Expecting the Unexpected: Oil in 2012 – A Year of Tail Risks

Commodities Research and Strategy

Edward L. Morse+1 (212) 723-3871

ed.morse@citi.com

See Appendix A-1 for Analyst Certification, Important Disclosures and non-US research analyst disclosuresCiti Investment Research & Analysis is a division of Citigroup Global Markets Inc. (the "Firm"), which 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.Published: 22 February 2012

2

Oil in 2012: binary tail risks skewed to the upside

2012 Brent range-bound $100-120, averaging $110

1H’12 downside price pressures: slower global growth, Eurozone systemic problems, China slowdown

2H’12 upside pressures from stimulus packages worldwide, cautious optimism on risk assets

Oil demand growth: +0.8-m b/d in 2012, +1-m b/d in 2013, based on Citi estimates of global GDP growth: 3.0% in 2012 and 3.6% in 2013

Bearish supply scenarios: Libyan return, higher Iraqi flows, Saudi replacements for sanctioned Iranian crude – but Saudi Arabia is targeting $100 price

And supply risks abound…– Escalation of violence in Iraq, with the potential of

civil war, and tensions between Israel and Iran top the list, but an EU embargo on Iranian oil, sanctions on Syria, succession and the possibility of strife in Saudi Arabia, elections in Venezuela and Angola and ongoing violence in Sudan, Nigeria and Yemen are on the list but do not complete it.

Brent range-bound between $100-$120/bbl in 2012, but tail risks could cause spikes/dips; potential supply risks abound, but $120+ could be pain point for global economy, with energy spend % of GDP at highs

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10%

'67 '71 '75 '79 '83 '87 '91 '95 '99 '03 '07 '11e '15e '19e

Ener

gy a

s %

of G

DP

0

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60

80

100

120

Bren

t Oil (

US$/b

bl)

Oil Gas Coal Nuclear Hydro Brent Oil (real): RHS

Supply growth and limited

competition for energy

Competition for energy between

non-OECD/OECD

Prices above 7% of GDP have been

disruptive to growth

Current Oil Prices Are Already In The Danger

Zone for the Global Economy

Energy expenditure as % of GDP nearing danger zone

Sources: Bloomberg, Citi Investment Research and Analysis

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Jul-11 Oct-11

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Jul-12

Prior 1Y Range Prior YTD Range Closing price Prior 1Y Avg

2008 2009 2010 2011$/bbl

Brent prices range-bound in 2012

3

OPEC may have some work to do in 2012, but risks to supply loom large

Only 2.5-m b/d of spare capacity in the world, all in Saudi Arabia, and really only 1.8-m b/d effective– And the IEA SPR can only release stocks at ~500-k

b/d, not officially claimed 4.5-m b/d, due to infrastructure constraints

With no supply disruptions, OPEC spare capacity should rise, but risks abound– Iraq, Israel/Iran and sanctions, Syria, Saudi Arabia

strife, Venezuela/Angola elections, Sudan, Nigeria, Yemen… and more

Base case constructive for oil prices– Bull case (25% probability): oil price spiking and

hurting global economy, could even be above $175 Brent, but not for long

– Bear case: Euro disintegration (Citi economists see 5% probability) or China hard landing. Brent below $100, dips even under $90

…and the world is operating with lean cushions of inventory or spare production capacity

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$20

$40

$60

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$100

$120

$140

$160OPEC Spare Capacity (k b/d) Brent ($/bbl) (rhs)

Source: Bloomberg, OPEC, Citi Investment Research and Analysis

OPEC spare capacity and Brent price

4

Base case scenario for 2012

Source: Citi Investment Research and Analysis estimates

Base Case Supply-Demand Balance

13.05.2113.0100.0105.0100.0100.095.094.893.889.7102.293.579.4WTI ($/bbl)

10.0-1.3120.0110.0115.0110.0110.0105.0111.4109.7113.3117.4105.080.3Brent ($/bbl)

