Oil and the Great Recession: Physical Reality or Investor Fantasy?

Adam Robinson RBS Sempra Commodities October 2009

Topics

The Great Recession and oil fundamentals

Oil and stagflation

Momentum trading and oil speculation

The Great Recession has created substantial spare capacity in the oil market, for now

But supply does matter if theres a possibility of a storage max-out

Mn bbls of Inventory WTI Prices, weekly avg

40 35 30 25 20 15 10
W TI

WTI falls as Cushing nears max storage

Lower inventories let "other factors" dominate

s rie to en Inv

$120 $110 $100 $90 $80 $70 $60 $50 $40 $30 5-Jun

26-Sep

Cushing Crude Oil Inventories (Left Axis)

19-Dec

WTI Prices, Weekly Avg (Right Axis)

22-May

13-Mar

21-Nov

27-Mar

16-Jan

30-Jan

10-Oct

24-Oct

10-Apr

13-Feb

27-Feb

24-Apr

5-Dec

8-May

7-Nov

2-Jan

Since February, the glut has shifted from crude to distillate, with some fearing that a distillate storage max-out this fall would weigh on crude
Distillate Stocks (mmb) 175 165 155 145 135 125 115 105 J F M A M J J A S
2008

N
2009

Prior 5 Year Range

Source: EIA

Prior 5 Year Average

Moreover, distillate spreads have been lower than gasoline spreads for so long that if possible, storage operators have put heating oil in tank
cents/gallon 4 3 2 1 0 -1 -2 -3 -4 -5 -6 2-Mar 16-Mar 30-Mar 2M-3M Heating Oil Spread 2M-3M Gasoline Spread

11-May

25-May

22-Jun

8-Jun

20-Jul

6-Jul

3-Aug

17-Aug

31-Aug

13-Apr

27-Apr

14-Sep

28-Sep

However, the market has been able to find an outlet on the water for distillate, so refiners have been able to continue to produce
cents/gallon 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0
7-Jul 17-Mar 31-Mar 17-Feb 20-Jan 23-Jun 21-Jul 3-Mar 3-Feb 6-Jan 9-Jun 18-Aug 15-Sep 12-May 26-May 29-Sep 4-Aug 14-Apr 28-Apr 1-Sep

2M-3M Heating Oil Spread

Storing oil products on the water is economic

But where then to put the gasoline?

Gasoline Stocks (mmb) 240 230 220 210 200 190 180 J F M A M J J A S O
2008

Feb-08 236 Sep-09 213

D
2009

Prior 5 Year Range

Prior 5 Year Average

Source: EIA

Conclusion: Storage economics link the present to the future

$/bbl 95 90 85 80 75 70 65 Nov-09 Nov-10 Nov-11 Jul-10 Jul-11 Jan-10 Jan-11 Mar-10 Mar-11 Jan-12 May-10 May-11 Mar-12 May-12 Sep-10 Sep-11 Jul-12

Heating Oil

Gasoline

Crude Oil

25 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05

10

Mn B/D 55

30 OECD Oil Demand

35

40

45

50

Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Non-OECD Oil Demand

So what then are investors thinking about?

Will cyclical factors in the economy finally start to create more oil demand in the US? Some banks believe so

Source: Bloomberg, Morgan Stanley Commodity Research

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But even if fiscal stimulus turns to drag and the economy does the W, will investors sell commodities?

August 2009 Update

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US fiscal deficit could be the stagflation trigger

Recession Double Dip Continued Unprecedented Rise in the US Fiscal Deficit Interest Rates Rise Fed does nothing Federal borrowing costs balloon; interest rate rise Higher interest rates and fear of higher taxes push economy back into recession Recession hurts tax revenues further, pushing up deficits and interest rates, starting the negative cycle again
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Fed loosens policy Monetary policy rules in time indicate tightening needed If Fed maintains looser policy, fears of inflation are stoked, pushing up nominal interest rates Inflation Loop: The more loose policy creates inflation fears, the more its needed to push down nominal yields

Why the Fed wont take the punch bowl away for a while

Rolling 12-month volatility of US CPI

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So far, what have we concluded?

The physical market is sloppy

But we have the capacity to store the glut Curves are reshaping to make that storage economic

Investors can drive the price of oil

As long as the Fed doesnt take the punch bowl away, commodities should do well in a recovery or stagflation scenario

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All this analysis presumes that investors are buying or selling oil based on their view of some aspect of the forward fundamentals

CTAs trade solely on price. Why? Because it works

$/bbl
160 140 120 100 80 60 40 20 0 Mar-07 Mar-08 Mar-09 Sep-07 Sep-08 May-06 May-07 May-08 May-09 Sep-06 Nov-08 Nov-07 Nov-06 Sep-09 Mar-06 Jan-08 Jan-09 Jan-07 Jan-06 Jul-06 Jul-07 Jul-08 Jul-09

Technical Bullish Indicator

Technical Bearish Indicator

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Price

Where does momentum come from in commodities?

