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by Joseph Dancy, LSGI Advisors, Inc.

Adjunct Professor, SMU School of Law
March 18, 2006

Last month we were asked to present our outlook for the energy sector to a dozen investors and interested executives at the Dallas Country Club. Previous speakers to the group included T. Boone Pickens, and investment banker and author Matthew Simmons. We were honored to be included in this select group of experts.

In a nutshell, our presentation and outlook can be distilled down to a few slides:

Economic Growth and Demand

Economic growth in the U.S. and most developed countries is highly correlated with energy use. In simple terms, economic growth requires an increase in energy consumption.

The U.S. economy has become much more energy efficient since 1983 as can be seen in the chart at right. The economies of a number of industrializing countries are still relatively energy inefficient � much like the U.S. economy in the 1950 to 1979 period depicted in the chart.

These less energy efficient economies require much higher energy inputs per unit of economic growth, and include China, India, Malaysia, and several other dynamic Asian economies undergoing rapid industrialization.

The �China Factor�

Over the last five years China has seen its� economy grow at an average pace of over 9% - an incredible growth rate. For 2006 it is estimated that the country will again grow at near double digit rates:

India, another dynamic economy, has seen its� economy grow at a rate of 6-8% over the last few years, and it is expected to grow nearly 8% in 2006.

Due to the dynamic nature of the Asian economies the incremental demand for energy � and specifically crude oil � is skyrocketing. The chart above illustrates the incredible demand increases from China in the last decade.

Note that China's oil production, while not declining, has not kept pace with demand growth. Note also that in 1993 � only a decade or so ago � China was a net crude oil exporter.

Per Capita Energy Use

Historically, in rapidly industrializing countries, we have seen a growing middle class and an accelerating growth in per capita demand for crude oil. Note the historical demand trends in the chart at right.

Currently the U.S. and Canada consume around 25 barrels of oil per capita per year. Japan and South Korea consume roughly 15 barrels of oil per capita per year.

China and India � two of the world's fastest growing and dynamic economies � each consume less than 3 barrels of oil per capita per year.

As the middle class in these countries expands � and their citizens begin to enjoy the luxury of automotive transportation, upscale housing, and other material comforts � expect the per capital demand for oil to expand at an accelerating pace.

Global Crude Oil Supply

While global demand for crude oil is growing at an impressive clip, and is expected to increase by 1.5 million barrels per day in 2006 to roughly 85 million barrels per day, the incremental growth in supply has not kept pace.

Part of the supply problem might be attributed to the volatility of the price of oil, and the difficulty justifying capital expenditures when future prices are assumed to return to the �historical� norm of roughly $30 a barrel.Part of the supply problem might be due to the fact that access to many promising exploration areas are restricted by foreign governments. In some cases the recoverable oil may constitute unconventional reserves requiring additional extraction expenses and expertise.

And part of the supply problem might be attributable to the fact that advances in technology have allowed us to harvest the easiest to recover oil and the largest reserves first � leaving the more difficult horizons for future development.

Our Prognosis for Future Energy Prices

Although experts disagree on the outlook for crude oil prices, what cannot be disputed is the fact that incremental worldwide demand for crude oil is rising much faster than the available supply. Today, for the first time in history, the global demand and supply for crude oil are roughly equal (at 85 million barrels per day according to the IEA).

The excess supply, the �margin of safety�, which as recently as five years ago stood at around 5 million barrels per day has disappeared. When we have a commodity whose short term demand is inelastic � we have no good substitutes for crude oil in the global transportation sector � and demand begins to approach supply limitations, prices tend to become much more volatile and tend to trend upward.

Small crude oil supply disruptions� in Iraq, Iran, Nigeria, Venezuela, Saudi Arabia, hurricanes in the Gulf of Mexico, or elsewhere � will tend to have a much larger influence on the price of the commodity than we have seen in the past.

In the end higher prices will be required to allocate increasingly scarce crude oil supplies to meet the skyrocketing global demand, and to encourage further investment in production. We don't think the current market price of $60 a barrel oil is sufficient to meet these goals.

While we won't predict a price target, we think crude oil prices must rise to prices much higher than current levels � which should benefit all the companies in the sector.

[Charts/data from Robert Hirsch presentation dated Oct, 2005 on trends in world oil production, presentations by Matthew Simmons of Simmons & Associates, and a new book entitled "A Thousand Barrels a Second" by Peter Tertzakian]

© 2006 Joseph Dancy

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