THE GUINNESS GLOBAL ENERGY REPORT

Transcription

1 THE GUINNESS GLOBAL ENERGY REPORT Developments and trends for investors in the global energy sector October 2014 GUINNESS GLOBAL ENERGY FUND Fund size: $330m ( ) The invests in listed equities of companies engaged in the exploration, production and distribution of oil, gas and other energy sources. We believe that over the next twenty years the combined effects of population growth, developing world industrialisation and diminishing fossil fuel supplies will force energy prices higher and generate growing profits for energy companies. The Fund is run by Tim Guinness, Will Riley and Jonathan Waghorn. The investment philosophy, methodology and style which characterise the Guinness approach have been applied to the management of energy equity portfolios since Important information about this report This report is primarily designed to inform you about recent developments in the energy markets invested in by the. It also provides information about the Fund s portfolio, including recent activity and performance. This document is provided for information only and all the information contained in it is believed to be reliable but may be inaccurate or incomplete; any opinions stated are honestly held at the time of writing, but are not guaranteed. The contents of the document should not therefore be relied upon. It is not an invitation to make an investment nor does it constitute an offer for sale. HIGHLIGHTS FOR SEPTEMBER OIL WTI & Brent down sharply over the month WTI and Brent oil fell during the month, ending September at $91.1 and $94.7 respectively. The decline coincides with further unwinding of NYMEX net non-commercial positions in oil, increased OPEC production and indications of weaker 2014 global oil demand. Leading edge global demand data is now looking stronger, but we await confirmation of this. NATURAL GAS US gas prices essentially flat Henry Hub closed up 1% on the month at $4.12 per mcf. The market looks to be around 2bcf/day oversupplied and is particularly sensitive to gas/coal switching at around this price level. Net production continues to grow, driven by gains in the Marcellus region and gas associated with shale oil supply growth. EQUITIES Energy underperforms the broad market The MSCI World Energy Index declined in September by 7.39%, underperforming the MSCI World Index which declined by 2.67% (all in US dollar terms). Year to date, the Energy Index is up 3.7%, versus the MSCI World up 4.4%. CHART OF THE MONTH: CSFB HOLT shows energy equities at cheapest level for over 10 years 60% 50% 40% ) (% e30% s id p u 20% LT O H 10% 0% -10% HOLT median upside/(downside) (Sample from energy universe) MSCI World Energy Index relative to MSCI World Equity Index Among several key indicators that we use to assess the valuation of enery equities is the upside of the energy universe implied by CSFB s HOLT valuation framework. The chart above illustrates the median upside of energy stocks, as judged by HOLT, versus the performance of energy equities relative to the broad market. The underperformance of energy equites over the last 3 months puts the sector cheaper than at any point since early 2002, with just over 30% upside. We observe that upside of 20%+ is generally a good leading indicator of outperformance from the sector ) d a s e b (re e x d in y rg e n e tiv la e R Tel: +44 (0) info@ Web: Guinness Asset Management Ltd is authorised and regulated by the Financial Conduct Authority

2 Contents 1. SEPTEMBER IN REVIEW MANAGER S COMMENTS PERFORMANCE PORTFOLIO OUTLOOK APPENDIX Oil and gas markets historical context SEPTEMBER IN REVIEW i) Oil market Figure 1: Oil price (WTI and Brent $/barrel) 18 months March to September $ Brent 70 WTI 60 Mar '13 Jun '13 Sep '13 Dec '13 Mar '14 Jun '14 Sep '14 Source: Bloomberg LP The West Texas Intermediate (WTI) oil price started September at $96.0 and fell steadily during the month, closing on its lows of $91.1 at the end of September. WTI has averaged $99.6 so far in 2014, having averaged $98.0 in 2013, $94.1 in 2012 and $95.0 in The Brent oil price followed a similar trajectory during September, moving from $103.2 to $94.7 over the month. The gap between the WTI and Brent benchmark oil prices therefore closed the month at around $3.6/bl. The WTI-Brent spread averaged $10.7/bl during 2013, having been well over $20/bl at times since Factors which weakened the WTI and Brent oil prices in September: Decline in NYMEX net non-commercial positions The New York Mercantile Exchange (NYMEX) net non-commercial crude oil futures open position has now fallen by 35% from the peak level of 459,000 net long contracts in June 2014 to 296,000 net long contracts at the end of September. Despite the recent decline, the net non-commercial crude oil futures open position still remains at elevated levels versus long run averages (although sharply lower than shorter term average levels). Deteriorating global economic and global oil demand expectations During the month, there was continued commentary and data indicating that global economic growth and accordingly global oil demand growth - has started to slow (led predominantly by China and Europe). We note that 2Q 2014 was clearly a weak period of oil demand growth and that most recent data implies a rebound in underlying 3Q 2014 oil demand growth; nonetheless, poor headline data has caused liquidiation of non-commercial positions in crude and weak underlying oil price performance. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 2

