oil-gas-basics-jp-morgan-2008.pdf
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M A R C H 2 0 0 8
O I L & G A S B A S I C S
STRIC
TLY
PRIVATE
AND
CO
NFIDENTI
AL Katherine Spector
(1-212) 834-2031katherine.b.spector@jpmorgan.com
Scott Speaker
(1-212) 834-3878
scott.c.speaker@jpmorgan.com
Kristi Jones
(1-212) 834-2835
kristi.l.jones@jpmorgan.com
Sung Yoo
(1-212) 834-7045sung.k.yoo@jpmorgan.com
Sachin Kirtane
(1-212) 834-8046sachin.p.kirtane@jpmorgan.com
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This presentation was prepared exclusively for the benefit and internal use of the client in order to indicate, on a preliminary basis, the feasibility of apossible transaction or transactions and does not carry any right of publication or disclosure to any other party. This presentation is incomplete withoutreference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contentsmay be used for any other purpose without the prior written consent of JPMorgan.
The information in this presentation is based upon management forecasts and reflects prevailing conditions and our views as of this date, all of which aresubject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness ofall information available from public sources or which was provided to us by or on behalf of the client or which was otherwise reviewed by us. In addition,our analyses are not and do not purport to be appraisals of the assets, stock, or business of the client. The information in this presentation does not takeinto account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuationand other effects.
JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loanarranging, financial advisory and other investment banking activities are performed by J.P. Morgan Securities Inc. and its securities affiliates, and lending,derivatives and other commercial banking activities are performed by JPMorgan Chase Bank and its banking affiliates. JPMorgan deal team members may
be employees of any of the foregoing entities.
O
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Agenda
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References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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From the well to the tank. . .
Source: JPMorgan Energy Strategy
2WHERE
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OIL
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Where are most of the worlds oil reserves?
Source: JPMorgan Energy Strategy, BP Statistical Handbook (June 2007)
Proved Oil Reserves (end 2006)Proved Oil Reserves (end 2006)
40.5 59.9
117.2 103.5
144.4
742.7
Asia Pacific North America Africa South & Central
America
Europe & Eurasia Middle East
In thousand million barrels
3WHERE
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ro ucer o ume
Russia 9396au ra a
Iran 3983
C ina 3729
Mexico 3083
UAE 2494Venezue a 2419
Kuwa t 2168N ger a 2162
Iraq 2083
orway
Cana a 1930
Brazi 1748L ya 1743
UK-o s ore 1433Ango a 1371
A ger a 1363
Kaza stan 1289
Azer aijan 860n ones a
a ar
Argentina 763
Oman 713
In ia 699
Ma aysia 695
Egypt 633
2.8%
4.7%
4.4%
3.6%
2.9%
are o o a ro uc on
11.0%
.
.
2.5%
2.5%
2.4%
.
1.5%
1.0%
2.3%
2.0%
2.0%
1.7%
0.8%
0.8%
0.7%
.
.
0.9%
0.8%
1.6%
1.6%
Who are the worlds top producers of crude oil?
The worlds biggest producers are not
necessarily the same as the worlds
biggest exporters. For example, the US
and China produce a lot of oil, but
export very little given high domesticdemand
OPEC members Saudi Arabia and Iran
are the worlds biggest exporters of
crude oil
2007 Averages (kbd)2007 Averages (kbd)
Note: Bold = OPEC membersSource: JPMorgan Energy Strategy, IEA
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How is crude oil related to other oils, like gasoline and heating oil?
Crude oil is what gets pumped out of the ground. Very little crude oil is consumed directly it is a
raw material that has to be refined into other products, such as gasoline and heating oil
Oil refining is the process of turning crude into the fuels that we use every day, such as gasoline,
heating oil, and jet fuel. Though refining processes differ according to the desired product, all begin
by heating crude at increasing temperatures to separate it into component parts
Source: JPMorgan Energy Strategy
ReRefining processAlkylation
Catalytic Reforming
Hydrocracker
Catalytic Cracker
Coker/Thermal Cracker
Hydrogen
Chemicals
Gasoline
Gasoline
Kerosene
Gasoline
Gasoil/Diesel
Naphtha
Gasoline
Heavy Gas Oil
Coke
Gasoline Blending Components
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Top Oil Consumers (2006)Top Oil Consumers (2006)
Where are the worlds top consumers of oil?
FSU
5%
Japan
6%
China
9%
United States
25%
Other49%
India
3%
Germany
3%
Source: JPMorgan Energy Strategy, BP Statistical Handbook (June 2007)
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References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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Energy markets cycle through periods of over- and under-investment
Low prices discourage investment all along the supply chain. As demand grows, spare capacity falls
and prices rise. High prices spur new investment. The lead-times for energy industry investment
means that periods of over-and under-capacity dont go away over night. But the market always
does its job eventually!
1,000
2,000
3,000
4,000
5,000
6,000
7,000
'75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07
# Rigs
$-
$20
$40
$60
$80
$100
$120
$140
$/bbl (real)
Global Rig Count (Left)
Real Price of Crude (Right)
Source: JPMorgan Energy Strategy
Baker Hughes World Oil & Gas Rig Count and Crude PriceBaker Hughes World Oil & Gas Rig Count and Crude Price
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The cycle of investment
OECD Oil Demand vs. Refinery CapacityOECD Oil Demand vs. Refinery Capacity
In million b/d
20
25
30
35
40
45
50
55
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06
Refined Products Import Gap
Refinery Capacity
Oil Demand
Source: JPM Energy Strategy , IEA, EIA
Downstream investment, or lack
thereof, is also cyclical and tends to
over-shoot in both directions
Theres no reason to think that thisinvestment cycle wont eventually
be the same
OECD demand exceeds OECD refinery
capacity. That means that, increasingly,
spare refinery capacity is in the non-OECD. That means that just like
crude production most of the worlds
refined products production is
geographically far away from most of
the worlds consumption
0
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Energy infrastructure/distribution capacity is still a constraint
Global Oil Demand Supplied By International TradeGlobal Oil Demand Supplied By International Trade
More refined products, in particular, have to travel greater distances to their end user. Ports,pipes, tankers, etc. are all an issue will they see the investment boom that refining is seeing?
