From the October 2008 issue of Research Magazine • Subscribe!

October 1, 2008

Significant Value

Commodity prices may shift in the short term, but the long-term demand outlook for energy and new deals are steadily propelling the sector in positive ways, analysts say.

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Jason GammelMacquarie Capital (USA) 212-231-2633Jason.gammel@macquarie.com

Energy Sector: Despite a recent pullback, natural gas prices in the U.S. have been resilient over the course of 2008. In fact, although the 12-month natural gas strip has declined by about US$1/mcf over the last two weeks (US$11.99/mcf vs. US$12.98/mcf on 3 July), the same strip is up 48 percent in 2008. We expect that storage volumes moving into winter will be about 3.4tcf, which indicates a supply/demand balance that will remain bullish for the remainder of 2008, and sets up for reasonable fundamentals for 2009, obviously dependent on winter weather conditions. We are increasing our natural gas price forecast for 2008 to US$10.60/mcf from US$9.50/mcf and for 2009 to US$9.50/mcf from US$8.75/mcf.

Macquarie is raising our oil price assumptions as well. Our WTI (West Texas Intermediate) price rises to US$119/bbl from US$102/bbl in 2008 and to US$103/bbl from US$90/bbl in 2009.

We are raising our EPS estimates for the integrated oil and E&P sectors to incorporate these new price forecasts. Our EPS estimates for the integrated oil sector increase by 14 percent in 2008 and 14 percent in 2009 on a market capitalization-weighted basis. Our EPS estimates for the integrated oil group is 10 percent above the consensus in 2008 and 4 percent above the consensus in 2009.

The E&P companies have more leverage to the commodity price environment, particularly for natural gas, and our EPS estimates thus increase at a greater rate.

We are raising our 2008 EPS estimates by 17 percent and our 2009 EPS estimates by 19 percent. Our estimates are 11 percent above the consensus in 2008, but 2 percent below the consensus in 2009.

Our target prices are based on a discounted cash flow methodology. The higher cash flows that will be achieved in the higher commodity price environment we now envisage through 2011 are being incorporated into our target prices. Our integrated oil target prices increase by 6 percent on average, and our E&P target prices increase by 5 percent on average.

The integrated oil target movement is larger due to the longer-term changes in the oil price forecast in 2010 and 2011; the integrated oil companies have more leverage to oil prices. Our natural gas price forecasts beyond 2009 remain unchanged.

We are still all-in on the integrated oil stocks, which we find compelling from a valuation standpoint. On average, the integrated oil stocks have 37 percent upside to our target prices, with a very favorable risk/reward ratio of -10 percent/+67 percent. We rate all of the integrated oil stocks Outperform, with Chevron our top pick.

We are still all-in on the integrated oil stocks. We have been calculating the implied oil price being discounted in these stocks since 1985, and currently estimate that US$46/bbl is being discounted into the longer-term earnings and cash flow of these companies, versus our long-term assumption of US$60/bbl.

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

Royal Dutch Shell: The Royal Dutch/Shell Group has operations focused on E&P, gas & power, oil products, chemicals, and renewables. Royal Dutch Petroleum has a 60 percent interest in the Royal Dutch/Shell Group of companies.

Q2/08 Results Look Better On Second Glance: RDS reported Q2/08 earnings were $2.56 per ADR. However, adjusted for special items as well as abnormally high mark- to-market charges on derivative contracts, we calculate that earnings were $2.78, which is close to our $2.83 estimate but below the $2.87 consensus forecast.

Combined oil and gas production in the latest period was 3.126 million Boe/d, which is a year/year decline of 2 percent. Approximately 200,000 Bbls/d of Nigerian production was shut in because of the ongoing turmoil, and about the same volume has been shut in during July.

The company has announced that capital spending in 2008 will increase, from $26-$27 billion, to $35-$36 billion. The increase mostly represents the inclusion of the Duvernay (DVY on TSX) acquisition, but also provides for rising costs, foreign exchange effects, and accelerated drilling activity.

The quarterly dividend rate of $0.40 per share ($0.80 per ADR) is unchanged. New projects have the potential to add 1 million Boe/d of new production and 0.3 million Bbls/d of new refining capacity over the medium/longer term, but we do not expect any short-term impact.