3 Higher OPEC oil production as Libyan production recovers, political uncertainty recedes According to Bloomberg, OPEC production reached 27.8 million barrels per day in September (up 400,000 barrels per day versus August levels). The increase was driven by Libya (280,000 b/day growth) and Angola (120,000 b/day growth). Saudi production was also up slightly at 9.65 million barrels per day. We fully expect Saudi Arabia to quietly reduce production in order to rebalance this market during the period of weaker than expected demand and returning production from Libya. Strong North American oil production growth North American oil production continues to grow, and July 2014 production is around 1.0 million barrels per day greater than July We monitor the rate of production growth closely and note that the rate of growth has remained quite static since late 2012, despite higher levels of oil price, higher rig counts and greater capital investment. We expect North American growth of around 2-3 million barrels per day over the next 3-5 years but note that this is dependent on WTI oil prices maintaining at least $80 per barrel. We wait with interest to see how recent oil price weakness will affect the capital expenditure plans for 2015 of the North American E&P companies. Speculative and investment flows The New York Mercantile Exchange (NYMEX) net non-commercial crude oil futures open position fell in September, ending the month 7% lower at 296,000 contracts long, versus 318,000 contracts long at the end of August. We regard a net long position of 296,000 contracts as still relatively high any unwinding is likely to dampen the WTI price, as it has done over the last three months. Figure 2: NYMEX Non-commercial net futures contracts: WTI January 2004 September `000 contracts ` Source: Bloomberg LP/NYMEX (October 2014) OECD stocks OECD total product and crude inventories at the end of August were estimated to be 2,690m barrels, up 19m barrels compared to July Total OECD inventories now sit in the upper middle of the 10 year high-low range, in line with the level seen last year. We believe that OPEC would like to manage supply so that OECD inventories remain comfortably within the 10 year range. Figure 3: OECD total product and crude inventories, monthly, 2004 to 2014 OECD stocks (m barrels) 2,800 2,600 2, spread Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: IEA Oil Market Reports (September 2014 and older) Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 3

4 ii) Natural gas market The US natural gas price (Henry Hub front month) opened September at $4.07 per Mcf (1000 cubic feet), and traded in a range of $ $4.15 over the month, ending just off the month s high at $4.12. So far in 2014, the gas price has averaged $4.55, assisted by a very cold US winter. If the spot price were to sustain at the current level, it would still imply the highest yearly average (spot) gas price since The price averaged $3.73 in 2013, well above the 2012 average of $2.75 but down on the 2010 and 2011 averages of $4.38 and $4.00 and significantly below the average in each of the previous 5 years ( ). The 12-month gas strip price (a simple average of settlement prices for the next 12 months futures prices) traded in a similar fashion, starting September at $4.04 and ending down slightly at $4.01. The strip price averaged $3.92 in 2013, having averaged $3.28 in 2012, $4.35 in 2011, $4.86 in 2010 and $5.25 in Figure 4: Henry Hub Gas spot price and 12m strip ($/Mcf) March to September $ Henry Hub Henry Hub 12 m strip 1 Mar '13 Jun '13 Sep '13 Dec '13 Mar '14 Jun '14 Sep '14 Source: Bloomberg LP Factors which weakened the US gas price in September included: US domestic production continues to grow Despite the low number of rigs drilling for natural gas, US gas production continues to grow. Gross gas production in July 2014 (the latest data point available) for the lower 48 states was up 0.4 bcf/day (month over month) and 4.6 bcf/day (year over year) to 79.1 bcf/day. The biggest contributor to the production growth over the past year has been the Marcellus region in the north-east of the country, which has grown year-on-year by around 4 Bcf/day. Underlying gas market looks oversupplied and storage injection rates are above average The most recent injections of gas into storage suggest the market is, on average, about 2 Bcf/day oversupplied, as indicated on the graph below. If this level is maintained, the natural gas inventory position will normalise by the start of the winter, albeit at the lower end of the historic range. Figure 5: Weather adjusted US natural gas inventory injections and withdrawals Gas storgae withdrawal / injection All data to Jan 2014 May-14 Jun-14 Jul-14 Aug-14 Sept-14 Poly. (All data to Jan 2014) Data points below the line indicate Undersupply -350 Heating Degree Days minus Cooling Degree Days Data points above the line indicate Oversupply Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 4

5 Factors which strengthened the US gas price in September included: Gas to coal switching reversing at the lower end of the current trading range The gas price has recently been trading in a range ($ $4.25) at which the market is particularly sensitive to the switch between gas and coal for electricity generation. With the price moving to the lower end of this range in August and the first half of September, switching to gas likely increased around 1-2 Bcf/day. However, we expect any move over $4.00 to cause this to reverse. Natural gas in storage Swings 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. Figure 6: Deviation from 5yr gas storage norm vs gas price 12 month strip (H. Hub $/Mcf) -1, Deviation from 5yr norm (Bcf) Gas price ($/Mcf) 14 Deviation from 5yr norm (Bcf) Natural gas price 12 month strip ($/Mcf) Source: Bloomberg; EIA (September 2014) The surplus of gas in the second half of 2008 and 2009, a result of oversupply during the recession, 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 over this 18 month period. This coincided with the gas strip price falling from a peak of over $13 in July to below $5. An unusually cold 2009/10 winter boosted demand and pushed the gas storage level back into balance, only for oversupply to persist again for much of the rest of A cold 2010/11 winter followed by a hot 2011 summer tightened storage again, with storage levels staying around the 5 year average for much of this period. 0 The very mild 2011/12 winter (in combination with rising production) caused gas storage levels to balloon to record levels, driving prices down to their lowest levels for a decade. Since then coal-to-gas switching and shut ins and the sharp rig count drop have worked in the other direction, seeing gas prices rising from their sub $2 lows in April 2012 to around $4 at the end of The most recent winter saw gas in storage tighten very considerably. Much of this can be attributed to an extremely cold 2013/14 winter rather than a structural tightening. Coal regained some market share in the spring and summer of 2014 as a result of the higher natural gas prices, though gas in storage remains lower than average. We watch movements in gas storage closely as a tightening from here, weather adjusted, is likely to be a coincident indicator for the start of the next leg of gas price recovery. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 5

