JP Morgan Commodity Outlook 2012

www.morganmarkets.com

Global Commodities Research 05 December 2011

Commodity Markets Outlook and Strategy

Commodities Year Ahead 2012: Brave new world

Commodities

Colin P. Fenton (1-212) 834-5648

[email protected]

JPMorgan Chase Bank NA

Jonah D. Waxman, CFA (1-212) 834-2203

[email protected]


Lawrence Eagles (1-212) 834-8107

[email protected]


Michael J Jansen (44-20) 7325 5882

[email protected]

J.P. Morgan Securities Ltd.

Scott C Speaker (1-212) 834-3878

[email protected]


See page 15 for analyst certification and important disclosures. J.P. Morgan 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.

Exhibit 1: Our view

Strategic allocation Underweight Portfolio weight 1% to 3% Path forecast Negative near-term TR followed by bounce in 2012

12M TR forecast DJ-UBS: +6% GSCI: +10% JPMCCI: +12%

Tactical overlay

Long 2013 ICE Brent calls (k=$125)Long Feb-12 CMX goldLong 2015 NYM natural gas straddles (k=$5.00)Long Spring 2012 NYM natural gas put (k=$3.50)

Source: J.P. Morgan Commodities Research Policy failures in the US and Europe have darkened prospects for

potential and actual economic growth heading into 2012. This, in turn, has resulted in a poor near-term outlook for the benchmark indices in commodities, which are not as supply constrained as a year ago.

After several months of a cautious posture, we downgraded the asset class to underweight two weeks ago. We expect outright total return losses in the benchmark indices in the short run, with an elevated chance for a large and sudden swoon in spot prices should the Eurozone fracture and disrupt global trade flows, though that is not our base case.

On the 12 month horizon, the outlook is more favorable, as near-term economic damage will likely force a significant policy reaction that establishes the necessary floor for the next commodity advance. Elements of this reaction are already coalescing. In doubt are the costs needed to elicit this remedy and the pain in taking the fiscal medicine.

Geopolitical risks are more two-sided than in early 2011: the potential for a sudden drop in Iranian crude exports (perhaps self imposed) or Venezuelan oil products is largely offset by the return of Libyan barrels and the potential for various presidential contests (e.g., US, France, China, Venezuela) to spur supply-side efforts to contain energy prices.

Consequently, as 2012 approaches, we want to be underweight commodities (1% to 3% long portfolio weight) in the strategic allocation. At the same time, on a tactical basis, we continue to favor owning Cal 2013 Brent calls (k=$125), Feb-12 CMX gold, and Cal 2015 NYM natural gas straddles (k=$5.00), though we hedge the risks to industrial production through a put on Spring 2012 NYM natural gas. Like last year, we believe “the volatility is the message”.

Commodity Markets Outlook and Strategy

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Global Commodities Research Commodity Markets Outlook and Strategy

05 December 2011

Colin P. Fenton (1-212) 834-5648 [email protected]

The Outlook for 2012: Brave new world

Two weeks ago (Nov 22), we downgraded commodities to underweight from neutral. The main drivers were: (a) a sudden and sharp deceleration in physical metals prices, which we interpreted as evidence of an incremental slump in manufacturing activity outside of the US, particularly in China and Europe, (b) the failure of the G20 meeting in Cannes and the US Deficit Supercommittee to get anything done, signaling that the largest funders of the IMF still have not gotten their arms around the gravity or immediacy of the global debt crisis, (c) Germany’s resistance to funding an IMF bailout of Europe through the ECB, leaving the underfunded EFSF on the rails, and (d) the ongoing failure of European policymakers to agree on some form of fiscal coordination in the Eurozone, threatening a domino effect all the way back to the AAA sovereign borrowers.

On the 1-to-3 month horizon, commodity total return indices are most likely to decline, while underlying volatility will likely increase, limiting the portfolio diversification benefits that are the essential rationale for a strategic allocation. This outlook suggests greater value in US Treasuries for the risk averse and greater value in DM large-cap equities for optimists who believe downside risks will soon resolve.

A few hours after our downgrade, the flash China PMI reading for November was released: at 48.0, it was the weakest report in three years. The next day, a German bond auction failed to reach its target raise. Two days after that, an Italian bond auction failed. By the end of the weekend, S&P had lowered its sovereign credit rating for Belgium, ahead of downgrading a number of US banks (including ours) the next day and Australian banks then soon afterward.

These developments underscore the validity of four truths that appear to have been lost on non-risk-takers who think the Deficit Supercommittee’s flop was a non-event: (1) the European and US debt crises are not hermetically sealed off from each other, (2) conditional probabilities are vitally important, (3) global markets, such as gold, will implicitly

price the risk of a sovereign credit rating change, regardless of whether an agency thinks or says it does not plan to make a change, and (4) the Supercommittee missed an opportunity to lift global confidence by tapping into powerful seasonal sentiments of hope and good will.

On conditional probabilities, a German bond auction that follows a failed Supercommittee, amid conditions of illiquidity, is not going to proceed in the same way as one that happens after a counterfactual $4Tn deficit reduction. A $1.2Tn spate of automatic budget cuts is not an interchangeable risk with $1.2Tn in cuts reached through bicameral and bipartisan compromise. A Supercommittee that ends with US Senators promising to reverse the automatic cuts to Defense expenditures set out in the Budget Control Act of 2011 shifts risk.

