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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 1
111
,
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
co
O
e
I, -
0
to
CO
Of
Of
on
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
Exhibit 3: Top 10 oil producers
Thousand barrels per day
12000
10000
6000
6000
4000
2000
0
CC
U
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
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
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- ra c4
s.s
s
A- 411- 44-449 4'k4
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%
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
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
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
m u,
2
CO
2
CO
2
CO
tti
Import volume
Import price
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
6
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
• Ni tia LNG
u In:I.:neva LNG
• Tuikmenistbn Pipetne
• Malsisie LNG
■YenefalIG
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
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.
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
Exhibit 18: Correlation between CADUSD and NG1
Poling 255 day moving average
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
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
ci nii•iS
53
7
Le,
•
eena::
chr
-
-A
r-F,
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
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
$
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.
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 VI
I I
III
II
I
0.0
N
E I
I 1 rg 1 1 I
• India •China
Exhibit 23: South African gold production
IGlogram pet day
1400
1200 lin
veivnivilve
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.
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. Corn and
other exports from the US to China will also contribute to
that result.
Moreover, the reality is that managed rebalancing in the
CNYUSD cross has been underway for some time. Beijing
has allowed the CNY to appreciate by 7% against the
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
the USD since the middle of 2006.
The rising middle class in China will increasingly spend its
wealth on goods and services that will require primary
J.P.Morgan
commodities as inputs. These inputs could be obtained from
Africa, Latin America, and elsewhere, but they are in
surprising abundance in the United States and Canada—
countries characterized by operational efficiency, reliable
product specifications, rule of law, sanctity of contracts. The
North Americans are starting to realize there is strong and
sustained business to be done.
From the perspective of the United States, this means jobs,
potentially millions of manufacturing jobs in particular.
According to the American Petroleum Institute (API), in
2009, the oil and gas industry accounted for 2.19 million
jobs directly and supported another 6.97 million jobs
indirectly, meaning that more than 8% of the full-time
employed workforce in the US are tied to the industry.
Industry consultants, working for API, have estimated that
development of the Marcellus Shale over the next ten years
could create upwards of another two hundred thousand jobs,
with potentially a million jobs created nationwide by 2020.
To us, these estimates actually sound low relative to
potential. Judging by the ongoing shortage of labor in the
Bakken play in North Dakota, if the United States were to
get serious about developing its oil and natural gas
endowment, we would not be surprised to see total job
creation (including indirect jobs) be closer to 2-to-3 million.
We hear anecdotal reports from the Midcontinent that truck
drivers are being offered wages of $200,000 per year and
experienced welders can now command up to $500,000 per
year.
Exhibit 25: Trade balances In China and the US
Percent of GDP
15
10
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cas CO Eno s,4
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Of
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In the US, the share of household consumption as a
percentage of GDP has been climbing since the late 1960s.
while the trade balance moved into a sustained deficit in
1976 (Exhibit 26).
In contrast, the share of household
consumption in Chinese GDP has been generally falling
13
EFTA01090486
Global Commodities Research
Commodity Markets Outlook and Strategy
IS November 2011
since the early 1980s (Exhibit 27). Fixed capital formation
surpassed it as the largest share in 2003.
Exhibit 26: US GDP components
Percent of GDP
80
eo
40
20
0
.20 HRMRFAIMERIEgEriin
.—.Household Consunpaon
—Fixed Capital Formation
—Government Expectiare
—Trade Balance
Exhibit 27: China GDP components
Percent of GDP
IRAAAAAA
Household Consunpaon
.
.Fixed Capital Formation
—Government Expen:litue
—Trade Balance
A longer-history chart of US household consumption as a
percent of GDP gives a sense of the potential size of the
coming changes (Exhibit 28). In the early stages of the
Great Depression, the household consumption share surged
from 75% to over 80%, as corporate activity slouched. The
subsequent economic devastation and world war reoriented
the composition of US growth toward government spending
in the form of public works programs and then a massive
shift toward industrial production, in support of the war
effort. By 1944, the household consumption share of GDP
in the US had bottomed at 49%, as Rosie's rivets supplanted
the raccoon coats of 1928.
We are not expecting either global depression or world war.
At the same time, given the evident geopolitical risks alive
today, one cannot entirely discount the possibility of
regional conflict in South Asia or the Middle East—a risk
underscored by this year's Arab Spring in the Middle East
J.P.Morgan
and more recently by the IAEA's announcement of nuclear
centrifuges in Iran.
