Clean Technology Initiation Report 03-11-2009 November 2009 ©Argus Research Company, Independent International Investment Research Plc and Pipal Research Group 2009. All rights reserved. Commodities: Resurgence Explored Commodities Initiation Report 25-11-09 Page 2 About PSQ Analytics PSQ Analytics is a ground-breaking research service for smaller and mid-cap companies on AIM and the Main Market, launched with support of the London Stock Exchange in March 2009. The PSQ Analytics service makes available the deep and broad research expertise of three leading independent research firms, whose traditional client bases would generally comprise global blue-chip companies and institutions. Working within a commercial framework that assigns companies randomly to an expert research provider, and developed with support from the London Stock Exchange, PSQ Analytics is able to reassure the investor audience that the work conducted is rigorously objective, and independent. 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Commodities Initiation Report 25-11-09 Page 3 CONTENTS 1.  Executive Summary .................................................................................................................................... 4  2.  Key characteristics and trends.................................................................................................................. 7  2.1. Business cycles and commodity prices ........................................................................................................ 7  2.2. Historically, inflation adjusted commodity prices have declined .................................................................. 8  2.3. The commodities sector is highly capital intensive ..................................................................................... 11  2.4. The commodities super cycle...................................................................................................................... 12  2.5. The gold-oil-dollar relationship.................................................................................................................... 14  3.  Key drivers................................................................................................................................................. 16  3.1. Strong demand from emerging markets ..................................................................................................... 16  3.2. Under-investment in the commodities sector.............................................................................................. 18  3.3. Huge disparity between per capita consumption amongst countries.......................................................... 19  3.4. Global infrastructure sector set to attract huge investment ........................................................................ 19  4.  Key challenges .......................................................................................................................................... 20  4.1. Relationship between technological advances and commodity prices....................................................... 20  4.2. Political, social and environmental challenges............................................................................................ 22  5.  Commodities sub-sectors ........................................................................................................................ 24 5.1. Upstream oil and gas .................................................................................................................................. 24  5.2. Mid- and down-stream oil & gas.................................................................................................................. 30  5.3. Coal & consumable fuels ............................................................................................................................ 37  5.4. Ferrous & base metals ................................................................................................................................ 49  5.5. Gold & other precious metals & minerals.................................................................................................... 58  6.  Case Study: Junior Mining & Exploration .............................................................................................. 65 Appendix – Profiles of Cleantech companies listed on the London Stock Exchange / AIM .................. 71   Disclaimer....................................................................................................................................................... 111 Commodities Initiation Report 25-11-09 Page 4 1. Executive Summary Although there is significant debate concerning the precise point at which we stand in the commodities super cycle, most analysts would agree that the current cycle started around 2003. The global financial crisis in the latter half of 2008 brought the cycle to a temporary halt, with prices of most commodity classes, with the notable exception of gold, tumbling from historical highs. Since the nadir of the crisis in March 2009, the global macroeconomic environment has stabilised somewhat and commodity prices have partly recovered. Our outlook for commodities is robust over the long term as the global economy recovers and emerging economies continue to grow rapidly. This report aims to provide a broad overview of the commodities sector, opening with a look at the key characteristics and trends of the sector as well as the key drivers and challenges. Following on from these broader themes we focus on the individual industries which make up the commodities sector. The commodities sector can be broadly classified into agricultural commodities and non-agricultural commodities. The scope of our research encompasses the energy commodities and the metals group, while excluding agricultural commodities and commodity chemicals. In this report we have classified the commodities sector into five major industries and explore each in terms of their framework, demand- supply dynamics, sector trends, demand drivers and recent transaction activities. The discussion on each sub-sector ends with our outlook. The five sub-sectors we focus on in this report are: Upstream Oil & Gas sector – comprises oil and gas exploration and production companies Mid- & Down-stream Oil & Gas – covers the midstream businesses of oil and gas transportation and storage as well as the downstream refining business Coal & Consumable Fuels – includes two of the most prominent primary fuels used in electricity generation - coal and uranium Ferrous & Base Metals – the ferrous metals section covers the iron ore and steel industries, while the section on base metals looks at the industry as a whole and also looks at the specific cases of copper and aluminium Gold & Other Precious Metals & Minerals – the industries covered include gold, silver, diamond and platinum group metals (PGM) The last section of the report is a case study on Junior Mining & Exploration. This section examines the investment trends and factors determining investment in the Junior Mining & Exploration sector and also the global transaction activities in the sector. To provide our readers with further insight into the smaller end of the commodities sector we have profiled 19 companies operating in this space which are listed on the London Stock Exchange and AIM. These can be found in the appendix of the report. Key characteristics and trends The commodities sector is extremely capital intensive in nature. Acquisition, exploration and development of reserves involve significant capital expenditure over a long period of time due to long project gestation periods, which explains the high leverage levels that characterize the industry. Although the supply of commodities is limited, technological progress has contributed towards reducing extraction costs, improving efficiencies and productivity in their production and usage, thus keeping a check on prices. Development of substitutes and change in consumption patterns has also been influential in keeping commodity prices under control. A notable trend identified in this report is that commodities, as an asset class, have lagged behind inflation over the longer term. This may be of particular interest to investors who are currently using commodities as a hedge against inflation. There are, of course, short term deviations from this trend, especially during times of uncertainty such as these, and one particular commodity class, crude oil, is a exception to this norm reflecting cartelization of the industry and lack of economically viable substitutes. There is a well established correlation between business cycles and commodity prices. In this report we look at the current commodity super cycle and analyse its main drivers. What is interesting now is whether the recent global recession will impact the commodities super cycle or whether the strength of the emerging markets will carry the sector through, resulting in a resumption of the super cycle. Although there are clearly challenges ahead, the current signs are good, with China expected to grow at 8.7% in 2010 according to the World Bank. Key Drivers: -China and India are transitioning from being producers of primary commodities to net consumers. Consistent with this change, global commodity price dynamics have displayed a stronger correlation with the growth trajectory of these Commodities Initiation Report 25-11-09 Page 5 economies. The rapid economic growth in the BRIC countries, particularly China, is in turn associated with profound structural changes such as trade liberalization, economic reforms, industrialization, and urbanization. These structural changes are making these markets more energy and resource intensive than ever, fuelling their growing appetite for commodities. -The historically low investment in commodity infrastructure could lead to the ushering in of another commodity boom in the medium to long term. With economies gradually emerging from the global downturn, demand for various commodities is expected to pick up. -Due to the chronic underinvestment in the past, supply may fail to keep pace with rising demand in the long term, thereby pushing commodity prices northward. We believe this indicates the tremendous need and scope for investments in mining, exploration, processing and refining activities, going forward. -As an end market for commodities, the infrastructure sector, which is attracting huge investments as a result of the numerous global stimulus packages, will be a key driver of the demand and prices of commodities. Both the developing and the developed economies will play a crucial role in such investment mobilization, albeit towards different needs and avenues. Significant investment will be required to fuel infrastructural expansion in the case of emerging economies and towards maintenance and upgrade of existing infrastructure in the case of developed economies. Key Challenges: -Political, social and environmental concerns are perhaps the biggest challenges facing companies operating in the commodities sector. Some of the most mineral rich countries around the world have historically suffered from chronic political instability and uncertainty. Furthermore, opposition from local communities, government opposition to foreign ownership of natural resources and legal and political uncertainties comprise other bottlenecks experienced by the commodities sector. -Mining and exploration activities, despite their contribution to economic development, are inherently associated with various environmental concerns. Every effort to mine and extract mineral resources inevitably leads to bio-degradation in various forms and to varying degrees. Controlling and reducing environmental degradation is one of the biggest challenges for countries across the globe against the backdrop of a constant trade-off between economic growth and the protection of the global environment. -Scientific development has played a significant role