Petrocapita Energy Update

January 2010

1
Summary

Barclays Capital recently stated “We expect 2010

to be a year of transition between the [oil] demand
concerns of 2009 and the supply concerns of 2011,
with geopolitical developments having a heightened
importance.” The last 24 months have pushed the
question of oil supply out of the limelight, while of
course the underlying issues remain unchanged and
perhaps magnified by the financial crisis.

At the heart of the matter is the fact that we live in a

peak oil world. No resource is infinite and conven-
tional oil supply is clearly demonstrating characteris-
tics of peaking production.

A recent survey paper from the UKERC found that:

CONTENTS
– The global average decline rate of post-peak 3 How does US Plan to Import 10 Million
fields is at least 6.5%/year and the corresponding BOPD with a Devalued Currency?
decline rate of all currently producing fields is at 3 Peak Oil as Predicted by the IEA
least 4%/year. This implies that approximately 3
mb/day of capacity must be added each year 3 China Oil Demand Thought Experiment
just to maintain production at current levels – 4 Quick Energy Facts
equivalent to a new Saudi Arabia coming on-
stream every 3 years. An additional 1 mb/day
must be added to meet demand growth.
– More than two thirds of existing capacity must
be replaced by 2030 solely to prevent production
from falling.
– A peak in conventional oil production before 2030
appears likely and there is a significant risk of a
peak before 2020. For example, a 2008 report
by The UK Industry Taskforce on Peak Oil and
Energy Security warned that a “peak in cheap,
easily available oil production” was likely by 2013.

1
Summary (continued)

To follow on the peak oil pricing model contained in

the last Energy Briefing, we have produced another
model which attempts to calculate the effect of
the transition to a middle class standard of living in
China will have on the global energy markets. Once
again, the purpose of this exercise was not to make
highly accurate predictions but rather to gain some
insight into the potential magnitude of changes given
fairly conservative production, demand and decline
assumptions.

The key assumptions are that China moves from

its current energy consumption levels (around 2.5
barrel per capita per year) to levels more closely
resembling South Korea (17 barrels per capita per
year). The projection period we used was 30 years,
which is longer than it took South Korea to make
this transition. The effect of this change on global
demand is quite dramatic. It would be necessary
to replace 26 million BOPD production by 2020 to
maintain supply (about 30% of current production
levels and almost 3 times Saudi Arabia output). Total
daily production will have to raise 22% from 84 million
BOPD to 102 million BOPD.

2
Energy Update
HOW DOES US PLAN TO IMPORT 10 MILLION
BOPD WITH A DEVALUED CURRENCY?
The US currently imports over 10 million bopd.  The
US government and Fed are clearly on the track to
substantially debasing the dollar.  The US has no
credible way to pay the on and off-balance sheet
liabilities that it has accumulated to date – without
even beginning to pay the massive future liabilities
of the social programs for boomers.   The US will
default on its debt via the printing press. The question
then becomes how its manages to maintain a way
of life that requires the import of 10 million bopd
from foreigners who may not be in a mood to accept
worthless US fiat in exchange or at the very least the
price of oil in USD terms will be astronomical.
PEAK OIL AS PREDICTED BY THE IEA
In 2009 The Guardian (UK) published a story about 2
whistleblowers from the International Energy Agency
(“IEA”). One of these sources, still with the IEA, said
“The IEA in 2005 was predicting oil supplies could
rise as high as 120 million barrels a day by 2030
although it was forced to reduce this gradually to
116m and then 105m last year [2008]. The 120m
figure always was nonsense but even today’s number
is much higher than can be justified and the IEA
knows this. Many inside the organization believe that
maintaining oil supplies at even 90m to 95m barrels
a day would be impossible but there are fears that
panic could spread on the financial markets if the
figures were brought down further.”
Christophe de Margerie, CEO of France’s national
oil company Total SA has issued a number of
predictions about world oil supply constraints. In
2007, he stated “production of 100 million barrels
a day will be difficult.” In 2008, he stated “world oil
production would peak at or below 95 million barrels
per day,” and later that “world oil production may
plateau below 90 million barrels per day.”
As the IEA has been warning for years, given current
tighter supply/demand balance and increasing
decline rates, a reduction in upstream oil investment
inevitably causes an oil supply problem later. IEA
Director Nobuo Tanaka stated that “Sustained
investment is needed mainly to combat the decline
in output at existing fields, which will drop by almost
2/3 by 2030.” Tanaka recently predicted that global
upstream spending had dropped $90 billion, or 19%,
during 2009 vs. 2008—the first decline in a decade.
The effects of a capex reduction will be compounded
by the production and decline limits that are being
seen in an increasing number of countries worldwide.
CHINA OIL DEMAND THOUGHT EXPERIMENT
As a thought experiment we modeled the effect
of China moving from its current energy world oil
consumption levels (around 2.5 barrel per capita per
year) to levels more closely resembling South Korea
(17 barrels per capita per year). The projection period
we used was 30 years, which is longer than it took
South Korea to make this transition. The effect of this
change of global demand is quite startling. Assuming
a modest level of decline in existing global production,
it would be necessary be replace 26 million BOPD
production to maintain supply (about 30% of current
production levels and 3 times Saudi Arabia output).
Total daily production will have to raise 22% from 84
million BOPD to 102 million BOPD.
3
Energy Update (continued)

