January 5, 2012

Energy Ruminations (EPX = $439, OSX = $224, XLE = $71)

Contemplating 2012

Summary

The outlook for ’12 is driven by a combination of uncertain Macro elements (collectively, economic, political and geopolitical), on the one hand, and reasonable to attractive equity valuations on the other. The highly fluid nature of the current Macro climate continues to drive the magnitude of the current risk premium and suppressed valuations. And given the incendiary mix of Macro elements, we are offering a formulation for favorite picks this year that contemplates both offensive and defensive scenarios. With respect to macro energy, broadly speaking, oil prices have been stubbornly resilient largely due to a thin margin of OPEC spare production capacity, disappointing non-OPEC supply growth and, notwithstanding the demand anemia in the OECD sphere, sufficiently well-behaved non-OECD consumption. Collectively, these helped sustain a reasonably tight supply/demand framework last year. What were bedrocks of support in ’11, however, are less resolute coming into this year as demand growth is decelerating and OPEC production is rising, while non-OPEC production continues to disappoint. The geopolitical risk premium has lately helped support oil prices largely due to Iran and, to a lesser extent, Iraq. And while most of the systemic risks appear to be known at this point (Europe, China, US ’12 elections), in the event any one of these devolve or destabilize sufficiently from their present holding pattern, then oil prices can very easily be redefined lower. Alternatively, another unforeseen supply disruption of considerable magnitude would lead to higher prices. Thus for the moment, the current strip (’12 Brent = $109/bbl, WTI = $102/bbl) is the least imperfect approximation of today’s version of economic reality. Natural gas on the other hand, has been a study in despondency accentuated by excessive capital investment on the part of E&Ps, astonishing productivity and a benign winter. Where we go from here will be largely a function of E&P capital discipline. If companies do what they should do, which is lay down rigs, shut-in production, and allow the supply/demand framework to become more balanced, then the market imbalances will become self-correcting over time. But, access to capital continues to be unfettered and companies have been loath to sacrifice near-term production gains in exchange for enhancing longer-term returns due to unclear if not distorted priorities on Wall Street. The easy answer in confronting this is to run the business with the objective of enhancing returns over the longer term and the market will eventually “get it,” irrespective of what the flavor of the day happens to be. Our working assumption coming into ’12, notwithstanding the myriad possibilities related to the Macro elements, is if current oil prices prove to be a reasonably accurate reflection of economic reality, then energy stocks should perform well. Then again, we made that assumption last year and we were misguided in doing so as the disconnect between oil price performance and energy stock price performance was almost unprecedented (refiners were the exception as they enjoyed a banner year). WTI prices last year averaged ~$95/bbl and were up 8% y/y and Brent prices averaged ~$110/bbl and were up 13% y/y. And notwithstanding this bounty, upstream beta energy stocks (E&P and oil service) were down 10-15% y/y, on average. We can’t recall the last time (perhaps ’02?) when we witnessed such an extreme divergence. A prominent difference between this year and last is valuation – stocks (both E&P, especially oil levered, and oil service, especially diversified service companies) are a lot cheaper coming into ’12 than they were going into ’11. Whether the market eventually believes in the forward-looking earnings estimates will determine stock price performance. And to this last point, a key difference between where we stand today and where we stood

last year is sentiment. While sentiment was constructive entering last year (remember when the economy was seemingly headed for “escape velocity,” inflation was becoming more than a trivial concern and the Euro, relative to the USD, was trading in the distant neighborhood of 1.40-1.50?), it is oppressively and uniformly negative today. And this is manifested by positive data points/surprises seemingly being rationalized and negative outcomes/surprises being sanctified. Whether this changes will partly if not largely be a function of the outcomes of the ten key themes we have identified for ’12. The following research note is segregated into 1) Identifying ten key themes for ’12 2) A brief discussion of macro energy (oil, nat gas, coal) 3) Summary discussions (prominent industry themes and fav stocks) on seven energy subsectors.

Ten Key Themes for 2012

1. China Economic Glide-Path - Soft-landing or hard landing? This is likely the key demand-related issue in ’12 with respect to oil price resilience or vulnerability.

2. Europe - Continued kicking of the can down the road (structural reforms are unlikely) or implosion? Again, this results in the difference between oil pricing resilience or vulnerability.

3. US Presidential and Congressional ’12 Elections - Republican victories will likely prove to be positive for upstream energy industries and the stock market, Democratic victories negative.

4. Iran - Continued saber rattling or decisive action/engagement/conflict? The imposition of an oil embargo likely lends upward pressure to oil prices. European foreign ministers meet in late-January to decide on the matter (Europe imports ~400-500kbd of Iranian crude) and then a number of deadlines are triggered over the course of ’12 with regard to US driven sanctions and its trading partners doing business with Iran.

5. Iraq – Orderly transition regarding exiting of US military or reversion to chaos? Relative stability in Iraq over the last year has contributed to the highest level of oil production in over 20 years at near 3 mb/d. Iraq oil supply growth for November was up about 0.4 mbd y/y (IEA statistics). The Deputy Prime Minister for Energy Affairs has stated expectations for production to rise to 3.4 mbd by the end of 2012, with exports increasing to 2.6 mbd from an average of 2.2 mbd in 2011. Should violence continue to escalate, both the level of production and the pace of growth could be negatively impacted.