in shaping the commodities sector. New technologies have increased supply of many commodities to a level that exceeds relative demand due to enhanced productivity. Ongoing scientific progress, coupled with environmental concerns, is also encouraging the recycling of metals, adding to secondary sources of supplies. Outlook: -Oil & Gas For upstream oil and gas, a stable pricing outlook for oil and gas points towards steady growth in exploration activities and investment. However, we anticipate the recovery of global demand for oil and natural gas to be gradual until the end of 2010 as most economies recover slowly from the global downturn. Beyond that, the emerging markets, particularly China and India, will contribute most to global oil and natural gas marginal demand increases over the long term. Increase in exploration activities will trigger the expansion of storage and refining capacities. This will, in turn, have a positive impact on the margins of mid- and downstream companies. We also expect these companies to benefit from deregulation of oil products retail prices in the long term. -Coal & Consumable Fuels Our outlook for coal remains strong as economies around the world recover from the recent economic downturn. With economic activity picking up, demand for thermal as well as coking coal is expected to witness healthy growth, primarily driven by emerging economies. The secondary inventory build up, in our opinion, is not significant enough to derail the recovery in the industry. With respect to uranium, while there is lack of visibility on the replacement of ageing reactors and delays encountered by many of the new units under construction, we believe robust growth in Chinese nuclear power generation and supply bottlenecks will be the key growth drivers in the near to medium term. In the longer term, uranium has the potential to perform well as countries around the world expand their nuclear power generation capabilities as a hedge against growing fossil fuel prices. Commodities Initiation Report 25-11-09 Page 6 -Ferrous & Base Metals The large scale capacity build-up of steel and the fragmented nature of the industry has somewhat damaged the fundamentals of the steel industry. This, coupled with rising competition from substitutes like aluminium, plastics and other composites will exert pressure on steel prices over the long term. However, we believe the stimulus packages from governments worldwide will lend support to steel prices over the near to medium term. We expect the rise in steel consumption, due to such government support, coupled with the cartelized iron ore pricing, to lead to a surge in annual contracted iron ore prices over the near to medium term. Nevertheless the over-dependence on a single product, steel, for its entire consumption and the large differential between production cost and selling prices points towards a decline in iron ore prices over the long term. Growth in demand for base metals in the near term will trail the levels observed in the current super commodity cycle as key consuming industries are yet to recover from the impact of the economic downturn. Robust demand for metals from emerging economies will be offset by low consumption in developed countries. Hence, after more than doubling from the low levels in late 2008, we have a neutral outlook on base metal prices with a negative bias over the near to medium term. However, we expect rising consumption from emerging economies and gradual weeding out of high cost plants to tighten the demand-supply dynamics, to support a rise in base metal prices over the long term. -Gold & Other Precious Metals & Minerals Gold prices have risen over the last few years to record levels. Gold appears to have regained its position as a store of value during the recent economic turmoil. Countries such as China have diversified their reserves away from traditional assets such as US Treasuries and have accumulated physical gold leading to a huge spike in prices. As the current de- facto global currency, the US dollar, continues to depreciate, gold continues to rise in value. This trend will continue in the near term and thus we expect gold prices to stay strong in the near future. However, we believe that as the US economy displays sustainable improvement, the value of the US dollar against other major currencies will improve and thus will regain investor confidence as the de-facto global currency. When this happens, we believe gold prices will fall sharply from these lofty levels. Case Study: After subdued investment activity in smaller mining companies over the past year, we expect junior mining companies to attract renewed investor interest and capital flow going forward. With demand for minerals set to rise yet again, fundamentally strong junior mining companies will attract acquisition interest from large mining companies, in their bid to prop up depleting reserves and generate better economies of scale. All major mining stock exchanges have witnessed increased trading activities in junior mining stocks over the recent past. However, the growth in the number of listings of mining companies has been much faster at the London Stock Exchange. An increasingly competitive environment and access to a wider set of investors are key factors contributing to the growing importance of the London Stock Exchange for this sector. Commodities Initiation Report 25-11-09 Page 7 2. Key Characteristics and Trends 2.1. Business cycles and commodity prices The expansion and contraction phases of a business cycle can range from as short as 6 months to as long as 6 years. While cycles cannot be determined accurately in advance they can be influenced to an extent by appropriate monetary and fiscal policies. Empirical evidence demonstrates a high correlation between business cycles and the price of commodities. Historical perspective • A slump in commodity prices in the late 1970s to the mid-1980s can be attributed to a deceleration in real economic growth in developed countries as well as high capacity and production of metals. Real economic growth declined from 4.9% in 1976 to 2% in 1980 and further down to 1.1% in 1982. • An acceleration in growth from 1983 to mid-1988 followed as economic activity picked up in developed countries. • This short-lived recovery was followed by another slump in commodity prices from mid-1988 to 1992 mainly due to weakening demand from durable goods manufacturers in Japan and the US. • From 1993 to mid-1997 there was a strong recovery in demand for commodities, driven by robust growth in emerging economies. • The Asian financial crisis precipitated the next slump in commodity prices from 1997 onwards. • A resurgence in commodity prices following a recovery in the Asian economies in 1999 was followed by a slump caused by the recession in the US during 2001. • 2003 marked the beginning of a new cycle, with commodity prices reaching a peak in 2008. Major contributors to the bull market were the robust growth in demand from China and housing boom in the US. However, recession in the US and the subsequent global downturn during the year resulted in a decline in demand for commodities and a slump in prices. Exhibit 1: Aluminium price growth / Global GDP growth 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% -40.0% -20.0% 0.0% 20.0% 40.0% 60.0% 1975 1980 1985 1990 1995 2000 2005 Growth rate in aluminium prices Growth rate in world GDP Source: Bloomberg, The US Geological Survey Commodity prices peak during the late expansionary phase Commodity prices peak during the late expansionary phase of a business cycle, characterized by strong profits and escalating stock prices, when strong demand for commodities has exhausted existing inventories and pressured supplies. Prices are weakest during the early stages of the business cycle when capacity utilization is weak and supplies exceed demand. Commodities Initiation Report 25-11-09 Page 8 However, in 2009, the recovery in commodity prices has taken place at a quicker pace than it did in the early 2000s recession, reflecting the robust demand from BRIC economies and inventory build up in China, helped by economic stimulus measures by governments, with low interest rates and surplus capital encouraging speculation. In 2009, the US government announced a USD787 bn stimulus package, while the Chinese government announced a USD586 bn program, including spending on housing, infrastructure, agriculture, health care and social welfare. The World Bank approved a USD4.3 bn loan to India to support its infrastructure development and boost its economic stimulus program. These government and multilateral agency efforts have translated into positive economic indicators such as strengthening Chinese industrial production data (+16.1% y-o-y in October 2009 compared to +12.3% y-o-y in August 2009), an increase in the global manufacturing purchasing manager's index (PMI – JP Morgan) from 53.0 in September 2009 to 54.4 in October 2009, improving US industrial production data (+0.9% in July 2009 compared to decline in the previous months of 2009), and rising energy and base metals demand in China and other countries Source: Bloomberg. These indicators suggest a recovery may be underway, with commodity and stock prices appreciating concurrently. Copper prices, considered to be a barometer of the global economy, have increased from last year's low of USD2,809 per tonne on 24 December 2008 to USD6,819.75 per tonne (+142.8%) on 20 November 2009. The oil price on the other hand has increased 144.3% from last year’s low of USD31.41 on 22 December 2008 to USD76.72 per barrel (bbl) on 20 November 2009. Production cuts and capex pullbacks impede supply during recovery During the 2008 recession, demand for commodities fell sharply as industrial activity declined. Demand for crude oil fell from 87.5 mn bbls per day (mmbpd) in 1Q 08 to 84.1 mmbpd in 2Q 09. The fall in demand saw crude oil prices trade in the range of USD30-USD50 per bbl between December 2008 and February 2009. As low realized prices prevailed, damaging bottom-line, many oil companies deferred expansion capex in 2009 to preserve capital and cash flow. • Suncor Energy Inc, the second largest oilsands producer in Canada deferred construction of its CAD20.6 bn Voyager upgrader. • Saudi Aramco delayed its USD8 bn capacity expansion plans for its Ras tanura refinery which would have raised capacity by 400,000 barrels per day (bpd). • Qatar and Exxon Mobil delayed the development of the USD5 bn Barzan gas field joint venture. However, demand for commodities has already improved. Crude oil demand was marginally above 2Q 09 at 84.6 mmbpd during 3Q 09. The International Energy Agency (IEA) expects consumption of oil to be 84.8 mmbpd in 2009 followed by growth to 86.2 mmbpd in 2010. Although capex cuts are a valid strategy in a depressed economic environment, deferral of production / capacity expansion could raise supply concerns in the future as there is a long gestation period before supplies come on-stream, which could potentially lead to another price spike. 