Oil Trade:Oil Demand
30%
35%
40%
45%
50%
55%
60%
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1987-91: 46%
1992-96: 53%
1997-01: 56%
2002-06: 60%
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Crude Refined Products
1987-1995 3.6% 1.8%
1996-2005 2.5% 3.8%
2001-2005 1.7% 5.4%
Growth In Waterborne
Crude & Products Transport
Source: Clarkson's Shipping Review
0%
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INVESTM
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CYCLE
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References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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Oil is a global market
Its impossible for oil prices to go up in one part of the world, without
prices in other parts of the world being impacted
If there is a disruption in any producing country that affects prices, that
disruption will affect prices everywhere, even in countries that do not getcrude supplies from the country with the disruption
Broadly speaking, oil is fungible: a commodity that is freely
interchangeable with another in satisfying an obligation
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Is all crude oil the same?
There are many different grades of crude oil. All grades have different qualities, and sell for
different prices based on their qualities
When we talk about light,
sweet crude, we mean grades
with a high API gravity number,and a low sulfur content. A
heavy, sour crude has a low
API gravity and a high sulfur
content
In general, light/sweet crudetends to sell at a higher price
than heavy/sour crude
In general, refiners can produce
a higher yield of high quality
refined products, such asgasoline, by running light/sweet
crudes. Heavy/sour grades yield
less gasoline, and more of the
dirty products such as fuel oilSource: JPMorgan Energy Strategy
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Major global crude benchmarks and oil market centers
Dubai
London (IPE)
Dated BrentUrals
WTINew York(NYMEX)
Tapis
Singapore
Oman
Source: JPMorgan Energy Strategy
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Source: JPMorgan Energy Strategy
How oil (gas, etc.) trades
Formal Exchanges (futures)
Intl Petroleum Exchange(London)
Brent Crude
1 lot = 1,000 bbl
Gas Oil
1 lot = 100 tonnes = 750 bbl
NY Mercantile Exchange
West Texas Intermediate(Light, Sweet) Crude
1 lot = 1,000 bbl
Heating Oil
1 lot = 42,000 gallons = 1,000 bbl
Unleaded Gasoline
1 lot = 42,000 gallons = 1,000 bbl
Henry Hub Natural Gas
1 lot = 10,000 MMBtu
Over-the-Counter (swaps)
Swaps/Options
Variety Of RegionalBenchmark Crudes andRefined Products. . .
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How to look at the futures screens
Nymex CL (crude) Nymex HO (heat)
Time spreads
e.g. Q1 vs. Q3; winter vs. summer, Cal 05vs. Cal 06
Regional spreads
e.g. NYMEX West Texas Intermediate vs.IPE Brent, NY Harbor gasoline vs. US Gulfgasoline
Crude vs. refined product spreads
Cracks (e.g. crude-gasoline;crude-heating oil)
Refinery margins
Crude grade differentials (physical trade only)
e.g. West Texas Intermediate vs.
West Texas Sour; Bonny Light vs. Brent
Product vs. product spreads
e.g. gasoline-heating oil
Interfuel spreads
e.g. natural gas-heating oil
Relationships To WatchRelationships To Watch
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Price relationships to watch. . .and what JPMorgan trades
Time spreads
e.g. Q1 vs. Q3; winter vs. summer, Cal 05vs. Cal 06
Regional spreads
e.g. NYMEX West Texas Intermediate vs.IPE Brent, NY Harbor gasoline vs. US Gulfgasoline
Crude vs. refined product spreads
Cracks (e.g. crude-gasoline;crude-heating oil)
Refinery margins
Crude grade differentials (physical trade only)
e.g. West Texas Intermediate vs.West Texas Sour; Bonny Light vs. Brent
Product vs. product spreads
e.g. gasoline-heating oil
Interfuel spreads
e.g. natural gas-heating oil
Oil
Crude WTI Brent Tapis
Dubai Refined products
US market:
NYMEX heating oil US Gulf Coast heating oil US Gulf Coast jet fuel
NYMEX gasolineEuropean market:
IPE gasoil Gasoil 0.2% CIF NWE Jet fuel cargoes CIF NWE EN590 cargoes CIF NWE
1% and 3.5% fuel oil cargoes FOB NWEAsian market: Singapore jet fuel
Natural Gas:
NYMEX natural gas
European natural gas priced as oil-referencedformula
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Some futures curves are seasonal
Some futures curves assume a more or
less standard seasonality
For example, the heating oil and
natural gas curves always reflect theexpectation that heating oil and natural
gas will be more expensive in the
winter. The gasoline curve reflects the
expectation that gasoline will be more
expensive in the summer
Traders look for opportunities to take
advantage of abnormalities in the
typical seasonality of the curves
Natural GasNatural Gas
Gasoline vs. Heating OilGasoline vs. Heating Oil
6
7
8
9
10
11
Mar08 Aug08 Jan09 Jun09 Nov0 Apr10 Sep10 Feb11 Jul11 Dec11
$/MMBtu
Source: JPMorgan Energy Strategy
Delivery Month
$/gallon
$2.20
$2.40
$2.60
$2.80
$3.00
$3.20
Apr08 Sep08 Feb09 Jul09 Dec09 May1 Oct10 Mar11 Aug11
Delivery Month
NYMEX Heating Oil
NYMEX Gasoline
Source: JPMorgan Energy Strategy
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Conventions of the oil market
Commodity Lot Size Quote Unit
Crude (global) 1,000 barrels US$/barrel
Gasoline (US) 42,000 gallons cents/gallon
Heating oil (US) 42,000 gallons cents/gallon
Gas oil (Europe) 100 metric tons US$/metric ton
Jet fuel (Europe) 100 metric tons US$/metric ton
Natural gas (US) 10,000 MMBtu US$/MMBtu
BenchmarksBenchmarks
Barges: 1,000 - 5,000 MT (2 - 8 days loading)
Cargoes: 10,000 - 25,000 MT (15 days loading)
ParcelParcel
Delivery specifications are factored into the cost of products. For example
Free on Board (FOB)
Cost Insurance Freight (CIF)
In the US, products may be priced as pipe, barge, or waterborne based on delivery method
Delivery MethodsDelivery Methods
Europe: Amsterdam-Rotterdam-Antwerp; Arab Gulf; Mediterranean; North West Europe; Rotterdam.
