EFTA01090474

Global Commodities Research J.P. Morgan 15 November 2011 Commodity Markets Outlook and Strategy Will US natural gas help save the world? Exhibit 1: Jigsaw puzzles are solved only when all pieces are used & in the right configuration Until now. Chinese-held US Treasuries and NAM gas and food have been largely absent from debt discussions Commodities ilk111 , Jonah D. Waxman, CFA Me an Hansen JPMorgan Chase Bank NA Bounce: J.P. Morgan Commodbes Research. Note: NMI. NonhMecum. • Policymakers try to solve a jigsaw puzzle, sitting on the China piece: In oil, natural gas, corn, and other commodity markets, global production and trade patterns are undergoing historic structural changes that will likely not reverse. The world is primed for a commodity-hued sovereign rebalancing akin to the 1985 Plaza Accord. The essential solution to achieve "escape velocity" from the debt crisis is to get capital into Europe and manufacturing jobs into the US by exchanging Chinese- held US Treasuries for long-run contracts in fuel and food from North America and for realistically-priced European distressed debt. • Natural gas catalysts are mounting: Elements of this solution are already breaking out in energy markets in the absence of a formal treaty. Since Sep 1, US politicians have proposed an oil-and-gas drilling boom to create jobs, Canada granted its first LNG export permit, Sinopec acquired a Canadian E&P company, and BG/Cheniere's landmark LNG deal punctured oil-linked pricing. Beijing says it is willing to post $100Bn or more to support Europe, its largest trading partner. • Last week we dropped the defensive posture we adopted on Aug 8, doubled down on our Bull Commodity Basket, and introduced long gas vol strategies: Until now, gas equities have seemed to offer better risk-adjusted value than the long-dated NYM natural gas curve. Risk is changing. We think there is significant value in now owning $3.50 puts on Spring 2012 and ATM straddles on Calendar 2015 (1c=$5.00). See page 23 for analyst certification and important disclosures. EFTA01090474 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Welcome to the 21st Century • This week, the total public debt outstanding of the US The incremental two billion is a headcount twice as large as is crossing $15Tn for the first time. This debt is 5.8X the entire population of the world in the year 1800, at the larger than Italy's, 32.5X larger than Greece's. dawn of the Industrial Revolution. Contrary to Malthusian prophecies, this growth can be accommodated by commodity • The Greek referendum fiasco scared away Chinese markets. The incremental population will include a dazzling capital (for now) but served a fresh reminder to the array of scientists, engineers, artists, and other persons of US Deficit Supercommittee: failure has a high cost. extraordinary and unique talent, who will create significant productivity in human economic systems. But the enormous • The Supercommittee must announce its plan within 8 scope of the growth needs to be acknowledged if it is to be days. The US Thanksgiving holiday is next Thursday, managed optimally. In thinking about the world's followed by December festivities. A bold plan could interlocking debt, food, fuel, and security challenges, it is tap into powerful and positive seasonal sentiment. vital to recognize the centrality of China. It is also important to specify the current strengths and weaknesses in the • The gold price appears to expect the Supercommittee world's largest economic blocs: doing so reveals the shape of to announce about $2Tn in deficit reduction. A the pieces in the jigsaw puzzle and how they may fit together number closer to $4Tn would likely crush gold but harmoniously. spur a major rally in global markets. Failure to get the job done likely sends gold to S2500 per oz and above in 2012, but crushes confidence in the USD. Europe is (a) long Mediterranean debt that might find stronger bids at lower prices, and (b) short capital and a Prompt gold is approaching $1800 per oz. Since Oct coordinated fiscal policy. The United States is (a) long 20, the average intraday price change between low dollars, natural gas, and food, and (b) short of tens of and high has been +$32 per oz. At this vol, the Sep 6 millions of jobs. China is (a) long US Treasuries ($1.2Tn, or all-time nominal high ($1920) could be touched within 38% of its F/X reserves), and (b) structurally short of many 4.5 trading days. We expect breach of $2000 in 2011. primary commodities. • Chinese natural gas demand is growing at an 18% Natural gas is one of the markets that can bring these pieces CAGR, against a domestic production CAGR of 13%. together for mutual benefit. As a result, historic events are The deficit is now -15%, heading to -35% by 2015. unfolding in natural gas markets that will likely alter the composition of global GDP over many decades. The US and • We outline a scheme for estimating risk in China's Canada—the world's first and third largest producers—have natural gas import portfolio. Today's score is equal to moved significantly in 2011 toward building gas export "Turkey"—an EU aspirant. Growing North American supply chains (and gas-related plastics, fertilizer, and gas imports to 3Bcfd in 2015 from zero in 2011 would chemical chains) that will deliver gas into Asia at prices cause risk to slip to "Kazakhstan". In the absence of based on North American gas, not world oil. This is a titanic US.tCanadian imports, risk slips to a score of "Syria". change from prior pricing schemes and represents an important evolution for world trade and future inflation • The price of Dec-11 NYM natural gas (NGZ1) has expectations among consumers, given the nearly US$100 per declined by nearly 30% since late July 2011. It is now boe price differential between Asian oils and North priced about $95iboe below prompt Shanghai fuel oil. American gas basis. Last week we advised exiting shorts and buying vol. Until now, a lack of political will and physical infrastructure Human civilization is grappling with an important transition: prevented this price gap from being arbitraged, to the the birth of the 21st Century. But we are 20th-Century economic disadvantage of all parties. This is now changing, people whose natural instincts expect the new century should aided by the fact that North American policymakers with look like the old. It will not. This is part of our problem. green credentials also see an environmentally-sound pathway for capturing this economic return. The human population now numbers seven billion and is on track to reach nine billion by 2050, according to UN demographers. 2 EFTA01090475 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 The United States is now the world's largest natural gas This is not to suggest that if the US made these investments, producer, having surpassed Russia in 2009. The US is also it would achieve energy independence. Even if US the world's third largest crude oil producer. Casual petroleum output reached 1 I mbd (a stretch), the US would observers would likely be surprised to learn that the US still remain the largest crude importer in the world, requiring could become the largest oil producer in the world in just a at least 4mbd more than China (the second largest importer). few years. if it so chose to make the necessary investment in The key concept is that the US would become a larger undeveloped resources in order to surpass Saudi Arabia and exporter of energy while also reducing its imports of energy, Russia (Exhibits 2 and 3). Including NGLs and condensates, to the benefit of its balance of payments. Precursors of this US petroleum output is 1.42mbd behind Saudi Arabia and trend are evident in the August 2011 export data for US 1.69mbd behind Russia. petroleum products, which surpassed 3mbd, or an amount equivalent to about 15% of US oil consumption. Exhibit 2: US petroleum production has reversed trend Thousand barrels per day The untapped oil and gas assets held in trust by the Federal 12.000 government of the United States are an enormous source of l0.000 underutilized wealth. Recently, political leaders and captains 8.000 of industry have become more vocal in pointing to these "off balance sheet" assets as a partial countenveight to the "off 6.000 - balance sheet" liabilities of the United States. In August, we 4.000 . presented research that showed the unfunded obligations of 2.000 - the United States now amount to at least $62Tn on a net present value (NPV) basis. These obligations are in addition 0 co co O CO e I, - I, - I, - I, - 0 03 03 to CO 03 Of 03 Of on Of CO Of e 0 0 Ir-- 0 .- to the $15Tn in national debt, SI6Tn in personal debt, and Of Of Of Of Of Of Of Of Of Of Of 01 0 0 0 0 $3Tn in state and municipal debt. It is this crushing debt that led to the loss of the US' AAA sovereign credit rating and the creation of the US Deficit Supercommittee. A one-two Source: BPSR. EI&J.P. Morgan Commochies Research punch of implementing some of the Simpson-Bowles Exhibit 3: Top 10 oil producers recommendations on deficit reduction (e.g., raising the Thousand barrels per day retirement age on unborn future generations) and allowing 12000 responsible access to these energy assets would likely yield a powerful effect on capital markets. 10000 6000 Actual and potential US oil and gas production growth has 6000 already driven a huge gap between world and North 4000 American hydrocarbon prices. North American spot gas is now priced just below $22 per barrel oil equivalent (boe). 