6 2. MANAGER S COMMENTS Setting some context around sub $100 oil Focussing on Brent crude oil (rather than the US domestic West Texas Intermediate crude), it has averaged $108 since the start of 2011 and has traded in a range of $90 to $125. It has been a period of low volatility. At the start of 2014, our outlook for the year was for Brent in a $90 to $110 range (with Brent averaging $105 per barrel) and until the end of August, actual Brent oil prices averaged around $108. Brent has since weakened to around $89, and if it stays at $90 for the rest the year, the outcome will be an average of around $103 so our 2014 forecasts for the year will prove to have been about $2 on the high side. $/bbl Brent oil price (spot) Brent oil price (48 month future) 50 Sep 2009 Sep 2010 Sep 2011 Sep 2012 Sep 2013 Sep 2014 Despite the weakness in front month Brent oil, we would highlight that long-dated oil prices (for example the four year forward Brent oil price) have fallen by just $5/bl since the middle of June, to just under $94/bl, while front month Brent oil prices have fallen by over $25 per barrel. Moreover, the four year forward oil price is actually up $2 per barrel since the start of the year! Suffice to say, longdated oil prices are much more important for company profitability and valuation, in our opinion, and we are comforted that oil prices still remain in the one hundred dollar range. Nonetheless, front month Brent oil has fallen sharply recently and we wanted to explore some of the implications. Why has this happened to the price of front month Brent since June? Some main reasons why this has happened: The spike in June was caused by real worries about how the political issues in Ukraine, Libya and Iraq/Kurdistan (ISIL) would affect the supply of oil A realisation has dawned that any immediate effect is so far modest and the medium-term threat (at least in terms of oil supply) also is looking rather less than once feared Global, and especially Chinese, oil demand was quite weak in Q The weakness was partly seasonal but there are worries it also reflects underlying economic realities. Recent GDP forecasts for Europe and China indicate some weakening in those economies North American oil production continues to grow strongly. This is probably as a result of the higher than expected WTI oil prices in the first half of 2014 (where the gap with Brent narrowed markedly), providing greater revenues for the producers to reinvest in new wells As a result of these supply and demand changes, global oil inventories have recovered in recent months, although they are still in the middle of the ten year range The improving macro issues have caused some significant liquidation of speculative interest (net noncommercial crude oil futures open positions) in the NYMEX crude oil markets. The number of net long contracts is down to 296,000 from 446,000 at the end of June. This liquidation has clearly had some negative oil price impact. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 6

7 What happens in the short term and long term now? Some bears see this recent front month price weakness as confirming their view that global oil demand will weaken further, that US oil supply growth will swamp the world and that the political uncertainty in the Middle East/Ukraine and Libya has just been a blip. We would argue that leading indicators for global oil demand in 3Q look a lot more positive (although we need to get this data confirmed in coming weeks) and that fundamentally, there has been no significant impact on global oil supply and demand balances. We feel that the bears cannot see the wood from the trees and that they miss the truly important point about world supply and demand that world demand growth (mainly from emerging economies) has greatly exceeded supply from the world (ex Saudi Arabia, Kuwait and the UAE) for three years. The oil price is only as low as it is because those three Middle East producers have ramped up production temporarily by 2.9 m b/d significantly above their long run average production to satisfy global demand. Despite higher US oil production, we are still living in tight oil markets. Longer term, we believe that the long-dated Brent oil price of $100 per barrel is a much better reflection of the underlying market dynamics. We have held a view for over two years now that Saudi, Kuwait and the UAE have tacitly determined to play the swing producer role in the world oil markets (played historically by first Standard Oil, then the Texas Railroad commission and then the Seven Sisters) and that their objective is to keep Brent oil prices at or above $100 per barrel on average. We believe that they will (quietly) cut back production by not just their 2.9m barrel/day current oversupply but probably twice that to ensure near-term price stability. This dwarfs everything else. Further ahead, Saudi et al will ultimately use up this spare capacity to lower prices as global oil demand growth outstrips non-opec oil production growth into the end of the decade. $100 per barrel appears to be the magic number for both supply and demand Why does Saudi seek a price of $100? $100/barrel for Brent is an acceptable level for both producers and for consumers. It is sufficient to incentivise new production from the unconventional oil developments in the USA (reference their recent years of strong production growth) and it is not so high that it stifles global oil demand growth (reference the IEA expectation of 0.9 and 1.2 million barrels per day of oil demand growth in 2014 and 2015 respectively). It enables Saudi and the other swing OPEC producers to balance their budgets and set some cash flow aside for a rainy day; and it ensures that Iran (Saudi s enemy) is affected by sanctions and is not bailed out by a Brent price surge. Limited implications from front month Brent oil weakness for the energy equity sector outlook The price of Brent is unlikely to sit below $95 for any great length of time and any such price weakness will be followed by a recovery, in our opinion. We believe that the trading range will be managed as $ for the great majority of the time, so the recent weakness is totally within the bounds of this normal range and typical crude price volatility. Energy equities remain cheap. Recent company results continue to reaffirm that the larger capitalisation oil and gas producers are progressing with their value over volume strategies, and we believe this is positive for the sector as a whole. Energy equities have underperformed the S&P500 and the MSCI World Index in 2011, 2012 and 2013; and having staged a rebound since February in 2014, they have fallen back over the summer on the crude price weakness. At the start of 2014, we argued that energy equities were around 20-30% cheap, and this yo-yo performance in 2014 has not changed that one iota. We are more convinced than ever that the energy sector is still around 20-30% cheap and that investors, therefore, are being presented with a similar opportunity to the one that appeared at the start of Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 7

