Supply constraints drive resource realignment

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1 The Goldman Sachs Group, Inc. Supply constraints drive resource realignment Oil shortages likely to re-appear with DM demand recovery January 2010 Jeffrey Currie Goldman Sachs International +44-(0) The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For important disclosures, see the text preceding the disclosures or go to

2 The commodity crisis is an obvious imbalance like the financial crisis was Million b/d 90 Global production capacity Global output By 2011 the market is back to capacity constraints Source: IEA, GS Global ECS Research Goldman Sachs Global Investment Research 2

3 However, the financial crisis created a collapse in company returns which has significantly interrupted the investment phase Average cash return among oil integrated companies 20% 18% 16% 14% 12% But policy constraints put a cap on further increases and on the ability to attract capital, regardless of price increases The revenge of the old economy creates a rise in returns, which attracts capital back to the sector 10% 8% 6% 4% 2% 0% Poor returns in the 1990s caused capital to be redirected into the new economy Real cash return over cash invested 40-year average 5-year moving average E Source: Goldman Sachs Equity Research Goldman Sachs Global Investment Research 3

4 The collapse in commodity demand was driven by the decline in GDP, not higher prices, which suggest as the economy recovers, so will demand Percent change year over year GDP on left axis Q2000 1Q2001 1Q2002 1Q2003 1Q2004 1Q2005 1Q2006 1Q2007 1Q2008 1Q2009 1Q2010 1Q World Real GDP growth Projected Real GDP growth World Oil Demand Growth Source: Goldman Sachs Global ECS Research. Goldman Sachs Global Investment Research 4

5 Two concepts that drive our views: 1. The adding up constraints Commodities are physical, not financial markets. So you cannot consume what you do not have, and you cannot store what you don t have space to store. 2. Don t begin an argument with price as it will only get you into trouble. Instead always start an argument with a fundamental event, i.e. inflation expectations and the impact of oil prices on economic growth. Goldman Sachs Global Investment Research 5

6 Commodities that are more difficult to store are more volatile Commodity Annualized volatility US Power (PJM West Hub - real time) US Power (PJM West Hub - day ahead) NYMEX Natural Gas 75.6 UK Natural Gas 74.8 WTI Crude Oil 64.2 NYMEX RBOB 54.9 LME Nickel 53.1 USGC Heating Oil 52.3 Brent Crude Oil 50.9 LME Zinc 43.8 LME Copper 43.6 CBOT Corn 42.0 CBOT Wheat 41.2 CME Lean Hog 39.9 London Silver 39.9 NYBOT Cocoa 38.4 NYBOT Sugar 37.9 CBOT Soybean 37.2 NYBOT Cotton 35.2 London Palladium 34.4 LME Aluminum 32.2 NYBOT Coffee 31.2 London Platinum 29.3 London Gold 22.9 CME Live Cattle 17.3 Source: Various exchanges and GS Global ECS Research. Goldman Sachs Global Investment Research 6

7 Commodity inventory drives volatility WTI volatility increases as inventories approach exhaustion and as inventories approach capacity Percentage, vertical axis; million barrels, horizontal axis Copper volatility increases as inventories approach exhaustion, but remains steady as inventories rise given few storage capacity constraints for metal Percentage, vertical axis; Thousand mt, horizontal axis 70% 60% % 50% month realized volatility 50% 40% 30% 1-month realized volatility 40% 30% 20% 20% 10% 10% Crude oil stocks deviation vs. 5-year average (ex SPR) 0% ,000 LME Copper stock ('000) Source: NYMEX, LME and GS Global ECS Research. Goldman Sachs Global Investment Research 7

8 Three emerging themes that are likely to dominate in 2010 and beyond 1. Differentiation between commodities driven by the extent of supply constraints that will likely drive greater price dispersion across the commodity complex i.e. the end of Btu convergence 2. Resource realignment as emerging markets are forced to bid away scarce commodities from the developed economies, especially when supply constraints are more restrictive, which shifts the focus away from the sustainability of higher prices and towards the sustainability of higher growth; 3. Increasing macroeconomic correlations as resource realignment will likely increase the relevance of the commodity prices and supply to the broader macroeconomic environment. Goldman Sachs Global Investment Research 8