Our sector performer rating and $90.00 price target for shares of Royal Dutch Corporation (RDS-A on NYSE) are unchanged. The shares, which trade at a relatively low P/E multiple and provide a relatively attractive dividend yield, are attractive for "value" oriented investors.

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Peter D. Ward, CFALehman Brothers212-526-4016Peter.ward@lehman.com

Coal: Despite strong out-performance over both the past year and the past decade, we remain bullish on the prospects for U.S. coal equities.

Our long-term thesis remains intact. That is, in a world increasingly short of energy, U.S. coal producers have a significant amount of energy value in the ground. And, in our opinion, this value remains underappreciated by many observers. With high barriers to entry, decades of reserves, and little exploration expense, we believe U.S. coal producers are likely to generate significant free cash flow for many years.

Recent enthusiasm for U.S. coal equities has been largely driven by a bullish outlook for U.S. exports. We believe this enthusiasm is well justified. Historically, the U.S. played a substantial role as swing supplier to the global market. Global demand for coal remains very strong. Meanwhile, export competitors such as South Africa, China, Australia, and Indonesia cannot meet demand. We believe net U.S. exports could reach 90 million tons in the next few years. In our opinion, the sustainability of high coal prices will surprise many observers. We are raising earnings estimates and target prices for all U.S. coal producers.

Despite this recent sell-off, U.S. coal equities have delivered significant out-performance over both the past year and decade. [Recently], the European spot coal price had a significant correction. Prices were down 10 percent at one point during the day before closing down 6 percent. Without question, this is a significant one day move for a commodity. However, in our opinion, some perspective is warranted. The coal price has "corrected" to about $216/ton. The price was $130/ton at the start of 2008. And, the price was as low as $30/ton in 2002. In our opinion, it is a real stretch to argue that coal is now in a bear market.

We believe the fundamentals for U.S. coal remain very strong. Indeed, rather than lower estimates, we are significantly increasing EPS estimates and price targets for all the equities and partnerships in our coverage universe. In most cases, our coal price assumptions are well below published spot prices. We remain confident the risk to all our coal price assumptions remains significantly to the upside.

As we have argued for years, the ownership of decades of developed coal reserves represents a bigger barrier to entry than many perceive. Coal equities typically have an enormous amount of energy value in the ground. In a world that is clearly short energy, these assets in the ground deserve increased recognition by investors, in our opinion.

With oil prices at near record highs and U.S. consumers demanding solutions to burdensome gasoline prices, it appears to us that policies encouraging coal-to-liquids conversion technology may gain favor. With coal representing about 90 percent of the fossil fuel reserves of the United States, coal-to-liquids should be a part of the energy solution for the United States in our opinion.

Natural Resource Partners: We are raising our earnings estimates for all coal companies within our coverage universe due to increases in our coal price forecasts. In our opinion, strong global demand for thermal and metallurgical coal combined with significant restraints on potential supply increases will provide support for higher pricing levels in the years ahead. NRP has exposure to higher coal pricing through the royalty payments it receives from its lessees.

Our new $46 target price assumes a 5.2 percent yield on our 2009 distribution estimate of $2.40. Our previous target price of $45 assumed a 5.3 percent yield on our 2009 distribution estimate.

With an attractive and well-protected yield, we believe the risk/return of these units is attractive. Our $46 target price for NRP is based on a 5.2 percent yield on our 2009 distribution estimate of $2.40 per unit.

The partnership has a high-multiple equity currency which can be used for acquisitions. Since its IPO, the company has acquired over 1 billion tons of reserves. Cash flows are leveraged to what we believe are strong fundamentals for coal prices and volumes.

After borrowing $23 million under its credit facility in the fourth quarter to fund the acquisition of an overriding royalty interest from Massey Energy on certain low-volatile metallurgical coal reserves and 17.5 million tons of low-vol met coal from National Resources, the partnership's debt/cap is now 41 percent. NRP currently has revolving borrowing capacity of $300 million under its credit facility that can be expanded to $450 million on similar terms.

We believe the steady and relatively low-risk cash flows of the coal royalty business are ideally suited for the MLP structure. More than other coal MLPs, NRP provides substantial leverage to what we believe will be significantly higher realized metallurgical coal prices.

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