2.2. Historically, inflation adjusted commodity prices have declined Although supply of commodities is limited, technological progress has reduced extraction costs, improved efficiencies in production and use, and kept prices in check. The development of substitutes and change in consumption patterns has also kept commodity prices under control. The impact of technological progress in reducing the average production cost has been most profound in aluminium. Until 1850 aluminium was more valuable than gold. However, following the introduction of electricity, the electrolysis process was developed, enabling extraction of aluminium from bauxite, which was available in abundance. With a sudden surge in supply, aluminium prices tumbled rapidly. With ready availability, aluminium was increasingly used to substitute other metals. As a result of this process, observed to differing levels in the history of the majority of commodities, inflation has outpaced commodity prices in the long term, although there have been short term deviations. Crude oil is a notable exception to this norm. The US’s dominant position in the global economy has led to most commodity prices being quoted in US dollars. Reflecting the long term availability of data, we have considered the CRB metals sub-index and US CPI as benchmark indices for metals and inflation respectively. US CPI has soared 665% from 1957 to date, surpassing the 563% gain in the CRB metal index during the same period. Commodities Initiation Report 25-11-09 Page 9 Exhibit 2: Inflation/ metal prices -100% 100% 300% 500% 700% 19571962196719721977198219871992199720022007CRB Metals Sub-index Consumer Price Index Source: Commodity Research Bureau (CRB), US Bureau of Labor Statistics Exceptional characteristics of gold and oil Gold differs from other metals as its major uses (investment and jewellery) are discretionary. While gold finds limited use in the real world, its character as store of value makes it an attractive investment asset, acting as a hedge against extreme events. Until the abandonment of the Bretton Woods System by the Nixon administration in 1971, the value of major global currencies was linked to gold, with the US dollar value pegged directly to the metal. The collapse of Bretton Woods led to a surge in gold prices from USD32 per ounce (oz) in 1971 to USD800 per oz in 1980. However, following the correction in price, the demand for gold subsided and the US dollar solidified its status as reserve currency. Although gold is trading at an all time high in nominal terms, inflation adjusted gold prices have declined from a peak of USD2,000 per oz in 1980. With approximately 98% of the gold ever mined still available for consumption, gold’s demand-supply dynamic is the worst of all commodities. While most other commodities perform well at the beginning of and during expansionary cycles, gold lags behind, with prices rising only after the cycle has overheated. Gold prices also exhibit an inverse relation to US dollar strength, as US dollar weakness drives investment away from US dollar denominated assets to 'safe haven' gold. Over the long term, but interrupted by short term deviations, gold prices are expected to trail inflation and other commodities. Exhibit 3: Inflation/gold prices -100% -50% 0% 50% 100% 150% 200% 1980198319861989199219951998200120042007Gold Consumer Price Index Source: World Gold Council, US Bureau of Labor Statistics While gold accumulates, oil depletes. Oil demand and prices have exhibited a different trend from other commodities, beating inflation, as a result of the following factors: Commodities Initiation Report 25-11-09 Page 10 • Cartelization/OPEC: While 1910-1960 inflation adjusted oil prices averaged USD17.1 per bbl, the formation of OPEC cartelized the industry and restricted supply. Following OPEC formation, the average oil price in real term soared to USD37.6 per bbl from 1960-2009. • Universal substitute: A more fundamental reason for this contrarian trend is a lack of economically viable substitutes. Alternative energy sources have not been popular amongst consumers either due to higher implied cost or operational difficulties faced in their usage. Moreover, several petroleum derivatives have emerged as substitutes for other commodities, while almost all substitutes for other commodities require additional energy, further boosting oil demand. • Exhaustive - cannot be recycled: Metals can be recycled, adding to the potential future supply. Agricultural commodities are not recyclable but renewable. The global oil supply, however, will be exhausted with use. Exhibit 4: Historical crude oil price (USD per bbl) 0 20 40 60 80 100 120 186218721882189219021912192219321942195219621972198219922002Nominal Inflation Adjusted Source: Bloomberg, US Bureau of Labor Statistics, US Department of Energy Thus, while the US CPI has risen by over 665% since 1957, oil prices have risen 2,936% over the same period. Exhibit 5: Inflation / crude oil price growth -1,000% 000% 1,000% 2,000% 3,000% 4,000% 5,000% 6,000% 19571962196719721977198219871992199720022007Crude Oil Source: Bloomberg, US Bureau of Labor Statistics Commodities Initiation Report 25-11-09 Page 11 2.3. The commodities sector is highly capital intensive Acquisition, exploration and development of reserves in the metals and energy commodities industries are extremely capital intensive. Capital expenditure also needs to be sustained over a long period as gestation times for exploratory and developmental projects and activities are very long. This explains the high leverage levels that characterize the industry. In the case of oil and gas, huge expenditure on exploration, extraction, refining and transportation is required. Costs depend on factors including location (onshore/offshore), size of the field, type and structure of the rock and information required. OPEC has the lowest average production costs in the oil industry, primarily due to the large and reasonably accessible oil reserves of many of the member countries. The oil price rise between 2003 and 2008 encouraged exploration of alternative sources for oil extraction, notably oil sands and shales. While these resources are plentiful, extraction remains a very cost intensive process. When the economic downturn set in, it was these companies that were hardest hit, as fixed costs exceeded the market price of oil. In the case of metals such as steel, manufacturing involves smelting of raw materials, refining to remove impurities, casting into semi-finished goods, and eventually rolling into finished products. The eventual cost of a steel plant can run into billions of dollars. • Reliance Industries (India) incurred expenditure of INR450 bn (approximately USD10 bn) to develop the gas fields at Krishna-Godavari basin during the period 2003-2008. • Suncor Energy, the second largest oilsands company in Canada, is expected to incur capex of USD10.7 bn to build an upgrader with 245,000 bpd capacity. • ArcelorMittal, the world’s largest steel maker, has plans to build two steel plants at a combined cost of USD20 bn in two Indian states, which will have a combined capacity of 24 mn tonnes (Mt) of steel. • Posco, the South Korean steelmaker is expected to invest USD12 bn to build a steel plant in Orissa, India, which would have a capacity of 4 Mt per annum. Given that the capex required in the industry is significant, there is also a major risk when prices and demand for commodities fall. In such instances, companies cut capex so as to protect cash flows. For example, Arcelor Mittal, which had an average 16% capex to revenue ratio over the period 2005-2006 cut its capex to 5% of revenues in 1H 09. Such cuts are vital to meet future capital requirements. Long gestation periods It usually takes years from the exploratory phase to discovery, testing, development and delivery of the final product. The mining, oil and gas sectors typically have to undertake surveys before and during the exploration, development and production phases. Geological surveys alone can take more than 3 years for an indication of metal/oil deposits on the site. Obtaining the licenses to conduct exploration and drilling is also time-consuming and bureaucratic. The exploratory drilling, which helps to identify the quality and quantity of deposits, often takes more than 4 years. If it is viable for the project to proceed, development of fields and setting up of platforms or rigs in the case of an offshore oil site, could require anything between 1 to 7 years. A company in this sector needs to have strong capital backup as it has to operate on zero revenue inflow for a number of years. • One of Canada's largest producers of crude oil, Imperial Oil's Kearl project was initially projected to produce 100,000 bbls of bitumen per day in 2011 on completion of the initial phase of the project. The company has been working on this project since 2004. The project received necessary authorization to commence preliminary work on the site only in June 2008. To add to the delays, the economic crisis led to postponement of the project by 8 months. The company is not expected to begin production from the project until late 2012. • In June 2005, Posco signed a memorandum of understanding with the Orissa government in India for a 12 Mt capacity steel plant to be built in three phases by 2016, with production scheduled to begin by the end of 2011 at the completion of the first phase. Construction, which was originally scheduled to begin in April 2008, has been delayed and is now expected to start only in 2010. The delay was due to protests by farmers in the region. Commodities Initiation Report 25-11-09 Page 12 Heavily leveraged Commodities companies, with the exception of some of the largest players like Exxon Mobil and EnCana Corporation, tend to operate on high leverage, given the capital intensiveness of the business. During the recent downturn, smaller companies became desperate for capital. While the healthier among them, which were in a position to reduce operating costs and capex, survived, some were forced to file for bankruptcy. Catalyst Energy Group Inc. and Trident Resources Corp. were among the energy companies that didn’t survive the crisis in 2008. The crisis did not spare large companies either. Reflecting easy liquidity available in the market, many mining companies had entered into acquisition deals over 2005 - 2008, including Arcelor Mittal, Tata Corus and Rio Alcan. However, with the deals made at the peak of the commodity cycle, valuations were significantly high. The credit crisis disrupted expected cash flows. Balance sheets were severely dented by the additional debt burden. Companies were forced to dilute equity at the trough of the cycle (Tata Steel, Rio Tinto), denting long term prospects for existing shareholders. 2.4. The commodities super cycle We have seen that commodity prices move with business cycles and have been beaten by inflation over the long term. When plotted over a longer time horizon it can be seen that some cycles have extended over periods of several years, and consist of smaller cycles with multiple troughs and peaks. These super cycles are typically multi-decade phenomena and can extend up to 50-60 years. Super cycles are started or sustained by events that are more profound than the triggers that spur regular business cycles. These include large-scale wars, very large scale industrialization, major technological innovations, a major shift in demography or socioeconomic factors, especially in countries with large populations, and transition of major economies into higher stages of development in a more abrupt than gradual manner. In the past, the world has witnessed 3 commodities super cycles: 1. The 1880 commodity super cycle involving industrialization and urbanization in the US, which lasted for 40 years, involving the industrialization and urbanization of 100 million people. 2. The 1960 Japanese industrialization super cycle, which lasted 20 years, involving 30 million people. 