9 Commodities with more restrictive supply constraints and greater leverage to emerging market demand growth have more positive outlooks Capacity utilization as of November 2009, EM vs. DM consumption growth is annual based on consumption, BRIC leverage is average of 2008 and % Corn Wheat 95% Rice Crude Coal Copper Lead Soybeans Zinc Capacity utilization 90% -5% 0% 5% 10% Platinum 15% 20% 25% Natural gas Refining Nickel 85% 80% Bubble size = BRIC leverage Aluminum 75% EM vs. DM consumption growth * Leverage score = (mkt share)^2 + (imp share), Capacity utilization for metals has been normalized by the historical maximum utilization for each metal. Source: Goldman Sachs Global ECS Research.ce: DOE. Goldman Sachs Global Investment Research 9

10 Credit normalization drove the most recent rally, as we still await the economic recovery rally

11 Decomposition of a commodity forward curve $/bbl In a cyclically tight market the spread is typically positive, reflecting a premium for prompt delivery The short-term, cyclical component of price 80 = MC In a cyclically soft market the spread is negative reflecting the cost of carrying inventory The long-dated, secular component of price Price = MC + d, where d is a delivery premium in a tight market or a discount in a soft market Source: GS Global ECS Research Goldman Sachs Global Investment Research 11

12 Long-dated commodity prices have remained very stable during the credit crisis, with most of the volatility in prices being driven by term structure $/bbl Long-dated Oil Prices (5-year Forward) Spot Oil Prices 20 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Source: NYMEX. Goldman Sachs Global Investment Research 12

13 In early May, oil market fundamentals looked terrible, but the oil market wasn t pricing oil fundamentals Million barrels Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: DOE. Goldman Sachs Global Investment Research 13

14 instead the oil market was pricing credit market fundamentals, as credit markets normalized so did oil market timespreads, which was worth $20/bbl $/bbl (left axis) ; % return (right axis) Spot-5 year forward Brent (left axis) Jan 09-Jan Source: ICE and US Federal reserve. 16-Jan 23-Jan 30-Jan 06-Feb 13-Feb 20-Feb 27-Feb TED Spread Inverted 06-Mar 13-Mar 20-Mar 27-Mar 03-Apr 10-Apr 17-Apr 24-Apr 01-May 08-May 15-May 22-May 29-May Goldman Sachs Global Investment Research

15 The discount of spot prices to forward prices was larger than inventory levels would have suggested owing to limited access to capital and surging funding costs Percent 1st vs. 60th month timespread (vertical); million barrels of US crude oil in storage (horizontal) 80% 60% 40% 10-year average 20% 0% Oct 3, % Dec 25, % -60% Darker observations are post- September 2008, during the credit dislocations May 5, % Source: NYMEX, Goldman Sachs Global ECS Research Goldman Sachs Global Investment Research 15

16 Normalizing the price action for credit, prices are just barely off their lows, suggesting more upside as the economic recovery takes hold $/bbl Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Credit normalized price Actual front month Source: NYMEX and GS Global ECS Research. Goldman Sachs Global Investment Research 16

17 Still on the cyclical trough, awaiting the recovery

18 The end of an economic recession corresponds to the trough in economic activity, not a return to normal Stylized economic cycle Economic recession Economic expansion trend activity recession ends expansion begins Source: GS Global ECS Research. Goldman Sachs Global Investment Research 18

19 The leading indicators point to a strong rebound in 2010 New orders to inventory ratio (left); diffusion index (right) Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct Source: ISM. ISM New Orders to Inventory (left axis) ISM New Orders Index (right axis) Goldman Sachs Global Investment Research 19

20 that has only just begun in the coincidental indicators $ bn (left axis); industrial production index (right axis) Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct US Retail Sales (left axis) US Industrial Production (right axis) Source: GS Global ECS Research Goldman Sachs Global Investment Research 20

21 As a result, US distillate demand has lagged, leaving it as the focal point Products supplied, Mb/d 4,800 4,600 4,400 4,200 4,000 3,800 3,600 3,400 3,200 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: DOE, GS Global ECS Research. Goldman Sachs Global Investment Research 21

22 EM market demand has been strong, but in oil not enough to offset the DM weakness

23 This also represents a transition from EM to DM growth leadership Industrial Production index 100 as of Dec Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 DM EM (ex China) EM (inc China) World Source: GS Global ECS Research. Goldman Sachs Global Investment Research 23

24 China is beyond recovery, as Chinese oil demand remains above the pre-recession highs thousand b/d Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Chinese National Bureau of Statistics and GS Global ECS Research. Goldman Sachs Global Investment Research 24

25 Chinese oil demand was largely driven by demand for industrial related other products Year-over-year changes in thousand b/d Other (incl. Naphtha) LPG Jet Fuel Fuel oil Diesel Gasoline Total products Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Source: China Customs, National Bureau of Statistics of China, Goldman Sachs Global ECS Research. Goldman Sachs Global Investment Research 25

