1. Wall Street and the price of oil
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Presentation to:
New York Energy Forum
Wall Street and the price of oil
Adam Robinson
Energy Research Analyst
April 10, 2008

2. Agenda Wall Street and today’s oil price environment
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Agenda
Wall Street and today’s oil price environment
Wall Street and the term structure of oil prices
Wall Street and the volatility of oil prices
Conclusions

3. Wall Street and the price of oil
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Wall Street and the price of oil
Wall Street’s financial crisis temporarily breaking the links between the physical and financial markets for crude oil
Wall Street facilitating huge financial demand for commodities
The investment vehicles created by Wall Street to express that financial demand are artifacts of a less liquid market and create distortions in the term structure of oil prices
Even when markets are functioning normally, if banks build up a concentrated position in the options market at particular strikes, they can affect crude oil price volatility 1

4. I. Wall Street and today’s oil price environment
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I. Wall Street and today’s oil price environment

5. There are two markets pricing oil for delivery in five years
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There are two markets pricing oil for delivery in five years
Long-dated NYMEX WTI (and natural gas) have shot up
WTI vs. HH NG 5-yr out in $/boe + 40/60 blended price
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Source: Bloomberg. 2

6. There are two markets pricing oil for delivery in five years
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There are two markets pricing oil for delivery in five years
While the price of US reserves has flat-lined
Price of US reserves valued through US M&A activity
Wall Street facilitates the reserve market vis-à-vis advising and financing M&A. Advantage of looking at this market is that speculators/portfolio diversifiers generally do not participate. Wall Street, by facilitating the M&A market, can help us gauge the price of oil or perhaps even the speculative impact on prices.
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Source: John S. Herold Upstream M&A Review 3

7. Higher costs in the US could explain the difference…
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Higher costs in the US could explain the difference…
The market for US oil assets provides another data point for long-dated crude oil prices, holding US costs and politics constant
US Oil Production Costs
US Tax Regime and Political Uncertainty
Global Supply-Demand Balance
Value of a US Oil Field
These should trend together if fundamentals are behind WTI price changes
Value of Long-Dated WTI
Financial Demand for Crude Oil
Global Supply-Demand Balance 4

8. But despite what some are saying, US costs are flattening
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But despite what some are saying, US costs are flattening
US PPI Oil Producer Cost Indices are flattening (3-month moving average)
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Source: US Bureau of Labor Statistics 5

9. US drilling cost rise and fall even more stark
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US drilling cost rise and fall even more stark
US Drilling cost PPI (3-month moving average)
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Source: US Bureau of Labor Statistics 6

10. Even deepwater drilling costs are flattening
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Even deepwater drilling costs are flattening
Deepwater Rig Day-Rates
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Source: ODS-Petrodata and Lehman Brothers Estimates 7

11. So with costs flat, what explains the markets’ divergence?
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So with costs flat, what explains the markets’ divergence?
Relative to the fundamentals, either US reserves are undervalued or WTI is overvalued
Index of WTI/HH prices vs US reserves valued through US M&A activity
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Source: John S. Herold Upstream M&A Review 8

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Wall Street turmoil may be allowing an arbitrage between the two markets to open
Rule of thumb for the US: To find the arbitrage equilibrium, multiply reserve valuation by 3-4x to get expected minimum realized blended oil/gas price
Assumptions
Cost of proposed reserve acquisition: $15/bbl
Lifting cost: $8/bbl
R/P Ratio: 10 years
Required minimum ROCE: 10%
Government take = 40%
Math
Total capex = $15/bbl for 10 years = $150/bbl of daily capacity
That requires $15/bbl of daily profit to make a 10% return on capex
Assuming a 40% tax rate, profit before tax must equal $25/bbl
Then you must cover capex of $15/bbl and lifting costs of $8/bbl, meaning your overall realized price must equal $25+$15+$8= $48, or 3.2x your capex cost
If reserve owner expects a 20% ROCE, then expected realized oil price is $73
A 30% ROCE could be achieved if $100/bbl is realized 9