3. The current super cycle initiated in the year 2003, led by industrialization in China and India, which involves industrialization of 2.5 bn people. Price rise illustrations: • LME copper prices averaged USD2,690 per tonne in 1990 and maintained a range of USD1,521–2,955 per tonne until 2003. In 2004 prices averaged USD3,046 per tonne and then doubled in just two years to average USD6,684 per tonne in 2006. Copper prices reached an average high of USD8,693 per tonne in 2Q 08 and plunged thereafter. • WTI crude prices traded in the range of USD15-31 per bbl between 1991 and 2003, and trebled over the period 2003-2008, increasing from USD31 per bbl in 2003 to USD97 per bbl in 2008. • LME aluminium prices traded in the range of USD1,143-1,773 per tonne between 1991 and 2003 and increased to USD2,473 per tonne in 2008. Commodities Initiation Report 25-11-09 Page 13 Exhibit 6: Aluminium and copper prices (USD per tonne) 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 Year199219941996199820002002200420062008Aluminium Copper Source: Bloomberg The Reuters Jefferies Commodity Price Index is a commodity price index compiling 19 commodities traded on the NYMEX, CBOT, LME, CME and COMEX exchanges. The commodities are weighted based on importance to global trade and are divided into 4 groups. Group 1 consist of oil based products with 33% weighting, Group 2 consists of highly liquid commodities with a weight of 42%, while Group 3 (liquid commodities) and Group 4 (commodities that may provide valuable diversification) are given weights of 20% and 5% respectively. Exhibit 7: Reuters Jefferies Commodity Index 0 50 100 150 200 250 300 350 400 19561960196419681972197619801984198819921996200020042008Source: Bloomberg Factors behind the current commodity super cycle Rising demand from India and China Over the period 2004-2008, China and India reported average real GDP growth rates of 10.4% and 8.6%, compared with growth rates over the period 1997-2003 of 8.0% and 5.6% respectively. Increased outsourcing to these regions has been a key factor driving growth, with the wide availability of cheap labour and skilled workforce. According to data released by the Central Statistical Organisation, India's per capita income has increased from INR26,003 in the year ending 31 March 2006 (FY 2006) to INR37,490 in FY 2009. Economic growth led by this and other factors, requires heavy investment in infrastructure, consuming large quantities of commodities. Chinese steel imports increased from 70 Mt in 2000 to 444 Mt in 2008. Commodities Initiation Report 25-11-09 Page 14 Demographics According to the Population Reference Bureau (World Population Data Sheet), the world's total population increased from 3 bn in 1959 to 6 bn in 1999 and is expected to reach 9 bn by 2043. Although the absolute rate of increase has remained more or less constant, the main differentiating factor in the period following 1999 has been the concentration of population growth in emerging Asia, where the infrastructure is far from adequate. China's population has grown by 4.3% over the period of 2001-2008 (CAGR of 0.6%), while India's population has grown by approximately 11.8% over the same period (CAGR of 1.6%). Although the total world population increased at a CAGR of 1.4% over the period 2000- 2008, significantly exceeding China's growth, the high bases from which China and India have grown have led these two economies to grow to account for 37.3% of the total world population in 2008. Another demographic factor driving the demand and prices for commodities in these countries is their relatively young population. The proportion of productive population (15-64 years) in China’s total population was 72.1% while for India it was 63.3% compared to 67% for the US and EU combined Source: CIA World Factbook, July 2009 est. While the proportion of productive population in India is currently relatively low, two factors place India on a high potential growth trajectory – (a) the huge size of the population presents a large pool of productive population in absolute terms; (b) the high youth proportion presents very strong future growth potential. Although India has a relatively high overall dependency ratio of 60% (compared to China’s 45%), the high youth dependency ratio of 52% and low old age dependency of 8% Source: US Census Bureau implies strong future growth potential. Post economic crisis scenario The current commodity super cycle has been interrupted by the 2008 economic crisis. As this cycle was initiated by the economic boom in China and India, a rebound and continuation will depend on the fundamentals of these economies. Over the near to medium term, a higher expected growth rate in these countries based on increased liquidity, is expected to support commodity demand. The Indian Prime Minister’s Economic Advisory Council forecasts the country's GDP to grow by 6.50%-6.75% for FY 2010, and 7.5% for FY 2011, while the World Bank forecasts China's GDP to grow by 8.4% in 2009 and 8.7% in 2010. Over the long term, we expect high growth in commodities demand from these countries based on population growth, increase in the middle class population and a high proportion of young people in India, indicating continuation of the commodity super cycle. 2.5. The gold-oil-dollar relationship The US dollar and commodity prices are inversely related to each other. The recent depreciation of the US dollar is a key factor in the recent appreciation of commodity prices. Exhibit 8: Correlation between US dollar index and oil prices Exhibit 9: Movement of US dollar index and gold prices -100% -50% 0% 50% 100% 150% 200% 250% 300% -40% -20% 0% 20% 40% 60% 80% 100% 19801984198819921996200020042008Change in oil pricesChange in US dollar indexDollar Index Crude Oil -60% -40% -20% 0% 20% 40% 60% 80% 100% 19801984198819921996200020042008Dollar Index Gold Source: Bloomberg Source: Bloomberg The credit crisis in the US and the subsequent flooding of US dollars into the economy in an effort to revive it, have raised doubts over the US dollar's continued position as the global reserve currency. Given that the US trade deficit is increasing, countries that export goods in large quantities to the US, like China, have been faced with a situation in which their reserves are rapidly losing value as the US dollar depreciates against other major currencies. Oil producing nations Commodities Initiation Report 25-11-09 Page 15 are also faced with the depreciation of the US dollar wiping away the value of their holdings. A few Arab nations and some of the world's largest consumers of oil are rumoured to be planning a long term severance from pricing oil trades in US dollars Source: The Independent. Recently Iran has made an announcement that it will no longer sell its oil in US dollars but in a basket of currencies including the Euro and the Japanese yen. Exhibit 10: Surge in money supply in the US -80% -60% -40% -20% 0% 20% 40% Jan-06Jun-06Nov-06Apr-07Sep-07Feb-08Jul-08Dec-08May-09Money supply in the US economy Source: Bloomberg Early in 2009, China called for an end to the use of the US dollar as the reserve currency and a stronger role for the IMF’s special drawing rights. China has stated that it is diversifying its foreign exchange reserves, totalling USD2 trillion (the highest in the world), to other instruments including gold, Euros, Japanese yen and other currencies. In June 2009, China sold USD25.1 bn worth of US treasury bills to bring its holdings to USD776.4 bn, signalling its intent. This bearish development for the US dollar in turn indicates a positive development for commodities. Although the price of gold and crude oil are positively correlated, their relationship is not linear. The reason for the fluctuation of the gold-oil ratio (the quantity of oil one can buy with an oz of gold) is the disproportionate relative movement of gold and oil prices to shared drivers and the varied factors affecting their prices. Over shorter time horizons the gold-oil ratio is impacted by global macroeconomic factors. Gold prices surge during recessionary phases or periods of uncertainty and fall during bullish phases; crude oil prices fall during economic downturns and increase with expansion in economic activity. Hence, the ratio rises in a recessionary global environment and declines during the expansion phase of economic cycles. A rise in oil prices also signals an inflationary trend, particularly in countries which are large consumers of crude oil such as the US. This in turn results in investors seeking diversification of dollar assets into other assets such as gold. However, while crude oil reserves are fast depleting, gold accumulates, adding to future potential supplies. Therefore, the secular trend is a gradual decline in the gold-oil ratio, with occasional short term volatility. Exhibit 11: Trend in gold/oil ratio 5.0 10.0 15.0 20.0 25.0 30.0 35.0 1985 1989 1993 1997 2001 2005 2009 Source: Bloomberg Commodities Initiation Report 25-11-09 Page 16 3. Key Drivers 3.1. Strong demand from emerging markets The profile of emerging markets has transitioned from that of a producer to a consumer of primary commodities. Consistent with this change, global commodity price dynamics have displayed an increasingly stronger correlation with the growth trajectory of these markets. While the commodity price rise of the 1990s correlated with a period of rapid growth in ASEAN economies, Thailand, Malaysia, Indonesia, Singapore, and South Korea; the subsequent fall in commodity prices was triggered by the Asian financial crisis of the late 1990s. More recently, the resumption of growth in developing markets China and India has spurred global commodity prices again. Increased money supply - a catalyst for investment In 2001, the US Federal Bank (the Fed) started loosening its monetary policy in order to stimulate spending, reducing interest rates from 6.5% to 1% by 2003. This had a direct impact on the economies of the BRIC nations, with most of the increased money supply entering India and China. Increased money supply boosted demand for commodities in these markets, marking the beginning of the recent commodity super cycle. Prices of a number of commodities tripled over the period 2003-2008 led by a stark demand-supply mismatch and supported by market participant speculation. The recent economic crisis however, dried up investment, depressing commodity prices, particularly of metals and oil. In response, the Fed started to cut rates again, reducing the rate to 0%-0.25% currently. This, along with financial stimulus packages in various countries and the continuation of expansionary economic policies in China and India, is expected to support sustained demand for commodities from emerging markets. Exhibit 12: China - Money supply (M2) growth 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% Jan-08Mar-08May-08Jul-08Sep-08Nov-08Jan-09Mar-09May-09Jul-09Sep-09 Source: Bloomberg China and India: the key consumers of commodities going forward China: China's population increased by 4.3% over the period 2000-2007 to account for nearly 20% of the world's population. Population density also increased from 442 people per square km (ppsk) in 2000 to 2,104 ppsk in 2007. The country is experiencing rapid urbanization. In 2008, 46% of the Chinese population lived in urban areas compared to only 36% in 2001 Source: Bloomberg. The government has set a target for urban residents' per capita disposable income to reach RMB13,390 by 2010. Along with the government’s broader efforts to stimulate economic growth, these factors are expected to spur infrastructure and housing construction activities. China has directed much of its recent stimulus towards infrastructure, with USD220 bn allocated for infrastructure development overall, including USD54 bn specifically for rural infrastructure projects. With plans to build 12 major routes across the country from north to south and east to west, China’s expressway network is expected to stretch to 53,000 miles by 2020, longer than the 47,000 miles of roadways in the US Source: The Wall Street Journal. The country's eleventh five-year plan had already set out a target to build 1.2 mn km of rural roads over the period 2006-2010. There are also plans to build six passenger railway lines, and expand ten of its main airports. Commodities Initiation Report 25-11-09 Page 17 China has also implemented a host of other initiatives to develop its infrastructure. The foreign ownership limit in the telecom sector (mobile voice and data services) was increased to 35% in 2002 and further to 49% in 2003. Housing construction, which is one of the largest consumers of commodities, was supported by the reduction of the minimum down payment requirement for home buyers from 35% to 20%, and the retention of a low tax rate for construction companies (7% for city areas, 5% for county and township areas and 1% for other areas) Source: Beijing Local Taxation Bureau. Reflecting the positive impact of these measures, residential property sales increased at a CAGR of 23.7% between 2002 and 2006 in China Source: National Bureau of Statistics. The