With respect to the United States, we are astounded by the draw-down in gasoline inventories. As seen in Chart Three, gasoline demand thus far in 2007 is surging.

Chart Three: U.S. Implied Demand for Motor Gasoline

And, as Chart Four shows, gasoline days of inventory cover vs. demand has now slipped below the five-year average. So much for a change in American driving habits! In our view, we believe that gasoline demand and low inventory levels will be a catalyst for higher crude oil prices through the U.S. summer driving season.

Chart Four: U.S. Motor Gasoline Days of Cover

On the supply side, OPEC production cutbacks appear to have finally had an effect. (See Chart Five)

Chart Five: OPEC 10 Monthly Output

Over the past 18 months, production cuts have totalled 2 Mbpd while approximately 1.35 Mbpd was cut over the last nine months alone according to CLSA Securities. The global energy market has been rightly sceptical of OPEC actually cutting production but it seems to now be taking hold. The oil market now appears headed to a tighter balance (See Chart Six). The tight demand/supply balance could lead to a rapid draw-down in crude inventories in the next few months.

Chart Six: OECD Crude Oil Inventories

As another example of maturing oil fields, the Wall Street Journal (April 5,2007) reported that Mexico's Canterell field, the world's second largest oil field by output (2% of daily global oil production), has seen production levels decline by 1/5 - falling from 2mm bpd to 1.6mm bpd in the past year. A mature field, poor maintenance and a lack of reinvestment account this. Some 70% of the world's oil reserves are controlled by national governments with the same lack of technical expertise and a lack of adequate reinvestment such as Mexico. We suspect that Canterell is the canary in the coal mine. No new fields of significant size have been discovered over the past two decades despite the enormous advances in oil field seismic technology.

And with growing political instability and the re-writing of production agreements, the world is becoming a smaller for multinational oil companies to invest.

We believe the outlook for natural gas is becoming very compelling over the next year. Drilling activity in Western Canada has virtually collapsed to levels not seen in four years. As of last week, only 107 of the 861 registered rigs in Western Canada were active. One has to look all the way back to spring break-up 1999 to see a lower weekly utilization number (See Chart Seven).

Chart Seven: Key Oilfield Indicators and Performance Metrics - Weekly Rig Count

* Canaccord Adams

Activity levels are also starting to drop in the U.S. with a 3% decline in the past week. In the United States, we believe that the natural gas industry is not seeing any sizable supply response to higher drilling after adjusting for hurricane losses (See Chart Eight).

Chart Eight: Year-over-Year Change in U.S. Natural Gas

Production after Adjusting for Hurricane Losses

According to First Energy, "Trends over the last few months are somewhat chilling in our view as the year over year gains have been slowly tending to zero. This is not an encouraging trend, especially if the rig count does indeed pullback modestly as we are suggesting". Reduced drilling activity combined with higher first year depletion rates and smaller reservoir discoveries will lead to a quick improvement in natural gas markets over the coming year.

Winter was slow to arrive but now does not seem to want to let go. As a result, natural gas in storage is in much better balance than thought just a few weeks ago (See Chart Nine).

Chart Nine: Natural Gas Storage

Although LNG imports in the U.S. are rising, we expect this influx to be offset by declining import levels from Canada (See Chart Ten). As well, the cost of LNG is likely headed higher as producers assess their alternatives and the cost of production.

Chart Ten: United States Net Imports of Natural Gas From Canada

Bottom line? We believe there is limited incremental supply for at least the next several years. The U.S. and Canada are facing "the same steadily growing issues of higher decline rates, smaller reserve sizes, and lower productivity wells" (First Energy). Alternative supplies (Mackenzie pipeline gas, coal-bed Methane etc.) require higher prices to be developed.

And finally, although perhaps early to suggest this, natural gas may garner a 'green halo' in the quarters ahead. With the green wave that is sweeping the globe (see quarterly market commentary), natural gas may begin to be viewed as an environmentally friendly alternative to coal and oil.

We remain strongly bullish on the longer-term outlook for natural gas markets in North America.

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