EFTA01090474.pdf

Global Commodities Research J.P. Morgan 15 November 2011 Commodity Markets Outlook and Strategy Will US natural gas help save the world? Exhibit 1: Jigsaw puzzles are solved only when all pieces are used & in the right configuration Until now. Chinese-held US Treasuries and NAM gas and food have been largely absent from debt discussions Commodities ilk1111 , Jonah D. Waxman, CFA Me an Hansen JPMorgan Chase Bank NA Bounce: J.P. Morgan Commodbes Research. Note: NMI. NonhMecum. • Policymakers try to solve a jigsaw puzzle, sitting on the China piece: In oil, natural gas, corn, and other commodity markets, global production and trade patterns are undergoing historic structural changes that will likely not reverse. The world is primed for a commodity-hued sovereign rebalancing akin to the 1985 Plaza Accord. The essential solution to achieve "escape velocity" from the debt crisis is to get capital into Europe and manufacturing jobs into the US by exchanging Chinese- held US Treasuries for long-run contracts in fuel and food from North America and for realistically-priced European distressed debt. • Natural gas catalysts are mounting: Elements of this solution are already breaking out in energy markets in the absence of a formal treaty. Since Sep 1, US politicians have proposed an oil-and-gas drilling boom to create jobs, Canada granted its first LNG export permit, Sinopec acquired a Canadian E&P company, and BG/Cheniere's landmark LNG deal punctured oil-linked pricing. Beijing says it is willing to post $100Bn or more to support Europe, its largest trading partner. • Last week we dropped the defensive posture we adopted on Aug 8, doubled down on our Bull Commodity Basket, and introduced long gas vol strategies: Until now, gas equities have seemed to offer better risk-adjusted value than the long-dated NYM natural gas curve. Risk is changing. We think there is significant value in now owning $3.50 puts on Spring 2012 and ATM straddles on Calendar 2015 (1c=$5.00). See page 23 for analyst certification and important disclosures. EFTA01090474  Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Welcome to the 21st Century • This week, the total public debt outstanding of the US The incremental two billion is a headcount twice as large as is crossing $15Tn for the first time. This debt is 5.8X the entire population of the world in the year 1800, at the larger than Italy's, 32.5X larger than Greece's. dawn of the Industrial Revolution. Contrary to Malthusian prophecies, this growth can be accommodated by commodity • The Greek referendum fiasco scared away Chinese markets. The incremental population will include a dazzling capital (for now) but served a fresh reminder to the array of scientists, engineers, artists, and other persons of US Deficit Supercommittee: failure has a high cost. extraordinary and unique talent, who will create significant productivity in human economic systems. But the enormous • The Supercommittee must announce its plan within 8 scope of the growth needs to be acknowledged if it is to be days. The US Thanksgiving holiday is next Thursday, managed optimally. In thinking about the world's followed by December festivities. A bold plan could interlocking debt, food, fuel, and security challenges, it is tap into powerful and positive seasonal sentiment. vital to recognize the centrality of China. It is also important to specify the current strengths and weaknesses in the • The gold price appears to expect the Supercommittee world's largest economic blocs: doing so reveals the shape of to announce about $2Tn in deficit reduction. A the pieces in the jigsaw puzzle and how they may fit together number closer to $4Tn would likely crush gold but harmoniously. spur a major rally in global markets. Failure to get the job done likely sends gold to S2500 per oz and above in 2012, but crushes confidence in the USD. Europe is (a) long Mediterranean debt that might find stronger bids at lower prices, and (b) short capital and a Prompt gold is approaching $1800 per oz. Since Oct coordinated fiscal policy. The United States is (a) long 20, the average intraday price change between low dollars, natural gas, and food, and (b) short of tens of and high has been +$32 per oz. At this vol, the Sep 6 millions of jobs. China is (a) long US Treasuries ($1.2Tn, or all-time nominal high ($1920) could be touched within 38% of its F/X reserves), and (b) structurally short