8 3. PERFORMANCE The main index of oil and gas equities, the MSCI World Energy Index, was down by by 7.39% in September. The MSCI World Index was down by 2.67% over the same period. The Fund was down by 8.60% (class B) over this period, underperforming the MSCI World Energy Index by 1.21% (all in US dollar terms). Within the Fund, September s stronger performers were ENI, Total, Dragon Oil, JA Solar and Trina Solar. Poorer performers were Newfield, Chesapeake, Helix, Valero and Bankers. The following tables show the Fund s performance* along with the performance of the MSCI World Energy Index over various periods to September as well as over calendar years. The base currency of the Fund is US dollars. USD performance (B class shares) Cumulative % returns* 1 year 3 years annualised 5 years annualised 10 years annualised 1999-to-date annualised Guinness Global Energy (B) +10.6% +13.7% +6.4% +11.1% +14.7% MSCI World Energy Index +11.0% +13.8% +8.8% +9.4% +9.7% Calendar year % performance* Guinness Global Energy (B) MSCI World Energy Index Source: Bloomberg, bid to bid, gross income reinvested, in US dollars *Calculation by Guinness Asset Management Limited, simulated past performance prior to , launch date of. The Guinness Global Energy investment team has been running global energy funds in accordance with the same methodology continuously since November These returns are calculated using a composite of the Investec GSF Global Energy Fund class A to (managed by the Guinness team until this date); the Guinness Atkinson Global Energy Fund (sister US mutual fund) from to (launch date of this Fund) and the class B since launch. Performance would be lower if an initial charge and/or redemption fee were included. Past performance should not be taken as an indicator of future performance. The value of this investment and any income arising from it can fall as well as rise as a result of market and currency fluctuations as well as other factors. You may lose money in this investment. Returns stated above are in US dollars; returns in other currencies may be higher or lower as a result of currency fluctuations. Investors may be subject to tax on distributions. The Fund s Prospectus gives a full explanation of the characteristics of the Fund and is available at Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 8

9 4. PORTFOLIO Buys/Sells There were no buys or sells in September. Sector Breakdown The following table shows the asset allocation of the Fund at September We have also shown the asset allocation of the Guinness Atkinson Global Energy Fund (our US global energy fund which was started in 2004 and is managed in tandem with the ) at year-end 2006 and 2007 for comparative purposes: 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 30 Sept Change (%) 2006* 2007* YTD Oil & Gas Integrated Integrated Can & Em Mkts Exploration & production Drilling Equipment & services Refining and marketing Solar Coal & consumables Construction & engineering Cash Total *Guinness Atkinson Global Energy Fund Source: Guinness Asset Management Basis: Global Industry Classification Standard (GICS) The Fund at September was on an average price to earnings ratio (P/E) versus the S&P 500 Index at 2,003 as set out in the table. (Based on S&P 500 operating earnings per share estimates of $56.9 for 2009, $83.8 for 2010, $96.4 for 2011, $96.8 for 2012, $107.3 for 2013 and $118.6 for 2014). This is shown in the following table: P/E S&P 500 P/E Premium (+)/ Discount (-) -50% -54% -46% -42% -33% -31% Average oi price (WTI $) $61.9/bbl $79.5/bbl $95/bbl $94/bbl $98/bbl $97/bbl Source: Standard and Poor s; Guinness Asset Management Ltd Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 9

10 Portfolio Holdings Our integrated and similar stock exposure (c.37%) is comprised of a mix of mid cap, mid/large cap and large cap stocks. Our four large caps are Exxon, BP, Royal Dutch Shell and Total. Mid/large and mid-caps are ENI, Statoil, Hess and OMV. At September the median P/E ratio of this group was 11.2x 2014 earnings. We have one Canadian integrated holding, Suncor. The company has significant exposure to oil sands and stands on an attractive P/E of 11.4x 2014 earnings given the company s good growth prospects. Our exploration and production holdings (c.38%) give us exposure most directly to rising oil and natural gas prices. We include in this category non-integrated oil sands companies, as this is the GICS approach. The stock here with oil sands exposure is Canadian Natural Resources. The pure E&P stocks are all largely in the US (Newfield, Devon, Chesapeake, Carrizo, Stone, Ultra, QEP and Bill Barrett), with three more US names (Apache, Occidental and Noble) which have significant international production and two (Enquest and Bankers Petroleum) which are European and North Sea focused. One of the key metrics behind a number of the E&P stocks held is low enterprise value / proven reserves. Almost all of the E&P stocks held also provide exposure to North American natural gas and include two of the industry leaders (Devon and Chesapeake). In P/E terms, the group divides roughly into two: (i) Apache, Occidental, Chesapeake, Devon, Ultra, Stone, Bankers and Enquest all with quite low P/Es (9x 14x 2014 earnings); and (ii) Noble, Bill Barrett, Newfield, Carrizo and QEP with higher P/E ratios. However, all look reasonably attractive on EV/EBITDA multiples. We have exposure to four (pure) emerging market stocks in the main portfolio, though two are half-positions. Two are classified as integrateds by the GICS (Gazprom and PetroChina) and two as E&P companies (Dragon Oil and SOCO International). Gazprom is the Russian national oil and gas company which produces approximately a quarter of the European Union gas demand and trades on 2.8 x 2014 earnings. PetroChina is one of the world s largest integrated oil and gas companies and has significant growth potential and advantages as a Chinese national champion. Dragon Oil is an oil and gas E&P company focused on offshore Turkmenistan in the Caspian Sea and trades on 7.9x 2014 earnings. SOCO International is an E&P company with production in Vietnam and exploration interests across East Africa in Angola, Democratic Republic of Congo and the Republic of Congo. We have useful exposure to oil service stocks, which comprise around 17% of the portfolio. The stocks we own are split between those which focus their activities in North America (land driller Unit Corp) and those which operate in the US and internationally (Helix, Halliburton, Wood Group and Shawcor). 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. Valero has a reasonably large presence on the US Gulf Coast and is benefitting from the rise in US exports of refined products seen in recent times. Our alternative energy exposure is currently a single unit split equally between two companies: JA Solar and Trina Solar. Both were loss making in 2012 and 2013 due to sharp falls in solar prices during the year but are expected to return to profitability during Trina is a Chinese solar module manufacturer and JA Solar is a Chinese solar cell manufacturer. Some measure of their continued recovery potential may be indicated by their 2010 P/Es of 3.6x and 1.2x respectively. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 10