United States: New York Harbour; Los Angeles; San Francisco; US Gulf Coast; Midcontinent; West Coast.
Singapore
Main LocationsMain Locations
Source: JPMorgan Energy Strategy
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For example. . .
What is the price of spot fuel oil (a heavy, refined product) relative to crude?
What region? Europe.
Rotterdam or Med? Med.
What sulphur content? 1%.
CIF or FOB? CIF.
Barge or cargo? Cargo. $239/tonne
Compare to what crude? Urals.
36.60 x $1.34 - $239 x 1 tonne = $13.16/bbl
1 bbl Urals 1 1 tonne FO 6.66 bbl
Extensions of this idea?
Look at the forward spreads; look at the spread to the US or Asian fuel cracks
Warning!
When using futures to compare different products, check for varying expiration dates.
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Market drivers to watch lots of moving parts!
Macro economy
Sectoral trends are growth sector
energy intensive?
Power generation trends what kind
of fuel does new generation use?
Transportation trends number and
type of cars sold?
Tax and subsidy regimes distort
price signals to consumers and
affect their consumption behavior
Weather, seasonality winter heating
demand, summer cooling demand,
holidays, vacation and travel trends
Non-oil fuel markets, substitution
(e.g. gas, coal, hydro, nuclear)
Misc events e.g. SARS, Sep. 11
Upstream investment capacity
additions? Cost? Location? Type of
crude?
Natural decline rates Field age, field
maintenance, geological makeup
Geopolitics (e.g. Iran, Nigeria)
Field maintenance, unplanned outages
Weather (e.g. hurricanes)
OPEC decisions and politics internal
politics, spare capacity, relationships
with consumer countries
Level relative to long term trend and
normal seasonality
Level relative to demand
Regional distribution
Levels at transit points
Crude versus refined product levels
Oil DemandOil Demand Oil SupplyOil Supply Oil InventoriesOil Inventories
Deals associated with
mergers/acquisitions
Speculative flows
Tanker supply/demand/rates
Seaborne disruptions weather, traffic,
accidents
Port capacity, availability
Pipeline capacity/nominations
Refinery capacity/investment
Planned outages, unplanned outages
Refining economics, run rates
Refined product yields
OtherOther
DistributionDistribution
Oil RefiningOil Refining
Source: JPMorgan Energy Strategy
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References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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$10
$20
$30
$40
$50
$60
$70
$80
$90
$100
95 96 97 98 99 00 01 02 03 04 05 06 07 08
$/bbl
Source: JPMorgan Energy Strategy
Futures are not a prediction of price
Nymex WTI Up in the Front, Up in the BackNymex WTI Up in the Front, Up in the Back
M01 price
As predicted by M12 fwd one year earlier
As predicted by M24 fwd two years earlier
Futures tell us where a buyer of tomorrows crude can find a seller of tomorrows crude inthe market today
Futures are not necessarily a commentary on what market participants believe about thefuture
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Backwardation vs. contango
Backwardation vs. Contango CurvesBackwardation vs. Contango Curves
$4.70
$4.80
$4.90
$5.00
$5.10
$5.20
$5.30
M01 M05 M09 M13 M17 M21 M25 M29 M33
In US$/bbl
contango curve
backwardation curve
Source: JPMorgan Energy Strategy
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The shape of the curve is important: backwardation vs. contango
CONTANGO means:
Crude for immediate physical delivery is
cheaper than crude for future delivery
People are not willing to pay a premium
to own oil right now. Historically
contango has implied a oversupply of
physical crude, high oil inventories, and
a weak market/low price
In theory, one could make money by
buying crude for immediate delivery,
putting it in storage, and selling more
expensive futures, then delivering the
stored crude against those futures when
they come due at a later date
BACKWARDATION means:
Crude for immediate physical delivery is
more expensive than crude for future
delivery
Everyone is willing to pay a premium to
own oil right now. Historically
backwardation has implied a real or
perceived shortage of physical crude,low oil inventories, and a strong
market/high price
One could make money by buying
relatively cheap futures, and selling
crude for immediate delivery at a
higher price
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More backwardation than contango
Contango vs. BackwardationContango vs. Backwardation The oil curve shifts regularly
between backwardation and
contango
Historically, oil has spent
more time in backwardation
than contango
Backwardation has been
steeper than periods of
contango
0
10
20
30
40
50
60
70
$(11) $(9) $(7) $(5) $(3) $(1) $1 $3 $5 $7 $9 $11
Note: M02M13 in US$/bbl
Source: JPMorgan Energy Strategy
ContangoBackwardation
Number of instances
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The crude oil market today
Crude Oil Price History & ForwardsCrude Oil Price History & Forwards
$5
$15
$25
$35
$45
$55
$65
$75
$85
$95
$105
1988 1991 1994 1997 2000 2003 2006 2009 2012
WTI Brent
In US$/bbl
Source: JPMorgan Energy Strategy
