Energy as an Asset Class for Volatile Times?

Research indicates that:

− Oil returns have exceeded equity returns over the last 40 years
− In the next 10 years we will have to find 44 million bbl/day or almost 5
Saudi Arabia’s to keep up with decline rates and increased demand
− The financial crisis, combined with low gas prices has seriously
reduced the ability of Western Canadian junior oil & gas companies to
raise capital and finance ongoing operations – it has become a buyers
market for smaller assets

economic, financial and marketing analysis

Introduction

Energy use is growing every day with global demand for oil projected to
increase approximately 25% by 2020. To achieve this production increase while
maintaining existing levels we would have to find the equivalent of up to 5 Saudi
Arabia’s. Despite this challenging supply/demand environment, oil is trading below
its inflation-adjusted peak of around US$105/bbl in the 1970s.

A major incremental driver of this demand growth is the emerging economies,

particularly China. China, of course, is undergoing a once in a life-time
industrialization that can be expected over time to increase its consumption from
its current lows of around 2-3 barrels per person per year to developed nation
levels of around 20 barrels per person per year.

Oil’s Return Characteristics

Direct investments in energy have had higher absolute returns than investments in
stocks. Over the last 50 years the S&P 500 had a compounded annual return of
6.8% (including dividends) while oil (“West Texas Intermediate”) had compounded
annual returns of 8.1%.

Oil’s Relationship to Emerging Market Growth

Western Canadian energy investments in some respects are an indirect way to

invest in developing market growth without having to assume developing market
political risk. At the margin it is emerging market growth that is driving energy
consumption.

Oil and Inflation

If you are concerned about the massive expansion in the global money supply
and the possible inflation that may precipitate then oil some useful financial
characteristics that you should consider – the prime being a high positive
correlation to inflation. During the last commodity bull market/high inflation period
in the 1970s, in nominal terms:
− Equities – increased 20%
− Hard assets – oil increased 1,100% and western Canadian farmland
increased 550%

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 Chart 1
12
– S&P 500 (around 2% returns pa)
10 – Farmland (around 17% returns pa)
– Oil (around 24% returns pa)
8

-2
1970 1972 1974 1976 1978 1980

Oil Markets Yesterday and Now

Oil is trading well below its inflation-adjusted peak of around US$105/bbl from
the 1970s.  The current oil markets, however, are dramatically different from their
1980s and 1990s counterparts.

1981
China consumption 1 bbl per person per year
US consumption 24 bbls per person per year
Global consumption 69 million bbl/day
OPEC spare capacity 10 million bbl/day
2009
3 bbls per person per year
24 bbls per person per year
84 million bbl/day
2-3 million bbl/day

The financial crisis has pushed oil supply questions out of the limelight, while of
course the underlying issue remains unchanged – supply is tight.

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China’s Energy Demand at the Margin

China is now the second largest oil consumer in the world (8 million bbl/day up
from 2 million bbl/day in 1981) but still at the early stages of increasing its per
capita energy consumption.

Chart 2: BRIC and Middle East Demand Outlook

(in Mmbl/d) 2008 2030E

Demand Demand Increase
Brazil 2.4 3.6 +1.2
Russia 2.9 3.9 +1.0
India 3.1 7.3 +4.2
China 7.9 17.0 +9.1
Middle East 5.9 10.0 +4.1
Total 22.2 41.8 +19.6

Sources: IEA World Energy Outlook 2008. Bank of America Merrill Lynch.

To gain some perspective on the magnitude of the incremental demand for oil
that will be created as China’s becomes more middle class we input the following
assumptions into a model of Chinese demand (contact us for access to the
model):
− China moves to South Korean
per capita consumption level
over the next 30 years
− No peak in production

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Based on the foregoing in the next 10 years we must find 44 million bbl/day or
almost 5 Saudi Arabia’s

− 26 million bbl/day to maintain supply - 30% of current production (almost

3 times Saudi Arabia’s output)
− 18 million bbl/day to keep up with demand - 22% of current production
(almost 2 times Saudi Arabia’s output)

So although, the financial crisis has pushed the issue of oil supply out of the
limelight, the underlying issue remains unchanged – supply is tight.