11 Portfolio at August 31st 2014 (for compliance reasons disclosed one month in arrears) 31 August 2014 Stock Curr. Country % of NAV B'berg B'berg B'berg B'berg B'berg B'berg B'berg B'berg mean PER mean PER mean PER mean PER mean PER mean PER mean PER mean PER B'berg mean PER Integrated Oil & Gas Exxon Mobil Corp USD US Royal Dutch Shell PLC EUR NL BP PLC GBP GB Total SA EUR FR ENI SpA EUR IT Statoil ASA NOK NO Hess Corp USD US OMV AG EUR AT Integrated / Oil & Gas E&P - Canada Suncor Energy Inc CAD CA Canadian Natural Resources Ltd CAD CA Integrated Oil & Gas - Emerging market PetroChina Co Ltd HKD HK Gazprom OAO USD RU 2.97 nm nm nm Oil & Gas E&P Occidental Petroleum Corp USD US Apache Corp USD US Devon Energy Corp USD US Noble Energy Inc USD US Chesapeake Energy Corp USD US QEP Resources Inc USD US 1.16 nm nm nm nm Newfield Exploration Co USD US Ultra Petroleum Corp USD US Stone Energy Corp USD US Bill Barrett Corp USD US nm nm Carrizo Oil & Gas Inc USD US International E&Ps Bankers Petroleum Ltd CAD CA 1.56 nm nm nm Dragon Oil PLC GBP GB EnQuest PLC GBP GB 1.48 nm nm nm nm Soco International PLC GBP GB Drilling Unit Corp USD US Equipment & Services Halliburton Co USD US Helix Energy Solutions Group Inc USD US Seventy Seven Energy Inc USD US 0.20 nm nm nm nm nm nm nm ShawCor Ltd CAD CA John Wood Group PLC GBP GB Solar Trina Solar Ltd USD US 1.74 nm nm nm 12.9 JA Solar Holdings Co Ltd USD US nm 1.2 nm nm nm Oil & Gas Refining & Marketing Valero Energy Corp USD US nm Research Portfolio Cluff Natural Resources PLC GBP GB 0.17 nm nm nm nm nm nm nm nm nm JKX Oil & Gas PLC GBP GB Ophir Energy PLC GBP GB 0.14 nm nm nm nm nm nm nm nm nm Shandong Molong Petroleum Machinery Co Ltd HKD HK nm nm nm Sino Gas & Energy Holdings Ltd AUD AU 0.35 nm nm nm nm nm nm nm 35.0 Triangle Petroleum Corp USD US 0.24 nm nm nm nm nm nm nm nm 20.8 Trinity Exploration & Production Ltd GBP GB 0.13 nm nm nm nm nm nm nm 3.1 nm WesternZagros Resources Ltd CAD CA 0.16 nm nm nm nm nm nm nm nm nm 1.63 Cash 1.06 Total 100 PER Med. PER Ex-gas PER 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. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 11

12 5. OUTLOOK i) Oil market The table below illustrates the difference between the growth in world oil demand and non-opec supply over the last 10 years, together with the IEA forecasts for 2014 and e 2015e IEA IEA IEA World Demand Non-OPEC supply (includes Angola and Ecuador for periods when each country was outside OPEC 1 ) Angola supply adjustment Ecuador supply adjustment Indonesia supply adjustment Non-OPEC supply (ex. Angola/Ecuador and inc. Indonesia for all periods) OPEC NGLs Non-OPEC supply plus OPEC NGLs (ex. Angola/Ecuador and inc. Indonesia for all periods) Call on OPEC Iraq supply adjustment Call on OPEC Angola joined OPEC at the start of 2007, Ecuador rejoined OPEC at the end of 2007 (having previously been a member in the 1980s) 2 Indonesia left OPEC as of the start of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi, U.A.E. Venezuela 4 Iraq has no offical quota 5 Algeria, Angola, Ecuador, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi, U.A.E. Venezuela Source: : IEA oil market reports; : September 2014 Oil market Report Global oil demand in 2013 was 4.6m b/day up on the pre-recession (2007) peak. This means the combined effect of the 2007/08 oil price spike and the 2008/09 recession was quite small and was been shrugged off remarkably quickly. The IEA forecast a further rise of 0.9m b/day in 2014 and then 1.3m b/day in 2015, which would take oil demand to an all-time high of 93.8m b/day. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 12