2000 This is about US$95 per hoe cheaper than Asian spot crudes, 0 even after accounting for the different energy content in gas and oil products. Put another way, spot natural gas at Henry CC U Hub is going for $3.45 per MMBtu, while crudes in Southeast Asia are priced above $20 per MMBtu. Propane at Source: BPSR. J.P. Morgan Commodhes Research Mont Belvieu is north of $15 per MMBtu; low-sulfur gasoil in Singapore is above $22 per MMbtu. Asian consumers Already, US output has grown by I.25mbd since 2006-a have very strong incentives to grow gas trading feat clearly driven by price, and reversal in trend not flagged arrangements with the Americans and Canadians. by the strong form of the "peak oil" argument. In North Dakota alone, crude production has increased to over 400kbd China wants natural gas from about 80kbd in 2003. The debate in industry is now whether this trajectory slows down above 500kbd or makes it China's production of natural gas has been growing at a all the way to Imbd. We incline toward the larger number. blistering 13.5% compound annual growth rate (CAGR) It is worth remembering that the modern global oil industry since 2000. However, even this fast rate of supply growth was born in Pennsylvania in 1859 and for most of the past has been insufficient to keep up with China's gas demand, 150 years the US has been the world's dominant producer. which is growing at a 16.1% CAGR, according to data from 3 EFTA01090476 Global Commodities Research Commodity Markets Outlook and Strategy J.PMorgan IS November 2011 the BP Statistical Review. At the current rate of demand the Cheniere/BG long-term LNG export deal through Sabine growth, China's annual natural gas consumption would grow Pass, which is the first deal of its kind, given its pricing in relative size from one-sixth as big as the US' last year to structure. about 40% the size of US demand within the next five years. A rapidly-growing supply shortfall would be a significant From 2000 through 2006, the Chinese natural gas market challenge for consumers in any commodity market. It is an was in structural surplus. Domestically produced natural gas especially pressing problem in a market as strategically exceeded domestic needs by 3% to 12% (1.1 to 3.5 billion important as natural gas—an essential feedstock for industry cubic meters) per year. However, the faster rate of growth in and agriculture and a growing resource for lighting and domestic demand pushed China's annual gas balance into a heating the homes of the rising middle class. As a result, sustained deficit starting in 2007 (Exhibits 4 and 5). natural gas figures prominently in China's 12th Five Year Plan. It would be imprudent to underestimate how important Exhibit 4: China's domestic natural gas balance this natural gas deficit is to China's security. The gap As a percentage of domestic consumption follows similar strategic shortfalls in iron ore, copper, and 15% -11.0%10.6%12.0% oil, which have been met with significant increases in net 10% - imports and a meaningful impact on global pricing. In most cases, these price moves were at first poorly understood in 5% - the OECD countries and were thus resisted on inaccurate 0% claims of being •"non-fundamental". As in other energy markets in China, maximizing security of supply at a .5% - reasonable price is a greater priority for Beijing than trying •10% to minimize prices paid at the expense of greater risk. To address its gas shortfall, like Japan and Korea, China has 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 turned to imports of liquefied natural gas (LNG). This is a logical first choice for a country blessed with a bulging Source: BPSR. J.P. Negev Commcdhes Research capital account but just beginning to build out its gas Exhibit 5: China's domestic natural gas balance production, storage, and distribution infrastructure. From Billion win meters virtually no import volume in September 2006, the LNG 6 import trade in China has increased to an average of 1.52 3.5 4 2.7 z.B s a 2.5 2.5 billion cubic feet per day (Bcfd) in 2011 (Exhibit 6). This 2• volume is equivalent to about 2.5% of US production and 0 was grown within the space of five years. •1.3 •1.0 -4 At first, China did what any household suddenly short of a .4.2 cup of sugar would do—it turned to a neighbor. From 2006 •8 •10 to 2009, Australian supplies dominated China's burgeoning •12 LNG trade flow. However, as the demanded volume has •14 -12.2 increased to larger requirements, China has moved to 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 diversify its supply base. There are now eight major supplying nations (Exhibit 7). Australia is still the biggest Source: BPSR. J.P. ►organ Commodties Research partner in the LNG trade, with a 30% market share. Indonesia, Malaysia, and Qatar follow, each with shares in That year, domestic consumption exceeded domestic the 14% to 16% range. Yemen (7.8% of 2011 ytd imports) production by 1.8%. Since then, the deficit has deepened and Nigeria (7.0%) have picked up market share at sharply: last year, it reached 12.2bcm. or a gap of about Australia's expense this year, but bring other operational 11.2%. Now, it is closer to 16%. Next year we project it challenges, as has been demonstrated in recent weeks by the will reach 20%. It is on track to reach 35% by 2015, even social unrest in Yemen. Neither the US nor Canada yet after allowing in our model for the start of Chinese shale gas export LNG to China. production in 2012. In volume terms, the projected deficit increases from —1.97Bcfd today to -8.75Bcfd in 2015. The latter volume is equivalent to 6X the off-take announced in Cheniere Energy and JP Morgan have a general contractual relationship. 4 EFTA01090477 Global Commodities Research J.PMorgan Commodity Markets Outlook and Strategy 15 November 2011 Exhibit 6: China's LNG imports by country of origin potentially stoking inflation expectations and outright dollar Ref per day inflation sooner than central bankers' plans. 2.0 - NAtiettera • Indonesia • Malaysia MNiperia I•Oatar • Russia Additional regasification capacity is welcome by domestic 1.5 STriaidad&Tobago •Yemen sr Other industry. Existing infrastructure is rapidly running toward full utilization. LNG import data for 2010 from China 1.0 - Customs Administration imply an 86% utilization rate for the Dapeng terminal, a 78% utilization rate for Putian, and a 0.5 - 49% rate for Yangshan. Based on monthly import data through September 2011, we estimate that capacity 0.0 utilization rates for the Dapeng and Putian terminals have sre- '4-3 ra c4 s.s s 0 0 •"' now risen above 90%, while capacity utilization at the A- 411- 44-449 4'k4 w k s w :t M M y/ Yangshan facility has also increased, to about 58%. Capacity utilization at the Rudong terminal, which opened Source: CG4.J.P. Morgan Commodities Research this year, is already at 16%. Exhibit 7: China's LNG imports by source, year-to-date 2011 Exhibit 8: Natural gas use as a percentage of total primary energy use Country share of total LNG imports (percent) Percent Other, 4.0% 30% 28% Trinidad& Yemen, 7.8% 23% 24% Tobago, 3.2% Australia. 25% Russia, 2.2% 30.5% 20% l 17% 15% 15% 11% 11% Qatar, 15.2% 10% 4% 5% 0% China Ind Total South Japan Australia Other Wald Nigeria. 7.0% Asia Korea Asia Indonesia, Pacific Pacific Malaysia. 16.1% 14.1% Source: Caa..J.P. Morgan Correrocilies Research Source: BPSR. J.P. Morgan Equity Research There are currently four LNG terminals operating in China: Yet, even with the rapid rate of demand growth and Dapeng (opened in 2006), Putian (2008), Yangshan (2009), associated infrastructure build-out, natural gas today only and Rudong (2011). Their collective import capacity is now accounts for 4% of China's total primary energy use (Exhibit about 16 million tonnes per year, or just over 2.0 Bcf per 8). This share is paltry by world standards: the global figure day. The largest is Dapeng in Guangdong (0.9 Bcf per day). stands at 24%. Even India has a gas usage share nearly 3X Another eight projects are in various stages of construction greater than China's, where coal still makes up 72% of or expansion, which we expect will boost capacity by nearly primary energy demand. 3.0 Bcf per day within the next three years. On October 25, PetroChina announced the Dalian terminal is "ready for This relative bias is unlikely to last for several reasons: operation". 