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Guinness Atkinson Energy Brief

Number 7 - February 2005

Oil Market

The oil price started January by resuming its climb from the low $41 level touched in mid and late December. By January 13 it broke $47 and thereafter range traded between $47 and $49.40. It has subsequently weakened to $45. For chartists, $42.50 is a possibly important support level and if it breaks down through this speculative selling could develop. Equally if it does not speculative buyers may make another attempt to break through $50 in the next few months.

Oil price (WTI – West Texas Intermediate crude oil) 25 months from 1st January 2003 to 7th February 2005

During the month the main factors influencing sentiment in the oil market were:

• The effect on Iraqi production of growing violence in the period leading up to the Iraq elections
• The weather
• Inventory data
• OPEC’s production cuts and upcoming January 31 meeting

December was the worst month in the whole of 2004 for Iraqi oil exports (at 1.16m bpd). January was not obviously any better. As violence and sabotage increased in January, the Iraqi oil minister, Thamir Ghadhban, was quoted as saying that the insurgents were waging “all out war” on Iraq’s oil infrastructure during the lead up to the January 30 elections. Northern pipeline flows were consistently disrupted. Oil flow through it was erratic. Meanwhile, sabotage- induced power cuts in the south affected output through Basra. Quite separately it was announced that necessary work to upgrade water injection capability will be cutting Iraq production from the Rumaila field by 160,000 bpd for six months from mid February.

Throughout the month weather was on the oil markets mind. At the beginning of the month it was particularly mild in the U.S. But winter storms hit the U.S. northeast beginning on the 8 / 9 January and there were blizzards in the northeast again in late January. Then more recently warmer weather has been forecasted. All this affected expectations about U.S. winter fuel demand.

Inventory data was another focus. Early January numbers showed rising inventories in the U.S. These were followed by better numbers on January 12 then much worse on January 19th and mixed numbers at the end of the month. We prefer to look at OECD wide numbers though these suffer from being out of date. The latest number which is for November shows 2.66bn barrels of crude and product inventories as shown in the chart below confirming our view of the need for OPEC action to curtail output to balance the market. OECD wide inventories are rising just as they did in 2001 before OPEC brought production back under control by cutting its quota to 21.7m b/d (barrels per day) (which it did in January 2002). We believe OPEC needs to reduce its OPEC10 quota to 24.5m b/d (from the current 27m) to tighten sufficiently and thus stabilize the market. We remain convinced OPEC will do enough in the medium term – whether they will do enough in the immediate future is less certain which is why we continue to factor in as quite likely the scenario of prices dipping to $35 during 2005 albeit recovering in the latter part of the year.

OECD Stocks of crude and Product by month Jan 1998 - Nov 2004

Not surprisingly, OPEC’s production levels (and were the 1mb/d cuts agreed in December being implemented) came under intense focus. Petrologistics, a tanker tracker, estimated OPEC production fell by 0.8m b/d in January.

Whilst at the beginning of the month it appeared that further production cuts were a likely outturn of the January 30 OPEC meeting - in the event, because of the over $45 oil price, production was left unchanged. The historic OPEC target band of $22 – 28 was abandoned. OPEC’s formal statement was:

“market changes…have rendered the Band unrealistic and [the Conference] has decided to temporarily suspend the current price band pending completion of further studies.”

The official communiqué recognized that commercial stocks were building above their five-year average leading to a moderation of the OPEC basket price to $36 in Q4 2004. It also noted that while Q1 2005 might be in balance Q2 2005 was not:

“aware of the expected seasonal drop in demand in the second quarter and given the stock build which might be accentuated in light of current market situation, the Conference further decided to continue monitoring market development and that its President should make consultations ahead of the next ordinary meeting…on 16th March …to ensure that a timely cut could be made as appropriate.”

I have set out below a chart of OPEC production over the last 6 years. It shows OPEC is more than capable of swinging production up and down. Our estimate for the level needed to balance the market – referred to earlier of OPEC10 production of 24.5m b/d is 27m on this chart which includes Iraq (say 2.5m b/d).

OPEC10 plus Iraq Production, Jan 1998 – Nov 2004 (‘000 barrels/day)

This needs to fall to 27m b/d to stabilize the market (i.e. OPEC10 to 24.5m b/d) on IEA assumptions.

