Subscribe to other Guinness Atkinson E-mail services View Archive Briefs brief Energy WWW.GAFUNDS.COM ENERGY BRIEF 1 Tim Guinness Commentary and Review by portfolio manager Tim Guinness October 2009 HIGHLIGHTS OIL • International Energy Agency (IEA) revise up 2009 and 2010 global oil demand forecasts (+0.5 million (m) barrels/day) • Organization of Petroleum Exporting Countries (OPEC) September meeting keeps production quotas unchanged NATURAL GAS • Very weak gas price followed by recovery as spot price bounces off $2 per 1,000 cubic feet (Mcf) and moves above $3, and 12 month strip recovers from $5 to $6 • US rig count slump starts to have effect: July data shows onshore production down 2.6 billion cubic feet per day (Bcf/day) (4.5%) from November 2008 high • Demand numbers also encouraging: industrial demand down 13% versus 5 year average, but electric power demand up 10% EQUITIES • MSCI World Energy Index continues recovery: up 5.49% in September
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WWW.GAFUNDS.COM ENERGY BRIEF 1
Tim
Gui
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Commentary and Review by portfolio manager Tim Guinness
October 2009
HIGHLIGHTS
OIL• International Energy Agency (IEA) revise up 2009 and 2010 global oil demand forecasts (+0.5 million (m) barrels/day)• Organization of Petroleum Exporting Countries (OPEC) September meeting keeps production quotas unchanged
NATURAL GAS • Very weak gas price followed by recovery as spot price bounces off $2 per 1,000 cubic feet (Mcf) and moves above $3, and 12 month strip recovers from $5 to $6• US rig count slump starts to have effect: July data shows onshore production down 2.6 billion cubic feet per day (Bcf/day) (4.5%) from November 2008 high• Demand numbers also encouraging: industrial demand down 13% versus 5 year average, but electric power demand up 10%
EQUITIES
• MSCI World Energy Index continues recovery: up 5.49% in September
Guinness Atkinson Global Energy Fund Performance Review
Guinness Atkinson Global Energy Fund Portfolio
Concluding Comments
Appendix: Oil and Gas Markets, Historical Context
Chart of the Month
Recent large oil discoveries in US Gulf of Mexico, offshore Sierra Leone and offshore Brazil are use-ful but not material in historic context and in the face of annual oil field decline rates worldwide.
October 2009brief
Energy
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The West Texas Intermediate (WTI) oil price began September at $69.96 and traded in a $65-73 band for the whole month. It reached a high of $72.47 on September 17 before declining a week later to a low for the month of $65.87 on September 25 before recovering to end at $70.61. The oil price now averages $57 for 2009 and should end up averaging just over $60 if oil averages $70 for the last 3 months of the year.
Brent traded at a discount to WTI for the whole of September. For most of the month the discount was around $2.
Factors which supported the oil price in September included:
•Global oil demand. The International Energy Agency (IEA) revised their 2009 and 2010 global oil demand forecasts both by around 0.5m barrels/day, mostly on stronger-than-expected data in Or-ganization for Economic Cooperation and Development (OECD) North America and non-OECD Asia. The IEA are now forecasting total 2010 oil demand at 85.7m b/day, up by 1.5% on the 2009 demand forecast of 84.4m b/day.
•Oil inventories. Preliminary indications for the August 2009 OECD total crude and product number (published in the September IEA Oil Market Report) suggest that total OECD inventories fell coun-ter-seasonally by 8 million barrels, giving a total stock of 2,770 million barrels. More locally, inven-tories at Cushing, Oklahoma, where WTI is stored, fell by 12% in the week ending September 16, the biggest drop since October 2007. This left Cushing stocks at their lowest level since last December.
•OPEC production quotas. OPEC met on September 9 in Vienna and declared that they were to keep production quotas unchanged. Although OPEC commented after the meeting that they remain concerned about the pace of global economic recovery, their action to leave quotas unchanged ap-peared to signal OPEC’s satisfaction with the gradual improvement in oil market fundamentals that is taking place.