Crude Oil Prices

0.20.0-0.90.10.60.3-0.9-1.3-0.8-0.7-0.6-0.8Stock Change

1.21.891.590.390.890.389.890.488.589.788.587.588.587.4Total Supply

0.30.636.836.436.436.336.236.935.836.335.935.235.834.8Total OPEC

0.10.46.46.26.36.36.26.25.96.05.95.85.85.3Other

0.20.330.430.230.130.030.030.729.930.330.029.430.029.5Crude

OPEC

0.91.154.853.954.354.053.653.552.753.452.652.352.752.6Total Non-OPEC

0.30.24.44.24.34.24.24.14.04.14.04.03.83.9Other

0.70.950.349.750.149.849.449.448.849.348.648.348.948.7Crude

Non-OPEC

Supply

1.00.891.390.391.790.189.190.189.491.089.388.289.188.3Total Demand

1.11.145.844.745.344.944.843.943.644.143.743.642.842.1Non-OECD Demand

-0.1-0.345.545.546.445.344.446.245.846.945.644.646.346.2OECD Demand

Demand

13v1212v1120132012Q4 2012

Q3 2012

Q2 2012

Q1 2012

2011Q4 2011

Q3 2011

Q2 2011

Q1 2011

2010m b/d

5

Product prices are above 2008 highs in non-US dollar terms…

German Diesel Prices in Euros Average UK Diesel Prices in £ India (Delhi) Diesel Price in INR

350

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850

2006 2007 2008 2009 2010 2011

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2006 2007 2008 2009 2010 2011

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27

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31

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35

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39

41

43

2006 2007 2008 2009 2010 2011

Source: Citi Investment Research and Analysis Source: Citi Investment Research and Analysis Source: Citi Investment Research and Analysis

Beijing 93 Ron Gasoline in CNY S Korea Gasoline Prices in Won Philippines Gasoline Price in PHP

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2006 2007 2008 2009 2010 2011

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2006 2007 2008 2009 2010

Source: Citi Investment Research and Analysis Source: Citi Investment Research and Analysis Source: Citi Investment Research and Analysis

Retail fuel and distillate prices are at or close to the highs of 2008 in non-US dollar terms, including Europe, and compounded by removal of subsidies in some cases in emerging markets

6

…and gasoline prices could be higher than ever this summer

Recent closures on East Coast– ConocoPhillips’ Trainer (185-k b/d) and Sunoco’s Marcus

Hook (178-k b/d) ; Sunoco Philadelphia (335-k b/d) is set to shut July 1 if not sold

– These are simple refineries that take light, sweet crudes from relatively expensive West Africa and North Sea;

Combined with Petroplus and other refinery closures in Europe, and Caribbean and Latin America refinery closures and outages, Atlantic Basin product markets have tightened significantly, particularly impacting the US East Coast

Summer gasoline could see retail prices over $4/gal as driving season comes around and these refinery closures bite– Summer specification gasoline is harder to make and

greater imports pull is expected from Latin America

Although US Gulf Coast and US midcontinent refinery capacity could supply the East Coast’s gasoline needs, transport is again a constraint– Colonial pipeline (Gulf Coast to East Coast) near capacity– US Midwest refining capacity could supply western PA,

upstate NY, but pipeline capacity constraints there too– A Jones Act waiver would be needed to ship products

from US Gulf Coast to the East Coast

Atlantic Basin refinery capacity has fallen by over 1.1-m b/d since end-2011, which is set to cause a gasoline shortage on the US East Coast this summer

Sources: IIR, FGE, CIRA

442

172At risk: Petroplus Coryton

Dec 2011105Lyondell Berre L’Etang

106At risk: Petroplus Ingolstadt

Jan 2011154Petroplus Petit Couronne

Jan 2011110Petroplus Antwerp

Europe

698

July 1 if not sold335Sunoco Philadelphia

Jan 201173Petroplus Cressier

Dec 2011178Sunoco Marcus Hook, PA

Nov 2011185ConocoPhillips Trainer, PA

US East Coast

DateCapacityRefinery

Selected major refinery capacity facing maintenance or closure(k b/d)

7

Crude looks set to stay tight during 2012The beginning of 2012 has seen supply disruptions in Nigeria, Sudan, Yemen, Syria, Colombia, Kazakhstan, technical issues in the North Sea, and cold weather impacting the Black Sea and boosting European demand

Despite a warm winter, Libya coming back faster than expected and a perception that the global economy was fragile – demand surprising to the upside, and there is no sign in the markets that the IEA’s balances are playing out

The market is looking for ~1-m b/d of supply overhang, but cold weather struck in Europe, and disruptions in South Sudan and Yemen took 0.5-m b/d off the market; with a partial loss of Iranian barrels that overhang could be gone