13 OPEC Five years ago, in order to put a floor under a plunging oil price, OPEC announced in its December meeting a new quota target of 25.0m b/day with effect from 1 January This figure represented a 4.2m b/day cut from the actual OPEC-11 September 2008 production level (29.2m b/day). From then, quotas remained unchanged until the OPEC meeting on December , at which OPEC substituted a 30m b/day target without specifying individual country quotas. The statement read as follows: In light of. the demand uncertainties, the Conference decided to maintain the current production level of 30.0 mb/day, including production from Libya, now and in the future. The Conference also agreed that Member Countries would, if necessary, take steps (including voluntary downward adjustments of output) to ensure market balance and reasonable price levels. In taking this decision, Member Countries confirmed their preparedness to swiftly respond to developments that might have a detrimental impact on orderly market developments. Given the ongoing worrying economic downside risks, the Conference directed the Secretariat to continue its close monitoring of developments in supply and demand, as well as non-fundamental factors, such as macro-economic sentiment and speculative activity, keeping Member Countries abreast at all times. The 30m b/day figure includes 2.7m b/day for Iraq, so in effect 25.0m b/day for OPEC-11 was moved up to 27.3m b/day. The timing of this announcement was clearly complicated by numerous issues: notably (1) a range of tricky problems in three OPEC member countries Libya (ongoing civil war), Iran (western sanctions over nuclear weapons development), Venezuela (a change of leadership)); (2) production problems in certain non OPEC countries that might or might not resolve themselves speedily (Yemen, Syria and Southern Sudan); and (3) a real problem in forecasting how Iraq might develop. We are now over two and a half years on from the establishment of the 30.0m b/day quota. Our view remains that it needs to be taken as a marker in the sand ( this is where we would like to see production all things being normal ) but little more than that. September 2014 production for OPEC-11 is reported to be around 27.8m b/day by Bloomberg, indicating that OPEC production is a little ahead of target. None of this changes our view that OPEC may be ill-disciplined when prices are high but remain capable of being totally effective at cutting production when the oil price weakens significantly as they did in December 2008, 2006, 2001 and OPEC met in early June 2014 and no changes to production levels were made for the fifth consecutive meeting. Little new came out of the conference, with OPEC noting the relative steadiness of prices in 2014 to date is an indication that the market is adequately supplied, with the periodic price fluctuations being more a reflaction of geopolitical tensions than a response to fundamentals. They also repeated their readiness to take steps to ensure market balance. The next meeting is scheduled for November The table below shows changes in production among OPEC-12 since the end of 2010 and shows how production is running well ahead of pre-mena unrest levels. Saudi production alone is up around 1.4m b/day at 9.65m b/day. We note that Libya has now recovered to around half of its pre-crisis levels and that a full recovery in Libyan and Iranian production would bring a further c1.5m b/day back into OPEC supply. We are sceptical that a full and sustained recovery in both will occur anytime soon but should it occur, we expect that Saudi, UAE & Kuwait, who are supplying over 2m b/day over their long-term average, would compensate with a cut to their production. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 13

14 ('000 b/day) 31-Dec Sep-14 Change Saudi 8,250 9,650 1,400 Iran 3,700 2, UAE 2,310 2, Kuwait 2,300 2, Nigeria 2,220 2, Venezuela 2,190 2, Angola 1,700 1, Libya 1, Algeria 1,260 1, Qatar Ecuador OPEC-11 26,800 27,835 1,035 Iraq 2,385 3, OPEC-12 29,185 30,935 1,750 Source: Bloomberg The graph below shows the estimated call on OPEC-11 for 2014, which we currently estimate to be around 26.6m b/day versus apparent production of 27.2m b/day in August (according to the IEA). The call on OPEC and OPEC s actual production have been reasonably in balance for a number of months now and this recent period of oversupply is likely to be short term. Figure 7: OPEC apparent production vs call on OPEC IEA 2014 call estimate = 26.6m b/day Million barrels per day OPEC-11* production Call on OPEC-11 Call on OPEC-11 in 2014 IEA August 2014 production = 27.2m b/day Source: IEA Oil Market Report (September 2014 and prior) Supply looking forward The non-opec world has, since the 2008 financial crisis, grown its production more meaningfully than in the five years before The growth was 0.2% p.a. from , increasing to 2.0% p.a. from Non-OPEC production growth in 2013 (1.4m b/day) was the strongest since Growth in the non-opec region over the last 3 years has been dominated by the successful development of shale oil and oil sands in North America (+3.1m b/day since 2010), implying that the rest of non-opec region has declined by 0.9m b/day over the period, despite the sustained high oil price. The IEA estimates aprroximately 1.6m b/day of growth in The expected supply is dominated by North America (+1.4 m b/day) with the rest of non-opec broadly flat in aggregate. Should non-opec supply grow this Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 14