Oil Market – September 2009 Review
Oil price (WTI $/barrel) 18 months – March 31, 2008 to September 30, 2009 Source: Bloomberg
Factors which weakened the WTI oil price in August included:
•Weaker US oil consumption. Total US consumption of refined oil products (gasoline and non-gas-oline) fell in the third week of the month by 3.3% to 18.5m b/day, the lowest level since the end of June. The release of this data coincided with the oil price declining from over $70 on September 22 to just below $66 on September 24.
Speculative and investment flowsThe New York Mercantile Exchange (NYMEX) net non-commercial crude oil futures open position in-creased steadily over the first three weeks of September from 29,000 contracts long to 62,000 con-tracts long before a sharp fall in the final week of the month to finish back at 42,000 contracts long.
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October 2009brief
Energy
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NYMEX Non-commercial net futures contracts: WTI November 2003 – September 2009 Source: Bloomberg/Nymex
OECD stocksThe July 2009 OECD total crude and product number published in the September IEA Oil Market Report increased by 13 million barrels, giving a total stock of 2,778 million barrels (vs 2,657 million barrels in July 2008). When expressed as number of days of demand cover (61.2 days), however, we see that we are well above last year’s level (55.8 days) and well above the top of the tight/loose spread of the last 10 years.
Preliminary indications for the August 2009 OECD total crude and product number (also published in the September IEA Oil Market Report) suggest that total OECD inventories fell counter-seasonally by 8 million barrels, giving a total stock of 2,770 million barrels. Even so, the market clearly remains very loose at this level, though our projections (in red) suggest that the stock level will return to within the 10-year range by the end of this year. This is a more positive outlook than we presented last month, driven by higher non-OECD demand in 2009 than previously anticipated.
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October 2009brief
Energy
(million barrels per day) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e 2009eIEA (A) GA (B)
Call on OPEC-115 24.8 24.3 24.1 25.3 26.5 28.3 28.6 29.1 28.5 25.7 25.8 1Angola joined OPEC at the start of 2007, Ecuador rejoined OPEC at the end of 2007 (having previously been a member in the 1980s)2Indonesia left OPEC as of the start of 20093Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi, U.A.E. Venezuela4Iraq has no o�cal quota5Algeria, Angola, Ecuador, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi, U.A.E. Venezuela
Supply and demand recent past plus 2009 forecastsThe table below illustrates the difference between world oil demand growth and non-OPEC supply growth over the last 9 years together with the IEA forecasts for 2009. Since the start of the year we have included an additional column in the table which shows our own estimates for global oil supply and demand in 2009.
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October 2009brief
Energy
Accordingly, since the market remains over-supplied and given the downside risks associated with the extremely fragile recovery, the Conference once again agreed to leave current production levels unchanged for the time being. In doing so, the Conference reiterated its determination to ensure sound supply fundamentals and an adequate level of spare capacity for the benefit of the world at large. Similarly, the Conference recorded the readiness of Member Countries to rapidly respond to any developments which might jeopardize oil market stability and their interests. Therefore, in ad-dition to continuing to maintain constant watch over supply/demand fundamentals, the Conference agreed to reassess the market situation at its 155th (Extraordinary) Meeting, to be held in Luanda, Angola, on 22nd December 2009.”
OPEC At its extraordinary meeting on December 17 2008, OPEC announced a 4.2m b/day cut from the ac-tual OPEC-11 September 2008 production level of 29.2m b/day, giving a new quota target of 25.0m b/day with effect from January 1, 2009. The previous quota was 27.3m b/day, implying an effective quota cut of 2.3m b/day – the largest single cut in OPEC history.
OPEC production for September 2009 was reported as 26.0m b/day, a decrease of 10,000 barrels per day from August. If this proves to be accurate, OPEC compliance will have fallen from a peak of around 90% to 75%, with Iran, Venezuela and Angola the principal over-producers.
OPEC met on September 9 in Vienna and while keeping production quotas unchanged issued the following statement:
“The Conference reviewed current oil market conditions and future prospects and observed that, whilst there are signs that economic recovery is underway, there remains great concern about the magnitude and pace of this recovery, especially in the major industrialized nations of the OECD. There has been some easing of the overhang in crude oil stocks but market fundamentals remain weak, refinery utilization rates are low and product inventories have risen considerably.
