J.P. Morgan Global Commodities Research

J.P. Morgan Global Commodities Research 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 Bounce: J.P. Morgan Commodbes Research. Note: NMI. Nonh Mecum. • 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. Commodities ilk 1111, Jonah D. Waxman, CFA Me an Hansen JPMorgan Chase Bank NA EFTA01090474 Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 Welcome to the 21st Century • This week, the total public debt outstanding of the US is crossing $15Tn for the first time. This debt is 5.8X larger than Italy's, 32.5X larger than Greece's. • The Greek referendum fiasco scared away Chinese capital (for now) but served a fresh reminder to the US Deficit Supercommittee: failure has a high cost. • The Supercommittee must announce its plan within 8 days. The US Thanksgiving holiday is next Thursday, followed by December festivities. A bold plan could tap into powerful and positive seasonal sentiment. • The gold price appears to expect the Supercommittee to announce about $2Tn in deficit reduction. A number closer to $4Tn would likely crush gold but 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. Prompt gold is approaching $1800 per oz. Since Oct 20, the average intraday price change between low and high has been +$32 per oz. At this vol, the Sep 6 all-time nominal high ($1920) could be touched within 4.5 trading days. We expect breach of $2000 in 2011. • Chinese natural gas demand is growing at an 18% CAGR, against a domestic production CAGR of 13%. The deficit is now -15%, heading to -35% by 2015. • We outline a scheme for estimating risk in China's natural gas import portfolio. Today's score is equal to "Turkey"—an EU aspirant. Growing North American gas imports to 3Bcfd in 2015 from zero in 2011 would cause risk to slip to "Kazakhstan". In the absence of US.tCanadian imports, risk slips to a score of "Syria". • The price of Dec-11 NYM natural gas (NGZ1) has declined by nearly 30% since late July 2011. It is now priced about $95iboe below prompt Shanghai fuel oil. Last week we advised exiting shorts and buying vol. Human civilization is grappling with an important transition: the birth of the 21st Century. But we are 20th-Century people whose natural instincts expect the new century should look like the old. It will not. This is part of our problem. The human population now numbers seven billion and is on track to reach nine billion by 2050, according to UN demographers. J.P.Morgan The incremental two billion is a headcount twice as large as the entire population of the world in the year 1800, at the dawn of the Industrial Revolution. Contrary to Malthusian prophecies, this growth can be accommodated by commodity markets. The incremental population will include a dazzling array of scientists, engineers, artists, and other persons of extraordinary and unique talent, who will create significant productivity in human economic systems. But the enormous scope of the growth needs to be acknowledged if it is to be managed optimally. In thinking about the world's interlocking debt, food, fuel, and security challenges, it is vital to recognize the centrality of China. It is also important to specify the current strengths and weaknesses in the world's largest economic blocs: doing so reveals the shape of the pieces in the jigsaw puzzle and how they may fit together harmoniously. Europe is (a) long Mediterranean debt that might find stronger bids at lower prices, and (b) short capital and a coordinated fiscal policy. The United States is (a) long dollars, natural gas, and food, and (b) short of tens of millions of jobs. China is (a) long US Treasuries ($1.2Tn, or 38% of its F/X reserves), and (b) structurally short of many primary commodities. Natural gas is one of the markets that can bring these pieces together for mutual benefit. As a result, historic events are unfolding in natural gas markets that will likely alter the composition of global GDP over many decades. The US and Canada—the world's first and third largest producers —have moved significantly in 2011 toward building gas export supply chains (and gas-related plastics, fertilizer, and chemical chains) that will deliver gas into Asia at prices based on North American gas, not world oil. This is a titanic change from prior pricing schemes and represents an important evolution for world trade and future inflation expectations among consumers, given the nearly US$100 per boe price differential between Asian oils and North American gas basis. Until now, a lack of political will and physical infrastructure prevented this price gap from being arbitraged, to the economic disadvantage of all parties. This is now changing, aided by the fact that North American policymakers with green credentials also see an environmentally -sound pathway for capturing this economic return. 2 EFTA01090475 Global Commodities Research Commodity Markets Outlook and Strategy 15 November 2011 The United States is now the world's largest natural gas producer, having surpassed Russia in 2009. The US is also the world's third largest crude oil producer. Casual observers would likely be surprised to learn that the US could become the largest oil producer in the world in just a few years. if it so chose to make the necessary investment in undeveloped resources in order to surpass Saudi Arabia and Russia (Exhibits 2 and 3). Including NGLs and condensates, US petroleum output is 1.42mbd behind Saudi Arabia and 1.69mbd behind Russia. Exhibit 2: US petroleum production has reversed trend Thousand barrels per day 12.000 l0.000 8.000 6.000 - 4.000 . 