13. How Wall Street may have broken the markets’ link
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How Wall Street may have broken the markets’ link
What may be preventing the arb?
No access to credit to purchase assets
Many producer hedges already underwater
Counterparty risk and margin calls
Grain elevator operators in 2008
Inability especially of big players to hedge all production
A big hedge could cause a major price drop (Mexico in Dec-06)
Arb may work again if:
Confidence rebuilds in the US banking system
Financial instruments to mitigate these risks become more widespread 10

14. So is NYMEX overvalued or reserves undervalued?
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So is NYMEX overvalued or reserves undervalued?
Cost of exploration and price of US oil assets are substitutes
Could provide an anchor to price of oil reserves as the arb closes, forcing NYMEX WTI down
But in the meantime, in the absence of producer selling or links to the market for physical oil reserves, WTI prices can trade purely on financial flows 11

15. So what might be fair value for long-dated NYMEX WTI?
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So what might be fair value for long-dated NYMEX WTI?
Higher US costs appear to explain much of the rise in long-dated WTI prices until the divergence in October 2007.
US monthly PPI data regressed against average monthly 5-yr out WTI prices 12

16. And if natural gas holds its gains, oil could drop even lower
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And if natural gas holds its gains, oil could drop even lower
Stronger natural gas prices take pressure off of oil to rise in order to provide an incentive for upstream investment
US monthly PPI data regressed against average monthly 5-yr out WTI prices 13

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Meanwhile, thanks to Wall Street, financial prices have no physical price ceiling and can trade on almost anything
While correlations have recently strengthened, there is no longer-term relationship to justify the moves in the medium-term
WTI 1M vs. DXY Index
WTI 1M vs. Inflation*
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*Inflation compensation as measured by the difference between 10-year treasuries and 10-year TIPS
Source: Bloomberg, Lehman Brothers Estimates 14

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What happens when Wall Street turmoil removes the physical ceiling on the financial market?
Investors buy commodities as an inflation hedge, pushing up commodity prices, which then pushes up inflation
How does this play out?
Oil stocks build if the price is too high for the physical market, causing suppliers to over-produce and consumers to under-consume
But eventually inflation will be real or it won’t
If commodity price inflation leads to core inflation, Fed will have to put a floor on interest rates, the dollar rallies and commodities tank
If the deflationary impact of the US recession offsets commodity price inflation, then investors have an expensive + unnecessary hedge vs inflation and commodities tank
Meanwhile:
High commodity prices may add to other pressures on the economy and aggravate the US recession and lower physical demand further
High commodity prices may aggravate any transmission of US economic weakness to the rest of the OECD as well as emerging market economies 15

19. II. Wall Street and the term structure of oil prices
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II. Wall Street and the term structure of oil prices

20. Wall Street as creator and seller of commodity indices
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Wall Street as creator and seller of commodity indices
After years of Wall Street going after pension funds, they finally started to listen early this decade
Efficiency Frontier for a 60/40 Portfolio of Stocks (S&P500) and Bonds (U.S. Agg.)
Return
60% LBCI
16%
15%
14%
13%
25% LBCI
12%
11%
10% 9%
0% LBCI 8% 7% 6% 7% 8% 9%
10%
11%
12%
13%
14%
Volatility
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Source: Lehman Brothers estimates 16

21. GSCI spot and roll returns, 1999-2007
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Wall Street benchmark commodity indices are channeling investment into the wrong part of the curve
Ideally a passive investor would buy a commodity and never sell it. So why invest at the very front of the futures curve?
In 1990s, liquidity only in the front
Producer hedging or OPEC’s market power kept curves backwardated
Passive investors are now herded into the front
GSCI roll has been negative since 2004
GSCI spot and roll returns,
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Source: Bloomberg, NYMEX, S&P GSCI 17

22. But liquidity should no longer be an excuse
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But liquidity should no longer be an excuse
Particularly in the energy sub-indices, liquidity in the back of the curve has grown much more quickly than in the front
Nymex WTI futures avg open interest
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Source: Bloomberg, NYMEX, S&P GSCI 18

