THE GUINNESS GLOBAL ENERGY REPORT

Transcription

1 THE GUINNESS GLOBAL ENERGY REPORT Developments and trends for investors in the global energy sector February 2017 GUINNESS GLOBAL ENERGY FUND Fund size: $315m ( ) 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 JANUARY OIL Brent and WTI down slightly; OPEC compliance looking good Brent and WTI oil traded down slightly in the month; WTI and Brent both fell by around $1 to $56/bl and $53/bl. In the US, onshore oil production for October and November was more resilient than initially expected and hedging activity by E&P management teams is putting downward pressure on long dated oil prices. Initial OPEC compliance with cuts has been reported at record high levels, with production down c.1m b/day in January, though the effect of the cuts has not been reflected in positive inventory data yet. NATURAL GAS US gas prices down as supply recovers Henry Hub prices fell in January, down from $3.72 to $3.12/mcf as a result of sharply stronger onshore US gas supply for November. Nonetheless, the US gas market remained substantially undersupplied during December and January. European and Asian gas prices continue a steady recovery. EQUITIES Energy underperforms the broad market The MSCI World Energy Index fell in January by 3.0%, underperforming the MSCI World Index which rose by 2.4% (all in US dollar terms). CHART OF THE MONTH It s about return on capital as much as it is the oil price The energy sector is close to a cyclical low in terms of oil prices and profitability. Underlying profitability is starting to improve as a result of standardisation, efficiencies and technology plus cyclical cost deflation and we believe that return on capital employed (ROCE) will move back to long run average levels. If long term relationships hold true, energy equities will re-rate as ROCE normalises and the Guinness Energy portfolio has in excess of 30% upside if ROCE returns to mid-range levels. Historic ROCE vs P/B of the current Guinness energy strategy Tel: +44 (0) info@ Web: Guinness Asset Management Ltd is authorised and regulated by the Financial Conduct Authority

2 Contents 1. JANUARY IN REVIEW MANAGER S COMMENTS PERFORMANCE PORTFOLIO OUTLOOK APPENDIX Oil and gas markets historical context JANUARY IN REVIEW i) Oil market Figure 1: Oil price (WTI and Brent $/barrel) 18 months July to January Source: Bloomberg LP The West Texas Intermediate (WTI) oil price started January at $53.7/bl and traded in a tight range all month, ending January at $52.8/bl. WTI has averaged $52.6/bl so far in 2017, having averaged $43.4 in 2016, $48.7 in 2015 and $93.1 in Brent oil traded in a similar way, opening January at $56.8/bl and closing at $55.7/bl. The gap between the WTI and Brent benchmark oil prices was broadly unchanged at the end of the month. The WTI-Brent spread averaged $1.7/bl during 2016, having been well over $20/bl at times since Factors which strengthened WTI and Brent oil prices in January: Signs of OPEC compliance with announced January 2017 production quota cuts Actual production data for January 2017 will not be available until later in February but, at the time of writing, indications are that OPEC has achieved high levels of compliance with its January production quotas. We expect January production cuts to be around 0.9mn b/d (75% compliance) based on comments from various OPEC oil ministers. Recently, the Algerian Oil Minister indicated that combined OPEC/non- OPEC cuts will total around 1.8mn b/d in February. Tanker loading data indicates that good compliance is likely to be maintained from OPEC in Febuary as well. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 2

3 NYMEX non-commercial net long position reaches new highs The New York Mercantile Exchange (NYMEX) non-commercial crude oil futures net position (WTI) increased further during January, reaching a new peak of 482,500 contracts. This surpassed the June 2014 peak of 460,000 contracts. Typically there is a positive correlation between the net position and the oil price. Crude oil inventory builds in the US The rush from OPEC to ramp up production prior to the January cuts has appeared in US oil inventories in recent weeks. The US market is the market of last resort for excess oil and we expect the impact of OPEC quota cuts to be reflected in lower US oil imports and lower US oil inventories starting later in February and through March. Brent crude oil time spreads indicate that European and Asian markets are much tighter in terms of supply/demand. Factors which weakened WTI and Brent oil prices in January: US onshore oil production increase The EIA reported that US onshore oil production increased by 104k b/d during October 2016 as a result of an increase in North Dakota Bakken oil production of around 70k b/d in October vs September. We believe that the is a high likelihood of some statistical anomalies in the data (some recalibration potentially). Later in January 2017, the EIA reported US onshore oil production for November 2016 which was broadly flat month on month. The rapid increase in the October data did provide some evidence that the United States may well be able to deliver reasonable onshore oil production growth at relatively low oil prices. US oil drilling rig count starting to increase The Baker Hughes oil directed rig count continued its recovery during the month, increasing from 525 at the end of December 2016 to 566 at the end of January 2017, up by a total of 41 rigs over the month. The rig count reached a low of 316 rigs in May 2016, having peaked in October 2014 at 1,609 rigs. Speculative and investment flows The New York Mercantile Exchange (NYMEX) net non-commercial crude oil futures open position (WTI) rose in January, ending the month at 482,500 contracts long versus 444,900 contracts long at the end of December. The current net long position is now slightly higher than the previous peak of 460,000 contracts in June The net short position declined from 164,000 contracts to 160,000 contracts. Figure 2: NYMEX Non-commercial net and short futures contracts: WTI January 2004 January 2017 Source: Bloomberg LP/NYMEX/ICE (2017) OECD stocks Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 3