1. domestic opposition to coal mining is growing in The cost to build all of these facilities, plus the planned-but- response to a number of fatal mine accidents; not-yet-started terminals, measures in the tens of billions of including two newsmaking incidents in the past two US dollars. But this cost is a small fraction of the value that weeks (Henan and Yunnan provinces), China's enormous F/X reserve portfolio (USS3Tn+) risks losing in relative value and real terms through its US 2. a broader trend in Chinese society toward greater Treasury holdings over the next five-to-ten years. CNY may social responsibility; in part spurred by public anger appreciate by up to 50% against the USD, and the Fed over the July 2011 high-speed rail accident in promises to extend zero interest rate policy into 2013, Wenzhou that claimed 39 lives, and EFTA01090478 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 3. the general global trend in the G20 countries toward For reference, through July 2011, Japan's LNG import use of cleaner fuels and China's planned adoption volumes had not actually surged as much as might have been of Euro 5 emission standards in Beijing in 2012. expected following the Tohoku earthquake, perhaps emphasizing the initial sluggishness in the recovery in The Beijing leadership is quite clear on its intention to industrial production. However, that pattern changed increase gas usage, as clearly spelled out in the Twelfth Five- suddenly in August, as imports surged from about 10.0Bcfd Year Plan (12FYP). To illustrate China's commitment, we to 12.6Bcfd at an average price above $16 per MMBtu, also cite several passages from the I 2FYP in Appendix B. reflecting oil-linked pricing mechanisms (Exhibit I I). Exhibit 9: China's LNG import volume and prices Exhibit 11: Japan's LNG import volume and prices Volume on BelId (LHS). prices in USS per taiStu (RHS) Volume in BOO (LHS). prices in US$ per M4ABIu (RHS) 16 $18 16 - SIB 14 $16 14 316 12 $14 12 $14 10 $12 10 $12 8 $10 $10 $8 8 $8 6 $6 6 $6 4 $4 4 S4 2 2 S2 0 ....... sg 0 SO ra e- I g o 41 la g s s 0 0 S ,R,a1,g,N14,t,as S i0 m cCs m u, 2 CO s- 2 CO s 2 CO co co li Import volume Import price tti Import volume Import price Source: CG4.J.P. Morgan Convexities Research Source: LNGJapan Coporacon. J.P. Morgan Commodbes Research Already, the data show that China today is willing to pay a This development is so important, it bears repeating. The higher import price than previously in order to boost its recent surge in LNG prices paid by China reveals: (I) a immediately-available natural gas import volumes and thus willingness to pay an oil-linked gas price for access to reduce its vulnerability to its domestic imbalance (Exhibit 9). immediate supply, and (2) a strong incentive to move away From 2006 to late 2009, contracted LNG import prices into from oil-linked pricing toward a delivered price tied to a China tended to be below US$4 per MMBtu, with some cheaper North American gas price. Both the Chinese and price spikes during the summer of 2008, when global energy Japanese LNG import price curves exhibit acceleration in prices made their cyclical peak. The most recent upward price momentum since mid-summer. Japan and observations from this summer and fall reveal trends toward China are now competing with each other, through price, more volume and higher price, passing US$10 per MMBtu for LNG molecules. in September, or nearly three times where it averaged in previous commercial arrangements. This pickup reflects higher exposure to oil-price-linked LNG cargoes. Exhibit 10: US natural gas imports ExhIbi 12: US natural gas exports Bd per day I3dper day 18 16 14 •Canada 14 • oPiPellm 12 12 sOther 10 10 •Nowcipelbe 8 8 • 8 6 • 4 4 • 2 2 • 0 0 0 3 • 0 0 I •- 43 0 0 I - 0, cr, 131 131 IR IR 8311?Malg EEE EA Source: DOE. J.P. Morgan Commocities Research Source: DCE.J.P. Morgan CiarrrroaciiDes Research 6 EFTA01090479 Corm P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Meanwhile, US Department of Energy (DOE) data continue geopolitical standpoint. We avoid using 100.0 in order to to show a secular trend toward lower gas shipments from acknowledge the small but real potential for terrorism, Canada into the US and quietly-but-steadily increasing natural disasters, and other intentional and unintentional exports from the US to its neighbors, especially Marcellus operational hiccups. molecules into Canada (Exhibits 10 and 12). Our sense is US industry, especially in Texas and Oklahoma, thinks of Following this method, we compute a portfolio risk score of Canadian trade in net terms and is not fully focused on the 90.0 for 2010, as domestic conventional production's ability fact that US gas pipeline exports already reached 4.5Bcfd in to cover 90% of demand significantly outweighed the risk March of this year, averaging 4.0Bcfd year-to-date through associated with, for example, Yemen's at-the-time 10% August Total US gas exports, which include flows of LNG share of the 10% sliver of demand supplied by imports. from Alaska to Japan, reached 4.7Bcfd in March and have averaged 4.1Bcfd year-to-date. This methodology also allows us to compute a geopolitical risk score for China's projected gas portfolio in 2015, using The global structural changes underway in gas markets have our estimates of flows from both new conventional and not escaped the attention of the Chinese as they contemplate unconventional sources (shale), as well as new suppliers, their strategic options and risks over the next five years. including Canada and the United States (Exhibit 14). Estimates from the US Department of Energy show that To frame the risks, we decompose China's physical natural China's shale gas resource is I275Tcf, which makes it larger gas portfolio by domestic and foreign sources. The total size than that of the US (750Tcf). (Unconventional production is of the portfolio is the volume of supply flowing to meet a grey tranche in Exhibit 14). Our volume estimates will Chinese gas demand in a calendar year in 2010, this was inevitably show slippage against realized developments. 10.5Bcfd (Exhibit 13). To compute an empirically-derived More important is the value in having a tool to quantify the and reasonably objective geopolitical security risk score for portfolio risk that China faces and accepts as it manages the this physical portfolio, we take the Heritage Foundation rapid rate of demand growth. Economic Freedom (HFEF) indices by country and calculate a portfolio score equal to the weighted average of the individual import flows multiplied by their freedom scores. Exhibit 13: China's natural gas portfolio by supplier (2010) Exhibit 14: China's natural gas portfolio by supplier (2015F) Bcf per day (Risk score of portfolio = 90.0. See text for explanation.) Bel per day (Risk score of portfolio = 82.0. See text for explanation.) 30 30 25 25 20 more risky ao• more risky 15 is ID less risky 10 less risky 5 0 1 5 0 a Careentbral • Unconvenlioral @AnnanLNG CanadatNG • Comertieval ✓ennet LNG Oa LNG • Malsisie LNG • USLNO Omar LNG • klalayss LNG 4 Kamiktnian snake S0liteaNG • Ni tia LNG u In:I.:neva LNG ■YenefalIG ■0ttierLN0 'Meseta LNG ■Incicoesla LNG Yemen LNG a Rutsliart0 • Tuikmenistbn Pipetne Nisla pcelhe • Russet LNG shrkmerislan Pwine.I PA owes While Source: Company Reports. BPSR. CGA. Waage Fourdation.al Commodites Research Source: Company Reports. BPSR. CGA. iiiifiElge Foundation. JPM Commodities Research We make one adjustment in incorporating China's domestic As China's consumption reaches 25Bcfd in 2015, we expect production into our analysis. Heritage gives China a score of significant growth in domestic production, as well as 52.0 in its methodology (ranking in between Cameroon and substantial pipeline imports from Turkmenistan, Myanmar, Mauritania for this measure of riskiness). For our purposes, and Russia. If China gets just 3Bcfd in combined imports we assign a value of 95.0 for China's conventional gas from the US and Canada in 2015 (among the other supply production and a score of 90.0 for China's as-of-yet- developments), the portfolio's projected riskiness score nonexistent unconventional gas production, as Beijing will drops only to 82 from 90 in 2010, comparable to the HFEF view these "baseload" supplies as very reliable from a score for Australia—a desirable result from a security of 7 EFTA01090480 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 supply standpoint. If North American supplies are not policymakers' commitment to a robust, commodity-intensive available and China instead fills that 3Bcfd sliver of demand solution to put together the jigsaw puzzle we describe. In with supplies from Russia and the Middle East, the September 1985, at a similar moment of imbalance in world portfolio's risk score likely drops closer to 77, which is currency markets, the governments of five G-7 nations riskier but still equivalent to the HFEF scores for Bahrain or signed the Plaza Accord in order to depreciate the USD. Chile, both of whom enjoy reputations as reliable partners in commodity export markets. But with the World Trade Organization (WTO) and other international bodies already facilitating cross-border These portfolio scores include China's domestic production. commercial flows, the Canadian and American governments If we isolate just the import component and score that have been more focused on reviewing and approving leases subportfolio through time, the picture is not as comforting. and gas export permits rather than searching for a "Grand Today's import portfolio scores 64, or about the equivalent Bargain" that links natural gas to broader imbalances in the of the HFEF score for Turkey—still in the realm of an EU world economy. Consequently, the recent sequence of aspirant but significantly riskier than the baseload supply. historic and market-changing catalysts in the US natural gas Even with the 3Bcfd we project will come from North market—many of which we have been anticipating would America, by 2015 the score drops to 62, on par with unfold in 201I —has largely been announced by the private Kazakhstan. If the 3Bcfd have to come from Russia or the sector (see Appendix A for a timeline). Middle East, the score drops to 51, on par with Syria, which ranks #140 out of the 179 countries on the HFEF list. That This is not to say that the Canadian and US governments gap from 62 to 51 looks to us like a tipping point in risk, have been disengaged. One historic breakthrough was leading us to conclude that China will continue to pursue Canada's granting of an export permit to the Kitimat deals in North America, typically as a minority, silent