Scurrying for replacement barrels for lost Iranian crude, as well as disruptions in the Black Sea, has put upward pressure on Urals, with renewed Buzzard issues also impacting Brent

Things get tighter from here, with global refinery runs going up ~2-m b/d into the summer; the actual loss of Iranian barrels will largely depend on China and India, and it remains unclear how they will play their strong hand

It is hard to see a non-bullish outcome from the Iran situation, especially with both Iran and the US in election years

OECD Stocks absolute - bn bbls

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4.1

4.2

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Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2007 2008 2009 20102011 2012

IEA Global Runs Forecast - mmb/d

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76

77

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2010 2011 2012

Sources: IEA, Citi Investment Research and Analysis

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Asia-Pacific Europe Africa and others

m b/d

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000s b/d

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Y-o-Y Change

Production Net Exports Jan '09 TargetsViable Capacity Production Growth (rhs) Export Growth (rhs)

8

Potential impact of the Iranian situation

EU embargo to be phased in by July 1, affecting 400-600-k b/d; Iran has countered with threat to cut preemptively, starting with the UK and France; scurried buying pushing up Urals, Dubai

US financial sanctions, discussion on targeting 18% of Iranian revenues (either through volumes or discounts)– Japan and South Korea (~500-k b/d combined)

should begin reducing imports in 1H’12– India (~500-k b/d) discussing buying some Iranian

volumes using rupees and other means to bypass Bank Markazi

– China (~550-k b/d) has reduced Iranian purchases -to win discounts but also as Xi Jinping visits the US; but Unipec may have an “agreement in principle” to renew term contracts

– Problems buying insurance has discouraged the chartering of tankers to transport Iranian crude

Where could replacement supplies come from?– Saudi Arabia at ~10-m b/d, spare capacity only 1.8-m

b/d (in 3 wks), further 700-k b/d could take six months– IEA SPR claims 4.5-m b/d but more like 500-k b/d– Iraqi de-bottlenecking of export facilities

Iran’s domestic politics and economy are facing severe pressures in the run-up to elections

Iran’s nuclear ambitions have led to US/EU efforts to impose stricter sanctions, while end-2011 saw Israeli military posturing, the storming of the UK Embassy, two explosions at military sites, attempted assassination of the Saudi Ambassador to the US…

Source: IEA, CIRA

Breakdown of exports from Iran by destination region

Saudi spare capacity dwindling

Source: JODI, Citi Investment Research and Analysis estimates

99

No other asset class responds so well and so protectively in times of heightened tail risks—including agriculture, gold and crude oil…– Weather and catastrophes: hurricanes, floods, refinery fires, tanker spills, outages, terrorism– Unpredictable geopolitical strife within OPEC—or even an SPR release—can lead to measurable changes in supply to market that can

have bullish or bearish implications

The WTI forward curve before and after Hurricane Katrina is an example when both prompt and deferred prices jumped >10% almost overnight with a sharp parallel move in the entire structure

Brent curve at the start of Libya’s civil war on February 15 last year showed nearby 1-2 month prices at +$0.90/bbl and in contango one year out; NATO involvement by March 31 showed a 1-2 month differential at -$2/bbl and the entire curve shifted into steep backwardation

Source: Bloomberg

WTI forward curve response to Hurricane Katrina Brent forward curve response to Libyan civil war

Source: Bloomberg

Tail risk events make commodities attractive investmentsPotential for tail risk events make commodities attractive investments…and makes oil a poor choice for a short (as current call skews point to on recent geopolitical tension in Iran)…

1010

Since early 2010, call option open interest for Dec-12 delivery with a strike price of $100/bbl to $140/bbl had risen substantially at the expense of in-the-money calls, and these are skewed heavily to upside risk

Big jump upward during the Arab Spring in early 2011 as traders appeared to be preparing for a positive price breakout and upside on the tail as opposed to negative price movement

August/September positioning in options market had seen fading of OI in the $100-180/bbl range compared to 1H’11 and July in part due to retrenchment of world GDP growth estimates that left market players wondering about the commodity bull-cycle—especially for oil—into 2012 without significant policy action in US and Europe

But the volatility smile as of September still remained skewed toward a higher likelihood of a breakout above the range than below the range, from the belief that OPEC would defend the floor, which itself is rising due to higher breakeven budgets in the wake of the MENA Spring

Today’s ‘bullish’ outlook on oil options is largely driven by geopolitical risk as well—this time with Iran. However, investors should note that purchases of call options also entail risk of loss of premium in the event of oil price decline.