of many 4.5 trading days. We expect breach of $2000 in 2011. primary commodities. • Chinese natural gas demand is growing at an 18% Natural gas is one of the markets that can bring these pieces CAGR, against a domestic production CAGR of 13%. together for mutual benefit. As a result, historic events are The deficit is now -15%, heading to -35% by 2015. unfolding in natural gas markets that will likely alter the composition of global GDP over many decades. The US and • We outline a scheme for estimating risk in China's Canada—the world's first and third largest producers—have natural gas import portfolio. Today's score is equal to moved significantly in 2011 toward building gas export "Turkey"—an EU aspirant. Growing North American supply chains (and gas-related plastics, fertilizer, and gas imports to 3Bcfd in 2015 from zero in 2011 would chemical chains) that will deliver gas into Asia at prices cause risk to slip to "Kazakhstan". In the absence of based on North American gas, not world oil. This is a titanic US.tCanadian imports, risk slips to a score of "Syria". change from prior pricing schemes and represents an important evolution for world trade and future inflation • The price of Dec-11 NYM natural gas (NGZ1) has expectations among consumers, given the nearly US$100 per declined by nearly 30% since late July 2011. It is now boe price differential between Asian oils and North priced about $95iboe below prompt Shanghai fuel oil. American gas basis. Last week we advised exiting shorts and buying vol. Until now, a lack of political will and physical infrastructure Human civilization is grappling with an important transition: prevented this price gap from being arbitraged, to the the birth of the 21st Century. But we are 20th-Century economic disadvantage of all parties. This is now changing, people whose natural instincts expect the new century should aided by the fact that North American policymakers with look like the old. It will not. This is part of our problem. green credentials also see an environmentally-sound pathway for capturing this economic return. The human population now numbers seven billion and is on track to reach nine billion by 2050, according to UN demographers. 2 EFTA01090475  Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 The United States is now the world's largest natural gas This is not to suggest that if the US made these investments, producer, having surpassed Russia in 2009. The US is also it would achieve energy independence. Even if US the world's third largest crude oil producer. Casual petroleum output reached 1 I mbd (a stretch), the US would observers would likely be surprised to learn that the US still remain the largest crude importer in the world, requiring could become the largest oil producer in the world in just a at least 4mbd more than China (the second largest importer). few years. if it so chose to make the necessary investment in The key concept is that the US would become a larger undeveloped resources in order to surpass Saudi Arabia and exporter of energy while also reducing its imports of energy, Russia (Exhibits 2 and 3). Including NGLs and condensates, to the benefit of its balance of payments. Precursors of this US petroleum output is 1.42mbd behind Saudi Arabia and trend are evident in the August 2011 export data for US 1.69mbd behind Russia. petroleum products, which surpassed 3mbd, or an amount equivalent to about 15% of US oil consumption. Exhibit 2: US petroleum production has reversed trend Thousand barrels per day The untapped oil and gas assets held in trust by the Federal 12.000 government of the United States are an enormous source of l0.000 underutilized wealth. Recently, political leaders and captains 8.000 of industry have become more vocal in pointing to these "off balance sheet" assets as a partial countenveight to the "off 6.000 - balance sheet" liabilities of the United States. In August, we 4.000 . presented research that showed the unfunded obligations of 2.000 - the United States now amount to at least $62Tn on a net present value (NPV) basis. These obligations are in addition 0 co co O CO e I, - I, - I, - I, - 0 03 03 to CO 03 Of 03 Of on Of CO Of e 0 0 Ir-- 0 .