For the moment the market is giving OPEC the benefit of the doubt.

There are also problems elsewhere in the world that are supporting the price. In mid January 500,000 b/d in the Gulf of Mexico and the Norwegian North Sea were shut in due to production problems. There were also problems in Nigeria and with Canadian Oil Sand production.

January saw speculative positions recover quite strongly from the short position of early December. By end January the net long non-commercial Nymex position had grown to c30,000 contracts long a turnaround from a short position of 17,500 contracts 7 weeks earlier.

Net Non-commercial positions on Nymex in Oil contracts (1 Contract = 1000 bbls)

Gas Market

In December, the gas market was still quite volatile but not so much so as in recent months. Stocks at 2,270 bcf end Jan are still well above (279 bcf or 14%) the 5 year average.

Henry Hub Gas Price (22 months, 31st March 2003 – 7th February 2005)

Turning to oil and gas equities, January, after a weak opening few days, saw energy stocks move up usefully. The main index of oil stocks, the MSCI World Energy index, was up 1.38% while the S&P500 fell 2.44%.

Performance Review

Over the month under the review (12/31/2004 – 01/31/2005), the Fund gained 2.36%, outperforming the MSCI World Energy Index by 0.98%. Within the Fund, January’s stronger performers were: Apache, Venture Production, Conoco Phillips Chesapeake Energy, and Canadian Oil sands Trust - the latter for a second month in a row. Poorer performers were Abbot Group (North Sea business declining faster than predicted); SASOL (rand weakness effect); and Shell Canada (repair and maintenance at new oil sands upgrader).

The Fund's performance since launch on 6/30/2004 to 1/31/2005 was +24.88%.

The return for MSCI World Energy Index over the same seven-month period (6/30/2004 - 1/31/2005) was +17.58%. The return for S&P 500 over the same seven-month period (6/30/2004 - 1/31/2005) was +4.57%.

Performance data quoted represent past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted. Performance data quoted to the most recent month end may be obtained by calling (800) 915-6566 or visiting our website at www.gafunds.com.

The Fund imposes a 1% redemption fee on shares held for less than 30 days.

Energy Fund vs. S&P500 and MSCI Energy Index Since Launch to Feb 9th 2005

Buys/Sells

We switched from Suncor into Encana. The latter was a good performer in 2004 but early in Jan suffered a fire at one of their upgraders that will reduce production by 50% for several months. Although there is insurance cover we thought it prudent to make a switch until the picture clarifies. Encana, Canada’s largest gas producer (the result of a merger of Pan Canadian Energy and Alberta Energy in 2002), has a great gas lease portfolio; specializing in unconventional gas plays and is a leader in SAGD based oil sands production.

The following table shows the asset allocation at various recent dates since end June.

Market Outlook

January was surprisingly strong. OPEC impressed the market with its cuts and gave the impression at its January 30 meeting that it would move swiftly to cut production if prices dropped. My fears that the oil price would test $35 have so far been overly pessimistic.

But the current rate of OPEC production that is easing the current supply tightness could still inadvertently drive prices considerably lower. Small amounts of over or undersupply can cause large price swings and one must recognize that a sharp tumble in oil prices potentially comes with the territory. OPEC must follow up with further cuts in production at the March meeting to support the price.

Looking forward we continue to hold the view that medium to long term OPEC can, and likely will, pursue policies which mean oil will trade considerably above the old $22-28 target range, probably over $40 WTI now. In simple terms OPEC can argue they need $5 to compensate for U.S. dollar weakness, $5 for the widening spread between the OPEC basket price and WTI (due to heavy oil – the marginal OPEC barrel – having less of a market due to shortage of complex refinery capacity); $5 for the greatly improved supply demand dynamics and an unquantifiable further premium for terrorism and similar uncertainties.

We believe the impending difficulty of growing non-OPEC supply is still underestimated. We have seen a good case made that Russia production growth could end as soon as 2006. Meanwhile, we are increasingly convinced that the increase in Chinese, Asian and Middle Eastern (and also possibly Russian) demand over the next decade will be much stronger than anyone is really imagining (maybe 2m b/d every year).

