Barcap Global Energy Outlook Feb 2010

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Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that

the firm may have a conflict of interest that could affect the objectivity of this report.

Investors should consider this report as only a single factor in making their investment decision.

This research report has been prepared in whole or in part by research analysts based outside the US who are not registered/qualified as

equity research analysts with FINRA.

FOR ANALYST CERTIFICATION(S), PLEASE SEE PAGE 68.

FOR IMPORTANT FIXED INCOME RESEARCH DISCLOSURES, PLEASE SEE PAGE 68.

FOR IMPORTANT EQUITY RESEARCH DISCLOSURES, PLEASE SEE PAGE 70.

RESEARCH

8 February 2010

GLOBAL ENERGY OUTLOOKCOMMODITY, CREDIT AND EQUITY VIEWS


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Barclays Capital | Global Energy Outlook

8 February 2010 1

GLOBAL ENERGY OUTLOOK

In this report we present our energy research analysts views on commodities, credit and

equities. Three consistent themes stand out:

1. Crude oil, coal and carbon pricing are expected to strengthen on a 12-24 monthhorizon; natural gas and US power prices may take longer to recover.

2. A preference for crude oil and upstream biased investments, relative to natural gas anddownstream oil. We see price support for crude in 2010 and even more so in 2011 as

demand recovers, inventories return to balance and new supply slows. We like the

commodity and oil biased E&P investments in credit and equities.

3. A clear negative view on downstream oil profitability, and investments sensitive to oilproduct margins. We expect refining capacity additions to exceed demand growth at

least until 2012. We are negative on independent refiners in credit and equities.

In commodities, we are structurally positive on energy. In the long run, we see demand

growth outstripping supply, and expect prices to rise faster than inflation. Historically,

energy commodities have outperformed energy credit and energy equities, and we expect

that relationship to continue.

In credit, our preferred investments broadly mirror our commodities views. In high grade,

we are Overweight oil services and Underweight refiners. In high yield, we recommend E&P

and pipelines. High grade pipelines are trading with little spread differentiation, and strong

returns in 2009 suggest difficulty in outperforming in 2010. In high yield coal, we expect the

sector to underperform the broader high yield index in 2010, given the current tight

spreads, although we see some opportunities for outperformance: for example, at 335bp,

the discount between MEE 5y CDS and BTU 5y CDS is too wide, and we therefore

recommend selling MEE protection. In US utilities, the best opportunities are among the BBB

regulated and electric utilities; in Europe, we are Underweight the utilities group.

Energy equities have underperformed the underlying commodities in the long run, but have

outperformed the main equity indices, and we expect that pattern to continue. We currently

recommend a more defensive equity investment stance, following the strong

outperformance of high beta names such as oil services in the last 12 months. We are

Overweight the US Majors, ExxonMobil and Chevron, and in Europe we are Overweight Eni.

In US E&P, we recommend the oil biased Apache, Canadian Natural Resources and

Talisman. We are also positive on coal names and recommend Peabody. In oil services, we

see the start of a new capital spending cycle, but also expect a better future entry point into

the shares given their strong recent performance. We remain cautious on US power as our

proprietary Barclays Power Margin Index indicates a deterioration in future electric utility

earnings. Our least preferred sub-sector is the independent refiners, in both the US and

Europe, given the bleak outlook we see for refining margins.

Our research analysts views on each asset-class and on individual sectors are summarised

in the following pages. Our detailed research reports are available on Barclays Capital Live.
https://live.barcap.com/go/keyword/homehttps://live.barcap.com/go/keyword/homehttps://live.barcap.com/go/keyword/homehttps://live.barcap.com/go/keyword/homehttps://live.barcap.com/go/keyword/home


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8 February 2010 2

RESEARCH CONTACTSCommodities

Gayle BerryCommodities Research

+44 (0)20 3134 [email protected]

Suki CooperCommodities Research


James CrandellCommodities Research

+1 212 412 [email protected]

Helima CroftCommodities Research


Paul HorsnellCommodities Research+44 (0)20 7773 [email protected]

Costanza JacazioCommodities Research+1 212 526 [email protected]

Natalya NaqviCommodities Research+44 (0)20 7773 [email protected]

Kevin NorrishCommodities Research+44 (0)20 7773 [email protected]

Biliana PehlivanovaCommodities Research


Amrita SenCommodities Research


Trevor Sikorski Commodities Research


Nicholas SnowdonCommodities Research


Sudakshina UnnikrishnanCommodities Research+44 (0)20 7773 3797

[email protected]

Quitterie ValetteCommodities Research+44 (0)20 3134 2686

[email protected]

Yingxi YuCommodities Research+65 6308 3294

[email protected]

Michael ZenkerCommodities Research+1 415 765 4743

[email protected]

Credit

Jim AsselstineUS Electric Utilities (HG)+1 212 412 5638

[email protected]

Neil BeddallUtilities+44 20 7773 9879

[email protected]

Laurence JollonUS Metals, Mining & Chemicals (HY)+1 212 412 7901

[email protected]

Harry MateerEnergy & Basic Industries (HG)+1 212 412 7903

[email protected]

Gary StrombergCo-Head of US High Yield Research+1 212 412 [email protected]