4 OECD stocks (m barrels) The Guinness Global Energy Report February 2017 OECD total product and crude inventories at the end of December (the latest data point available) were estimated by the IEA to be 2,985m barrels, down by 35m barrels versus the previous month. The decline compares to an average 30 million barrel decrease that has been witnessed over the last ten years. The six month rolling average for changes to inventories indicates that oversupply has fallen to close to zero. Despite the tightening of the market, inventories are still considerably above the top of the 10 year historic range. Figure 3: OECD total product and crude inventories, monthly, 2004 to ,200 3,000 2,800 2,600 2, spread Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: IEA Oil Market Reports (February 2017 and older) ii) Natural gas market The US natural gas price (Henry Hub front month) opened January at $3.72 per Mcf (1,000 cubic feet). The price traded lower very sharply in the beginning of the month and stayed range bound,ending January close to its lows at $3.12. The spot gas price averaged $2.55 in 2016 which compares to an average gas price of $2.61/mcf in 2015 and $4.26 in 2014 (assisted by a very cold 2013/14 US winter). The price averaged $3.72 over the preceding four years ( ). The 12-month gas strip price (a simple average of settlement prices for the next 12 months futures prices) traded lower in January, down from $3.63 to $3.40. The strip price averaged $2.84 in 2016, having averaged $2.86 in 2015, $4.18 in 2014, $3.92 in 2013, $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) July to January Source: Bloomberg LP Factors which strengthened the US gas price in January included: Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 4

5 Structurally undersupplied market Adjusting for the impact of weather in January, the most recent injections of gas into storage suggest the market is, on average, around 4 bcf/day undersupplied (as indicated by the green dots on the graph below). The gas market shifted into structural undersupply in November 2015, but this was initially trumped last winter by warmer weather, causing natural gas inventory levels to expand rapidly. These recent high levels of undersupply have now been existing for around two months. Figure 5: Weather adjusted US natural gas inventory injections and withdrawals Source: Bloomberg LP; Guinness Asset Management Factors which weakened the US gas price in January included: Higher level of rigs drilling for natural gas The number of rigs drilling for natural gas has been steadily increasing since summer There were 81 gas-oriented drilling rigs at the end of August 2016 but that has increased to 145 rigs as of 27 January 2017; a rate of 13 new rigs added per month. Stronger US onshore natural gas production Onshore US natural gas production averaged 79.7 Bcf/day in November 2016, up by 4.1 Bcf/day on the level reported for October 2016 and up 1.8 Bcf/day on the November 2015 level. The sharp increase in production in the month brought to an end a sustained period of lower US natural gas production with the November production level being only slightly lower than the recent peak production level of 80 Bcf/day achieved in December Natural gas inventories Swings in the supply/demand balance for US natural gas should, in theory, show up in movements in gas storage data. Natural gas inventories at 20 th January 2017 were reported by the EIA to be 2,798 Bcf. The 562 Bcf draw in inventories over the previous 4 weeks was slightly less than the ten year average of 647 Bcf, leaving inventories above the top of the five year range. Figure 6: Deviation from 5yr gas storage norm vs gas price 12 month strip (H. Hub $/Mcf) Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 5

6 Source: Bloomberg; EIA (October 2016) 2016 was a year of transformation for the US natural gas markets as inventories corrected from being sharply higher than five-year average levels at the start of the year to being within the efive year range at the end of the year. The oversupplied situation arose because of a mild 2015/2016 autumn and winter which saw gas in storage expand at a faster than average rate. The overhang at the end of January 2017 was around 200bcf, well down on the c.900 Bcf overhang at the end of the 2015/16 winter. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 6

7 2. MANAGER S COMMENTS It's about return on capital as much as it is about the oil price The energy sector is close to a cyclical low in terms of oil prices and profitability. Underlying profitability is starting to improve as a result of standardisation, efficiencies and technology plus cyclical cost deflation and we believe that return on capital employed (ROCE) will move back to long run average levels. If long term relationships hold true, energy equities will re-rate as ROCE normalises and the Guinness Energy portfolio has in excess of 30% upside if ROCE returns to mid-range levels. Energy sector started to underperform well before the oil price collapsed The oil price is often considered to be the largest driver of energy sector equity performance. While it is obviously a key factor, it is important to note that the energy sector underperformed broad markets for around 3 years from late 2010 until late 2013 despite oil prices remaining stubbornly at around $100/bl. So what caused the energy sector de-rating over this period? The view expressed in this note was that it was because return on capital employed (ROCE) metrics deteriorated. Energy equities de-rating before oil price fall ROCE of Guinness Energy Fund equities Source: Bloomberg, Company Data. Analysis includes all 'full position' holdings in the December 2016 and assumes they were held constant over the period ROCE started to erode relative to the oil price after the 2008 crisis The energy sector's underlying profitability started to fall at the end of the 2008/09 global financial crisis, when the companies increasingly found themselves forced to surrender part of their returns to a combination of Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 7