2.000 - 0 coO e I,- 0 toCO Of Ofon co CO I,- I,- I,- 03 03 03 03 Of Of Of Of Of Of Of Of Of Of Of Of Of CO e 0 0 Ir-- Of 0 .- 01 0 0 0 0 Source: BPSR. EI&J.P. Morgan Commochies Research Exhibit 3: Top 10 oil producers Thousand barrels per day 12000 10000 6000 6000 4000 2000 0 CCU Source: BPSR. J.P. Morgan Commodhes Research Already, US output has grown by I.25mbd since 2006-a feat clearly driven by price, and reversal in trend not flagged by the strong form of the "peak oil" argument. In North Dakota alone, crude production has increased to over 400kbd from about 80kbd in 2003. The debate in industry is now whether this trajectory slows down above 500kbd or makes it all the way to Imbd. We incline toward the larger number. It is worth remembering that the modern global oil industry was born in Pennsylvania in 1859 and for most of the past 150 years the US has been the world's dominant producer. J.P.Morgan This is not to suggest that if the US made these investments, it would achieve energy independence. Even if US petroleum output reached 1 I mbd (a stretch), the US would still remain the largest crude importer in the world, requiring at least 4mbd more than China (the second largest importer). The key concept is that the US would become a larger exporter of energy while also reducing its imports of energy, to the benefit of its balance of payments. Precursors of this trend are evident in the August 2011 export data for US petroleum products, which surpassed 3mbd, or an amount equivalent to about 15% of US oil consumption. The untapped oil and gas assets held in trust by the Federal government of the United States are an enormous source of underutilized wealth. Recently, political leaders and captains of industry have become more vocal in pointing to these "off balance sheet" assets as a partial countenveight to the "off balance sheet" liabilities of the United States. In August, we presented research that showed the unfunded obligations of the United States now amount to at least $62Tn on a net present value (NPV) basis. These obligations are in addition to the $15Tn in national debt, SI6Tn in personal debt, and $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 punch of implementing some of the Simpson -Bowles recommendations on deficit reduction (e.g., raising the retirement age on unborn future generations) and allowing responsible access to these energy assets would likely yield a powerful effect on capital markets. Actual and potential US oil and gas production growth has already driven a huge gap between world and North American hydrocarbon prices. North American spot gas is now priced just below $22 per barrel oil equivalent (boe). This is about US$95 per hoe cheaper than Asian spot crudes, even after accounting for the different energy content in gas and oil products. Put another way, spot natural gas at Henry Hub is going for $3.45 per MMBtu, while crudes in Southeast Asia are priced above $20 per MMBtu. Propane at Mont Belvieu is north of $15 per MMBtu; low-sulfur gasoil in Singapore is above $22 per MMbtu. Asian consumers have very strong incentives to grow gas trading arrangements with the Americans and Canadians. China wants natural gas China's production of natural gas has been growing at a blistering 13.5% compound annual growth rate (CAGR) since 2000. However, even this fast rate of supply growth has been insufficient to keep up with China's gas demand, which is growing at a 16.1% CAGR, according to data from 3 EFTA01090476 Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 the BP Statistical Review. At the current rate of demand growth, China's annual natural gas consumption would grow in relative size from one-sixth as big as the US' last year to about 40% the size of US demand within the next five years. From 2000 through 2006, the Chinese natural gas market was in structural surplus. Domestically produced natural gas exceeded domestic needs by 3% to 12% (1.1 to 3.5 billion cubic meters) per year. However, the faster rate of growth in domestic demand pushed China's annual gas balance into a sustained deficit starting in 2007 (Exhibits 4 and 5). Exhibit 4: China's domestic natural gas balance As a percentage of domestic consumption 15% -11.0%10.6%12.0% 10% - 5% - 0% .5%- •10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: BPSR. J.P. Negev Commcdhes Research Exhibit 5: China's domestic natural gas balance Billion win meters 6 4 2.7 z.B s a 2.5 2.5 2• 0 -4 •8 •10 •12 •14 -12.2 3.5 •1.3 •1.0 .4.2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: BPSR. J.P. ►organ Commodties Research That year, domestic consumption exceeded domestic production by 1.8%. Since then, the deficit has deepened sharply: last year, it reached 12.2bcm. or a gap of about 11.2%. Now, it is closer to 16%. Next year we project it will reach 20%. It is on track to reach 35% by 2015, even after allowing in our model for the start of Chinese shale gas 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 J.PMorgan the Cheniere/BG long-term LNG export deal through Sabine Pass, which is the first deal of its kind, given its pricing structure. A rapidly-growing supply shortfall would be a significant challenge for consumers in any commodity market. It is an especially pressing problem in a market as strategically important as natural gas—an essential feedstock for industry and agriculture and a growing resource for lighting and heating the homes of the rising middle class. As a result, natural gas figures prominently in China's 12th Five Year Plan. It would be imprudent to underestimate how important this natural gas deficit is to China's security. The gap follows similar strategic shortfalls in iron ore, copper, and