Just When You Thought You Had It Figured Out: As we had suggested in our last letter, the hurricane season was shaping up to be a nasty one. But little did we know what was in store. First, with Katrina and then with Rita. Needless to say, these where two very nasty storms.

At its peak, Katrina removed almost 9 bcf/day of natural gas production and 1.6m/m of oil production from the system. (See Charts One and Two).

The industry was able to get half the production lost back on stream relatively quickly but then seemed to struggle and production went sideways. Rita then appeared and production off-stream shot back up for a second time. (See Chart One and Two again) No doubt production will quickly be brought back on-line in the next few weeks but we have concerns as to the ability to return the last 50% back into service. With Ivan last year, only seven platforms were lost or damaged. With Katrina, the number was 52. A further 63 were lost and 30 platforms damaged with Rita. Furthermore, a large percentage of the offshore service facilities were located south of New Orleans and approximately 60% of the workforce lived in the New Orleans area. Our concern is simple enough. Platforms and facilities not damaged (approximately 50% of production off-line) were brought quickly back in production. It is the remaining 50% off-line that we are worried about. If these facilities (both on and offshore) have been badly damaged, there may be issues with manpower and repair yards that suggest the return to service of the last 50% may take longer than many observers expect.

If so, North America will experience very tight natural gas markets this winter as the industry will be stressed to build inventories. In our view, $20/mcf is not out of the question if we have a cold winter. Consequently, we have shifted our energy weighting to highly levered natural gas producers and service companies.

Investors need to recognize that despite higher drilling rates, U.S. domestic natural gas production remains in decline. (See Chart Three)

And the size of discoveries has diminished significantly over time despite vast improvements in seismic capability used to search for oil and gas deposits (See Chart Four).

As a sidebar, we find it interesting to note that in the course of our research, many oil and gas management teams in Calgary have opted to hedge their production forward. It’s as if they do not believe that higher prices are here to stay. Thus far, they have been wrong and it has cost unit & shareholders dearly.

In essence, the cushion of space capacity is gone as a result of demand growth and a lack of reinvestment. (See Chart Five) Oil and gas markets have shifted from supply driven to demand driven and future production disruptions will continue to put upward pressure on prices. Unless and until the industry accepts higher prices, energy markets are likely to remain tight.

The ultimate impact of Katrina and Rita is still difficult to assess. However a month of bad news on the television coupled with significantly higher prices at the pump will undoubtedly harm consumer confidence in the short term. Consumers were stung by the speed and magnitude of the price increase at the pumps. Our best guess is that we are in- store for some relatively negative economic numbers during the next two to three months and some slowing in economic activity. Inflation may briefly re-accelerate, consumer spending will likely drop and oil prices are set to correct from current levels. The very recent revelations of the irregular accounting practices at Refco, a large futures and derivatives broker, may further suppress investor confidence. The fourth quarter of 2005 may prove challenging for investors. However, our sense is that with time (three months?) and the stimulus provided by the efforts to re-build, the economic numbers may begin to improve early in the New Year. We suspect that the costs to re-build New Orleans are dramatically understated and that the growth of mould will make many structures uninhabitable.

In the fullness of time, the current downward move in equities may be seen as a gross overreaction. Judging by the herd mentality that currently exists, this may be the case as the herd is seldom right. However, we will monitor the situation carefully to watch for further signs of deterioration in the U.S. economy as well as the fall-out from the Refco situation.

With respect to China, in our last letter, we voiced concerns regarding an imminent slowdown in the economy. However, based on August trade numbers, our concerns now appear overblown. August imports of iron ore into China were up 33% year over year. Other raw material imports including oil were up significantly as well. UBS Securities maintains a proprietary construction index that has trended down since the authorities in Beijing began tightening lending over a year ago. Interestingly, the index has taken a major upward turn in August. From our earlier concerns regarding the Chinese economy, we now believe that China is firmly on track for 9% growth in GDP this year and that a soft-landing is not imminent. (See Chart Six).

There is further evidence to suggest that Japan’s recovery, forever in the making, has finally developed legs. (See Chart Seven)

The Japanese economy has been a non-factor in the world economy for well over a decade. Any improvement will be significant in terms of global demand. A re-acceleration in China coupled with a continuing recovery in Japan will likely provide a floor for global energy consumption.

On another note, investors perhaps do not realize the cost inflation that has taken place in the energy industry. In a recent report by Nesbitt Burns, their oil team asserts that the break-even price on a risk-adjusted basis for oil exploration in North America has reached $40 per barrel.

Input costs for steel, cement and now drilling day-rates have skyrocketed resulting in the industry facing much higher costs. Our contention is that the price of both oil and natural gas will have to remain higher and longer than equity markets currently discount if we are to have the necessary re-investment to bring new supplies to market. Otherwise the current situation of tight markets will simply be pushed further out in time. The current predicament that we are in has been the result of 25 years of a lack of re-investment (see Chart Eight).

The major energy companies (BP, Shell, Exxon etc.) have failed to re-invest the capital necessary to ensure production growth to meet on-going and growing demand. Twenty-five years of under-investment will not be turned around in a quarter or two.

While we don’t subscribe to the Hubbert’s Peak theory, we do believe that the world has grown out of all the cheap and easily accessible oil and natural gas. In defence of the majors lack of reinvestment, the oil and gas industry suffers from a lack of good quality exploration potential in stable countries with known reserves.

