Oil and Gas Integrated Oils chapter. Global Gambits The Right Moves for Right Now. See jpmorgansavant.com for global sector valuation tools

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1 June 28, 2006 Global Gambits The Right Moves for Right Now Oil and Gas Integrated Oils chapter The following is a chapter from, dated June xx, This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.

2 Oil and Gas - Integrated Oils Robust Fundamentals Still Not Priced In Global Sector Coordinator Gordon Gray (44-20) gordon.m.gray@jpmorgan.com J.P. Morgan Securities Ltd. Full sector coverage details on page 7 Key Drivers Crude oil. Our current WTI forecast calls for US$67.40 in 2006 and US$54.10/barrel in We see upside risks for 3Q06 from hurricanes and US product spec changes, and downside risks in 4Q06 when year-end profit taking tends to generate downward price pressure. Refining margins. Our detailed bottom-up view of global capacity expansions supports the view that in the absence of a major deterioration in demand growth, global capacity utilization will remain around the levels until the end of the decade, giving good support to complex margins in the near and medium terms. Integrated oils/refiners: Positive outlook. We were concerned about high commodity prices rekindling fears of demand destruction, leaving the group vulnerable to a pullback. Those fears have played out, with the integrated oils having underperformed again in recent weeks. However, we remain positive on the sector, as long-term fundamentals, including high cash returns to shareholders and solid production growth outlooks, remain robust and valuation levels appear reasonable. Russian oils: Downstream is key. Effect of strong crude prices on Russian oils is limited by high upstream taxes, but refining is becoming increasingly attractive. We expect this trend to continue, driven by numerous upgrades currently under way. We believe strong refining margins will be the main cause for stock re-ratings going forward, especially for well-placed companies with ongoing refinery upgrade programs like Lukoil and Surgutneftegaz. Asian oils. We remain positive on a 12-month view. This is partly because of improving upstream fundamentals (e.g. PetroChina) and partly due to the view of improving Chinese refining margins and sustained robust refining utilization rates across Asia at least through 2009 as new capacity merely keeps pace with demand. 2

3 Our Non-Consensus Views Integrated oils valuation. We continue to view free cash flow as a better measure of valuation for oils than the more common metric of debt-adjusted cash flow, since the latter fails to account for differences in capital efficiency and asset intensity across companies. Valuation using EV/FCF adjusts for asset intensity differences across companies and can give a good guide to the prospects of cash returns to shareholders. Near-term refining profits. We believe the market continues to underestimate the strength of near-term earnings outlook in refining, with prospects of an extremely strong 2Q06 offering a good potential catalyst, in our view. Russian oils: Declines in crude exports by non-pipeline means. Given the relative attractiveness of downstream operations, we expect a continuing decline in Russian nonpipeline exports, which should accelerate with the completion of the first wave of Russian refinery upgrades, and allay concerns of a lack of export capacity. Chinese refining. Domestic refining margins have turned positive with the government s recent 12% product price hike. We see further gradual price hikes until a refining margin of about US$3-4/bbl is achieved, and consequently expect refining losses to end by early 2007 for many companies. US gas. We believe US natural gas fundamentals are bearish in the near-to-medium-term, yet the potential for a hot summer, hurricanes and rapid storage injections by gas utilities are currently supporting pricing. We expect record seasonal gas storage levels to continue through and beyond the summer, and see storage capacity limitations being tested well before winter. This could lead to considerable pressure on prices in 3Q06. 3