6. OPEC – Tension has risen within OPEC as pre-existing quotas became outdated and divergent views on pricing developed. The tension and discord on these and other fronts was manifestly obvious at the summer OPEC meeting. In the December meeting, OPEC agreed to a production target of 30 mb/d, but failed to agree on individual country allocations necessary for enforcement. How will growth in Iraq and Saudi Arabia, a recovering in Libya, potential sanctions against Iran, and evolving political dynamics impact OPEC’s continuity and influence?

7. Global Oil Demand - OECD’s Swan Song: 2012 could mark the last year that OECD oil demand will exceed non-OECD demand, given our expectation for continued secular contraction in the developed world and well established and seemingly inexorable trends of industrialization, urbanization, and higher levels of economic growth (and hence higher oil demand growth) in the developing world. This is quite remarkable when considering that just 10 years ago, OECD demand outpaced non-OECD demand by nearly 20 mbd.

8. Lethargic Non-OPEC Production Growth – Another year of disappointing or meager production growth? Non-OPEC production was only flat-to-up last year following 1.1 mb/d of growth for each of ’09 and ’10, respectively.

9. NAM Supply & Infrastructure Growth – How will the pace of supply and infrastructure development evolve in 2012? Will oil prices support further rapid development (yes, absent an implosion)? Will infrastructure (pipeline, rail, etc) proceed as scheduled or will further delays impede development?

10. Natural Gas - Day of judgment looming for the industry given astonishing productivity of unconventional resources, continued access to capital for the E&P industry and benign winter?

Macro Energy Discussion

Oil As we enter 2012 the oil markets are relatively balanced. Oil prices are at sufficient thresholds in order to attract upstream capital spending, although there is the potential for significant volatility during the year. The Brent oil price has remained range-bound between $100/bbl and $115/bbl, while the WTI price enters the year at ~$100/bbl, having rebounded sharply from lows of around $80/bbl in Sept. Inventory days of demand cover are at 57.2 days, down from near 60 days last summer, but still above the 5-year average of 56 days. Effective OPEC spare capacity of about 4 mbd (4.7% of global demand) remains thin, below the recession highs of near 6%, but up from the 2% levels experienced in the 2003-2007 period. We enter 2012 with decelerating demand growth, poor non-OPEC supply performance, and rising OPEC production, resulting in an estimated 2012 call on OPEC crude supply of 30.2 mbd, down modestly from the average call in 2011 and slightly below recent OPEC production of 30.7 mbd. Modest 2012 demand growth is factored into our S&D balances (2012 +1 mb/d, 1.1% y/y). The IEA has downwardly revised its demand outlook for 5 consecutive months and its 2012 outlook is approaching our assumptions (IEA +1.3 mb/d, SCI +1 mb/d). Our estimate is consistent with global GDP growth of 3% to 3.5%, down from ~4% in 2011. China remains the dominant growth area, having provided 1 mbd of growth in 2010 (37% of the WW total) and 0.43 mbd in 2011 (60% of WW total). We are assuming China demand growth remains on trend at 0.4 mbd (+4.5%) in 2012. We expect non-OPEC supply growth in 2012, but the dismal 2011 performance raises doubts (2012 +1 mbd y/y). 2011 non-OPEC supply disappointments included 500 kbd of unplanned maintenance, 2.5x normal unplanned maintenance. Every region experienced disappointing results with the exception of NAM, where the growth in unconventional production exceeded expectations. We expect easy 2011 comparisons, along with supply growth in the US, Canada, Brazil, the Caspian, Russia and Australia to result in supply growth in 2012. That said, we believe there is more downside than upside to our supply outlook for 2012. OPEC supply is on the rise (Nov 30.7 mbd) and slightly above the call on OPEC (2012 avg 30.2 mbd). Libya supply continues to rise at a rapid pace, increasing from 350 kbd in Oct to 550 kbd in Nov and 900 kbd in Dec. Production is reported to have exceeded 1 mbd by year-end and the NOC in Libya expects supply to return to pre-war levels by year-end 2012 (production 1.6 mbd, exports 1.3 mbd). Rising supply from Angola and an unexpected Nov Saudi Arabia supply increase raised OPEC production to 30.7 mbd in Nov. Nov OPEC production was consistent with the call on OPEC crude in Q4, but is slightly above our 2012 estimate of 30.2 mbd. We are modeling OPEC NGL growth of 0.3 mb/d in 2012, following 0.5 mbd of growth in 2011. The threat of supply interruption in the Middle East continues in 2012, raising the potential for price volatility. 2011 MENA supply interruptions were significant in Libya, Egypt, Syria, Sudan and Yemen, many of which are recovering in 2012. However, new risks have emerged, especially in the form of Iran and Iraq. The US and the EU have threatened sanctions against Iran (Nov production 3.55 mbd) in reaction to Iran’s nuclear development program and Iran has responded by threatening to close the Strait of Hormuz, a major export route for Middle East crude supplies. In Iraq (2.7 mbd), the departure of US troops in Dec was rapidly followed by increased tension between Sunni and Shia political factions within Iraq, bringing into question not only the potential for future growth but also the ability to maintain existing production.