Last week, in response to the sudden blizzard of incrementally bad news, six central banks announced coordinated action to lower borrowing costs on emergency F/X swap lines and to make multiple currencies available to distressed borrowers. Around the same time, in its first acts of accommodation in months, China lowered its reserve requirement ratio and promised to make infrastructure investment outside of its own borders―one of the items on our “scorecard” of what it would take to get us more bullish about commodities again. And in a notable volta face, Germany is now signaling it is warming to the idea of some kind of ECB-financed action through the IMF, as well as treaty revisions on sovereignty issues and member rights and obligations, to be determined in a EU summit on December 9.

Global markets, including commodities, have cheered these maneuvers. But the optimism seems naïve. First, the idea that the elusive grand bargain will be found in the next four days is a long stretch. Our European specialists emphasize that Germany’s aims are far more modest: a pragmatic funding solution in order to avert near-term catastrophe, not yet a political commitment for fiscal union. Second, the central bank action addressed liquidity but does little for the core problem of solvency. Moreover, while program extension is helpful, it does not prevent risk spreads from simply filling

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the gap: we note that LIBOR-OIS spreads are still widening, now 43bp in the US and nearly 100bp in Europe, according to Bloomberg data.

As we go to press, S&P has placed 15 Eurozone nations on CreditWatch negative ahead of the December 9 EU summit, including AAA-rated Austria, Finland, France, Germany, Luxembourg, and the Netherlands.

Against this somber backdrop, there are some rays of light. In oil, natural gas, corn, copper, iron ore, and other commodity markets, global production and trade patterns are undergoing historic structural changes that will likely not reverse. This reality will offer a number of novel and attractive opportunities across a wide gamut of commodity-related investments, many of which will likely become increasingly visible in 2012 even if economic and market conditions deteriorate as we expect in the near term.

In a Gold Rush spirit of ‘it’s less risky to sell shovels to miners than to try to live off mining’, this environment is likely to favor investors who correctly rank order conditional probabilities and are nimble in adjusting them as events evolve. Some of our favorite ideas, for example, are indirect strategies tied to natural gas infrastructure, rather than a direct investment in natural gas futures themselves. We anticipate enormous value creation in commodity finance projects involving gas liquefaction, storage, LNG carriers, and gas-fired power generation.

However, the ongoing OECD public debt debacle will continue to challenge the global economy through 2012 and beyond, even if Europe does manage to achieve some form of fiscal policy cooperation in the near-term, as we expect will happen. In November, the total public debt outstanding of the US crossed $15Tn for the first time. This debt is 5.8X larger than Italy’s and 32.5X larger than Greece’s. The US will have to come to terms with both this sovereign debt and the even larger debt held separately by consumers and state and local governments.

The essential solution to achieve “escape velocity” from the global debt and security crisis and advance to the next stage of the global

business cycle 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.

Chinese natural gas demand is growing at an 18% CAGR, against a domestic production CAGR of 13%. The deficit is now –15%, heading to –35% by 2015. China will increasingly look toward North America to fill this growing gap, at prices tied to North American gas basis, not the oil-linked mechanisms that have prevailed heretofore.

Petroleum

We expect oil to trend higher throughout 2012, but within a core range of $100 to $120/bbl, as global economic growth recovers from the 2011 oil price shock and oil balances tighten from the demand side. However, economic and geopolitical risks are elevated and could quickly bring step-change price shifts should the limits of producer rebalancing become tested by either supply or demand shocks. The recession in Europe and the new threat of a manufacturing slump in the United States and China will likely keep Brent crude oil prices in the lower half of our defined range for much of the first quarter, around $105/bbl, with prices rising gradually to $120/bbl by the end of 2012 as policymakers finally make the tough decisions they have so far avoided (Exhibit 2).

Exhibit 2: ICE Brent crude oil price forecast and risks US$/bbl

Source: J.P. Morgan Commodities Research

Several governments in the Middle East and North Africa responded to the Arab Spring by increasing budget outlays on social assistance programs. These expenditures have raised

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budget breakeven levels (Exhibit 3). This spending is likely to continue to grow, which alongside increased domestic energy demand, creates producer incentives for oil prices to hold over $100/bbl.

Exhibit 3: Budget breakeven rate for selected producers US$/bbl

Source: J.P. Morgan Commodities and Economics Research

Libyan production is returning to the market quicker than even the most optimistic observers expected. Production is currently reported by the Libyan National Oil Company at 850kbd, and at the current rate of recovery could easily top 1mbd by the end of the first quarter. Also, Iraq is due to commission its Single Point Mooring export facility in early 2012, which could allow production to make a significant leap higher in the new year.

Kuwait, Saudi Arabia and the United Arab Emirates raised output by a cumulative 1.8mbd in response to strong demand at the end of 2010 and to fill the void left by Libya in 2011. As Libyan barrels return, these leaders in the producing community will likely adjust again in order to keep the global market in balance and maintain adequate spare capacity as 2012 progresses. If prices are to remain within the $100-to-$120 per bbl range, these OPEC swing producers will need to act with sufficient agility to avert the build-up of excess inventories, particularly in the first half of 2012. Though the requirements for action are not onerous, the ability to swing production is finite, and could be challenged in 2Q2012 should world economic growth weaken more than we expect.