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US Crude inventories versus backwardation
[Katherine to add]Adjusted Midwest Crude Stocks vs. WTI BackwardationAdjusted Midwest Crude Stocks vs. WTI Backwardation
Historically the market is in backwardation when stocks are low and contango when
stocks are high
Backwardation / Low stocks
Contango / Low stocks Contango / Full stocks
Backwardation / Full stocks
R2
= 0.5756
$(4)
$(3)
$(2)
$(1)
$-
$1
$2
$3
$4
-15,000 -10,000 -5,000 0 5,000 10,000 15,000
PADD 2 crude stocks ('000 bbl)
M
02-M04NYMEXWTI
History
Previous Two Months
03/21/2008
Source: JPMorgan Energy Strategy , EIA
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The mix of participants in the financial market has changed
Supply/demand determine price in the
long run, but increased participation in the
financial energy markets increasingly
influences the path we take to get there
Increased participation has increasedliquidity, but has also changed the way
that the market responds to bullish
fundamentals
In the short-term, we see dislocations and
exaggerations as a new mix of players
compete for deferred price
One result is that certain market
paradigms are no longer applicable to
energy markets. One is the idea that oil
prices are mean reverting to a long-term
average price of about $20. Futures prices
today no longer approach that level
Front-month NYMEX West Texas Intermediatewith Snapshot in Time Future Strips`
Front-month NYMEX West Texas Intermediatewith Snapshot in Time Future Strips`
In US$/bbl
$(10)
$10
$30
$50
$70
$90
$110
'96 '98 '00 '02 '04 '06 '08
Source: JPMorgan Energy Strategy
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Volatility of Various MarketsVolatility of Various Markets
Energy is significantly more volatile than other markets
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
Jan-01 Sep-01 Jun-02 Mar-03 Nov-03 Aug-04 May-05 Feb-06
Power EUR GLD CL NG HO SPX 10-yr T bills
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A new paradigm for price and curve shape
WTI Flat Price vs. Backwardation (in US$/bbl)WTI Flat Price vs. Backwardation (in US$/bbl)
$(2)
$(1)
$-
$1
$2
$3
$4
$5
$6
$7
$8
'88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
$-
$20
$40
$60
$80
$100M01-M02 NYMEX WTI (left) M01 Nymex WTI (right)
Source: JPMorgan Energy Strategy
M01-M02 NYMEX WTI M01 NYMEX WTI
Backwardation
Contango
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Back to backwardation?
M1-M13 NYMEX WTI SpreadM1-M13 NYMEX WTI Spread
This most recent upward move in flat price has been accompanied by backwardation the first timesince 2005!
-10
-8
-6
-4
-2
0
2
4
68
10
12
Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
Source: JPMorgan Energy Strategy
$/bbl
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Who trades energy derivatives and why?
Banks: Market makers(liquidity providers) and
proprietary traders
Corporates: riskmanagers
Refiners: Buyers of crude,sellers of products
Consumers: Buyers ofproducers, e.g. airlines
Producers: Sellers of crude,e.g. E&P companies
Trading Houses / Merchants:Market makers andproprietary traders
Brokers: Market makers(liquidity providers). No
warehousing of risk.
Investors
Model Traders: e.g.Commodity Trading Advisors
(CTAs)
Macro Hedge Funds:Employ a variety of
strategies usually includingrelative value trading
Institutional Investors: e.g.pension funds, mutualfunds, retail investors
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Focus on Corporates
Increased flexibility in timing ofhedge execution; growingpreference for options-basedstrategies.
More involvement from smallconsumers as energy takes biggershare of business risk and cost
structure. Shift towards hedging specific risk
exposure as traditional proxyhedge correlations break down
Up If anything consumershave hedged more actively asprices have risen, thepercentage of hedges donewith options rather than swapshas increased to guarantee
upside protection withdownside participation
Buyers The natural buyers in the energymarkets. Consumers typically hedge 1-3years out, but increasingly may go out asfar as 5-7 years in products with sufficientliquidity.
Active May trade anywhere from daily to
annually depending on hedging program.
Old Active hedgers since the early-1990s.
Energy Consumers
(Utilities, airlines,railroads, industrials)
Some heightened interest in forwardselling from high cost producers asprices dipped early in the year.
Section 29 hedging has also featuredprominently in recent period.
Down Significantly less day-
to-day tactical hedging at highprices. Remaining deals large,occasional, one-off M&Arelated strategic hedges.Options strategies generallypreferred over swaps, fordownside protection withupside exposure.
Sellers The natural sellers in the energy
markets. Producers typically hedge 2-3years out but can now find sufficientliquidity to hedge as much as 7 years out.
Old Active hedgers since the early-1990s.
Active May trade anywhere from daily toannually depending on hedging program
Energy Producers
(E&P companies)
Recent TrendsActivity Versus 3 Years Ago?
Active orPassive?
Buyers orSellers?