CHART 1: CAPACITY ADDITION NEEDED QUICK ENERGY FACTS

BY 2015 Shale Gas: For more than a decade the US
Congress has exempted the oil industry from a
120 Natural
World Oil Demand Fields Gas Yet to Find federal law protecting drinking water. In particular that
Million Barrels per Day

Under Liquids
110 Appraisal the law should not be applied to hydraulic fracturing,
Smaller Fields/
100 Upgrades the process that is essential to extracting the US’
natural gas reserves – particularly shale gas. In 2005
90 Congress passed a law prohibiting such regulation.
80
Projects
(>10,000bd)
Now the US Congress is revisiting the exemption
and has asked the EPA to undertake a review of
70 Existing Production Capacity
how hydraulic fracturing may affect drinking water
(6% decline per annum)
60 supplies. The EPA itself has expressed “serious
reservations” about allowing shale gas drilling in
50
2006 2008 2010 2012 watersheds. If the EPA were to decide to remove the
Source: Cambridge Energy Associates hydraulic fracturing exemption what effect will it have
on shale gas drilling and the current abundant North
American natural gas supplies?

Click Here for Link to the Login Page for the China’s Oil Consumption: China recently surpassed
China Oil Demand Calculator the Germany and Japan in terms of total oil
consumption and now buys more of Saudi Arabia’s
oil exports than the US.

Barclays Capital: “We expect 2010 to be a year of

transition between the [oil] demand concerns of 2009
and the supply concerns of 2011, with geopolitical
developments having a heightened importance.”