Looking at the big picture, I remain ever more convinced that the medium term outlook is for a decisive break with the $25 oil of the 1986- 2000 period and a shift back to the $55+ world of 1975 – 1985. Meanwhile, the odds on a sizeable dip are reducing as OPEC starts taking the necessary action.

The fund portfolio at 31st January 2005 was on a PER (price to earnings ratio) (2004) of 10.8X (40% below the S&P500 which is on 17.9X (2004) if earnings are 65.8(Zacks) and the S&P 500 is 1181 (31st January) 2004)).

Portfolio Holdings

Our integrated stock exposure (c31%) is principally comprised of midcap stocks (Conoco-Phillips; Occidental; Petro-Canada; OMV) and stocks we also categorize as E&P/Refining (Marathon; Amerada Hess). Mid caps continue to be less expensive stocks on PER and CFROI (Cash Flow Return on Investment) valuation bases. All four mid cap stocks held, and likewise the two E&P/Refiners, are on PERs between 8.0X and 10.4X 2004. This approach has led to underweighting titan stocks like Exxon Mobil (13.3X 2004) and BP (13.9X 2004). We do, however, hold Royal Dutch Shell (10.1X 2004) and Chevron Texaco (8.9X).

Our E&P and Oil Sands exposure (c46%) gives us exposure most directly to a rising oil price. Of the oil sands stocks, Encana, Shell Canada, and Canadian Oil Sands Trust give the most immediate exposure to current production of oil from oil sands. The PERs 2004 of these companies are between 12.9X and 18.7X. This is justified in that they have reserves with very long lives. The other two, Canadian Natural Resource and Nexen, also give exposure to Canadian gas, a likely beneficiary of medium-term supply shortages. They are more like pure E&P stocks as their oil sands projects are in the future. The pure E&P stocks include 6 in the US (Anadarko, Apache, Burlington, Chesapeake, Devon and Newfield), and one UK (Venture Production). All of these stocks (including Canadian Natural Resources and Nexen) are on PERs between 8.3X and 11.7X 2004, with the exception of Venture Production which trades on a higher multiple (31.6X) because it is expanding its production in the North Sea from legacy fields very rapidly, particularly of North Sea gas where the price has firmed markedly.

We have exposure to a diverse group of Emerging Markets stocks. Some are mainly E&P focused (for example, Petrochina), others have significant downstream businesses. SASOL is a leader in coal/gas to oil technology. All of our four principal Emerging Market stocks are on PERs (2004) of under 10.3X (Petrobras, Repsol, SASOL and Petrochina). Indeed Petrobras, is on 6.8X.

Of other holdings, Peabody is on a fairly high rating (30.3X). It does however give exposure to steadily improving coal prices as higher oil prices drag them up. Their earnings in 2005 are projected to more than double. Lastly, Abbot (17.4X 2004), our only exposure to equipment and services, (although its original business – North Sea production drilling - is declining), is well positioned in several markets with a good future, particularly the Former Soviet Union and Middle East and yet sits on a sizeable valuation discount to its US counterparts. It guided expectations for 2004 lower in the month (due to slower than projected North Sea results) which knocked the price but it has nearly recovered this since. We continue to hold the view that generally equipment and service stocks are overvalued, notwithstanding likely strong growth over the next year.

Overall, the Fund seeks to be well placed to benefit from rising share prices across the sector, which we expect to occur if, as forecast, the oil price is destined to stay in a much higher trading range than we had become used to in the last 18 years.

Tim Guinness
10 February 2005

The information contained in this report is from sources deemed reliable. No assurances can be made that all of the data contained is accurate. Investors should not rely on the data in this report in making decisions regarding individual stocks.

Short term performance, in particular, is not a good indication of the Fund’s future performance and an investment should not be made based solely on returns. Total return for the Fund reflects a fee waiver in effect and in the absence of this waiver, the total return would be lower.

PER - Price to Earnings ratio is calculated by dividing current price of the stock by the company's trailing 12 months' earnings per share.

