From the October 2007 issue of Research Magazine • Subscribe!

October 1, 2007

On Track

Production growth, acquisitions and other factors are improving results for energy firms despite today's highly complex regulatory environment, analysts say.

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Robert Plexman, CFABC World Markets Inc.416-956-6218Rob.Plexman@cibc.ca

Area of coverage: Oil and gas

Sector outlook: After weakening in the first quarter of 2007, crude benchmark prices recovered sharply in the second quarter of 2007. WTI and Brent prices in were 12 percent and 17 percent higher quarter over quarter, respectively.

The second quarter of 2007 was a quarter of exceptional downstream strength, as reflected in the strength of refining margins. A key refinery crack spread, the NYMEX 3-2-1 spread, averaged $24.37 per barrel in the quarter, nearly double the first quarter 2007 average. Sour processing economics were also favorable, with the U.S. Gulf Coast coking spread averaging $27.21 per barrel in the second quarter.

About Royal Dutch Shell (RDS-A): Royal Dutch Shell reported earnings from operations per ADR of $2.19, and $2.40 on a total reported basis in the second quarter of 2007. The latest results were in line with the consensus outlook but below our estimate. Petroleum products results were better than expected, but our outlook for the upstream was too optimistic.

Combined oil and gas output averaged 3.178 million barrels of oil equivalents per day (boe/d) in the second quarter of 2007. Production guidance for 3.3 million to 3.5 million boe/d for 2007 is unchanged, but management indicates that the actual result will likely be at the lower end of the range.

The company is in the early stages of reestablishing a stronger upstream presence by pursuing opportunities in more technically complex areas such as oil sands and gas-to-liquids. Reliability and the efficiency of the petroleum products operations have improved.

Production growth prospects appear limited over the near term, and there is a risk that legacy assets may suffer from natural decline before the new projects have an impact. In the meantime, a relatively attractive dividend rate of $2.88 per ADR should provide support for the stock, in our view.

Shell has reiterated its 3.3 million to 3.5 million boe/d guidance range for 2007 but indicated that it expects to track the lower end of this range.

Longer term, Shell highlighted that all of its key projects remain on track. Roughly speaking, Royal Dutch expects about 296,000 boe/d of new production to start up over 2007-2008. However, taking natural declines into account, Shell's stated production growth expectation for the 2007-2010 horizon is 1 percent to 2 percent per year and believes that a 2 percent to 3 percent growth rate can be sustained thereafter.

In the upstream, Shell has made four major discoveries in the first half of 2007, two in Australia and one each in Nigeria and Malaysia. The company has continued to increase its acreage in Australia and the United States.

Shell continues to refocus its portfolio, selling non-core assets and building positions in long-life assets and key growth markets. In this vein, Shell decided to sell its interests in several mature northern North Sea assets in the second quarter of 2007. It also completed the sale of the Los Angeles Refinery, the Wilmington Products Terminal and about 250 retail sites in the United States.

In Malaysia, Shell plans to buy Conoco Jet, the wholly owned subsidiary of ConocoPhillips (COP) that will give it access to 44 branded retail service stations and 14 vacant land sites.

Shell's recent $7.1 billion acquisition of its Canadian subsidiary was also in line with this portfolio refocusing strategy. Shell highlighted that with this purchase it has bought about 60.0 billion barrels of reserves in place. The integration of Canadian subsidiary appears to going smoothly, and Shell reiterated its goal for $500 million worth of pre-tax savings from the acquisition.

In the second quarter of 2007, Shell's stake in the Russian Sakhalin project was halved to 27.5 percent for a price $4.1 billion.

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Robert LaneSanders, Morris, Harris Capital713-250-4210mrobert.lane@smhgroup.com

Area of coverage: Natural resource MLPs

Sector outlook: We are still seeing construction of new coal-fired electricity, and we are trying to make coal burn cleaner. One of those processes is the production of synthetic fuels. It's a process that's 60 years old. The success of the process depends on who you are talking to. The firms trying to introduce the process say it's going well.

Coal fuels 50 percent of the nation's electricity generators, and it is the fuel of which the United States has the most reserves. One cloud over the industry has been its safety record. We had the collapse in Utah and Sago in 2006. But the safety record was pretty clean in 2005. The MLP space was severely hit in early August. We had not expected that. The reason for the hit was due to the credit crunch.