If our projection for oil prices is borne out next year, GDP, rather than supply limitations, will

become the key driver of realized oil demand growth (Exhibit 4). A slower rate of oil price appreciation will create a downdraft on inflationary pressures in 2012, which in turn will help China and other Emerging Market (EM) countries to throttle back or reverse the monetary tightening seen over the past year.

Exhibit 4: Global oil demand growth Million barrels per day

Source: IEA, JODI, J.P. Morgan Commodities Research

This is already apparent in Beijing’s moves last week to loosen reserve requirement ratio, following the worst Chinese PMI number in about three years. While consumers are getting used to prices above $100 per bbl, sustained “three-digit” oil prices provide strong motivation for energy efficiency incentives. This factor too is already apparent in the 54mpg target for fleet efficiency that the Obama Administration and industry agreed upon last week—a doubling of the current realized level. It will take some time for slower price appreciation to aid EM retail markets, given lagged pricing mechanisms (Exhibit 5).

Spot WTI should continue to narrow from its record price gap against Brent crude oil as 2012 progresses, with pipeline reversals, future expansions, and a rapid build-out of rail infrastructure lowering the cost of moving crude from the WTI pricing point of Cushing, Oklahoma to the Gulf Coast. The recent aggressive easing of this spread represents the partial transition of the marginal barrel of onshore production from truck to rail. In 2012, while trucking will still be used to move oil from non-connected fields to hubs, and even from fields close to Gulf Coast refiners, we see rail as setting the marginal price for transporting WTI-based crude oil.

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Exhibit 5: Increase in Asian transport fuel prices from Jan-09 Percent

Note: Singapore prices are mean of Platt's Prices (MOPS) *Demand weighted Asian average. Source: Platts, J.P. Morgan Economics and Commodities Research

As the 2011 oil price shock works its way through the system in the New Year, the global economic outlook and related uncertainties become the most critical drivers of our oil demand forecast. In the near term, already-low consumer and business confidence are vulnerable to further disappointment, threatening our forecast of below-trend global oil demand growth of 1.1mbd. Should realized 2012 global GDP growth weaken toward 1% (the JPM View is 2%), the oil market would likely push the limits of producer rebalancing and the floor of our defined price range.

The second half of 2012 should bring with it a more optimistic economic tone, particularly if there are strong stimulus measures in EM economies. But as 2011 has shown, supply risks are manifold, and the limited spare capacity and inventory buffer leaves oil markets exposed to production outages. While international strategic stockpiles are more likely to be used in such an environment, particularly with election pressures in Europe and the United States, their usefulness is far from guaranteed—another lesson of 2011.

Natural Gas

For the first six-to-nine months of 2012, the North American natural gas market will likely remain fundamentally oversupplied. We see few gas-specific catalysts that could propel pricing materially higher in the near- to intermediate-term, save a record-cold winter throughout the key gas-consuming regions and drilling prudence in the upstream community. We currently assign a low probability to material

price recovery in prompt natural gas before 2013.

We have recently seen signs of increased coal displacement, but the growing year-over-year storage surplus and slow early start to the natural gas winter threaten high winter exit inventory. There has also emerged some doubt as to the certainty of full implementation of environmental standards, such as the Cross-State Air Pollution Rule (CSAPR), along the proposed timeline—another bearish development given our assumption of increased power generation demand for natural gas due to compliance and implementation.

Our 2012 gas price forecast assumes a generally progressive path, where periods of exceedingly low prices in the spring allow some recovery beyond through inventory adjustment (Exhibit 6). A wintertime rally on the front of the New York Mercantile Exchange (NYM) forward curve would allow producers to hedge intermediate-term tenors at more attractive pricing levels. It seems relatively clear that it will take lower prices in the near-term to impact the supply-side of the balance.

Exhibit 6: US natural gas working inventory Bcf

Source: EIA, J.P. Morgan Commodities Research

The first quarter of 2012 will be essential to price formation over the remainder of the upcoming year and into 2013, as capital expenditure decisions currently being made by the independent exploration and production (E&P) companies could lead to a tighter balance should a sharp drop in gas-directed drilling occur. E&P third quarter earnings reports suggest that more hedging is likely in the offing—should price cooperate. Our current

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assumption for winter weather is colder-than-normal but milder than last winter. Given that the market is headed toward a substantial year-over-year inventory surplus situation and December is not yet shaping up to be as cold as expected, it will likely be difficult for the market to rally significantly in the early part of 2012. To guard against this risk, we have presented the idea of owning $3.50-strike puts on the Mar-12, Apr-12, and May-12 NYM contracts.

This strategy has already shown value, with the option premium rising from $0.17 per MMBtu at introduction of the idea on November 10 to $0.29 per MMBtu on November 16. The premium is currently around $0.25 per MMBtu.