- to the $15Tn in national debt, SI6Tn in personal debt, and Of Of Of Of Of Of Of Of Of Of Of 01 0 0 0 0 $3Tn in state and municipal debt. It is this crushing debt that led to the loss of the US' AAA sovereign credit rating and the creation of the US Deficit Supercommittee. A one-two Source: BPSR. EI&J.P. Morgan Commochies Research punch of implementing some of the Simpson-Bowles Exhibit 3: Top 10 oil producers recommendations on deficit reduction (e.g., raising the Thousand barrels per day retirement age on unborn future generations) and allowing 12000 responsible access to these energy assets would likely yield a powerful effect on capital markets. 10000 6000 Actual and potential US oil and gas production growth has 6000 already driven a huge gap between world and North 4000 American hydrocarbon prices. North American spot gas is now priced just below $22 per barrel oil equivalent (boe). 2000 This is about US$95 per hoe cheaper than Asian spot crudes, 0 even after accounting for the different energy content in gas and oil products. Put another way, spot natural gas at Henry CC U Hub is going for $3.45 per MMBtu, while crudes in Southeast Asia are priced above $20 per MMBtu. Propane at Source: BPSR. J.P. Morgan Commodhes Research Mont Belvieu is north of $15 per MMBtu; low-sulfur gasoil in Singapore is above $22 per MMbtu. Asian consumers Already, US output has grown by I.25mbd since 2006-a have very strong incentives to grow gas trading feat clearly driven by price, and reversal in trend not flagged arrangements with the Americans and Canadians. by the strong form of the "peak oil" argument. In North Dakota alone, crude production has increased to over 400kbd China wants natural gas from about 80kbd in 2003. The debate in industry is now whether this trajectory slows down above 500kbd or makes it China's production of natural gas has been growing at a all the way to Imbd. We incline toward the larger number. blistering 13.5% compound annual growth rate (CAGR) It is worth remembering that the modern global oil industry since 2000. However, even this fast rate of supply growth was born in Pennsylvania in 1859 and for most of the past has been insufficient to keep up with China's gas demand, 150 years the US has been the world's dominant producer. which is growing at a 16.1% CAGR, according to data from 3 EFTA01090476  Global Commodities Research Commodity Markets Outlook and Strategy J.PMorgan IS November 2011 the BP Statistical Review. At the current rate of demand the Cheniere/BG long-term LNG export deal through Sabine growth, China's annual natural gas consumption would grow Pass, which is the first deal of its kind, given its pricing in relative size from one-sixth as big as the US' last year to structure. about 40% the size of US demand within the next five years. A rapidly-growing supply shortfall would be a significant From 2000 through 2006, the Chinese natural gas market challenge for consumers in any commodity market. It is an was in structural surplus. Domestically produced natural gas especially pressing problem in a market as strategically exceeded domestic needs by 3% to 12% (1.1 to 3.5 billion important as natural gas—an essential feedstock for industry cubic meters) per year. However, the faster rate of growth in and agriculture and a growing resource for lighting and domestic demand pushed China's annual gas balance into a heating the homes of the rising middle class. As a result, sustained deficit starting in 2007 (Exhibits 4 and 5). natural gas figures prominently in China's 12th Five Year Plan. It would be imprudent to underestimate how important Exhibit 4: China's domestic natural gas balance this natural gas deficit is to China's security. The gap As a percentage of domestic consumption follows similar strategic shortfalls in iron ore, copper, and 15% -11.0%10.6%12.0% oil, which have been met with significant increases in net 10% - imports and a meaningful impact on global pricing. In most cases, these price moves were at first poorly understood in 5% - the OECD countries and were thus resisted on inaccurate 0% claims of being •"non-fundamental". As in other energy markets in China, maximizing security of supply at a .5% - reasonable price is a greater priority for Beijing than trying •10% to minimize prices paid at the expense of greater risk. To address its gas shortfall, like Japan and Korea, China has 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 turned to imports of liquefied natural gas (LNG). This is a logical first choice for a country blessed with a bulging Source: BPSR. J.P. Negev Commcdhes Research capital account but just beginning to build out its