Nat Gas As reflected by natural gas prices near a 27 month low and the Cal ’12 strip at $3.35/Mcf, investors are currently bearish with respect to the U.S. gas outlook. While some may be tempted to take a contrarian bent as there is a surplus of pessimism surrounding gas, we caution investors from fighting the trend as the negative bias to

natural gas is more than justified in our view. Unrelenting natural gas production growth due to increased drilling efficiencies, higher per well recoveries and associated gas are the culprits for anemia afflicting nat gas (prompt NYMEX: $2.99/Mcf, Cal ’12: $3.35/Mcf, Cal ’13: $4.00/Mcf). U.S. gas production reached a record 64.6 bcf/d in Oct ’11 (the most recent monthly data from the EIA) which was up 4.9 bcf/d y/y and up 4.0 bcf/d since YE’10. While gas production appeared to flatten out around 63.0 bcf/d from Apr-Jul ’11, it has subsequently accelerated an additional 1.6 bcf/d higher as more infrastructure has been built-out in the Marcellus as well as in some liquid-rich plays such as the Eagle Ford. The net result is gas in storage is at record levels (3.548 tcf as of 12/23/11 which is 428 bcf higher than the 5 year average and 297 bcf higher than 2010). We are currently updating our ’12 gas-supply demand model and an in-depth report on the ’12 gas outlook will soon be forthcoming. At this point, we expect the ’12 U.S. gas market will be oversupplied by ~1.2 bcf/d. If we were to assume a ~110 gas-directed rig count reduction from the gas directed rig count average of Q4’11 to the average for Q4’12 (~13% decline), U.S. gas production would still increase by 0.5 bcf/d y/y from Dec ’11 to Dec ’12 of which associated gas growth would account for all of this production growth. (Note: this is our base case production growth assumption and does not take into account curtailments which we believe are likely). Of the ~110 rigs that are assumed to be dropped, ~70% are horizontal rigs with reductions focused primarily in the Haynesville, Barnett, Woodford and the Granite Wash. Even under these assumptions, gas in storage would reach full capacity of 4.15 tcf in October which would lead to curtailments. Bottom Line: the 2012 gas market will continue to be challenged and could deteriorate even more barring a deeper cut to the natural gas rig count or production discipline on the part of operators in curtailing production.

Coal The coal market in 2012 was positioned for another year of gloom and oppression. However, the 11th hour court ordered delay of the EPA’s CSAPR has served to alleviate some industry pessimism, at least temporarily. Structural challenges nonetheless persist. The U.S. thermal market is in disarray as overall demand contraction due to low natural gas pricing and new environmental regulations have hit the industry hard. We believe that CAPP thermal pricing is near a bottom, but we have not seen the production impacts that will likely come from lower pricing and demand levels. Our view on natural gas has pricing that will not incentivize utilities to revert back to coal anytime soon. Retrospectively, our original 2011 supply/demand forecast was accurate as U.S. utility inventories have fallen back to historical averages. However, utilities are much more comfortable than we thought they would be at current inventory levels due to a lack of forecasted coal burn in ‘12. The recent court ordered stay placed on the EPA’s proposed CSAPR means that ‘12 has the potential to generate improved demand levels for coal. In the short-term, the delay will likely improve coal contracting, especially in the East, and move NYMEX pricing off of the current $70/ton level. For metallurgical coal, we believe the downward pricing trend will continue into the next quarterly contract as global market demand remains moderate. We expect the current $235/tonne met price marker to fall to $200-$215/tonne for calendar Q2’11 deliveries. With these lower prices, growth economies such as China and India could step-in meaningfully to support prices. This pricing backstop combined with potentially improving global demand, could prove more fruitful for met coal in the back half of 2012 and we have modeled a $215/tonne average price assumption for the full year.

Energy Subsector Summaries and Favorites

E&P

o Defense = APC, NBL, PXD; Offense = DNR, PXP, SD

Oil Service and Capital Equipment

o Defense = SLB, OIS; Offense = WFT, HAL, KEG

Offshore Drillers

o Defense = DO; Offense = RDC, ESV, NE

IOCs

o Defense = RDS ; Offense = MRO, OXY, SU

Refining

o Defense/Offense = VLO

Coal

o Defense = CLD; Offense = ANR

Alternative Energy

o Defense = CLNE; Offense = FSLR, SPWR

E&P 2012 Key Themes: As we begin 2012, the economic manifestations of the European financial outlook and the corresponding ripple effect influence on emerging markets will likely be the biggest driver of the equity market and energy stocks. However, looking beyond the global macro environment, 2012 looks similar to 2011, where once again natural gas looks to be challenged due to resilient production growth that continues to overwhelm demand and oil appears structurally tighter leading us to favor oil/liquids-levered names. For 2012, we believe there are five key themes E&P investors should focus on:

1. Stay away from gas. The 2012 U.S. natural gas outlook is exceptionally poor. We currently anticipate supply exceeding demand by ~1.2 bcf/d which would result in full storage capacity being reached in October with curtailments likely. Under this environment, gassy names should be avoided. While we recognize that both producers and investors share this outlook, incenting some investors to want to take a contrarian approach, the valuations of many gas-levered E&P’s nonetheless offer limited upside to their NAV based on current strip prices.