About Natural Resource Partners, L.P. (NRP): This firm is unique among both master limited partnerships (MLPs) and coal companies as the only pure coal-royalty play. As such, it provides investors with an opportunity to participate in the commodity price of coal in a tax-advantaged vehicle without being subject to operational, regulatory, or environmental expenses.

While NRP does not have any financial hedges in place to lock in the price of coal, most of its lessees do have long-term contracts that are as effective as hedging in capturing today's high prices for the long term. As coal prices continue to remain high and contract terms continue to lengthen and benefit the producer, the higher realized sales prices should mean higher revenues and earnings for NRP.

The firm owns or controls 2.0 billion tons of coal reserves that it leases to third-party operators, which, in turn, mine the coal and pay NRP a royalty.

Although the partnership does assume some commodity price risk, it avoids or mitigates most of the operational and environmental challenges that most coal companies must manage. The result is that it has one of the highest earnings before interest, taxes, depreciation and amortizations, net margins, and cash flows of not only all coal companies, but of most MLPs as well.

The partnership is actively seeking acquisitions in a number of coal basins. We believe its increased presence in the Illinois Basin, while lowering their overall per-ton royalty rate, will continue to benefit unit holders through increased distributable cash flow.

Natural Resource Partners continues to perform well and make solid acquisitions. We still see liquidity as a potential problem for investors. And while we believe that the recently executed 2-for-1 unit split and the conversion of the remaining NSP units to NRP in November will help, it remains a thinly traded partnership. Nonetheless, we believe it will continue to be a stellar performer. We are maintaining our buy rating and increasing our 12-month price target to $41 per unit from $37 per unit.

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Samuel BrothwellWachovia Capital Markets. LLC212-214-5044msamuel.brothwell@wachovia.com

Area of coverage: Utilities

Sector outlook: With a few exceptions, second-quarter earnings were generally in line to better than expected. Against shaky broader markets, credit concerns, and recession fears, it would seem that this sector's defensive characteristics would kick in at some point, though there remain a number of issues to be concerned about.

KKR and Texas Pacific Group's planned leveraged buyout of TXU Corp. has survived despite escalating concerns over credit. But it should be abundantly clear by now that the fount of private equity money that buoyed sector valuations earlier this year has probably dried up. Australian fund manager Macquarie, which acquired Pittsburgh-based Duquesne Light on May 31, has reportedly suffered a 25 percent drop in one of its big real estate funds. As Montana's flat rejection of Babcock & Brown's bid for Northwestern Corp. has shown, regulators pose another challenge.

With private equity pulling in its horns, the door could open wider for strategic buyers, particularly those from outside the U.S. given their size and currency advantage. Indeed, if the TXU deal were to break, we would expect to see interest from European players, who have consolidated their continent about as far as they can. But here again, regulators could be a major hurdle, and not just at the state level; ownership of nuclear assets could pose a major challenge to any non-U.S. buyout proposal.

The initial fear that sparked the sell off in interest rates several weeks ago may be reversing itself as investors flock to Treasuries. On that note, the relatively defensive nature of the utility sector could kick in as yields become more attractive.

Near term, we expect natural gas to remain under pressure with full storage at this stage of the cycle. At the margin, Japan's nuclear woes will likely drive increased demand for liquefied natural gas, which could slow volumes into the U.S. We also believe that staunch opposition to coal and a sense that the much-heralded nuclear renaissance will take longer and cost more than previously thought will force the U.S. to re-embrace natural gas for power generation. While our core natural gas-exposed names (which includes Questar) will likely trade in sympathy with the commodity, we believe they are well-protected by hedging and are underpinned by long term fundamentals.

About Questar Corp (STR): Questar is an integrated natural gas company with its core operations located in the Rocky Mountains. Through its market resources division, STR conducts gas and oil exploration, production, gathering, energy marketing, trading, and risk management services. STR also provides gas transmission, storage, and distribution services through its regulated services division.

STR's primary value driver is its accelerating production and cash flow from its prolific natural gas reserves in the Rockies. Rocky Mountain natural gas will be increasingly called upon to meet projected U.S. natural gas demand. This should create complementary expansion opportunities for STR's midstream operations. Regulated operations should provide a stable source of earnings to support the dividend.

The second quarter was good with adjusted earnings of $0.68 a unit versus our estimate of $0.58 and the consensus of $0.60. Key drivers for the quarter included strong hedged natural gas realized prices (something that continues to be underappreciated), solid production growth and stronger than expected midstream results, offset by slightly weaker regulated segments.

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Clifton Linton is a Bay Area-based writer specializing in energy.

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