Source: Bloomberg, Citi Investment Research and Analysis

Preference for sharp upside price break from Feb-July ‘11 WTI Dec 12 options volatility smile and open interest

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0-60 61-80 81-100 101-120 121-140 141-160 161-180 181+0

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60Open Interest (lhs)Avg Implied Vol (rhs)

Source: Bloomberg, Citi Investment Research and Analysis

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50.0%

0-80 81-100 101-120 121-140 141-160 161-180 181-

Change in OI% from2/15/11 to 7/29/11

% of total OI

strike price

Investor sentiment turning bullishBullish investor sentiment increased after Libyan supply disruption, although had faded afterwards in 3Q’11 on weaker global economic growth outlook…

1111

Oil prices have been bolstered by the ratcheting up of tensions with Iran, and open interest in deep out-of-the-money calls ($140 to $180/bbl) for June 2012 has surged as the market prices in the potential for more surprises to come, but Brent structure has also responded in impressive fashion

Source: Bloomberg, Citi Investment Research and AnalysisSource: Bloomberg, Citi Investment Research and Analysis

Brent Dec 12 Call Option Open Interest

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15%

25%

35%

45%

0-80 81-100 101-120 121-140 141-160 161-180 181-

9/30/201110/31/201111/30/20111/18/2012

% of total OI

strike price

WTI June 12 Call Option Open Interest

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10%

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0-80 81-100 101-120 121-140 141-160 161-180 181-

9/30/201110/31/201111/29/20111/26/2012

% of total OI

strike price

Geopolitical turmoil adding risk premiumGeopolitical turmoil in the Middle East has more recently added a ‘risk premium’ to the more liquid June (m) and December (z) crude oil call option contracts…

1212

Source: Bloomberg, BP Statistical Review, Citi Investment Research and Analysis

Iraqi oil production since 1973

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1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

kb/d Iraq Oil Production ('000 b/d)

Iran-Iraq War Post-1990 Gulf WarEmbargo

2003 Iraqi Freedom and breakdow n of UN oil-for-food program

Source: Jerusalem Post

Iraqi production had thought to be reaching 3-m b/d by end-2011, but has stalled out at 2.8-m b/d to 2.9-m b/d, due to constraints from export infrastructure to bring expanded production to market

Political crisis is deepening, with Iraqi politicians openly discussing the probability of civil war or breakup– Former Vice President fled the country– Sectarian violence is flaring up, with bomb attacks

Stabilizing force not apparent, with the US leaving Iraq not exactly on its own terms

Could the first wave of divestment be starting?– Statoil looks to exit the giant 1.8-m b/d West Qurna-2 field development

Iraqi oil fields

Bullish risks #1: Instability in Iraq

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Iranian naval exercises in the Strait, US sanctions and an EU embargo, the attacks on the UK embassy, and two explosions at military sites recently put at risk the 17-m b/d of oil flows through the Strait of Hormuz

If the US and Israel use military force, what are the potential oil consequences?– Could gasoline imports to Iran be impeded?– Would damage be done to Iran’s 4 export terminals,

especially the huge Kharg Island, to deprive Iran of exports?

– How vulnerable is Iran’s shipping fleet (the largest in OPEC)?

Iranian counter attack strategy– Could Iran effectively block the 17-m b/d Strait of

Hormuz, through which 90% of Persian Gulf Exports flow?

– Could Iran effectively cut off Iraqi oil exports?

Bab el-Mandab Bosporus

Malacca

Suez

Strait of Hormuz

02468

1012141618

m b/d

Source: EIA

Strait of Hormuz is a key chokepoint

Source: EIA

Bullish risks #2: Iran

Nuclear ambitions, the Strait of Hormuz, and potential targeting of Iraqi exports

1414

Possible Strategies1. Mining the Strait of Hormuz2. Missile Attacks on tankers in the Persian Gulf

Is this plausible?1. Mining the Strait of Hormuz has been tried before

The issue is less the danger than the resistance of double-hulled tankersIran mined the Gulf during the Iran-Iraq war and the open question is whether there are “new” Chinese mines that are any stronger than those in 1980-1988