2. Focus on companies that can execute. Since we are not expecting a huge tailwind on the commodity price front, we believe investors should focus on companies that have a proven track record for operational execution. These companies typically are well capitalized, have superb technical teams and are relentlessly focused on developing their resources (and growing production) in a low cost manner. We believe execution will be the margin of difference between those E&P’s that outperform and those that do not in 2012.

3. Seek exposure to attractive, liquids-levered emerging plays. We expect plays like the Utica, Miss Lime and HZ Wolfcamp to continue to gain investor and industry interest in 2012. DVN’s recent joint venture with Sinopec for ~$5,000/acre in their 5 new venture plays offers further proof of the potential value in these emerging plays.

4. Look for more consolidation ahead. 2011 witnessed BHP’s acquisition of HK and we expect more of the same in 2012. Top M&A candidates by category (especially for NOCs/IOCs): Large Gas Resource (COG, RRC), Liquids Growth (OAS, PXP, ROSE), Management Transition (EOG) and Leading Large Cap (APC).

5. Production growth might be tempered, but this is not necessarily bad. Given the poor gas outlook, we expect producers to reduce gas production volumes which likely translates into lower total company production growth. However, gas margins are likely to be very small and in some cases negative. As such, as producers concentrate primarily on increasing high margin oil volumes, then cash flows and earnings will actually increase.

Favorites: Defense: APC, NBL and PXD. All three of these companies are well capitalized and have excellent diversified portfolios and are defensively postured companies. While they have outperformed in ’11, we expect more of the same in ’12. Most important, these companies have proven recent track records for execution which we believe will be important. Offense: DNR, PXP and SD. All three companies have oil-leverage which we prefer. While two of these three companies outperformed in 2011, we believe there is significant upside in a more “risk on” world specifically for SD which offers over 100% upside to our NAV.

Oil Service and Capital Equipment 2012 Key Themes: Our base case assumptions for ’12 are driven by the following commodity price assumptions: WTI = $90/bbl (Current ’12 Strip ~$102/bbl), Nat Gas = $4.00 (Current ’12 Strip ~$3.30/mcf), Brent = $100/bbl (Current ’12 Strip ~$109/bbl). This collective framework drives a flat-to-up US onshore rig count relative to Q4’11 (or +7% y/y) , a y/y increase of 7% in the Canadian rig count and a ~10% y/y increase in the international rig count. Key themes are as follows:

1. Oil Service NAM capacity expansion likely leads to a normalization in pricing/margins rather than resilience or a collapse. Bigger companies with a more diversified geographic presence and PSL portfolio, however, will likely display better relative margin insulation vs their smaller cap more specialized and narrowly focused peers. That said, margins over the course of ’12, even for the bigger oil service companies with GOM exposure should drift lower due to due capacity expansion, supply chain stresses and oil service cost of goods sold inflation. Moreover, the implosion in nat gas prices will accentuate E&P hawkishness and fray oil service willpower.

2. NAM oil service consolidation prospects will likely gain impetus due to growing labor constraints as well as the cycle transitioning into a more mature phase resulting in increased competitive pressure, especially given the implosion in nat gas prices.

3. Execution reliability is increasingly a key consideration for NAM operations as the margin for error is diminishing given less generous pricing leverage, on the one hand hand, and growing supply chain stresses and oil service cost of goods sold inflation on the other.

4. Subsea capital equipment is expected to witness a step-change increase in orders in ’12. Following the halcyon days of ’05-’08, during which subsea tree awards averaged 445 per annum, the last three years the industry has slumbered as subsea tree awards have averaged ~350 per annum over the ’09-’11 period. While the prophecy of Quest Offshore calling for in excess of 600 subsea tree awards this year may be exuberant, the award total could easily exceed 500 based on compelling project visibility.

5. Will international deliver another uninspiring year of relatively listless revenue and margin performance? Considering that Brent averaged $110/bbl last year, ’11 was one of the most undistinguished years for international oil service rev/margin performance we have ever witnessed. Our expectation is that ’12 will generate high-single digit, low double-digit revenue gains (essentially in-line with rig count) and labored margin improvement driven by better cost absorption. Thus, while this year should be improved over last, we aren’t expecting a step-change improvement in margins.

