Energy Brief - July 2005

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Guinness Atkinson Energy Brief

Number 12 - July 2005
by Tim Guinness, Lead Manager of the Global Energy Fund

Market Background in June 2005

The oil price (WTI - West Texas Intermediate) spent the first half of June trading between $52 and $55. However, following the OPEC (Organization of the Petroleum Exporting Countries) meeting in Vienna on June 15th, the price of WTI surged to $58.47 on the 17th and $59.64 a week later. On June 27th it hit a then record price of $60.54 before falling back to $56.50 on the last day of the month in the light of larger than expected inventory builds. WTI has since rallied, closing yesterday (July 13th) at $60.01.

Date	Crude	Gasoline	Distillates	Total
June 2	1.5	1.3	0.8	3.6
June 8	-3.1	-0.03	1.3	-1.83
June 15	-1.8	-0.9	2.4	-0.3
June 22	-1.9	0.2	1.8	0.1
June 29	1.1	0.3	1.6	3.0
Total	-4.2	0.87	7.9	4.57

Non Commercial net futures – Nymex crude oil contract 4th Nov 2003 – 30th June 2005

Overall, the rise in the price of WTI from $47 to c. $60 over the last six weeks appears to have had no impact on demand.

Gas prices rose steadily over the first three weeks of the month from $6.37 per mcf (thousand cubic feet) on the 1st to $7.82 on the 20th, before falling sharply back to $7.00 at the end of the month. It has since rallied, closing at $7.77 yesterday (13th July).

Turning to oil and gas equities, June saw equities decisively reverse the decline that started in March. The main index of oil stocks, the MSCI World Energy index, rose 7.1% which compares with a flat (-0.1%) performance of the S&P500. In the year to end June the MSCI Energy Index is up 15.6% against a decline in the S&P500 of 1.7%.

Performance Review

Over the month under review, the Fund rose 11.0% and thus outperformed the MSCI World Energy Index by 3.8%. Over the year to date the fund is up 31.5% whilst the MSCI World Energy Index is up 15.6%. Within the Fund, June’s stronger performers were Canadian Natural Resources, OMV, Venture Production and Petrochina. Poorer performers were Repsol and Newfield.

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. Click here for the most current month-end and quarter-end performance or call (800) 915-6566.

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

Buys/Sells

There was no significant activity in the month. We bought a small holding (0.2%) in Granby Oil & Gas a pure North Sea exploration company. Our total exposure to pure exploration companies (ie companies that have no significant production) is deliberately kept very modest and now totals around 0.5% only when this is added to Afren and Imperial.

The following table shows the asset allocation at various recent dates since end June 2004:

Market Outlook

The following table compiled from data in yesterday’s (13 July) IEA monthly oil report is helpful to understanding what is going on.

Note in particular how the call on OPEC plus OPEC NGL growth has jumped by 3.0 Mbd (highlighted in blue) in the 2003 – 2005 period. This jump is a key driver behind the current oil price strength. The call on OPEC has taken OPEC production to within 1 or 2 million barrels of believed OPEC capacity. This strengthens significantly OPEC’s ability to secure a higher price for its oil. And this in turn has been greatly assisted by the fact that the experience of a “doubled” oil price (ie $50 recently vs $25 (the real level 1986 – 2002)) has had little adverse impact on the world’s economy.

On the other hand it is important to note that the IEA have revised World demand down by 0.4 Mbd from their highest forecast of two months ago of 84.3 Mbd whilst at the same time they recognise that Russian production growth is anaemic. Projecting this at 300,000 b/d (barrels per day) vs 740,000 b/d in 2004.

I again show below a chart of recent OPEC production levels on which the call on OPEC numbers numbers are shown by the horizontal bars. This shows graphically how current OPEC production levels are currently well above the call on OPEC.

The fact OPEC appears to be overproducing by 1M / 2 Mbd means I continue to caution that a period of renewed short term weakness is still possible. Last month I said this was quite likely rather than just possible but I find myself forced to temper my warning. The weak 2nd quarter for world demand is behind us and OPEC seem to have clearly put a floor of $40 under the price. And now we have recently apparently had the OPEC president opining that a price of $53 “would be ideal”.

