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COMMODITY OUTLOOK: GEOPOLITICS, GROWTH AND VOLATILITY STRICTLY PRIVATE AND CONFIDENTIAL March, 2011 F&O Disclaimer Copyright © 2009 JPMorgan Chase & Co. (“JPMorgan Chase”) All rights reserved worldwide. MORCOM® and MORganCOMmunicationsTM are registered trademarks of JPMorgan Chase. OIL MARKET OVERVIEW J.P. Morgan is the marketing name for JPMorgan Chase and its subsidiaries and affiliates worldwide. The JPMorgan Chase Bank, N.A. is a member of the FDIC. J.P. Morgan Securities Inc. ("JPMSI") and J.P. Morgan Clearing Corp. (“JPMCC”) are separately registered broker-dealer subsidiaries of JPMorgan Chase and are members of FINRA, NYSE and SIPC. JPMSI, JPMCC and J.P. Morgan Futures Inc. are separately registered futures commission merchant subsidiaries of JPMorgan Chase and are each members of the NFA. Issued and approved for distribution in the European Economic Area by J.P. Morgan Securities Ltd. and J.P. Morgan plc, and J.P. Morgan Europe Limited and J.P. 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This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other European Economic Area countries the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. In Singapore, this report, which has been prepared with the intention of it being for general circulation, is distributed only to accredited or expert investors, purely as a resource and for general informational purposes only. Accordingly, this report does not take into account the specific investment objectives, financial situation or particular needs of any particular person and is exempted by regulation 34 of the Financial Advisers Regulations from the same (as required under section 27 of the Singapore Financial Advisers Act). Macroeconomic Outlook for 2011 The world economy appears to be on track to return to synchronous above-trend growth in 2011. The foundation for a strong synchronized global upturn lasting 4-8 quarters is in place High oil prices, inflation and possible sovereign debt are the key forecast risk factors –Volatility will be the norm High oil prices driven by a supply shock are likely to be more damaging than those driven by strong economic growth The IEA and OPEC can offset supply disruptions – Delayed or partial response could trigger hoarding activities Major economies in the emerging world, including China, India, and Brazil are in a much better place than the G3, but need to find a balance between growth and inflation High oil prices have a greatest influence on importing countries with low energy taxes In the 2007/8 oil rally, high oil prices contributed to a weaker dollar While the Fed may be forced to raise interest rates quicker than expected, high OIL MARKET OVERVIEW unemployment may lead to it remaining ‘behind the curve’ in 2011 Both factors could weaken the US dollar, which would be supportive for commodity prices A shift from a zero interest rate policy will be extremely significant for the commodity markets Impact strongest for those with high inventories A weaker dollar encourages inventory accumulation as a store of value 1 Commodity markets have moved higher as emerging market growth surges INDUSTRIAL METALS TOTAL RETURN AGRICULTURE TOTAL RETURN 23-Feb-11 23-Feb-11 2,300 1,000 2,200 950 2,100 900 2,000 850 1,900 800 1,800 750 1,700 700 1,600 650 1,500 600 1,400 550 1,300 500 1,200 1,100 450 Source: J.P. Morgan Energy Strategy, Bloomberg Source: J.P. Morgan Energy Strategy, Bloomberg 17-Feb-11 28-Jan-11 8-Jan-11 19-Dec-10 29-Nov-10 9-Nov-10 20-Oct-10 30-Sep-10 10-Sep-10 21-Aug-10 1-Aug-10 12-Jul-10 22-Jun-10 2-Jun-10 13-May-10 23-Apr-10 3-Apr-10 22-Feb-10 17-Feb-11 28-Jan-11 8-Jan-11 19-Dec-10 29-Nov-10 9-Nov-10 20-Oct-10 30-Sep-10 10-Sep-10 21-Aug-10 1-Aug-10 12-Jul-10 22-Jun-10 2-Jun-10 13-May-10 23-Apr-10 3-Apr-10 14-Mar-10 22-Feb-10 