As of January 31, 2005, the Fund did not hold any shares of Exxon Mobil or British Petroleum. The Fund’s holdings, industry sector weightings and geographic weightings may change at any time due to ongoing portfolio management. References to specific investments and weightings should not be construed as a recommendation by the Fund or Guinness Atkinson Asset Management, LLC to buy or sell the securities.

The Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differences in accounting methods. The Fund is non-diversified meaning it concentrates its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund. The Fund also invests in smaller companies, which involve additional risks such as limited liquidity and greater volatility.

The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. The MSCI World Index is an unmanaged index composed of more than 1,400 stocks listed on exchanges in the U.S., Europe, Canada, Australia, New Zealand and the Far East. They assume reinvestment of dividends, capital gains and excludes management fees and expenses. They are not available for investment.

This information is authorized for use when preceded or accompanied by a prospectus for the Guinness Atkinson Global Energy Fund. The prospectus contains more complete information, including investment objectives, risks, charges and expenses related to an ongoing investment in the Fund. Please read the prospectus carefully before investing. Mutual fund investing involves risk and loss of principal is possible. Quasar Distributors, LLC (02/05).

Historical Context

Oil price (WTI) last 18 years

For the oil market, the period since the Iraq-Kuwait war (1990/91) can be divided into two distinct periods: The first 8-year period was broadly characterized by decline. The oil price steadily weakened 1991 - 1993, rallied between 1994 –1996, and then sold off sharply, to test 20 year lows in late 1998. This latter decline was partly induced by a sharp contraction in demand growth from Asia, associated with the Asian crisis, partly by a rapid recovery in Iraq exports after the UN Oil for food deal, and partly by a perceived lack of discipline at OPEC in coping with these developments.

The last 5 3/4 years, by contrast, have seen a much stronger price and upward trend. There was a very strong rally between 1999 and 2000 as OPEC implemented 4 m b/d of production cuts. It was followed by a period of weakness caused by the roll back of these cuts, coinciding with the world economic slowdown, which reduced demand growth and a recovery in Russian exports from depressed levels in the mid 90s that increased supply. OPEC responded rapidly to this during 2001 and reintroduced production cuts that stabilised the market relatively quickly by the end of 2001.

Then, in late 2002 early 2003, war in Iraq and a general strike in Venezuela caused the price to spike upward. This was quickly followed by a sharp sell off due to the swift capture of Iraq’s Southern oil fields by Allied Forces and expectation that they would win easily. Then higher prices were generated when the anticipated recovery in Iraq production was slow to materialize. This was in mid to end 2003 followed by a much more normal phase with positive factors (China demand; Venezuelan production difficulties; strong world economy) balanced against negative ones (Iraq back to 2.5m b/d; 2Q seasonal demand weakness) with stock levels and speculative activity needing to be monitored closely. OPEC’s management skills appeared likely to be the critical determinant in this environment. By mid 2004 the market had become unsettled by the deteriorating security situation in Iraq and Saudi Arabia and increasingly impressed by the regular upgrades in IEA forecasts of near record world oil demand growth in 2004 caused by a triple demand shock from strong demand simultaneously from China; the developed world (esp. U.S.A.) and Asia ex China. Higher production by OPEC has been one response and there is now some worry that this, if not curbed, may cause an oil price sell off. The spotlight is now on OPEC and inventory levels worldwide.

N American Gas price last 13 years (Henry Hub)

On the gas market, the price traded between $1.50 and $3/Mcf (thousand cubic feet) for the period 1991 - 1999. This was followed by two significant spikes up to $8-10/Mcf, one in late 2000 and one early in 2003. The spikes were caused by very tight supply situations because there is an underlying problem with supply in the rapid depletion of North American gas reserves. On both occasions, the price spike induced a spurt of drilling which brought the price back down. More recently we have seen another period of very firm (over $5/Mcf) gas prices. North American gas prices are important to many E&P companies. In the short-term, they do not necessarily move in line with the oil price, as the gas market is essentially a local one. (In theory 6 Mcf of gas is equivalent to 1 barrel of oil so $40 per barrel equals $6.67/Mcf gas). It is a regional market more than a global market because Liquid Natural Gas imports cannot rapidly respond to increased demand because of the high infrastructure spending needed to increase capacity.

Portfolio at 31st January 2005:

For more information, visit www.gafunds.com.