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September2009brief
Energy
Supply looking forwardNon-OPEC supply growth is still some way off, if possible at all. The truth is that the non-OPEC world is struggling to grow production. The growth was 2% per annum between 1998-2003, 1% from 2003-2008 and is forecast 0.5% from 2008-2013 and we believe that has a good chance of not be-ing realized. Significantly, the IEA have now cut their forecast for non-OPEC supply growth in 2009 from 1.1m b/day (September 2008 estimate) to growth of just 0.4m b/day (September 2009 esti-mate). Furthermore, they are also forecasting 0.5m b/day of growth in 2010, which looks optimistic: Simmons, the US energy investment bank, have a far better track record of predicting non-OPEC output based on more thorough field-by-field modelling, are expecting a decline of 0.9m b/day. We tend towards this view.
Demand looking forwardWe think that a comparison with the 1973-1975 and 1979-1983 recessionary periods is appropriate. Given the structural shift away from oil as a source of heating and power generation in OECD coun-tries and the recent rapid retreat in the oil price it is likely that the demand drop will not be as severe as the 17% OECD fall in 1979-83. It is likely, however, to be somewhat greater than the 7% OECD demand fall in 1973-75.
We project a drop of 8 - 10%.
The IEA increased their 2009 and 2010 world demand estimates by 0.5m b/day in the September Oil Market Report. They are currently forecasting global oil demand for 2009 at 84.4 m b/day, com-prising a decline of 2.2m b/day in the OECD and an increase of 0.4m b/day in non-OECD territories. Despite this, when added to declines that have already occurred in the OECD in 2007 and 2008, (1.9m b/day), the IEA are forecasting a total decline in the OECD between 2007 and 2010 of c.4m b/day, or 8%. Our OECD demand estimate for 2009 is slightly more pessimistic. We consider the IEA’s view to be a good ballpark estimate if one compares it to demand destruction periods of 1974 and 1980.
In this scenario we believe that the oil market will likely tighten gradually until the end of the year. It is possible that OPEC will make one further cut to ensure that the market does indeed revert to bal-anced/tight, but we also think that OPEC would be satisfied with the current position as long as the oil price remains no less than $50 for the rest of the year. Although we continue to think that OPEC would ultimately like the oil price back at $70-$75, we think they would accept an average oil price of around $55 this year to play their part in any economic recovery that may take place. Of course if the oil price remains at $70 for the remainder of the year the average price will be around $60.
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October 2009brief
Energy
Conclusions about oilFrom the low of $31.42 on December 22 2008 we have seen the oil price (WTI) recover to above $70 by May, and most recently range trade between $65 and $75. This is not particularly supported by the immediate supply/demand and inventories balance which shows that though OPEC cuts match de-mand destruction, inventories remain high. It follows that some combination of speculative demand, a dollar hedge and the animal spirits of traders have been at work. As I write it appears possible that a new $50 – 75 trading range is being established. However, the oil price is always volatile and short-term spikes and troughs will continue to surprise us.
The table below illustrates our target oil price estimates, and for comparison the rises in percentage terms that we have seen in the period from 2002 to 2008. We have nudged our 2009 estimate up from $50 to $55 given recent price strength. This assumes oil averages $60 for 2H 2009.
e = estimate + using midpoint Source: Bloomberg, Guinness Asset Management estimates (October 2009) *-year-over-year
This drop equates to around 5mb/day (vs IEA c.4.5m b/day), of which by the end of 2008 we had seen 2.2m b/day (OECD demand was 49.8m b/day in 2005 versus 47.6 m b/day in 2008). An inher-ent difference between the current outlook and the 1979-83 period is that back then the world was faced with a prolonged high oil price environment after the overthrow of the Shah in Iran, as well as the attendant recession: this time the recession might be deeper, but the high oil price effect will be less. The other point of comparison - the 1973-5 recession - saw an oil price spike similar in scale to the recent one (although the price did not weaken as quickly as it has recently), and a recession of slightly smaller magnitude to the one we are entering. In non-OECD we expect small growth this year from Asia, the Middle East and others (perhaps 0.4m b/day) - down from 1.8m b/day growth in 2008.