Turning to a slightly longer time horizon I remain confident the US and China along with the rest of emerging Asia and the Middle East and the FSU (Former Soviet Union) are going to continue to provide robust demand growth. We accept it will likely fall back from the 2004 level which was exceptional but equally 2005 looks to be another year of well over 1 Mbd growth (IEA above predict +1.4 Mbd). In the medium term, growth in car ownership in eg China is going to be hard to stop and with that will come high rates of oil consumption growth for 10 – 20 years. We also see an emerging consensus that the global economy can cope with oil prices at much higher levels than previously thought.

We also believe the impending difficulty of growing non-OPEC supply is considerable.

Therefore over the 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 and we would not be remotely surprised to see a new target range within a few years of $50 - $60 which is where the price in real terms averaged for 12 years 1974 -85. Current price action may be telling us that we will be there sooner rather than later. Also I cannot rationally discount the oil price moving up to $85 for an extended period as if one adjusts for 33% increased energy efficiency since 1980 which is what the $57 (inflation adjusted) average price 1974 – 85 adjusts to.

The invested fund at 30th June 2005 was on a PER (Price to Earnings Ratio) (2005) of 11.3X and on a PER on last year’s (2004) earnings of 14.9X.

There is clearly an issue as to what is the right level for energy stocks to trade on. The PER of 14.9X 2004 reflects a year (2004) when the oil price (WTI) averaged $41.7/b and the gas price Henry Hub $5.80/mcf. and the PER of 11.3X 2005 reflects estimates based in part on the $52.8 average WTI over the year to date. In assessing whether these multiples represent good value one increasingly has to have a view on the long run oil price. If it is over $53, and growing, then to me a 11.3X multiple still looks inexpensive. If the market were to move the rating of oil stocks to a market multiple we would see a 50% appreciation. By the same logic if the long run price falls back to $32 there is downside of 15% and of course there would be considerable further downside if the oil price traded back down to $25. Lastly if the oil price averages $42 this logic gives an upside from here of 14%.

Portfolio Holdings

Our integrated stock exposure (c28%) is principally comprised of midcap stocks (Conoco-Phillips; Occidental; Petro-Canada; OMV) and stocks we also categorise 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 7.9X and 10.6X 2005 . This approach has led to underweighting titan stocks like Exxon Mobil (12.1X 2005) and BP (11.6X 2005). We do, however, hold Royal Dutch Shell (11.6X 2005) and Chevron (9.4X 2005).

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, OPTI and Canadian Oil Sands Trust give the most immediate exposure to current production of oil from oil sands. The 2005 PERs of these companies (except OPTI which is a new project company) are between 9.7X for Canadian Oil Sands Trust and 16.9X-17.5X for Encana and Shell Canada. The latter higher multiples are 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 Nexen) are on PERs between 8.8X and 11.1X 2005. Canadian Natural Resources meanwhile trades on 13.7X.

We also 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. Three of our four principal Emerging Market stocks are on PERs (2005) of under 10X (Petrobras (7.5X), Petrochina (7.9X) and Repsol (9.0X)). SASOL is on a PER of 11.3X 2005.

Of other holdings Peabody is on a fairly high rating (17.4X 2005) but gives exposure to steadily improving coal prices as higher oil prices drag them up and their earnings in 2006 are projected to grow more than 25%. Tesoro, our newly acquired refining company, is well positioned to benefit from current higher refining margins in California. It is on a 2005 PER of 9.6X and it looks reasonably valued both absolutely and relative to Valero and Premcor, its peers. Lastly, Abbot (24.3X 2005), 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 2005 lower in January (due to slower than projected North Sea results) which knocked the price but it has more than recovered this since and recent news has been encouraging. We continue to hold the view, however, that equipment and service stocks are generally overvalued, notwithstanding likely strong growth 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.

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 June 30, 2005, the Fund did not hold any shares of Exxon Mobil, British Petroleum, Valero, or Premcor. 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 (07/05).

Historical Context

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 characterised 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 6 1/4 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 Mbd 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 materialise. 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 2.5 Mbd; 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 USA) 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.

On the gas market, the price traded between $1.50 and $3/Mcf 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.