development of its infrastructure has already made China one of the most significant consumers of base metals and energy commodities in the world. Its share of global steel demand reached 30.7% in 2008 from only 17.3% in 1999, while its copper share rose from 13% in 2000 to 28.5% in 2008 Source: MEPS International and Dundee Wealth. Chinese iron ore imports registered a CAGR of 24.5% over the period 2003-2008 Source: Bloomberg. Going forward, China’s economic expansion and the resultant demand for commodities is set to continue (albeit at a slower rate), with China expected to consume 5% more steel in 2010 than in 2009 and 45.8% of expected total global steel Source: World Steel Association. India: Meanwhile, India’s infrastructure investment had risen from 4.9% of GDP in FY 2003 to 5.8% in FY 2009, while the country's eleventh five-year plan (FY 2007-2012) envisaged an outlay of over USD500 bn, taking infrastructure investment to 9.34% of the country's GDP in 2011-2012. This projected investment in infrastructure would require extensive participation from private players, which is targeted to rise from 19.8% in 2002-2007 to 30.1% in 2012. A large proportion of the investment has been allocated to power and road development. Investment in the country's power sector is expected to rise from USD17.7 bn in FY 2008 to USD42.9 bn in FY 2012, while construction of roads and bridges is expected to attract investment of USD17.3 bn in FY 2012, up from USD11.2 bn in FY 2008. In 2008, Indian Railways drew up a plan to upgrade rail infrastructure and procure new rolling stock, with an estimated spend of USD8 bn. This should boost economic activity and growth in other core as well as ancillary sectors of the economy, and will lead to considerably higher steel consumption within the country. To reach the country's investment goals, various measures have been adopted, including an increase in the FDI limit in the telecom sector (from 49% to 74%) to expand penetration, which currently stands at 37%. Other measures include benefits to infrastructure companies engaged in the maintenance of roads and highways in the form of exemptions from service tax, tax relief to housing companies (if ongoing projects are completed before 2012) and an enhanced interest subsidy for the purchase of houses valued at less than INR2 mn. India's iron and steel imports increased from a value of USD476.26 mn in 2003 to USD2,264 mn in 2007, registering a CAGR of 47.7%, while its crude oil imports increased at a CAGR of 6.5% from 32,527 thousand tonnes in 2004 to 39,246 thousand tonnes in 2007 Source: Bloomberg. Although India's commodity consumption level remains miniscule compared to China, the continuation of economic growth and focus on infrastructure is expected to sustain an increase in its demand for commodities. The Joint Plant Committee, which monitors the iron and steel industry in India, has projected steel manufacturing capacity in the country to increase to 100 Mt by 2018, up from the current level of about 31 Mt. Brazil and Russia – tapping production capabilities for domestic infrastructure needs Brazil and Russia differ from India and China in that they are net exporters of key commodities. Russia is a major producer and exporter of copper, gold and natural gas, while Brazil is an important iron ore producer. Meanwhile, demand for commodities in these two countries has been rising steadily, reflecting a growing focus on domestic infrastructure development. Both Brazil and Russia have capped exports to ensure greater use of domestically produced commodities to meet domestic infrastructure needs. The rapid economic growth experienced in the BRIC countries reflects profound structural changes including trade liberalization, economic reforms, industrialization, urbanization and massive investment in the power and infrastructure sectors. These structural changes are making markets more energy and resource intensive than ever, fuelling a growing appetite for commodities. Apart from driving commodity prices, the rapid transformation of the emerging markets into key consumers of commodities will intensify competition in trade and investment and will fundamentally reshape commodity market dynamics in the long term. Commodities Initiation Report 25-11-09 Page 18 3.2. Under-investment in the commodities sector After commodity prices normalized, following the oil crises of the 1970s, there was a prolonged period of under- investment in exploration, mineral processing, refining and transport infrastructure. This reflected a lack of incentives to engage in such capital-intensive activities, given the depressed pricing conditions seen during the period (see chart below). However, this led to a widening of the demand-supply gap which, amid the economic upturn since 2003, produced a sharp spike in commodity prices. Recent years saw renewed interest in exploration and development activities, however the onset of the financial crisis in 2H 08 (with its widespread retreat of capital and tumbling commodity prices) has put many investment projects on hold once again. Exhibit 13: Depressed commodity prices, 1980-2007 -200% -100% 0% 100% 200% 300% 400% 500% 1980198319861989199219951998200120042007Aluminium (USD/tonne) Iron ore (USD/tonne) Copper (USD/tonne) Crude oil (USD/bbl) Source: Bloomberg Natural gas is a case in point. Over recent decades, it became increasingly clear that reserves were declining. Falling Reserve-to-Production (R/P) ratios, accelerating field decline rates and dwindling investment were obvious cues for fresh investment in exploration and refining initiatives on a global scale. Despite these signs, natural gas consumers did not appreciate the importance of securing the long term purchase arrangements that would have provided gas producers with the incentive to increase exploration. The conservative mood of the market led to the diversion of exploration investment to quick payback drilling programs that would accelerate cash flow at the expense of reserve life. Similar imbalances arising from under-investment existed in the case of virtually every natural resource and base metal. In early 2008, the prices of most commodities rocketed, as consumption from all major economies increased rapidly, while supplies were limited as a consequence of the years of under-investment in mine development, processing plants, pipelines, railroads, and the other industrial infrastructure needed to produce and transport raw materials. In the oil sector, low prices from 1980-2006 prevented sufficient exploration and development of existing fields. Although soaring commodity prices over 2007-2008 led to a huge increase in exploration investment, the trend was short-lived. The credit bubble ended with the collapse of global financial markets and a steep decline in commodity prices, reflecting anticipation of a deep recession. With the oil price collapsing to USD35 in December 2008, oil companies reduced their workforces and the number of rigs in service, and delayed or cancelled projects. A similar trend was experienced by other commodity players. This prolonged phase of low investment in commodity infrastructure could lead to another commodity boom in the medium to long term. With economies gradually emerging from the global downturn, demand for various commodities is expected to pick up. If the increase in supply fails to keep pace, commodity prices will further rise. This also points to the tremendous scope for investment in the commodities sector going forward. The rapid growth of emerging markets is expected to lead to a flurry of economic activity which will spur demand for commodities, particularly for energy commodities and base metals. This should provide a strong incentive to commodity producers to considerably increase investment in mining, exploration, processing and refining activities. Commodities Initiation Report 25-11-09 Page 19 3.3. Huge disparity between per capita consumption amongst countries Consumption of energy or commodities in any country primarily depends on economic growth and level of development. While developed economies comprise only one fifth of the world's population, consumption of commodities remains disproportionately high, at almost three fifths of the world's primary energy. The world’s total energy consumption is projected to increase by 44% from 2006 to 2030. Total energy demand in the non-OECD countries is expected to increase by 73%, compared with an increase of 15% in the OECD countries. China is expected to become the largest consumer of energy by 2030 Source: EIA, Annual Energy Outlook 2009. Developing nations are expected to witness much higher growth in electricity consumption than developed nations. The EIA International Energy Outlook 2009 forecasts electricity consumption in non-OECD Asia to grow at a CAGR of 4.4%, compared to just 1.2% for OECD countries. Exhibit 14: Per capita consumption in 2008 Commodity Unit US Europe India China Japan World Steel kg 320.2 369.7 45.8 321.4 598.3 178.6 Oil bpd per 1,000 people 68.7 29.3 2.4 5.7 39.3 31.7 Coal tonnes 3.6 N/A 0.3 1.0 1.2 1.2 Natural Gas cubic meters 2,168 1,019 37 53 787 768 Source: World Steel Association, BP Statistical Review, Population Reference Bureau Exhibit 15: Total consumption in 2008 Commodity Unit US Europe India China Japan World Steel Mt 98 182 53 426 76 1,197 Oil mmbpd 19.4 N/A 2.9 8.0 4.8 84.4 Coal Mt oil equivalent 565 N/A 231 1,406 129 3,304 Natural Gas billion cubic meters 657 N/A 41 81 94 3,019 Source: World Steel Association, BP Statistical Review Steel consumption is also closely linked to economic development, and richer countries remain the largest consumers of steel. The World Steel Association identifies that consumption of finished steel products ranges from approximately 370 kg per person in Europe, 320 kg in the US and 598 kg in Japan, compared to approximately 20 kg in Africa and 48 kg in India. However, while developed nations have the highest commodity consumption rates, they also have mature infrastructure networks. Per capita consumption of commodities is climbing rapidly in Asia due to significant investment in industry, transport infrastructure, construction and overall improved standards of living, as well as the gradual transfer of the world’s labour intensive manufacturing activities. In the past decade, per capita consumption of steel has risen by approximately 470% in Malaysia, 240% in South Korea and 80% in China. India’s per capita steel consumption is one of the lowest in the world despite being the 5th largest steel producer. However, with a strong and growing economy, rising income levels and shifting consumer spending patterns, India’s appetite for steel is expected to grow to match the developed countries over the next 10 to 20 years. Almost all major commodities show a similar relationship. There remains ample scope for the world’s commodity consumption rate to expand further, with most of this incremental demand expected to come from developing nations. Fast growth in Asia combined with commodity-intensive industrialization and urbanization will continue to fuel the demand for primary commodities from this region. 