Favorites: Defense: SLB and OIS. SLB’s relative weighting to international and deepwater should lead to more insulated operating income relative to peers in the event oil prices retrench and valuation (15x ’12, 12x ’13) isn’t excessive. That said, the ’12 Street estimate of ~$4.90 (SCI = $4.65) are on the high-side. OIS was one of the best performing stocks in ’11, rising by 18% last year as 2/3 of its EBITDA is derived from non-NAM related activity and its Accomodations and Offshore Products businesses command above-average revenue visibility. Trading at 11x ’12 and ‘10x ’13, OIS is not arrestingly cheap on a relative basis but screens cheap on an absolute basis – at long last this company is being recognized for superior execution and reliability. Offense: WFT, HAL and KEG. WFT continues to prosecute a quiet internal transformation which should lead to more consistent performance and reliable expectations management. Moreover, the company’s production based businesses in NAM and land-based businesses internationally provide above average insulation relative to

capacity creep (NAM) and irrationally competitive pricing behavior in the international deepwater markets tendencies. Trading at 10-11x ’12 and 8x ’13, WFT is cheap and representative of good value. HAL’s absurd valuation is simply too cheap to ignore (8-9x ’12, 7-8x ’13) and the likely resolution of Macondo within the next few months provides for a decent catalyst. The longer term well intervention story is real and this will be important for KEG. Mgmt is executing well and the recent acquisition program has been completed in a disciplined manner and should allow KEG to show significant y/y earnings growth in ‘12. Valuation is reasonable trading at 9-10x ’12 earnings and 4.5x EBITDA.

Offshore Drillers 2012 Key Themes: The offshore drillers enter 2012 with a day rate tailwind at their back and rising cost and downtime challenges (the latter more specific to floaters) serving as militating headwinds – and ample debate on the Street as to which will ultimately prevail with respect to earnings revisions over the course of next year. Our FY’12 earnings estimates are on average (only) -5% below the Street and ours reflect anywhere between 4-7% baseline inflation assumptions, which we concede are not entirely without risk of being proven optimistic. That said, we have also frequently highlighted the numerous areas in which our day rate assumptions are likely to prove conservative if the cycle holds up. It is well appreciated that the ultradeepwater market is tight near term (i.e., effectively sold out until 2013) and that day rates are going up, but the pace and vigor of rate momentum could surprise positively, especially if recent scuttlebutt about PBR taking picking up 6-7 incremental rigs next year materializes (the most recent tender deadline appears to be Jan 12, although this has been an exceedingly fluid timeline). The global jackup market quietly improved last year with utilization firming over the course of last year (total utilization improved from 68% to 79% and marketed utilization from 70% to 92%) as global demand improved by close to 20% from 323 units to 385 units, while day rate improvement was characterized by baby steps. Fair to reason, in our estimation, that 2012 should range between fair and very good for the jackup market.

1. Deepwater exploration success fueling increased rig demand. Whether it’s been STL et al with Skrugard and Aldous/Avaldsnes, TLW in French Guiana, NBL’s continued successes with Med gas, or most recently CIE’s intriguing results on Block 21 Angola, the hits have just kept coming, and the pull-through for rig demand could be materially needle-moving sooner than later. We have brought most of our UDW rate assumptions to the $475-$550k/d range (low end = Ensco 8500s, high end = top drillships), but what if we’re already seeing $550-$600k/d printed with frequency 6 months from now – that’s not in the stocks, and yes it could happen.

2. New valuation demarcations emerging via high-end and low-end pure plays. Essentially all of the mid/large cap US listed offshore drillers are comprised of hybrid fleets, either in terms of their age profile and/or their floater vs. jackup orientation. Hybrid typically means less transparent when compared to pure-play, especially along the fleet age continuum, but the toolkit for benchmarking these companies is presently being expanded by the recent listings of ORIG and PACD (pure UDW fleets currently trading at $600-$700M per rig), and will be further enhanced by the expected divestitures by NE and/or RIG of significant swathes of their respective legacy (old) jackup fleets. In a second-hand jackup market seemingly crowded with sellers rather than buyers, adequate realizations (broadly speaking, ≥$45-50M per legacy jackup) achieved in scale could prove supportive to the stocks.

3. Day rate gains have the potential to outrun corresponding newbuild additions. While the industry enjoyed a brisk demand revival over the preceding 12-15 months, newbuild orders arguably overwhelmed day rate momentum over this period. Today however, simply by virtue of the industry having less collective dry powder and, on balance, more restrained risk appetite (most recent newbuilds are still without contracts), 2012 holds the potential to be a fundamentally better behaved “up year” than 2011 was.

4. Prominent risk factors: i) baseline opex inflation exceeding the 4-7% in our models (Street estimates are less conservative), and ii) floater uptime. Brazil carries above avg risk in both departments, with some speculation of double digit y/y inflation in store this year and PBR’s well documented exacting standards on operational thresholds for day rate achievement. There is no clear answer as to how/when/by how much floater uptime will begin to “normalize” at higher, closer to historical levels. With rising pricing power, the drillers are testing better contract terms on this front, but that does little to insulate 2012 earnings. Consensus speculation for most at risk 2012 estimates in these regards are DO and NE (RIG is excluded because 2012 has already been ratcheted way down and there is diminishing shock value from

here) – ESV carries a self-imposed best-in-class operational standard that must be met, and SDRL has directionally indicated the possibility for internal efficiency gains to offset inflation next year.

