oil and gas basics jp morgan (2008)

For example, the US and China produce a lot of oil, but export very little given high domestic demand OPEC members Saudi Arabia and Iran are the world’s biggest exporters of crude oi

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reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan Neither this presentation nor any of its contents

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The energy investment cycle

From the well to the tank .

Source: JPMorgan Energy Strategy

Where are most of the world’s oil reserves?

Source: JPMorgan Energy Strategy, BP Statistical Handbook (June 2007)

Proved Oil Reserves (end 2006)

In thousand million barrels

Who are the world’s top producers of crude oil?

The world’s biggest producers are not

necessarily the same as the world’s biggest exporters For example, the US and China produce a lot of oil, but

export very little given high domestic demand

OPEC members Saudi Arabia and Iran

are the world’s biggest exporters of crude oil

2007 Averages (kbd)

Note: Bold = OPEC members

Source: JPMorgan Energy Strategy, IEA

How is crude oil related to other oils, like gasoline and heating oil?

Crude oil is what gets pumped out of the ground Very little crude oil is consumed directly — it is a

raw material that has to be refined into other products, such as gasoline and heating oil

Oil refining is the process of turning crude into the fuels that we use every day, such as gasoline,

heating oil, and jet fuel Though refining processes differ according to the desired product, all begin

by heating crude at increasing temperatures to separate it into component parts

Source: JPMorgan Energy Strategy

Re Refining processAlkylation

Gasoline Gasoil/Diesel Naphtha Gasoline Heavy Gas Oil Coke

Gasoline Blending Components

Top Oil Consumers (2006)

Where are the world’s top consumers of oil?

FSU 5%

Japan 6%

China 9%

United States 25%

Other 49%

India 3%

Germany 3%

Source: JPMorgan Energy Strategy, BP Statistical Handbook (June 2007)

The energy investment cycle

Where does oil comes from - and where does it go? 1

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 don’t go away over night… But the market always

does it’s job eventually!

Source: JPMorgan Energy Strategy

Baker Hughes World Oil & Gas Rig Count and Crude Price

The cycle of investment

OECD Oil Demand vs Refinery Capacity

Source: JPM Energy Strategy , IEA, EIA

Downstream investment, or lack

thereof, is also cyclical and tends to over-shoot in both directions

There’s no reason to think that this

investment cycle won’t — eventually —

be the same

OECD demand exceeds OECD refinery

capacity That means that, increasingly,

‘spare’ refinery capacity is in the OECD That means that — just like crude production — most of the world’s refined products production is

non-geographically far away from most of the world’s consumption

Energy infrastructure/distribution capacity is still a constraint

Global 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

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

How oil is priced – terms and conventions

The energy investment cycle

Where does oil comes from - and where does it go? 1

Oil is a global market

It’s 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 get crude supplies from the country with the disruption

Broadly speaking, oil is fungible: a commodity that is freely

interchangeable with another in satisfying an obligation

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 crude

tends to sell at a higher price

than heavy/sour crude

In general, refiners can produce

a higher yield of high quality

refined products, such as

gasoline, by running light/sweet

crudes Heavy/sour grades yield

less gasoline, and more of the

‘dirty’ products such as fuel oil Source: JPMorgan Energy Strategy

Major global crude benchmarks and oil market centers

Dubai

London (IPE)

(NYMEX)

Tapis

Singapore Oman

Source: JPMorgan Energy Strategy

Source: JPMorgan Energy Strategy

How oil (gas, etc.) trades

Formal Exchanges (futures)

Int’l Petroleum Exchange

How to look at the futures screens

Time spreads

— e.g Q1 vs Q3; winter vs summer, Cal 05

vs Cal 06

Regional spreads

— e.g NYMEX West Texas Intermediate vs

IPE Brent, NY Harbor gasoline vs US Gulf gasoline

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

Price relationships to watch .and what JPMorgan trades

Time spreads

— e.g Q1 vs Q3; winter vs summer, Cal 05

vs Cal 06

Regional spreads

— e.g NYMEX West Texas Intermediate vs

IPE Brent, NY Harbor gasoline vs US Gulf gasoline

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

— 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 fuelNatural Gas:

NYMEX natural gas

European natural gas priced as oil-referenced

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 the expectation 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

Conventions of the oil market

Benchmarks

Barges: 1,000 - 5,000 MT (2 - 8 days loading)

Cargoes: 10,000 - 25,000 MT (15 days loading)

Parcel

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 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

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

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

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

Deals associated with

Planned outages, unplanned outages

Refining economics, run rates

Refined product yields

Source: JPMorgan Energy Strategy

Interpreting the curve- why market participation matters

How oil is priced – terms and conventionsThe energy investment cycle

Where does oil comes from - and where does it go? 1

Source: JPMorgan Energy Strategy

Futures are not a prediction of price

Nymex 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 tomorrow’s crude can find a seller of tomorrow’s crude in

the market today

Futures are not necessarily a commentary on what market participants believe about the

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

More backwardation than contango

Contango vs Backwardation

The oil curve shifts regularly

between backwardation and

contango

Historically, oil has spent

more time in backwardation

than contango

Backwardation has been

steeper than periods of

contango

0 10 20 30 40 50 60 70

Note: M02–M13 in US$/bbl Source: JPMorgan Energy Strategy

The crude oil market today

Crude Oil Price History & Forwards

US Crude inventories versus 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

Source: JPMorgan Energy Strategy, EIA

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 increased

liquidity, 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 Intermediate with ‘Snapshot in Time’ Future Strips`

Front-month NYMEX West Texas Intermediate with ‘Snapshot in Time’ Future Strips`

Volatility of Various Markets

Energy is significantly more volatile than other markets

A new paradigm for price and curve shape

WTI Flat Price vs Backwardation (in US$/bbl)

Source: JPMorgan Energy Strategy

Back to backwardation?

M1-M13 NYMEX WTI Spread

This most recent upward move in flat price has been accompanied by backwardation – the first time since 2005!

Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

Source: JPMorgan Energy Strategy

Who trades energy derivatives and why?

Banks: Market makers (liquidity providers) and proprietary traders

Corporates: risk managers

Refiners: Buyers of crude, sellers of products

Consumers: Buyers of producers, e.g airlines Producers: Sellers of crude, e.g E&P companies

Trading Houses / Merchants:

Market makers and proprietary 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 including relative value trading

Institutional Investors: e.g

pension funds, mutual funds, retail investors

Focus on Corporates

• Increased flexibility in timing of hedge execution; growing preference for options-based strategies

• More involvement from small consumers as energy takes bigger share of business risk and cost structure

• Shift towards hedging specific risk exposure as traditional ‘proxy hedge’ correlations break down

Up — If anything consumers have hedged more actively as prices have risen, the

percentage of hedges done with options rather than swaps has increased to guarantee upside protection with downside participation

Buyers — The natural buyers in the energy markets Consumers typically hedge 1-3 years out, but increasingly may go out as far as 5-7 years in products with sufficient liquidity

Active — May trade anywhere from daily to annually depending on hedging program

Old — Active hedgers since the early-1990s.

• Section 29 hedging has also featured prominently in recent period.

Down — Significantly less to-day tactical hedging at high prices Remaining deals large, occasional, one-off M&A related strategic hedges

day-Options strategies generally preferred over swaps, for downside protection with upside exposure.

Sellers — The natural sellers in the energy markets Producers typically hedge 2-3 years out but can now find sufficient liquidity to hedge as much as 7 years out

Old — Active hedgers since the 1990s

early-Active —May trade anywhere from daily to annually depending on hedging program

Energy Producers

(E&P companies)

Recent Trends Activity Versus 3 Years Ago?

Active or Passive ? Buyers or Sellers ? New or Old ? Participant