partner terminal on October 13, which echoed a similar license out of respect for political sensitivities, especially in the granted by the Federal government of the US to Sabine Pass United States. in May (see timeline). The Kitimat permit is the first export license granted by Canada's National Energy Board since The Beijing leadership has this summer witnessed street deregulation of the gas industry in 1985, according to the protests in London, Rome, and various cities in the US, Board's website. providing hints of the cost of getting this forward gas risk wrong. Beijing wishes to avoid comparable social unrest in Less than two weeks later, Cheniere and BG announced a Chinese cities where millions of rural citizens resettle each 20-year LNG export deal through a to-be-built liquefaction year. Beijing has a strong incentive to help finance North facility at the existing Sabine Pass terminal in Louisiana. American commodity production and export infrastructure in The new train will be the first modern liquefaction plant built exchange for long-term supply security, even under floating in the US. The contracted volume is 3.5mmt per year (20% price agreements. There is a real option value to reducing of projected capacity) in a take-or-pay arrangement. China's physical gas portfolio risk, with benefits not only for Cheniere expects to be exporting by 2015. BG will pay 115 China but also for the peace of the world. North American percent of the Henry Hub price plus $2.15 per MMBtu plus industry should keep this in mind when trying to interpret the transportation cost. bids of Chinese energy companies vying for North American energy assets. Cheniere estimates transportation costs from the US Gulf Coast to Asia are now about $2.80 per MMBtu. Given that We estimate that China's natural gas imports (pipeline plus China and Japan are already paying $12 to $16 per MMBtu LNG) to meet domestic demand will increase by a factor of for LNG on a delivered basis, if the Sabine Pass option were six from 2010 to 2015. This represents an incremental available today, spot Henry Hub physical gas could be $6.13 7.9Bcfd, before any linepack fill or baseload stocking. As to $9.61 per MMBtu today and still be competitively priced China's need for imported gas grows, the nation will likely with oil-linked molecules in North Asia. The midpoint of attempt to minimize both import security risk as well as the the imputed range implies $7.87 per MMBtu. This is more risk associated with the overall gas supply portfolio. than 2X the current spot price. The imputed range is also generally above the price level that many in industry believe In a prior era, sovereign-level treaties would have taken the will be the ceiling for the spot price for many years. lead role in inaugurating these new international pathways for investment and trade. Given the seriousness of the global But violation of that supposed ceiling is an outcome debt crisis, a special treaty might yet occur in order to affirm consistent with the economics of marginal cost and the wide 8 EFTA01090481 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 dispersion in fuel prices waiting to be arbitraged. There is a crude oil pipelines, and 18.9 thousand km of refined product ready analogue in the rail and truck investments that have pipelines. been pursued in 2011 to narrow the historically-wide Brent- WTI spread. Rail shipments of petroleum and petroleum For reference, the US, with six times China's demand, had products in the US Midcontinent as of October, for example, nearly 500 thousand km of natural gas pipelines for interstate are up 19.4% YoY, according to the Association of and intrastate traffic in 2009, according to the EIA. Thus, American Railroads, as Bakken barrels are moved toward the the American network is more than ten times bigger than NYM delivery hub at Cushing, OK and onward to the Gulf China's current network. As China's gas demand rises Coast. toward one-half the size of the US over the next 7 years, it is not unreasonable to expect its gas pipeline network to double Similarly, the potential for North American gas prices to to 80 thousand km and likely much more (CNPC projects its reflect the marginal molecule in Asia consumption, rather network alone will be 64 thousand km), especially when one than local production costs in a US basis, is reminiscent of considers that logical sites for storage (e.g., the depleted oil the marginal cost economics that became so obvious in oil in fields of Dalian and other potential assets in Northeastern 2008. That year, an oilsands producer in Canada or a China) are nearly 3 thousand km away from the fast-growing deepwater producer in the Western Gulf of Mexico or cities of the South, such as Chongqing. Clearly, China will offshore Angola, who might have carried production costs also look to build more convenient storage in southern somewhere between $50 and $65 per bbl, still received coastal provinces, but this sensible strategy will incur cost. upwards of $140 per bbl on every barrel for a short period of time because at that instant the marginal molecule of global Independent confirmation of the general soundness of these oil demand (driven by Asia) called upon the marginal expectations comes from the US-China Economic and molecule of supply (biofuels in Romania and the US) and Security Review Commission, which believes China will every bane! in the world cleared off that marginalprice. increase its total oil and gas pipeline length by 150 thousand km in the next five years. Meanwhile, the recent and sudden increase in demand for LNG has rapidly strained shipping capacity. LNG carrier The scope of likely costs for such investments are signaled rates have increased by nearly 300% since early summer. by CNPC's recently completed second West—East gas We understand recent charter contracts are over $120,000 pipeline, an 8,704 km project that became operational this per day, among the highest rates ever. Waterborne LNG year and transports imported gas and domestic reserves from data show that through 2017, an additional 58.2mtpa the west. It cost RMB142.2 billion (US$22 billion) or about (7.65Bcfd) of liquefaction capacity will likely be added US$2.5 million per kilometer, according to company data. around the world. As substantial as this volume would be This implies upwards of $100Bn of gas pipeline investment, against current needs, this number is smaller than our or another US$20Bn per year for at least the next five years. projection for China's likely growth in import demand We expect actual expenditure will persist at close to that through 2015 (two years earlier than Waterbome's window), level beyond the five-year-forward window. implying that Central Asian pipelines also are likely to be a vital component of the solution to balance the Chinese gas Properly assessed over the time horizon of the next decade market. Our analysis suggests China's physical gas portfolio and longer, China's real option in accessing molecules from will call on at least half of the new global liquefaction North America is likely to prove extremely valuable, worth capacity. far more than might be inferred from the recent behavior of North American producers selling the long-dated curve. China's gas infrastructure is making rapid strides, but it is from a small base and much work remains to be done. At US natural gas is cheap on a btu basis: in spot terms, it is the end of 2010, China National Petroleum Corporation about US$3.45 per MMBtu. This price is the equivalent of (CNPC) had 32.8 thousand kilometers (km) of natural gas US$22 per bee, or $95+ per bee cheaper than distillate-rich pipelines, 14.8 thousand km of crude oil pipelines, and 9.3 crudes in Asia and low-sulfur gasoil in Singapore (Exhibit thousand km of refined product pipelines, according to 15). Moreover, work by our colleagues in Equity Research company data. CNPC's estimates of its total pipeline market reveals that global LNG projects between 2000 and 2010 share in 2010-80.5% in natural gas, 69.2% in crude oil, and (largely sited in Qatar, Trinidad, Egypt, Australia) 49.1% in refined product pipelines—implies China's total experienced significant construction delays and cost pipeline network at the end of 2010 consisted of about 40.7 overruns (see: Benjamin Wilson et al., LNG Execution Risk, thousand km of natural gas pipelines, 21.3 thousand km of 8 March 2011). Their data show that 34% of projects in that 9 EFTA01090482 Colin P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy J.P Morgan IS November 2011 interval fell behind schedule and 38% came in over budget and wane with the quantity of US demand for Canadian (Exhibit 16). These are not welcome numbers for China, imports. In some years, the correlation has been as high as where unexpected time delays equal security risk. 0.30; today it is about 0.12. Exhibit 15: US gas is cheap; China would be a terrific customer Exhibit 17: Correlation between CNYUSD and NG1 US$ per MMBiu Boling 255 day moving average .—Sing LS Gasoil —Murbancrude 0.6 —Mont Belvieu Propane WC S Crude , FIN NG 0.4 0.2 0.0 O.2 O.4 O.6 C k8- Ig,AW-4. 8 Source: Bloomberg. J.P. Morgan Canmcdtes Research Source: Bloomberg. J.P. Morgan Ccenmcdnes Research Exhibit 16: LNG construction schedule and cost overruns Exhibit 18: Correlation between CADUSD and NG1 Global projects between 2000 and 2010, percenl Poling 255 day moving average 45% 42% 0.6 15-Nov-11 40% 37% 38% 34% 0.4 0.122 35% 29% 30% 0.2 25% 21% 0.0 20% 15% 0.2 10% 0.4 5% 0% 0.6 On Behind Ahead of On budget Over Under §1 A schedule schedule schedule budget budget Source: Company Reports. J.P. Morgan Equites Research. Ccnstnxbon IN . 