Exhibit 28: US household consumption
Percent of GDP
0
'Si LOCO 91
, - 0 03 CO Of 0.1 1.0
e
• N. 0 Of CO en cm in
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1.0 COCO LO CO (0(0 N. N.
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0 0
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Exhlb t 29: Breakdown of GDP components in China and US (2010)
Percent of GDP
46%
6%
Household
Fixed Capital
Govemment
Consumption
Formation
Expenditure
• USA •China
Current Account
Balance
Looking forward over the next decade or more, we would
not be surprised to see the trade balances flip toward +5% for
US and toward —5% for China, from —4% and +6%
respectively in 2010, moves of +9%-points and —11%-points
respectively. Given the ongoing gross underinvestment in
commodity capacity and the propensity toward cost overages
and unexpected delays in large-scale infrastructure projects,
we also take seriously the proposition that consumption and
investment could see swings of as much as 10%-to-15%
points in each country, bringing US consumption from 71%
toward 56% to 60% and Chinese consumption from 34% to
about 45% to 49%. Fixed capital formation might rise
toward 30% from 15% in the US, and fall toward 30% from
46% in China. These are structural swings attendant to long-
lived supercycles for investment and consumption, which are
impossible to align perfectly in the short run. Guessing of
future demand (and which technologies "win" in the future)
is unavoidable.
14
EFTA01090487
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
In essence, if these long-cycle structural changes evolve as
we describe, the two economies would look far more similar
from a compositional perspective than they do today, which
could enable far less friction over balance of payments and
currency valuation than is the case today.
In constructing our long-run commodity views, our operating
assumption is the CNY will trade around 4.0 to the USD by
2015 and at a cross of 3.0 by no later than 2020, though we
defer to the JP Morgan F/X strategy team for their official
forecasts.
Implications for risk and valuation
The title of this report asks whether US natural gas will help
save the world. We believe the answer is yes. US natural
gas offers a potential solution for escape velocity from the
current phase of the global financial mess, though any escape
likely will be a bumpy ride for many years to come. This
bumpiness appears absent in forward NYM natural gas
options prices, where Calendar 2015 ATM straddles can be
bought today for about 20% in implied volatility terms. This
is a noteworthy fact, given that volatility is mean reverting,
sometimes violently so in the hardest-to-store commodities,
like natural gas.
Among all commodity markets, only
electricity is harder to store.
As the Ca12015 NYMEX natural gas contracts become more
prompt, we believe Ca12015 implied vol will be substantially
higher than it is priced today. Our conviction in this view is
reinforced by the backwardation in the term vol curve and
the historical distribution of implied volatility since 1993
(Exhibits 30 and 31).
Recent measurements of actual
volatility, the stage of the business cycle, the stage of the
commodity supercycle (year 12 of projected 25), and the
term structure of the volatility curve suggest that a roll up to
40% or higher by expiry enjoys a meaningful probability.
Exhibit 30: NYM natural gas implied volatility term curve
Percent
50
45
40
35
30
25
20
15
!
T
I
T
I
T
I
T
I
CO
'al'
•
wr
Y
LO
hn u)
4 2 ta n2
$. 4 2 4- $, 4
4. $. a
J.P Morgan
Exhibit 31: Implied volatility distribution of prompt NYM natural gas
Frequency by implied vol (Y.). Histogram since 3/6/9.3. Gray ino--mcent distrbution
0.10
0.09 •
0.08 •
0.07 •
0.06 •
0.05 •
0.04 •
0.03 •
0.02 •
0.01 •
0.00
14-Nov-11
34.65
0 I0 20 30 40 50 60 70 80 90 100110120130140150
0.10
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
It may not take four years to get paid for taking this risk.
Along the way, the entire natural gas forward curve is also
likely to experience strong swoons and advances. By 2017,
we believe prompt natural gas prices will be priced
significantly above $6.50 per MMBlu in the dollars of the
day. We note that current producer hedges for that interval
are struck in nominal dollars, not real dollars, and they make
no contingency provision for the value of the Chinese
renminbi or any measure of inflation. Producers face the risk
of higher-than-expected received prices for their physical
molecules but some potentially significant pain in their paper
hedges if they are not careful in how they structure them.
North American natural gas has been experiencing a strong
structural change: shale gas now accounts for about a third of
US production.
