Since our last letter, there has been a notable change in both oil and natural gas markets. First we will address oil. Global oil demand remains exceedingly robust exceeding expectations that were in the market at the end of Q1. Healthy global economy and increased oil demands from China seem to be key factors. We believe it is fair to now say that oil demand is proving to be far more resilient to higher prices than many analysts originally thought.

While oil will always remain a cyclical market, we believe that in the current global environment, there has been a structural upward shift in oil prices. The pundits looking for a return to oil prices in the $40 range will be waiting for a long time. We think oil markets are firmly bound in a price range between $55-$75 per barrel.

One of the key drivers for this shift is the astounding increase in global finding and development (FD&A) costs, which have risen from $2.76 per BOE in 1999 to almost $20 BOE in 2007 (see Chart One).

Chart One: World FD&A Costs - Excluding Changes in FDC (1999 to 2006)

This staggering increase is a function of higher industry input costs and the increasing difficulty of finding significant hydrocarbon deposits. As we have said many times before, reserve replacement is more challenged with every passing year. The large, integrated oil companies have added no net new oil reserves this decade. This situation will persist unless there is a dramatic increase in reinvestment and activity levels.

Yet with rapidly escalating costs, smaller and more marginal prospects are becoming more and more uneconomic. In a sense, the global oil industry finds itself 'in a box'. And the only solution to this situation is for the price of oil to remain in a higher range going forward.

If that isn't enough, simply add the global geo-political scene into the mix. From Venezuela to Russia to Nigeria, the world is becoming a more difficult place for big oil to operate in. The risk premium in oil prices may ebb and flow over time but it is not going away any time soon. The simple reality is that national oil companies (NOC's) now control some 77% of the world's known oil reserves (PFC Energy Corp). In most countries where these NOC's exist, they are simply used as a cash cow to fund social programs. As a result, reinvestment suffers and reserves will likely to surprise on the downside, such as in Mexico.

Biofuels (ethanol, bio-diesel) have received much attention from the press in the past few months but we doubt that this source of alternative energy will have any significant impact on conventional fuels. The logistics are simply too daunting in order to produce significant quantities of biofuels. And we question the wisdom of turning food into fuel. In our view, there will be a role for biofuels but it will not be that significant to be a threat to oil markets. In an interesting turn, OPEC has warned that it may cut investment in new oil production in response to moves by the developed world to use more biofuels. While it may be just 'talk' at this stage, it bears watching.

With respect to climate change and CO 2 emissions, we see negligible impact on the industry at this point. There will be some compliance costs for oil companies and refiners but we believe that these additional costs are not that significant and can be handled in the current environment. What we do see is the oil industry investing in so-called 'green alternatives'. For example, British Petroleum has morphed itself into Beyond Petroleum and is investing wind farms. Could we see Suncor planting trees or investing in alternative energy projects to offset CO 2 emissions from its oil sands operations? Anything is possible now since public perception is everything when it comes to climate change.

All in all, we remain bullish for the long-term outlook for oil prices. In the very short-term, we would not be surprised to see a pullback in oil prices, as oil is now trading close to our upper price level of $75 per barrel. But short-term trades aside, the price of oil is set to stay higher, for longer.

Natural Gas

The outlook for natural gas pricing in North America is more problematic than that of oil. While we remain bullish over the longer term, a couple of changes have conspired over the past quarter to alter our view of the near term outlook.

To begin with, LNG imports into the U.S. market have surged over the past few months. In part, this is due to a warm winter in Europe and Asia and a diversion of LNG to U.S. facilities (see Chart Two).

Chart Two: United States imports of LNG

This surge has effectively offset declining Canadian production that has resulted from reduced activity levels. (As of June 12, 2007, active rigs in Canada were down 28% from year ago levels.) As a result, gas storage levels have increased significantly in the April and May period (see Chart Three).

Chart Three: Estimated Working Natural Gas Storage - Levels in Western Canada

U.S. gas storage is on track to eclipse the very high level of October 2006 and possibly push to a new all time high (See Chart Four).

Chart Four: United States Working Natural Gas Storage

This situation of higher LNG imports (which frankly caught us off guard) offsetting diminished Canadian supply, looks likely to persist for several months to come.   Added to this, the strength of the Canadian dollar vs. the U.S. dollar has taken its toll on Canadian price realizations. The economics of Canadian natural gas production are now very challenged due to continued high costs and lower price realizations. Activity levels are down year-over-year and will likely remain depressed for the next 6-9 months.

If there is any good news in this negative turn of events, its that the natural gas industry has historically been very good at self-correcting. Lower prices beget lower activity and supplies dry up. That is especially the case today, when first year production decline rates run 50%. It won't take long before a significant negative supply response is felt. What that means of course is that when the turn comes, it will likely be violent.

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