4
Petrocapita Macro Update
January 2010
Summary

DEMOGRAPHICS ARE DESTINY

The 19th century belonged to the UK, the 20th century belonged to
the US and it appears that the 21st century may belong to China.
A consistent theme in the emergence of a new global power is a
young population with a large and growing pool of domestic savings
and a focus on investing in the capital base of the economy rather
than consumption. The world’s western economies find themselves
heavily in debt with deteriorating demographics (our populations are
aging and our birth rates are low) and economies skewed towards
consumption. We are accruing ever-greater liabilities to cover vast
social, medical and retirement programs that we currently do not
have the workers or more importantly the high growth economies
to pay for. It has been said that “demographics are destiny’.
Unfortunately, rather than face these issues, our governments
are attempting to fix our manifest problems by accelerating the CONTENTS
consumption friendly policies that were largely responsible for M1 Demographics Are Destiny
getting us into this situation in the first place. As an example of M3 Forty Percent of US Corporate
this, the US Federal funding gap is growing rapidly. Over the last six Profits From Finance!
years: M4 America’s Current Export –
Inflation
– unfunded obligations increased approximately 50% from US$79 M4 How Can this End Well?
trillion to US$114.7 trillion; but M4 ZIRP and Commodity Prices –
– revenue rose approximately 12%. Is There A Link?
M5 Money Velocity Increasing
The US government is now in the position of increasing its liabilities M6 Interest on US Debt
four times faster than its tax receipts. This is a trend being repeated M6 US Residential Housing Sector
throughout the developed world. The US Federal Reserve recently – Losses Now Nationalized?
disclosed that it purchased half of the newly issued US Treasuries M7 Private Sector Growth is
in the second quarter of 2009 – all of which would have been Absent in the US
purchased with newly created money – direct debt monetization. M7 US Bailout Cost
M7 Equity and House Price
Investors must be alive to the growing divergence between the Declines – Over?
economies of the west and those in the emerging world and M7 Government Fiscal Deficits Will
position themselves accordingly. We believe that the way to benefit Continue to Worsen
from long-term Chinese growth is to invest in what China needs M8 Top 10 Points for Canadian
in politically stable parts of the world. That gives you the best of Limited Partnership Investors
M9 Quick News Review

M1
both options – first world political risk and transparency combined
with emerging world growth rates. Clearly a category that fits this
description is commodity investment in western Canada
– Agriculture
– Energy

And to a lesser degree commodity linked investment in western

Canada:
– Businesses that service the commodity sector
– Businesses and sectors that benefit from general population/
economic growth in Western Canada

M2
Global Macro Update
FORTY PERCENT OF US CORPORATE PROFITS
FROM FINANCE!
Given the rapid reflation of the prices of speculative
assets and the collapse of risk premiums, the
ongoing money printing efforts in the developed
world are having limited effect outside of the “finance
economy”. It is estimated that up to 40% of US
corporate profits are generated by the finance sector
– largely from speculative activities. Corporate profits
attributable to the finance sector were effectively
stable until the 1970s when the growth in the US
money supply turned sharply higher on a sustained
basis. Given the finance sector’s intimate relationship
with the US Federal Government and the Federal
Reserve banking system it is not surprising that the
newly printed money has flowed into and through
the finance sector acting as a wholesale subsidy
that drove corporate profits, compensation and
speculation.
QUICK FACTS
China
GDP: $4.3 trillion – increased a total of 430% in last
10 years
20% percent of economy in state sector
Consumer demand is 35 per cent of GDP
Savings rate is 40 percent of household disposable
income (one of the highest in the world)
Despite widespread belief to the contrary,
government intervention into broad swathes of the
economy to support “too big to fail” companies
or more accurately to prevent capital destroying
business activity from being eliminated to the benefit
of the entire economy is not a positive for future
growth. There is an economic truism that whatever
you subsidize you get more of – hence by subsidizing
failure we are ensuring bigger failures in the future
and worst of all penalizing well run businesses. The
firms that were prudently managed leading up to the
crisis should have benefited from the demise of their
poorly run competitors – in a free economy capital
would have flowed to the profitable businesses rather
than the loss making ones. The fact that this didn’t
happen creates a perverse “if you can’t beat’em,
join’em” mentality with respect to risky and imprudent
business practices.
US
GDP: $14.2 trillion - increased a total of 18% (real
terms) in last 10 years and added ZERO private
sector jobs
30% percent of economy in state sector
Consumer demand is 70 per cent of GDP
Savings rate is 6 percent of household disposable
income
M3
Global Macro Update (continued)

AMERICA’S CURRENT EXPORT – INFLATION

CHART 2: CRB SPOT INDEX (1967 = 100)
The US zero-interest rate policy (“ZIRP”) has lead to
sustained efforts to cause currency devaluations on 550

the part of its trading partners. The idea is that if they 500

weaken their currencies, domestic producers will be 450

able to maintain market share in the US. The net 400

result is that the US is effectively exporting inflation to 350

its global trading partners. 300

250

200
HOW CAN THIS END WELL? 150

100
Often a picture is worth a thousand words…
50
1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

CHART 1: FEDERAL SURPLUS OR DEFICIT Source: Commodity Research Bureau

(USD$ BILLIONS)
400,000

200,000 CHART 3: 2009 CRB INDEX CONSTITUENT

0

-200,000
RETURNS
(Millions of Dollars)