8 governments, labour and third party service providers. This resulted in the companies requiring an increasingly higher level of oil price to deliver a steady level of ROCE in the subsequent years. Looking back over the whole cycle since 1998, as the next chart shows, the relationship between ROCE and the oil price was remarkably different in two periods: notably between the energy equity 'bull market' of (when energy equities performed strongly) and subsequently the energy equity 'bear market' of (when energy equities performed poorly). The difference between the two periods was that in the 'bear market' period oil companies required a much higher oil price to deliver the same ROCE that they used to deliver in 'bull market'. The chart below clearly shows the sizeable shift in the relationship which was caused by capital and operating cost inflation, tax increases and balance sheets swelling (with low return on capital assets) as the companies invested heavily to deliver future growth. It is quite a thought that, on average, the industry required a $60/bl higher oil price in the period than it did in the period to deliver the same level of ROCE. Large-cap oil companies' ROCE vs oil price ( ) Source: Bloomberg; data set comprises Exxon, Chevron, Hess, Occidental, Murphy, ConocoPhillips, Marathon Oil, BP and Royal Dutch Shell The Guinness Energy portfolio was not immune from this effect, as shown below, with ROCE falling from 18% in 2008 (at a $100/bl oil price) to only 2.7% in 2015 (at a $54/bl oil price). We see reason to believe that underlying profitability has improved in the recent period, however, noting that ROCE fell only 0.6% (to 2.1%) in 2016 despite average oil prices falling a further $9/bl relative to Historic ROCE of the current holdings Source: Bloomberg, company data. Assumes December 2016 fund holdings were constant over the period Not surprisingly, as the ROCE of the Guinness Energy portfolio has fallen through the energy bear market, so has the price/book valuation of the holdings. Indeed, the portfolio displays a strong relationship between ROCE and price/book valuation over time (84% r-squared from 2000 to 2015), as you might expect from a capital-intensive sector. The price/book valuation for 2017E is 1.53x, broadly speaking the lowest level of the entire period. The 15 year historic relationship implies that the Guinness Energy portfolio: is being valued as if it were going to deliver a 5% ROCE into perpetuity; a level which we believe is very conservative for a group of companies that has historically produced an average ROCE of 12%. would benefit in a 0.15x increase in price/book valuation for every 2% increase in ROCE would increase by over 30% if the companies delivered average levels of ROCE again. The total return Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 8

9 upside outlook could be as much as 50% when coupled with retained earnings and dividends generated over the next 2-3 years. Historic ROCE vs P/B of the current Guinness energy strategy* Source: Bloomberg; Company Data But will ROCE really return to 12%? We have conviction that energy sector ROCE will not remain at these depressed levels because we have no reason to believe that energy sector profitability has been structurally impaired. There are four main factors that should help ROCE to recover: 1. Cost deflation from service industry over-capacity, cheaper consumables and lower labour costs 2. Delivery of efficiency gains from use of technology/standardisation 3. Achievement of production from previously unutilised capital employed 4. Pursuit of 'cost cutting' M&A strategies 1. Cost deflation from service industry over-capacity and much lower labour costs It is remarkable how strong the correlation has been between the operating cost of producing a barrel of crude oil and the annual average of the price of crude oil at any one time. For a group of 33 oil-oriented E&P companies that we follow closely, we found a 93% r-squared between the two metrics since Oil prices and costs are tightly correlated but phased; margins peak before oil prices Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 9