Exhibit 7: North America potential LNG export capacity Bcf per day

Source: Company Reports, J.P. Morgan Commodities Research

For more deferred tenors on the NYM natural gas forward curve, we continue to view upside price risks as greater than downside risks, but higher volatility as the principal story. There is a substantial disconnect between the weak fundamentals on the front of the curve and the bullish fundamental story in the back, which will likely be guided by increased environmental regulation, an emerging gas demand renaissance in North America, and the likelihood that the US and Canada will join the global marketplace through liquefied natural gas exports (Exhibit 7). Our assumptions about supply and demand in the 2013 tenor have been recently colored by the sticky rig count and notable lack of announced reductions in capital expenditure budgets from the E&P community.

Base and Precious Metals

The outlook for global industrial metals consumption has deteriorated significantly. Physical prices in Asia have softened materially in recent weeks, presaging the drop in Chinese demand that is now evident in manufacturing surveys. While we do think that the bottom is only months away, further negative macro news is still likely to pressure prices in the near-term.

As our economists note in their latest Global Data Watch, published today: “Our global PMI survey has posted readings below 50 for three consecutive months, with the orders index currently standing at 48.5. An important element of the global downshift reflects the onset of recession in the Euro area, where the November PMI orders index fell to 42.3. However, the combination of a significant fall in China’s November PMI reading (orders slipped to 45) and continued evidence of weakness in production readings across Emerging Market economies points to a broad-based slowdown outside the US…As the disappointment on demand looks likely to extend the inventory correction and interact with a tightening in credit conditions as European banks delever, the risks to the near-term EM growth outlook are skewed to the downside (Kasman et al, Let’s get cyclical, 5-Dec-11).

Putting the pieces together, though the latest round of announcements on policy is encouraging, it took a significant amount of damage in the real economy and in markets to get policymakers to respond and real action still remains elusive. We believe the turn in the global business cycle will arrive in Spring 2012.

Copper

The year that is ending was supposed to be constructive for copper prices, given a paper deficit of 350,000mt to 500,000mt and the prospect that massive destocking in China would deliver a significant surge in pricing and imports. While much of this view materialized as expected, Europe’s fall into recession in 3Q2011 and the sharper-than-expected slump in Chinese manufacturing in early November have caused metals use to fall short of projections.

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As actual metals use has faltered, the forward outlook has also darkened: government-sponsored spending projects are increasingly reaching completion and a capital-constrained private sector will struggle to pick up the slack.

As a result, even with significant Chinese destocking (about 500kmt in 2011), a declining trend in LME copper inventories, and a collapse in expected production for 2012 given the ongoing problems plaguing mine supply (strikes, declining grades, project delays, environmental constraints), the LME copper price has dropped by 17% this year.

In 2012, the global copper market is set to register another deficit. This time, it enters a deficit year with even less of a stock buffer than before—global exchange stocks are at about the lowest point in the past two years. However, decelerating demand, led by a downshift in China, seems likely to exert downward pressure on copper prices in 1H2012 before a rebound in market fundamentals engineers a strong rally into 2H2012.

China remains the global hub for copper demand, in terms of both levels and growth. We estimate China’s domestic copper stock has dropped toward 50-to-55 days of domestic coverage, and underlying consumption trends remain relatively robust even through growth is slowing (Exhibit 8).

In particular, commercial projects have been decelerating, but could pick up pace from a meaningful policy easing. While the target for affordable homes has been cut in 2012 from 10 million units to 8 million units, the lost copper use from this shift in the private sector housing plan will likely be more than offset by growth in commercial floor area under construction.

The story in China for copper is that policy has engineered a material slowing in consumption—primarily through constraints on private sector housing, the suspension of subsidies for white goods, especially in the rural areas, and a much slower automotive sector, especially for local brands—but actual consumption has held up well. A meaningful policy easing could quickly reignite copper demand through the property

channel in particular. As 2012 begins, we expect policy in China to be cautious, albeit less restrictive than in 2H2011. Full year demand in 2012 should be robust. We anticipate that copper will rally sharply from 2Q2012 into year end and lift prices from a level at or below $7000 per mt toward $9000 per mt.

Exhibit 8: China’s copper cathode inventory Thousand metric tonnes (RHS), days of consumption (LHS)

Source: Company Reports, J.P. Morgan Commodities Research

Aluminum

Aluminum, at prices below $2100 per metric tonne, is finding some support from shut-ins at higher cost marginal primary metal facilities in China. Chinese ingot production in 2011 has disappointed, largely due to power restrictions in a number of key producing provinces. Chinese primary aluminum production in 2012 will likely exceed 2011 levels by about 5 million metric tonnes, with most of this new production from relatively low cost capacity, albeit within the context of Chinese power costs. Chinese demand, the backbone of the global consumption base, will likely grow by at least 15% y/y in 2012. We project a global aluminum surplus of 1.4 million metric tonnes in 2012, falling toward a deficit of 400kmt in 2015.

Globally, aluminum demand should pick up cyclically in 2H2012, driven by the Chinese fabrication sector where capacity continues to expand at a rapid pace. However, global supply is on track to expand by at least 4mmt in 2012, and this ought to ensure that the market tends toward surplus. The key dynamics for market risk will continue to be on input cost inflation and how the primary aluminum sector will maintain margins in an oversupplied

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environment featuring elevated inflationary pressures on the input side.