gas Exhibit 5: China's domestic natural gas balance production, storage, and distribution infrastructure. From Billion win meters virtually no import volume in September 2006, the LNG 6 import trade in China has increased to an average of 1.52 3.5 4 2.7 z.B s a 2.5 2.5 billion cubic feet per day (Bcfd) in 2011 (Exhibit 6). This 2• volume is equivalent to about 2.5% of US production and 0 was grown within the space of five years. •1.3 •1.0 -4 At first, China did what any household suddenly short of a .4.2 cup of sugar would do—it turned to a neighbor. From 2006 •8 •10 to 2009, Australian supplies dominated China's burgeoning •12 LNG trade flow. However, as the demanded volume has •14 -12.2 increased to larger requirements, China has moved to 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 diversify its supply base. There are now eight major supplying nations (Exhibit 7). Australia is still the biggest Source: BPSR. J.P. ►organ Commodties Research partner in the LNG trade, with a 30% market share. Indonesia, Malaysia, and Qatar follow, each with shares in That year, domestic consumption exceeded domestic the 14% to 16% range. Yemen (7.8% of 2011 ytd imports) production by 1.8%. Since then, the deficit has deepened and Nigeria (7.0%) have picked up market share at sharply: last year, it reached 12.2bcm. or a gap of about Australia's expense this year, but bring other operational 11.2%. Now, it is closer to 16%. Next year we project it challenges, as has been demonstrated in recent weeks by the will reach 20%. It is on track to reach 35% by 2015, even social unrest in Yemen. Neither the US nor Canada yet after allowing in our model for the start of Chinese shale gas export LNG to China. production in 2012. In volume terms, the projected deficit increases from —1.97Bcfd today to -8.75Bcfd in 2015. The latter volume is equivalent to 6X the off-take announced in Cheniere Energy and JP Morgan have a general contractual relationship. 4 EFTA01090477  Global Commodities Research J.PMorgan Commodity Markets Outlook and Strategy 15 November 2011 Exhibit 6: China's LNG imports by country of origin potentially stoking inflation expectations and outright dollar Ref per day inflation sooner than central bankers' plans. 2.0 - NAtiettera • Indonesia • Malaysia MNiperia I•Oatar • Russia Additional regasification capacity is welcome by domestic 1.5 STriaidad&Tobago •Yemen sr Other industry. Existing infrastructure is rapidly running toward full utilization. LNG import data for 2010 from China 1.0 - Customs Administration imply an 86% utilization rate for the Dapeng terminal, a 78% utilization rate for Putian, and a 0.5 - 49% rate for Yangshan. Based on monthly import data through September 2011, we estimate that capacity 0.0 utilization rates for the Dapeng and Putian terminals have sre- '4-3 ra c4 s.s s 0 0 •"' now risen above 90%, while capacity utilization at the A- 411- 44-449 4'k4 w k s w :t M M y/ Yangshan facility has also increased, to about 58%. Capacity utilization at the Rudong terminal, which opened Source: CG4.J.P. Morgan Commodities Research this year, is already at 16%. Exhibit 7: China's LNG imports by source, year-to-date 2011 Exhibit 8: Natural gas use as a percentage of total primary energy use Country share of total LNG imports (percent) Percent Other, 4.0% 30% 28% Trinidad& Yemen, 7.8% 23% 24% Tobago, 3.2% Australia. 25% Russia, 2.2% 30.5% 20% l 17% 15% 15% 11% 11% Qatar, 15.2% 10% 4% 5% 0% China Ind Total South Japan Australia Other Wald Nigeria. 7.0% Asia Korea Asia Indonesia, Pacific Pacific Malaysia. 16.1% 14.1% Source: Caa..J.P. Morgan Correrocilies Research Source: BPSR. J.P. Morgan Equity Research There are currently four LNG terminals operating in China: Yet, even with the rapid rate of demand growth and Dapeng (opened in 2006), Putian (2008), Yangshan (2009), associated infrastructure build-out, natural gas today only and Rudong (2011). Their collective import capacity is now accounts for 4% of China's total primary energy use (Exhibit about 16 million tonnes per year, or just over 2.0 Bcf per 8). This share is paltry by world standards: the global figure day. The largest is Dapeng in Guangdong (0.9 Bcf per day). stands at 24%. Even India has a gas usage share nearly 3X Another eight projects are in various stages of construction greater than China's, where coal still makes up 72% of or expansion, which we expect will boost capacity by nearly primary energy demand. 