2. Missile batteries could likely be neutralized within days if the US used overwhelming force

An Iranian counter attack would likely lead to a very short-lived price spike

Bullish risks #2a: Iran and closing of the Strait of Hormuz

1515

Iran currently produces about 3.6-m b/d, exports about 2.3- to 2.6-m b/d, and imports about 90.5-k b/d of gasoline (in 2009, from 108.1-k b/d in 2008)– Much talk has focused on Iran’s potential use of its “oil weapon,” reducing output significantly to raise prices and “punish”

various partiesUnlikely because:

Saudi Arabia alone could just about cover Iranian productionUS, IEA could release strategic stocks (1.5 billion barrels), a credible instrument, since stock release after hurricanes in 2005

Iran reluctant to risk earning nothing from oil exports and is more likely to use its influence to cut off Iraq exports from Basra (1.3 to 1.6-m b/d)– This potential risk is credible since Iran could plausibly deny it – Such a cut-off would tighten markets, raise prices and raise Iran’s income– While Saudi Arabia and others might react by raising output, they would likely do so to offset and take advantage of already

much higher prices, which would be further bolstered by speculators

Bullish risks #2b: Iran could respond by hitting Iraqi oil production

1616

Saudi spare capacity dwindling Impact of attacks on Abqaiq and Ras Tanura

Saudi total claimed capacity is 12.5-m b/d, with market believing commercial capacity of 11.8-m b/d

Production of ~10-m b/d leaves < 1.8-m b/d viable spare capacity

Markets seem less concerned by Saudi instability than by potential terrorist/other attacks

Saudis claim (1) an attack at Abqaiq is unlikely and (2) facilities could be rebuilt quickly. – But what if there is an attack and facilities cannot be rebuilt quickly?

This is one of the most credible longer-term risks in the oil market– Saudi Arabia could replace Iranian exports; but it could not replace itself– This sort of attack would test the ability of IEA countries to actually logistically release stocks– Doubts on IEA’s ability to physically release enough oil to replace 5 to 7-m b/d of Saudi oil

Saudis claim to have redundancy and replacement equipment stored nearby

No successful sustained attack yet, but 2004 attack in Yanbu followed by 2006 attack on 7-m b/d processing in Abqaiq

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000s b/d

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Production Net Exports Jan '09 TargetsViable Capacity Production Growth (rhs) Export Growth (rhs)

Source: JODI, Citi Investment Research and Analysis estimates

Bullish risks #3: Saudi disruption

1717

Venezuela output declining…– IEA estimates sustainable crude production capacity

for Venezuela at 2.57-m b/d for 2012, increasing to 2.89 in 2014 and staying roughly flat onwards, with growth of only 140-k b/d between 2010 and 2016

– By comparison, IEA estimates that Libya – still working to resume pre-conflict production – will have increased its sustainable crude production capacity by 170-k b/d between 2010-2016

Iran output decline at around 100 to 300-330-k b/d per year– Output declining in southern fields– Lack of foreign investment due to international

sanctions for new field development, and enhanced oil recovery of existing fields

– IEA estimates Iran’s sustainable crude production capacity could fall by over 800-k b/d between 2010-2016

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4,100

2005 2006 2007 2008 2009 2010 2011

k b/d

Venezuelan crude production

Source: EIG, Citi Investment Research and Analysis

Iranian crude production

Source: EIG, Citi Investment Research and Analysis

Bullish risks #4: Collapsing OPEC output

18

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Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12

18

859095

100105110115120125130

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11

$/bbl

Libyan disruption was real and not easily replaced last year…– Approximately 1.5-m b/d in light, sweet crude production

taken offline almost overnight in Feb/March 2011– While this represents only 1.5% of daily global consumption it

is far more critical in the sense that it represents nearly 10% of “high quality” light/sweet output in the marketplace

Citi forecasts Libyan production to resume fitfully into 2012 to c. 75% of its pre-war export capacity by early-2012 could be fully returned at Dec’12 – currently at astonishing 1.4-m b/d per NOC—well above consensus estimates in Aug/Sept 2011

The initial impact of Libyan civil war was “bullish” for Brent and coincided with the doubling of WTI-Brent average spread in February from January to nearly $-14/bbl

What if more Libyan-like light, sweet crude were to be disrupted?