3.4. Global infrastructure sector set to attract huge investment Globally, the infrastructure sector is expected to attract huge investment, supporting commodity demand and prices. Both developing and developed economies will play key roles in investment mobilization; however, whereas developing countries are expected to focus on infrastructure development and expansion, as discussed in detail above, developed countries are expected to channel investment on maintaining and upgrading existing infrastructure. Commodities Initiation Report 25-11-09 Page 20 Infrastructure maintenance and upgrade in developed countries Unlike developing countries, the key driver for infrastructure investment in developed countries is the maintenance, upgrade and replacement of existing infrastructure. In these countries, much of the existing infrastructure for energy distribution and transport has been in service for many decades. In the US, for example, while huge amounts of money have been spent on building power plants, the country's transmission grid uses dated technology and is in need of an upgrade. There has been no significant investment in high voltage grids for the past 20 years. In October 2009, President Obama announced a USD3.5 bn plan to upgrade the country’s ageing power grid, while private players have agreed to invest USD4.7 bn in this area. US railways have also been neglected for the past 50 years, with increasing calls for the entire network to be rebuilt as, apart from California, none of the routes meet international standards for high-speed trains. The US has now started to invest in high-speed intercity networks. President Obama has approved an initial USD8 bn to be spent on railways. This is however, only a fraction of the cost of building a new network, with the total amount estimated to be more than USD100 bn. Similarly, out of the 2.4 mn km network of gas pipelines in the US, approximately 1.6 mn km of it is over 30 years old. Replacing and modernizing this essential infrastructure is expected to continue to create demand for steel and other metals in the US. The following table outlines projected global demand for pipelines over the next five years: Exhibit 16: Gas pipeline projects Region No of Projects Total Length (km) In USD bn North america 183 69,953 17 Latin america 52 33,934 8 Europe 97 45,974 11 Africa 47 17,368 4 Middle east 107 43,655 11 Asia 130 90,825 22 Australia 60 15,899 4 Total 676 317,608 77 Source: Simdex, May 2009 4. Key Challenges 4.1. Impact of technological advances on commodities Scientific development has contributed enormously to the development of the commodities sector, with the impact felt from exploration to extraction to use. The emergence of new technologies can lead to rapid growth in demand for specific commodities, causing a temporary mismatch in demand-supply dynamics, which then prompts the development of new methods and tools to boost supplies. This, in turn, increases supply to a point that it exceeds relative demand. Ongoing scientific progress, coupled with environmental concerns, is also encouraging the recycling of metals, adding to secondary sources of supplies. More recently, concern over the depletion of commodity reserves has driven R&D in search of viable alternatives for fossil fuels and metals. Scientific innovations and technological applications have enhanced our capabilities to explore and harness natural resources. The invention of electricity boosted the capacity of blast furnaces to produce more metals. Better drilling tools like pumpjack allowed extraction of oil from deep oil wells. Increased knowledge of geology and engineering allowed for the exploitation of fossil fuel reserves in the oceans through the construction of offshore drilling rigs and pipelines, enabled by the development of durable and stronger alloys to connect the energy supply and demand centres. Now, technologies like geographic information system (GIS) and satellite imagery help to uncover unexplored potential resource bases for commodities while keeping exploration costs under control. The surge in coal demand triggered by the industrial revolution and subsequent inventions to increase coal production exemplify the relationship between technology and commodities. Initially, coal mined from near the surface was sufficient Commodities Initiation Report 25-11-09 Page 21 to meet industrial demand. Although coal reserves were available deeper beneath the earth's surface, the risk of flooding and poisonous gases restricted their exploitation. The development of new equipment enabled coal mining at greater depth, leading to a 25 fold increase in coal production in England during the 19th century. Exhibit 17: Growth of Coal Production in England Year Annual Coal Production in England (mn tonne) CAGR 1700 2.7 0.9% 1750 4.7 1.1% 1800 10 1.5% 1850 50 3.3% 1900 250 3.3% Source: The Energy Journal, 1998 Later, improving shipping facilities and infrastructure projects like the Suez Canal, the Panama Canal and the Trans- Siberian railway improved accessibility and reduced transportation cost, facilitating exploitation of natural resources in remote regions and bridging the gap between resource rich and deficient centres. Increase in efficiency and productivity While major breakthroughs in technology enabled the exploitation of natural resources, efforts by industry players to cut costs and make products economically viable have improved efficiency and productivity across various product lines. As a result, cars can travel more miles per gallon of gasoline, less metal is consumed in the manufacture of machinery and appliances and computers are becoming smaller and increasingly power efficient. These enhancements have led to lower per unit consumption of commodities. Rising environmental concerns over the accumulation of metal waste necessitated the development and application of recycling, adding to the overall supply of metals. However, efforts to improve efficiency are concentrated during an upward trend in natural resources prices, while complacency sets in at times of low prices. While rising efficiency lowers consumption of metal and fossil fuels, exerting downward pressure on prices, resulting low prices in turn diminish the return from productivity improvement efforts. The US decision to supply Israel during the Arab-Israeli conflict of 1973 caused the Arab members of OPEC to first increase oil prices by 70% to USD5.11 per barrel as retaliation and then implement an oil embargo, in which they continued to cut oil supplies by 5% per month. As the Middle East was the leading supplier of crude oil, contributing more than one third of global output, global crude oil prices surged by more than 250% to USD11.58 per barrel in 1974. The situation was aggravated further in the latter part of the decade by the Islamic revolution in Iran and in the 1980s by the Iran-Iraq conflict. Reeling under high oil prices, western economies hastened efforts to introduce energy efficient technologies to avert an impending energy crisis. To combat the threat, many governments enacted laws mandating improvement in fuel economy (more than half the oil was consumed in transportation), consumers opted for more fuel efficient appliances (particularly heating systems), investment was made in the exploration and development of new oil fields and private players boosted R&D to raise productivity. The efforts bore results in the early 1980s as an increased number of fuel efficient vehicles and appliances slowed growth in consumption, and production from new oil fields boosted supplies. The average car fuel economy in the US jumped from 13.5 miles per gallon (mpg) in 1975 to 24.1 mpg in 1988. Oil importing economies also focused on finding viable alternative sources of energy. While France shifted to nuclear energy for electricity generation, the UK and Scandinavian nations explored and developed natural gas fields in the North Sea. Oil supplies from the Middle East returned to normal levels by the mid 1980s; as a result, increased global supply and controlled growth in demand led to low oil prices for over a decade, leading in turn to diminishing economic returns on efforts to improve energy efficiency, which almost came to a halt (observed in the fuel economy plateau after 1988). Commodities Initiation Report 25-11-09 Page 22 Exhibit 18: Fuel efficiency / oil prices 0 10 20 30 40 50 60 70 80 90 100 10 12 14 16 18 20 22 24 197519781981198419871990199319961999200220052008Nominal Oil Price USD/bblFuel Economy mpgFuel Economy Nominal Oil Price Source: Bloomberg, US Department of Energy On the back of underinvestment and rising demand from emerging economies, the oil demand-supply situation tightened once again after 2002. Consequently, oil prices experienced another surge after having remained depressed for over a decade, causing anxiety amongst consumers and policy makers. Taking note of the rising fuel prices, the US government revised its fuel economy mandate for cars and trucks to 39 mpg (27.5 mpg in 2009) and 35.5 mpg (23.4 mpg in 2009) respectively by 2016. The potential to improve fuel efficiency remains immense as auto companies attempt to develop 100 mpg hybrid cars. Renewed interest in improving fuel efficiency is likely to reduce oil consumption in developed economies, partially offsetting the anticipated surge in oil demand from emerging economies. Substitutes Commodities derive value from inherent properties rather than their crude form. Oil and fossil fuels are valued for the energy that they provide while metals are valuable due to their strength and durability. As a consequence, commodities often act as substitutes for each other, like natural gas for crude oil, aluminium for copper and steel. In the energy sector, efforts have been made to replace fossil fuels with renewable energy sources for over a century. Although alternative energy sources including solar energy, wind energy and biofuels have been recognized for a long time, they haven’t replaced conventional fuels as the primary source of energy due to higher costs and technological difficulties. While nuclear, wind, solar and hydro energies have all been successfully harnessed to produce electricity, no sustainable alternative has been found to replace crude-based fuel in cars in any significant proportions. Biofuels, in which gasoline is blended with ethanol derived from agricultural sources like corn and sugarcane, are being experimented with and commercially used in developed economies, as well as predominantly agrarian emerging economies like Brazil. However, biofuels are currently only viable when oil prices are high, and the diversion of crops to non-dietary uses also causes inflation in food prices. Nevertheless, attempts across the globe to economize the already available alternatives and find new solutions to reduce dependence on the finite reserve of fossil fuels are ongoing. Metals have faced much tougher competition from substitutes than fossil fuels. Plastics and glass have crowded out metals in various fields, especially packaging. Carbon composites are increasingly used to replace metals in aircraft, launch vehicles and spacecraft. Advancement in technology has also led to the replacement of traditional metals with other metals; the abundance of aluminium, for example, with its highly recyclable properties, conductivity and durability, as well as low cost and light weight, prompts researchers to explore new ways of using the metal to replace base metals. R&D activities in new fields such as nanotechnology have raised hopes of replacing metals with more durable and cost effective allotropes like fullerene in the auto and construction industries. These nano particles will be much lighter than metals, which will also make cars more fuel efficient. 