35):cost IN .24). Source: Bloomberg. J.P. Morgan CcenmccUies Research Based on three recent field trips to the US Midcontinent, our Gold confounds bears that make the sense is that gas producers in Texas, Oklahoma, and mistake of seeing only momentum, not vol Louisiana underestimate the coming influence of the Chinese currency on price variation in their product, largely because Another market-based view into the evolving capital account it is true there is no discernible effect today. This is entirely and current account relationships among China, Europe, and understandable. With CNY still carefully managed by the United States can be found in the gold price. Since late Beijing and physical natural gas not trading between China summer, gold options prices have given surprisingly useful and North America, the correlation is zero (Exhibit 17). signals on the likely probabilities of a European sovereign debt default, Euro or USD crisis (vs. the CNY), and the However, many operators working exclusively in the Barnett coming success or failure of the US Deficit Supercommittee. and other US basis markets who do not have international customers also seem to think the Canadian dollar has little In mere days in August, following the downgrade of the US bearing on local gas prices. Yet, a simple correlation sovereign credit rating and the intensification of the analysis shows that the Canadian dollar tends to exhibit a European debt crisis, average at-the-money (ATM) implied positive correlation with the prompt NYM gas futures price, volatility in the prompt CMX gold contract doubled (Exhibit even on low frequency horizons, such as rolling 1-year 19). windows (Exhibit 18). This relationship has tended to wax 10 EFTA01090483 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 Exhibit 19: ATM implied volatility. 1st month COMEX gold prices as "bearish": by definition, high implied volatility Percentage tannualtzech requires strong up and down movements for validation. 60 Average since Aug 8: 50 28.5% Because of the movements in vol space, gold prices have proven to be a useful analytic tool even for market observers 40 who do not invest in precious metals. It has been a bizarre 30 coincidence that the Deficit Supercommittee (a derivative of Regime shirt it risk". Congress) happens to have been given by statute a lifespan ••••,...4.. t pAnt 10 whose expiry (Dec 23) happens to align neatly with the YTD AveragethroughAug 5: 14.6% expiry of the Dec-11 CMX gold contract (Dec 28). In • 0 August, this strange congruence suddenly enabled way out- g g22 ci nii•iS 53 of-the-money (OTM) premia to serve as a kind of barometer 7 Le, -A - • on news flow related to deficit reduction and European eena:: chr r-F, sovereign bailouts, as far OTM strikes on near-dated Source: CUL J.P. Morgan Commodities Research contracts had little else to price other than the probability of At times in August and September, this measure of riskiness a policy error. In our work, we have focused on the $2500 further spiked from the new baseline of 30% toward 50% in strike, because this is the price level that would mark a new the prompt contract. Intraweek vols were even higher, all-time high in real terms and because it is close to the spiking toward 70%. This regime shift in volatility is the industry's marginal cost (inclusive of capital costs), set by strongest in more than thirty years—since early 1980—when projects such as the proposed expansion of Olympic Dam—a gold made what is still the all-time high in real terms ($2540 large uranium and metals deposit in Australia, which is per oz in Oct-11 USD). winding its way through a political review process. Exhibit 20: CBOE Gold VIX (GVZ) Exhibit 21: Range of potential gold price implied by 10%0TM options 1.65 US$ per troy oz. 45 $3,000 40 12,500 35 $2.000 30 $1.500 25 $1.000 20 I5 $500 10 $ AA A LL Source: MOE. J.P. Morgan Commodities Research Source: CMX. J.P. Morgan Ccarmodties Research In our view, it is not possible to assess accurately what is There is also an underappreciated fundamental story in gold. happening in gold without first: (a) recognizing that this Physical demand from India and China has doubled to 1.83 huge move in implied volatility has happened, and (b) million kg per year since 2008 (Exhibit 22). Production in understanding what the move in implied volatility means for South Africa, long the dominant producer, has halved to perceived riskiness and the range of potential prices. about 0.19 million kg per year since 2003 (Exhibit 23). In between, Central Banks have emerged as some of the most But judging by market chatter, even now, the volatility forceful buyers of physical bullion: Russia's gold reserves regime shift does not appear to have been widely recognized, have increased by 14.5 million ozs since 2006, rising to 27.3 despite the availability of prices for exchange-traded million oz from 12.8 million oz (Exhibit 24). instruments that enable real-time tracking of it, such as the Gold VIX ETF (Exhibit 20). These volatility charts ably Gold is not a safe haven in a high-vol environment. Gold is help illustrate an important point. It is a mistake to think of a risk asset with surprisingly strong potential upside for the sharply rising prices only as "bullish" and sharply falling balance of 2011. For example, significant uncertainty 11 EFTA01090484 Global Commodities Research J.P.Morgan illillom Commodity Markets Outlook and Strategy IS November 2011 lingers about next steps for Europe. If Greek sovereign debt Exhibit 22: Consumer demand for gold in India and China (O40Bn, US$462Bn) is the domino that leads to Italian 12.ronth running total in million kg sovereign debt (€1899Bn, US$2,582Bn), is the next piece to 2.0 1.8 drop really France (€1,591Bn, US$2,163Bn)? As the world 1.6 focuses on Europe, attention seems to have become rather 1.4 complacent about the debt problem in the United States 1.2 (US$15,000Bn, El I ,029Bn). Yet, by its legal mandate the US Deficit Supercommittee must vote a plan out of committee within the next 8 days, or 0.2 I 0.0 III VI I III II I by the day before the US Thanksgiving holiday. This timing presents the intriguing possibility that the N E I I 1 rg 1 1 I Supercommittee has deliberately and successfully driven • India •China expectations so low that global markets are positioned for Source: GFMS. J.P. Morgan Commodies Research a positive surprise. Exhibit 23: South African gold production If so, this could be a particularly successful strategy, with IGlogram pet day beneficial effects for the entire global economy, as the 1400 Thanksgiving holiday will immediately lead on to a 1200 lin veivnivilve te.itrevr. succession of December holidays, giving markets strong tailwinds on consumer and business sentiment. Conversely, 1000 if the Supercommittee is as deadlocked as it appears on the 800 surface to be and frustrates already weak expectations, then 600 public sentiment could swiftly deteriorate, hurting holiday retail sales, in turn sending the OECD economies into a 400 tailspin. It seems important that the Supercommittee not fail. 200 0 Given the central path we assign to the muddle-through g g g g g g g scenario for the Deficit Supercommittee, we expect spot gold £1 to spurt above $2000 per oz within the remainder of 2011. Source: INNS. J.P. Morgan Commodties Research At current levels of realized volatility, it would take only 4.5 trading days to reclaim the all-time nominal high price that Exhibit 24: Russia gold reserves ounces was achieved intraday on September 6 ($1920 per oz). 30 If the Deficit Supercommittee were to fail in achieving its 25 mandate, then gold prices could move sharply higher than $2500 per oz, as confidence in the USD would likely be 20 impaired. Contrariwise, if the Supercommittee credibly 15 reduce the deficit by $4Tn or more, gold prices would likely stumble and copper, oil, and global equities would likely 10 surge. Putting all the pieces together, our sense is 5 commodity markets generally are embedding the expectation the Deficit Supercommittee will do $1.5Tn to $2.0Tn, or in 0 other words, what they are supposed to do, plus a little extra. 