Written by Michael Waring

To say that 2006 was a disappointing year to be invested in energy shares and trusts is certainly an understatement. The price of oil peaked in August at $70 per barrel driven by concerns of the Israeli-Hamas confrontation. From the peak, prices headed south and at the time of writing, the price stands at $51.21 and many pundits project it to head lower in the months ahead. Natural gas prices in North America never recovered from the lack of cold weather last winter and the resulting high levels of gas in short term storage. The weakness in natural gas markets was exacerbated by the collapse of a large hedge fund (Amaranth) that had placed an enormous bet that natural gas prices were set to go up. In the weeks following the collapse, natural gas traded as low at $4.07 per Mcf on September 27, 2006 from a peak of $15.78 per Mcf set on December 13, 2005.

If all that wasn't bad enough, the Conservative Federal Government reneged on an election promise and decided to tax the income trusts after a four-year grace period. For an industry that had been a major driver of the Canadian economy, this move appears to us to be snatching defeat from the jaws of victory. We wholeheartedly disagree with the government's assessment of the situation and we believe their conclusions were misguided.

As a consequence of this litany of bad news, the S&P/TSX Capped Energy Index (price only) rose only 1.5% for the year in 2006, while the Capped Energy Trust Index (price only) fell a whopping 12.1%. Thank you Mr. Flaherty.

So where does that leave us? As the moment, the consensus outlook from analysts has turned decidedly cautious and price targets for shares and trusts have been reduced across the board. In the very short term, the price of oil is headed lower based on technical trading patterns that are driving momentum players and hedge funds. But from our contrarian stance, we believe we are now closer to a bottom than a top and valuations in the energy sector are becoming very attractive for longer-term investors. We believe this to be the case because despite the plethora of negative headline news, the underlying fundamentals that we have been talking about in previous letters haven't really changed. In fact, one can argue that lower commodity prices currently and the taxation of royalty trusts will only defer development programs leading to much higher prices within the next several quarters.

We would like to review several topical issues that we believe are relevant to our constructive view on the outlook for energy prices. We begin with oil markets.

After his landslide victory in December, the leftist President of Venezuela, Hugo Chavez, has announced plans for further nationalization of the country's key industries. As part of this initiative, Chavez identified the Orinoco heavy oil belt as a strategic national asset and he seems determined to take control. Five companies including Chevron, Conoco, Exxon Mobil, BP, Statoil and Total had invested approximately U.S. $20 billion for a 60% joint venture interest with the state oil firm, PDVSA, holding the remaining 40%. Venezuela currently supplies the Unites States with 1.5 million barrels per day of oil or about 11% of U.S. imports. Over the years, we have learned that nationalization of oil assets typically leads to lower production over time. With respect to the heavy oil industry in Venezuela in particular, a large number of experienced technologists left the country in 2003 after a purge within the state oil company (PDVSA) following a 2½-month strike (as an aside, many resettled in Ft. McMurray). Venezuela simply lacks the capital and the expertise to develop these resources on their own and production levels will likely suffer as a result.

In Russia, President Putin seems very determined to regain the 'glory' days of the Russian empire using the country's energy resources as a means to accomplish this. According to an article in the Financial Times of London (December 12, 2006; Page 21), "Russia wants control over all strategic projects and will use any means to get it". Exxon Mobil, Shell and BP are essentially being subjected to blackmail and having control of their Russian investments wrestled away. This will undoubtedly lead to reduced capital investment and expertise that will end with project slippage. We are not optimistic regarding continued growth in energy exports from Russia in the near term.

According to a recent report by academic Roger Stern at John Hopkins University, "Iran's oil exports could dwindle to almost nothing by 2015 if it did not change its energy policies." Iran is currently the world's fourth largest exporter, supplying approximately 2.4 million barrels per day to global markets. In essence, the concern is that "every aspect of oil infrastructure has been starved" for capital. As its older fields decline, Iran must develop new projects, which will require billions of dollars in new investment. In 1995, the U.S. imposed sanctions on involvement in Iran's oil industry thereby limiting new technology to maintain output. Iran does not allow any foreign ownership of its oil resources.