Inelasticity of supply and demand Inventory trends tend to persist

Autocorrelation of inventories is above 90% for the vast majority of commodities

Inventories also relate to prices

Price trends, therefore, tend to persist as well
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Inventories predict prices, but prices predict prices better

Long-short portfolio of commodities sorted by inventories and sorted by prior spot returns
Avg Annual Return
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Inventories 12-mth Spot Returns 8.8% 12.8% 13.4%

Std Dev
16.0%

(1) The Fundamentals of Commodity Futures Returns. Gorton, Hayashi, and Rouwenhorst. NBER Working Paper No. 13249. Published July 2007.

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But prices predict prices even better

Inventories are difficult to observe Past prices are more informative of future prices than observable inventories
Inventory problems: publication delays, revisions, and data limits in non-OECD

Which inventories should be counted?

Inventories that cannot be immediately delivered? Inventories held in raw form below ground?
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In addition to the momentum traders, banks are also positioned to push prices toward $60 in the short run

When banks buy calls, they have to sell in a rising market When banks sell puts, they have to sell oil in a falling market
Currently producers have bought $60 puts and sold $80 calls to banks

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On the long side are pension investors, China and retail players

China willing to buy in size at $55 for strategic stocks For retail players, peak oil and China provide a plausible enough long-term fundamental bull story without any clear price target Young/immature asset class + career risk in bucking a trend = upward pressure on oil prices by some index investors

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So what have we concluded, and where are prices going?

To forecast prices with any accuracy, the physical glut is relevant but not paramount Ultimately, either way the economy goes, commodities should outperform other risk markets Momentum traders turned bearish in September and that indeed could be the short term trend as a knee-jerk reaction to recent economic data worsening Banks may also have to sell the market down to $60 to hedge positions
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Ultimately, however, the bull case is intact, and if the economy rebounds before 2015, prices could spike
Brazilian deepwater = at least a North Sea of oil The rig market has finally responded, but first output 5 years away Alternative energy and conservation also will play a part Another price spike is likely before 2015 if the economy rebounds
# rigs 35 30 25 20 15 10 5 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: ODS-Petrodata
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Global Deepwater Rig Deliveries 30 29

13 4 2 3

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Intro to RBS Sempra Commodities

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RBS Sempra Commodities Overview

Overview
On 1 April 2008, RBS and Sempra Energy formed RBS Sempra Commodities LLP (RBS Sempra Commodities).

RBS Sempra Commodities is a top tier global commodities trader whose primary activities
include
Physical commodities merchant (buyer from producers, seller to consumers) Commodity derivatives (financial trading) Creation of risk management products and solutions (combination of financial and physical)

RBS Sempra Commodities principal commodity lines include the following

Energy natural gas, power, coal, crude oil and products Metals base metals, precious metals, plastics and steel Other green credits, bio fuels, agricultural commodities

RBS Sempra Commodities profile

Geographically diverse trading in Western Europe, CEEMEA, Asia Pacific, and the Americas Prudent strong risk management controls have been tested during the last several commodity cycles Sizable employs approximately 1,100 FTEs worldwide and transacts with over 2600 customers

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Global Commodities Presence

London Calgary Stamfor d Houston Geneva

Singapor e

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Trading Capabilities

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Natural Gas
Business Overview
Worldwide natural gas RBS Sempra Commodities is an international natural gas marketer with a primary focus on the North American (ranked #1 non-producing gas marketer in North America in Q1 2009 by Platts) and European wholesale markets as well as the international Liquefied Natural Gas (LNG) market. RBS Sempra Commodities Natural Gas franchise offers physical trading, market making, and risk management solutions to its global customer network. RBS Sempra Commodities natural gas services include Customer Types

North American natural gas

Continental United States Canada (western and eastern border points)

Exploration & production Utilities Independent power

producers

European natural gas

United Kingdom Germany Netherlands Belgium

Industrials Commercial Residential (energy

aggregator supply)

LNG trading Gas storage Derivative and Structured Products (financial and physical) Management of physical assets and options

Municipalities and
government entities

Pipelines and storage Trading companies Financial institutions Hedge funds

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RBS Sempra Commodities is the #1 Physical Trader amongst bank platforms

RBS Sempra is uniquely positioned to provide extensive expertise in the physical market combined with a strong presence in the financial market.

We are not a producer affiliate.

As such, we are not limited to marketing gas from our own affiliated assets. This reduces the likelihood of conflict of interest and enables us to offer more competitive pricing.

