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Guinness Atkinson Energy Brief

Number 16 - November 2005
by Tim Guinness, Lead Manager of the Global Energy Fund

Market Background in October 2005

The price of WTI (West Texas Intermediate crude) opened at $66.24 on October 3rd, and closed at $59.80 on October 31st. The fall in price was gradual over the month, with short-term spikes to $64+ on the 12th and 17th caused by concerns over a shortage of winter fuel and the possible threat of Hurricane Wilma.

Oil price (WTI) 20 months from 1st March 2004 to 31st October 2005

Source: Bloomberg

Sentiment was dominated by a focus on developments in the US. Notably the effects of hurricanes Katrina and Rita on supply (due to shut ins and damage to US oil fields and infrastructure) and to demand (from damage to industry and consumer demand particularly in Louisiana and Texas and also from a possibly colder winter).

Regarding supply

1. At the end of the month on October 31st, four refineries with combined 1MMBD (million barrels per day) capacity remained shut-in, as well as 68% of GOM (Gulf of Mexico) oil production. Reports suggested that production will not return to pre-hurricane levels until the end of March.

2. During the month worries that the winter weather might be colder than normal surfaced. The IEA (International Energy Agency) Oil Monthly Report published on October 12th projected a 0.4% colder winter in the lower-48 States in terms of heating degree-days which would be 3.2% colder than last winter. In the final week of the month, colder weather took hold in the Northeast, causing a rally in oil prices: WTI rose 3.5% on October 25th. and DOE (Department of Energy) inventory data released on October 26th showed distillate demand up 10% for the week.. This was somewhat ironic as the weather in October was actually unusually mild – both in the US and in Europe.

3. Hurricane Wilma. WTI was up 2.8% on October 17th ($64.36 from $62.63) as the 21st named storm of the season formed in the Caribbean. However, oil prices receded over the week as the hurricane headed towards Florida, away from Gulf of Mexico production and refining facilities.

Regarding demand

1. the effect on demand directly from the hurricanes worried the market but the actual impact was very unclear;

2. there was much speculation however as to whether or not the resultant crude oil price spike plus record refining margins which had pushed gasoline and other refined product prices to record inflation adjusted highs since 1980 was or was not causing significant demand destruction. Weekly US inventory data which possibly implied this spooked the markets and the notion of oil demand destruction then took hold.

The principal non US factors to impinge on the market were Russian crude production data; Chinese demand and strikes at European refineries.

1. Russian Production increased modestly to a new post-Soviet high level of 9.49MMBD in September. This meant average production in the first nine months was up 2.8% y-o-y, and Reuters quoted Russia’s Energy Minister, Viktor Khristenko, saying that he expected a 2.5% crude production increase in 2006. These figures were released on Monday 3rd October and the market decided to take it bearishly and the price of WTI fell 5.2% by the close on Wednesday.

2. Chinese demand in September rebounded showing an 8.6% increase YoY (year over year).

3. Strike action at European refineries. Total’s Gonfreville refinery in Normandy (with 328 KBD (thousand barrels per day) of production) was shut from 3rd – 21st October following a wage dispute. As the month ended, workers at Shell’s Pernis refinery in Rotterdam (capacity 418 KBD) went on strike over pension disputes.

All in all the month saw a clear retracement in crude oil prices back towards the $50 – 60 range seen in the months immediately before Katrina.

Inventory data published very recently in the November IEA Oil Market Report showed that OECD (Organization for Economic Cooperation and Development) inventories of crude and product were unchanged in September. It also reported lost US oil production of 81m bbls from the hurricanes in the period 27th August to 8th November. I interpret this to be telling us that the big picture effect of the hurricanes has been to stop the loosening in the market that current levels of OPEC (Organization of the Petroleum Exporting Countries) production would otherwise have produced. They also continue to support the theory that something is awry with the commonly published oil supply and demand statistics as supply lost in September – say 40m bbls is below OPEC supposed overproduction (60m bbls say).

OECD Total Product and Crude Inventories – Monthly 1998 to Sept 2005

Source: IEA Oil market report

Gas Price

The US gas price has continued to be strong, although the meteoric rise is over. The price moved 15% over the month, falling to $12.76 before recovering to $14.65. It has since fallen sharply, closing at $9.65 on 4th November, its lowest level since August 22nd.

Henry Hub Gas price 1st March 2004 – 31st October 2005

Source: Bloomberg

The post month end move has taken the gas price back to above the 6:1 gas:oil ratio which has historically been a floor. At $9.65 vs. oil at $60 the ratio is 6.2X. Last month I said “ $14.5 (per mcf (thousand cubic feet))..…has the unmistakable smack to me of a spike that is unlikely to last more than two/three months”. This seems to have been correct.

