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I was talking last night with an old boss at Exxon – he was the best boss I ever had. Unfortunately, for me, he retired. He had called to tell me about his trip to Spain and the wonderful time He and his wife had had on their vacation. He also wanted to share some vacation pointers. My husband and I are preparing a trip there for next October.

My boss wanted to share also his immense surprise at the construction boom he saw in every town and city he visited, as well as the significant amount of traffic he experienced both in the highways and in the cities. He was truly amazed at how people drove there even when gasoline prices were high --$4.50+/gallon. And we think we have a problem?

His point to me was that he thought energy prices were going to stay high for a while and had room to grow more given that Spain and most of Europe have learned to live with higher prices —food for thought for the whiners.

My boss also wanted to know what was causing the steep increases in gasoline prices recently. I told him that a combination of turnaround at major refineries, and a few fires here and a few other operational disruptions here and in Europe, combined with increases in gasoline demand, had all collective conspired to push prices up.

In addition, we agreed that the cost push effect of higher crude prices may have also contributed to gasoline increases.

I also told him that the new gasoline and diesel regulations that are taking effect this year combined with past tightening of quality requirements were making storage and distribution of gasoline and diesel, very expensive. These regulations have increased tremendously the number of segregations that are required as compared to a decade ago --and this is costly. And the specs for both gasolines and diesel will continue to tighten until I believe 2010. So forget lower prices.

I told him that I expected some price relief at the pump soon, when all of this capacity and operational issues are over and done with. But I added that I thought the temporary relief in prices was going to be short-lived if summer driving demand were to increase significantly once again. And of course, who knows what's going to happen with hurricanes.

As we spoke, my old boss pulled out of his computer files a 2003 document he had prepared on the supply/demand balance outlook, and with it the list of key assumptions regarding the future environment.

Looking back at old predictions is something ingrained in us xom folks—it allows us to calibrate our thinking as we examine key elements of our assumptions. It is a means to learn some insights from the comparisons and deviations from actual. In 2003 my boss saw little possibility for supply demand relief until past 2008. I think he is on track on this one.

As he was relating to me his basic 2003 assumptions of the future environment as it looked from the perspective of 2003, I was saying quietly to myself – it looks to me like the future supply/demand environment today looks a lot, but a lot worse than what he thought it would be.

As we discussed the issues he asked me to jot down the reasons why prices are likely to stay high -- he came up with 9, which I emailed to him, and asked him for permision to share it with this board. After I had emailed to him the 9 reason, I added a 10th one.

Here are 10 reasond, and not necessarily in order of importance. If any of you can think of more, let us have it.

1.- China is consuming more than anyone thought would be sustainable for so long. And their economy has yet to slow down as "experts" had been predicting. And India is not far behind.

2.- High prices have not had the assumed impact on reducing world wide demand as was expected. Consider that for the first 5 months of this year, gasoline demand growth in the U.S. has been close to 2% despite the higher prices. Crude prices have essentially doubled since the beginning of 2002, and demand still has kept growing, at a not insignificant pace.

In fact, this year, worldwide demand is expected to add another 1.5 million barrels per day to the consumption base of 2006, and it is scary to think that new net non-Opec production will once again fall short of meeting this world wide demand increase.

3.- Back in 2003, everyone was assuming that Russia, Venezuela, Iraq and Iran were going to become the primary provinces for future oil production increases for an energy-hungry world. No such luck. And there is little medium term prospects that it will happen.

You all read the news. Russia, has now turned supra-nationalist -- so forget accelerated development of oil resources there. Besides, their port and export infrastructure are so deficient that even if production increases were put on-stream, the additional oil would not be able to be exported.

Venezuela's Chavez is a nut case -- and He is in the process of nationalizing or taking over big chunks of oil investments the International Oil companies have made over the past decade -- So to me the future production increases seem bleak in that country.

And in Iraq?

Well we all know the mess that country is, and the little prospect I see that it will see experience stability in the near term to attract big oil exploration and production investments.

And what about Iran?

The President is a loose canon ball. With a potential military crisis looming, who will invest there, soon? And aside from the potential military confrontation issue, Iran is not making the necessary investment in the base case to even maintain production for exports. So, that alone will continue to put pressure on future prices. It is a deteriorating base case, worst than Venezuela.

4.-We now know that the assumed declined rates from old oil producing provinces have proven to be much steeper than expected, so less oil is being produced than we had anticipated 4 or 5 years ago. And the prospects in some places such as Mexico, do not look good.

5.- Delays implementing and bringing new projects onstream have been widespread mostly on account of runaway costs and the severe shortages of personnel and equipment that the industry is experiencing. The skill set is not there; and quite a number of projects have been delayed or dropped for the time being. This has not been helpful to the supply environment.

6.- Our U.S. government continues to demonstrate supine incompetence, and politicians are still unable to have the courage to open up areas for exploration and production, and ease the regulatory burden for refineries.

And wait!!! If the Democrats have their way, and "windfall profit taxes" are enacted, watch prices climb, and climb into the future. I cringe when I read what is being discussed under the guise of "energy independence." The mood of politicians is, "let's kick the oil companies, lest they discover that our policies and politics are the real cause of the difficult supply and high price environment we have today." Talk about a political wild card?

7.-The Saudis have said they will not expand their production capacity to the level that was assumed (15 MBD) they would do by 2012-2015. It now looks it will fall short of that assumption by 3 MBD. Ouch!!!

8.- Supply disruption in Nigeria, and other smaller operational disruptions elsewhere, have cumulative reduced potential oil production that could have been onstream today, accentuating the effects of the supply tightness.

9.- Opec has been more effective at managing supplies that anyone had assumed. Part of the reason is that the only one that has any major oil producing capacity to spare are the Saudis. So imposing supply discipline on OPEC is very simple ... it is a one man show. The rest of the countries are essentially producing flat out.

10.- Hurricanes are a crap shoot -- who knows how they will affect prices. But, prices will move up when one is seen swirling in the Atlantic potentially threatening the Gulf Coast.

If any of you can think of other reasons, pile them on.

I think I can safely conclude that there is only one way to balance supply with desired demand, and the flywheel is called higher prices -- and that is precisely what we have been seeing in the last 5 years, non-stop.

Does this suggest that oil company stocks have peaked as some analyst are now saying? … well, maybe, but I don't think that the fundamentals outline above suggest that lower prices are anywhere in sight in the next few years and any dip in oil stocks is an opportunity to jump.

In fact, my belief is that oil company stocks will continue their climb for a somewhat longer period. Their P/E's are ridiculously low compared with the rest of the market, esepcially tech. So if you want to sell, sell it to me. I'll take it off your hands.

Madame Butterfly
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