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Oil and Oil Products

Business Overview
Worldwide crude oil and oil products RBS Sempra Commodities is a worldwide trader of oil and oil products, specializing in physical delivery of crude oil and crude related product, storage and transportation, as well as on-shore and off-shore blending capabilities. RBS Sempra Commodities oil desk offers physical trading, market making, and risk management solutions to its extensive customer network. Worldwide oil and oil products services include Customer Types

Crude (WTI, Brent and Dubai benchmark crudes) Heavy products (high and low sulfur fuel oil, and bunker fuel) Light products (jet, naphtha, kerosene, gasoline, distillates) Natural Gas Liquids (NGLs) Physical storage Physical and OTC products for a majority of crude oil and oil products Derivative and structured products (financial and physical)

Independent power
producers

Utilities Industrials Commercial Pipeline and storage

companies

Integrated oil companies Refiners Financial institutions Hedge funds Traders and marketers

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Power
Business Overview
Worldwide power RBS Sempra Commodities is an industry leading power marketer with a primary focus on the North American and the European wholesale markets. RBS Sempra Commodities Global Power team offers physical trading, market making and risk management solutions to its extensive customer network RBS Sempra Commodities power services include

North American power (physical trading and otc)

United States (East, West, ERCOT) Canada

Customer Types

Utilities Independent power

producers

European power (physical trading and otc)

United Kingdom Nordic Area Continental Europe Germany, Austria, France, Netherlands, Belgium and Spain

Commercial Industrial Trading and marketing

companies Emerging power markets Poland, Czech Republic, Slovakia, Hungary, Croatia, Serbia, Romania, Financial institutions Bulgaria, Greece, Italy, Portugal

Await deregulation of markets in Asia, Latin America, CEEMEA Structured products (financial and physical), management of physical assets and options

Hedge funds

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Metals
Business Overview
Worldwide Metals RBS Sempra Commodities is a leading metals trading group, specialising in base metals, precious metals, steel and plastics. RBS Sempra Commodities offers market making and execution, risk management solutions, physical trading and warehousing to its extensive customer network. Worldwide metals services include

Physical trading
Provide liquidity and a reliable partnership to some of the industrys largest producers and consumers globally Base Metals, Plastics & Steel - focused on trading LME-deliverable material both on-warrant and physical and concentrates across all major world locations

Warehousing Approved by the London Metal Exchange, the London International Financial Futures and Options Exchange and the New York Board of Trade to store and issue exchange-traded warrants for commodities including aluminium, aluminium alloy, copper, zinc, lead, nickel, tin, plastics, steel, cocoa and coffee

Futures and structured products The Royal Bank of Scotland plc is a ring-dealing member of the London Metal Exchange (LME) Customer Types The Royal Bank of Scotland plc is a member of the London Bullion Market Association (LBMA), Producers a member of the London Platinum and Palladium Market (LPPM) Smelters Our range of hedging products includes: Structured swaps and options Averaging Two asset arbitrage options Cross commodity indexation

Industrials Commercial Financial institutions Hedge funds Traders and marketers

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Coal & Dry Bulk Freight

Business overview
Worldwide coal RBS Sempra Commodities is a major participant in the international physical and financial wholesale coal and dry freight markets. RBS Sempra Commodities coal franchise offers physical trading, market making, and risk management solutions to its extensive customer network. RBS Sempra Commodities worldwide coal services include

Customer Types Coal aggregators and producers Utilities producers

Steam/thermal coal trading physical and financial Structured products (physical and financial), management of physical assets and options Producer financing
Core competencies: Structured transactions Hedging structures Marketing Producer optimization (continental arbitrage) Directional and relative value trading

Independent power Industrials Steel producers Trading and marketing

companies

Financial institutions Hedge funds

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Agricultural Products
Business overview
Agricultural products RBS Sempra Commodities agricultural products trading group has a growing business in ethanol and biofuels primarily focused on North America. Through its Henry Bath Warehousing division, RBS Sempra Commodities provides storage for coffee and cocoa for London International Financial Futures and Options Exchange (LIFFE) and New York Board of Trade. The agricultural products trading group is committed to growing its grain and oilseeds business to include financial markets worldwide as well as physical markets. Agricultural products services include Ethanol Physical and financial Risk management solutions

Customer types

Suppliers Industrials Commercial Bio fuels project Traders and marketers

North American listed grain markets

Corn Wheat Soybean Coffee Cocoa

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Disclaimer

This report reflects the current views of RBS Sempra Commodities and is intended for informational purposes only. RBS Sempra Commodities may make investment, hedging and trading decisions inconsistent with the views expressed in this report and/or based on information not reflected in this report. RBS Sempra Commodities assumes no obligation to advise of any changes in its views and assumes no responsibility or liability for the accuracy or completeness of the information provided or any loss suffered. RBS Sempra Commodities does not act as a fiduciary or financial, investment or commodity trading advisor for its customers, each of which is responsible for its own investment, hedging and trading decisions. The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St. Andrew Square, Edinburgh EH2 2YB. The daisy device logo, Make it happen and RBS are trade marks of The Royal Bank of Scotland Group plc. Sempra is a trade mark of Sempra Energy. Sempra Energy Trading LLC and Sempra Energy Solutions LLC, each a subsidiary of RBS Sempra Commodities LLP, are not the same company as the utility, SDG&E or SoCalGas, and Sempra Energy Trading LLC, Sempra Energy Solutions LLC and RBS Sempra Commodities LLP are not regulated by the California Public Utilities Commission.

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