Speculative positions

There is not at present a big speculative overhang risk. Net non commercial Nymex futures continued short in October and are some 42,000 contracts short at 1st November. This means that when bearish sentiment gets exhausted we could see quite a violent oil price bounce.

Non Commercial net futures – Nymex crude oil contract
4th Nov 2003 – 1st Nov 2005

Source: Bloomberg/Nymex

Turning to oil and gas equities, October saw a fall in stock prices across the board. The main index of oil stocks, the MSCI World Energy index, was down -9.42% during the month. This takes its performance year to date to 23.06%.

Performance Review

Over October the Fund fell 10.27% and thus underperformed the MSCI World Energy Index by 1.6%. Over the year to date the fund is up 54.69% whilst as already mentioned the MSCI World Energy Index is up 23.06%. Within the Fund October’s stronger performers were Abbot, Sunoco, Anadarko, ConocoPhillips and Royal Dutch Shell. Poorer performers were Sasol, Petro-Canada, Encana, Shell Canada, and Apache.

As of September 30, 2005, the one-year return is 62.80% and the average annual return is 60.80%.

Energy Fund vs. S&P500 and MSCI Energy Index 16 months since launch
30 June 2004 to 31st October 2005

Source: Bloomberg

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. For each Fund the total returns reflect a fee waiver in effect and in the absence of this waiver, the total returns would be lower.

Buys/Sells

The remainder of the Newfield holding was switched into Plains Exploration & Production, decreasing our exposure to gas and increasing our exposure to oil production with low enterprise value / reserves metrics.

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

Market Outlook

The future price of equities involved in the energy business will continue for a period to be determined by evolving perceptions of the likely medium term level of the oil and gas price. Much of what I say below repeats last months commentary.

The immediate future path that the oil price will take is harder than usual to predict. Important imponderables are what will be the demand and supply responses to the late summer’s Katrina/Rita inspired $60+ oil price.

The driver of higher oil prices in the last 18 months has been the sharp rise in the call on OPEC caused by buoyant Asian (esp. China) and US demand, combined with weakening supply growth from Russia and falling production from the maturer producing areas such as the US and North sea. The following table compiled from data in the latest IEA monthly oil report shows how the call on OPEC has jumped by 2.4 mb/d (thousand barrels per day) (highlighted in blue) in the 2003 – 2005 period.

Estimated Annual World Oil Demand Growth 2000 – 2005

The call on OPEC has taken OPEC production to within 1 or 2 million barrels of believed OPEC capacity. (31.8m b/d per IEA Nov 2005) This strengthens significantly OPEC’s ability to secure a higher price for its oil. Will this growth now be blunted by $50+ oil. My best guess is yes it will but probably by rather less than many commentators expect because although the price is now on an inflation adjusted basis back to the 1974 -85 level we use 33% less of it per $ of constant dollar GDP so the amount we spend on it is still well below the amount we spent in that period.

As regards supply again I expect a response principally from independent oil & gas companies but I doubt this will be enough to make a big difference. The important controllers of supply are the National Oil Companies and the Oil majors and here I expect their strategy to continue to be one of growing supply to meet demand growth but NOT to create oversupply.

The graph below compares purported OPEC production with the call on OPEC per the earlier table.

Source: Bloomberg/IEA Oil Market Report

I have been cautioning in previous months that if this continues a period of renewed short term weakness is almost inevitable and to an extent recent weakness is just reflecting this. There is, it should be mentioned, a mystery as this over production is not showing up nearly enough. You can see from the graph that the over production over the last 2 years has been roughly 2 million b/d. That should have pushed stocks up by 700 m barrels over a full year. A cursory inspection of the chart shown earlier of OECD stocks of crude and product shows no such thing has occurred. They have risen around 100m barrels only. To me this implies that the numbers we have on OPEC supply are overstated (the alternative is that the statistics on demand are understated). Anyway the implication of this is that the supply demand situation may be even tighter than it appears.

In the course of my work I come across many pieces on the oil market. A CSFB (Credit Suisse First Boston) piece entitled "10 Reasons 2005 Is Not Like 1980" was one such. I set out below seven points I particularly agree with:

• The oil price is still well below its 1980’s inflation adjusted highs ($80-100).
• The [annual] increases in oil prices since 2000 have been well below those in 1974 and 1979 (In the 70s it went from $2.20 to $15 then $14 to $40).
• The global economy is less oil sensitive than in the 1980s (oil 33% lower share of GDP).
• Oil is still affordable for individual consumers (even now only 4% of US disposable income).
• Other demand centers are starting to reaccelerate (e.g. China, Asia ex China; Middle East).
• Refining is significantly less a threat to integrated oil earnings than in 1980s.
• Sector valuations are already discounting a substantial correction in oil prices.