4.2. Political, social and environmental challenges In recent history, some of the world's most resource-rich countries have suffered from chronic political instability. Global reliance on such regions for the supply of commodities continues to increase as reserves deplete and production costs rise in developed economies (e.g. coal production in Japan has almost come to a halt since 2002) while environmental Commodities Initiation Report 25-11-09 Page 23 concerns restrict the development of reserves (e.g. offshore drilling was banned in the US Outer Continental Shelf from 1981 to 2008 due to the dangers of oil spill). The delicacy of the situation can be observed in the dependence of the US on crude oil from the Middle East or Europe’s reliance on Russian natural gas. Along with this traditional geopolitical aspect, rising opposition from local communities, increased awareness of environmental and economic concerns, government opposition to foreign ownership of natural resources and uncertain legal and political situations add to the already heavy political burden on the commodities sector. In recent decades, commodity markets witnessed supply shortages due to political conflicts in sensitive areas, such as the impact of the twin oil crises experienced in the 1970s, as discussed above. More recently, Russian-Ukrainian disputes over debts and payments for natural gas have led to disruptions of supplies into the EU over the last 5 years. Similarly, the Indo-Iran natural gas pipeline project has been sidelined for more than 3 decades, due to Indian concerns over blockades by Pakistan. Ongoing political disruptions and armed conflict in resource rich African countries pose yet another threat to global energy supplies. Even politically stable areas with long established traditions of democracy and political tolerance like Australia and India have experienced constant political infighting, thwarting investment in the commodities sector. In Australia, opposition has been raised to the transfer of ownership of its natural resources to foreign hands, visible in political opposition to the Aluminum Corporation of China acquiring a controlling stake in Rio Tinto. Meanwhile, India's commodities sector is heavily regulated and stifled by a lack of strategic consensus among political leaders. Social and economic aspects of the development of mines, like the displacement of local communities, and contamination of soil and underground water sources, have further accentuated the problems in developing and exploiting natural resources. Posco’s USD12 bn integrated steel plant project in the Indian province of Orissa has faced protests from local communities, who will be forced to relocate, and certain political parties on the pretext that the company has been granted unfair concessions. Consuming industries often lobby against the export of natural resources to keep input costs under control (for example, Indian steel producers oppose exports of iron ore). Moreover, the sudden surge in profits of natural resource companies following commodity price increases tends to attract calls for higher taxes and royalties. Political opposition often leads to delays in project development and increases investment requirements. Uncertainties associated with the impact of politics on the commodities sector raise the overall risk of developing natural resources and limit competition, largely restricting access only to well established long term players with deep pockets and political influence. Environmental challenges Environmental degradation and climate change are significant issues facing governments in relation to the commodities sector, particularly in terms of balancing a perceived trade-off between economic growth and environmental conservation. It is beyond the scope of this report to fully detail the links between the commodities sector and global climate change, which are complex and many. However, these are well documented in research published in scientific journals, as well as in multilateral publications, such as those released by the UN's Intergovernmental Panel on Climate Change (IPCC). Governments and multilateral bodies have implemented a number of measures intended to arrest or reverse climate change, and to limit environmental degradation. These include: • The Kyoto Protocol was adopted in December 1997 and implemented in February 2005, signed by 187 countries as of October 2009. The protocol focused on reducing carbon emissions, primarily by mining companies. According to the IPCC, the global steel industry emits 6%-7% of the total carbon dioxide released in the environment. The protocol set a target for 37 industrialised countries to reduce GHG emissions by an average of 5% from 1990 levels over the five-year period 2008-2012. The UN Climate Change Conference in Copenhagen in December 2009 is now expected to lay the groundwork for a successor treaty. 192 countries are expected to be involved, with the main objective of reducing GHG emissions. • In October 2009, a climate change pact was signed by China and India, in which the two countries agreed to strengthen bilateral dialogue and practical cooperation on climate change through information sharing. The two governments have decided to work together on issues including scientific assessment of the impact of climate change, joint research and development activities and energy conservation and efficiency. Commodities Initiation Report 25-11-09 Page 24 • Clean energy sources: More and more governments are encouraging the use of clean energy sources generated from sunlight, wind, rain and tides. Wind power generation capacity increased from approximately 30 GW in 2002 to 59 GW in 2005 and annual investment in clean energy sources increased from approximately USD19 bn in 2001 to USD36 bn in 2005 Source: Renewable Global Status Report. • Funding of USD1.5 bn by the Australian government to local coal mining companies for adoption of low emission coal technologies Source: official website of the Australian Labor party. • There are government programs offering incentives and rebates to compensate for the cost of solar panels purchased by companies across a wide range of developed and emerging countries. In September 2009, the French government announced a plan to increase solar incentives offered to businesses and individuals to install photovoltaic (solar) technologies. • Out of China's recent USD586 bn stimulus package, 14.5% was allocated to the development of clean energy sources Source: Climate progress. • In the US, the Clean Energy and Security Act of 2009 requires utility companies to supply an increasing proportion of energy through renewable sources (6% in 2012, 9.5% in 2014, 13% in 2016, 16.5% in 2018, and 20% in 2021-2039). • A number of governments have set up - or are planning to set up - trading programs in air pollutants to control emissions of various GHGs. The main feature of these trading programs is the capping of the amount of a pollutant that can be emitted by any country or company. If they wish to exceed their given quotas, these entities must buy credits from other entities with surplus credits. The main concerns for the commodities sector, going forward, will be whether and by how much governments further restrict Exploration and Production (E&P) operations, whether feasible and environmentally friendlier substitutes are developed, and whether the sector is able to adapt and address environmental concerns. For example, coal industry actors are working on Carbon Capture and Storage technology, which has the potential to nearly eliminate carbon emissions into the atmosphere from coal mining. 5. Commodities Sub-sectors 5.1. Upstream oil & gas Oil exploration represents the first stage of the long petroleum value chain. The E&P sector, or the upstream oil sector, is responsible for discovery, recovery and production of crude oil and natural gas. The key participants in this business include oil and gas exploration companies, oilfield service companies such as seismic surveyors, drillers, vessel, engineering and service providers and also its consumers - the downstream sector - which refines raw crude products provided by the upstream sector. Demand and supply of crude oil After the severe price volatility of 2008, the global E&P industry has witnessed some stabilization in 2009. While the strong appreciation in hydrocarbon prices in early 2008 benefited the upstream companies’ bottom-lines, the subsequent decline in oil prices has had a sharp adverse impact due to their high fixed costs. The IEA's Oil Market Report forecasts global oil demand to decline 1.5% to an average of 84.8 mmbpd in 2009 followed by an increase of 1.3% to an average of 86.2 mmbpd in 2010. Global oil supply in October 2009 was 85.6 mmbpd. Commodities Initiation Report 25-11-09 Page 25 Exhibit 19: Oil demand, supply and price history 0 20 40 60 80 100 120 68 72 76 80 84 88 2001 2002 2003 2004 2005 2006 2007 2008 Oil prices ( USD per barrel)mn barrels per dayOil Supply Oil Demand Oil Prices Source: BP Statistical Review, June 2009, Bloomberg Demand and supply of natural gas While crude oil prices increased from USD31.41 per bbl on 22 December 2008 to USD76.72 on 20 November 2009, the natural gas price plummeted from USD5.37 per mmbtu to around USD3.11 per mmbtu over the same period. Global demand for natural gas remains low reflecting the global recession and a cool summer in the US this year. The impact of this on prices is exacerbated by the effect of technological advancements allowing extraction of previously unobtainable gas locked in shale rock. This has led to a significant increase in the US natural gas reserve, impacting gas prices globally. Recently deployed technologies to improve extraction rates include horizontal drilling and hydraulic fracturing. Horizontal drilling enables a company to cover a larger portion of the resource bearing area. Hydraulic fracturing involves the injection of a mixture of water and sand at high pressure to create multiple fractures throughout the rock, liberating the trapped gas. Such developments in unconventional gas exploration led the Potential Gas Committee to announce in June 2009 that US natural gas reserves are 35% greater than believed two years ago. The committee estimates total natural gas resources in the US at 2,074 trillion cubic feet, an increase of 542 trillion cubic feet from its last report, including 238 trillion cubic feet of proven gas reserves. As well as depressing gas prices, the supply glut has also led to a significant reduction in drilling activity. According to the EIA November 2009 release, the number of natural gas rigs operating in the US has declined by more than 54% since its peak at 1,600 in August 2008. The EIA expects total natural gas production in the US to decline by 3.8% y-o-y in 2010. However, with demand for gas picking up, gas prices are expected to increase from 2010. The US is expected to use more natural gas in the long term, given stricter climate regulations and its huge reserve base. The world’s total natural gas consumption is expected to increase by an average of 1.6% per year from 104 trillion cubic feet in 2006 to 153 trillion cubic feet in 2030 Source: EIA International Energy Outlook 2009. OPEC actions OPEC countries control around 68% of global oil reserves and contributed 36% of total oil production in 2008 Source: BP Statistical Review. As the key actor in this industry, OPEC has the power to cut or expand global supply when oil prices fluctuate to protect the margins of its members. After a fall in oil prices to USD31.41 per bbl in 2008, the cartel reduced its output by 4.2 mmbpd. In response to concerns over OPEC's market power, governments around the world have encouraged oil E&P activities in non-OPEC regions through tax breaks, subsidies and deregulation. The following charts identify the world’s major exporters and importers of oil. Commodities Initiation Report 25-11-09 Page 26 Exhibit 20: Largest net oil importers in 2008 (thousands of bbls per day) 0 2,000 4,000 6,000 8,000 10,000 12,000 USJapanChinaGermanyS KoreaIndiaFranceSpainItalyTaiwanNetherlandsSingaporeBelgiumTurkeyThailand Source: EIA Exhibit 21: Largest net oil exporters in 2008 (thousands of bbls per day) 0 2,000 4,000 6,000 8,000 10,000 Saudi ArabiaRussiaUAEIranKuwaitNorwayAngolaVenezuelaNigeriaAlgeriaIraqLibyaKazakhstanCanadaQatar Source: EIA The Middle East controls 59.9% of proven global oil reserves and 41.0% of global proven gas reserves Source: BP Statistical Review – World Energy 2009. Its R/P ratio is an impressive 78.6 years for crude oil and more than 100 years for natural gas, compared to international averages of 42 years and 60.4 years respectively. Exhibit 22: Regional oil reserves and R/P ratios (2008) Regions Proven reserves (bn bbl) y-o-y growth % share R/P ratio Total North America 70.94 (0.4%) 5.6% 14.80 Total S. & Cent. America 123.17 (0.3%) 9.8% 50.30 Total Europe & Eurasia 142.19 (1.7%) 11.3% 22.10 Total Middle East 754.12 (0.1%) 59.9% 78.60 Total Africa 125.56 0.2% 10.0% 33.40 Total Asia Pacific 42.00 1.8% 3.3% 14.50 Total World 1,257.98 (0.2%) 100.0% 42.00 Source: BP Statistical Review, June 2009 Commodities Initiation Report 25-11-09 