oil, which have been met with significant increases in net imports and a meaningful impact on global pricing. In most cases, these price moves were at first poorly understood in the OECD countries and were thus resisted on inaccurate claims of being •"non-fundamental". As in other energy markets in China, maximizing security of supply at a reasonable price is a greater priority for Beijing than trying to minimize prices paid at the expense of greater risk. To address its gas shortfall, like Japan and Korea, China has turned to imports of liquefied natural gas (LNG). This is a logical first choice for a country blessed with a bulging capital account but just beginning to build out its gas production, storage, and distribution infrastructure. From virtually no import volume in September 2006, the LNG import trade in China has increased to an average of 1.52 billion cubic feet per day (Bcfd) in 2011 (Exhibit 6). This volume is equivalent to about 2.5% of US production and was grown within the space of five years. At first, China did what any household suddenly short of a cup of sugar would do—it turned to a neighbor. From 2006 to 2009, Australian supplies dominated China's burgeoning LNG trade flow. However, as the demanded volume has increased to larger requirements, China has moved to diversify its supply base. There are now eight major supplying nations (Exhibit 7). Australia is still the biggest partner in the LNG trade, with a 30% market share. Indonesia, Malaysia, and Qatar follow, each with shares in the 14% to 16% range. Yemen (7.8% of 2011 ytd imports) and Nigeria (7.0%) have picked up market share at Australia's expense this year, but bring other operational challenges, as has been demonstrated in recent weeks by the social unrest in Yemen. Neither the US nor Canada yet export LNG to China. Cheniere Energy and JP Morgan have a general contractual relationship. 4 EFTA01090477 Global Commodities Research Commodity Markets Outlook and Strategy 15 November 2011 Exhibit 6: China's LNG imports by country of origin Ref per day 2.0 - NAtiettera • Indonesia MNiperia I•Oatar 1.5 STriaidad&Tobago •Yemen 1.0 - 0.5 - 0.0 • Malaysia • Russia sr Other sre-'43-rac4s.ss A-411-44-4494'k4 Source: CG4.J.P. Morgan Commodities Research 0 0 •"' w k M s M w y/ :t Exhibit 7: China's LNG imports by source, year-to-date 2011 Country share of total LNG imports (percent) Other, 4.0% Trinidad& Yemen, 7.8% Tobago, 3.2% Russia, 2.2% Qatar, 15.2% Nigeria. 7.0% Malaysia. 14.1% Source: Caa..J.P. Morgan Correrocilies Research Australia. 30.5% Indonesia, 16.1% There are currently four LNG terminals operating in China: Dapeng (opened in 2006), Putian (2008), Yangshan (2009), and Rudong (2011). Their collective import capacity is now about 16 million tonnes per year, or just over 2.0 Bcf per day. The largest is Dapeng in Guangdong (0.9 Bcf per day). Another eight projects are in various stages of construction or expansion, which we expect will boost capacity by nearly 3.0 Bcf per day within the next three years. On October 25, PetroChina announced the Dalian terminal is "ready for operation". The cost to build all of these facilities, plus the planned-but- not-yet-started terminals, measures in the tens of billions of US dollars. But this cost is a small fraction of the value that China's enormous F/X reserve portfolio (USS3Tn+) risks losing in relative value and real terms through its US Treasury holdings over the next five-to-ten years. CNY may appreciate by up to 50% against the USD, and the Fed promises to extend zero interest rate policy into 2013, J.PMorgan potentially stoking inflation expectations and outright dollar inflation sooner than central bankers' plans. Additional regasification capacity is welcome by domestic industry. Existing infrastructure is rapidly running toward full utilization. LNG import data for 2010 from China Customs Administration imply an 86% utilization rate for the Dapeng terminal, a 78% utilization rate for Putian, and a 49% rate for Yangshan. Based on monthly import data through September 2011, we estimate that capacity utilization rates for the Dapeng and Putian terminals have now risen above 90%, while capacity utilization at the Yangshan facility has also increased, to about 58%. Capacity utilization at the Rudong terminal, which opened this year, is already at 16%. Exhibit 8: Natural gas use as a percentage of total primary energy use Percent 30% 25% 28% 23% 24% 20% l 17% 15% 15% 10% 5% 4% 11% 11% 0% China Ind Total South Japan Australia Other Wald Asia Korea Asia Pacific Pacific Source: BPSR. J.P. Morgan Equity Research Yet, even with the rapid rate of demand growth and associated infrastructure build-out, natural gas today only accounts for 4% of China's total primary energy use (Exhibit 8). This share is paltry by world standards: the global figure stands at 24%. Even India has a gas usage share nearly 3X greater than China's, where coal still makes up 72% of primary energy demand. This relative bias is unlikely to last for several reasons: 1. domestic opposition to coal mining is growing in response to a number of fatal mine accidents; including two newsmaking incidents in the past two weeks (Henan and Yunnan provinces), 2. a broader trend in Chinese society toward greater social responsibility; in part spurred by public anger over the July 2011 high-speed rail accident in Wenzhou that claimed 39 lives, and EFTA01090478 Global Commodities Research Commodity Markets Outlook and Strategy 15 November 2011 3. the general global trend in the G20 countries toward use of cleaner fuels and China's planned adoption of Euro 5 emission standards in Beijing