Quarterly Report – June 30, 2005

July 20, 2005

As noted many times in prior communications, our strategy is based on our strong belief that this energy cycle will be long and more demand driven than in the past. Importantly, we believe we are one of the few investment managers who focus on the entire “energy chain” thereby enhancing diversification and reducing volatility (risk). For example, while we have been overweighted in oil and gas exploration and production and oil service stocks, the portfolio also includes such non-commodity related companies as AES, General Electric, Chicago Bridge & Iron, Norfolk Southern, Quanta Services, Global Power Equipment, and subsectors such as Master Limited Partnerships (MLPs) and utilities. We note that the media has recently completed major positive stories on some of these names.

We remain very bullish on the future outlook for energy investments. While near-term corrections are expected, they provide buying opportunities. One important reason for this view is the fact that this cycle is driven by supply concerns and strong demand growth. Although OPEC is producing record oil volumes, China and India are consuming most of the incremental capacity. Also, world oil demand has been surprisingly inelastic, notwithstanding a doubling in the price over the past 18 months. It is noteworthy that the United States has absorbed higher gasoline prices while Europe and China have absorbed a significant rise in distillate prices. Some economists have attributed this to the reduced impact of energy on U.S. GDP growth, and a favorable impact of the weaker dollar in Europe and other countries.

Another reason for our positive outlook is that companies have been slow to recognize that a new consensus oil price floor is now $40-$45/bbl up from $28-$30/bbl. As a result, capital spending has lagged even though cash flow has sky rocketed. Stock buybacks, increased dividends, consolidations as well as new infrastructure investments, are now expected. Also, unlike the 1970s, the U.S. public, and politicians have not targeted the oil industry for “ripping off the consumer”.

Analysts and investors have used very conservative oil/gas prices to forecast company profits and cash flow. This has allowed continued upside in earnings projections. Stocks tend to appreciate as analysts increase their estimates. Also, despite a strong market performance in 2005, valuations are reasonable since rising cash flow and earnings have matched the increase in stock prices.

Despite a favorable absolute and relative performance of the energy sector, compared with the overall stock market, it only represents about 6-7% of the market capitalization value of the S&P 500, versus approximately 30% in 1980. This is despite the sector representing 23% of the indexes' earnings in 2004. Over time, we believe that it could reach 10-15%, or higher, as greater recognition to the new dynamics in this sector unfold.

In summary, we continue to be optimistic about 2005, and, increasingly, 2006 and 2007. As stated in our last communication to you, “overall, we believe that for the first time in many years, a longer term case for energy investment can be made. The current cycle is unlike any others in that demand growth for oil and gas is outstripping incremental supply and cash flow is at record levels, a trend that is expected to continue over the foreseeable future. Our emphasis on the total energy chain provides diversification, a risk management tool, and wider exposure to investment opportunities.

Certain statements contained herein may contain "forward-looking statements" within the meaning of the Private Securities and Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Fund to be materially different from any future results, performance or achievements expressed or implied by such forward- looking statements. Such factors include, among others, risks and uncertainties associated with the timing and costs of energy sector production, the demand for and prices of oil/gas products, the timing and amount of capital spending in the nation and world wide, and general economic factors.

« Library »

About ELCO Management, LLC
Established in 1995 and based in New York, ELCO Management (www.elcomanagement.com) offers investment solutions to high net worth individuals and institutions. ELCO also manages two highly specialized energy funds: the ELCO Energy Fund, L.P. and the ELCO Select Fund L.P.