However, a commodity market can
experience multiple structural changes at the same time. We
see at least two others. The first—the opening of LNG
exports—is already unfolding. The second—the leasing of
Federally-held and currently off-limits parcels in the Outer
Continental Shelf (OCS) for oil and gas drilling—had a
chance to change course last week, but the US government
chose not to exercise that option.
Specifically, on November 8, the Obama Administration
announced its plan for the next 5-year cycle of OCS leasing
(2012-to-2017).
The government will make 15 leases
available for development, with the first auction set for
December 14, 2011.
Importantly, the plan moots any
development off the West and East Coasts, including a
parcel off of Virginia that the Administration had earlier
indicated would be offered. The plan does include two
parcels in the Eastern Gulf of Mexico that are not in the
current moratorium zone but are close to its boundary. This
perhaps represents a baby step toward future development of
that zone, however, those properties are not due to be
auctioned until 2014 and 2017. Thus, the OCS plan as it
15
EFTA01090488
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
stands actually diminishes if not removes (for now) one of
the strongest levers for getting US gas prices down even
further. The inaction on OCS reduces downside price risk.
For most of the past year, industry consensus has argued that
spot Henry Hub natural gas would remain range-bound
between S4.50 and $6.50 per MMBtu due to the structural
impact of shale gas. We have disputed this view, arguing
that both the floor and the ceiling in this range would be
violated within the next five years. We have already been
proven correct on the floor violation. Spot gas is now priced
at $3.45 per MMBtu. If the Obama Administration were to
tack again and surprise consensus (and us) with an
aggressive opening of Eastern Gulf of Mexico leases outside
of the traditional practice of the 5-year planning exercise, we
would not be surprised to see flushes down to a price with a
$2 handle. Such flushes could also be spurred by a very
warm winter (not our view) or a collapse in economic
activity in a 2012 US recession (also not ow view).
Though we have been flagging the relative value emerging in
natural gas for more than a year, we have not formally
recommended a long position in natural gas as a trading
strategy. This has been because we have seen greater risk-
reward in owning gas-related equities rather than gas
commodity exposure. Indeed, the Bull/Bear relative value
J.P.Morgan
(RV) framework we introduced on August 8 was short
prompt NYM natural
gas
and
other US-intensive
commodities, against length in commodities geared toward
Asia capex.
However, the gap between US gas prices and Asian oil
prices has become very wide, and structural changes are
starting to emerge to close that gap. These developments are
sufficiently advanced that last week (Nov 10) we changed
our tactical posture and introduced new ideas for institutional
investors to consider. Specifically:
> We took off the Bear leg of the RV strategy at what
would have been about a 6.5% profit for the short.
We presented the idea of redeploying that capital
into the Bull leg (see page 21 for list of
commodities in this basket).
> We also advanced the investment idea that
institutional investors buy straddles on Cal 15 NYM
natural gas (k-_$5.00) and protect themselves by
owning puts on Spring 2012 (k=$3.50, NGH2,
NGK2, NGI2). So far, the puts have gained by
about 8 cents per MMBtu against a 3-cent decline
for the straddle, for a modest net gain.
16
EFTA01090489
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
J. P Morgan
Hedging and investment ideas for long-dated NYM natural gas
Strategy
Producers
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
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
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
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
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.
Consumers
Index Investors
Tactical Traders
17
EFTA01090490
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
Appendix A: Timeline of key puzzle pieces
J.P.Morgan
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
US Dotal St.pCY:Ce-en MC< ms-
r.>
$4011
The EC8 has rcpertly .syPts,:o Ct.rC ace sprish are Italian -
orator JOI11(10 says tin:
:I
Ail
tom the ccerenetoo. Soparato/y. argon Stalk arrourcos Ns resignation Item the EC8.
.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
at ria
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
.,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
31 Coo II SCE tract Nava G.t wear signs accord to bald $140 m lb:.
• •
r LNG tc-nt
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.
INeity al 2
edO by IM erd ot 2012 wth Rays mcmen set
18
EFTA01090491
Global Commodities Research
Commodity Markets Outlook and Strategy
IS November 2011
J.P.Morgan
Appendix B: Gas excerpts from China's 12th 5-Year Plan
"Promote diversified and clean energy
sources: Strengthen the exploration and
development of petroleum and natural gas
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
coal-bed gas and shale gas."