Current aluminum prices ($2100 per mt) appear to be right on the break-even level. Should prices trade down to the $1850-to-$1900 area (likely in 1H2012), announcements of shuttering-in of capacity would likely quickly follow. This in turn suggests that dips toward lower price levels, while potentially sharp, will likely be short lived.

Nickel

Given our outlook for OECD nickel demand―which sees prospects for building and construction industries in Europe and North America as still lackluster—it is likely that stainless steel production will increase by less than 4% in these regions and could in fact be stagnant. This means that any growth remains very much a China and Asia-centric story. China is steadily on track to increase stainless production to around 15.5 million metric tonnes in 2012 from 14.0 mmt in 2011, accounting for more than half of global growth. While we expect a surplus in 2012, it will not necessarily be a surplus of refined nickel cathode or briquette. We see value in refined nickel at prices below $18,000 per mt.

Nickel will find it difficult to outperform other base metals in 2012 as Chinese demand has been displaced by the fast expansion of Nickel Pig Iron (NPI) production in China. Given this year’s NPI production is likely to exceed 55% of total primary nickel supply, we think the bottom is not yet near for nickel prices, and a drop towards $15,000-to-$16,000 per mt is possible in early 2012.

Chinese refined nickel production is also steadily on track to increase by 33% in 2011, further depressing prices. We assume there are inventories of both NPI and refined nickel being accumulated, placing additional downward pressure on prices in the early part of 2012. The Chinese nickel market will likely stay balanced in 2012, but the main swing factor will be large-scale NPI production.

Globally, on current production trends, the nickel market is on track for a period of multi-year surpluses and this will likely limit the upside in the nickel price to the $22,000-to-$24,000 per mt range. The current nickel price is already building in a solid surplus.

Yet, careful attention should be paid to production costs. Around one-quarter of operations are already facing negative “all in” production costs (i.e., C3 costs) and on a pure cash cost basis (i.e., C1), around 10% of the industry has negative cash flow. As such, the large surpluses that exist on paper are at significant risk of not materializing, should producer discipline rationalize output.

It will likely be some months before producers acknowledge this reality and start to retrench production in response to price. While we are bearish this market in the short-term, we expect the balance to clean up better in the medium term.

Lead

Our 2012 lead price forecast assumes consistent consumption growth in China and stable consumption levels globally. The Chinese government inspections on lead-acid battery plants for environmental compliance that began in the summer are nearing completion. Primary and secondary producers that passed these inspections are now in a position to capture market share from those firms that failed. We expect to see a wintertime pickup in sales orders.

Stronger orders are supported by price: lead at $2100 per mt is relatively inexpensive. Given still-strong demand from e-bikes and battery replacement requirements from a vastly expanded vehicle fleet, the coming year is on track for a modest deficit in China’s domestic balance, on the order of 30 thousand metric tonnes. Thereafter, the global deficit will likely deepen swiftly, as rising EM demand meets the reality of DM countries moving away from lead production for heath reasons.

Because of this structural imbalance, the global market will increasingly be reliant on growing secondary metal supply. At the same time, EM

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countries are themselves becoming more focused on environmentally-conscious development (as signaled by China’s summertime plant inspections), which will also begin to threaten the availability of secondary lead capacity in China as well as the production of batteries from recycled materials. Consequently, we expect to see significantly higher lead prices by the middle part of the decade, if not sooner. However, liquidity in futures markets will likely increasingly be a challenge for hedgers and speculators.

Zinc

We project the global zinc market will post a surplus in 2012 of 250kmt. Though this would be the smallest global surplus since 2007, this market remains weighed down by very ample inventory coverage in refined product. This is especially true in China, where a very modest domestic deficit in 2012 will likely do little to chew through the stock overhang. On the plus side for producers, pending shortfalls in global zinc concentrate production will likely support regional pricing.

China’s refined zinc production in 2012 will likely exceed this year’s level by 5%, with new smelting capacity coming on stream. Mine production may continue to grow even with prices in the range of $1900-to-$2100 per mt, as this level still leaves room for profit for low cost miners.

On the demand side, Chinese zinc consumption prospects are constrained by the tepid outlook for crude steel production. Conversations with steel producers during our recent trip to China reinforce our doubts about the near term outlook. We expect Chinese refined zinc imports in 2012 to be minimal: similar to, or less than, this year’s level of about 400kmt.

Gold

The ongoing failures of OECD policymakers to get their arms around the sovereign debt problems in Europe and the US are threatening confidence in the euro and the US dollar. So far, this deterioration has nonetheless been relatively dollar supportive, as neither the Swiss franc nor

the Chinese yuan have been allowed to appreciate sharply by their respective central banks. Similarly, fears of a global economic collapse have constrained the rally in gold. But the latter outcome still seems likely to us. We continue to believe this market will retest its all-time real price high of around $2500 per oz, as yet another round of fiscal and monetary policy easing is deployed in coordinated efforts by authorities around the world.