10 Source: Bloomberg; Guinness Asset Management As oil prices (and therefore the margins of the producing companies) expand, so do the various factors that impact the cost of supply, such as labour rates, the cost of consumables and service company margins. We see about an eighteen-month lag between oil price movements and production cost movements, such that: in the oil price 'up cycle' operating and capital costs permanently lag rising oil prices and the producers generate sustained excess economic rent and report higher than expected ROCE for any given level of oil price. In the oil price 'down cycle' operating and capital costs are slow to adjust such that the producers are permanently suffering from negative economic rent and reporting lower than expected ROCE for any given level of oil price is a standout year in this correlation as oil prices fell sharply but production costs had not yet fully adjusted. It appears that operating costs were about $3-4/bl higher than they should have been. Reducing operating costs by $3-4/bl would increase current ROCE by around 1%. 2. Delivering efficiency gains from use of technology/standardisation The oil and gas industry has long had to search for hydrocarbons in increasingly hostile regions or reservoir settings. For example, when the oil and gas majors were kicked out of the Middle East in the 1960s, they experimented with offshore drilling and platform construction in order to develop the North Sea and the Gulf of Mexico. The intent to deliver standardised solutions to reduce capital costs, and to use technology to deliver more efficient operations, is ever-present, but the complexity of the challenge has often trumped the intent. With ROCE depressed, we see a greater drive, and therefore likelihood, that efficiency improvements, standardisation and correctly-engineered solutions could be delivered. A reduction of 10% in capital costs and 10% in operating costs would typically increase a project's ROCE by over 2%. The industry has a greater chance now to deliver on these efficiency gains than it has had for the last 15 years. 3. Providing production from unutilised capital employed Higher oil prices between 2003 and 2012 motivated the oil and gas industry to increase investment in new projects to deliver future production growth. According to Bernstein Research, upstream capex rose from under $300bn in 2005 to over $800bn in 2014 as the industry targeted these new projects. These projects are now increasingly in the production phase and this period will continue for another year or two. Prior to starting production, these partly developed projects have the effect of reducing ROCE by inflating the capital employed and then once in production, they improve ROCE by driving the 'net income' line higher. In a previous commentary 'Return of Returns' in June 2014 we highlighted that the negative effects of 'capital enlargement' have reduced sector ROCE by as much as 3%. 4. Pursuing 'cost cutting' M&A strategies Cyclical commodity price troughs generally tempt greater levels of M&A activity as companies acquire cheap companies with the plan to strip out 'duplicate' costs and deliver more profitable growth. The oil and gas industry pursued this strategy with good success in through a number of mega-mergers which created, among other things, the super-majors: Chevron-Texaco, Exxon-Mobil, TOTAL-Fina-Elf and BP-Amoco-Arco. The Super Majors increased ROCE from 7.5% in 1998 to 14.3% in 2001 via a combination of higher oil prices (up $12/bl over the period) and a relentless focus on stripping out costs from their newly acquired entities. At a $40/bl Brent oil price, a typical SG&A cost of $3 per barrel produced is meaningful when net income is only $5 per barrel produced and ROCE is only 2%. Merging with a similar sized peer and stripping out that SG&A and duplicated capital employed has a substantial effect on increasing margins and ROCE. Cost cutting has certainly been a more successful ROCE improvement strategy than growth for larger oil companies over the last decade; we would expect to see this return in the coming years. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 10

11 The combined effect could be ROCE in the 12% range again We think it is not unreasonable to postulate that the combined effect of these would be enough to allow the industry to return to an average level of ROCE generation (per dollar of oil price) as represented in Exhibit 3. If so we could expect to see ROCE in the 10-14% range as the industry fully adjusts to normalised long run oil prices. Implications of these ROCE improvement strategies on energy equities These ROCE estimates would imply that the energy sector is not a long-term value-destroying sector. And as commented above if the long-run relationship between ROCE and price/book valuation were to hold true, then it would imply a price/book valuation for the Guinness energy portfolio of around 2.0x, a 30% uplift to the current level of 1.53x which could be further enhanced by retained earnings and dividends to give an upside of around 50%. If this analysis is correct there is an attractive outlook ahead of recovering energy sector profitability and valuations. We continue to try to position the Guinness Global Energy portfolio in names that offer an attractive combination of ROCE improvement and valuation. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 11

12 3. PERFORMANCE The main index of oil and gas equities, the MSCI World Energy Index, was down 3.0% in January, while the MSCI World Index rose by 2.4%. The Fund was down by 2.5% (class E) in the month, outperforming the MSCI World Energy Index by 0.5% (all in US dollar terms). Within the Fund, January s strongest performers were Statoil, PetroChina, CNOOC, Noble Energy and Halliburton while the weakest performers were ExxonMobil, ENI, BP, Hess and Imperial Oil. Performance (in USD) 31/01/2017 Annualised % returns 1 year 3 years 5 years 10 years 1999 to date Guinness Global Energy MSCI World Energy Index Calendar year % returns Guinness Global Energy MSCI World Energy Index Source: Financial Express, bid to bid, gross income reinvested, in US dollars Calculation by Guinness Asset Management Limited, simulated past performance prior to , launch date of Guinness Global Energy Fund. 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), the Guinness Global Energy Fund class A (1.00% AMC) from launch to , and class E (0.75% AMC) thereafter. 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. 12