in 2012. The Beijing leadership is quite clear on its intention to increase gas usage, as clearly spelled out in the Twelfth Five- Year Plan (12FYP). To illustrate China's commitment, we cite several passages from the I 2FYP in Appendix B. Exhibit 9: China's LNG import volume and prices Volume on BelId (LHS). prices in USS per taiStu (RHS) 16 14 12 10 8 6 4 2 0 S $18 $16 $14 $12 $10 $8 $6 $4 ....... ssg ra e- I S ,R,a1,g,N14,t,as li Import volume Import price Source: CG4.J.P. Morgan Convexities Research Already, the data show that China today is willing to pay a higher import price than previously in order to boost its immediately -available natural gas import volumes and thus reduce its vulnerability to its domestic imbalance (Exhibit 9). From 2006 to late 2009, contracted LNG import prices into China tended to be below US$4 per MMBtu, with some price spikes during the summer of 2008, when global energy prices made their cyclical peak. The most recent observations from this summer and fall reveal trends toward more volume and higher price, passing US$10 per MMBtu 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 Bd per day 18 14 •Canada 12 10 8 8 4 2 0 sOther 0 3 • 0 0 I • - 4 3 0 0 I - 0, cr, 131 131 IR IR 8311?Malg EEE EA J.P.Morgan For reference, through July 2011, Japan's LNG import volumes had not actually surged as much as might have been expected following the Tohoku earthquake, perhaps emphasizing the initial sluggishness in the recovery in industrial production. However, that pattern changed suddenly in August, as imports surged from about 10.0Bcfd to 12.6Bcfd at an average price above $16 per MMBtu, also reflecting oil-linked pricing mechanisms (Exhibit I I). Exhibit 11: Japan's LNG import volume and prices Volume in BOO (LHS). prices in US$ per M4ABIu (RHS) 16 14 12 10 8 6 4 2 0 0 0 g o 41 la g i0 m cCs s s s- s mu, 2 CO 2 CO 2 CO tti Import volume Import price Source: LNGJapan Coporacon. J.P. Morgan Commodbes Research coo co - SIB 316 $14 $12 $10 $8 $6 S4 S2 SO This development is so important, it bears repeating. The recent surge in LNG prices paid by China reveals: (I) a willingness to pay an oil-linked gas price for access to immediate supply, and (2) a strong incentive to move away from oil-linked pricing toward a delivered price tied to a cheaper North American gas price. Both the Chinese and Japanese LNG import price curves exhibit acceleration in upward price momentum since mid-summer. Japan and China are now competing with each other, through price, for LNG molecules. ExhIbi 12: US natural gas exports I3dper day 16 14 • 12 10 8 • 6 • 4 • 2 • 0 oPiPellm •Nowcipelbe Source: DOE. J.P. Morgan Commocities Research 6 Source: DCE.J.P. Morgan CiarrrroaciiDes Research EFTA01090479 Corm P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 Meanwhile, US Department of Energy (DOE) data continue to show a secular trend toward lower gas shipments from Canada into the US and quietly-but-steadily increasing exports from the US to its neighbors, especially Marcellus molecules into Canada (Exhibits 10 and 12). Our sense is US industry, especially in Texas and Oklahoma, thinks of Canadian trade in net terms and is not fully focused on the fact that US gas pipeline exports already reached 4.5Bcfd in March of this year, averaging 4.0Bcfd year-to-date through August Total US gas exports, which include flows of LNG from Alaska to Japan, reached 4.7Bcfd in March and have averaged 4.1Bcfd year-to-date. The global structural changes underway in gas markets have not escaped the attention of the Chinese as they contemplate their strategic options and risks over the next five years. To frame the risks, we decompose China's physical natural gas portfolio by domestic and foreign sources. The total size of the portfolio is the volume of supply flowing to meet Chinese gas demand in a calendar year in 2010, this was 10.5Bcfd (Exhibit 13). To compute an empirically -derived and reasonably objective geopolitical security risk score for this physical portfolio, we take the Heritage Foundation 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) Bcf per day (Risk score of portfolio = 90.0. See text for explanation.) 30 25 30 25 20 more risky ao• more risky 15 is ID less risky 10 less risky 5 5 1 0 0 J.P.Morgan geopolitical standpoint. We avoid using 100.0 in order to acknowledge the small but real potential for terrorism, natural disasters, and other intentional and unintentional operational hiccups. Following this method, we compute a portfolio risk score of 90.0 for 2010, as domestic conventional production's ability to cover 90% of demand significantly outweighed the risk associated with, for example, Yemen's at-the-time 10% share of the 10% sliver of demand supplied by imports. This methodology also allows us to compute a geopolitical risk score for China's projected gas portfolio in 2015, using our estimates of flows from both new conventional and unconventional sources (shale), as well as new suppliers, including Canada and the United States (Exhibit 14). Estimates from the US Department of Energy show that China's shale gas resource is I275Tcf, which makes it larger than that of the US (750Tcf). (Unconventional production is a grey tranche in Exhibit 14). Our volume estimates will inevitably show slippage against realized developments. More important is the value in having a tool to quantify the portfolio risk that China faces and accepts as it manages the rapid rate of demand growth. Exhibit 14: China's natural gas portfolio by supplier (2015F) Bel per day (Risk score of portfolio = 82.0. See text for explanation.) •Comertieval S0liteaNG a Rutsliart0 ✓ennet LNG