The energy market remains volatile, and we expect it will remain so for some time. Some of the recent developments that we think will have an impact on future market and portfolio performance include the following:

• As of last week the Gulf of Mexico still had 373,000 barrels a day of crude oil shut in from last years' hurricanes, or 25% of normal Gulf production. Shut in natural gas production was approximately 1.6 billion cubic feet, or 16% or normal production. Two refineries remain closed due to the hurricane damage.
  
  The Mineral Management Service projects that 255,000 barrels a day and 400 million cubic feet of gas a day will probably not be restored to production prior to the start of the 2006 hurricane season. The economic cost of the disruption, and the cost of repairs, has been incredible - much higher than originally anticipated.

• Iraqi oil production fell by 8 percent in 2005, with a sharp decline near year's end that left average daily production at half the 3 million barrels envisioned by U.S. officials at the outset of the war in 2003. Instead of steadily increasing production the annual output fell in 2005 to 1.83 million barrels a day, including a sharp decline over the final quarter - capped by a December dip to 1.57 million barrels daily.

• OPEC producer Kuwait's oil reserves are only half those officially stated according to internal Kuwaiti records seen by industry experts last month. The consensus has been that Kuwait holds the world's fourth largest reserves of crude oil.

• U.K. North Sea production continues to decline at a rapid rate according to a recent study by the Royal Bank of Scotland. The Bank reported that the daily average output for oil and gas production in November was down 14 percent compared with a year ago. Oil production fell by 238,000 barrels per day to 1.5 million b/d. U.K. natural gas production is also in decline, and recorded a decline of 14 percent on the year.

• Foreign oil companies accustomed to high tension in Nigeria's oil-rich Niger Delta are being forced to grapple with a new level of violence one industry official called "shocking." Nigeria's oil industry, including pipelines, company offices and a pumping station, has been the target of rebel attacks in the past two weeks. As much as 9 percent of the country's oil production has been interrupted. The country is Africa's leading oil exporter and the fifth-biggest source of US oil imports.

• The extremely cold weather in Russia last month is likely to knock 2% to 4% off Russian oil companies' first quarter estimated crude oil production figures according to analysts at Aton Capital. Temperatures have averaged -40 C in some key production areas, causing power outages, well shutdowns, and postponing maintenance work.

• China 's economy surged 9.9% in 2005, and growth is expected by some experts to accelerate this year. Growth in 2004 was 10.1%, and in 2003 was 10.0% according to official statistics. Some private analysts note that China's economic growth may have been more in the 12-15% range, with the country downplaying the rapid rate of growth for political purposes.
  
  Due to the dynamic nature of the Chinese economy it is less energy efficient per unit of GNP than that of the U.S. - and total energy use most likely expanded at a rate faster than the rate of economic growth. Longer term, this economic growth is very bullish for energy and commodity prices.

• The Reserve Bank of India raised a key short-term interest rate amid higher than expected economic growth. The central bank raised its forecast for economic growth for the fiscal year ending March 31 to 7.5-8.0%. Like China's vibrant economy, this rate of economic growth will add to global demand for energy and commodity supplies.

• OPEC has increased production but has little spare production in reserve, leaving the global oil markets vulnerable to a supply shock. This reserve capacity stands at 1.5 million barrels per day (bpd), almost all of it in Saudi Arabia, compared to between five and six million bpd in 2002. Iraq, Nigeria, Iran, Venezuela, and Kuwait are among the OPEC countries whose current domestic problems are creating concerns in the energy markets. OPEC  supplies 40 percent of the world's crude oil and accounts for 55 percent of world exports.

• The International Energy Agency, adviser to 26 industrialized nations, forecast global crude oil demand would grow at 2.2 percent in 2006, up from 1.3 percent growth in 2005, due to higher demand from China and the U.S. The IEA noted current OPEC spare capacity of less than 1.5 million bpd was "below comfort levels." Total world supply for 2005 stood at 84.1 million bpd, outpacing global demand of 83.3 million bpd according to the IEA. China , the largest consumer after the U.S., will average 7 million barrels a day in 2006, a 5.9 percent increase over last year.

• Petroleos Mexicanos , Mexico 's state oil monopoly, noted that production at its largest oil field was expected to decline in 2006. The decline in Cantarell, the eight largest in the world, will be gradual at first. Total production from Mexico is expected to drop as newly developed fields are unable to make up for the reduced output. Discovered in 1969, Cantarell accounts for nearly 60% of Mexico's production.

• Oil refiners in the U.S. will be subject to the new ultra-low sulfur diesel fuel restrictions starting June 1, 2006. At least 80% of the on-highway diesel fuel must have no more than 15 parts per million (ppm) sulfur content. Current fuel standards allow a sulfur content of up to 500 ppm.
  
  The sulfur acts as a lubricant in the engine, and the new fuel will have 1% less energy content. Some expect operational issues to arise in the transition with the injectors - although others see no issues.
  
  Refinery modifications to meet these reduced sulfur levels are largely on track. With lower quality of crude oils on the market, and the sulfur restrictions, firms like Graham Corporation (GHM) should do well over the next several years. The trick in meeting the EPA guidelines will involve transporting the ultra-low sulfur fuel without contaminating it in pipelines or terminals that have held much higher sulfur fuels and may have residues in those systems (jet fuel can contain 3000 ppm sulfur, for example).
  
  The EPA has concerns that compliance with the low sulfur standard may be difficult or impossible to meet due to transmission and storage contamination issues, and has already extended compliance times. Contaminated fuel may be required to be returned to the refinery for reprocessing. In any event, even without supply issues the new regulations are another factor which will keep diesel fuel prices higher than they otherwise would have been.

• Hermitage Capital's Bill Browder has performed a regression analysis from past oil shocks and used them to calculate what might happen when the supply from an oil-producing country was cut off in six different hypothetical situations today. The fall of the House of Saud, a low probability event, generates a price of $262 a barrel. More realistic is the scenario where Iran declares an oil embargo, which Browder's model indicates could cause oil to rise to $131 a barrel.
  
  Other scenarios include an embargo by Venezuelan President Hugo Chavez ($111 a barrel), civil war in Nigeria ($98 a barrel), unrest and violence in Algeria ($79 a barrel) and additional major attacks on infrastructure by the insurgency in Iraq ($88 a barrel). Even without these events transpiring, a "risk premium" is already built into the current energy markets.