New orOld?Participant
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Risk exposure and management strategies
Production
Consumption
Source: JPMorgan Energy Strategy
Exposure Type Risk Management Strategy
Price of crude
Cost of transportation,insurance, duty/tariff
Cost of carry (time valueof money), time spread
Refinery margins
Refined product price
Locational/basis risk
Retail margins
Producer hedging: swaps or put options
Freight hedging
Hedging with time spreads
Hedging cracks (spread between crudeand refined products) or full margins
Consumer hedging: swaps or call options
Hedging product product risk,or regional risk
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Buying & selling fixed price SWAPS
Market price for Crude
Swapprice
PRODUCER
receivesdifference
PRODUCERpaysdifference
Hedged
Unhedged
Potential gains
Potential costs
Market price for Crude
Swapprice
CONSUMER
paysdifference
CONSUMERreceivesdifference
Hedged
Unhedged
Potential gains
Potential costs
Producer SELLS a fixed price swapProducer SELLS a fixed price swap Consumer BUYS a fixed price swapConsumer BUYS a fixed price swap
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Buying/selling fixed price swaps
Objective
To lock in a fixed Crude forward price
Advantages
Producer / consumer locks in a fixed price over a time period and is protected fromany price variation from the swap price
Producers are compensated for price declines in the physical market by hedging
gains. Consumers are compensated for price increases in the physical market byhedging gains
No upfront premium required
Disadvantages
Producers lose the potential gain from an upside price move above the swap price.Consumers lose the potential relief from a downside price move below the swapprice
Key considerationsKey considerations
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Understanding OPTIONS
Options give the bearer the right, but not the obligation, to buy or sell a
commodity at a given price
A buyer of a put option reserves the right to sell oil at a specified strike price
during a specified time period. If oil prices dip below the strike during the specified
tenor of the option, it is in the money and the owner of the put may choose to
exercise it by selling oil above current market value. If the strike price does not dip
below the strike price during the life of the option, it will not be exercised and will
expire with a value of zero
A buyer of a call option reserves the right to buy oil at a specified strike priceduring a specified time period. If oil prices exceed the strike during the specified
tenor of the option, it is in the money and the owner of the call may choose to
exercise it by buying oil at a price below current market value. If the strike price does
not dip below the strike price during the life of the option, it will not be exercised
and will expire with a value of zero
Buyers of options pay a premium upfront. Premiums vary based on the length of
time to expiry of the option, based on the distance of the strike from current market
prices, and based on the market supply of/demand for options at any given time
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Buying/selling options
Objective
Buying insurance to protect against price drops/increases by paying premium
upfrontAdvantages
Producers participate fully in upside price movements while protecting against
price decreases below the put level. Consumers participate fully in downside price
movements while protecting against price increases above the call level
The worst case scenario is known upfront. The premium paid for the option is the
maximum cost of this strategy
Disadvantages
There is an upfront cost associated with this strategy. This strategy may prove to
be prohibitively expensive when hedging potentially large volumes
Key considerationsKey considerations
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Focus on Investors
Ongoing interest seen incommodities as an asset class;strategies are getting significantlymore diverse and sophisticated asinvestors shun traditional indices.
Up significantly Majorinflow of money andinterest in commodities asan asset class that reallydid not exist in ameaningful way 3 yearsago.
Buyers Institutionals enter the market almostexclusively from the long side via products likeCommodities Indices and oil-linked notes.
Passive Take long-term, generally directionalviews. Tend not to enter or exit positions on short-term price fluctuations.
New Institutional investors have really onlystarted to participate in the energy space in thepast ~3 years.
InstitutionalInvestors
(Pension funds,mutual funds, retail
investors)
End-year profit-taking came early in2006, and was characterized byselling in the front of the curve tohedge deferred length. Littleliquidation of long-dated positions
was observed. Exiting of one large risk taker had
some notable impact on curvestructure and volatility in natural gasbut was reasonably well absorbed inthe market.
Up Generally moredollars in energy, but also
more sophisticated andvaried involvement in fullrange of energy products.
Buyers or sellers Depending on view of themarket. On average in recent years, hedge fundsmore long than short given price trend. Funds mayparticipate in any part of the curve and haveshown particular interest in owning deferred priceand volatility, adding liquidity and price clarity tothat part of the curve.
Active Take proprietary risk daily. May havelong or short term views, and take directional orrelative value positions in the full range of energyproducts.
Old and new Not new to energy per se but moreprofessional and putting more money towards thisspace in the last ~3 years.
Macro Hedge Funds
No significant change. Mostsuccessful in a trending market.
Up Generally moredollars in energy
Buyers or sellers Depending on market trend.
Active Fast moving, directional, tend to enterand exit positions quickly.
Old CTAs have traded energy for years.
Trend Players
(Commodity TradingAdvisors)
Recent Trends
Activity Versus 3 Years
Ago?
Active orPassive?
Buyers orSellers?
New orOld?Participant
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New participants view commodities as an asset class
WHY?
The dot.com bust, weak dollar, and low interest rates encouraged investors to seekother opportunities. The significant amount of money searching for yield has meanta boom for alternative asset classes such as commodities, emerging markets, and
real estate
Commodities are good for portfolio diversification, and viewed as a good hedge forinflation and event risk
HOW? Commodity equities buying/selling shares of publicly traded companies where
profits are directly tied to commodity prices. e.g. commodity producers or refiners,
companies that service those primary industries, companies that transport
commodities
Commodity assets direct ownership or private equity in commodity production,
processing, storage or transport
Commodity ETFs/commodity-linked notes/commodity indices structured products
that allow for direct participation in underlying commodity price moves
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What are commodity indices?