Non-OECD demand for 2009 is forecast to be 39.1m b/day, up by 1% from 2008. We share the IEA’s view that growth in demand in 2010 is likely to accelerate: they forecast non-OECD demand for 2010 at 40.3m b/day (up by around 3%), driven mainly by higher consumption in China and the Middle East.
Inventory levelsOECD total crude and product inventories look loose - the August 2009 inventory level is at the top of the ten-year range - but is expected to tighten during the last 4 months of the year.
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October 2009brief
Energy
Natural Gas Market – July 2009 Review
The US spot
Natural Gas Market – August 2009 Review
The US spot natural gas price (Henry Hub, Louisiana) opened the month at $2.40 per Mcf (1000 cu-bic feet). The price fell over the first week to below $2, closing at $1.88 on September 4, the first time it had been below $2 since December 2001. It then recovered dramatically, moving up 91% to reach $3.60 on September 25, before falling back to end the month at $3.28. The 12-month gas strip price (a simple average of settlement prices for the next 12 months’ futures prices) also moved up con-siderably over the month of September, from $5.00 to $5.93. The percentage difference between the spot price and the strip price, which was 45% at the month end, was close to the highest level for around 15 years.
Henry Hub Gas price ($/Mcf) 18 months –March 31, 2008 to September 30, 2009 Source: Bloomberg
Factors which strengthened the US gas price in September included:
•Lower production. The Energy Information Administration (EIA) production data for July which was published at the end of September showed onshore production down 0.9 Bcf/day month on month, as the heavily reduced rig count finally began to take its toll on supply. Onshore production is down 2.6 Bcf/day from the peak in November 2008, although some of this is offset by a 1.8 Bcf/day rise in Gulf of Mexico production over the same period (recovery from post-hurricane levels).
•Robust demand numbers. The July data also illustrated that the dent in US natural gas demand has been considerably smaller than feared. While industrial demand is down 13% year to date versus the five-year average, demand for natural gas for electricity generation is actually up 10%. Industrial and electric power demand each account for approximately 1/3 of total US natural gas demand. Total demand is down only 0.3% versus the five-year average, which suggests that when post-recessionary industrial demand recovers we could see a material snapback in demand in 2010.
•Smaller than average injections into storage. The amount of gas committed to storage in the first two weeks of September was some way below the five-year average. 135 Bcf were injected, versus an average of 159. This left the storage level at 3,458 Bcf, which was still 18% above the five-year average, but down from 20% above two weeks earlier. Some commentators point out that as stor-age approaches full capacity it becomes very much more difficult to inject the gas which might be a contributing factor here.
•Traders covering short positions. A significant open short position had built up on NYMEX and this was reduced over the month from 174,000 contracts on 15 September to 146,000 contracts on September 29.
Natural gas storageSwings in the supply/demand balance for US natural gas should, in theory, show up in movements in gas storage data. The following graph shows the 12 month gas strip price (in black) against the amount of gas in storage expressed as the deviation from the 5 year storage average (in green). Swings in storage have frequently been a leading indicator to movements in the gas strip price.
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October 2009brief
Energy
The surplus of gas in the second half of 2008 can be seen in gas storage data, with the inflection point in storage occurring in July 2008 and the storage line moving from negative (i.e. deficit) to positive (i.e. surplus) territory at the end of the year. This coincided with the gas strip price falling from a peak of over $13 in July to around $6 by the end of the year. The surplus has continued to build in the first 9 months of 2009, helping to push the gas strip price below $5 for the first time since 2003. Over the past 26 weeks (from the start of the ‘injection season’), the growth in storage above the 5-year aver-age indicates that the US gas market is around 1.5 Bcf/day oversupplied.
The total amount of natural gas in storage at the end of September was 3,589 Bcf, the highest level for September over the past 15 years. There are concerns that as gas continues to be injected into storage during the Autumn, total storage capacity (of around 3,800 Bcf) may be filled, leading to gas-on-gas competition as producers are unable to store excess supply.
The moment when the storage line turns decisively will likely be a coincident indicator for the start of a sustained gas price recovery. We may be there now.