At time of writing, prompt gold is around $1722 per oz. Since Oct 20, the average intraday price change between low and high has been about +$32 per oz. At this volatility level, the Sep 6 all-time nominal high ($1920) could be touched within 7 trading days. There is also an underappreciated fundamental story in gold. Physical demand from India and China has doubled to 1.83 million kg per year since 2008. Production in South Africa, long the dominant producer, has halved to about 0.19 million kg per year since 2003. In between, Central Banks have emerged as some of the most forceful buyers of physical bullion: Russia’s gold reserves have increased by 14.5 million ozs since 2006, rising to 27.3 million oz from 12.8 million oz. A bullish tone to gold prices could arrive very swiftly, much as it did in August.

Agriculture

Global agriculture balances in 2012 will likely be fundamentally constrained, especially in corn, soybeans, and high-protein wheat; however, like 2011, this bullish complexion will likely not easily translate into investment total returns, given curve structure and significant price volatility. In January 2011, we warned that energy total returns would likely beat agriculture over the next year, even though grain ending stocks were likely to reach multi-decade lows and crude was already closing in on $100 per bbl. This assessment proved correct. Year-to-date in 2011, the S&P GSCI agriculture total return index is down 19.5%, while the S&P GSCI energy total return has gained by 7.7% over the same interval.

Looking forward, we continue to prefer energy, especially on a risk-adjusted basis, though we recognize that agricultural balances will likely

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be tight. Weather-related grain production disruptions are likely in 2012, due to a nascent La Niña, ongoing dryness in the US southern plains, flooding in Australia, and emerging drought in the Ukraine. These weather problems hold the potential to impact disproportionately the high-protein wheat market traded in Minneapolis, which we would once again prefer to the lower-protein market traded in Chicago.

The 2011/12 global corn balance will likely be in a deficit of 0.2%, dropping projected ending stocks coverage to a meager 46.1 days, the lowest level in nearly four decades. This follows a 2010/11 harvest that put the global corn balance into a deficit of 14.6mmt and pushed global ending stocks-to-use levels to the second-lowest level in the past 37 years.

With market focus largely centered on corn and wheat, soybeans may be the row crop to watch for a meaningful price reversal in 2012. As China ramps up its corn imports, planted acres in the US are likely to shift away from beans toward corn, and the global soybean balance is likely to shift into a deficit of 1.2%—the first since 2008/09.

Corn

The recent US corn harvest was disappointing relative to expectations, as dry and hot weather in the corn belt damaged yields and flooding of the Northern Plains and Missouri River destroyed planted acres. We project US corn stocks by September 2012 will be 703 million bushels, close to minimum operating levels of about 650 mil bu (5.0% ending stocks-to-use) (Exhibit 9).

But demand rationing is most likely to occur in US exports rather than in ethanol or feed, especially with improved production prospects in Ukraine and South America. Favorable growing conditions could see Ukrainian corn exports more than double from last year. Furthermore, improved returns for corn growers in South America have increased area planted with corn in Brazil and Argentina.

This dynamic of competitor nations undercutting US export prices in order to win market share is

a more bearish price dynamic than would be associated with price-driven supply rationing in feed or fuel uses. Thus, the US ending stock projection, like last year, may give an exaggerated sense of upward price potential and prospects for total returns in index investments.

Exhibit 9: US ending stock levels and stocks-to-use Stocks in million bushels (LHS), stocks-to-use in percent (RHS)

Source: USDA, J.P. Morgan Commodities Research

This is not to suggest that upside is capped or cannot be quite positive, despite our cautious outlook. In prior years, China has participated in the corn import market sporadically and for short periods. However, we expect to see a sustained and growing Chinese presence in the global corn trade over the next five years.

As China’s middle class grows and becomes wealthier, meat consumption (especially pork) will continue to increase, driving demand for corn and soybeans for feed. Pork prices in China have risen by more than 28%y/y. We expect Chinese corn production in 2011/12 will not exceed 183 million metric tonnes, falling well short of domestic demand (about 189 mmt).

Our latest forecast suggests 4 mmt of Chinese corn imports in 2011/12, although there is considerable upside to this estimate (Exhibit 10). Beijing currently allows corn imports only from the US, Thailand, and Peru. We expect Argentina soon to join this list, with cargoes possible as soon as early 2012. We project the global corn balance will be in a deficit of 0.2% in 2011/12, with stocks-to-use near decade-low levels.

0%

10%

20%

30%

40%

50%

60%

70%

0

1,000

2,000

3,000

4,000

5,000

6,000

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2011

F JP

M

Ending stocks (mil bu)

Ending Stocks-to-use (%)

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Exhibit 10: China's corn imports Thousand metric tonnes


Soybeans

The poor US weather conditions that adversely affected corn production also reduced US soybean production. Meanwhile, Chinese soybean imports are likely to reach the highest level in at least four decades. Chinese crush margins using imported beans from the US and Brazil have been positive since September (we surmise because the Chinese government lessened pressure on crushers to freeze prices on soybean products). Anecdotal evidence on product quality suggests that Brazilian beans are more popular with Chinese buyers because of higher protein content in the meal. Lower production prospects in the US and higher Chinese soybean imports could tighten market fundamentals in 2012. Our forecasts suggest a deficit of 1.2% in the global soybean balance.

Wheat

Wheat production in the Black Sea region rebounded significantly from drought-plagued 2010 production levels. Russia ended its wheat export ban on July 1, 2011 and has since returned as a major global supplier, with exports expected to more than quadruple from last year. Barring significant capacity constraints, Russia could remain a major exporter into 2012.