Commodities indices take passive long
positions in a basket of commodities
(energy, metals, softs)
Positions are held near the front of the
curve, but not in the prompt monthcontract
Crude Oil Price History & ForwardsCrude Oil Price History & Forwards
$29
$30
$31
$32
$33
$34
M01 M05 M09 M13 M17 M21 M25 M29 M33
In $/bbl. Source: JPMorgan Energy Strategy
2. Positive Roll Yield
1. Increase in Flat Price
Composition of Benchmark IndicesComposition of Benchmark Indices
(% weights) as of January 2008
GSCI DJ-AIG JPMCCI
Energy 72 32 50
Industrial metals 8 20 19
Precious metals 2 11 8
Agriculture 14 29 21
Livestock 4 8 2
Total 100.00 100.00 100.00
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2006: a tough year for commodity indices
GSCI& DJ-AIGSM Commodity Index ReturnsGSCI& DJ-AIGSM Commodity Index Returns
During a period of low
interest rates and relatively
few opportunities in
traditional investmentarenas, the notion of
commodities as an asset
class and vehicle for
portfolio diversification
caught on, aided by a
supportive fundamental bullstory
-20%
-15%
-10%
-5%
0%5%
10%
15%
20%
25%
1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05 1Q06 3Q06 1Q07 3Q07
GSCI Q/Q Returns
DJ-AIG Q/Q Returns
GSCI Annual Average Returns
DJ-AIG Annual Average Returns
Source: JPMorgan Energy Strategy
Investor products, such as commodity indices, commodity-linked notes, and exchange-traded
funds (ETFs) give the non-expert an opportunity to add commodity exposure to a diversified
portfolio. Branded indices, such as the Goldman Sachs Commodity Index and the Dow Jones AIG
Commodity Index, are long-only baskets of commodities and have been the most popular productfor passive participation in the commodities space
The negative roll return associated with all index commodities except metals and negative spot
return on energy meant that total returns year to date on pure GSCI and DJ-AIG investments have
been negative
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Index flows pick up in late 07, early 08
Value of Index Investment Monthly Chg.Value of Index Investment Monthly Chg.Value of Commodity Index InvestmentValue of Commodity Index Investment
For some time now, the great unknown for crude price has been index investment inflows tocommodities. We have routinely cited larger than expected inflows into commodities from institutionalinvestors as an upside risk to our price view, and according to both S&P and Dow Jones, licensors of themarkets two biggest commodity indices, there has been a lot already this year. Anticipation of investorinflows has informed our somewhat contrarian view that a recession, or economic slowdown couldactually be bullish for commodities
The market really has no hard data on how much money is invested in commodities as an asset class. Weknow commodities investment has grown considerably, but we cant really measure it!
By our methodology, our best estimates suggest that there is now some $180bn invested in commodityindices, compared to $125bn in Feb07, and $99bn in Feb06 and
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How investors are adapting (and how banks manage index risk)
Reallocating between commodities
Based on mean reversion algorithms
Based on momentum algorithms
Based on a view Long / short strategies
Distributing the investment to the deferred
part of the forward curve
The combined liquidity of the entire curve
is greater than the liquidity in the frontcontracts alone
Buying longer dated contracts and rolling
less frequently reduces transaction costs
Avoids the steepest part of the contango
Investment in the deferred part of theforward curve now participates more fully
in a spot price move than it did
historically.
Changing roll dates
1995-2003 2004-Present
Chg in Month 12 $0.40 $0.72
R2 0.62 0.85
Chg in Month 24 $0.28 $0.61
R2 0.42 0.75
For Each $1 Move In the Spot Price of Crude
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Agenda
Page
References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
46
1
7
11
22
46
54
60
65
O
IL
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Top geopolitical hotspots: No strangers to disruptions
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Top geopolitical hotspots: No strangers to disruptions
In million b/d
0
1
23
4
5
6
'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05
Source: JPMorgan Energy Strategy , BP Statistical Handbook
Iranian
Revolution
In million b/d
0
1
2
3
4
'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05
Source: JPMorgan Energy Strategy , BP Statistical Handbook
Iran-Iraq
War
Gulf War I
Gulf War II
In million b/d
0
1
2
3
'79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Strike cripples
production
NigeriaNigeria
IranIran
VenezuelaVenezuela
IraqIraq
In million b/d
0
1
2
3
4
'67 '70 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Strike cripples
production
48GEOPO
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Oil production: An inherently risky business
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Oil production: An inherently risky business
OECD Reserves as % of GlobalOECD Reserves as % of Global
More and more of the worlds remaining oil reserves are in geopolitically risky parts of the world,and thats not going to change
OECD Reserves: Global Reserves
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
'82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Oil Reserves by Risk of LocationOil Reserves by Risk of Location
0
50
100
150
200
250
300
350
400
450
500
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10
Average of Country Risk Rating & Corruptionion Perception Index
(0 = highest risk/most corrupt)
Total Reserves (in '000 billion bbl)
Source: JPMorgan Energy Strategy, BP Statistical Handbook, Transparency International, UNCTAD
5 = 329
More corrupt/risky Less corrupt/risky
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Energy intensity in emerging economic powers moderates as they grow
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Energy intensity in emerging economic powers moderates as they grow
Energy Intensity/GDP China & JapanEnergy Intensity/GDP China & Japan
Oil bbl consumed per US$1,000 GDP
0
1
2
3
4
5
6
7
8
0 1,000 2,000 3,000 4,000 5,000
GDP (in billion current US$)
Japan China
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Find from same publication (above)
Energy Intensity Declines As GDP IncreasesEnergy Intensity Declines As GDP Increases
0
1
2
3
4
5
6
7
8
9
250 5,250 10,250 15,250 20,250 25,250
GDP (in billion current US$)
OECD Non-OECD
Oil bbl consumed per US$1,000 GDP
Source: JPMorgan Energy Strategy, BP Statistical Handbook
Chinese oil demand growth will continue to be significant to the global balance, especially in thelead-up to the Beijing Olympics. But the energy intensity to growth ratio does moderate ascountries get richer
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What is OPECs role
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What is OPEC s role
OPEC does not set prices. OPEC sets production quotas. Currently 10 of the
cartels 12 members are subject to group quotas; Iraq is exempt. Saudi Arabia is
by far the groups biggest and most influential member
What is OPECs ideal price?
