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Energy Wars!

That the International Energy Agency should cite China's growing thirst for oil as surpassing expectations and therefore a prime driver behind rising oil prices should not come as a big surprise. After all this is a country with one and quarter billion people and it is only in the past decade that many of them, particularly in the cities, are increasing their energy use. It is an economy that grew at 9% in 2003 and over the past decade China has often grown even faster. China has now become the world's second largest consumer of crude oil in the world although still far behind the United States who alone consumes 25% of the world's energy supplies.

But with growing demand comes growing concerns. China, who used to be a net exporter of oil, is now like the United States a net importer. So like the United States China now competes for global supply and also like the US has growing energy security concerns. As a result Chinese oil companies are flexing their muscles in securing supplies in the Middle East, Africa and South America. Often in securing supply contracts particularly with Middle Eastern sources it involves exchanges of weapons and technology.

That the world has crossed or nearing the crossing to the downside of conventional sources of energy particularly oil is not in dispute. Numerous studies have demonstrated with global demand increasing by at least 2-3% per year and depletion of current oil fields at an average of 3-5% per year that we will reach a point of crisis at some point in the future (known by some as the Hubbert Peak named after studies by M. King Hubbert in 1956). With no new major discoveries in years that point is estimated to come sometime after 2010. For natural gas that point is somewhat later between 2020 and 2030.

There are of course numerous additional sources of "unconventional" oil such as the Alberta tar sands, the shale fields of Venezuela, natural gas from coal, deep water oil and others. Studies show that reserves here dwarf current known reserves of conventional oil. But given that the cost of production is high and the resources are in difficult to get at places, environmentally sensitive areas and politically sensitive zones, considerably higher prices are required to tap into these large reserves. It is, though, estimated that these non-conventional sources could provide the equivalent of Saudi production by 2030.

Given a world of potential growing shortages plus soaring demand it should come as no surprise that oil prices (and gas prices as well) are climbing. We do keep hearing from some pundits that oil prices should fall as there is still plenty of oil to pump and despite threats from OPEC to cut production the OPEC producers are notorious at breaking quotas. As well Russia is a major non-OPEC producer and has become a swing supplier to the global markets. Finally the price of conventional is now well above the old band and has remained above $30 throughout 2004. Expect this to continue.

But clearly rising oil prices are hitting home. In the US they are paying record prices at the gas pump. The US Administration in an election year can ill afford to have high gas prices becoming a significant issue. But if there is anything that drivers hate is paying are high prices to fill up their SUV's. We can only say "get used to it". It's going even higher. Still that has not stopped the US Administration from trying to fill the ears of in particular the Saudi's and its possible negative effect on the upcoming election.

Some have suggested that the current high oil prices are a direct result or "blowback" because of US policy. The US is a nation with huge trade and current account deficits and as such is in effect transferring its wealth to other nations. But oil imports make up a portion of this deficit as the US imports roughly 54% of its oil of which about ¼ of that comes from the Persian Gulf. But with the fall of the US$ foreign producers would in fact be getting less then they were previously if prices had remained in the mid twenties as per the earlier band. As a result it is possible that the current price is reflecting a re-pegging of oil prices with the Euro without actually pricing it in Euros.

As well there is the political "blowback" of the ongoing problems in Iraq and the Israeli/Palestinian war. It has been suggested that the higher prices led by OPEC reflect their displeasure and it is meant to punish the US Administration in the year of an election. What a lot of this has done though is lead to suggestions that this might be a time for a new oil pricing mechanism. This was suggested in a recently issued report of FirstEnergy Capital Corp.

Paul Michael Wihbey, President of GWEST (Global Water & Energy Strategy Team) writing for FirstEnergy noted that "It is now time to recognize we are living in a new world after the fall of the Soviet Union and especially 9/11". Whibey's case explains that geopolitical factors have helped drive up the price of oil over the past few years. The war in Iraq and instability and threats from Hugo Chavez in Venezuela that if the US threatens the country they would cut US exports (Venezuela is, for the US, their fourth largest oil importer of approximately 1.2 million barrels per day). There is also the ongoing "palace intrigue in the House of Saud".