3.0 Bcf per day within the next three years. On October 25, PetroChina announced the Dalian terminal is "ready for This relative bias is unlikely to last for several reasons: operation". 1. domestic opposition to coal mining is growing in The cost to build all of these facilities, plus the planned-but- response to a number of fatal mine accidents; not-yet-started terminals, measures in the tens of billions of including two newsmaking incidents in the past two US dollars. But this cost is a small fraction of the value that weeks (Henan and Yunnan provinces), China's enormous F/X reserve portfolio (USS3Tn+) risks losing in relative value and real terms through its US 2. a broader trend in Chinese society toward greater Treasury holdings over the next five-to-ten years. CNY may social responsibility; in part spurred by public anger appreciate by up to 50% against the USD, and the Fed over the July 2011 high-speed rail accident in promises to extend zero interest rate policy into 2013, Wenzhou that claimed 39 lives, and EFTA01090478  Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan 15 November 2011 3. the general global trend in the G20 countries toward For reference, through July 2011, Japan's LNG import use of cleaner fuels and China's planned adoption volumes had not actually surged as much as might have been of Euro 5 emission standards in Beijing in 2012. expected following the Tohoku earthquake, perhaps emphasizing the initial sluggishness in the recovery in The Beijing leadership is quite clear on its intention to industrial production. However, that pattern changed increase gas usage, as clearly spelled out in the Twelfth Five- suddenly in August, as imports surged from about 10.0Bcfd Year Plan (12FYP). To illustrate China's commitment, we to 12.6Bcfd at an average price above $16 per MMBtu, also cite several passages from the I 2FYP in Appendix B. reflecting oil-linked pricing mechanisms (Exhibit I I). Exhibit 9: China's LNG import volume and prices Exhibit 11: Japan's LNG import volume and prices Volume on BelId (LHS). prices in USS per taiStu (RHS) Volume in BOO (LHS). prices in US$ per M4ABIu (RHS) 16 $18 16 - SIB 14 $16 14 316 12 $14 12 $14 10 $12 10 $12 8 $10 $10 $8 8 $8 6 $6 6 $6 4 $4 4 S4 2 2 S2 0 ....... sg 0 SO ra e- I g o 41 la g s s 0 0 S ,R,a1,g,N14,t,as S i0 m cCs m u, 2 CO s- 2 CO s 2 CO coo co li Import volume Import price tti Import volume Import price Source: CG4.J.P. Morgan Convexities Research Source: LNGJapan Coporacon. J.P. Morgan Commodbes Research Already, the data show that China today is willing to pay a This development is so important, it bears repeating. The higher import price than previously in order to boost its recent surge in LNG prices paid by China reveals: (I) a immediately-available natural gas import volumes and thus willingness to pay an oil-linked gas price for access to reduce its vulnerability to its domestic imbalance (Exhibit 9). immediate supply, and (2) a strong incentive to move away From 2006 to late 2009, contracted LNG import prices into from oil-linked pricing toward a delivered price tied to a China tended to be below US$4 per MMBtu, with some cheaper North American gas price. Both the Chinese and price spikes during the summer of 2008, when global energy Japanese LNG import price curves exhibit acceleration in prices made their cyclical peak. The most recent upward price momentum since mid-summer. Japan and observations from this summer and fall reveal trends toward China are now competing with each other, through price, more volume and higher price, passing US$10 per MMBtu for LNG molecules. in September, or nearly three times where it averaged in previous commercial arrangements. This pickup reflects higher exposure to oil-price-linked LNG cargoes. Exhibit 10: US natural gas imports ExhIbi 12: US natural gas exports Bd per day I3dper day 18 16 14 •Canada 14 • oPiPellm 12 12 sOther 10 10 •Nowcipelbe 8 8 • 8 6 • 4 4 • 2 2 • 0 0 0 3 • 0 0 I •- 43 0 0 I - 0, cr, 131 131 IR IR 8311?Malg EEE EA Source: DOE. J.P. Morgan Commocities Research Source: DCE.J.P. Morgan CiarrrroaciiDes Research 6 EFTA01090479 Corm P. Fenton Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 Meanwhile, US Department of Energy (DOE) data continue geopolitical standpoint. We avoid using 100.0 in order to to show a secular trend toward lower gas shipments from acknowledge the small but real potential for terrorism, Canada into