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October 2009brief
Energy
US natural gas price (Henry Hub 12 month strip $/Mcf) vs deviation from 5yr gas storage norm
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Deviation from 5yr gas storage norm vs gas price 12 month strip Source: Bloomberg, EIA (September 2009)
Natural Gas Market - Outlook
Supply & demand recent pastThe sharp contraction in the gas price since July 2008 reflects the fact that supply/demand funda-mentals have changed materially.
The supply side fundamentals for natural gas in the US are driven by 5 main moving parts: onshore and offshore domestic production, net imports of gas from Canada, exports of gas to Mexico and imports of liquefied natural gas (LNG). In the last 2 years onshore production has been growing at an accelerating pace as gas shales have been developed using advances in horizontal drilling and “fraccing” techniques; by contrast offshore production and imports from Canada and of LNG (until recently) have been declining.
On the demand side, industrial gas demand and electricity gas demand, each about a third of total US gas demand, are key. Commercial and residential demand, which make up the final third, have been fairly constant on average over the last decade - although yearly fluctuations due to the cold-ness of winter weather can be marked. Growth in gas’ market share of the residential and commercial heating market has been balanced by efficiency gains.
Industrial demand tends to trend up and down depending on the strength of the economy; the level of the US dollar; and the differential between US and international gas prices. Until mid-2008 a weaker dollar, high international gas prices and a strong economy saw industrial demand recovering after declining in the first half of this decade. Not surprisingly, 2009 demand has turned down (July 2009 industrial demand was 15.1 Bcf/day vs 16.9 Bcf/day for July 2008), but as I touched on above, this demand void is less than we feared and has not been accompanied by falls in demand elsewhere and notably electricity demand has held up well.
Generally speaking, the majority of incremental electricity demand over the last few years has been met by gas rather than coal, nuclear or hydro power. While electricity demand has grown 1-2% per an-num (pa), gas demand for electricity generation has grown by on average 5% pa (1 Bcf/day per year). The numbers for 2009 show growth slowing to zero but not declining.
Supply Outlook
Fall in Rig CountThe most important immediate short term supply driver is a sharply dropping onshore rig count. The rig count dropped from a peak of 1,606 gas land rigs in September 2008 to a trough of 665 rigs in July 2009. Most recently the rig count has recovered slightly, back to 710 at the end of September, but still down substantially from the peak. This has halted the rapid supply growth seen in 2008 and, indeed, has begun to bring onshore supply back down. The most recent data point (July) from the US Department of Energy (DOE) shows that onshore gross production has declined 2.6 Bcf/day between November 2008 and July 2009.
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October 2009brief
Energy
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October 2009brief
Energy
Liquid natural gas (LNG) arbitrageThe UK national balancing point (NBP) gas price – which serves as a proxy to the European gas price – was up 34% in dollar terms from $3.20 to $4.30, before falling back to $3.80. The differential to Henry Hub remains very small and may encourage LNG cargoes to the US that were previously be-ing diverted to Europe. In October 2008 this NBP gas price stood at the equivalent of $14.90 ($1.49/therm). In fact this hasn’t been happening and demand for spot LNG from a wide variety of countries – Chile, UK, Italy, France, Korea, Japan, China for example seem to be absorbing it.
Canadian imports into the USThese were down approximately 5% for full year 2008 vs. 2007, though 10% for the second half of the year. So far in 2009 to end July they are down approximately 11% (around 1.1 Bcf/day). Falling rig counts, a less attractive royalty regime enacted in 2007, and increased demand from Canadian oil sands development are all factors at work here.
Demand OutlookSo far in 2009 total US gas demand is down 3.1 Bcf/day. This is less than the 5-6 Bcf/day we feared a few months ago. As I mentioned earlier, if industrial demand recovers we could see a material snap-back in natural gas demand in 2010.
Other Relationship between gas price and other energy commodity prices in the USThe oil/gas price ratio ($ per bbl WTI/$ per mcf Henry Hub) of 21.5x at the end of September was well outside the more normal ratio of 6-9x. If oil averages, say, around $60 in 2010 and the relation-ship between the oil and gas price returns to its longer-term average of 6-9x, this implies the gas price increasing back to around $8 once the gas market has returned to balance.