Even though our models suggest that total global wheat production could remain comfortable heading into 2012, higher-protein wheat varieties will still likely be in tighter supply. Another emerging risk is that a severe drought has set in throughout Ukraine’s autumn planting season, which could significantly diminish

wheat production and exports in 2012/13. The Ukrainian farm ministry announced that Ukraine could import 1.3 mmt of wheat in 2012/13 as continuing drought conditions may damage production of the wheat crop planted in the fall of 2011. This would be the largest import volume since 2003 and could curtail exports next year.

In the US, wheat production will likely be disappointing, as significant portions of Texas, Kansas, and Oklahoma continue to suffer from “exceptional” drought conditions (Exhibit 11). This is likely to negatively impact production of hard red winter wheat. Also, while total wheat harvest quantities in Australia are expected to be about 26 mmt, similar to last year, early harvest results suggest low protein levels, and heavy rains in eastern Australia could be further depleting wheat quality. Therefore, even though our global wheat balance implies a 1.5% surplus, the spreads of KBOT and MGE wheat contracts against CBOT will likely trade wide.

Exhibit 11: Kansas winter wheat yields Bushels per acre


0500

10001500200025003000350040004500

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

F U

SDA

2011

F JP

M

0

10

20

30

40

50

60

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

F JP

M

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Implications for risk and valuation

We believe natural gas will emerge as a dominant commodity theme in 2012, anchoring a wide range of investment opportunities within the commodity asset class and across other asset classes. For example, whether gas prices rise or fall in 2012, the necessary build-out of global distribution infrastructure (e.g., pipelines, liquefaction terminals, LNG carriers) will highly favor specialty metal and logistics companies, as well as steel-related metals, such as nickel. J.P. Morgan analysts who cover companies in these industries include Joe Allman, Rodolfo Angele, Fred Lucas, Corrine Png, and Benjamin Wilson. We encourage you to consult their research for cross-market investment ideas.

US natural gas offers a potential solution for escape velocity from the current phase of the global financial mess, though any escape likely will be a bumpy ride for many years to come. This bumpiness appears absent in forward NYM natural gas options prices, where Calendar 2015 ATM straddles can be bought today for about 20% in implied volatility terms. This is a noteworthy fact, given that volatility is mean

reverting, sometimes violently so in the hardest-to-store commodities, like natural gas. Among all commodity markets, only electricity is harder to store. As the Cal2015 NYMEX natural gas contracts become more prompt, we believe Cal2015 implied vol will be substantially higher than it is priced today. Our conviction in this view is reinforced by the backwardation in the term vol curve and the historical distribution of implied volatility since 1993. Recent measurements of actual volatility, the phase of the business cycle, the stage of the commodity supercycle (year 12 of projected 25), and the term structure of the volatility curve suggest that a roll up to 40% or higher by expiry enjoys a meaningful probability.

Consequently, as 2012 approaches, we want to be underweight commodities (1% to 3% long portfolio weight) in the strategic allocation. At the same time, on a tactical basis, we continue to favor owning Cal 2013 Brent calls (k=$125), Feb-12 CMX gold, and Cal 2015 NYM natural gas straddles (k=$5.00), though we hedge the ideas through owning a put on Spring 2012 NYM natural gas. Like last year, we continue to believe the volatility is the message.

Commodity total return forecast tables Percent

Source: Source: S&P, DJ, Exchanges, J.P. Morgan Commodities Research. Note: total returns are gross returns before fees, data as of 5-Dec-11.

Forecast2008 2009 2010 2011YTD Next 12 Months

S&P GSCI -46.5 13.5 9.0 0.9 10.0

Energy -52.4 11.2 1.9 7.7 14.0Non-Energy -31.1 16.9 26.3 -12.9 1.9

Industrial Metals -49.0 82.4 16.7 -18.3 2.5Precious Metals 0.5 25.1 34.5 18.8 6.0Agriculture -28.9 3.8 34.2 -19.5 0.0Livestock -27.4 -14.1 10.5 -0.6 4.0

JPMCCI -35.0 20.5 13.8 -1.4 12.0

Energy -42.3 10.4 0.6 5.4 16.0Non-Energy -27.4 30.3 27.8 -7.3 8.0

Industrial Metals -45.8 80.6 16.1 -17.3 11.0Precious Metals -4.6 28.2 39.0 17.1 8.0Agriculture -21.1 10.1 35.5 -12.8 6.0Livestock -24.3 -12.7 15.3 2.4 2.0

S&P GSCI Enhanced -41.1 21.6 12.2 2.4 12.0

DJ-UBS -35.7 18.9 16.8 -10.3 6.0

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Price ForecastsUSD, quarterly averages

Source: Exchanges, J.P. Morgan Commodities Research. Data as of close on December 5, 2011. Forward prices are the average of the contracts in the quarter.

