Petrocapita UpdateDecember 2010

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IF YOU CAN KEEP YOUR HEAD WHEN ALL ABOUT YOU ARE LOSING THEIRS ... YOU DON’T WORK FOR THE FEDERAL RESERVE

Apologies to Mr. Kipling for using his work to create an inflammatory headline. A considerable amount of ink is being spilled on the topic of whether there is a recovery underway in the west and if so, whether that recovery is sustainable. So much ink in fact that one would have thought that when combined with the mighty labors of our central banks to single-handedly create an ink shortage this lowly substance would have been used up long ago. Fortunately, or perhaps unfortunately depending on your view of my monthly musings, we haven’t run out yet so let me give you my view on the recovery debate - a recovery in nominal or real terms? With the printing presses running full time (ink supplies notwithstanding) some form of nominal recovery will occur in the western economies. Sadly, it’s not going to be anywhere nearly as satisfying as other post-war recoveries because it largely will be an illusion in real terms. Our recovery is not being built on the sound fundamentals for growth:

– Favorable demographics;– Low national debt levels;– High savings rates; and– Persistent trade surpluses.

Please take a moment and consider which so-called developed nation has these characteristics. Stumped? None. Now turn your gaze to the emerging world - I doubt you are still stumped as the list is long and obvious.

Petrocapita Update

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Petrocapita Update (continued)

Take Canada as an example of a country suffering from the western growth malaise. Canada has:

– An aging population;– Large unfunded liabilities for social benefits;– High total debt-to-GDP levels;– Low savings rates;– Large and increasing government intervention in

the economy;– Large fiscal deficits; and – An overly accommodative monetary authority.

I’m sorry to be the bearer of bad tidings but these are not the seeds from which mighty recoveries are grown. By insisting on printing over the systemic solvency issues in the financial sector, by actively preventing the liquidation of decades of mal-investment, by subsidizing speculation and consumption to the detriment of production (and so on) our valiant central bankers will not create a recovery. Unless these problems are addressed they are creating an inflationary environment with poor real growth dynamics - i.e. the ideal raw materials for stagflation in the west. What are our investment options? It should come as no surprise to anyone who has read one of my letters that I believe its important to find investments in politically stable regions of the world that are directly exposed to emerging economy growth - i.e. regions that export what the emerging economies need and are not exposed to emerging economy competitive advantages - i.e. regions that do not export what the emerging economies make. In my funds’ backyard, western Canada, energy and agriculture are dominant industries. In fact, western Canada, with only 10 million inhabitants,

is one of the world’s largest net exporters of both energy and agricultural commodities. As we know, energy and food consumption undergo rapid growth as a developing economy makes the transition to a middle class standard of living. These markets already appear to be tightening and demand is still accelerating. Here are some quick numbers to give you an idea of western Canada’s resources endowment:

Energy– Oil (13% of world reserves; 4% of world

production) – Uranium (8% of world reserves; 20% of world

production)

Agriculture– Potash (60% of world reserves; 30% of world

production) – Wheat (21% of the world export market)– Oil seeds (10% of the world export market) – Farmland (80% of Canadian total)

The Canadian economy appears bifurcated between the lower growth east and the higher growth west. Investing in western Canada provides exposure to emerging market consumption patterns in energy and agriculture in a politically stable market. I believe a good approach is to make direct investments in commodity production assets - in addition to providing less volatile exposure to commodity price trends, production assets are excellent inflation hedges that, unlike gold, generate cash flow. In addition, investors who have a value orientation have been provided what I believe is an attractive entry point into the Western Canadian conventional oil market. The credit crisis has caused financing to

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Petrocapita Update (continued)

become scarce for junior oil & gas companies while low natural gas prices are reducing their profitability. They are being forced to sell assets to stay in business. This has created a buyers’ market for the acquisition of smaller oil production assets - assets that are highly cash flow positive at current oil prices. Shifting gears for a moment - I want to ask when we gave permission for central banks to take over the tax role of our governments? Central bankers now seem to feel free to increase the money supply by any quantity they deem necessary to keep the banking sector solvent. In effect, they are extracting a massive tax from savers everywhere via the historically low interest rates they have engineered. When questioned about what they are doing with our money they get downright testy and roll out the cliché of “central bank independence”. Let’s take a look at what that vaunted “independence” is costing Canadians using some Bank of Canada (“BOC”) data. There is C$1.2 trillion on deposit with Canadian chartered banks. If

we assume that BOC actions are keeping interest rates at least 4% below their equilibrium level then Canadian savers are being taxed by the BOC to the tune of $50 billion annually in the form of lost interest income. Canadian federal government income tax revenues are approximately $150 billion, so is it not accurate to say the BOC has unilaterally increased Canadian income taxes by around 33%? Let me leave you with this. If central banks really believe that printing money and giving it to the government and the banking sector is solving our problems and is not inflationary why not print much, much more and be done with the crisis once and for all? Perhaps all this money printing will usher in a new era of wealth, prosperity and low inflation - what do you think?

Kind Regards

Stephen Johnston - PartnerPetrocapita Income Trust & Agcapita Farmland Investment Partnership

Stephen is a partner at Petrocapita, an energy investment fund built around the core premise that the world is in a bull market in commodities driven by inflation and a step-change increase in demand and, accordingly, that investments with direct or indirect exposure to commodities in a politically stable environment such as Canada will provide above average returns. Petrocapita holds a portfolio of low risk, producing energy assets.

Stephen graduated from London Business School and is the founder of one of Canada’s largest farmland investment funds, and Petrocapita. He has over 15 years experience as a fund manger – working for organizations such as the European Bank for Reconstruction and Development, Societe Generale and Baring Brothers.

Stephen has appeared on Business News Network and CBC News and been quoted in such media outlets as Fortune, the Financial Times and The Globe and Mail.

#400, 2424 4th Street SWCalgary, Alberta T2S 2T4Canada

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