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US natural gas production 2005 – 2009 (Lower 48 States) Source: EIA (September 2009)
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October 2009brief
Energy
The following chart of the front month US natural gas price against heating oil (No2), residual fuel oil (No5) and coal (Sandy Barge adjusted for transport and environmental costs) seeks to illustrate how coal and residual fuel oil switching provide a floor and heating oil a ceiling to the natural gas price. The gas price has now bounced off the coal price support level, both having declined steeply over the past 12 months, whereas the residual and heating oil prices are well above gas and coal.
Conclusions about US natural gas
We expect relative weakness in the US natural gas price (notwithstanding the recent move-up from very depressed levels) to continue until the reduced US land rig count takes more supply off the mar-ket. This should bring supply back into balance with recessionary demand 2.9 Bcf/day lower (actual so far as mentioned above). With onshore supply down 2.6 Bcf/day from peak and offshore hurricane recovery growth mostly offset by declining Canadian imports we could see this happening now. Re-cent weaker storage injections support this contention.
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October 2009brief
Energy
Performance as of September 30, 2009
Expense Ratio: 1.31%
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. For most recent month-end and quarter-end performance, visit www.gafunds.com/performance.asp or call (800) 915-6566. The Fund imposes a 2% redemption fee on shares held for less than 30 days. Total returns reflect a fee waiver in effect and in the absence of this waiver, the total returns would be lower. Performance data does not reflect the redemption fee and, if deducted the fee would reduce the performance noted.
Inception date June 30, 2004
Full Year 2007
Full Year 2008
One year (annualised)
Last 2 years (annualised)
Last 5 years (annualised)
Inception to end 2008
(annualised)
Since Inception
(annualised)
Global Energy Fund
37.25% -48.56% 2.29% -6.11% 16.33% 10.23% 18.12%
MSCI World Energy Index
30.86% -37.88% -5.73% -11.62% 9.81% 8.81% 11.25%
S&P 500 Index
5.49% -37.00% -6.91% -14.72% 1.01% -3.16% 0.60%
Guinness Atkinson Global Energy Fund Performance Review
The main index of oil and gas equities, the MSCI World Energy Index, was up 5.49% over the month of September. The S&P 500 was up 3.73% in September. The Fund was up 9.23% over the month outperforming the MSCI World Energy Index by 3.74% (all in US dollar terms).
Within the Fund, September’s stronger performers were Helix, Pioneer Natural Resources, Forest, Chesapeake and Anadarko. Poorer performers were Dragon Oil, ConocoPhillips, Chevron, BP and OMV AV.
Buy/Sells
There were no buys or sell in the month of September.
Sector Breakdown
The following table shows the asset allocation of the Fund at September 30, 2009.
Source: Guinness Asset Management Basis: Global Industry Classification Standard (GICS)
(%) 31 Dec 2006
31 Dec 2007
31 Dec 2008
30 Sept 2009
Change in 2009
Oil & Gas 95.4 103.5 96.4 96.4 0.0
Integrated 45.2 66.2 53.7 43.3 -10.4 Exploration and production 30.3 25.8 28.7 35.5 6.8
Equity valuationWhile it is hard to be precise, the current price of energy equities reflects a medium to long-term oil price of around $40/barrel. You can make a rough calculation that takes the 2007 price to earnings ratio (PER) of the Fund (7.5x) which reflected earnings when the oil price was $72 and work out what oil price would reduce earnings by enough to put the Fund on the same P/E ratio as the broad market is currently – 19.6x (S&P 500 operating earnings which exclude write-downs). Today that implied oil price is around $40. The sum is very crude and makes heroic assumptions (for instance, that finding and development (F&D) and lifting costs are $20/barrel) but is in my view a perfectly respectable approach to give an in-dication of oil price implicit in current energy equity valuations.