14-Mar-10 400 1,000 PRECIOUS METALS TOTAL RETURN 23-Feb-11 Broad rally in commodities as the world economy 2,000 has recovered from the global recession 1,900 1,800 Sustainable recovery in commodities, despite 1,700 anemic growth in OECD shows consumption driver from emerging market economies 1,600 1,400 Agricultural markets have seen some of the 1,300 strongest recoveries 1,200 1,100 Supply disruptions have played their role, but low Source: J.P. Morgan Energy Strategy, Bloomberg ending stocks have been a significant driver 17-Feb-11 28-Jan-11 8-Jan-11 19-Dec-10 29-Nov-10 9-Nov-10 20-Oct-10 30-Sep-10 10-Sep-10 21-Aug-10 1-Aug-10 12-Jul-10 22-Jun-10 2-Jun-10 13-May-10 23-Apr-10 3-Apr-10 14-Mar-10 1,000 22-Feb-10 OIL MARKET OVERVIEW 1,500 13 Demand-supply situation for 2011 Hurdle rates required for global demand to catch up with global production in 2011 Demand growth required by commodity is relative to JPM projections for global production 14% 11.7% 12% 10% 9.0% 7.4% 7.1% 8% 6.0% 5.1% 6% 3.9% 3.4% 4% 2.3% 2.1% 2% 2.3% 2.3% 3.0% 1.7% 1.9% 1.1% -2.1% 0% 0.1% -1.8% -0.1% Total Palladium Platinum Cocoa Silver Lead Coffee Zinc Nickel Cotton Sugar Aluminium Soybeans Corn Copper Wheat Gold Iron ore Steel -4% Petroleum -2% Source: JPMorgan Commodity Research. “Total” equals world-value-weighted average using 2010 YTD prices and production OIL MARKET OVERVIEW A 1.5% to 2.0% global real GDP growth rate is all that is required to send most commodity markets, including oil, into deficit in 2011. Our economists expect global real GDP growth of 3.5% in 2011, suggesting ample room for any would-be downshift in growth expectations to arrive at the same conclusion. Inventories are already low in softs and grains, higher in metals and energy; but across sectors, the fact that US real interest rates are negative means global carrying costs are abnormally low and there are strong incentives to accumulate stocks for anticipated demand well into the future, especially in non-USD-based jurisdictions. 4 Geopolitical risk takes over from demand as oil price driver Volatility to remain heightened Brent and WTI Historical Price In $/bbl 160 140 120 100 80 60 40 20 WTI Civil unrest is rapidly redrawing the political map in North Africa, market concern tensions will spread to major oil producing and transporting regions Brent Price spike risks have materially increased World oil demand growth of 2.7 mbd in 2010 will moderate to 1.7 mbd in 2011 Demand seen above trend, driven by EM demand and healthy GDP growth Risks include an overly aggressive rise in price hurting global economic recovery and Eurozone financial market volatility 4-Jan-08 9-Jan-09 15-Jan-10 21-Jan-11 Global Supply & Demand and Forecast In mbd 92 Demand OPEC output restraint by key members has kept a cap on supply, but there are signs they are upping output in the face of outages and +$100/bbl prices Supply Robust diesel demand is once again driving crude prices as refiners run more crude 90 High product inventories and seasonal refinery maintenance will lead to reduced crude 88 demand in the coming months 86 Although we do not envisage a significant retracement in prices having hit our price target 84 for 1Q2011, a dramatic increase in OPEC output provides downside risk 82 Q1'10 Q3'10 Q1'11 Q3'11 Q1'12 Q3'12 US Total Product Inventories Five-Year Range Five-Year Average 2010 2011 Mb 850 800 OIL MARKET OVERVIEW J.P. Morgan Crude Oil Price Forecast In $/bbl 750 650 600 J F M A M J J A S O N D Source: JPMorgan Energy Strategy, IEA, government and industry sources 1Q11 2Q11 3Q11 4Q11 2011 1Q12 2Q12 3Q12 4Q12 2012 Brent Forecast* … … … … … 108.00 105.00 102.00 102.00 104.00 110.00 105.00 110.00 115.00 110.00 Prev ious Brent Forecast** … … … … … 95.00 95.00 90.00 100.00 95.00 105.00 100.00 105.00 110.00 105.00 Brent Actual To Date 700 1Q10 2Q10 3Q10 4Q10 