Investment Solutions

Quarterly Report – December 31, 2005

January 31, 2006

In our last report, we emphasized our belief that while periodic corrections can be expected, given the energy industry’s history, we continue to be very positive on the longer-term outlook. Therefore, the strategy adopted at the Fund’s inception, i.e. that energy markets have changed and will remain tighter than in past cycles still holds.
Importantly, there are an increasing number of encouraging developments that we believe support our positive approach towards investing in most energy related sub sectors of the “energy chain”. For example:

  1. The International Energy Agency (IEA), the primary global source for oil forecasts and advisor to 26 consuming countries, forecasts world oil demand will increase 2.2% in 2006, up from a 1.3% gain in 2005. They look for Chinese consumption to reaccelerate, following a slowdown to a 2.9 percent increase in 2005 from a 15 percent jump in 2004.

  2. The Energy Information Agency (EIA), a part of the US Department of Energy projects tight oil and gas supply and demand fundamentals to persist over the foreseeable future and forecasts average prices of $63/bbl and $9.30/mcf in 2006.

  3. Natural gas, a domestic North American fuel, is particularly supply constrained. Demand in the lower 48 states is estimated to be up at least 1-2 percent in 2006, following a flat year in 2005. However, production continues to drop, i.e. -3.1 percent in 2005, the fourth consecutive year of declining volumes. Additionally, Canada, the swing supplier over the past decade currently accounting for about 17% of total US consumption, is not likely to further increase its market share. To help fill the void, Liquefied Natural Gas (LNG) is expected to become more important, but may not become as significant a supply source as believed earlier. Environmental roadblocks are slowing down permit approvals for new terminals and competition for cargoes from Asia and the EU restrict imports.

  4. OPEC spare capacity approximated 2 MBLS/day in 2005, less than 2.5% of worldwide demand and the lowest level since the Gulf War in 1991. Given concerns emanating from geopolitical difficulties in both OPEC and non-OPEC countries, it now seems likely that crude worldwide oil supplies will remain firm over the foreseeable future.

  5. Following years of excess electric generating capacity, reserve margins are now beginning to show signs of falling in most regions of the country. This should result in higher power prices in the future. Surplus capacity is projected to be the lowest in five years in 2006, and reserve margins in eight of ten North American Reliability Counsel (NERC) regions are set to significantly decline over the next few years. This should benefit companies that have the ability to recontract low cost contracts, and particularly utilities that operate non-regulated coal fired and nuclear plants.

  6. Master Limited Partnerships (MLPs) continue to offer investors superior total returns. This asset class, providing high current and partially tax deferred dividend yields, is playing an important role in the country’s growing energy infrastructure with its emphasis on a pipeline and gas gathering and processing businesses.
The key question to be answered today is how long will this energy cycle last? In our judgment, given structural difficulties that characterize the overall energy industry and constraints that impact the broader energy industries, the favorable fundamentals are likely to persist over the next several years. Consequently, we believe earnings and cash flow growth should continue to outstrip current investor expectations, both in terms of magnitude and duration. As this realization unfolds, energy’s stature and importance, when compared to the overall stock market should rise significantly.  For example, energy’s weighting in the S&P 500 Index in the 1970s and early 1980s approximated 30% versus a present weighting of only 10%.

In summary, as we noted in our last report, there is a strong case to be made for taking a bullish position on energy and it’s related sub sectors. This is particularly evident with natural gas prices at the $9/mcf level and crude oil back to almost $70/bbl, despite mild winter temperatures in the month of January, and concerns about the threat of industrial “demand destruction” when prices are too high. Therefore, as value investors, we are taking advantage of stock pullbacks and utilizing all available tools and strategies to reduce volatility i.e. risk. As always we would like to take this opportunity to once again thank all our partners for their support.

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.

 

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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.