the US and quietly-but-steadily increasing natural disasters, and other intentional and unintentional exports from the US to its neighbors, especially Marcellus operational hiccups. molecules into Canada (Exhibits 10 and 12). Our sense is US industry, especially in Texas and Oklahoma, thinks of Following this method, we compute a portfolio risk score of Canadian trade in net terms and is not fully focused on the 90.0 for 2010, as domestic conventional production's ability fact that US gas pipeline exports already reached 4.5Bcfd in to cover 90% of demand significantly outweighed the risk March of this year, averaging 4.0Bcfd year-to-date through associated with, for example, Yemen's at-the-time 10% August Total US gas exports, which include flows of LNG share of the 10% sliver of demand supplied by imports. from Alaska to Japan, reached 4.7Bcfd in March and have averaged 4.1Bcfd year-to-date. This methodology also allows us to compute a geopolitical risk score for China's projected gas portfolio in 2015, using The global structural changes underway in gas markets have our estimates of flows from both new conventional and not escaped the attention of the Chinese as they contemplate unconventional sources (shale), as well as new suppliers, their strategic options and risks over the next five years. including Canada and the United States (Exhibit 14). Estimates from the US Department of Energy show that To frame the risks, we decompose China's physical natural China's shale gas resource is I275Tcf, which makes it larger gas portfolio by domestic and foreign sources. The total size than that of the US (750Tcf). (Unconventional production is of the portfolio is the volume of supply flowing to meet a grey tranche in Exhibit 14). Our volume estimates will Chinese gas demand in a calendar year in 2010, this was inevitably show slippage against realized developments. 10.5Bcfd (Exhibit 13). To compute an empirically-derived More important is the value in having a tool to quantify the and reasonably objective geopolitical security risk score for portfolio risk that China faces and accepts as it manages the this physical portfolio, we take the Heritage Foundation rapid rate of demand growth. Economic Freedom (HFEF) indices by country and calculate a portfolio score equal to the weighted average of the individual import flows multiplied by their freedom scores. Exhibit 13: China's natural gas portfolio by supplier (2010) Exhibit 14: China's natural gas portfolio by supplier (2015F) Bcf per day (Risk score of portfolio = 90.0. See text for explanation.) Bel per day (Risk score of portfolio = 82.0. See text for explanation.) 30 30 25 25 20 more risky ao• more risky 15 is ID less risky 10 less risky 5 0 1 5 0 a Careentbral • Unconvenlioral @AnnanLNG CanadatNG • Comertieval ✓ennet LNG Oa LNG • Malsisie LNG • USLNO Omar LNG • klalayss LNG 4 Kamiktnian snake S0liteaNG • Ni tia LNG u In:I.:neva LNG ■YenefalIG ■0ttierLN0 'Meseta LNG ■Incicoesla LNG Yemen LNG a Rutsliart0 • Tuikmenistbn Pipetne Nisla pcelhe • Russet LNG shrkmerislan Pwine.I PA owes While Source: Company Reports. BPSR. CGA. Waage Fourdation.al Commodites Research Source: Company Reports. BPSR. CGA. iiiifiElge Foundation. JPM Commodities Research We make one adjustment in incorporating China's domestic As China's consumption reaches 25Bcfd in 2015, we expect production into our analysis. Heritage gives China a score of significant growth in domestic production, as well as 52.0 in its methodology (ranking in between Cameroon and substantial pipeline imports from Turkmenistan, Myanmar, Mauritania for this measure of riskiness). For our purposes, and Russia. If China gets just 3Bcfd in combined imports we assign a value of 95.0 for China's conventional gas from the US and Canada in 2015 (among the other supply production and a score of 90.0 for China's as-of-yet- developments), the portfolio's projected riskiness score nonexistent unconventional gas production, as Beijing will drops only to 82 from 90 in 2010, comparable to the HFEF view these "baseload" supplies as very reliable from a score for Australia—a desirable result from a security of 7 EFTA01090480  Global Commodities Research Commodity Markets Outlook and Strategy J.P.Morgan IS November 2011 supply standpoint. If North American supplies are not policymakers' commitment to a robust, commodity-intensive available and China instead fills that 3Bcfd sliver of demand solu