-400,000
Wheat -11.46%
-600,000 Nat Gas -0.89%
Live Cattle 0.15%
-800,000
Corn 1.72%
-1,000,000 Soybeans 6.97%
Lean Hogs 7.84%
-1,200,000 Coffee 21%
Gold 22.91%
-1,400,000 Cocoa 23.41%
-1,600,000 Aluminium 44.81%
1895 1910 1925 1940 1955 1970 1985 2000 2015
Silver 48.5%
Heating Oil 50.73%
Cotton 54.22%
Source: St. Louis Federal Reserve, White House – Office of Nickel 58.33%
Crude 77.94%
Management and Budget (shaded areas indicate recessions) Orange Juice 88.25%
RBOB 102%
Sugar 128.19%
Copper 138.38%
-30 0 30 60 90 120 150

Source: Reuters
ZIRP AND COMMODITY PRICES – IS THERE A
LINK?

The CRB Index of 19 raw materials increased 23 The rebound in commodity prices was lead by oil
percent in 2009 as can be seen in Chart 2 – this copper and sugar (see Chart 3) as China’s demand
represents the largest annual increase since 1979 – continued to grow even in the face of the global
the last period of highly inflationary monetary policy. recession.

M4
Global Macro Update (continued)

Interestingly, the rebound in the CRB index is mirrored increasing after it started falling in the first quarter
by another powerful upward surge in US base money of 2007 - six quarters before economic growth
supply (M0) after its initial doubling in late 2008, early slumped. The recent increase in MZM velocity may
2009. point to increased economic activity, the question
then becomes whether it will be sustained as can be
MONEY VELOCITY INCREASING seen in the capacity utilization numbers.

For those who are adherents of the money velocity

theory of economic activity, the velocity of MZM is CHART 6: MZM VELOCITY (DARK BLUE)
V. US GDP % GROWTH (LIGHT BLUE)

CHART 4: US M0 (US$ BILLIONS) 2.4 10.0%

GDP Growth current terms

8.0%
2.2
6.0%
MZM Velocity

2,400
2.0 4.0%
2,000
2.0%
1,600 1.8
(Billions of Dollars)

0.0%
1,200
1.6 -2.0%
800
1.4 -4.0%
400
Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09
0

-400
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source: St. Louis Federal Reserve

Source: St. Louis Federal Reserve (shaded areas indicate

recessions) CHART 7: ESTIMATED US INTEREST
PAYMENTS
CHART 5: CAPACITY UTILIZATION (PERCENT OF
CAPACITY) $800 in billions
90 700

85
600
(Percent of Capacity)

500
80
400
75
300
70
200
65
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2010 2019
Source: St. Louis Federal Reserve (shaded areas indicate Source: GAO
recessions)

M5
Global Macro Update (continued)

Further increases in this velocity are considered
by many as an essential precursor for sustained
economic growth.
INTEREST ON US DEBT
More than half of the $9 trillion in debt the US Federal
government is expected to build up over the next
decade will be incurred to pay interest charges -
US$4.8 trillion.
In 2015 $533 billion in interest payments will be
equal to a third of the federal income taxes expected
to be paid that year – obviously a dangerous trend
given that longer term interest rates can be expected
increase from their currently historically low levels.
The other issue for the US is that the duration of
its borrowing is rather short – in simple terms that
means the US federal government must constantly
refinances its existing debt in addition to borrowing
more to fund ongoing deficits. The magnitude of this
issue is shown in that the US Treasury estimated
in November 2009 that “approximately 40 percent
of the debt will need to be refinanced in less than
one year.” This shortened duration leaves the US
quickly exposed to any increases in borrowing costs
demanded by the markets.
Treasury department’s recent announcement that it
will provide unlimited backing to Freddie Mae and
Fannie Mac these two organizations now underwrite
almost 80% of all new mortgage lending in the US
– de facto nationalizing of the market, a market that
represents:
– $14.6 trillion in total U.S. mortgage debt
outstanding
– $8.9 trillion in total U.S. mortgage-related
securities.
– $7.5 trillion in pooled mortgages, of which about
$5 trillion is securitized or guaranteed by Freddie
Mae, Fannie Mac or FHA
Charts 8 & 9 show that while most mortgage lenders
have been withdrawing from the US residential
housing market, Freddie and Fannie loan books are
exploding.
CHART 8: REAL ESTATE LOAN AT COMMERCIAL
BANKS (US$ BILLIONS)
4,000
3,600
3,200
(Billions of Dollars)

