Quarterly Report – December 31, 2003

February 9, 2004

The oil and gas sector experienced many changes over the last decade. The days of the natural gas “bubble,” when prices declined to as low as one dollar MCF and oil traded between ten and fifteen dollars per barrel, are long gone. Today finds an oil and gas sector restored to financial health. Independent exploration and production companies are now an industry with a market capitalization exceeding $150 billion and accounting for roughly 65% of all natural gas and 45% of oil produced in North America. Reflecting higher energy prices and cash flow, companies have begun aggressively paying down debt, initiating dividend payments, and repurchasing stock. Increasingly, free cash flow appears not the exception, but the norm. However, even with strong oil and gas prices, company managements continue to avoid excessive capital expenditure budgets, which contrasts with the industry’s past periods of aggressive spending and high leverage.

This remains an excellent time to invest in energy equities. Oil and gas company valuations, as reflected by the current price earnings ratios are about 25% below the S&P 500. In our opinion, several factors should continue to drive investment in this group:

• The strengthening economy should continue to positively impact energy stocks. As the economy expands, and manufacturing levels increase, companies that use natural gas as a product component, such as those in the aluminum, chemical, and fertilizer industries, will increase energy usage.


• Expect oil and gas prices to remain tight. Limited supplies of natural gas, coupled with increased demand, should maintain a firm price structure, as Canadian gas exports, which account for about 17% of the total U.S. demand, has reached a peak and is not expected to continue to increase. LNG (liquefied natural gas) imports will help to offset some demand, but should not become significant until the 2005-2007 period during which it could account for approximately 8%-10% of total U.S. usage.


• Energy stocks historically outperform the overall stock market during periods of rising interest rates. Should interest rates rise, energy stocks remain one of the best groups to own. A study of 11 tightening periods since 1954, places the sector as the second best performer of all S&P 500 industry groups six months after the first Federal Reserve tightening and the top performer three months after the first rate rise.


• Increasing numbers of electric power plants and homes use natural gas. Over the 2002-2005 period, a record number of new power generators are going into service. Most use natural gas to produce electricity. In addition, most new homes use natural gas. Increasingly inelastic demand provides natural gas with a solid base of price support.


• Industry rotation favors the energy sector. Despite posting company earnings that exceeded most other groups, the oil and gas industry lagged in stock price performance. We believe investment results should improve in 2004 as the stock market realizes its oversight of the energy sector.


• Under-investment in energy stocks. The sector accounts for only about 6% of the S&P 500 Index compared to as high as 20 % in the past. Given the strengthening outlook and attractive valuations, investment in the sector should increase in 2004.

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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.