Most economic indicators suggest that we are in the midst of a global mid-cycle slowdown. This is a material change from our last letter. A reduction in corporate profit will lead to weaker growth in capital spending and non-residential construction. Anecdotally, on past visits to China, we have always come away with a positive view and many sound new investment ideas. On a recent trip in May, after only three days in the country, we determined to sell all our direct Chinese holdings. Our sense is that for now, the sizzle is off the steak.

In our view, activity levels in China are today a barometer for the rest of the world. Whether it’s a mid-cycle inventory correction or worse, global activity appears to be slowing down. Dr. Jim Walker, the economist from CLSA securities, downgraded his estimate of Chinese GDP from between 8% and 10% for 2005 to between 6% and 7% shortly after the conference. However, China’s GDP grew at 9.5% in Q1, and an average 8% rate of growth in 2005 is closer to consensus and it matches the government’s own numbers. Although this forecast represents a gentle downturn, it still requires the remaining quarters in 2005 fall below 8%. The last time this happened was in Q2-03 (refer to Chart One)—to China’s economy was damaged by SARS.

The good news (as we discussed in our last letter) is that inflation appears to have peaked and is on the wane. Inflation in China is a sensitive indicator and it remains very moderate at 2.8% in Q1-05.   

Overall, slower economic growth and moderating inflation may prompt the U.S. Federal Reserve to pause in its efforts to raise short-term interest rates. And this would be positive for equities.

However, we believe that equity markets in general will remain range bound for the next few months. Markets appear reasonably valued, and short of a severe drop in oil prices or a reversal in interest rates, we do not see a catalyst to move markets higher. Perhaps by the end of the third quarter, investors will have better sense of what lays ahead in 2006.

The oil price increased during the last two weeks of June and as of today is at a new all time high of $61 per barrel. Yet, as we stated in our last letter, oil markets and equities remain a conundrum. There appears to be a complete disconnect between the oil price and the energy stocks. According to Scotia Capital, large cap exploration and production (E & P) and integrated oil stocks are discounting a long-term escalated WTI price of $39 to $41 per boe. It seems as though the higher the price of oil, the more nervous investors become. Too much of a good thing perhaps? Equity and royalty trust markets clearly believe that the oil price cannot be sustained anywhere close to current levels.

In the remainder of this letter, we intend to highlight what we believe are the factors responsible for the upward move in the price of oil and the reasons that prices will stay much higher than equity and royalty trust markets currently expect, despite our sense that a near-term correction is possible.

To begin with, the situation in Iraq continues to deteriorate. Car bombings and suicide bombers are the order of the day. Insurgency has become a way of life. Iraq’s oil production will not likely come anywhere close to full capacity anytime soon.

As we discussed in our last letter, oil production from Russia remains very challenged in the near term. A lack of reinvestment in facilities and infrastructure has caused oil production growth in Russia to flatten out year to date (See Chart Two). The timeline to address this situation is lengthy, and the sums of capital investment required are enormous. Also, the Yukos affair only serves as a reminder of the risk of investing in Mother Russia. We believe that further expansion of Russian oil production is unlikely in the near term as a consequence.

As The Economist points out, "The real problem is not scarcity but concentration. About two-thirds of the world’s proven oil reserves lie in the hands of just five Persian Gulf countries. As the market share of those regimes soars, so too will the chance of disruption, embargo or worse." With the recent bombing in London, the security premium will remain intact.

Unseasonably hot, humid weather over much of central and eastern North America will likely lead to a reduction in natural gas inventory builds for the winter heating season. Utilities are running flat out to meet electrical loads. In addition, a furious hurricane season seems to be shaping up as evidenced by the Category Four magnitude of Dennis so early in the year. Hurricanes typically become stronger as the season progresses and ocean temperatures grow warmer. Further cuts to Gulf of Mexico production are likely, and damage to offshore production rigs cannot be ruled out.