Guinness Atkinson Global Energy Fund Portfolio
The fund at September 30, 2009 was on a PER (2008) of 6.8 x (7.5x 2007) with a median PER (2008) of stocks held of 7.1x. By comparison the S&P 500 Index at 1057.08 was on a PER of 21.4x (2008) (Based on S&P 500 ‘operating’ earnings per share estimates of 49.51 for 2008). This is shown in the following table:
Average oil price (WTI) $ $72.2/bbl $99.9/bbl $57.1/bbl (YTD)
Source: Standard and Poor’s; Guinness Asset Management Ltd (S&P500 ‘operating’ EPS consensus 2009: 54.06)
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October 2009brief
Energy
Portfolio Holdings
Our integrated and similar stock exposure (c.35%) is comprised of a mix of mid-cap and large-cap stocks. Our four large caps are Royal Dutch Shell, BP, Chevron and Total. Mid-caps are ENI, Statoil-Hydro, ConocoPhillips, Marathon, Hess, Repsol and OMV. At the end of July the median PER of this group was 6.5x 2008 earnings (and 13.2x 2009).
Our exploration & production exposure (c.39%) gives us exposure most directly to any sustained recovery in the oil price. The stocks with oil sands exposure are Imperial Oil, Encana, OPTI Canada, Suncor, Nexen and Canadian Natural Resources. The pure E&P stocks are all now largely in the US (Anadarko, Forest, Newfield, Pioneer Natural Resources, Swift, Chesapeake), with two more (Apache and Noble) having significant international production as well. The metrics behind four of the E&P stocks held are low enterprise value/proven reserves (Noble, Forest, Swift, and Pioneer). All of them also give us exposure to North American natural gas (they are each maximum 50% oil) and they include two of the industry leaders (Apache and Chesapeake) and one of the more leveraged com-panies (Anadarko).
We have exposure to two (pure) emerging market stocks; CNOOC and Dragon Oil. CNOOC is E&P fo-cused and has significant growth potential and advantages as a Chinese national champion. We also have a smaller position in Dragon Oil, which we previously held in our ‘research’ portfolio. Dragon Oil has producing oil assets in the Caspian Sea and trades on 8.4x 2008 earnings (12.9x 2009 earnings) and has recently been the subject of a formal take-over approach.
We have useful exposure to North American oil service stocks. On 2008 earnings they are all trad-ing with PERs of between 6.0x and 12.5x - Helix (6.1x), Transocean (6.0x), Unit (6.1x) , Patterson UTI (6.4x), and Halliburton (12.5x).
Our independent refining exposure is currently in the US in Valero, the largest of the US refiners, which is currently trading at significant discount to book and replacement value.
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Energy
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Guinness Atkinson Global Energy Fund 30 September 2009Wtd. Av. 2008 2009 2010 30/09/2009
Average PER of Fund P/E 6.8 16.0 10.7Median PER stocks held Med. PER 7.1 13.4 9.5nm' = Not meaningfulResearch position
The Fund’s portfolio may change significantly over a short period of time; no recommendation is made for the purchase or sale of any particular stock.
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Concluding Comments
Our view remains that energy equities represent a good store of value and potential for above aver-age returns as the oil price stabilizes around the level sought by OPEC ($60 - $80). We mentioned earlier we believe they discount an oil price well below this (indeed possibly only $40 per barrel and unlikely more than $55). Then, a few years thereafter when the oil price resumes its rise to the level that will balance dwindling supply and relentless demand from developing economies, further up-side awaits. We still find it easier to see how energy equities can rise 50% or perhaps even double from their current level than for the broad market to do the same.
There are signs that oil demand is now recovering, especially in the non-OECD region: the data from China on oil imports and car/vehicle sales is strong. In the OECD signals are also now strengthening. For example, in the US both gasoline and non-gasoline sales have been recovering notwithstanding a weak recent data point. On the non OPEC supply front a marked slowdown in new project comple-tions is also in prospect, foreshadowing a drop in non OPEC supply of nearly 1 million b/day in 2010 vs 2009. This is the latest forecast from Simmons – the reputable Houston energy investment bank. Our judgement is that quite a sharp economic recovery is likely as vehicle sales and housing starts retrace from very depressed levels (there was a sharp jump in car sales in the US in August). However, as oil inventories remain very loose, there is clearly a tension in the market between these improving fundamentals and trade and commodity index fund buying either as a hedge against a weak dollar or rising inflation or anticipating macro improvement.
The US natural gas market remains weak, though the bottom may have been seen as the more than halved level of the US rig count does its work. We expect a smart snap-back in the US natural gas price when evidence this is happening becomes clear. This again should be supportive of equity pric-es in 2010.