4 Oil and Gas - Integrated Oils: Top Picks Company Key Financials Rationale and Catalysts Royal Dutch Shell A Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: RDSA LN / RDSa.L E 2007E Exchange: London Stock Exchange P/E (Calendar) Price (Local): 1706p 2006E 2007E Mkt Cap (US$): 123.8bn Analyst: Gordon Gray EV/EBITDA (Calendar) Phone: (44-20) E 2007E gordon.m.gray@jpmorgan.com Marathon Oil Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: MRO US / MRO E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 27.1 bn Analyst: Jennifer C. Rowland, CFA EV/EBITDA (Calendar) Phone: (1-212) E 2007E jennifer.c.rowland@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, We believe Shell s recent strategy update presentation laid out the prospects for a solid long-term outlook. E&P volume targets remain at 3.8-4ombd for 2009E, implying 2-3% p.a. growth versus 2007E. Although Shell s near-term growth rates are below peers, the long-term outlook looks healthier than most and extremely robust well into the next decade. We think details on Shell s resource base support our view of the strength of its underlying reserves (particularly relative to a negative market perception), and the lack of need for a major acquisition. Meanwhile, Shell s R&M business continues to perform strongly, and provides a very good free cash buffer in the face of higher capex. We continue to believe the market could be surprised by the magnitude of 2006 buybacks, which we expect to be around US$10 billion despite this higher spending. We view Shell as a very good value play with one of the highest free cash yields in the sector and an unwarranted EV/CF valuation on par with the European mid-caps. Marathon is the most levered integrated oil company in the downstream sector, where we see the most upside given the strong industry fundamentals. The company looks strategically well positioned to capture value from the increasing Canadian oil sands production given the potential projects at the Detroit refinery (100,000 bpd coker), the Robinson, IL refinery (150,000bpd expansion) and the Catlettsburg, KY refinery (170,000bpd coker). We believe the robust pipeline of projects will fuel organic growth in both the upstream and downstream segments, reducing the acquisition risk. Marathon has a strong upstream growth outlook with a robust pipeline of projects for long-term growth. The company s 2008 production guidance of mboepd represents 13% annual growth over 2005 at the midpoint. We estimate an annualized production growth of over 7% from 2005 to

5 Oil and Gas - Integrated Oils: Top Picks (cont d) Company Key Financials Rationale and Catalysts Valero Energy Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: VLO US / VLO E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 37.1 bn Analyst: Jennifer C. Rowland, CFA EV/EBITDA (Calendar) Phone: (1-212) E 2007E jennifer.c.rowland@jpmorgan.com Lukoil Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: LKOH RU / LKOH.RTS E 2007E Ticker ADR: LKOD Exchange: Russian Trading System P/E (Calendar) Price (Local): U$ E 2007E Mkt Cap (US$): 60.0 bn Analyst: Bidzina Bejuashvili EV/EBITDA (Calendar) Phone: (44-20) E 2007E bidzina.x.bejuashvili@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, Valero is our top pick in the refining space. We view the company as super-independent as its total refining capacity of 3.2 million barrels/day is more than three-and-a-half times that of the next largest independent refiner. Significant scale and diversification could provide strategic advantage. With 17 refineries spanning the US, Canada and Aruba, Valero is the most geographically diverse independent refiner. Such geographic diversity could provide it with a competitive advantage versus its peers, as it can better optimize crude purchases and can move products around as needed and where they are most economical. Valero has the ability to process more heavy, sour crude oil than most of its peers, giving the company a cost advantage by enabling it to purchase key raw material crude oil at a discount to light sweet crude. By 2007, the company plans to process over two million bpd of heavy/sour crude. It has the highest complexity of its peers. Not only is Valero able to process more heavy/sour crude oil than most of its peers, but is also able to upgrade much of its heavy/sour crude slate into valuable light products such as gasoline and diesel fuel. The weighted average complexity of Valero s refining system is 12.2, the highest among the US refiners. Internal improvement projects drive organic EPS growth. Valero has a laundry list of strategic projects aimed at increasing the yield of high-value products, reducing feedstock costs by adding more heavy/sour processing capability, and improving energy efficiency. Strategic opportunities for low-cost, high-return internal improvement projects should be a source of organic earnings growth for Valero, estimated at over 3% in Lukoil is Russia s only bluechip oil stock, providing investors with a diversified resource base, shareholder-friendly ownership structure, transparency, liquidity, a strategic alliance with a western major (ConocoPhillips) as well as exposure to oil producing assets in CIS countries and downstream assets in Eastern Europe. In upstream, Lukoil should maintain reasonable growth rates (a five-year CAGR of 3.7%) for a number of years. While the company s operations will continue to be based predominantly in Western Siberia, we expect the growth will come mainly from the less-developed Timano-Pechora Basin in North Russia and abroad. In addition, we believe its foreign operations provide it with another advantage a relatively low tax burden on crude export sales and, therefore, the ability to capitalize on the high oil price environment. In downstream, the company has already started to reap benefits from its large-scale investments in various refinery upgrade programs, in Russia and Eastern Europe. Completion of the second wave of investments, planned for , should give Lukoil s refineries European quality and provide the company with an extra edge over its domestic rivals. Lukoil trades at a premium to its domestic peer group, on our estimates, which we view as justified on a historical and prospective basis in light of its relatively low risk profile and strong fundamentals. 5

