oil-gas-basics-jp-morgan-2008.pdf

7/27/2019 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) [email protected]

Scott Speaker

(1-212) 834-3878

[email protected]

Kristi Jones

(1-212) 834-2835

[email protected]

Sung Yoo


Sachin Kirtane



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Oil & Gas Basics_20080324

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.

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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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From the well to the tank. . .

Source: JPMorgan Energy Strategy

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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


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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Agenda

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LNG







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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)


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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Agenda

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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


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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

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Mar08 Aug08 Jan09 Jun09 Nov0 Apr10 Sep10 Feb11 Jul11 Dec11

$/MMBtu


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


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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


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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


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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


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


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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

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20

30

40

50

60

70

$(11) $(9) $(7) $(5) $(3) $(1) $1 $3 $5 $7 $9 $11

Note: M02M13 in US$/bbl


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


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Oil & G B i 20080324


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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


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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)


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


$/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


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


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


47/73

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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48/73

Agenda

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Top geopolitical hotspots: No strangers to disruptions


50/73

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


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


Strike cripples

production

48GEOPO

LITICS,

POLI

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AND

ECO

NO

M

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Oil production: An inherently risky business


51/73

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


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

49GEOPO

LITICS,

POLI

CY

AND

ECO

NO

M

ICS


Energy intensity in emerging economic powers moderates as they grow


52/73

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


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


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

50GEOPO

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NO

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What is OPECs role


53/73

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

51GEOPO

LITICS,

POLI

CY

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ECO

NO

M

ICS


Until this bull run loss of market share was a real concern for OPEC


54/73

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

52GEOPO

LITICS,

POLI

CY

AND

ECO

NO

M

ICS


Angola and Saudi Arabia lead OPEC in capacity additions


55/73

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


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

53GEOPO

LITICS,

POLI

CY

AND

ECO

NO

M

ICS

Agenda



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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

GAS

SPEC

IFICS


The US natural gas market


58/73

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

56NATURAL

GAS

SPEC

IFICS


Natural gas: How is it measured?


59/73

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

57NATURAL

GAS

SPEC

IFICS


Major market drivers


60/73

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

58NAT

URAL

GAS

SPEC

IFICS


Coal still dominates base load power generation


61/73

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

59NAT

URAL

GAS

SPEC

IFICS

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The US needs LNG to meet growing gas demand


63/73

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

61LNG


LNG imports growing, but still well short of US terminal capacity


64/73

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

62LNG


LNG imports are growing more seasonal as the market matures


65/73

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

63LNG


Major Market Drivers of LNG Pricing and Availability


66/73

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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Recommended Reading & Resources


68/73

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

66REF

ERENCES,

W

EBS

ITES

AND

DATA

RELEASES

TO

W

ATCH


Important data releases


69/73

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)

67REF

ERENCES,

W

EBS

ITES

AND

DATA

RELEASES

TO

W

ATCH


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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oil-gas-basics-jp-morgan-2008.pdf

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