13 4. PORTFOLIO Buys/Sells There were no stock switches made during the month. Sector Breakdown The following table shows the asset allocation of the Fund at January 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 2007 for comparative purposes: 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Jan (%) 2007* 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 January was on a price to earnings ratio (P/E) for 2017 of 21.6x versus the S&P 500 Index at 17.4x as set out in the table. (Based on S&P 500 operating earnings per share estimates of $83.8 for 2010, $96.4 for 2011, $96.8 for 2012, $107.3 for 2013, $113.0 for 2014, $100.4 for 2015; $107.3 for 2016 and $113.0 for 2017). This is shown in the following table: P/E S&P 500 P/E Premium (+) / Discount (-) -64% -64% -63% -54% -48% -4% 76% 24% Average oil price (WTI $) $79.5/bbl $95/bbl $94/bbl $98/bbl $93/bbl $49/bbl $43/bbl $53/bbl Source: Standard and Poor s; Guinness Asset Management Ltd Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 13

14 Portfolio holdings Our integrated and similar stock exposure (c.46.7%) is comprised of a mix of mid cap, mid/large cap and large cap stocks. Our five large caps are Exxon, Chevron, BP, Royal Dutch Shell and Total. Mid/large and mid-caps are ENI, Statoil, Hess and OMV. At January the median P/E ratios of this group were 34.0x/16.9x 2016/2017 earnings. We also have two Canadian integrated holdings, Suncor and Imperial Oil. Both companies have significant exposure to oil sands in addition to downstream assets. Our exploration and production holdings (c.35.6%) 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 have a bias towards the US (Newfield, Devon, Carrizo and QEP Resources), with four other names (Apache, Occidental, ConocoPhillips, Noble) having significant international production and one (Tullow) which is African 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 US E&P stocks held also provide exposure to North American natural gas. We have exposure to four (pure) emerging market stocks in the main portfolio, though one is a half-position, and in total represent 11.6% of the portfolio. Two are classified as integrateds (Gazprom and PetroChina) and two as E&P companies (CNOOC 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 3.8x 2017 earnings. PetroChina is one of the world s largest integrated oil and gas companies and has significant growth potential and, alongside CNOOC, enjoys advantages as a Chinese national champion. SOCO International is an E&P company with production in Vietnam. We have useful exposure to oil service stocks, which comprise around 10.7% 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 and Schlumberger). Our independent refining exposure is currently in the US in Valero, the largest of the US refiners. 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 split between across two companies: JA Solar and Sunpower. JA Solar is a Chinese solar cell and module manufacturer whilst Sunpower is a more diversified US solar developer. We see them as well placed to benefit from the expansion in the solar market we expect to continue for a number of years. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 14

15 Portfolio at December 31 st 2016 (for compliance reasons disclosed one month in arrears) 31 December 2016 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 Chevron USD US Royal Dutch Shell PLC EUR NL BP PLC GBP GB Total SA EUR FR ENI SpA EUR IT nm 24.9 Statoil ASA NOK NO Hess Corp USD US nm nm nm OMV AG EUR AT Integrated / Oil & Gas E&P - Canada Suncor Energy Inc CAD CA nm 24.2 Canadian Natural Resources Ltd CAD CA nm 41.2 Imperial Oil CAD CA Integrated Oil & Gas - Emerging market PetroChina Co Ltd HKD HK Gazprom OAO USD RU Oil & Gas E&P Occidental Petroleum Corp USD US nm 51.6 ConocoPhillips USD US nm nm Apache Corp USD US nm nm 48.9 Devon Energy Corp USD US nm 29.8 Noble Energy Inc USD US nm nm QEP Resources Inc USD US 2.44 nm nm nm nm Newfield Exploration Co USD US Carrizo Oil & Gas Inc USD US International E&Ps CNOOC Ltd HKD HK nm 14.8 Tullow Oil PLC GBP GB nm nm Soco International PLC GBP GB nm nm Drilling Unit Corp USD US nm nm Equipment & Services Halliburton Co USD US nm 53.3 Helix Energy Solutions Group Inc USD US nm nm Schlumberger Ltd USD US Solar JA Solar Holdings Co Ltd USD US 0.53 nm 0.7 nm nm nm nm Sunpower Corp USD US nm nm 0.87 Oil & Gas Refining & Marketing Valero Energy Corp USD US 3.66 nm Research Portfolio Cluff Natural Resources PLC GBP GB 0.22 nm nm nm nm nm nm nm nm nm EnQuest PLC GBP GB 0.62 nm JKX Oil & Gas PLC GBP GB nm nm nm Ophir Energy PLC GBP GB 0.05 nm nm nm nm nm 3.6 nm nm nm Shandong Molong Petroleum Machiner HKD HK nm nm nm nm nm nm Sino Gas & Energy Holdings Ltd AUD AU 0.13 nm nm nm nm nm nm 23.0 WesternZagros Resources Ltd CAD CA 0.01 nm nm nm nm nm nm nm nm nm 1.28 Cash 2.44 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. 15