15 strongly in 2014, we expect it to have a loosening effect on the global oil balance, with the growth absorbed by rising demand and a reduction in OPEC supply (led by Saudi Arabia). Looking further ahead, we must consider in particular increases in supply from two regions: Iraq and North America. Starting with Iraq, the questions of how big an increase is likely, in what timescale, and how other OPEC members react are all important issues. Our conclusion is that while an increase in Iraqi production may be technically possible (say, 2m barrels per day over the next 5 years), if it occurs it will be surprisingly easily absorbed by a combination of OPEC adjustment, if necessary, modest non-opec supply growth and continuing growth in demand from developing countries of c.15m b/day over the next 10 years. Iraqi production was running at 3.1m b/day in September 2014 (according to Bloomberg), down from a high of 3.6m b/day in mid Despite this potential, the recent unrest in the country and a likely slowdown investment from foreign partners does not fill us with confidence that growth can easily be achieved. We expect that large oil companies will choose not to invest significant sums into Iraq unless there is much greater political stability. The recent growth in US shale oil, in particular from the Bakken, Permian and Eagleford basins, raises the question of how much more there is to come. So far, new oil production from these sources amounts to over 3m b/day. Our assessment is that US shale oil is a high cost source of oil but one that is viable at current oil prices and attractive for North American producers to develop. In total, it could be comparable in size to the UK North Sea, i.e. it could grow by around a further 3m b/day over the next five years. We observe that since the discovery of the Bakken, Eagleford and Permian, the US has struggled to find another large shale resource, despite 3 years of trying, but that there is now the opportunity to fully expoit those three discoveries. Moreover, the annual rate of growth from these new plays appears to have settled at around 1 million barrels per day (per year) despite higher rig activity and greater capital expenditure. Other opportunities to exploit unconventional oil likely exist internationally, notably in Argentina (Vaca Muerta), Russia (Bazhenov), China (Tarim and Sichuan) and Australia (Cooper). However, the US is far better understood geologically; the infrastructure in the US is already in place; service capacity in the US is high; and the interests of the landowner are aligned in the US with the E&P company. In most of the rest of the world, the reverse of each of these points is true, and as a result we see international shale being 5-10 years behind North America. Demand looking forward The IEA reported growth in oil demand in 2013 of around 1.2m b/day, comprising an increase in non-oecd demand of around 1.0m b/day and an increase in OECD demand of 0.2m b/day. The components of this non- OECD demand growth can be summarised as follows:- Figure 8: Non-OECD oil demand m b/d Demand Growth e 2015e Asia M. East Lat. Am FSU Africa Europe Source: IEA Oil Market Report (September 2014) As can be seen, Asia has settled down into a steady pattern of growth since Collective growth in the Middle East, Latin America, FSU and Africa in 2013 almost exactly matched that in Asia. These other non-oecd regions are all central to the developing world industrialisation and urbanisation thesis: it is much more than just Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 15

16 a China story. For 2014, further non-oecd growth of 1.1m b/day is expected, the Asian component of this up on 2013 to 0.6m b/day (of which China represents 0.3m b/day). Looking into 2015, non-oecd oil demand is expected to further accelerate, yielding 1.3m b/day of growth with a similar split between Asia and other non- OECD. For OECD demand in 2013, the IEA now estimates that demand grew by 0.2 million barrels per day, made up of North American demand growth of 0.5m b/day and declines in demand from Europe and Asia Pacific. We believe that the decline in the Pacific region reflects the gradual switching away from the temporary move to oil by Japan post Fukushima. OECD demand in 2014 is forecast to be down by 0.25m b/day, with North America up slightly, Europe and Pacific down. Global oil demand over the next few years is likely to follow a similar pattern, with a flat to shallow decline picture in the OECD overshadowed by strong growth in the non-oecd area. The small decline in the OECD reflects improving oil efficiency over time, though this effect will be dampened by economic, population and vehicle growth. Within the non-oecd, population growth and rising oil use per capita will both play a significant part. Price and the trajectory of global GDP will have an effect at any point in the short term, but overall we would not be surprised to see average annual non-oecd demand growth of around 1.5m b/day to the end of the decade. This would represent a growth rate of 3% p.a., no greater than the growth rate over the last 15 years (3.2% p.a.). Conclusions about oil From the low of $31.42 on December we saw the oil price (WTI) recover to above $70 by May 2009, and range trade around $65-$85 for the subsequent 20 months. Since November 2010 it has generally moved above this range, trading in a wider range of $80-$110. Brent s trading range over the same period has been higher, at $90-$125. The table below summarises our view by showing our oil price forecasts for WTI and Brent in 2014 against their historic levels, and rises in percentage terms that we have seen in the period from 2002 to Figure 9: Average WTI & Brent yearly prices, and changes e Average WTI ($) Average Brent ($) Average Brent and WTI Average Brent and WTI Change + y-o-y ($) Avge Change + y-o-y (%) 33% 39% 18% 10% 35% -37% 28% 29% 0% 0% -3% We think the most likely scenario going forward is that we will see the average price of Brent and WTI in the trading range of $ Once the floor of this range looks threatened, OPEC will start to cut back and any significant price weakness below $100 (Brent) will be prevented by OPEC cuts. Should the oil price rise much over $125 and we think demand will start to weaken, putting a ceiling on the price for the time being (absent a supply shock). At the heart of it all, we believe that Saudi are working hard to try and maintain a good oil price (Brent at $ ). So far, they are succeeding. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 16