"Strengthen energy transmission channels:
Accelerate the construction of strategic
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
create a gas supply layout in which natural gas
and coal based gas are balanced:
"Build out oil and gas pipeline networks:
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
the construction of gas storage facilities."
"Energy consumption per unit of GDP will
decrease 16% and CO2 emissions per unit of
GDP will decrease 17%: Improve the incentive
mechanism of energy conservation and emission
reduction, optimize energy consumption
structure. improve pricing mechanisms and
taxation, and strengthen the related laws.
regulations and standards?
200.000km of power transmission lines, upgrade
substations to smart-substations, increase use of
smart meters, and construct EV charging facilities."
"Upgrade bulk vessels, oil tankers, and
container vessels to international standards:
Improve the ship equipment industry and loading
rate, prioritizing LNG and LPG vessels:
"Optimize energy development: Construct five
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
petroleum reserve system, and strengthen the
`capacity of natural gas and coal reserves.'
"Stabilize oil output and increase gas output:
Create 5 large-scale oil and gas producing areas in
the Tarim and Ju nggar 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
refining capability appropriately."
"Improve the mechanism for setting prices for
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."
"Build out the power grid: Accelerate construction
of outward power supply projects from large coal
power. hydropower and wind power bases. and
create some cross-regional power transmission
channels using advanced technologies. Complete
EFTA01090492
Global Commodities Research
Commodity Markets Outlook and Strategy
IS November 2011
Price Forecasts
USD. quarterly averages
J.P.Morgan
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
96.46
9935
98.91
9119
97.55
98.501.
37
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
310
4.01
155
3.61
372
196
371
1116810 "(Ma r
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
35.88
34.50
34.13
3417
342?
34.25 Al
W4I5
Platinum
US111 oz.
1643
1614
1793
1788
1773
1900
1822
1903
1902
1925
1935
1915
Award pate
1785
1643
1648
1651
M55.-
2649 Al
Palladbm
USIO 62.
667
530
79D
760
752
800
783
820
840
860
880
8-50
lorward pate
742
669
670
670
MI.
670 Ai
Base Metals
Aluminum
USSMII
2114
2178
2511
2603
2404
2200
2448
2350
2453
2550
2600
2503
forward pate
14
2408
2117
2129
2155
2184X
2146 In
cave
US5M9
7677
7548
9634
9152
8979
7250
8791
6250
8502
9250
9000
8750
ICAOrd poet
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
forward pate
1906
2197
1907
1927
1947
1965
tax 1.
Lead
USS4111
1991
2152
2592
2546
2452
2000
2397
2175
2253
2275
2330
2250
lomevd pate
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
53 40
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
karacvd pate
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
karacvd pate
27.88
24.81
24.16
23.75
2165
24.09 In
20
EFTA01090493
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
Ideas for institutional investors
J.P.Morgan
Active trading ideas
Maned as al: 15-hloy.11
Date of recommendation
Cost'
Last closing price
Change since
recommendation
Long Dec-11 CM% Gold
Long CT2013 Brent cal options (IC • 125)
Long put on Spring 2012 NYIA natural gas
(k s 3.50, contracts NGH2, NOJ2, till(2)
Long Cal 2015 straddle In WM natural gas (k • 5.00)
25-Feb-2011
23-Feb.2011
10-P4ov-2011
1044ov-2011
1421.10
7.30
0.17
1.54
1782.20
7.53
0.25
1.51
25.4%
0.23
0.08
-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%
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
Co nrodity total returns
2008
2009
2010
2011YT0
Forecast
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
21
EFTA01090494
Cohn P. Fenton
Global Commodities Research
Commodity Markets Outlook and Strategy
IS November 2011
Colin P. Fenton, Head of Global Commodities Research and Strategy
Oil
Lawrence E. Eagles
David G. Martin
Jeff G. Brown
Ryan F. Sullivan
Upadhi Kabra
J.P.Morgan
Metals
Michael J. Jansen
Yubln Fu
Natural Gas
Scott C. Speaker
Shikha Chaturvedi
unwauarastaws
Jonah D. Waxman, CFA
Megan V. Hansen
Elizabeth M. Volynsky
22
EFTA01090495
Global Commodities Research
Commodity Markets Outlook and Strategy
IS November 2011
Disclosures
J.PMorgan
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23
EFTA01090496
Global Commodities Research
Commodity Markets Outlook and Strategy
15 November 2011
J.PMorgan
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