I am cautious, however, that this may be bull market over enthusiasm. So as stated last month my reaction to the imponderables we currently face is to conclude there are three main scenarios worth contemplating. (i) there is a pronounced demand and supply response and the oil price retreats to the mid $40s but is supported then by OPEC production cuts ; (ii) the price comes back to $55 and then $50 – $60 (or $45 – $65) becomes the new “normal trading range for several years; and (iii) that after averaging $55 in 2005 the price inexorable moves up through $65, $75 to say $85 over a several year period till we get to a natural long term price where demand is constrained sufficiently to match slow growing supply and properly encourage the development of alternative energy sources. As to probabilities I give them 30%; 40% and 30%.

Current Portfolio

The invested fund at 31st October 2005 was on a PER (Price to Earnings Ratio) (2005) of 10.3X with a median PER (2005) of stocks held of 9.6X and also on a PER (2004) of 16.2X,. By comparison the S&P500 Index at 1207 was on a PER 16.7X(2005) and of 19.9X (2004) (Based on S&P500 EPS (Earnings Per Share) of 60.7 (2004) and Zacks estimate of 74.5 (2005)). The discounts and the average WTI oil price in the relevant period is shown in the following table.

I continue to show this table because of the issue as to what is the right level for energy stocks to trade on. The PER (2004) of 16.2X reflects a year (2004) when the oil price (WTI) averaged $41.7/b and the gas price Henry Hub $5.80/mcf. I have then done an exercise to calculate the PER of the portfolio at end June prices on the 2003 earnings of the stocks I hold – it is 22.1X. This was a year when WTI averaged $31.2/b and H Hub $5.44/mcf. On the other hand we see the forward looking PER (2005) of 10.3X which reflects a year where in the first 43 weeks WTI has averaged $56.2/barrel.

In assessing whether this picture represents good value one increasingly has to have a view on the long run oil price. If it is over $55 (let alone $65), and growing, then to me a 10.3X multiple looks to me cheap and there could easily be 57% upside (taking the fund multiple to the market 16.2X). If the long run price falls back to $30-35 the PER of 22.1X would likely be expensive. There could be a 27% downside on the same logic. And if the long run price is $42 say we are more or less fairly priced.

Portfolio Holdings

Our integrated stock exposure (c29%) 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 although the gap is steadily narrowing. All four mid cap stocks held, and likewise the two E&P/Refiners, are on PERs between 7.1X and 10.8X 2005. This approach has led to underweighting titan stocks like Exxon Mobil (10.8X 2005) and BP (10.4X 2005). We do, however, hold Royal Dutch Shell (9.9X 2005) and Chevron (8.4X 2005).

Our E&P and Oil Sands exposure (c42%) gives us exposure most directly to a rising oil price. The stocks with oil sands exposure, Shell Canada, Encana, OPTI, Nexen and Canadian Oil Sands Trust are on PERs of between 10.9X and 14.7X (except OPTI which is a new project company). The higher multiples can be justified in that they have reserves with very long lives. The pure E&P stocks are all now in the US (Anadarko, Apache, Burlington, Devon, Pioneer Natural Resources, Plains Exploration and Whiting). 5 of these stocks are on PERs between 7.9X and 10.9X 2005. Two of our new purchases are on higher PERs due to the effect of hedging losses. Their PERs fall into this range for 2006 as these fall out of the picture.

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. Three of our four principal Emerging Market stocks are on PERs (2005) of under 9X (Petrobras (6.7X), Petrochina (7.4X) and Sasol (8.9X)). Repsol is on 9.4X.

Of other holdings Peabody is on a fairly high rating (25.2X) but gives exposure to steadily improving coal prices as higher oil prices drag them up and their earnings in 2006 are projected to grow by a third. Tesoro and Sunoco our independent refining companies are well positioned to benefit from current higher refining margins in the US. They are on 2005 PERs of 7.3X and 10.0X respectively. Lastly, Abbot (24.1X 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. We continue to hold the view 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. In two of the three main scenarios outlined above ($55 oil and $55 rising to $85) we expect this to occur.

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 October 31, 2005, the Fund did not hold any shares of Exxon Mobil, British Petroleum, or Newfield Exploration. 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. Distributed by Quasar Distributors, LLC (11/05).

Tim Guinness 
17 October 2005

Historical Context

Oil price (WTI) last 18 years

Source: Bloomberg

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 6 1/2 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 stabilized 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. 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 prior to Katrina/Rita has been on OPEC and inventory levels worldwide.

N American Gas price last 13 years (Henry Hub)

Source: Bloomberg

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 and another spike. 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 but that is slowly becoming less true as LNG infrastructure is put in place.

Portfolio at 10/31/2005:

Net Assets of Guinness Atkinson Global Energy Fund since launch

Source: Investors Bank & Trust / Guinness Atkinson

For more information, visit www.gafunds.com.