KBC NOTE ON VPC, TLW AND DNX

KBC note from 13/02/2007

UK spot gas price is looking pretty sick so far in 2007. The daily price has averaged 27p year to date while the forward price for the remainder of 1Q07 is now 18.5p per therm. One year ago, the futures contract for 1Q 2007 gas was trading at 90p per therm and the last quoted price before expiry of the contract was over 40p, in November.So what is going on? Clearly the weather is the main driver. It is likely that gas suppliers, intending not to be caught short of gas as they were in 1Q06 (see the chart below) were more heavily covered than normal and have been absent from the market, depressing demand for spot gas. With this very poor start, and two quarters ahead in which prices are seasonally weaker, the volume-weighted average price realised by producers selling into the spot market (after allowing for seasonally lower 2Q and 3Q production) looks like it will be no better than26p per therm assuming the current futures prices for the forward quarters. This is a more adverse position than we had assumed mid-January, when we published 2007 forecasts based on a 30p weighted spot price.The key question is whether this is just the reverse of the spike we had one year ago. It probably is. There is a credible argument for a long-term linkage between oil prices and gas prices along the following lines: Gas markets are now far more closely tied together by pipeline connection than even five years ago. In the future, global trade in LNG (liquefied natural gas) will also have an increasing influence on the UK gas market. Thus as domestic UK gas supply dwindles, global markets will have increasing influence on the UK gas price.Historically, European gas contracts were indexed to fuel oil prices and Japanese LNG contracts linked to crude oil. Thus, provided there is no structural oversupply of gas, oil prices will tend to drag gas prices along withthem. Thus on the basis of our central assumption of a Brent oil price of $50 per barrel, we would consider 35p to be a reasonable trend level of the UK gas market. (This assumes a fuel oil price of 20% less than crude and anenergy equivalence based on 6,000 cubic feet to the barrel of oil, giving a gas price of $6.66/mcf which equates to 34p per therm). Clearly spot prices at any one time would be influenced by weather conditions and seasonality as well as any relevant operational issues that tend to arise from time to time, but we believe this assumption to be a reasonable basis for assessing the economics of UK gas production and is the centralassumption in our NAV models.In the short term, however, the spot price will undoubtedly influence the financial performance of a handful ofcompanies: Dana, Tullow and Venture being the main ones to consider, all having substantial exposure tocurrent UK gas production.

Dana Petroleum (DNX) – UK Gas price – FCAST: No Change, REC: SELLOur views on the Dana share price are more driven by long term valuation issues than short term earnings. Consensus valuations on several important UK assets (Johnstone, Cavendish, Melville, Barbara and Babbage in particular) seem to be very optimistic and we think our Core NAV of 604p per share is actually quitegenerous. Then one needs to ask whether the international exploration is actually worth the £350m implied by the current share price.

Tullow Oil (TLW) – UK Gas price – FCAST: No Change, REC: REDUCETullow has already modified its drilling programme in the UK in the light of the gas price development, choosing not to extend a rig contract for a second term. This shows financial discipline for which the UK independents are not historically known and which we applaud. In terms of valuation, there is quite a lot in the share price for exploration – our Core NAV estimate is just over 200p. There are 2 or 3 exploration plays that could transformthe Core NAV in the medium term, the largest of which is in Uganda. Short term, the Kingfisher well in Uganda could have a significant influence on the share price – possibly with as much downside potential as upside, ifthe results do not fully match expectations. Uganda aside, there price Tullow paid for Hardman could well be looking over-generous also.

Venture Production (VPC) – UK Gas price – FCAST: No Change, REC: HOLDWe are generally very positive on Venture Production in the longer term. As the company deliberately targets development and production rather than exploration as its investment thesis, less hope value can be attached to the stock. Our caution is based on a view that consensus forecasts for 2007 earnings are too high (even after taking into account the hedging programme disclosed by the company in its recent strategy presentation) and that there may be some significant downgrades to come. The shares may trade lower in the short term.