According to Cambridge Energy Research Associates (CERA), global oil demand increased 3.4% in 2004, the strongest growth in 28 years, and consumption is up 2.8% year to date in 2005 compared with a 10-year average growth rate of 1.6%. Thus far, it would seem that higher oil prices have done little in the way to destroy demand.

CERA recently produced a report suggesting that worldwide oil capacity could rise by as much as 16 million barrels per day between 2004 and 2010—a 20% increase over the period or 3.1% per annum. According to CERA, this new supply will be more than enough to meet expanding demand later in this decade and beyond.

The authors "argue that unconventional oil will play a much larger role in the growth of supply than is currently recognized. These unconventional oils include condensates, natural gas liquids (NGL’s), extra heavy oils (such as Canadian oil sands), and that from ultra-deep water (greater than 2,500 feet deep). By 2020, they could be almost 35 percent of supply".

However, we would suggest that the increase in production of "unconventional oil" will occur only with significantly higher prices than the market is currently discounting. Also, by their very nature, unconventional oil projects typically involve considerably higher capital costs and are much more sensitive to changes in the political and operating climate in which they are located.

In our view, CERA’s forecast is far from a sure thing. This is a very important point as OPEC itself has now admitted that it is unable to meet the demand projections for Western countries in 10 to 15 years.

A recent article published by the Energy Intelligence Group Inc. was entitled "Big Oil CEOs Don’t Believe in $50 Oil". In essence, the article stated that the CEO’s of both Exxon and BP believe that the current oil price structure cannot be maintained and that $30 oil is more realistic. Using an oil price assumption of $30 per barrel will simply limit the number of projects that receive approval. As we have argued in past letters, the lack of reinvestment by the major oil companies has been partly responsible for the tight global market that we are currently experiencing.

Berstein Research published a fascinating report that indicated, "over the last 4-5 years upstream costs have escalated at 13-14% per annum, or almost 10% per annum excluding the impact of royalty taxes. The increase in the cost base has been partly driven by rising oil prices, but also reflects the decline in average resource additions per well, the increase in oilfield services and the ageing of the workforce. The decline in average resource adds per well has been particularly rapid driving up DD & A per barrel and with a tightening rig market, the outlook is for further material price escalation." The report further states "the marginal pretax cost of supply for the US has risen from $19.50 per barrel in 1995 to $23 in 2000 and broke through $27 in 2004." (Note that according to Berstein, "a $27 marginal pretax cost equates to a marginal cost of $35 per barrel, once we account for an average capital employed of $45 per barrel, a return of 12% and a tax rate of 35%".) Berstein is projecting that the marginal cost of U.S. oil production will reach $60 per barrel in 2010 and may rise as high as $80 if cost-based inflation cannot be contained. As the world’s second largest producer (behind Russia), one of the most mature regions, and one of the highest cost, the U.S. sets the marginal cost of supply.

What this tells us is extremely significant. If prices were to decline towards cash costs (now thought to be $30 to $35 per barrel), oil companies will reduce investment, decline rates will intensify, and production will decrease.

As we have argued for some time, higher oil prices are necessary if only to flatten the natural production decline rate of 8%, let alone lead to growth in net production.

Some concern has been expressed regarding the build in the drilling rig fleet and the threat of overcapacity. However, a recent report form Raymond James highlights that 20 years of underinvestment in the sector have finally caught up. Over the past 20 years, instead of building new equipment and new rigs, operators have consumed the excess supply built in the 1970’s. Today, we are at a point where excess supply has been cannibalized and the existing rig fleet is 25 years old. (See Chart Three for a historical picture of the U.S. rig count.)

The U.S. rig fleet is forecast to increase 50% over the next five years or a 7% compounded annual growth rate (CAGR). Rig crews and skilled labour will likely be the biggest limiting factor to activity levels. But most importantly, adding rigs to the domestic rig fleet has historically done little to affect overall productivity. As provided by Raymond James, a plot of annual oil and gas production per active domestic rig shows a trend of diminishing returns that is astounding. As Chart Four depicts, incremental rigs will likely not add much if anything to domestic productivity.

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