2,800
2,400
2,000
1,600
US RESIDENTIAL HOUSING SECTOR – LOSSES 1,200
NOW NATIONALIZED? 800
400
0
The US automobile industry has been nationalized, -400
the banking sector has been nationalized, medical 1940 1950 1960 1970 1980 1990 2000 2010

care has been nationalized and now the residential Source: St. Louis Federal Reserve (shaded areas indicate
housing sector has been nationalized. With the recessions)

M6
Global Macro Update (continued)

EQUITY AND HOUSE PRICE DECLINES – OVER?

CHART 9: TOTAL FEDERAL GOVERNMENT AND
SALLIE MAE CONSUMER LOANS Research (Aftermath of Financial Crisis, Reinhart and
(US$ BILLIONS) Rogoff, 2008) shows that the average real decline
in equity and house prices following a banking
200
180
crisis is 56% and 35% over 3.4 years and 6 years
(Billions of Dollars)

160 respectively. If this historical average holds, and

140
120 arguably the current crisis far exceeds virtually all the
100
80
others over the past 100 years, then both house and
60 equity prices will fall much farther in real terms.
40
20
0
-20 GOVERNMENT FISCAL DEFICITS WILL
1975 1980 1985 1990 1995 2000 2005 2010
CONTINUE TO WORSEN
Source: St. Louis Federal Reserve (shaded areas indicate
recessions) Research shows that even with the current dramatic
deterioration in G7 government finances we can
expect worse to come (Aftermath of Financial Crisis,
PRIVATE SECTOR GROWTH IS ABSENT IN THE US Reinhart and Rogoff, 2008). Over the course of the
typical banking crisis government debt levels rise an
Private sector has actually shed jobs in the
last decade and generated very little in inflation
adjusted GDP growth – hence the nagging feeling CHART 10: US JOB GROWTH BY DECADE
in the middle class that they are not getting ahead.
Unfortunately the same cannot be said for the US % change in
gross domestic
% change in
household net

government that continues to grow relentlessly. product

By decade,
worth
By decade,
38% inflation adjusted inflation adjusted

1940s 72.0% unavailable

US BAILOUT COST 1960s 53.1% 44%

1970s 38.1% 28%

Despite the varied and often conflicting reports 1950s

1980s
51.3% unavailable
34.9% 42%
about the total cost of the US bailouts – when all 1990s 38.6% 58%
the programs are taken into account the cost is
approximately US$14 trillion. Given the pre-bailout 0%
money supply of the US was around US$ 15 trillion 0 2000s 17.8% -4%
Year in Decade
this represents a truly staggering amount of money. 1 2 3 4 5 6 7 8 9 10