Algeria’s ~1.2-m b/d light, sweet crude– Continued protests in Algiers against government – Youth bulge: median age of 27.6 and 10% unemployment in

2010 (though down from 14% in 2007 and 29% in 2000), in a country of 36.2 million

Nigeria’s ~2.3-m b/d light, sweet crude– Terrorism (Qaeda-affiliated Boko Haram) in poorer,

predominantly Muslim north– Groups targeting oil infrastructure (Movement for the

Emancipation of the Niger Delta (MEND)) in the oil-rich, mostly Christian, southern Niger Delta

– Opposition to lifting of fuel subsidies– Religious and ethnic tensions, income inequality, youth bulge:

median age of 19.2 and 19.7% unemployment in a country of 155 million people

Source: EIG, Citi Investment Research and Analysis

Libya wellhead production, 000s b/d

Source: Bloomberg, Citi Investment Research and Analysis

ICE Brent prices

Bullish risks #5: MENA Spring contagion on light, sweet crude

1919

Increased social spending to stave off restless public, increasing oil producers’ minimum targeted oil prices required to balance budgets, pressuring all MENA producers to be price hawks

However, Saudi Arabia is able to sustain lower crude prices due to low debt and significant cash balances and crude inventories

As part of these social programs, subsidies for petroleum products further drive rampant domestic product demand growth in the region, including direct burning of crude oil for power generation during the summer

Domestic oil consumption necessarily diminishes the surplus crude available for export

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Direct Burn Direct Burn, % of Demand (rhs)

Saudi direct burn of crude

Source: JODI, Citi Investment Research and Analysis estimates

0

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Crude production (lhs) Oil demand, % of production (rhs)

k b/d

Source: JODI, Citi Investment Research and Analysis estimates

Saudi domestic crude demand as % of production

Bullish risks #6: Long-term consequences of the MENA Spring

2020

Citi forecasts Libyan production to resume fitfully into 2012 toabout 75% of its pre-war export capacity by early-2012 or ~1-m b/d in 1Q’12; could be fully returned at Dec’12 – currently could be as high as 1.4-m b/d per NOC– But the final leg on the journey to full production could be

more challenging

But observers have a wide range of estimates; this could happen even sooner than expected—or later…

Transitional National Council (TNC) should honor all existing contracts, and have been open to discussions with governments that had lent less enthusiastic support earlier in the conflict

IOCs have been eager to re-enter, with Eni and Total at the forefront; the TNC needs oil revenues

The oil sector may be delinked from wider political problems

War-damage was relatively light compared to Iraq after second Gulf War

But… oil export terminal damage, looting of facilities, clogged wells from months of neglect, clearing of mines around certain fields needed

Political tensions within the victorious rebel leadership could resurface

Source: EIG, Citi Investment Research and Analysis

Libya wellhead production, 000s b/d

50

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1,050

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1,450

Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12

Bearish risks #1: Libyan oil revival

2121

Source: Bloomberg, BP Statistical Review, Citi Investment Research and Analysis

Iraqi oil production since 1973

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3500

4000

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

kb/d Iraq Oil Production ('000 b/d)

Iran-Iraq War Post-1990 Gulf WarEmbargo

2003 Iraqi Freedom and breakdow n of UN oil-for-food program

Source: Jerusalem Post

Although Iraqi stability is in question, going forward, Iraq is also starting to talk up major supply increases this year

A new 900-k b/d single-point mooring (SPM) buoy in the southern part of Basrah is scheduled to start-up at the end of January

IEA’s medium-term outlook projects 2.76-m b/d for 2011, rising to 2.95-m b/d for 2012, and just shy of 4-m b/d by 2015

Iraqi oil fields

Bearish risks #2: Iraq on the march

2222

If demand falls…

Global economic weakness spreads on financial contagion and drop in inter-regional trade

– Uncertain outlook crimp lending, investment appetiteand consumer confidence

– Lower global goods demand leads to lower trade

Further financial contagion freezes lending and damages sentiment

– Euro zone sovereign debt crisis weighs on bank balance sheet, thereby restricting lending

– Debt problems and austerity further limit government support when private sector and consumers hesitate and look to retrench

Slower regional growth affects other economies– Consumption falling in major economies reduces

demand for exports from developing countries– Stimulus measures in developing countries may run

counter to the need to dampen inflation, especially when monetary stimuli are again deployed to help growth

Global energy demand falls as global economic growth spirals downward

– Sustained weakness in traditional major economies even slows down growth in developing countries, reducing physical demand for oil

…and supply rises

Saudi production stays high causing further over-supply

Strategic reasons:– Higher production pushing down oil prices, thereby

punishing Iran for as long as Iran remains as in OPEC’s presidency

– Disciplining other OPEC members to stay in line after very divergent stances after the OPEC meeting early in the year