111 Source: IMF. J.P. Morgan Canino:Res Research 12 EFTA01090485 Cohn P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 A rerate, not a reset, in the composition of commodities as inputs. These inputs could be obtained from Chinese and US GDP Africa, Latin America, and elsewhere, but they are in surprising abundance in the United States and Canada— Proposals for how to fix the world's debt problem and get countries characterized by operational efficiency, reliable the world "back on track" start with a central conceptual product specifications, rule of law, sanctity of contracts. The flaw, because the global economy is not trying to get back on North Americans are starting to realize there is strong and track. It has already jumped the rails into a new century. sustained business to be done. The pm-crisis world of 2007 is gone forever. There are new tracks for getting fuel, food, and metals from North America From the perspective of the United States, this means jobs, and other major commodity producers into Asia. potentially millions of manufacturing jobs in particular. According to the American Petroleum Institute (API), in Global investment and trade patterns, for example, are likely 2009, the oil and gas industry accounted for 2.19 million to significantly recalibrate the compositional mix of GDP in jobs directly and supported another 6.97 million jobs the world's two largest economies (US, China). These old indirectly, meaning that more than 8% of the full-time friends are likely to deepen commercial ties and start looking employed workforce in the US are tied to the industry. more like each other in terms of decomposition of shares of GDP. This is a contrarian view to the bias held by many old- Industry consultants, working for API, have estimated that hand policymakers, whose prescription for America's ills is development of the Marcellus Shale over the next ten years to increase government debt in an attempt to kick start US could create upwards of another two hundred thousand jobs, household consumption. Given the large jobless rate, the with potentially a million jobs created nationwide by 2020. debt overhang, and the long-run structural imbalances, the To us, these estimates actually sound low relative to old-hand approach will struggle to succeed, which is partly potential. Judging by the ongoing shortage of labor in the why President Obama's jobs bill was defeated. Bakken play in North Dakota, if the United States were to get serious about developing its oil and natural gas It may be useful to recall that the equation for GDP is endowment, we would not be surprised to see total job simply: creation (including indirect jobs) be closer to 2-to-3 million. We hear anecdotal reports from the Midcontinent that truck GOP - Consumption + Government Spending + Investment + Trade, drivers are being offered wages of $200,000 per year and where Trade is Exports less Imports experienced welders can now command up to $500,000 per year. For decades it has been axiomatic that the US trade balance will be in deficit and the Chinese trade balance will be in Exhibit 25: Trade balances In China and the US surplus. Indeed, the widening of trade gaps between the two Percent of GDP nations has contributed to frictions over currency valuations 15 for nearly 20 years. But this is now changing (Exhibit 25). The surplus balance in China, and the deficit balance in the 10 US, may have already reached their peak/trough. We believe Canadian gas imports displaced from the US to China will 5 help drive these two curves toward each other. Corn and 0 other exports from the US to China will also contribute to that result. Moreover, the reality is that managed rebalancing in the -10 SJ , cas CO Eno s,4 cas &as, C•1 CO 0 CNYUSD cross has been underway for some time. Beijing Of Of .......... Of Of Of 01 Of Of Of Of 0 O O C•1 o 0 C•1 o 0 o 0 C•1 .- 0 OJ has allowed the CNY to appreciate by 7% against the Source: IMF. J.P.Morgan Ccentrokes Research greenback since June 2010, resuming a gradual trend after a two-year hiatus during the recession when the exchange rate was fixed at 6.83. The CNY has appreciated by 20% against In the US, the share of household consumption as a the USD since the middle of 2006. percentage of GDP has been climbing since the late 1960s. while the trade balance moved into a sustained deficit in The rising middle class in China will increasingly spend its 1976 (Exhibit 26). In contrast, the share of household wealth on goods and services that will require primary consumption in Chinese GDP has been generally falling 13 EFTA01090486 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 since the early 1980s (Exhibit 27). Fixed capital formation and more recently by the IAEA's announcement of nuclear surpassed it as the largest share in 2003. centrifuges in Iran. Exhibit 26: US GDP components Exhibit 28: US household consumption Percent of GDP Percent of GDP 80 eo 40 20 0 .20 HRMRFAIMERIEgEriin .—.Household Consunpaon —Fixed Capital Formation 'Si LOCO 91 e • N. 0 Of CO en cm in r- —Government Expectiare —Trade Balance 0 010101 MOO 03 , - 0 03 CO Of 0.1 1.0 1.0 COCO LO CO (0(0 N. N. 03 03 0303 Of 0)0) 0 03 Of Of Of Of Of 0)0) Of Of 0 Of Of Of Of Of Of Of 0 0 0 0 0 0 Source: IMF. J.P. Morgan Ccennzdtes Research Source: IMF. J.P. Morgan Commodtes Research Exhibit 27: China GDP components Exhlb t 29: Breakdown of GDP components in China and US (2010) Percent of GDP Percent of GDP 46% 6% IRAAAAAA Household Fixed Capital Govemment Current Account Household Consunpaon . .Fixed Capital Formation Consumption Formation Expenditure Balance —Government Expen:litue —Trade Balance • USA •China Source: IIIF. J.P. Morgan Comrrxdtes Research Source: IMF. J.P. Morgan Commoibes Research A longer-history chart of US household consumption as a Looking forward over the next decade or more, we would percent of GDP gives a sense of the potential size of the not be surprised to see the trade balances flip toward +5% for coming changes (Exhibit 28). In the early stages of the US and toward —5% for China, from —4% and +6% Great Depression, the household consumption share surged respectively in 2010, moves of +9%-points and —11%-points from 75% to over 80%, as corporate activity slouched. The respectively. Given the ongoing gross underinvestment in subsequent economic devastation and world war reoriented commodity capacity and the propensity toward cost overages the composition of US growth toward government spending and unexpected delays in large-scale infrastructure projects, in the form of public works programs and then a massive we also take seriously the proposition that consumption and shift toward industrial production, in support of the war investment could see swings of as much as 10%-to-15% effort. By 1944, the household consumption share of GDP points in each country, bringing US consumption from 71% in the US had bottomed at 49%, as Rosie's rivets supplanted toward 56% to 60% and Chinese consumption from 34% to the raccoon coats of 1928. about 45% to 49%. Fixed capital formation might rise toward 30% from 15% in the US, and fall toward 30% from We are not expecting either global depression or world war. 46% in China. These are structural swings attendant to long- At the same time, given the evident geopolitical risks alive lived supercycles for investment and consumption, which are today, one cannot entirely discount the possibility of impossible to align perfectly in the short run. Guessing of regional conflict in South Asia or the Middle East—a risk future demand (and which technologies "win" in the future) underscored by this year's Arab Spring in the Middle East is unavoidable. 14 EFTA01090487 Global Commodities Research J.P Morgan Commodity Markets Outlook and Strategy 15 November 2011 In essence, if these long-cycle structural changes evolve as Exhibit 31: Implied volatility distribution of prompt NYM natural gas we describe, the two economies would look far more similar Frequency by implied vol (Y.). Histogram since 3/6/9.3. Gray ino--mcent distrbution from a compositional perspective than they do today, which 0.10 0.10 0.09 • 14-Nov-11 0.09 could enable far less friction over balance of payments and 0.08 • 34.65 0.08 currency valuation than is the case today. 0.07 • 0.07 0.06 • 0.06 In constructing our long-run commodity views, our operating 0.05 • 0.05 assumption is the CNY will trade around 4.0 to the USD by 0.04 • 0.04 2015 and at a cross of 3.0 by no later than 2020, though we 0.03 • 0.03 0.02 • 0.02 defer to the JP Morgan F/X strategy team for their official 0.01 • 0.01 forecasts. 0.00 0.00 0 I0 20 30 40 50 60 70 80 90 100110120130140150 Implications for risk and valuation Source: WYM. J.P. Morgan Ccomodtes Research The title of this report asks whether US natural gas will help save the world. We believe the answer is yes. US natural It may not take four years to get paid for taking this risk. gas offers a potential solution for escape velocity from the Along the way, the entire natural gas forward curve is also current phase of the global financial mess, though any escape likely to experience strong swoons and advances. By 2017, likely will be a bumpy ride for many years to come. This we believe prompt natural gas prices will be priced bumpiness appears absent in forward NYM natural gas significantly above $6.50 per MMBlu in the dollars of the options prices, where Calendar 2015 ATM straddles can be day. We note that current producer hedges for that interval bought today for about 20% in implied volatility terms. This are struck in nominal dollars, not real dollars, and they make is a noteworthy fact, given that volatility is mean reverting, no contingency provision for the value of the Chinese sometimes violently so in the hardest-to-store commodities, renminbi or any measure of inflation. Producers face the risk like natural gas. Among all commodity markets, only of higher-than-expected received prices for their physical electricity is harder to store. molecules but some potentially significant pain in their paper hedges if they are not careful in how they structure them. As the Ca12015 NYMEX natural gas contracts become more prompt, we believe Ca12015 implied vol will be substantially North American natural gas has been experiencing a strong higher than it is priced today. Our conviction in this view is structural change: shale gas now accounts for about a third of reinforced by the backwardation in the term vol curve and US production. However, a commodity market can the historical distribution of implied volatility since 1993 experience multiple structural changes at the same time. We (Exhibits 30 and 31). Recent measurements of actual see at least two others. The first—the opening of LNG volatility, the stage of the business cycle, the stage of the exports—is already unfolding. The second—the leasing of commodity supercycle (year 12 of projected 25), and the Federally-held and currently off-limits parcels in the Outer term structure of the volatility curve suggest that a roll up to Continental Shelf (OCS) for oil and gas drilling—had a 40% or higher by expiry enjoys a meaningful probability. chance to change course last week, but the US government chose not to exercise that option. Exhibit 30: NYM natural gas implied volatility term curve Percent Specifically, on November 8, the Obama Administration 50 announced its plan for the next 5-year cycle of OCS leasing 45 (2012-to-2017). The government will make 15 leases 40 available for development, with the first auction set for 35 December 14, 2011. Importantly, the plan moots any 30 development off the West and East Coasts, including a parcel off of Virginia that the Administration had earlier 25 indicated would be offered. The plan does include two 20 parcels in the Eastern Gulf of Mexico that are not in the 15 ! T I T I T I T I current moratorium zone but are close to its boundary. This CO 'al' • wr Y LO hn u) perhaps represents a baby step toward future development of 4 2 ta n2 $. 