Contrary to popular believe, it is not to OPECs advantage to target as high an oil
price as possible. The cartel wants to maximize revenues, but needs consumers as
much as consumers need OPEC oil. At very high oil prices, OPEC faces two risks:
1. High oil prices could reduce economic growth and oil demand growth
2. High oil prices could encourage higher-cost non-OPEC producers to
make investments that would increase global oil supply, and reduceOPECs market share
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Until this bull run loss of market share was a real concern for OPEC
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Until this bull run, loss of market share was a real concern for OPEC
Shifting Market ShareShifting Market Share
34%
35%
36%
37%
38%
39%
40%
41%
42%
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
5.5
6.5
7.5
8.5
9.5
10.5
11.5
12.5
OPEC Share of Global Production
Saudi Oil Production
FSU Oil Production
OPEC Share of Global Oil Production (%) FSU/Saudi Oil Production (mbd)
Source: JPMorgan Energy Strategy, IEA, OPEC
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Angola and Saudi Arabia lead OPEC in capacity additions
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Angola and Saudi Arabia lead OPEC in capacity additions
OPEC Spare Capacity vs. PriceOPEC Spare Capacity vs. PriceExpected Additions toOPEC Capacity* (in kbd)
Expected Additions toOPEC Capacity* (in kbd)
* Excluding declines
Note: This is not a complete list and is subject to changeSource: JPMorgan Energy Strategy, government reports,media reports
In kbd
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
Jun-97 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07
$-
$20
$40
$60
$80
$100
$120Spare Capacity Nymex WTI Price
Source: JPMorgan Energy Strategy
US$/bbl2008 in kbd
Saudi Arabia 850
Angola 200
Iran 160
Nigeria 650
Venezuela 75Algeria 100
2009
Saudi Arabia 1200
Angola 205
Nigeria 150
Venezuela 150
Algeria 100
Qatar 325
2010
Saudi Arabia 250
Angola 640
Iran
Nigeria 180
Indonesia 140
2011-2012
Saudi Arabia 900
Angola 620
Iran 85
Nigeria 680
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Agenda
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Agenda
Page
References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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How is gas different from oil?
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g
Natural gas is a regional commodity, whereas oil is a global commodity
In other words, oil is fungible in a way that gas is not
Why? The physical properties of natural gas make it harder to transport,particularly inter-continentally. Most natural gas is transported in gaseous
form via pipeline. This means that the US gas market is effectively a
closed system
For this reason, regional gas markets are unrelated. For example, the UKgas market has little relationship to the US gas market. In fact, European
natural gas is priced using an oil-referenced formula
The widespread adoption of liquefied natural gas (LNG) when and if ithappens will change the gas market from a regional market to a global
market. In other words, the development of LNG will make the gas
market look more like the oil market
55NATURAL
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The US natural gas market
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g
Natural gas is transported in the U.S. through pipelines to different locations called Hubs
Hubs are market places where the physical commodity can be bought and sold. Different
market places have different prices due to different supply and demand factors
Henry Hub is the most liquid physical natural gas market, because Henry Hub is where
futures contracts are settled for the physical commodity. It is the market which is most
closely represented by the NYMEX futures curve
Producers and consumers of natural gas have incentives to not only hedge their physical
commodity exposure using futures contracts, but also to hedge the location (basis) risk
associated with dealing in different markets across United States, Canada and Mexico The basis market provides this added hedging ability
In the basis market hub locations trade at a differential to NYMEX futures contracts on a
forward basis
Hence leading to the ability to buy the NYMEX +/ the appropriate basis differentialforward to hedge a future sale of the physical commodity
Some of the most frequently quoted basis markets are: the Rocky Mountain region, the
Houston Ship Channel Hub, AECO (Canada), and the Panhandle Hub
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Natural gas: How is it measured?
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g
In the United States, natural gas derives its value from its British thermal unit (Btu)
content, or heating capability
British thermal unit: a unit of heat equal to about 252 calories; quantity of heat required
to rise the temperature of one pound of water one degree Fahrenheit
Volumetrically natural gas is measured in cubic feet (cf) on a 24-hour flowing basis, and
consequently a standard conversion was adopted whereby 1 cf = 1,000 Btus, which allows
for natural gas to be bought and sold in terms of its Btu value
Useful gas conversions:Useful gas conversions:
1 MMbtu = 1 million Btus
1 Mcf 1 MMBtu, depending upon the purity of the gas
1 MMcf = 1,000 MMBtu
10 MMcf = 10,000 MMBtu = 1 NYMEX contract
1 Bcf = 1 billion cubic feet = 1,000,000 MMBtu
1 Tcf = 1 trillion cubic feet
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Major market drivers
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Weather is both a demand and supply factor
Summer storage injection season (AprilOctober) is influenced by cooling demand
Winter storage withdrawal season (NovemberMarch) is influenced by heating
demand
Shoulder Months (March, April, May and September, October, November) are less
weather sensitive
But hurricane disruptions most typically in the late-summer to fall can affect
the supply side of the balance
Drought conditions in areas that depend on hydropower for electricity generation
can also boost gas demand
Oil price is also a driver of gas price, because there is some degree of
substitutability between the two fuels
Liquefied Natural Gas (LNG) is a minor factor in the gas market now, but will
become increasingly important as the market develops. LNG will make the gas
market more global
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URAL
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Coal still dominates base load power generation
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Coal generates almost 50% of all power produced in the United States and,
combined with nuclear power, provides mainly baseload power that is
dispatched first whenever available
Power Generation by Source (Dec 07)Power Generation by Source (Dec 07)