23. 4/1/ :14 PM
Investing exclusively in the front contract exposes passive investors to unnecessary risks
Risk 1: Other investors agree with index players
Risk 2: Index overcrowding
Risk 3: No way to exit the front contract after a spike
Indices gave back all of their gains in natural gas after Hurricane Katrina and in oil after the Iraq War of 2003 in the four months following the spike
If oil spikes, it can hurt performance of non-energy commodities by weakening the global economy
LBCI vs LBPB after 2003 Iraq War
LBCI vs LBPB after Hurricane Katrina
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Source: Lehman Brothers estimates 19

24. Wall Street and new structured product innovation
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Wall Street and new structured product innovation
To address these risks, Wall Street is designing new indices that are likely to catch on, spreading index length along the oil curve and taking pressure off the front during roll periods
New indices should focus on roll methods
Should balance transaction costs vs footprint
New indices should invest in longer-dated futures but also take open interest into account
If the ideal is the spot return ex-roll yield, why not buy the contract whose spot + roll return best correlates to the spot return?
Lehman Pure Beta boosts index returns regardless of commodity weights used
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Source: Bloomberg, Lehman Brothers estimates 20

25. III. Wall Street and the volatility of oil prices
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III. Wall Street and the volatility of oil prices

26. 4/1/ :14 PM
Oil market volatility likely to stay high for fundamental and flow-related reasons
Tight markets become more volatile as demand runs up against supply limits, then retreats with additions of new capacity
Stealth supply + black hole demand obscure signals about tightness
Wall Street option-positioning now means that banks will tend to buy in a rising market and sell in a falling one, accentuating price swings
1M WTI Implied ATM Volatility (30-day rolling average to March 26, 2008)
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Source: Bloomberg 21

27. Telling the 2007 price story as a Wall Street options trader
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Telling the 2007 price story as a Wall Street options trader
It all started with producers using options to hedge the falling market of late 2006
Banks sold $50 and $60 puts to producers
Producers sold $70 and $80 calls to banks
Banks also sold lottery tickets to hedge funds
As oil prices dropped in early 2007, banks sold oil to hedge
Once oil turned around, banks bought back their hedges
As oil pushed to $70, banks started selling to hedge calls bought from producers
On the other side of $80, banks had to worry about the calls they sold to hedge funds, buying and pushing prices quickly to $100
If hedge funds roll out their strikes to $120-$150, prices and volatility could continue to run higher 22

28. Telling the 2007 price story as a Wall Street options trader
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Telling the 2007 price story as a Wall Street options trader
WTI Dec 07 vs WTI Dec calls
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Source: Bloomberg, as of 29 Oct 07 23

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IV. Conclusions

30. To conclude, Wall Street matters on many levels
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To conclude, Wall Street matters on many levels
Wall Street’s current crisis has made it difficult and scary for physical players to access the oil markets
Meanwhile it has made it easier for financial players to enter
And through options it has created more volatility in the market in certain times 24

31. How will Wall Street change the markets going forward?
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How will Wall Street change the markets going forward?
As more banks make markets and longer-dated liquidity deepens, it will be easier for producers to hedge oil price risk
May take some risk premium out of oil prices
Wall Street also to convince pension funds to transfer length from front to back
Curve may shift to contango
Current Wall Street turmoil may exacerbate China overcapacities vis-à-vis the stock market
Refining business about to undergo massive changes
Requires new risk management solutions from Wall Street 25

32. Most critical, Wall Street needs to fund frontier investments
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Most critical, Wall Street needs to fund frontier investments
If cost inflation ending, non-OPEC supply may finally respond to higher prices
Financing critical to development of the deepwater, arctic, biofuels, GTL and oil shale
Wall Street will be critical to financing the supply gap post-2010 if the politics in OPEC do not improve
OPEC production capacity growth vs. global oil demand growth
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Source: ODS-Petrodata and Lehman Brothers Estimates 26

33. Analyst Certification and Disclosures
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Analyst Certification and Disclosures
Analyst Certification
I, Adam Robinson, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
"To the extent that any of the views expressed in this research report are based on the firm's quantitative research model, Lehman Brothers hereby certify (1) that the views expressed in this research report accurately reflect the firm's quantitative research model and (2) that no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report."
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