At the same time, domestic demand for oil is rising by 5% per year (or 80,000 bpd) in 2007. This implies that Iran must increase oil production by 430,000 bpd just to stand still given current reservoir decline rates. Interestingly, according to a Deutsche Bank report, Iran's seven million cars consume approximately 420,000 bpd of gasoline, which is the same amount as Britain with 35 million cars. Obviously, something does not add up with respect to Iran's oil industry. As with Venezuela and Russia, we are not optimistic with respect to the continued level of oil exports going forward.

Perhaps, in part, driven by the higher political risk, the world oil industry has barely increased its investments in new oil and natural gas production. A recent Wall Street Journal article (WSJ, November 8, 2006) noted that "Adjusted for inflation, the oil industry's investment increased by 5% between 2000 and 2005." Since large oil and gas projects today take many years to complete and entail a large degree of engineering and procurement, the net affect of a paltry 5% increase in investment will become evident over the next few years.

According to Morgan Stanley, "In the exploration market, the potential for billion barrel discoveries has fallen annually. Yet large size discovery is increasingly what is needed to move the needle. Generally speaking, billion-barrel projects are becoming logistical projects with long lead times and extensive project management skills required".

Even ignoring stronger global energy demand from China and India, the industry's investments will not materially add to the world's spare oil production or cushion. This suggests to us that a sizeable risk premium in the price per barrel of oil continues to be warranted.

The limited reduction thus far in OPEC output appears to be translating into lower U.S. crude oil inventories. These inventories have dropped steadily over the past three months despite the again warmer than normal winter affecting the North-eastern U.S. (See Chart One). For all these reasons, we remain bullish on the longer-term supply and demand fundamentals of global oil markets.

Chart One: Total U.S. Petroleum Inventories

With respect to North American natural gas markets, we believe the table is being set for much higher gas prices in the years ahead. New taxation of the trust structure in Canada and the dramatic drop in natural gas prices over the past year will cause companies to defer capital spending resulting in tighter markets in the months ahead. There are several factors that lead us to this conclusion.

First year decline rates of natural gas production have increased sharply over the past several years to over 50% in 2005. This trend is set to continue as operators increase activity in unconventional reservoirs (coal bed methane gas, tight sands and shales) where they extract more of the reserves earlier with improvements in completion technology. By way of example, the Barnett Shale has been the most successful non-conventional resource play over the past five years in the U.S. domestic gas market. According to a Raymond James report (November 27, 2006), the average first year decline rates are approximately 65%. This implies that the rig count must continue to increase by 21% in 2007 just to keep Barnett gas production flat! As a Raymond James report points out, "Although it is somewhat counter-intuitive, the trend toward lower quality reservoir rock that is typical of resource plays has also driven initial production rates per new well lower. As seen in Chart Two, the initial first-year production per new well in the U.S. has declined by over 65% during the past decade.

Chart Two: First Year U.S. Gas Well Decline Rate

Because of the maturity of the natural gas market in North America, the industry is having to drill deeper and target smaller formations. Going forward, higher decline rates, higher costs and smaller reservoirs will change the economics of bringing new natural gas supplies to market. The price of natural gas will need to stay higher if investment is to proceed and new supplies are to be brought to market.

In Canada, natural gas producers have been particularly hard hit as a strong Canadian dollar has meant lower realized returns for their production. In addition, Alberta has a high proportion of shallow gas wells that deplete rapidly and are not profitable to drill with lower gas prices. At the same time, there is growing demand from the oil sands for increased natural gas volumes as new projects come on-stream (natural gas is used in the process to separate the oil from the sand). The result is a potentially dramatic drop in the amount of natural gas available for export to the U.S., perhaps as much as 11%, according to First Energy. Investors have long been worried about natural gas in storage (a short term concern) while we believe the market needs to focus on longer-term reserves and deliverability.

Although markets are concerned with the very short term and instant gratification, we believe that we are facing a looming crisis with respect to natural gas supplies in North America in the years ahead. In our view, the price of the commodity is headed much higher and longer-term investors should see the recent weakness as a buying opportunity. The turn, when it comes, could be swift.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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