16 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 11 years, together with the IEA forecasts for 2016 and E 2017E World Demand Non-OPEC supply (includes Angola, Ecuador and Indonesia for periods when each country was outside OPEC 1 ) Angola supply adjustment Ecuador supply adjustment Indonesia/Gabon supply adjustment IEA IEA 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 2009; rejoined at 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; : January 2017 Oil market Report Global oil demand in 2015 was 8.0m 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 small and was shrugged off remarkably quickly. The IEA forecast a rise of 1.5m b/day in 2016, which would take oil demand to an all-time high of 96.5m b/day followed by a further rise in 2017 of 1.3m b/day which would take demand to 97.8m b/day. OPEC In December 2011, OPEC-12 introduced a group-wide target of 30m b/day without specifying individual country quotas. The 30m b/day figure included 2.7m b/day for Iraq, so the target for OPEC-11 (excluding Iraq) was 27.3m b/day. At the date of the announcement, and in the period since, OPEC s production has been complicated by numerous issues: notably (1) erratic production from Libya, affected by the ongoing civil war; (2) depressed production in Iran due to western sanctions over its nuclear programme; (3) real difficulty in forecasting how Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 16

17 Iraq might develop. In response to lower Libyan, Iranian and Nigerian production, and to cope with rising global oil demand, the three key swing producers within OPEC (Saudi, Kuwait and UAE) have each raised their production significantly, as the following table shows: ('000 b/day) 31-Dec Nov Dec-16 Change vs Dec 2010 Change vs Nov 2014 Saudi 8,250 9,650 10,480 2, Iran 3,700 2,780 3, Iraq 2,385 3,370 4,610 2,225 1,240 UAE 2,310 2,800 3, Kuwait 2,300 2,790 2, Nigeria 2,220 1,970 1, Venezuela 2,190 2,350 2, Angola 1,700 1,640 1, Libya 1, Algeria 1,260 1,100 1, Qatar Ecuador OPEC-12 29,185 30,241 32,890 3,705 2,649 Source: Bloomberg, DOE The effect from 2011 to the middle of 2014 was OPEC-12 (ex Indonesia) producing at around 30m b/day, plus or minus 1m b/day, in an attempt to keep the global oil market in balance. Since the second half of 2014, we have moved into a period where the global oil balance has become looser, driven principally by surging non-opec supply (+2.4m b/day in 2014 and +1.4m b/day in 2015). The effect of $100+ oil, enjoyed for most of the period, emerged in the form of an acceleration in US shale oil production and an acceleration in the number of large non-opec (ex US) projects reaching production. And as a result, we estimate that the call on OPEC-11 for 2015 was reduced to 25.8m b/day, around 1.6m b/day lower than December 2015 production of 27.4m b/day (according to the IEA). In the graph below we show how the call on OPEC-11 has evolved since 2000 and how the call has increased for 2016 versus 2015, bringing the market into better balance. Figure 7: OPEC-11 apparent production vs call on OPEC Source: IEA Oil Market Report (Sept 2016 and prior); Guinness estimates OPEC-12 met in November 2014, with the growing looseness in the physical market and a falling oil price (in the mid $70s at the time of the meeting) prompting a significant change in strategy to one that prioritised market Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 17

18 share over price. As a result, there was no quota cut, as many had anticipated, and a confirmation that the 30m b/day target would be maintained. Post the November 2014 meeting, OPEC-14 (Indonesia and Gabon joined the group) not only maintained their quota but also raised production significantly, up over 18 months by 2.5m b/day. Iraq recovered its production by 1.2m b/day; Iran by 0.8m b/day post the lifting of sanctions relating to their nuclear programme; and Saudi by 0.9m b/day. In September 2016, OPEC stepped back from their market share stance, announcing plans for the first production cut since 2008, taking overall production to m b/day (representing a cut of m b/day). This announcement became known as the Algiers Accord. The proposal was ratified on 30 th November 2016 when OPEC have opted for a new production limit of 32.5m b/day, representing the first action from the group since November The 'referenced' OPEC production, for October 2016, and used as a starting point for the cuts, was around 33.7m b/day, so the announcement represented a cut of 1.2m b/day (all numbers for OPEC-14 including Gabon). There was also an understanding that non-opec, including Russia, would cut production by 0.6m b/day, which would bring the total reduction to 1.8m b/day - well in excess of most expectations in the lead up to the meeting. The announcement amounts then to a 5% cut for all members except for 1) Libya and Nigeria, recognising their unusually depressed levels of production due to unrest, and 2) Iran, recognising its journey back to normalised production post the lifting of sanctions in January Indonesia has been suspended from the group since, as a net importer of oil, it chose not to participate. The agreed cuts are effective from 1st January 2017, and will be kept in place initially for six months, extendable for another six months depending on how the oil market evolves. Clearly, OPEC economies are under significant stress, which is the near-term driver for the decision to cut. There is also the growing concern that the oil industry will be unable to supply enough in the future, leading to the next oil price spike, though that is probably a secondary concern to OPEC at present. Saudi s actions at the head of OPEC appear designed to achieve an oil price that to some extent closes their fiscal deficit (though $80/bl is needed to close the gap fully), whilst not spiking the oil price too high and overstimulating non-opec supply. Longer term, we believe that Saudi seek a good oil price, well in excess of current levels to balance their fiscal needs, but they realise that patience is required to achieve that goal. Overall, we reiterate two important criteria for Saudi: 1. Saudi is interested in the average price of oil that they get, they have a longer investment horizon than most other market participants 2. Saudi wants to maintain a balance between global oil supply and demand to maintain a price that is acceptable to both producers and consumers Nothing in the market in recent years has changed our view that OPEC have the ability to put a floor under the price as they did in 2008, 2006, 2001 and 1998 and now again in Supply looking forward The non-opec world has, since the 2008 financial crisis, grown its production more meaningfully than in the seven years before The growth was 0.9% p.a. from , increasing to 2.1% p.a. from Growth in the non-opec region over the last 5 years has been dominated by the successful development of shale oil and oil sands in North America (up around 4m b/day between 2010 and 2015), implying that the rest of non- OPEC region grew by only around 0.5m b/day over the period, despite the sustained high oil price until mid Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 18