4 2 4- $, 4 4. $. a that zone, however, those properties are not due to be Source: J.P. Morgan Commodties Researdi auctioned until 2014 and 2017. Thus, the OCS plan as it 15 EFTA01090488 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 stands actually diminishes if not removes (for now) one of (RV) framework we introduced on August 8 was short the strongest levers for getting US gas prices down even prompt NYM natural gas and other US-intensive further. The inaction on OCS reduces downside price risk. commodities, against length in commodities geared toward Asia capex. For most of the past year, industry consensus has argued that spot Henry Hub natural gas would remain range-bound However, the gap between US gas prices and Asian oil between S4.50 and $6.50 per MMBtu due to the structural prices has become very wide, and structural changes are impact of shale gas. We have disputed this view, arguing starting to emerge to close that gap. These developments are that both the floor and the ceiling in this range would be sufficiently advanced that last week (Nov 10) we changed violated within the next five years. We have already been our tactical posture and introduced new ideas for institutional proven correct on the floor violation. Spot gas is now priced investors to consider. Specifically: at $3.45 per MMBtu. If the Obama Administration were to tack again and surprise consensus (and us) with an > We took off the Bear leg of the RV strategy at what aggressive opening of Eastern Gulf of Mexico leases outside would have been about a 6.5% profit for the short. of the traditional practice of the 5-year planning exercise, we We presented the idea of redeploying that capital would not be surprised to see flushes down to a price with a into the Bull leg (see page 21 for list of $2 handle. Such flushes could also be spurred by a very commodities in this basket). warm winter (not our view) or a collapse in economic activity in a 2012 US recession (also not ow view). > We also advanced the investment idea that institutional investors buy straddles on Cal 15 NYM Though we have been flagging the relative value emerging in natural gas (k-_$5.00) and protect themselves by natural gas for more than a year, we have not formally owning puts on Spring 2012 (k=$3.50, NGH2, recommended a long position in natural gas as a trading NGK2, NGI2). So far, the puts have gained by strategy. This has been because we have seen greater risk- about 8 cents per MMBtu against a 3-cent decline reward in owning gas-related equities rather than gas for the straddle, for a modest net gain. commodity exposure. Indeed, the Bull/Bear relative value 16 EFTA01090489 Global Commodities Research Commodity Markets Outlook and Strategy J. P Morgan 15 November 2011 Hedging and investment ideas for long-dated NYM natural gas Strategy Industry consensus has believed in a $4.50-to-$6.50 per MMBtu range-bound spot Henry Hub market through 2013. We have doubted these levels as hard boundaries—a skepticism that proved correct as the "floor- disintegrated since late July 2011. The permitting and financing of terminals for exporting natural gas and NGLs out of North America represents a significant structural Producers change. Producer hedges are struck in nominal USD and reflect a price, volatility, and currency regime which is looking backward, not forward. Long- dated gas prices are vulnerable to a swift rerating to higher levels in nominal USD terms, as physical consumers look to lock in long-term physical supply contracts, tightening available supplies in forward basis markets. The myth that there is no global gas market has been put to rest. Once US consumers realize they are competing with the Chinese for forward physical molecules—which are now priced US$100 boe below competing oil prices— forward NYM markets could tighten rapidly. We see parallels with the LME Consumers aluminum market of 1994. when a sovereign-brokered Memorandum of Understanding to cut global production by 6% at a very low price level in both absolute and relative terms led to a huge scramble for property rights on physical inventory that in turn lifted 3M aluminum prices by 80% within the year. This is a good time to layer in long-dated. options-based gas hedges. We have argued for the inevitability of the US gas export solution for more than a year. Until now, equities have represented for most investors a better risk-adjusted vehicle for exposure to the theme. This positioning found support on the day of the BarCheniere announcement, when the Cheniere share price gained by 68.6% in one day, while the average loss in the NYM strip Index Investors was 1.4%. However, risk is changing. We do not believe the nominal prices and volatilities embedded in the NG forward curve can remain where they are, as new domestic demand and trade pathways open up and the CNY likely appreciates by at least one-third vs. USD over the next half decade. We like the idea of buying 2015 straddles, but also see value in owning variance swaps. Between August 8 and November 10, we favored a defensive, relative value (RV) strategy long a basket of commodities geared toward Asia, capex, and inflation. paired against a short or underweight in a basket of 5 commodities geared toward the US. consumption, and disinflation. The shortunderweight basket included prompt NYM natural gas—our only active idea in that market Tactical Traders at that time. Last week we exited the Bear side of this RV idea (at around a 6.5% gain) and suggested the idea of: (1) redeploying the capital into the Bull basket, (2) owning puts on Spring 2012 NYM natural gas, and (3) simultaneously buying straddles on Calendar 2015 NYM gas. We are skeptical implied vols can remain this low. even if timings and catalysts are opaque. Source: J.P. Morgan Commcdtes Research 17 EFTA01090490 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 Appendix A: Timeline of key puzzle pieces Dale De salption LNG ern pOl peen'. Pots DOE Other epjjWay 'MOO/ remen 'An? Cigna 1,111 IsttrNtsp- GDT C"JVC I st.srls tr tots: sou fr t'en:crtal :tato gas ,c1 5aup11 CnO0C announces it imp,. um. g LAO tmocri local,! •,3, 0 polite in incb2014 ifs and lie&an Eton* Per dew 0Aup II Dung industry sotto's. Pa tors reports that LAG horn raos Isobar...14y: LNG sNpmonis through Sues Canal (*sob/ WM .sa En 3 won' to 3 9:crn ey 2015 IA A.° 72 Aupo II Cnra arrounees robalec on import of natural gas hem 2011 to 200011'700000 pesos aro nix. I1aa acmost solo owes it UrS uS nrµn 40 003, , r, 11 0, a 'C'ic ol (.4 1- I' µb uplp asultps 3I-A 11 Shell to 'cwt.! Sa0 i I cn r "thole oar. oc,4:1IOn L • tc ctIttereS: sE MOMS'S Ste 0W1 kV. hey r•f•fa to do ,roe Thstt lea, cl r.> US Dotal St.pCY:Ce-en MC< ms- orator JOI11(10 says tin: :I Ail tom the ccerenetoo. Soparato/y. argon Stalk arrourcos Ns resignation Item the EC8. $4011 The EC8 has rcpertly .syPts,:o Ct.rC ace sprish are Italian - .0 I ... tapserty at :Inc Hcc -pc+. I sty ro ta P(10.2. SOWN( stewI Cowes CEO says the el and CS eosin may add hall a ninon jobs by 2030 I CNIX)C r. 1 µIll a )1 Colon tiab Sly Odd, 84,10l/1:46 Vial BC hb 10 renew LNG. intIalro targeting twee someone LNG mom pr OOS by 2020 it C' •"c al wih I Eb, Wheat t'c Weslccs AsstrAts gel kfttin frarbeltb *to fill ON shaman.' 