Oa LNG •Nitia LNG u In:I.:neva LNG • Tuikmenistbn Pipetne • Malsisie LNG ■YenefalIG Source: Company Reports. BPSR. CGA. Waage Fourdation.al Commodites Research We make one adjustment in incorporating China's domestic production into our analysis. Heritage gives China a score of 52.0 in its methodology (ranking in between Cameroon and Mauritania for this measure of riskiness). For our purposes, we assign a value of 95.0 for China's conventional gas production and a score of 90.0 for China's as-of-yet- nonexistent unconventional gas production, as Beijing will view these "baseload" supplies as very reliable from a a Careentbral •USLNO ■0ttierLN0 Nisla pcelhe • Unconvenlioral Omar LNG 'Meseta LNG •Russet LNG @Annan LNG CanadatNG • klalayss LNG 4 Kamiktnian snake ■Incicoesla LNG Yemen LNG shrkmerislan Pwine. I PA owes While Source: Company Reports. BPSR. CGA. iiiifiElge Foundation. JPM Commodities Research As China's consumption reaches 25Bcfd in 2015, we expect significant growth in domestic production, as well as substantial pipeline imports from Turkmenistan, Myanmar, and Russia. If China gets just 3Bcfd in combined imports from the US and Canada in 2015 (among the other supply developments), the portfolio's projected riskiness score drops only to 82 from 90 in 2010, comparable to the HFEF score for Australia —a desirable result from a security of 7 EFTA01090480 Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 supply standpoint. If North American supplies are not available and China instead fills that 3Bcfd sliver of demand with supplies from Russia and the Middle East, the portfolio's risk score likely drops closer to 77, which is riskier but still equivalent to the HFEF scores for Bahrain or Chile, both of whom enjoy reputations as reliable partners in commodity export markets. These portfolio scores include China's domestic production. If we isolate just the import component and score that subportfolio through time, the picture is not as comforting. Today's import portfolio scores 64, or about the equivalent of the HFEF score for Turkey—still in the realm of an EU aspirant but significantly riskier than the baseload supply. Even with the 3Bcfd we project will come from North America, by 2015 the score drops to 62, on par with Kazakhstan. If the 3Bcfd have to come from Russia or the Middle East, the score drops to 51, on par with Syria, which ranks #140 out of the 179 countries on the HFEF list. That gap from 62 to 51 looks to us like a tipping point in risk, leading us to conclude that China will continue to pursue deals in North America, typically as a minority, silent partner out of respect for political sensitivities, especially in the United States. The Beijing leadership has this summer witnessed street protests in London, Rome, and various cities in the US, providing hints of the cost of getting this forward gas risk wrong. Beijing wishes to avoid comparable social unrest in Chinese cities where millions of rural citizens resettle each year. Beijing has a strong incentive to help finance North American commodity production and export infrastructure in exchange for long-term supply security, even under floating price agreements. There is a real option value to reducing China's physical gas portfolio risk, with benefits not only for China but also for the peace of the world. North American industry should keep this in mind when trying to interpret the bids of Chinese energy companies vying for North American energy assets. We estimate that China's natural gas imports (pipeline plus LNG) to meet domestic demand will increase by a factor of six from 2010 to 2015. This represents an incremental 7.9Bcfd, before any linepack fill or baseload stocking. As China's need for imported gas grows, the nation will likely attempt to minimize both import security risk as well as the risk associated with the overall gas supply portfolio. In a prior era, sovereign -level treaties would have taken the lead role in inaugurating these new international pathways for investment and trade. Given the seriousness of the global debt crisis, a special treaty might yet occur in order to affirm J.P.Morgan policymakers' commitment to a robust, commodity -intensive solution to put together the jigsaw puzzle we describe. In September 1985, at a similar moment of imbalance in world currency markets, the governments of five G-7 nations signed the Plaza Accord in order to depreciate the USD. But with the World Trade Organization (WTO) and other international bodies already facilitating cross-border commercial flows, the Canadian and American governments have been more focused on reviewing and approving leases and gas export permits rather than searching for a "Grand Bargain" that links natural gas to broader imbalances in the world economy. Consequently, the recent sequence of historic and market-changing catalysts in the US natural gas market—many of which we have been anticipating would unfold in 201I—has largely been announced by the private sector (see Appendix A for a timeline). This is not to say that the Canadian and US governments have been disengaged. One historic breakthrough was Canada's granting of an export permit to the Kitimat terminal on October 13, which echoed a similar license granted by the Federal government of the US to Sabine Pass in May (see timeline). The Kitimat permit is the first export license granted by Canada's National Energy Board since deregulation of the gas industry in 1985, according to the Board's website. Less than two weeks later, Cheniere and BG announced a 20-year LNG export deal through a to-be-built liquefaction facility at the existing