17 Natural gas market US supply & demand: recent past 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 coldness of winter weather can be marked. Industrial demand (of which around 35% comes from petrochemicals) 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. Between 2000 and 2009 industrial demand was in steady decline, falling from 22.2 Bcf/day to 16.9 Bcf/day. Since 2009 the lower gas price (particularly when compared to other global gas prices) and recovery from recession has seen demand rebound, up in 2013 to around 20.2 Bcf/day. Electricity gas demand (i.e. power generation) is affected by weather, in particular warm summers which drive demand for air conditioning, but the underlying trend depends on GDP growth and the proportion of incremental new power generation each year that goes to natural gas versus the alternatives of coal, nuclear and renewables. Gas has been taking market share in this sector: in 2013, 27.2% of electricity generation is estimated to have been powered by gas, up from 21.6% in The big loser here is coal which has consistently given up market share over the past 10 years. Total gas demand in 2013 (including Canadian and Mexican exports) is estimated to have been 75.7 Bcf/day, up by 1.4 Bcf/day (1.9%) vs 2012 and up 6.5 Bcf/day (9%) vs the 5 year average. The biggest change in 2013 vs 2012 was in power generation (-2.6 Bcf/day), as much of the coal to gas switching seen in 2012 unwound as the gas price recovered. This, however, was more than offset by a rise in commercial demand (+2.4 Bcf/day), driven by a cold finish to the 2012/13 winter, and a rise in industrial demand (+0.7 Bcf/day). Overall, whilst gas demand in the US has been reasonably strong over the past four years, it has been trumped over this period by a rise in onshore supply, pulling the gas price lower. 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). Of these, onshore supply is the biggest component, making up over 80% of total supply. Since the middle of 2008 the weaker gas price in the US reflects growing onshore US production driven by rising gas shale and associated gas production (coming from growing onshore US oil production). Interestingly, the overall rise in onshore production has come despite a collapse in the number of rigs drilling for gas, which has dropped from a 1,606 peak in September 2008 to 314 at the end of June However, offsetting the fall, the average productivity per rig has risen dramatically as producers focus their attention on the most prolific shale basins. Onshore gas supply (gross) is now at 74.7 Bcf/day, around 17.3 Bcf/day (30%) above the 57.4 Bcf/d peak in 2009 before the rig count collapsed. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 17

18 Figure 10: US natural gas production (Lower 48 States) Total/Onshore production (Bcf/day) Offshore production (RHA) Total production (LHA) Onshore production (LHA) Source: EIA 914 data (June 2014 published in Sept 2014) The trends in US onshore production were initially were mitigated by declining offshore production and falling net Canada and LNG imports and rising exports to Mexico. More recently, from about September 2011, the mitigating factors became exhausted and a net imbalance developed between supply and demand. Supply outlook The outlook for gas production in the US depends on three key factors: the rise of associated gas (gas produced from wells classified as oil wells); expansion of the newer shale basins, principally the Marcellus, and the decline profile of legacy gas fields. If US onshore oil production grows by a further 2-3m b/day between now and 2017, we expect associated gas to grow by around 5-8 Bcf/day. The Marcellus region, which includes the largest producing gas field in the US and the surrounding region, currently accounts for around 15 Bcf/day of supply. Further growth of 3-4 Bcf/day is likely over the next few years. Balanced against these increases is an expected decline in legacy gas fields, particularly if the gas drilling rig count stays low. We estimate that other gas (onshore production ex associated and Marcellus) declined by around 4.5 Bcf/day in Declines in 2014 and beyond from other gas may though moderate as declines from legacy fields flatten (a result of moving along the decline curve). Considering these factors together, we expect production gains to continue (c.1-3 Bcf/day per annum for the next two or three years), but with an inflection point in demand coming (see discussion below), higher production than may well be needed e Onshore production - average (Bcf/day) Change (Bcf/day) Change (%) 1.7% 4.8% 10.2% 5.9% 2.6% 4.7% Source: EIA; Guinness estimates Liquid natural gas (LNG) arbitrage The UK national balancing point (NBP) gas price which serves as a proxy to the European traded gas price recovered a little in August, but still reflects the lasting effect of a warm European winter and spring and relatively high levels of gas in inventory. We note that it still remains at a premium to the US gas price (c.$8.20 versus c.$4.10), albeit reduced from 12 months ago. LNG supplies to the UK have been somewhat constrained, particularly in light of strong demand for LNG to Asian markets. US LNG imports remained well below 0.5 Bcf/day in September as cargoes took advantage of the higher prices in Europe and Asia. Asian LNG prices have also weakened substantially in recent months as a result of weather patterns, the restart of South Korean nuclear Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 18

19 generating capacity and slightly lower Japanese LNG demand. While $12/mcf is still much higher than European and US natural gas prices, it is sharply down from around $18/mcf at the start of the year. Natural gas price ($/mcf) Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Euro Spot US Spot Japan LNG Price Canadian imports into the US Net Canadian imports of gas into the US dropped from 9.1 Bcf/day in 2007 to 5.0 Bcf/day (estimated) in The fall was initially driven by falling rig counts and a less attractive royalty regime enacted in 2007 and has accelerated due to increased domestic demand from Canadian oil sands development and the depressed US price. We expect net imports in 2014 to remain around 5 Bcf/day. Demand outlook Assuming average temperatures for the rest of the year, we expect US total demand in 2014 (including exports to Canada and Mexico) to be just over 76 Bcf/day, around 1 Bcf/day higher than The very cold start to 2014 accounts for around 1 Bcf/day of this growth, so adjusting for weather, we expect to see underlying demand flat versus Demand from power generation is expected to decline slightly, although recent weaker gas prices have tempered the switching from natural gas to coal that we witnessed earlier in Residential and commercial gas demand for the rest of the year will as ever be weather dependent, but assuming average temperatures, demand should be about unchanged from And we expect industrial consumption about 0.9 Bcf/day above Looking out further, the low US gas price has stimulated various initiatives that are likely have a material impact on demand from 2016 onwards. The most significant is the group of LNG export terminals in the US and Canada which are in the planning/early construction stages. There are over 26 bcf/day of LNG export projects proposed in the US today, plus a further 27 bcf/day in Canada, as shown below: Proposed NAM LNG export terminals Location of proposed terminals Number of terminals Non-FTA approval (bcf/day) US Export approved US FERC review US Proposed US - Total Canada NEB export approved Canada Proposed Canada - Total North America - Total Not all the proposed facilities will be built but we think that exports of between 4-8 bcf/day from the US by 2020, or around 5-10% of new demand, are likely. Additional LNG exports from Canada will contribute a few Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 19