6 Oil and Gas - Integrated Oils: Stocks to Underweight Company Key Financials Rationale and Catalysts Repsol-YPF Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: REP SM / REP.MC E 2007E Exchange: Madrid Stock Exchange P/E (Calendar) Price (Local): E 2007E Mkt Cap (US$): 32.0 bn Analyst: Gordon Gray EV/EBITDA (Calendar) Phone: (44-20) E 2007E gordon.m.gray@jpmorgan.com Tatneft Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: TATN RU / TATN.RTS E 2007E Ticker ADR: TNT Exchange: Russian Trading System P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 8.7 bn Analyst: Bidzina Bejuashvili EV/EBITDA (Calendar) Phone: (44-20) E 2007E bidzina.x.bejuashvili@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, Repsol s shares have been amongst the sector s weakest performers since their 25% reserves downgrade in early It remains one of our key Underweight recommendations. The reserve downgrades were prompted largely by politically driven events in Bolivia and Venezuela, and economic factors in these and other countries, notably Argentina. We continue to believe there is a risk of futher downgrades, notably in Bolivia following recent moves from the government there. We expect no net growth from Repsol s E&P portfolio over the next few years, coupled with a fairly high maintenance capex if it is to control core field declines. In addition, the Argentinian fiscal regime continues to limit the company s upside from high commodity prices. Repsol s share decline has taken valuations to the bottom end of the comparable universe on E EV/CF. However, we believe this is appropriate in view of: (1) the ongoing political risk; (2) limited growth opportunities; and (3) less attractive free cash valuations and free cash distributions than most peers. Despite poor asset quality, lack of its own refining capacity, virtually non-existent production growth, poor transparency, major corporate governance-related issues and a negative consensus market stance, Tatneft has consistently outperformed its rivals on heavy local buying of its shares. In upstream, the company s operations are limited to the territory of the Russian Republic of Tatarstan. The fields in Tatarstan are highly depleted, well flow rate is very low, while extracted liquid is rich in sulphur, paraffin and other unpleasant additives. As one of the highest cost producers in the country, a decline in crude prices would hit Tatneft the most, in our view. Tatneft is one of the few Russian oil majors with effectively no refining capacity of its own, which has prevented it from realizing significant downstream profits. A disagreement with a partner made the company s investment in a refinery in Nizhnekamsk fruitless. A new greenfield project, pursued by Tatneft, envisages the construction of an integrated refining-petrochemical complex by 2010, and is worth US$3.1 billion. Given the risks that we believe investors assume when investing in Tatneft, they deserve a major discount in valuation multiples, which Tatneft does not provide them with currently. We estimate it trades above the sector average across all multiples, particularly on a P/E basis. 6

7 JPMorgan Global Oil and Gas Team Research Equity Research Credit Research Integrated Oils Downstream Gas Oil Services Gordon Gray Gordon Gray, Coordinator Michael LaMotte, Coordinator Global Sector Americas Americas Americas Americas Americas Coordinator United States Joe Allman Brian Kuzman Nick Pope Rodney Clayton United States Jennifer C. Rowland Daniel Vetter Katherine Lucas United States Brooke Glenn Mullin United States Michael LaMotte Kevin Pollard David Smith United States James C. Gibbons (/HY- Energy, Natural Gas Pipelines) Xin Liu (HY-Energy) Robin Levine (HG-Energy, Natural Gas Pipelines) Latin America Bidzina Bejuashvili Katya Shiro Latin America Bidzina Latin America Bejuashvili Katya Shiro EMEA EMEA EMEA Pan Europe Gordon Gray Pan Europe Gordon Gray CEEMEA Tao Ly Tao Ly Ross McCormick Ross McCormick William W Perry Douglas Krehbiel CEEMEA Bidzina Bejuashvili Katya Shiro CEEMEA Bidzina Bejuashvili Katya Shiro Asia Pacific Asia Pacific Asia Pacific Asia Pacific Asia Pacific Pan Asia Pacific Graham Pan Asia Pacific Graham Cunningham Pan Asia Pacific Graham China Frank Li Australia, New Zealand Allison Bellows Tiernan Australia China Mark Greenwood Ryan Martyn Graham Australia Jessica Smith China Graham Singapore Winnfred Heap Ex-Japan Asia Allison Bellows Tiernan China Graham Thailand Sukit Chawalitakul Japan Rie Kajiyama Indonesia Ami Tantri HongKong Graham Thailand Sukit Chawalitakul Thailand Sukit Chawalitakul 7

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