Page 27 Exhibit 23: Regional natural gas reserves and R/P ratios (2008) Regions Proven reserves (bn bbl) y-o-y growth % share R/P ratio Total North America 8.87 (0.1%) 4.8% 10.90 Total S. & Cent. America 7.31 0.6% 4.0% 46.00 Total Europe & Eurasia 62.89 9.6% 34.0% 57.80 Total Middle East 75.91 2.3% 41.0% <100 years Total Africa 14.65 0.8% 7.9% 68.20 Total Asia Pacific 15.39 4.0% 8.3% 37.40 Total World 185.02 4.5% 100.0% 60.40 Source: BP Statistical Review, June 2009 Geopolitical issues Geopolitical issues in oil producing countries and regions (such as the Middle East, Nigeria and Venezuela) raise concerns over the security of global oil supplies. Most recently, Nigerian rebels have warned oil and gas industry players operating within the region to brace for new attacks as they want a bigger share of the country's oil wealth. In the three years up to October 2009, Nigeria's oil output is believed to have fallen from 2.6 mmbpd to 1.7 mmbpd Source: Mail&Guardian online. Iraq boasts the world's third largest reserves of oil, behind Saudi Arabia and Iran. There has been limited exploration or development of fields in the country over the past three decades, due to wars and the international embargo imposed following the Gulf War. Recently, there has been heightened industry interest in the country's fields. On 02 November 2009, ENI finalized a contract to boost production in the Zubair field near Basra, which it estimates to have 6 bn bbls of reserves. Oil majors, including Royal Dutch Shell (Shell), Exxon Mobil and ConocoPhillips are also in talks with the government. Assistance from major E&P firms could help Iraq to boost its oil production significantly. However, the country may face opposition from OPEC, which is attempting to enforce tighter quotas during the current period of muted demand. Although Iraq is a member of OPEC, it is exempt from its quotas. Meanwhile, international E&P companies entering the Iraqi oil market are likely to face a raft of challenges, such as a shortage of skilled workers and inadequate infrastructure, including a lack of oil terminals and pipeline capacity. Investment in the country's ageing energy infrastructure has been hampered by the division of responsibility between the central government and Iraq's provinces. Strategic importance While the role of the state is declining in nearly every sector of world economic activity, in hydrocarbons the pattern is quite different. High energy prices have encouraged governments to concentrate authority in the hands of state firms. According to the EIA, national oil companies accounted for 52% of global oil production and 88% of proven oil reserves in 2007, as governments across the globe actively engaged in acquiring potential reserve bases to ensure energy security for their countries. Some of the largest national oil companies include Saudi Aramco, National Iranian Oil Company, Petroleo de Venezuela and Qatar General Petroleum Corporation. The largest national oil company in the world, Saudi Aramco, produced close to 8.9 mn barrels of oil per day in 2008 (or 10.3% of global production). Over the same period, the largest international oil company in the world, Exxon Mobil, produced almost 2.4 mn barrels of oil per day (2.8% of world production). In the Upstream Oil & Gas sub-industry, CNOOC is the largest company by market cap while Encana Corporation is the largest by revenues. Commodities Initiation Report 25-11-09 Page 28 Exhibit 24: Key industry players All figures in USD mn, except ratios Market Capitalization Enterprise Value TTM revenues TTM EBITDA EV/TTM revenues EV/TTM EBITDA TTM P/E CNOOC 70,664 66,157 14,144 7,551 4.7x 8.8x 16.5x Oil and Natural Gas Corp Ltd 52,910 50,611 22,466 9,682 2.3x 5.2x 12.5x EnCana Corporation 42,826 55,448 25,578 12,926 2.1x 4.2x 7.4x Canadian Natural Resources Limited 35,552 46,724 10,030 9,670 4.7x 4.8x 7.5x Apache Corp 33,238 36,890 7,959 2,321 4.6x 15.9x NA Anadarko Petroleum Corp. 31,865 41,424 8,306 3,318 5.0x 12.5x 73.7x Woodside Petroleum Ltd. 31,539 35,974 4,996 3,603 7.2x 10.0x 20.0x Devon Energy Corporation 30,217 36,926 10,790 8,377 3.4x 4.4x NA OGX Petroleo e Gas Participacoes S/A 28,396 23,823 N/A (157) N/A N/A 111.6x XTO Energy Inc. 25,100 35,457 8,520 6,205 4.2x 5.7x 13.4x Oil and Gas E&P Industry 894,823 1,049,504 484,666 199,510 3.5x 6.5x 155.4x Source: Capital IQ Regulatory and policy framework Trading regulations In reaction to the wide swings in oil prices during 2008, federal regulators in the US are currently considering regulations to place restrictions on hedge funds and other speculative traders in the market. They are also expected to consider fresh limits on the volume of energy futures contracts that pure investors would be allowed to hold. When these regulations will take effect is unclear. Operational regulations Oil subsidies are prevalent in developing countries, designed to reduce the price burden on the end customer. Under a levy introduced in March 2006 in China, upstream companies have to bear a windfall tax on revenue from crude oil sold for more than USD40 a barrel. Recently, a proposal submitted by China Petroleum and the Chemical Industry Association recommended raising the trigger level for the tax to help oil producers including PetroChina and China Petroleum and Chemical Corp. China is now expected to increase the threshold for the windfall tax on crude oil gains to USD60 per barrel. In India, state-run upstream companies are asked to discount crude sales to state refineries, which in turn sell oil products to the public at regulated prices. In FY 2009, ONGC's net profit dipped 3% to INR161.3 bn due to a huge subsidy discount of INR282.3 bn (+28% y-o-y). Companies across the world are expected to pay royalties in the countries in which they operate. In the US, E&P companies are given the option to pay royalties in cash or in kind. However, the Government Accountability Office (the investigative agency of the US Congress) has identified that energy companies may have underpaid their oil and gas royalties during 2006 and 2007 by USD160 mn, as a result of inaccurate data supplied to the Department of the Interior. The US is now planning to scrap its royalty-in-kind program to make the system more transparent and accountable. Industry transaction activity In response to the financial crisis, investment in the Upstream Oil & Gas sub-industry has already been cut by more than USD90 bn this year (-19% from 2008). Recently, however, there has been a revival in activity and interest. For example, in October 2009 state-run Korea National Oil Corp. (KNOC) signed a contract to buy Canada's Harvest Energy Trust for CAD1.8 bn (USD1.7 bn), marking the largest acquisition of a foreign oil firm by a South Korean company. The acquisition is expected to boost KNOC's production from 70,000 to 123,400 barrels per day, taking the company one step closer to achieving its daily output goal of 300,000 barrels by 2012. The IEA, in its 2009 World Energy Outlook, forecasts oil demand to start recovering from 2010, reaching 88 mmbpd in 2015 and up to 105 mmbpd in 2030. In order to meet this demand, the sector requires considerable investment; under-investment could prove greatly detrimental to the development of the world economy. The following tables list the largest transaction activities in the Upstream Oil & Gas sub-industry over the past 12 months. Commodities Initiation Report 25-11-09 Page 29 Exhibit 25: Largest 10 upstream M&A deals of the last 12 months Buyer/Investor Target company Total transaction value (USD mn) BG Group plc Queensland Gas Co. Ltd. 8,882 ONGC Videsh Limited Imperial Energy Corporation PLC 5,761 Sistema JSFC Bashkir Oil and Energy Group 4,162 Centrica Resources (UK) Ltd. Venture Production Plc 4,025 Precision Drilling Trust Precision Drilling Oilfield Services Corporation 4,000 Sinopec International Company Tanganyika Oil Company Limited 3,300 Statoil ASA Anadarko Petroleum Corp., 2,500 PetroChina Co. Ltd. CNPC Hong Kong Ltd. (SEHK:135) 2,317 GDF Suez Nederlandse Aardolie Maatschappij, Offshore and Pipeline Assets 1,854 Atlas Energy, Inc. Atlas Energy Resources LLC 1,727 Source: Capital IQ Exhibit 26: Largest 10 upstream public offerings of the last 12 months Issuer Total transaction value (USD mn) Anadarko Petroleum Corp. 1,365 Nabors Industries Inc. 1,125 Halliburton Company 997 Total Capital S.A. 996 Noble Energy, Inc. 995 Weatherford International Ltd. 995 Halliburton Company 995 Chesapeake Energy Corporation 951 EOG Resources, Inc. 898 Smith International Inc. 742 Source: Capital IQ Exhibit 27: Largest 10 upstream private placements of the last 12 months Issuer Total transaction value (USD mn) Aabar Investments PJSC 1,820 Nabors Industries Inc. 1,125 Oil Search Ltd. 823 Forest Oil Corp. 571 Tullow Oil plc 551 Petrohawk Energy Corporation 548 Pacific Rubiales Energy Corp. 446 Petrobank Energy and Resources, Ltd. 400 Enerplus Resources Fund 300 Zhaikmunai LP 300 Source: Capital IQ Commodities Initiation Report 25-11-09 Page 30 Outlook Our outlook for Upstream Oil & Gas is positive. Crude oil prices have more than doubled to trade well above USD70 per barrel. Prices are expected to average approximately USD90 per barrel for the next three years. A stable price outlook suggests steady growth in E&P investment. Global supplies of natural gas remain abundant and prices currently hover at low levels. However, as the cleanest of all fossil fuels, gas is likely to be the least affected by any legislation against GHG emissions. In the long term, natural gas-fired electricity generation is expected to grow at the fastest rate after renewables. While global demand for oil and natural gas is expected to increase from here on, the recovery is expected to remain depressed until the end of 2010 as most economies recover only gradually from their deepest recession in over half a century. China and India are expected to contribute the bulk of growth in demand for natural gas. 5.2. Mid- and down-stream oil & gas Crude oil is consumed in various forms: gasoline/petrol, diesel, heating oil, jet fuel, residual fuel oil, and many other products. Crude oil extracted in its raw form is converted into end-use products by refining companies (downstream players). Crude oil used in the refining process is available in various forms based on characteristics including appearance and viscosity. These types are classified into two main categories, heavy and light crude oil. Heavy crude oil is more difficult to refine and transport and hence is priced at a discount to light crude oil. Total oil products consumption has increased from 61.6 mmbpd in 1980 to 85.8 mmbpd in 2008. To meet this demand, refinery throughput has increased by almost the same magnitude, from 59,243 kbopd in 1980 to 75,179 kbopd in 2008. Exhibit 28: Last 10 years – Crude throughput and consumption data World oil consumption (kbopd) 1999 67,043 70,201 2000 68,566 71,025 2001 69,161 71,421 2002 68,518 72,111 2003 70,545 73,446 2004 73,018 76,216 2005 74,093 77,236 2006 74,707 77,881 2007 75,432 78,788 2008 75,179 78,557 Year Refinery throughput (kbopd) Source: Capital IQ Key downstream industry players Exhibit 29: Key downstream industry players (All figures are in USD mn except ratios) Reliance Industries Ltd. 68,612 78,160 29,267 5,328 2.7x 14.7x 14.6x Formosa Petrochemical Corp. 23,115 28,068 17,907 N/A 1.6x N/A 226.9x Indian Oil Corp. Ltd. 16,179 22,776 61,075 2,994 0.4x 7.6x 29.2x Valero Energy Corp. 9,758 15,503 68,937 2,304 0.2x 6.7x N/A Sk Energy Co., Ltd. 8,715 15,277 45,032 2,315 0.3x 6.6x 11.5x Rabigh Refining & Petrochemical Company 8,876 17,387 3,261 N/A 5.3x N/A N/A Nippon Oil Corp. 6,881 22,794 63,720 (1,665) 0.4x N/A N/A S-Oil Corp. 5,580 5,947 19,778 1,347 0.3x 4.4x 15.1x TonenGeneral Sekiyu k.k. 5,156 6,155 28,327 1,592 0.2x 3.9x 6.9x Neste Oil Corp. 4,549 6,656 12,927 275 0.5x 24.2x NA Industry Overall - Oil and Gas Refining and Marketing 213,311 338,926 1,180,679 (962) 0.4x 15.3x N/A EV TTM Revenues TTM EBITDA EV/TTM Revenues Company Market Cap EV/TTM EBITDA TTM P/E Source: Capital IQ