Source: Washington Post

M7
Global Macro Update (continued)
average of 86 percent in the three years following.
The buildup in government debt has been a defining
characteristic of the aftermath of banking crises for
over a century. The question that will inevitably
arise is that if investment demand is not present
for the huge debt issuances that this will entail, will
the worlds central banks revert to monetizing their
governments’ debts – or in simple terms printing the
money.
TOP 10 POINTS FOR CANADIAN LIMITED
PARTNERSHIP INVESTORS
Investors in private limited partnerships are faced
with a wide range of offerings – from classic private
equity vehicles to real estate development projects.
Here are some simple criteria to help you make your
decisions about what private LPs to consider for their
RRSP portfolio this year.
1. Experienced management team – A significant
number of investment teams have NO experience
in fund management or even in the sector in
which they are investing your capital. Work
with teams that have a track record at both
the investment management level and at the
operational level – there is NO substitute for
a track record of successful investment and
operation in the business area by the team you
are trusting to act on your behalf.
2. Clear investment premise – The investment
premise should be based on sound fundamental
analysis that is simple to understand and clearly
laid out in the presentation. Avoid momentum-
based investments where the core rationale is
effectively that “everyone else is doing it”. To
quote Sir John Templeton - “It is impossible to
produce a superior performance unless you do
something different from the majority...”
3. Tax efficient structure – Tax can have a major
effect on your returns. Make sure that all
reasonable and credible steps have been
taken by the management team to manage tax
obligations.
4. Audited financial statements – Management must
provide annual audited financial statements. A
past failure to do so should act as a red flag.
5. Regular operational reporting – Management
must be open and available to answer your
questions about the business.
6. Clearly defined hold period – Make sure that
the hold period is clearly defined and cannot
be arbitrarily changed or extended by the
management team. You need to know how long
your investment will be committed and exactly
when you can expect repayment.
7. No non-arms length transactions – Situation
where the management team acquires the target
assets first and then sells them to the fund for
an upfront profit. Even if disclosed in the offering
documents this is a poor practice and creates
a mismatch between the economic interests of
the management team and the interests of the
investors.
8. No acquisition fees - Fees where the
management team gets paid a portion of all
capital deployed. This creates a mismatch
between the economic interests of the
management team and the interests of the
investors, as acquisition fees are not tied to
returns.
9. No fee escalation – Management fees should not
be tied to appraised or calculated asset value that
is an unrealized gain. The only valuations that
matter are the purchase price and the sale price.
M8
Global Macro Update (continued)
Management should receive the bulk of their
fees based on gains that are actually realized for
investors.
10. Incentives reward ACHEIVED performance –
Favor investments where the manager makes
the bulk of his return only when you make a
return. This fee structure is commonly referred
to as “success based”. Lifts, acquisition fees,
escalating annual management fees are not
success based.
QUICK NEWS REVIEW
Venezuela Devalues: “Shouting “buy, buy, the world
is going to die,” Venezuelans went on a frantic
shopping spree on Saturday following a sharp
currency devaluation that is expected to drive up
prices. President Hugo Chavez announced a dual
system for the fixed rate Bolivar Friday night while
much of the country was watching a baseball game.
“I’ve been lining up for two hours outside to buy a
television and two speakers because by Monday
everything is bound to be double the current price,”
said Miguel Gonzalez, a 56-year-old engineer
standing in the tropical sun outside a popular
store. The government acknowledges prices will
rise after the devaluation, but say the upward trend
will be more gradual. State run television and radio
stations avoided using the word “devaluation,”
preferring the word “adjustment.” One pro-Chavez
radio station responded to critics of the measure by
playing a popular Argentine song called “Imbecile.”
With oil crowding out other sectors of the economy,
Venezuela heavily relies on imports for consumer
goods, leaving it subject to big price swings
depending on the exchange rate. Older Venezuelans
are accustomed to sharp losses in the value of their
money, with numerous devaluations and currency
regimes over the last three decades of economic
turmoil. Inflation, the highest in the Americas, at
25 percent last year, reached 103 percent in 1996
after a previous president lifted exchange and price
controls. Chavez’s high-spending policies during an
oil bonanza fueled a massive consumer boom and
fast growth that shuddered to a halt when oil prices
plunged a year ago. The sharp drop in oil revenues
also undermined the Bolivar and made a devaluation
inevitable at some point.” Source: Reuters Jan 2010
M9
 DISCLAIMER:

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contained herein are provided as of the date hereof and are subject to
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