5. Return of Cash initiatives remain a key investment consideration. Our summary expectations: SDRL will bump their $3.04 annual dividend incrementally higher, with balance sheet capacity and fleet expansion constraining material dividend expansion; RIG’s $1B annual dividend is not necessarily a sure thing for renewal – they just did a rather shocking equity infusion, after all – Macondo settlement weighs prominently on the dividend possibilities, obviously; DO’s $3.50 can be maintained according to our model, with a modicum of balance sheet expansion – we don’t see it increasing or being cut based on the current capex slate – more aggressive fleet investment could alter this base case view; ESV’s $1.40 dividend is biased higher over time as the company has a 12-14% apparent FCFR yield in 2014-15, but not necessarily a near term event; NE’s CHF 0.52 per share dividend appears locked in from our perspective; RDC recently announced an opportunistic $150M buyback, but we would expect more emphasis on fleet investment (more drillships) going forward as opposed to meaningful cash returns to shareholders.

Defense: DO. We’re generally a bit more offensively than defensively disposed toward the drillers based on our aforementioned expectations for healthy fundamentals. . . But, if that cornerstone premise is invalidated, DO tends to be one of the better safe haven stocks in oil service due to its deepwater backlog, dividend yield (6%), and pristine balance sheet (8% net D/C). One can find most of these qualities (ahem, ex balance sheet strength) in RIG as well, but DO obviously comes without the massive wild card of Macondo settlement. DO currently trades at a relatively low EV/RV of 83% on our estimates and its 1.8x tangible P/B is 15% below its Jan ’09 trough of 2.1x (note, DO’s book value is suppressed relative to peers to DO’s long established high dividend payout legacy). Offense: RDC, ESV, NE. RDC admittedly more offensive than ESV and NE. We highlight RDC as an offensive pick for two reasons: a) most-in-class jackup exposure which is by definition more economically sensitive than deepwater, and b) its embryonic deepwater footprint consists of three spec drillships, thus a higher risk/reward deepwater position than peers in a rising rate environment. RDC is the cheapest name in the group on our asset valuation metrics, trading at 78-80% of RV. It is also trading at 0.9x tangible book. Screens decently well vs. group on ’12-’13 multiples as well, generally 10-15% cheaper than the balance of peers at ~9x P/E,~6x P/CF, and ~5.5x EV/EBITDA. We have recently been thinking of RDC as being somewhat catalyst short, but the quickening UDW market could spell material contract news for RDC sooner as opposed to later. ESV possesses an above avg jackup fleet and an above avg deepwater fleet. Two of ESV’s key positive distinctions continue to be its relatively open UDW fleet (7 of its 14 UDW floaters open up by or within ’13 and three more are open in ’14) and its burgeoning FCF visibility (~7% FCF yield for ’12-’13, then 12-15% for ’14-’15) which carries weight for a company with a distinguished and shareholder-friendly track record on capital allocation. ESV was a dominant stock in Q4 (+20% vs peers ex HERO +5%) and is thus no longer categorically cheapest on all accounts, but it does still screen attractively on a few key metrics – its ’12-’13 P/Es of ~8x are 20-25% cheaper than avg and its ’12-’13 P/CFs of 5.5-6.0x are 10% cheaper than avg. Unique blend of growth, value, deepwater, jackups and, not least, uber-reliable management. Along with RDC, NE is the other driller that is undergoing the most pronounced metamorphosis in terms of fleet complexion – RDC’s is a diversification from high end jackups into high-end hybrid, while NE’s is a upgrade from sub-spec hybrid to high-end hybrid. A sale of a substantial portion of its low-end jackup fleet represents a key next step in this process and could be a positive catalyst (at the right price) in terms of accelerating this process and potentially narrowing NE’s spending deficit which we estimate at about $700-$800M over the next two years. Like RDC and ESV, valuation is relatively attractive at 9x P/E and 5x P/CF on both ’12 and ’13. Currently at 1.1x tangible book vs. Dec ’08 trough of 1.1x. Not without near term catalyst potential as the looming Jim Day contract announcement(s) should set a modern era day rate record.

Integrated / Major Oils 2012 Key Themes As we begin 2012, amidst an uncertain macroeconomic backdrop, the super major coverage universe will continue to offer attractive defensive characteristics, not the least of which is an average combined yield (dividend + repos) of almost 7%, as well as reasonable valuation. And while the higher beta US Mid-Cap and International stocks underperformed in 2011, should broader economic headwinds subside during the year, causing investors to transition to a more offensive positioning, we believe these companies are well positioned given our macro energy outlook. For the most part, these companies are much more levered to those commodities with more favorable fundamentals (oil and international gas prices) than they are to US natural gas. We believe global energy investors will be well served to focus on a few key themes during the year, namely:

1. A Better year for Growth: 2012 should be a better year for production growth, especially relative to the disappointment that was 2011.

2. Higher Level of Major Project Startups: Total 2012 major project startups (1.6 mb/d) will exceed startups in 2011 by 20% and will come from a more diverse assortment of developments (We count 12 major projects in 2012 with gross capacity of 100 kboed or more vs. just 5 in 2011)

3. Rising Capex, With Focus on Upstream, North America, and Global Exploration: Overall, we currently expect total capex for our coverage universe to rise by approximately 11% y/y in 2012 (excluding PBR), compared to an increase of 16% in 2011. We calculate that a subset of 8 companies under our coverage is likely to spend ~$47B in US/NAM capex in 2012, representing an increase of ~18% from the 2011 total and ~72%, or almost $20B, from the 2010 total.