Coal
50.7%
Nuclear
20.9%
Natural Gas
19.3%
Other Renewables
2.6%
Conventional Hydro
5.4%
Petroleum Liquids
0.8%
Source:: JPMorgan Energy Strategy, EIA
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URAL
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Page
References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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The US needs LNG to meet growing gas demand
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500
700
900
1,100
1,300
1,500
1,700
1,900
2,100
2,300
'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Lower-48 Production Canadian/Alaska Production Demand
Source: JPMorgan Energy Strategy, E IA
In Bcf/day
The long-term gas price will depend heavily on LNG to fill the growing disconnect between demandfrom residential, commercial, industrial and power generation consumers and North Americansources of supply
The declining domestic production scenario makes LNG vital to satisfying projected US demandgrowth. . . or price will have to ration demand
In Tcf
0
The growing US LNG supply gapThe growing US LNG supply gap
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LNG imports growing, but still well short of US terminal capacity
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Low European natural gas prices have led to a flood of shipments across the
Atlantic to US terminals, but imports are still well short of total US terminal
capacity
US LNG Imports By Terminal (Monthly)US LNG Imports By Terminal (Monthly)
In Bcf
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb
Everett (MA) Lake Charles (LA) Cove Point (MD) Elba Island (GA) Gulf Gateway (Offshore)
Source: JPMorgan Energy Strategy, Waterborne LNG Report
Sustainable Capacity
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LNG imports are growing more seasonal as the market matures
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Annual LNG ImportsAnnual LNG Imports
The last two years have seen the start of what we see as a growing trend toward increased USimports of LNG during shoulder periods mainly in the spring. While last winter was seen asanomalous in Europe, the decreased springtime demand and increased Norwegian deliveries into theUK should continue to free up cargoes during that time of year
20
30
40
50
60
70
80
90
100
110
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2004 2005 2006 2007 2008
In Bcf
Source: JPMorgan Energy Strategy , Waterborne LNG Report
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Major Market Drivers of LNG Pricing and Availability
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Upstream Additions (Equatorial Guinea, Egypt, Nigeria, etc.)
Demand patterns in different regions (Atlantic Basin)
Hydro conditions in Spain
Norwegian flows into the UK
French nuclear generation levels
Asian demand levels (Japanese nukes), displacement of other cargoes
Simple price for Trans-Atlantic arbitrage, with transport included
Crude oil, crude product pricing in regions where contracts continue to be
tied to formulas utilizing baskets of other parts of the energy complex
Operations, maintenance at upstream LNG liquefaction and export
terminals as well as downstream import terminals
64LNG
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Page
References, Websites and Data Releases to Watch
LNG
Natural Gas Specifics
Geopolitics, policy and economics
Interpreting the curve- why market participation matters
How oil is priced terms and conventions
The energy investment cycle
Where does oil comes from - and where does it go?
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Recommended Reading & Resources
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Books:
The Prize (Daniel Yergin) --- This history of oil won the Pulitzer Prize in 1992, and was turned into
a PBS documentary
Oil on the Brain: Adventures from the Pump to the Pipeline (Lisa Margonelli) -- Travels the
world following the entire oil supply chain
The Little Ice Age: How Climate Made History, 1300-1850 (Brian Fagan) The role of climate
change in human history
The Middle East (Bernard Lewis) - Comprehensive history of the region
Websites:
www.eia.doe.gov US Department of Energys Energy Information Adminstration. Data and
informational/educational materials about US and global energy
http://blogs.wsj.com/energy/ -- A roundup of the days energy news headlines, posted by theWall Street Journal online
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Important data releases
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EIA Weekly Petroleum Status Report (Wednesdays 10:30 AM)
EIA Weekly Natural Gas Storage Report (Thursday 10:30 AM)
EIA Petroleum Supply Monthly Report (end of month)
EIA Short Term Energy Outlooks (beginning of month)
IEA monthly Oil Market Report (~10th of the month)
Euroilstock inventory report (~10th of the month)
CFTC Commitment of Traders report (Fridays)
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Key websites
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US Department of Energy, Energy information Administration
www.eia.doe.gov
Organization of Petroleum Exporting Countries
www.opec.org
BPs Statistical Review of World Energy
www.bp.com
New York Mercantile Exchangewww.nymex.com
Commodity Futures Trading Commission
www.cftc.gov
International Energy Agency
www.iea.org
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Bloomberg codes
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Prices:Prices: News & Info:News & Info:
Main energy page NRG
EIA inventory data DOE
Global crude oil prices CRUD
Exchange menu CEM
Nymex WTI crude CL1 [cmdty]
Nymex heating oil HO1 [cmdty]
Nymex RBOB gasoline XB1 [cmdty]
Nymex natural gas NG1 [cmdty]
IPE Brent crude CO1 [cmdty]
IPE gasoil QS1 [cmdty]
Cash values for refined products USPD
EUPD
FEPD
Top energy pages OTOP
ETOP
TGAS
All energy news NI NRG
Oil news NI OIL
Gas news NI GAS
Power news NI ELC
Refinery news NI REF
OPEC NI OPEC
Energy glossary REFG
Keeping time IC
Calendars CDR
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Reuters codes
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Prices:Prices: News & Info:News & Info:
Main energy page Q: ENERGY
EIA inventory data Q: EIAA
Nymex WTI crude Q: CLc1
Nymex heating oil Q: HOc1
Nymex gasoline Q: HUc1
Nymex natural gas Q: NGc1
IPE Brent crude Q: LCOc1
IPE gasoil Q: LGOc1
Cash values for Q: PRODUCT/1refined products
Energy highlights Q: nTOPO or TOP/O
Link to energy codes O/CODES
All energy news O
Oil news OIL
Gas news NGS
OPEC news OPEC
EIA inventory report EIA/S
US refinery news REF/US
Energy glossary ENERGY/3
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Basic oil conversions
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42 gallons = 1 barrel
159 liters = 1 barrel
7.33 barrels of crude = 1 ton
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