2020 Peak Oil Pricing Projections

Given the highly inelastic nature of demand for oil, coupled with resilient demand
growth in the emerging economies, global peak oil can be expected to cause
large sustained real price increases in prices. The challenge in forecasting is that
peak oil models attempt to reflect an enormously complex system like oil supply/

Chart 3: US$ per barrel

250

200

150

100

50

0
2010 2012 2014 2016 2018 2020

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demand and pricing. Even a simplified model will be highly sensitive to post peak
decline rates, reserve replacement rates, elasticity of demand and total reserves
remaining amongst other variables.

In the spirit of education rather than prediction, we have produced a basic peak
oil-pricing model. If you manipulate the core assumptions you begin to see
how modest changes in the underlying assumptions can have dramatic effects
on derived post peak prices – even in a highly simplified model like ours (please
contact us for access to our peak oil model).

Using the following assumptions oil prices would increase approximately 250% in
real terms over the next 10 years – something would have to give on the demand
side far before this price level:
− Current production 84 million bbl/day
− 2020 peak production 100 million bbl/day
− Post peak decline rate of 3-4%
− Elasticity of demand of -0.3

Is Peak Oil Here?

The International Energy Agency (“IEA”) has rejected allegations from an

anonymous internal source that world oil reserves have been exaggerated even
though in its own words “We’re the ones that are out there warning that the
oil and gas is running out in the most authoritative manner. But we don’t see it
happening as quickly as some of the peak oil theorists,” Richard Jones, deputy
executive director of the IEA. In its recent annual outlook, the IEA repeated its
prediction that oil supplies would rise to 105 million barrels by 2030. “Generally,
we’re viewed as more pessimistic than we should be by the (oil) industry,” Jones
added.

The anonymous internal source reported that the IEA is more pessimistic than its
public disclosures indicate…”Many inside the organization believe that maintaining
oil supplies at even 90 million to 95 million barrels a day would be impossible, but
there are fears that panic could spread on the financial markets if the figures were
brought down further. We have already entered the ‘peak oil’ zone. I think that the
situation is really bad.” Another anonymous IEA source stated that it was deemed
“imperative not to anger the Americans” who were said to play an influential role in
encouraging the body to underplay potential supply shortfalls.

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Even so, the IEA’s 2009 World Energy Outlook is explicit in its warnings about the
impact of a “business as usual” approach to energy over the next 20 years. “The
scale and the breath of the energy challenge is enormous -- far greater than many
people realize. But it can and must be met,” the report said. The chief economist
of the IEA recently stated that the public and many governments appeared to be
oblivious to the fact that oil is running out far faster than previously predicted and
that global production is likely to peak in about 10 years – at least a decade earlier
than earlier IEA estimates based on the finding that production from existing oil
fields is dropping much faster than previously measured. The IEA now estimates
that the decline in oil production in existing fields is now running at 6.7 per cent a
year compared to the 3.7 per cent decline it had estimated in 2007.

Even more alarming is according to the US Army “A severe energy crunch

is inevitable”. In a recent report to the Joint Operating Environment or JOE,
Army analysts wrote “To meet even the conservative growth rates global energy
production would need to rise by 1.3% per year going forward. By the 2030s,
demand is estimated to be nearly 50% greater than today and even assuming
more effective conservation measures, the world would need to add roughly the
equivalent of Saudi Arabia’s current energy production every seven years (1.4
MBD per year). The discovery rate for new petroleum and gas fields over the
past two decades (with the possible exception of Brazil) provides little reason for
optimism that future efforts will find major new fields.

At present, investment in oil production is only beginning to pick up, with the
result that production could reach a prolonged plateau. By 2030, the world will
require production of 118 MBD, but energy producers may only be producing 100
MBD unless there are major changes in current investment and drilling capacity.
By 2012, surplus oil production capacity could entirely disappear, and as early as
2015, the shortfall in output could reach nearly 10 MBD.

A severe energy crunch is inevitable without a massive expansion of

production and refining capacity. While it is difficult to predict precisely what
economic, political, and strategic effects such a shortfall might produce, it surely
would reduce the prospects for growth in both the developing and developed
worlds. Such an economic slowdown would exacerbate other unresolved
tensions, push fragile and failing states further down the path toward collapse,
and perhaps have serious economic impact on both China and India. At best, it
would lead to periods of harsh economic adjustment.” Emphasis ours.

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economic, financial and marketing analysis