Lastly the economics of oil and gas producing companies are improving as service industry costs weaken ( we are seeing costs fall by up to 25%) and operating efficiencies are achieved.
We recognize that there are also risks in our medium term positive analysis of the fundamentals. It may turn out that OPEC have not yet taken enough barrels off the market and that if compliance fal-ters further the market will loosen even more. The US natural gas market may not rebalance as fast as we hope. But we keep coming back to one key proposition: oil and gas are running out and it does seem reasonable to believe that before they do run out they will trade at much higher prices than we have yet seen and shareholders in companies that are part of that world will be duly rewarded.
Overall, the Fund continues to seek to be well placed to benefit from the oil and gas price environ-ment described above and to enable investors to benefit from the recovering picture in energy mar-kets described above.
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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 Manage-ment, Inc. to buy or sell the securities. Current and future portfolio holdings are subject to risk.
Mutual fund investing involves risk and loss of principal is possible. The Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differ-ences 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 Energy 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 man-agement fees and expenses. They are not available for investment.
Price to earnings ratio reflects the multiple of earnings at which a stock sells.
Earnings per share (EPS) is calculated by taking the total earnings divided by the number of shares outstanding.
This information is authorized for use when preceded or accompanied by a prospectus for the Guin-ness 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.
Distributed by Quasar Distributors, LLC. (10/09)
Appendix: Oil and Gas Markets, Historical Context
Oil price (WTI $) last 20 years. Source: Bloomberg
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For the oil market, the period since the Iraq Kuwait war (1990/91) can be divided into two distinct periods: the first 9-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 9 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/day of production cuts. It was followed by a period of weakness caused by the rollback of these cuts, coinciding with the world eco-nomic slowdown, which reduced demand growth and a recovery in Russian exports from depressed levels in the mid 90’s that increased supply. OPEC responded rapidly to this during 2001 and reintro-duced 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 materialise. This was in mid to end 2003 followed by a much more normal phase with positive factors (China demand; Venezuelan produc-tion difficulties; strong world economy) balanced against negative ones (Iraq back to 2.5 m b/day; 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 environ-ment.
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 simultane-ously from China; the developed world (esp. USA) and Asia ex China. Higher production by OPEC has been one response and there was for a period some worry that this, if not curbed, together with demand and supply responses to higher prices, would cause an oil price sell off. Offsetting this has been an opposite worry that non OPEC production could be within a decade of peaking; a growing view that OPEC would defend $50 oil vigorously; upwards pressure on inventory levels from a move from JIT (just in time) to JIC (just in case); and pressure on futures markets from commodity fund investors.
Since 2005 we saw a further strong run-up in the oil price. Hurricanes Katrina and Rita which devas-tated New Orleans caused oil to spike up to $70 in August 2005, and it spiked up again in July 2006 to $78 after a three week conflict between Israel and Lebanon threatened supply from the Middle East. OPEC implemented cuts in late 2006 and early 2007 of 1.7 million barrels per day to defend $50 oil and with non-OPEC supply growth at best anaemic demonstrated that it could to act a price-setter in the market at least so far as putting a floor under it.
Continued expectations of a supply crunch by the end of the decade, coupled with increased specu-lative activity in oil markets, contributed to the oil price surging past $90 in the final months of 2007 and as high as $147 by the middle of 2008. This latest spike has now unwound and the oil price fell back early 2009 to bottom just above $30 from where it is now recovering.
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October 2009brief
Energy
With regard to the US natural 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 followed by a hurricane induced spike. Since the big spike in late 2005 the gas price has traded mainly in the $6-$8 range, with a significant move down precipitated by the collapse of Amaranth in 2006 and most recently a new but short-lived spike in 2008 above $10 and in 2009 a very weak period below $4 as progress achieved in 2007-8 in developing shale plays boosted supply while the 2009 recession cut demand. The response to this has been a dramatic fall in the US gas land rig count which should lead to a rebalancing in the market by 2010 and the effects of this are currently playing out 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 $60 per barrel equals $10/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 spend-ing needed to increase capacity but that is slowly becoming less true as LNG infrastructure is put in place.
North American gas price last 18 years (Henry Hub $/Mcf) Source: Bloomberg