Economic reasons:– As a member of G20, low prices from high

production could serve as the third leg of the global economic stimulus stool, when fiscal stimuli are limited by political gridlock or debt issues, and monetary stimuli at already low rates are increasingly less effective

Lower prices

Bearish risks #3: Double-dip, Saudi overproduction

2323

Trade-offs in taming rising inflation – Similar factors driving prosperity and inflation, so taming inflation

would involve further slowdown in economic growth– Previous growth models assuming unlimited supply of

resources, limiting price gains– Constraints in materials and food supplies amid strong demand

growth accelerating price rise– Higher primary goods prices possibly lifting costs faster than

what downstream sectors can pass on to consumers, or inflation becoming more severe

– Wage inflation comes from increased opportunities and increased appreciation of workers rights

Property bubble– Rising amounts of non-performing loans as a result of

policy directive to boost economy through bank lending and generally lax lending standards

– Local governments raising more debt to finance construction projects either for “show” or to boost local economy as signs of achievements

– Corruption-driven lending

Social discontent – Rising economic disparities due to severely uneven

growth and income distributions– Weak checks-and-balances of governments breeding

excessive use of power and corruption

Environmental degradation– Worsening air and water pollution feeding further social

discontent– Health degradation limiting productivity – Environmental degradation, particularly water, limiting

further growth

The drag from weak global growth– Shift from export-led growth to internal consumption driven

growth possibly too gradual amid deteriorating conditions in traditional foreign markets and lower expected growth in the future

– Rising wages eroding competitiveness in the global labour arbitrage, squeezing export-focused enterprises with lower revenue and higher costs

Intrinsics Extrinsics

Bearish risks #4: Chinese economic shock scenario

24 24

Flat to lower demand amidst rising supply from domestic and friendly sources to displace imports with…

– Slow economic growth, efficiency measures, and fleet turnover to keep demand flat to lower

…Rising domestic production– Bakken production gaining on successes with horizontal

drilling and hydraulic fracturing– Deep water Gulf of Mexico growing on improvements in

drilling technology and discoveries of major reserves, despite the Macondo oil spill

…Increasing Canadian imports– Imports from strong ally and neighbor reducing

dependence on other sources– Republicans looking to push a decision on XL in 60 days

as opposed to 2013 in the Senate

…Biofuel mandates still in place– Use of ethanol continues to displace gasoline

US liquids import requirements could fall to 6.15-m b/d by 2022, of which 3.5-m b/d would be from Canada

– US total liquids production for 2010 at 7.5-m b/d, potentially increasing 3.5-m b/d to 11-m b/d in 2022

– US consumption in 2010 was around 19.15-m b/d, potentially decreasing to 17.15-m b/d in 2022

Source: State of North Dakota, EIA, Citi Investment Research and Analysis

Western Canada Oil Supply

-

5001,000

1,5002,000

2,500

3,0003,500

4,000

2005 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E

000s

b/d

Total Supply Light Heavy

Source: CAPP, Citi Investment Research and Analysis

0

100

200

300

400

500

600

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

North Dakota Montana

k b/d

North Dakota production reportedly at 540-k b/d in January 2012

Bearish risks #5: Accelerated US energy independence

2525

North American crude and NGLs could nearly double from 14-m b/d in 2010 to 25-m b/d in 2020-22

The obstacles are mainly political, rather than geological or technological:– Environmental factors, particularly in the US– Revenue sharing and the rights of competing groups,

particularly first nation issues in Canada– Constitutional, particularly in Mexico

Developing a natural gas surplus faces fewer obstacles, certainly in the US and Canada, but include:– Politics of resource nationalism in the US– Canadian politics impeding adequate export pipeline

development– Mexico: restrictions on import of foreign capital, human

resources, technology– In all cases, North American natural gas could support

globally competitive energy intensive industries, with energy input costs amongst the lowest worldwide

Source: EIA (updated May 9, 2011)

Abundant shale plays, accessed by hydraulic fracturing and horizontal drilling technology, are the key driver behind North America becoming the

globe’s “energy island” by 2020

Bearish risks #5: North America, the new Middle East?North America is poised to be a growing hydrocarbon net exporting center, with the lowest cost natural gas feedstock in the world, propelling exports of energy-intensive goods from petrochemicals to steel

26

Appendix A-1

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