Current 2010 2011 2012 4Q2012 2012 average

Units Price average 1Q 2Q 3Q 4Q average 1Q 2Q 3Q 4Q average y/y change y/y change

EnergyWTI Crude US$/bbl 100.99 79.61 94.60 102.34 89.54 94.00 95.00 98.00 105.00 110.50 116.00 107.00 23.4% 12.6%

forward price 101.13 101.23 100.50 99.64 100.63Brent Crude US$/bbl 109.81 80.34 105.52 116.99 112.09 108.00 110.50 105.00 110.00 115.00 120.00 112.00 11.1% 1.4%

forward price 109.51 108.62 107.56 106.42 108.03Natural Gas US$/MMBtu 3.46 4.38 4.20 4.38 4.05 3.75 4.10 3.95 3.50 4.25 4.70 4.10 25.3% 0.0%

forward price 3.48 3.59 3.71 3.96 3.68Precious MetalsGold US$/t oz. 1731 1228 1388 1508 1703 2150 1687 1925 1875 1850 1825 1869 -15.1% 10.8%

forward price 1731 1582 1733 1756 1759 1764 1753Silver US$/t oz. 32.14 20.24 31.95 38.32 38.81 35.80 36.22 35.00 34.10 33.60 33.20 34.00 -7.3% -6.1%

forward price 32.14 35.30 32.29 32.73 32.78 32.83 32.66Platinum US$/t oz. 1533 1614 1793 1788 1773 1900 1813 1900 1900 1925 1935 1915 1.8% 5.6%

forward price 1533 1555 1559 1562 1552Palladium US$/t oz. 645 530 790 760 752 800 775 820 840 860 880 850 10.0% 9.7%

forward price 645 737 646 648 648 648 648Base MetalsAluminum US$/mt 2133 2178 2511 2603 2404 2200 2430 2350 2450 2550 2600 2500 18.2% 2.9%

forward price 2133 2413 2138 2145 2169 2197 2162Copper US$/mt 7922 7548 9634 9152 8979 7250 8754 8250 8500 9250 9000 8750 24.1% 0.0%

forward price 7922 8922 7938 7953 7963 7965 7954Nickel US$/mt 18493 21823 26913 24181 22010 18000 22775 20000 21000 22000 22000 21250 22.2% -6.7%

forward price 18493 22899 18507 18523 18536 18543 18527Zinc US$/mt 2039 2163 2399 2254 2227 1900 2195 2000 2100 2150 2200 2113 15.8% -3.7%

forward price 2039 2230 2037 2053 2071 2086 2062Lead US$/mt 2105 2152 2592 2546 2452 2000 2400 2175 2250 2275 2300 2250 15.0% -6.3%

forward price 2105 2424 2118 2135 2152 2169 2143Tin US$/mt 19964 20418 29927 28598 24630 20500 25915 22500 23000 24000 25000 23625 22.0% -8.8%

forward price 19964 25780 19992 20017 20031 20043 20021AgricultureCorn US$/bu 5.80 4.30 6.71 7.32 6.93 6.40 6.80 6.70 7.00 6.80 6.30 6.70 -1.6% -1.5%

forward price 5.80 6.69 5.91 5.99 5.89 5.54 5.83CME Wheat US$/bu 5.99 5.86 7.91 7.50 6.96 6.50 7.22 6.90 7.20 7.10 7.30 7.10 12.3% -1.7%

forward price 5.99 7.09 6.12 6.29 6.51 6.80 6.43Soybeans US$/bu 11.26 10.49 13.82 13.61 13.55 12.20 13.30 12.30 12.50 12.20 12.10 12.30 -0.8% -7.5%

forward price 11.31 11.47 11.55 11.50 11.46Soybean Oil US cents/lb 50.07 42.12 57.13 57.26 55.76 51.80 55.50 54.40 52.80 53.40 56.00 54.20 8.1% -2.3%

forward price 50.07 55.05 50.50 51.06 51.42 51.20 51.04Soybean Meal US$/short ton 281.1 299.5 368.7 353.9 353.1 325.0 350.2 358.3 354.3 366.8 337.8 354.3 3.9% 1.2%

forward price 281.1 339.22 284.8 290.6 296.0 295.4 291.7Sugar US cents/lb 24.08 22.28 30.50 24.46 28.68 23.50 26.78 22.00 21.50 21.50 21.00 21.50 -10.6% -19.7%

forward price 24.08 23.70 23.32 23.42 23.63

2011 2012

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Oil

Lawrence E. Eagles

[email protected]

(1-212) 834-8107

David G. Martin [email protected]

(44-20) 7777-0211

Jeff G. Brown [email protected]

(65) 6882-2215

Ryan F. Sullivan [email protected]

(1-212) 834-3935

Upadhi Kabra [email protected]

(44-20) 7777-8241

Metals

Michael J. Jansen [email protected]

(44-20) 7325-5882

Yubin Fu [email protected]

(44-20) 7777-2902

Natural Gas

Scott C. Speaker [email protected]

(1-212) 834-3878

Shikha Chaturvedi [email protected]

(1-212) 834-3245

Agriculture and Strategy

Jonah D. Waxman, CFA [email protected]

(1-212) 834-2203

Megan V. Hansen [email protected]

(1-212) 834-3747

Elizabeth M. Volynsky

[email protected]

(1-212) 834-4021

Colin P. Fenton, Head of Global Commodities Research and Strategy [email protected]

(1-212) 834-5648

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Disclosures

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JP Morgan Commodity Outlook 2012

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