LNG? It will be a factor but only in 2008-2011 due to long lead times and difficulty obtaining site approval. And do economics justify the Mackenzie Valley Pipeline? Assuming current roadblocks with Aboriginal People are overcome, the entire projected through-put of the pipeline is required in Fort McMurray just to satisfy expansion demands of the oil sands producers based on current expansion plans. And if that weren’t enough, the costs of finding and producing natural gas in the northern regions are simply staggering. Northern exploration is not likely if natural gas trades below $7/mcf.

In sum, twenty-five years of a lack of re-investment has led us to where we are today. Whether we discuss coal, uranium, electricity or oil and natural gas, the challenge and the difficulty is a lack of re-investment that spans many years. Our current predicament has been a long time coming. It will not be turned around any time soon. If energy prices were to retreat, then the problem simply gets pushed further out in time.

Short of a major global recession, we fail to see what could meaningfully reduce energy demand enough in the near term to allow for a collapse in pricing. While SUV sales have slowed by 20% or more, they have yet to be parked. Real changes in consumer behaviour remain elusive this time around. Some demand destruction will occur as a consequence of Katrina and Rita and the price of oil will surely correct over the next few months. This is needed. But we believe that investors now, more than ever, need to take the longer-term view and stay the course.

And now to some stocks:

HIGH ARTIC (Listed HWO-U-TSX $11.86)

High Artic is a global oilfield services business providing under-balanced drilling and related services using proprietary technology and equipment. Under-balanced drilling provides the ability to produce from smaller reservoirs that were not economical to drill in a conventional manner. This technique reduces production losses and formation damage normally caused during conventional drilling. Under-balanced drilling is recognized worldwide as a viable technique in addressing difficult reservoir problems and improving overall production rates. The company has a market cap. of $120 million and projected growth as follows:

2005E
Revenue $79.5Mln.
EBITDA $30.0Mln.
Dist. CF $24.3Mln.
Payout Ratio 75%

2006E
Revenue $116Mln.
EBITDA $45.5Mln.
Dist. CF $42.5Mln.
Payout Ratio 69%

WESTERN PROSPECTOR (Listed WNP-TSX $5.20)

Galileo recently completed a due-diligence site visit to Western Prospector's Saddle Hills uranium project in eastern Mongolia. As we reported in our last letter, the company has assembled 12 contiguous exploration licenses covering 1,900 square kilometers. Historical work on the properties by the Russians in the mid-1980's discovered 4 uranium deposits in a cretaceous-age rift basin. One underground development at Gurvanbulag comprised three vertical shafts with the deepest to more than 560 meters. WNP is working on an unrecognized uranium camp. The geological controls on this mineralization are basin-wide covering an area similar in size to western Lake Ontario. Not only does WNP have existing resources but we now believe that there are more bodies of deposits to be found here.

WNP is drilling the known redefined Russian resource at Block 6 on 50-metre centres. At the Block 6 up dip from the Main Gurvanbulag zone, it has completed roughly 21 holes (5000 m) of a 40-hole program. Assay results for the initial 6 holes yield grades significantly higher than global averages for uranium producers and range from 0.09% to 8.10%. To date, WNP's drill program has confirmed the earlier results reported by the Russians. By way of comparison, the world's largest uranium company, Cameco, mines uranium using in situ-leach methods at grades of 0.11% from its Smith Ranch property in Wyoming and will soon start up production in Kazakstan from ore grading as low as 0.06%.

Galileo also reviewed Western Prospector's new coal licenses at Baganuur in central Mongolia and Choibalsan in northeastern Mongolia. Both concessions are within a few kilometers of existing coal operations. At Baganuur, WNP has been granted 20,000 hectares next to vast open pits that produce 5.0 million tonnes annually. At Choibalsan, WNP was been granted 7000 hectares next to a producing pit. WNP started work with ground mapping and regional reconnaissance, and will follow up with a regional resisistivity survey and drilling in late 2005.

MIDNIGHT OIL EXPLORATION LTD. (Listed MOX-TSX $4.25)

Midnight Oil Exploration was created Nov. 30/04 via the reorganization of Midnight Oil & Gas into Daylight Energy Trust and Midnight Oil Exploration. Midnight’s current production of 1,150 barrels per day is over 80% gas weighted, completely unhedged. The company receives strong wellhead prices for its light oil and for its high heat content natural gas.

Midnight will attract increased attention as it ties-in its H1/05 drilling successes and increases its drilling activity levels. Management also sees production doubling to 2,300 boe/d by year-end 2005 with significant additional light oil production to come on-stream in 2006. The company is well positioned due to the quality asset base and above average production per well from the company’s high impact Peace River Arch and West Central Alberta asset base. Based on its substantial asset land position and management’s proven ability to generate new plays, there is substantial opportunity beyond the current 120 well drilling inventory stated by the company.

SPARTON RESOURCES (Listed SRI-Cdnx $0.16)

Sparton is a little known exploration company that has an 80% interest in the Luxi gold belt in Southern China. So far, 34 drill hole intersections have been published and have allowed the Company to publish an uncategorized "possible" resource on the order of 4.2 to 7.6 million tonnes grading 1.5 to 1.2 g/t gold at a cut-off grade of 1.0 g/t and 0.50 g/t respectively.

Total gold content ranges from 210,000 to 320,000 ounces depending on the cut-off grade. These results represent only 25% of a 3 km structure that is part of a mineralized 28 km belt. Sparton also holds an estimated 20 BCF through a 12.5% (est. 6% unitized) interest in the undeveloped Chebucto natural gas field offshore Nova Scotia. Major partners are Exxon Mobil (the operator) and Shell Canada. In June 2005, Sparton reported an updated valuation of its interest that shows the after-tax net present value to be in the range of $0.62 to $0.77 per share. We believe that the stock is grossly undervalued.

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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