19 After the strongest year for non-opec production in 2014 (+2.4m b/day) since 1978, non-opec growth in 2015 was also strong, at 1.4m b/day. Whilst the sub-$60 oil environment has caused significant deferral and cancellation of new developments, start-up projects that were sanctioned before the fall in the oil price are still coming to completion, creating this resilience in production. However, the effect of a low oil price impacts more in 2016, when non-opec supply is expected to fall by around 0.8m b/day. Based on current forecasts of higher oil prices next year, the IEA has recently forecast that non-opec supply recovers by 0.4m b/day in Looking further ahead to how global oil supply may evolve in the current oil price environment, we must consider in particular increases in supply from three regions: North America, Iraq and Libya. The growth in US shale oil production, in particular from the Bakken, Permian and Eagleford basins, raises the question of how much more there is to come. New oil production from these sources amounts peaked in April 2015 at around 4m b/day and is now in decline. Our assessment is that US shale oil is a high cost source of oil but one where growth is viable, on average, at $50-70 oil prices. 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, but only if the price is sufficiently high to incentivise growth. The rate of development is heavily dependent on the cashflow available to producing companies, which tends to be recycled immediately into new wells. Naturally, cashflows available for reinvestment in a sub $50 world are far lower than in a $100+ world, so initially slowed the growth rate, then sent production into month on month decline. Indeed, we note that production has declined since the peak by over 1.0m b/day, as of August As for Iraq, the questions of how big an increase is likely, in what timescale, and how other OPEC members react are all important issues. Iraqi production was running at 4.6m b/day in December 2016 (according to Bloomberg), up from 3.7m b/day at the start of However, unrest in the country, strained government finances and a likely slowdown in investment from foreign partners does not fill us with confidence that significant growth beyond here can easily be achieved. With the recovery in Iranian production in 2016, the one country globally that still has the potential for a meaningful rebound is Libya. At its peak, Libya was producing around 1.6m b/day, but civil war since 2012 has reduced production to around m b/day for most of the last four years. If the country is able to re-open its key export facilities (Es Sider, Zawiya, Ras Lanuf and Zuetina), we believe it possible for production to recover by around 0.5m b/day, however any further gains are likely to be muted given the extent of above-ground damage to oil infrastructure that has occurred. The National Minister indicated in January 2017 that he hoped Libyan oil production would reach pre-war levels around Looking longer term, other opportunities to exploit unconventional oil likely exist internationally using techniques established in the US, 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 that demand grew in 2015 by around 1.8m b/day, and expect 2016/2017 growth of 1.5m/1.3m b/day. We see it as logical that demand growth in 2016 would be lower than 2015, since lower oil prices generally stimulate one-off positive demand events. That said, demand growth of anything over 1m b/day in 2016, despite weaker macro-economic factors, would still represent above average growth when compared to the last 5 years. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 19