Sabine Pass terminal in Louisiana. The new train will be the first modern liquefaction plant built in the US. The contracted volume is 3.5mmt per year (20% of projected capacity) in a take-or-pay arrangement. Cheniere expects to be exporting by 2015. BG will pay 115 percent of the Henry Hub price plus $2.15 per MMBtu plus transportation cost. Cheniere estimates transportation costs from the US Gulf Coast to Asia are now about $2.80 per MMBtu. Given that China and Japan are already paying $12 to $16 per MMBtu for LNG on a delivered basis, if the Sabine Pass option were available today, spot Henry Hub physical gas could be $6.13 to $9.61 per MMBtu today and still be competitively priced with oil-linked molecules in North Asia. The midpoint of the imputed range implies $7.87 per MMBtu. This is more than 2X the current spot price. The imputed range is also generally above the price level that many in industry believe will be the ceiling for the spot price for many years. But violation of that supposed ceiling is an outcome consistent with the economics of marginal cost and the wide 8 EFTA01090481 Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 dispersion in fuel prices waiting to be arbitraged. There is a ready analogue in the rail and truck investments that have been pursued in 2011 to narrow the historically -wide Brent- WTI spread. Rail shipments of petroleum and petroleum products in the US Midcontinent as of October, for example, are up 19.4% YoY, according to the Association of American Railroads, as Bakken barrels are moved toward the NYM delivery hub at Cushing, OK and onward to the Gulf Coast. Similarly, the potential for North American gas prices to reflect the marginal molecule in Asia consumption, rather than local production costs in a US basis, is reminiscent of the marginal cost economics that became so obvious in oil in 2008. That year, an oilsands producer in Canada or a deepwater producer in the Western Gulf of Mexico or offshore Angola, who might have carried production costs somewhere between $50 and $65 per bbl, still received upwards of $140 per bbl on every barrel for a short period of time because at that instant the marginal molecule of global oil demand (driven by Asia) called upon the marginal molecule of supply (biofuels in Romania and the US) and every bane! in the world cleared off that marginal price. Meanwhile, the recent and sudden increase in demand for LNG has rapidly strained shipping capacity. LNG carrier rates have increased by nearly 300% since early summer. We understand recent charter contracts are over $120,000 per day, among the highest rates ever. Waterborne LNG data show that through 2017, an additional 58.2mtpa (7.65Bcfd) of liquefaction capacity will likely be added around the world. As substantial as this volume would be against current needs, this number is smaller than our projection for China's likely growth in import demand through 2015 (two years earlier than Waterbome's window), implying that Central Asian pipelines also are likely to be a vital component of the solution to balance the Chinese gas market. Our analysis suggests China's physical gas portfolio will call on at least half of the new global liquefaction capacity. China's gas infrastructure is making rapid strides, but it is from a small base and much work remains to be done. At the end of 2010, China National Petroleum Corporation (CNPC) had 32.8 thousand kilometers (km) of natural gas pipelines, 14.8 thousand km of crude oil pipelines, and 9.3 thousand km of refined product pipelines, according to company data. CNPC's estimates of its total pipeline market share in 2010-80.5% in natural gas, 69.2% in crude oil, and 49.1% in refined product pipelines—implies China's total pipeline network at the end of 2010 consisted of about 40.7 thousand km of natural gas pipelines, 21.3 thousand km of J.P.Morgan crude oil pipelines, and 18.9 thousand km of refined product pipelines. For reference, the US, with six times China's demand, had nearly 500 thousand km of natural gas pipelines for interstate and intrastate traffic in 2009, according to the EIA. Thus, the American network is more than ten times bigger than China's current network. As China's gas demand rises 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 to 80 thousand km and likely much more (CNPC projects its network alone will be 64 thousand km), especially when one considers that logical sites for storage (e.g., the depleted oil fields of Dalian and other potential assets in Northeastern China) are nearly 3 thousand km away from the fast-growing cities of the South, such as Chongqing. Clearly, China will also look to build more convenient storage in southern coastal provinces, but this sensible strategy will incur cost. Independent confirmation of the general soundness of these expectations comes from the US-China Economic and Security Review Commission, which believes China will increase its total oil and gas pipeline length by 150 thousand km in the next five years. The scope of likely costs for such investments are signaled by CNPC's recently completed second West—East gas pipeline, an 8,704 km project that became operational this year and transports imported gas and domestic reserves from the west. It cost RMB142.2 billion (US$22 billion) or about US$2.5 million per kilometer, according to company data. This implies upwards of $100Bn of gas pipeline investment, or another US$20Bn per year for at least the next five years. We expect actual expenditure will persist at close to that level beyond the five-year-forward window. Properly assessed over the time horizon of the next decade and