4. Potential for Continued Levels of Heightened M&A Activity, particularly in NAM: Deal flow could remain elevated, particularly in NAM, as majors continue to place a premium on the relative predictability and scalability that NAM unconventional provides.

5. Downstream Challenges: The broad refining landscape remains challenged, primarily characterized by industry-wide overcapacity, although tight distillate markets could serve as a bright spot. Companies will remain focused upon cost control and optimization of downstream portfolios to enhance returns and profitability.

Favorites

In constructing our list of 2012 favorite stocks, we highlight two core holdings with above average 2012 and longer-term production, earnings, and cash flow growth potential (RDS & OXY), as well as two oil-levered equities we believe are mispriced, therefore offering potential for enhanced returns through multiple expansion as stock specific concerns dissipate (SU & MRO). Defense: RDS. RDS is a favored defensive holding in 2012 as we believe the stock offers superior production and cash flow generation potential that is not fully captured in valuation. RDS additionally offers the most impressive backlog of major projects among our coverage, featuring sizeable near-term start-ups/ramp-ups, above average visibility into longer-term production growth, above average oil weighting, and sizeable LNG contributions. ~5% dividend yield with room for growth offers nice support. Offense: OXY, SU, MRO. We view OXY as core energy holding offering top tier oil leverage on reserves and production, above average growth potential in 2012, as well as impressive long-term growth visibility underpinned by a substantial domestic resource base. OXY also offers impressive returns, solid balance sheet,

above average FCF generation, and top tier net income/bbl. SU has been a laggard that declined 25% in 2011, despite EPS that likely rose ~100% y/y and FCF which likely grew ~90% y/y. Stock now trades at cash flow and earnings multiples in-line with the Super Majors, despite the fact that SU offers potential production growth of ~8% pa through 2020, most impressive resource base under coverage, highest oil exposure in sector, and unique benefits from its truly integrated business model. MRO trades at the cheapest cash flow multiple among our coverage and one of the cheapest earnings multiples, meaning many positive elements of the MRO story are largely overlooked, namely a leadership position in one of the most attractive unconventional US plays (Eagle Ford), above average cash flow generation capability for the peer group, above average oil leverage, solid balance sheet, and largest dividend among the US mid-caps. The key to releasing value is in convincing the market that the Company can successfully execute in the Eagle Ford– which will likely take a few quarters. We believe the management team, which is now solely focused on upstream operations, fully understands that the MRO story now hinges on execution and is up to the challenge.

Refining

2012 Key Themes: 1. We expect refining global capacity growth of over 2 mb/d net of closures in 2012, almost double

expected global demand growth which will be largely dependent on global economic growth (given increasing US product exports and international trade).

2. WTI discounts will be a critical variable again in 2012 and we expect a fair amount of volatility in the differential. WTI/Brent/LLS discounts peaked in Sept at $28/bbl, averaged $16/bbl in 2011, current spot is $9/bbl, the 2012 forward diff is about $6/bbl and current earnings estimates factor in about $9/bbl. The differential could be impacted not only by the pace of NAM supply and infrastructure development, but also events that impact global supply & demand balances. We expect WTI discounts to narrow in 2013 and 2014 toward new pipeline tariffs of about $4-$5/bbl.

3. USEC/Atlantic Basin refining rationalization could be a factor in 2012, as the possible closure of ~700 kb/d of existing refining capacity could create infrastructure constraints and arbitrage opportunities.

Favorites Defense/Offense: VLO is both our defensive and offensive pick for 2012. While we see no urgency for initiating a position in VLO due to near-term downward earnings revisions, VLO has a positive outlook for 2013 post the completion of its major capital projects. VLO’s major project investments should add incremental EBITDA of over $1B (20% EBITDA growth relative to our 2012 estimate) which is more organic growth than the peer group. That said, the volatility in the refining sector and the near-term potential economic challenges has investors hesitant to look to 2013 at this point. VLO has not been a major beneficiary of the WTI discounts for feedstock, and the stock is the closest to its 2008/09/10 lows (mid-teens) of any in the peer group. VLO is cheap trading at 3.5x 2012 EBITDA (peer group 3.2x, VLO 5-yr range 3.5x to 6x), 22% of replacement costs and 70% of book value.

Coal 2012 Key Themes: The coal market in 2012 was positioned for the same despondency that permeated the industry for the bulk of 2011. However, the 11th hour court ordered delay of the EPA’s CSAPR alleviated some industry woe, at least temporarily. Following two excellent annual coal equity performances, 2011 was more than a mild digression as coal equities finished the year down 50% on average. For 2012, we believe there are five key themes coal investors should focus on:

1. Weather is always a key issue and has the potential to swing the market in 2012. Temporary market euphoria in early 2011 developed as Australian rains curtailed significant met supplies and a harsh winter globally strengthened thermal demand. However, this strength proved unsustainable as pricing for both met and thermal coal has been in free-fall since hitting high-water marks in March/April.

2. Overall demand contraction due to low natural gas prices and new environmental regulations have hit the U.S. thermal market hard. We believe that CAPP thermal pricing is near a bottom, but we have not seen the production impacts that will likely come from lower pricing and demand levels. Our view on natural gas has prices remaining between $2.50-$4.50/mmbtu, levels that will not incentivize utilities to look back to coal anytime soon.