There is clear tension with America's former ally. Saudi diplomats have been expelled from the US and now US diplomats are being ordered to leave. There is tension on the northern borders with Iraq where Shia's are sympathetic to the plight of Shia's in Iraq. They want political and economic concessions from Riyadh. There is tension amongst competing Princes in the House of Saud; reformists are seeking major changes in Saudi and have approached the US for assistance; tension in some of the provinces; and potential threats of attacks on the Saudi oil fields and the potential for attempted coup d'etats. The US has apparently military contingency plans to intervene if necessary.

One area of tension that is not as noticeable is all along the borders with Russia. There are now US bases in numerous former Soviet satellite states such as Kazakhstan and especially Georgia. While ostensibly there because of the war on terrorism is important to keep in mind that all are interconnected with the huge Caspian oil reserves and where Georgia is at the centre of pipeline conflicts. The jailing of Yukos chief Mikhail Khodokovsky was a move by the Putin government to re-gain control over Russian oil interests after the Yukos chief was becoming too cosy with American interests. Russia is looking to re-establish some semblance of control over it former interests and could at some point come in conflict with US interests in the region.

Out of all of the instability there is an opportunity according to Wihbey for Canada and the US to set a new non-OPEC pricing mechanism to ensure pricing stability and security of supply. Higher prices are clearly needed to allow producers to develop the higher cost development of areas such as the Alberta oil sands, frontier natural gas and offshore deep water oil. Consumers would have to understand the reasons for this if there was to be acceptance. Polls have shown that upwards of 46% if Americans would pay more for gas if it came from a reliable source and ally such as Canada. Even more would come on board if there was a proper political debate.

Studies have shown that oil and gas stocks remain cheap relative to their cash flows. Many of the stocks are in strong up trends and with higher prices would move considerably higher. Charts are showing that a number of the large producers have broken out to new highs. Oddly many of the junior producers remain in corrective modes but the chart signals remain positive. These technical characteristics are prevalent in the stock picks listed below courtesy of our man in the Calgary oil patch "Crude Ken".

We remain very positive on the oil and gas sector and view corrections as buying opportunities. Dwindling global supplies of conventional oil, slow development and acceptance of alternative forms of energy, high costs needed to tap into unconventional sources and instability on the geopolitical front that will ensure that energy wars remain at the forefront well into the 21st century. Stocks in the sector should continue to be a major part of portfolios. "Crude Ken's" picks are listed below.

Crude Ken's picks Symbol/Exchange Internet/Phone
Large Caps
Suncor Energy Inc. SU/TSX www.suncor.com, 403-269-8151
Canadian Natural Resources Ltd. CNQ/TSX www.cnrl.com, 403-517-7345
EnCana Corp. ECA/TSX www.encana.com, 403-645-2000
Small Caps
High Point Resources Inc. HPR/TSX www.highpointres.com, 403-264-2487
Niko Resources Ltd. NKO/TSX www.nikoresources.com, 403-262-1020
Ketch Resources Ltd. KER/TSX www.ketchresources.com, 403-213-3111
StarPoint Energy Ltd. SPN/TSX 403-268-7800
NuVista Energy Ltd. NVA/TSX www.nuvistaenergy.com, 403-213-4300
US Stocks
Devon Energy Corp. DVN/AMEX www.dvn.com, 405-235-3611
Burlington Resources BR/NYSE www.br-inc.com, 713-624-9500
Apache Corp. APA/NYSE www.apachecorp.com, 713-296-6000
EOG Resources Inc. EOG/NYSE www.eogresources.com, 713-651-7000
Pogo Producing PPP/NYSE www.pogoproducing.com, 713-297-5000
Service Companies
Precision Drilling Corp. PD/TSX www.precisiondrilling.com, 403-716-4517
Trican Well Service Ltd. TCW/TSX www.trican.ca, 403-266-0202
Pason Systems Inc. PSI/TSX www.pason.com, 403-301-3401

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