26 implying positive upside surprise to our forecast if demand for transportation fuel follows total product demand Thousand b/d Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec Source: IEA, Goldman Sachs Global ECS Research. Goldman Sachs Global Investment Research 26

27 Chinese retail sales growth has more than offset US weakness Change in Real Retail Sales Since January USD Billion January 2007 Bil$ China U.S Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Source: GS Global ECS Research Goldman Sachs Global Investment Research 27

28 The distillate market needs to rebalance to support a sustainable move higher

29 Distillate demand is not that out of line with IP growth that has been slow to rebound Yoy change in thousand b/d (lhs); yoy % change (rhs) Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan US distillate demand (left axis) US Industrial Production (right axis) Source: US FRB, DOE, GS Global ECS Research Goldman Sachs Global Investment Research 29

30 Trucking has now shown signs of rebounding in the past month or so as destocking reverses Index, Jan-08=100 (lhs); thousand b/d (rhs) Manufacturers' Shipments of Durable Goods Truck Tonnage Index Distillate Fuel Oil Demand 4-wk average (right axis) Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov Source: American Trucking Association, Census Bureau and DOE. Goldman Sachs Global Investment Research 30

31 A recovery in DM demand growth should push the market back towards effective production capacity by 2011

32 Oil and agriculture are running at the highest capacity utilization Commodity Most recent Reference period Corn 97% 97% 100% 97% 2008/2009 Copper 94% 91% 90% 96% 2Q2009E Petroleum 98% 97% 98% 95% Jun09 Wheat 90% 87% 89% 94% 2008/2009 Coal 99% 98% 99% 93% Jun09 Coffee 76% 91% 83% 93% 2008/2009 Zinc 88% 91% 89% 92% 2Q2009E Soybeans 99% 100% 93% 89% 2008/2009 Natural gas 99% 99% 99% 88% Jun09E Sugar 86% 92% 91% 86% 2008/2009 Cocoa 90% 79% 86% 85% 2008/2009 Nickel 96% 94% 83% 83% 2Q2009E Cotton 95% 97% 92% 83% 2008/2009 Platinum 100% 100% 92% 82% 2Q2009E Aluminum 90% 93% 89% 76% 2Q2009E * Capacity utilization for metals has been normalized by the historical maximum utilization for each metal. Source: GS Global ECS Research Goldman Sachs Global Investment Research 32

33 Change vs. 4Q2007, thousand b/d Declines in DM oil demand were accelerated by the recession, freeing up oil supply, which has allowed EM demand to grow unimpeded, likely returning global oil demand back to pre-recession levels by 3Q2010 8,000 historical demand forecasted demand 6,000 non-oecd demand 4,000 2, ,000-4,000-6,000 Global demand OECD demand -8,000 1Q2008 3Q2008 1Q2009 3Q2009 1Q2010 3Q2010 1Q2011 3Q2011 Source: GS Global ECS Research. Goldman Sachs Global Investment Research 33

34 The commodity crisis is a supply problem more than a demand problem

35 2009 is about as good as it will get for the next three years as sanctioned projects peaked in mn boe Source: Company data, Goldman Sachs Research estimates. Oil Gas Oil price (GS estimates post 2008) 0 Goldman Sachs Global Investment Research 35

36 Why are we not seeing investment and a supply response? The terra-concentration ratio is the lowest since 1650 under mercantilism Percentage of total global terrain controlled by superpowers 70% 60% 50% Chinese American French 40% Spanish 30% 20% Russian 10% Portuguese British 0% date Source: GS Global ECS Research. Goldman Sachs Global Investment Research 36

37 The Last industry year represented has sanctioned the peak very in few new projects greenfield in the projects period new start-ups boe addition by year in each region 1,600 1,400 1,200 1, E 2010E 2011E 2012E 2013E 2014E Latin America Russia Canada Australasia US Caspian Other regions Source: Company data, Goldman Sachs Research estimates, Top 230. Goldman Sachs Global Investment Research 37

38 Non-OPEC could decline by about 1 mn b/d in two realistic scenarios in 2011E 2014E Non-OPEC yoy production growth/decline kb/d 1,500 1, ,000-1, E 2010E 2011E 2012E 2013E 2014E Perfect delivery Delivery in line with history One percent more decline in the base Source: Company data, Goldman Sachs Research estimates, Top 230. Goldman Sachs Global Investment Research 38