20 The Guinness Global Energy Report February 2017 The IEA s global demand growth forecast for 2016 comprises an increase in non-oecd demand of 1.2m b/day and 0.3m b/day in OECD demand. The components of this non-oecd demand growth can be summarised as follows: Figure 8: Non-OECD oil demand m b/day Demand Growth e 2017e e 2017e Asia Middle East Latin America FSU Africa Europe Total Source: IEA Oil Market Report (January 2017) Asia has settled down into a steady pattern of growth since 2010, and accounts for the majority of expected growth in 2016 and Historically, China has been the most important component of this growth, but signs are emerging that India is likely to be the greatest contributor in OECD demand in 2016 is forecast to be up slightly, with growth in North America offset by decline in Japan. In the US the sharp fall in gasoline prices since 2014 has stimulated a reversal in improving fuel efficiency, as drivers switch back to purchasing larger vehicles, and a rise in total vehicle miles travelled, as shown in the chart opposite. Total vehicle miles travelled had stalled between 2007 and 2014, after two decades of growth, and are now growing again at a rate of around 3-4% per year. m miles US vehicle miles traveled (12m MAV) The trajectory of global oil demand over the next few years will be a function of global GDP, pace of the consumerisation of developing economies, and price. At current prices, the world oil bill as a percentage of GDP is around 1.5-2%, the lowest level since 1998/99, and a likely stimulant of strong multi-year demand growth. If oil prices return to a higher range (say $75-100/bbl, representing 3-4% of GDP), we probably return to the pattern established over the past 5 years, with a flat to shallow decline picture in the OECD more than offset 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. 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.). We keep a close eye on developments in the new energy vehicle fleet (electric vehicles; hybrids etc), but see nothing that makes a significant dent on the consumption of gasoline and diesel in the next few years. Sales of electric vehicles (pure electric and plug-in hybrid electrics) globally were around 0.4m in 2015, up from 0.3m in Sales of 0.4m electric vehicles represents around 0.4% of total light vehicle sales, and increases EV s share of the world car fleet to 0.1%. We expect to see EV sales accelerate in 2016 to around 0.6m, or 0.6% of total global sales. Even applying an aggressive growth rate to EV sales, we see EVs comprising only around 1% of the global car fleet in Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 20

21 Conclusions about oil The table below summarises our view by showing our oil price forecasts for WTI and Brent in 2016 against their historic levels, and rises/falls in percentage terms that we have seen in the period from 2002 to Figure 9: Average WTI & Brent yearly prices, and changes Oil price (inflation adjusted) Est 12 month MAV WTI Brent Brent/WTI (12m MAV) Brent/WTI y-on-y change (%) 8% 12% 30% 37% 15% 9% 26% -35% 24% 27% -4% 0% -7% -47% -11% 20% Brent/WTI (5yr MAV) We expect oil to trade in a $50-60 range in the near term, supported at the lower end by OPEC. If this price range persists, we expect North American unconventional supply declines to flatten and subsequently deliver some growth. In 2016/17 the likelihood is that the price will fluctuate quite widely but move on an upwards trajectory as accelerating emerging country demand growth and US shale oil growth flattening slowly tightens the global oil supply/ demand balance. The world oil bill at around $50 per barrel would represent 2% of 2015 Global GDP, 42% under the average of the period (3.4%). A return to oil representing 3.4% of GDP implies an oil price of around $85/barrel. We believe that Saudi s long-term objective remains to maintain a good oil price, significantly higher than current levels, that will allow the country to IPO Saudi Aramco during 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 2015 to around 21.2 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 2015, 33% of electricity generation was powered by gas, up from 22% in The big loser here is coal which has consistently given up market share over the past 10 years. Total gas demand in 2015 (including Canadian and Mexican exports) was around 80.9 Bcf/day, up by 3.1 Bcf/day (4.0%) vs 2014 and up 7.2 Bcf/day (10%) vs the 5 year average. The biggest change in 2015 vs 2014 is power generation (+2.9 Bcf/day), with low prices causing an acceleration in coal to gas switching by the electric utility sector. Exports of gas to Mexico (+0.7 Bcf/day) were also up strongly in 2015, as the network of gas pipelines from Texas into Mexico expands. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 21

22 Overall, whilst gas demand in the US has been strong over the past five years, it has been overshadowed 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 85% 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 (a by-product of 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 112 at the end of October 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 79.7 Bcf/day, 22.3 Bcf/day (39%) above the 57.4 Bcf/d peak in 2009 before the rig count collapsed. Figure 10: US natural gas production (Lower 48 States) Supply outlook Source: EIA 914 data (November 2016 published in Jan 2017) 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/Utica, and the decline profile of legacy gas fields. The outlook for US oil production growth has changed significantly over the last 12 months with the decline in the oil price. US onshore oil production peaked in March 2015 and is now declining, which has caused associated gas production to decline, though only a little (there has been a shift to gassier shale oil basins such as the Permian). Generally, we expect to see rates of around 1-2 Bcf/day of associated gas per 1m b/day of oil production. The Marcellus/Utica region, which includes the largest producing gas field in the US and the surrounding region, reached production of around 17 Bcf/day in Further growth is likely over the next couple of years, but only if local price differentials improve from the extreme levels seen in recent months. Then there is an expected decline in legacy gas fields, particularly if the gas drilling rig count stays low. Considering these factors together, we expect US onshore gas production to shift into shallow decline in 2016 (around 0.5 bcf/day) but see potential for a recovery in growth rates (to c.1-2 Bcf/day per annum for the next two or three years) if the price remains in the $2.50-$3.50mcf range. Guinness Asset Management is authorised and regulated by the Financial Conduct Authority. 22