longer, China's real option in accessing molecules from North America is likely to prove extremely valuable, worth far more than might be inferred from the recent behavior of North American producers selling the long-dated curve. US natural gas is cheap on a btu basis: in spot terms, it is about US$3.45 per MMBtu. This price is the equivalent of US$22 per bee, or $95+ per bee cheaper than distillate-rich crudes in Asia and low-sulfur gasoil in Singapore (Exhibit 15). Moreover, work by our colleagues in Equity Research reveals that global LNG projects between 2000 and 2010 (largely sited in Qatar, Trinidad, Egypt, Australia) experienced significant construction delays and cost overruns (see: Benjamin Wilson et al., LNG Execution Risk, 8 March 2011). Their data show that 34% of projects in that 9 EFTA01090482 Colin P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 interval fell behind schedule and 38% came in over budget (Exhibit 16). These are not welcome numbers for China, where unexpected time delays equal security risk. Exhibit 15: US gas is cheap; China would be a terrific customer US$ per MMBiu .—Sing LS Gasoil —Murbancrude —Mont Belvieu Propane WC S Crude ,FIN NG k8-Ig,AW-4 .Source: Bloomberg. J.P. Morgan Canmcdtes Research Exhibit 16: LNG construction schedule and cost overruns Global projects between 2000 and 2010, percenl 45% 42% 0.6 40% 37% 34% 38% 0.4 35% 30% 29% 0.2 25% 21% 0.0 20% 15% 0.2 10% 5% 0.4 0% 0.6 On Behind Ahead of On budget Over Under schedule schedule schedule budget budget J.P Morgan and wane with the quantity of US demand for Canadian imports. In some years, the correlation has been as high as 0.30; today it is about 0.12. Exhibit 17: Correlation between CNYUSD and NG1 Boling 255 day moving average 0.6 0.4 0.2 0.0 O.2 O.4 O.6 Source: Bloomberg. J.P. Morgan Ccenmcdnes Research Exhibit 18: Correlation between CADUSD and NG1 Poling 255 day moving average Source: Company Reports. J.P. Morgan Equites Research. Ccnstnxbon IN . 35):cost IN .24). Based on three recent field trips to the US Midcontinent, our sense is that gas producers in Texas, Oklahoma, and Louisiana underestimate the coming influence of the Chinese currency on price variation in their product, largely because it is true there is no discernible effect today. This is entirely understandable. With CNY still carefully managed by Beijing and physical natural gas not trading between China and North America, the correlation is zero (Exhibit 17). However, many operators working exclusively in the Barnett and other US basis markets who do not have international customers also seem to think the Canadian dollar has little bearing on local gas prices. Yet, a simple correlation analysis shows that the Canadian dollar tends to exhibit a positive correlation with the prompt NYM gas futures price, even on low frequency horizons, such as rolling 1-year windows (Exhibit 18). This relationship has tended to wax §1 A Source: Bloomberg. J.P. Morgan CcenmccUies Research C 8 15-Nov-11 0.122 Gold confounds bears that make the mistake of seeing only momentum, not vol Another market-based view into the evolving capital account and current account relationships among China, Europe, and the United States can be found in the gold price. Since late summer, gold options prices have given surprisingly useful signals on the likely probabilities of a European sovereign debt default, Euro or USD crisis (vs. the CNY), and the coming success or failure of the US Deficit Supercommittee. In mere days in August, following the downgrade of the US sovereign credit rating and the intensification of the European debt crisis, average at-the-money (ATM) implied volatility in the prompt CMX gold contract doubled (Exhibit 19). 10 EFTA01090483 Global Commodities Research Commodity Markets Outlook and Strategy 15 November 2011 Exhibit 19: ATM implied volatility. 1st month COMEX gold Percentage tannualtzech 60 Average since Aug 8: 50 28.5% 40 30 Regime shirt it risk". ••••,...4.. t pAnt 10 YTD AveragethroughAug 5: 14.6% • 0 g g22 cinii•iS 53 7 Le, • eena:: chr - -A r-F, Source: CUL J.P. Morgan Commodities Research At times in August and September, this measure of riskiness further spiked from the new baseline of 30% toward 50% in the prompt contract. Intraweek vols were even higher, spiking toward 70%. This regime shift in volatility is the strongest in more than thirty years—since early 1980—when gold made what is still the all-time high in real terms ($2540 per oz in Oct-11 USD). Exhibit 20: CBOE Gold VIX (GVZ) 1.65 45 40 35 30 25 20 I5 10 AA A LL Source: MOE. J.P. Morgan Commodities Research In our view, it is not possible to assess accurately what is happening in gold without first: (a) recognizing that this huge move in implied volatility has happened, and (b) understanding what the move in implied volatility means for perceived riskiness and the range of potential prices. But judging by market chatter, even now, the volatility regime shift does not appear to have been widely recognized, despite the availability of prices for exchange-traded instruments that enable real-time tracking of it, such as the Gold VIX ETF (Exhibit 20). These volatility charts ably help illustrate an important point. It is a mistake to think of sharply rising prices only as "bullish" and sharply falling J.P.Morgan prices as "bearish": by definition, high implied volatility requires strong up and down movements for validation. Because of the movements in vol space, gold prices have proven to be a useful analytic tool even for market observers who do not invest in precious metals. It has been a bizarre coincidence that the Deficit Supercommittee (a derivative of Congress) happens to have been given by statute a lifespan whose expiry (Dec 23) happens to align neatly with the expiry of the Dec-11 CMX gold contract (Dec 28). In August, this strange congruence suddenly enabled way out- of-the-money (OTM) premia to serve as a kind of barometer on news flow related to deficit reduction and European sovereign bailouts, as far OTM strikes on near-dated contracts had little else to price other than the probability of a policy error. In our work, we have focused on the $2500 strike, because this is the price level that would mark a new all-time high in real terms and because it is close to the industry's marginal cost (inclusive of capital costs), set by projects such as the proposed expansion of Olympic Dam—a large uranium and metals deposit in Australia, which is winding its way through a political review process. Exhibit 21: Range of potential gold price implied by 10%0TM options US$ per troy oz. $3,000 12,500 $2.000 $1.500 $1.000 $500 $ Source: CMX. J.P. Morgan Ccarmodties Research There is also an underappreciated fundamental story in gold. Physical demand from India and China has doubled to 1.83 million kg per year since 2008 (Exhibit 22). Production in South Africa, long the dominant producer, has halved to about 0.19 million kg per year since 2003 (Exhibit 23). In between, Central Banks have emerged as some of the most forceful buyers of physical bullion: Russia's gold reserves have increased by 14.5 million ozs since 2006, rising to 27.3 million oz from 12.8 million oz (Exhibit 24). Gold is not a safe haven in a high-vol environment. Gold is a risk asset with surprisingly strong potential upside for the balance of 2011. For example, significant uncertainty 11 EFTA01090484 illillom Global Commodities Research Commodity Markets Outlook and Strategy IS November 2011 lingers about next steps for Europe. If Greek sovereign debt (O40Bn, US$462Bn) is the domino that leads to Italian sovereign debt (€1899Bn, US$2,582Bn), is the next piece to drop really France (€1,591Bn, US$2,163Bn)? As the world focuses on Europe, attention seems to have become rather complacent about the debt problem in the United States (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 by the day before the US Thanksgiving holiday. This timing presents the intriguing possibility that the Supercommittee has deliberately and successfully driven expectations so low that global markets are positioned for a positive surprise. If so, this could be a particularly successful strategy, with beneficial effects for the entire global economy, as the Thanksgiving holiday will immediately lead on to a succession of December holidays, giving markets strong tailwinds on consumer and business sentiment. Conversely, if the Supercommittee is as deadlocked as it appears on the surface to be and frustrates already weak expectations, then public sentiment could swiftly deteriorate, hurting holiday retail sales, in turn sending the OECD economies into a tailspin. It seems important that the Supercommittee not fail. Given the central path we assign to the muddle-through scenario for the Deficit Supercommittee, we expect spot gold 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 J.P.Morgan Exhibit 22: Consumer demand for gold in India and China 12.ronth running total in million kg 2.0 1.8 1.6 1.4 1.2 0.2 III VIII III II I 0.0 NE II 1 rg 1 1 I • India •China Source: GFMS. J.P. Morgan Commodies Research Exhibit 23: South African gold production IGlogram pet day 1400 1200 linveivnivilve te.itrevr. 1000 800 600 400 200 0 g g g g g g g £1 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. Source: IMF. J.P. Morgan Canino:Res Research 111 12 EFTA01090485 Cohn P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy 15 November 2011 A rerate, not a reset, in the composition of Chinese and US GDP Proposals for how to fix the world's debt problem and get the world "back on track" start with a central conceptual flaw, because the global economy is not trying to get back on track. It has already jumped the rails into a new century. The pm-crisis world of 2007 is gone forever. There are new tracks for getting fuel, food, and metals from North America and other major commodity producers into Asia. Global investment and trade patterns, for example, are likely to significantly recalibrate the compositional mix of GDP in the world's two largest economies (US, China). These old friends are likely to deepen commercial ties and start looking more like each other in terms of decomposition of shares of GDP. This is a contrarian view to the bias held by many old- hand policymakers, whose prescription for America's ills is to increase government debt in an attempt to kick start US household consumption. Given the large jobless rate, the debt overhang, and the long-run structural imbalances, the old-hand approach will struggle to succeed, which is partly why President Obama's jobs bill was defeated. It may be useful to recall that the equation for GDP is simply: GOP - Consumption + Government Spending + Investment + Trade, where Trade is Exports less Imports For decades it has been axiomatic that the US trade balance will be in deficit and the Chinese trade balance will be in surplus. Indeed, the widening of trade gaps between the two nations has contributed to frictions over currency valuations for nearly 20 years. But this is now changing (Exhibit 25). The surplus balance in China, and the deficit balance in the US, may have already reached their peak/trough. We believe Canadian gas imports displaced from the US to China will help drive these two curves toward each other.