39 DM demand will have to contract going forward to make room for EM demand due to supply constraints

40 We expect emerging market demand growth to crowd out developed market demand as supply growth will be limited Thousand b/d EM Growth Rates DM Growth Rates 1Q2006 2Q2006 3Q2006 4Q2006 1Q2007 2Q2007 3Q2007 4Q2007 1Q2008 2Q2008 3Q2008 4Q2008 1Q2009 2Q2009 3Q2009 4Q2009 1Q2010 2Q2010 3Q2010 4Q2010 Source: IEA and GS Global ECS Research. Goldman Sachs Global Investment Research 40

41 Metals and agriculture are the most leveraged to China Average 2008 Figures China China China China Global Demand Net Import Leverage Commodity Units Consumption Production Net Imports Output % Global % Global Score* Cotton mmmt % 9.5% Soybeans mmmt % 16.9% Copper kmt % 7.4% Soybean Oil mmmt % 7.0% Zinc kmt % 2.3% Lead kmt % 0.0% Nickel kmt % 8.0% Aluminum kmt % -1.5% Rice mmmt % -0.2% Petroleum mmb/d % 4.6% Soybean Meal mmmt % -0.3% Corn mmmt % -0.1% Wheat mmmt % -0.5% Cocoa mmmt % 1.7% Sugar mmmt % 0.5% Coffee mmmt % 0.2% Natural Gas Bcf/d % 0.1% * Leverage score = (mkt share)^2 + (imp share) Source: GS Global ECS Research Goldman Sachs Global Investment Research 41

42 Due to a lack of copper supply, DM demand will likely be crowded out by BRIC demand Copper demand in kmt BRIC & Rest of World G-3 Source: Brook Hunt, GS Global ECS Research Goldman Sachs Global Investment Research 42

43 Germany and Japan have the lowest willingness to pay for commodities Regional willingness to pay for oil $1,800 $1,600 Australia Russia Willingness to pay ($ per barrel) $1,400 $1,200 $1,000 $800 $600 $400 Japan France Spain Canada Brazil United States Mexico India China Saudi Arabia Argentina $200 Germany South Africa Source: GS Global ECS Research $- 0% 20% 40% 60% 80% 100% 120% Oil Intensity Goldman Sachs Global Investment Research 43

44 Accordingly, they have seen the largest reductions in demand already Total Petroleum consumption (rebased to 100 in 2000) 110 United States France 95 Germany Japan Source: IEA, GS Global ECS Research Germany Japan United States France Goldman Sachs Global Investment Research 44

45 Rising prices over the past 6 years have already reduced demand over 5.0 million b/d Thousand b/d Had price remained at $20/bbl, we would likely see global demand over 92.2 mmb/d Over 5 mmb/d of demand is being held out of market by higher prices Source: IEA and GS Global ECS Research. Goldman Sachs Global Investment Research 45

46 The macroeconomic linkages

47 The oil price and USD were highly correlated in the 1970s as the causality is oil to FX, not vice versa Oil in $/bbl (let axis); EUR/USD (right axis) Both periods experienced a high level of oil-to-fx correlation EUR/USD (right axis) Crude Oil Price - $/bbl (left axis) Source: Oil & Gas journal and Goldman Sachs Commodities Research. Goldman Sachs Global Investment Research 47

48 Oil as a share of US imports is rising back towards 1970 levels Percent 35% 30% 25% 20% 15% 10% 5% 0% Source: Haver Analystics Goldman Sachs Global Investment Research 48

49 Relative to the barrels of oil that oil companies could hedge, index investors are holding a relatively small amount of oil price risk million barrels (end of 2007) Company Proven Reserves (million barrels) Exxon Mobil 11,075 Petrobras 9,613 Chevron 7,087 ConocoPhillips 6,320 Suncor Energy 2,515 Occidental Petroleum 2,224 Canadian Natural Resources 1,358 Apache Corporation 1,134 Marathon Oil 1,071 Hess Corporation 885 Index Investors 855 Nexen 835 Talisman Energy 648 Petro-Canada 597 Murphy Oil 307 Source: Goldman Sachs Equity Research and Goldman Sachs Commodity Research. Goldman Sachs Global Investment Research 49

50 Crude Oil Speculators vs Index Investors Crude oil prices move with speculators percentage (vertical axis), million barrels(horizontal axis) but not with index investors percentage (vertical axis), million barrels (horizontal axis) y = 0.13x R 2 = y = 0.00x R 2 = Source: NYMEX, CFTC, and Goldman Sachs Commodities Research. Goldman Sachs Global Investment Research 50

51 RegAC I, Jeffrey Currie, hereby certify that all of the views expressed in this report accurately reflect my personal views, which have not been influenced by considerations of the firm's business or client relationships. Goldman Sachs Global Investment Research 51

52 Disclosures January 6, 2010

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