'check/ea for 2018 IOCCE 11 S4rOccc to C-TaCiai f IC' 5- Ono. Milk 7 cl kcoccCurc e.rp C.ACWC .41 ire ups o1 LNG to power Ions vats. namely redruire more than 10%0145501 caroglr WOO used Osna rtoorterni at ria .,InR seaacn ;hat COrcLii- O cttitst, pot yew. lest l 14 eft 11 1<4a:. ncr p, CUriccc a scstrfsim 'optort plan lor US. The than seats to MOW 1.2 maw lobs Ittough thp.rong west= re &texts of and gas. 17.0tt.11 lOrcler Morgan announces deal to aced,. El Pam* S38 ellen 1RIB,, in cane ?bat II Rol:an:al ore:arta Cied04!c -•cf '00 on to pay a 201142 tax on meanie 250<t-I I ecootrans anemias MC, terminal in Daiwa is "ealy b COOn,,Cr. 11 rp:rt 44rrrt cot /Or Eec'p t ja,I CILNG by afat Saf Norco ac ;cccn>l atq<a 26-Ce1.1 dote so SO drYCleCe LISSCen LNG tos,, ,yetrnent for 3 B miha,ICI 04 sc wit 1.5 wort Cl the Merry Hub price plus 32.15 pee 1.0.18tu 31CooII SCE tract Nava G.t wear signs accord to bald $140 m lb:. • • r LNG tc-nt INeity al 2 edO by IM erd ot 2012 wth Rays mcmen set ib.. Cimma Ad- irestrut in s -rtcri:eo In pat 'or Vie rot 5-year cycle or CitS relaying OW to 2(tir: Mc pOtticmcct mil f, ...1,: 15 ..vs ea ScsJkidc 'of clecippriefIl imponetcy. the ankrell plan asos na ccludo any do -Maynard ca tho West and East Coasts. inchsina a axed o101 Vinynia that the Adminstrahon had oarliorindICatei noui:1 be olktol The plan tots wicks," No pa,Cels in the Eastern Oil of Wilco that are rot in the theatre moialortrn cent. Source: Company reports. Moomberg. Reuters. JP. lAorgar, Comm odbas Research 18 EFTA01090491 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Appendix B: Gas excerpts from China's 12th 5-Year Plan "Upgrade bulk vessels, oil tankers, and "Promote diversified and clean energy container vessels to international standards: sources: Strengthen the exploration and Improve the ship equipment industry and loading development of petroleum and natural gas rate, prioritizing LNG and LPG vessels: resources, stabilize domestic petroleum output. and promote the rapid growth of natural gas output and the development and utilization of unconventional oil and gas resources, such as "Optimize energy development: Construct five coal-bed gas and shale gas." national integrated energy bases in Shanxi. the Ordos Basin, eastern Inner Mongolia. SW China and Xinjiang. Improve local energy processing and transformation to reduce the pressure of large- scale and long-distance energy transmission. Construct energy storage facilities, improve the "Strengthen energy transmission channels: petroleum reserve system, and strengthen the Accelerate the construction of strategic `capacity of natural gas and coal reserves.' transmission channels in China and improve the domestic trun k oil and gas pipeline network. Unify planning of natural gas import pipelines. LNG receiving stations, and cross-regional trunk gas transmission and distribution networks, and "Stabilize oil output and increase gas output: create a gas supply layout in which natural gas Create 5 large-scale oil and gas producing areas in and coal based gas are balanced: the Tarim and Junggar Basins. the Liaosong Basin. the Ordos Basin, the Bohai Bay Basin and the Sichuan Basin. Accelerate the exploration and development of offshore and deepwater oil and gas fields, and strengthen the production and utilization of coal-bed gas in coal mine areas. Increase oil "Build out oil and gas pipeline networks: refining capability appropriately." Construct the Ch ina-Kazakhstan crude oil pipeline (Phase 2), the China-Myanmar oil and gas pipeline (domestic section), the Central Asia natural gas pipeline (Phase 2). and the West-to- east Gas Transmission Lines 3 and 4. Accelerate "Improve the mechanism for setting prices for the construction of gas storage facilities." resource products: Press ahead with progressive pricing for household electricity and water consumption. Make the price ratio of natural gas to alternative energy sources more reasonable." "Energy consumption per unit of GDP will decrease 16% and CO2 emissions per unit of GDP will decrease 17%: Improve the incentive "Build out the power grid: Accelerate construction mechanism of energy conservation and emission of outward power supply projects from large coal reduction, optimize energy consumption power. hydropower and wind power bases. and structure. improve pricing mechanisms and create some cross-regional power transmission taxation, and strengthen the related laws. channels using advanced technologies. Complete regulations and standards? 200.000km of power transmission lines, upgrade substations to smart-substations, increase use of smart meters, and construct EV charging facilities." Source: China's 12th Re Year Plan granstaton from Delegation cd the European Una) n Cigna), J.P. Morgan Commodlies Research EFTA01090492 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Price Forecasts USD. quarterly averages Energy WT1 Crude U54/118 99.37 79.61 94.60 102.34 89.54 90.00 94.12 90.03 90.00 100.00 110.00 97.50 lerleardpike 37 96.46 9935 98.91 9119 97.55 98.501. Brent Cnide USIM:bl 112.39 80.34 105.52 116.99 112.09 115.00 112.40 115 CO 110.03 115.00 120.00 115.00 lerleardpike 11239 111.75 111.75 110.61 109.51 ?08.22 rro.cell. Natural Gas US$illuBlu 3.40 4.38 4.20 4.38 0.05 375 4.18 3.95 3.50 4.25 4.70 4.10 1116810"(Ma r 310 4.01 155 3.61 372 196 371 Precious Metals Gad ussn 1782 1228 1388 1508 1703 2150 1696 1925 1875 1650 1825 1869 loneardprice 782 1595 1784 1784 1787 1790 &het ussn 34.46 20.20 31.95 38.32 38.81 35.80 36.43 35.03 34.10 33.60 3123 34.00 ketardprIce W4I5 35.88 34.50 34.13 3417 342? 34.25 Al Platinum US111 oz. 1643 1614 1793 1788 1773 1900 1822 1903 1902 1925 1935 1915 Awardpate 1785 1643 1648 1651 M55.- 2649 Al Palladbm USIO 62. 667 530 79D 760 752 800 783 820 840 860 880 8-50 lorwardpate 742 669 670 670 MI. 670 Ai Base Metals Aluminum USSMII 2114 2178 2511 2603 2404 2200 2448 2350 2453 2550 2600 2503 forwardpate 14 2408 2117 2129 2155 2184X 2146 In cave US5M9 7677 7548 9634 9152 8979 7250 8791 6250 8502 9250 9000 8750 ICAOrdpoet 7686 8863 7686 7695 7700 7700 7695 ticket USSMII 17547 21823 26913 24181 22010 18003 -8880 20030 21030 22003 22030 21250 IrIontardpoce 17811 22729 17556 17569 17582 17565 17573 In Znc USS4111 1906 2163 2399 2254 2227 1900 2215 2003 2103 2150 2230 2113 forwardpate 1906 2197 1907 1927 1947 1965 tax 1. Lead USS4111 1991 2152 2592 2546 2452 2000 2397 2175 2253 2275 2330 2250 lomevdpate 1991 2395 2005 2024 2042 2059 2032 Al Tn USS4111 21155 20418 29927 26698 24630 20503 25999 22500 22030 24003 25030 23625 Ionvardpoce 21165 26080 26(76 21194 21208 21220 21200 Al Agriculture Corn US$Ibu 646 4.30 670 7.31 696 640 6.80 6.70 7.00 6.80 6.3D 6.70 fontan1pricre 686 655 6.61 6.36 6.84 634 III C.V.E Meat USSrou 633 5.86 7.86 7.45 690 6.50 7.22 6.90 7.20 7.10 7.30 7.10 fontan1pricre 4133 713 648 6.64 6.90 7.26 682 Soybeans USSbu 12.00 10.49 13.79 13.61 13.56 12.70 13.40 13.10 13.40 13.20 12.70 13.10 karat(price = 1165 1205 1232 12.23 121? /2151.1 Soybean 01 US cellist 52.60 42.12 56.98 57.21 55.72 51.80 55.53 54.40 52.80 5340 56.03 54.20 tome&pate 1 5260 55.63 5102 5153 5387 537? 53.53111 Soybean Meal LISfahat ton 301.4 299.5 367.2 353.2 352.4 325.0 350.2 358.3 354.3 366.8 337.8 354.3 karacvdpate 301.4 34156 304.8 309.4 3136 3017 309.31. Sugar US Ceedtal 24.81 2228 30.50 24.46 25.68 23.50 26.78 22.03 21.50 21.50 21.03 21.50 karacvdpate 27.88 24.81 24.16 23.75 2165 24.09 In Source: Exchanges. J.P. 1.Ictgan Ccnimcdses Research. Data as c4 dose on November 15. 2011. Forward prices are the average of the contracts in the quarter. 20 EFTA01090493 Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 Ideas for institutional investors Active trading ideas Change since Maned as al: 15-hloy.11 Date of recommendation Cost' Last closing price recommendation Long Dec-11 CM% Gold 25-Feb-2011 1421.10 1782.20 25.4% Long CT2013 Brent cal options (IC • 125) 23-Feb.2011 7.30 7.53 0.23 Long put on Spring 2012 NYIA natural gas 10-P4ov-2011 0.17 0.25 0.08 (k s 3.50, contracts NGH2, NOJ2, till(2) Long Cal 2015 straddle In WM natural gas (k • 5.00) 1044ov-2011 1.54 1.51 -0.03 New Bull basket 10-ibv-2011 100.0 100.7 0.7% ICE Brent crude oil (C0H2) 0.1% ICE gasol (05112) 1.5% MX gold (GCG2) 1.3% ICE raw sugar (5BH2) -2.3% LME copper (LPH2) 2.6% CBT corn (C 112) 0.0% M0E %teat (MINH2) 1.3% Long SSP GSCI Total Return 30-Sep-2010 4303.80 5056.00 17.5% Long S&P GSCI Enhanced TR 30-Sep.2010 621.52 737.89 18.7% Long JPPA Commodity Curve TR 30-ser2oto 443.75 504.80 13.7% Source: Exchanges. J.P. Morgan Commodore Research 'UM costa tie official dose on the day before the dale cd pudication. Al ideas and cakUated changes are br rilormacrel purposes to Ira& the performance d ideas. Nore are actual inrestmercs. basket' was original/gone-hall cd a relate value strategy ntroduced on August 8.2011 as a nears Y3 manage neaRerm financial morsel tistobrce related to the sovereign debt challenges n Europe and the United Slates. 1.ear basker idea was cbsed on Ncnerrter 10.2011 a a 6.5% rnpled return net of tradng costs. met the theatre cal capital redepbyed to Bul basket. beclouding the guarotymposures. Due to shminere expires. in estadishrg the New Pol Basket. we are using Metalcontracts rather than in December. Commodity total return forecast tables Conrodity total returns Forecast 2008 2009 2010 2011YT0 Next 12 Months S&P GSCI -46.5 13.5 9.0 2.3 15.0 Energy -52.4 11.2 1.9 8.3 19.0 Non-Energy -31.1 16.9 26.3 -9.7 6.9 Industrial Metals 49.0 82.4 16.7 -20.8 8.0 Precious Metals 0.5 25.1 34.5 22.8 4.5 Agriculture -28.9 3.8 34.2 -13.7 8.5 Livestock -27.4 -14.1 10.5 2.1 2.0 JPMCCI 45.0 20.5 13S -0.2 17.0 Energy -42.3 10.4 0.6 5.7 22.0 Non-Energy -274 30.3 27.8 -5.2 12.1 Industrial Metals 46.8 80.6 16.1 -191 15.0 Precious Metals -4A 28.2 39.0 20.3 6.0 Agriculture -211 10.1 35.5 -7.4 14.5 Livestock -24.3 -12.7 15.3 3.1 2S S&P GSCI Enhanced -41.1 21.6 12.2 3.6 16.0 DJ-UBS -35.7 18.9 16.8 4.2 12.0 Source: SP. DJ. Schanges. J.P. Morgan Commodes Research Note: Val returns are cross returns teeore lees. data as of 15-Nov-11. 21 EFTA01090494 Cohn P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Colin P. Fenton, Head of Global Commodities Research and Strategy Oil Metals Lawrence E. Eagles Michael J. Jansen David G. Martin Yubln Fu Jeff G. Brown Natural Gas Scott C. Speaker Ryan F. Sullivan Shikha Chaturvedi Upadhi Kabra unwauarastaws Jonah D. Waxman, CFA Megan V. Hansen Elizabeth M. 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