3. Although U.S. utility inventories have fallen back to historical averages, utilities are much more comfortable than we thought they would be at current inventory levels due to a lack of forecasted coal burn in 2012. The recent court ordered stay placed on the EPA’s proposed CSAPR means that 2012 has the potential to post improved demand levels for coal. In the short-term, the delay will likely improve coal contracting, especially in the East, and move NYMEX pricing off the current $70/ton quote.

4. We believe the downward pricing trend for metallurgical coal will continue into the next quarterly contract as global market demand remains moderate. We expect the current $235/tonne met price marker to fall to $200-$215/tonne for calendar Q2’11 deliveries. With these lower prices, growth economies such as China and India could step in meaningfully to support prices.

5. Global economic growth levels will significantly influence met coal as the year progresses. Even with pricing support from China and India, improving global demand is necessary for met coal pricing improvement during the back half of 2012. We have modeled a $215/tonne average price assumption for the full year.

Favorites: Defense: CLD. Cloud Peak continues to operate the most stable company within the coal sector. We have not given enough credit to this stability that includes excellent operational performance and a consistent forward commitment strategy. CLD currently trades at 3.5x and 3.1x 2012 and 2013 EV/EBITDA respectively, representing a 35% and 38% discount to our coal universe averages. Offense: ANR. We believe 2012 will be a better relative performance year for ANR. With a 25 MM ton met footprint, as met goes, so ANR will go. We believe this is the best name to own on a met upswing due to their cheap relative valuation, their improving cost footprint in CAPP, and limited exposure to lower quality met coal. They have significant exposure within the Eastern market and production curtailments will likely be a headwind, but we believe shutting higher cost mines has advantages that outweigh the production losses.

Alternative Energy

2012 Key Themes: The alternative energy industry considerably lagged the overall market’s performance in 2011 for the second year in a row. Traditional alternative energy markets witnessed significant changes with subsidy regimes and, in general, solar and wind producers have had a tough time finding utilities willing to take on projects during the year. Bright spots exist in select markets, with the U.S. posting both solar and wind installation gains and China continuing to provide an avenue for growth, but the European market in particular continues to rely on the subsidy related boom-bust cycles that hurt industry consistency. For 2012, we believe there are five key themes alternative energy investors should focus on:

1. Wind energy installations in 2012 have the potential to improve from 2011 levels as order flow has improved throughout the year. The U.S. posted improving figures in 2011, but global growth was muted by unfavorable economic conditions. Stabilization in 2012 would go a long way to incentivize additional wind power installations.

2. Offshore wind developments will hit the headlines frequently, but that portion of the market is still many years from gaining significant share. Wind market influences vary by country, but overall low power demand, depressed natural gas prices, attainable renewable energy goals and even renewable overbuilds are all factors muting utility enthusiasm for new wind projects, onshore and off.

3. We continue to believe that the longer natural gas prices remain low, the easier it is to make a case for natural gas as a domestic transportation fueling option. Policy and incentives would help, but the economics make sense on their own and have started to garner more attention. It is still too early to discern whether this attention will translate into capital spending, but the potential is there.

4. Solar subsidy markets are in disarray, margins are being compressed, trade disagreements are heading to court and the solar market remains significantly oversupplied. These are not the cornerstones of a salutary thesis for solar in the short-term. Industry consolidation has already begun with numerous companies filing for bankruptcy or actively seeking financing options. Only strong companies will survive and even those will do so with lower margin business for quite some time. Cheap traditional power prices have had an effect on the industry and an excess of solar cell/panel/module supply prevents any pricing power for producers.

5. A new solar strategy for FSLR is the boldest move seen within the solar market. Under their current three-year plan, they intend to reduce costs and target new markets where utility scale solar can compete unsubsidized with traditional generation. The strategy has raised eyebrows and it will be very interesting to see if the global solar market is capable of sustaining a solar leader like FSLR utilizing this strategy.

Favorites: Defense: CLNE. With ample capital and an ever improving project (station) build-out plan, CLNE could have a solid 2012. Volume growth has been decent, but we worry somewhat about continued margin compression as additional regional trucking gallons roll-in. The company expects margin compression as a sacrifice for higher total volume sales, but this could temper investor enthusiasm in the short-term. Offense: FSLR and SPWR. These two names both have valuation backstops in the form of outside or internal balance sheet support and could potentially benefit as additional solar manufacturers go belly up. We believe FSLR screens cheaply on 2012 earnings, but it is the longer term earnings power that worries us. Margin compression is coming, but the magnitude is unknown. SPWR has financial backing from Total and catalysts for

the name include utility scale potential and access to emerging markets. For those that want to take a flyer on solar, these two names are the list to choose from, but we believe the risk/reward is still tough to quantify.

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Appendix D

Analyst Certification:

I, Bill Herbert, hereby certify that the views expressed in this research report to the best of my

knowledge, accurately reflect my personal views about the subject compan(ies) and its (their) securities;

and that, I have not been, am not, and will not be receiving direct or indirect compensation in exchange

for expressing the specific recommendation(s) or views in this research report.

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