2010 77.37 79.41 76.96 87.45 80.34 100.08 … … … … ... … … … … WTI Forecast* … … … … … 96.00 103.00 95.00 92.00 97.00 100.00 98.00 103.00 110.00 103.00 Prev ious WTI Forecast** … … … … … 93.00 93.00 88.00 98.00 93.00 104.00 99.00 104.00 109.00 104.00 Actual To Date 78.88 78.05 76.21 85.24 79.61 89.43 … … … … ... … … … All forecasts are period averages. Actual to date prices are as of February 21, 2011. Source: JPMorgan Energy Strategy 8 … Probability assessment: a useful guide Different Price Scenarios Unrest in Middle East/North Africa Contagion 5% Continuation 35% Resolution 60% Geopolitical concerns increase Supply outages remain Political unrest moderates Further supply shocks emerge OPEC only partially offsets loss Additional supplies balance the market OIL MARKET OVERVIEW IEA does not release Price $180 Price $120 Price $95 Av Weighted Price $9 Av Weighted Price $42 Av Weighted Price $57 Average Weighted Price $108 But low-high variance $85 9 Three reasons why OPEC needs a higher oil price Middle East Oil Demand Surges as % of Production Budget Breakeven (BBE) Oil Price $/bbl 40% $ bbl 200 38% BBE Price - +7% spend, flat production, flat demand 36% 34% 150 BBE Price - +7% spend, flat production, 4.5% demand 32% 30% 100 28% 26% 50 24% 22% 20% 1Q2000 Note: Does not include Israel, Jordan and Lebanon 3Q2002 1Q2005 3Q2007 0 1Q2010 2007 Source: J.P. Morgan Energy Strategy, IEA, Government Statistics 2011 2013 2015 2017 2019 Source: J.P. Morgan Energy Strategy, Various National Sources UK Gasoline Prices—With and Without Tax $/bbl Social spending rising by 7% per year 350 Government spending on wages and capital projects has risen UK Gasoline Retail Price Ex Tax $/BBL UK Gasoline Retail Price $/BBL 300 in tandem with higher oil prices: Abu Dhabi : $20/bbl in 2004; Bahrain $30/bbl in 2003 – now 2-3 times that level 250 200 Energy demand rising rapidly, production is stagnating OIL MARKET OVERVIEW 2009 150 Energy export revenues fall unless prices rise 100 Stemming taxation in consumer countries 50 If prices fall, consuming countries are likely to use the 0 opportunity to raise taxes—the end user price remains high regardless 1978 11 1982 1986 1990 1994 1998 2002 2006 2010 (Dec) Commodities Outlook for 2011 Outlook: The outlook for commodities in 2011 is positive, spurred by global cyclical recovery and easy hurdles for global consumption to surpass constrained global production. For long exposures heading into 2011, we prefer Brent crude oil, Wheat, Corn and Copper. Demand growth:. In 2011, the cyclical re-ignition of demand growth expectations will likely become a more dominant factor in guiding the performance of physical commodities and their associated futures markets. Macroeconomic Policy: The low interest rate regime in place around the world will push money into commodities and other hard assets as a hedge against the value of paper money. Inflationary risks: Rising inflation expectations and actual rate hikes in 2011 will tend to steepen upward-sloping commodity forward curves, as rising forward valuations and higher carrying costs are embedded in term structures. OIL MARKET OVERVIEW Supply Side Risks: A number of commodity forward curves are already exhibiting backwardation, providing concrete evidence of the very low level of inventories that prevail in a number of agricultural markets. Low stock levels will continue to be an important factor in 2011. Apart from this, a number of markets face individual supply risks arising from weather related phenomena which can spike prices. Policy Risks (Part 2): The risks to our central view are skewed toward higher price volatility and higher returns, especially should governments implement price controls and other trade barriers that increase friction in the movement of scarce inventories to jurisdictions where they are needed most. 3