Equities

Paul ChengUS Integrated Oil and Refiners+1 212 526 1884

[email protected]

James D. CrandellUS Oil Services & Drilling+1 212 526 4865

[email protected]

Thomas DriscollUS Exploration & Production+1 212 526 3557

[email protected]

Daniel FordUS Power & Utilities+1 212 526 0836

[email protected]

Richard Gross, IIUS MLPs and Natural Gas+1 212 526 [email protected]

Lucy HaskinsEuropean Integrated Oil+ 44 20 3134 [email protected]

Rahim KarimEuropean Integrated Oil+44 20 3134 [email protected]

Gregg OrrillUS Power+1 212 526 [email protected]

Mick PickupEuropean Oil Services & Drilling+44 20 3134 [email protected]

Lydia RainforthEuropean Independent Refiners+44 20 3134 [email protected]

Jeffrey W. RobertsonUS Exploration & Production+1 214 720 9401

[email protected]

Peter D. WardUS Coal+1 212 526 [email protected]

James C. WestUS Oil Services & Drilling+1 212 526 8796

[email protected]

Tim WhittakerHead of European Equities Research+44 20 3134 [email protected]


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8 February 2010 3

CONTENTS

Summary of Energy Themes 4

COMMODITIES

Oil - Bridge of sighs 8

Natural Gas - Snow blind 12

Global LNG - Wind of change 14

Coal - The patient is getting better 16

Power - Twilight 18

Carbon - This is a low 20

Geopolitics - Year of living dangerously 22

CREDIT

US High Grade Energy - Value is elusive in 2010 26

US High Yield Energy - Financial leverage to decline in 2010 27

US High Grade Pipelines - As the beta trade winds down, credit selection takes over 28

US High Yield Coal - Expect coal credits to underperform 29

US High Grade Electric Utilities - Stable outlook for 2010 30

European High Grade Utilities - Stable 2010 as demand recovers 31

EQUITIES

US Integrated Oil - Risk/Reward shifts in favor of Super Majors 34

Europe Integrated Oil - The challenge of differentiation 36

US Independent Refiners - Bottom may be close, but the Dark Age continues 38

Europe Independent Refiners - Limited value in European refining 40

US Oil & Gas: E&P (Large-Cap & Mid-Cap) - Favor oil-orientated producers 42

US Oil Services & Drilling - At an inflection point 44

Europe Oil Services & Drilling - Fair, but not normal 47

US Natural Gas - Gas markets in transition 50

US Power - After the gold rush 52

US Coal - Poised for an eventual strong recovery 56

Equity Valuation Table 58

Valuation Methodology and Risks 63


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8 February 2010 4

SUMMARY OF ENERGY THEMES

INVESTMENT VIEW KEY RECOMMENDATIONS

Commodities

Oil 2010 is likely to be a transition year between the demand-sideweakness of 2009 and supply-side tightness in 2011. Nigerias

internal politics, Irans nuclear programme and the Iraqiparliamentary election increase price uncertainty.

We expect the price of WTI to average $85/bbl this year and$97/bbl in 2011 versus an average of just $62/bbl in 2009.

Natural Gas US natural gas supply is expected to be down 0.9 Bcf/d in2010. Lower power sector demand overwhelms any recoveryled gains and overall is expected to fall 0.8 Bcf/d in 2010.

Our forecast for 2010 Henry Hub is $5.25/MMBtu.

LNG As liquefaction trains come online in 2010, production growthshould be 4.5-5.5 Bcf/d.

The global recovery should allow LNG demand outside of theUS and Europe to grow at around 2.5-2.7 Bcf/d. This still

leaves roughly 2 Bcf/d to be absorbed by the US and Europe.

The expected oversupply should pressure spot LNG prices

around the world to again trade closely together in 2010.

With forward price differentials favoring US ports, Atlantic basinspot cargoes are increasingly likely to sail west.

Coal Strong Asian demand, as well as a lack of improvement in

infrastructural problems leading to supply bottlenecks willsupport upside momentum.

We are positive on coal, forecasting averages of $90/t, $84/t

and $90/t for API 2, API 4 and Newcastle prices in 2010, against$71/t, $66/t and $72/t for 2009.

Power - US As the US economy recovers and temperatures regain bite we

forecast demand growth of 3.5%.

We project that coal-fired output will be up 10.3% from 2009

and gas generation will fall 6% in 2010.

Forward power prices will depend on fuel prices as well as the

extent of demand recovery in 2010.

Market heat rate curves show backwardation in the front, but

contango in later years, suggesting expectations of furtherloosening giving way to eventual tightening

Carbon We expect the market to be long EUAs out to 2012 and 2013being the first year that is net short. Hedging of 2013 positionsshould become a more significant in H2 10.

Our price forecasts for Q1 10 is 12.0 /t while H2 10 pricesforecast is 15 /t.Prices are expected to increase to18 /t in2011 and 24 /t in 2012.

Credit

US High Grade

Energy

Market Weight

We expect the independent E&P sector to perform in line withthe market and the integrated sector to lag the broader index.

We believe oil services activity levels have bottomed andservice-intensive shale activity will remain robust.

We are Overweight the oil field service sector and Underweightrefiners.

Buy Nexen cash (OW); Sell Suncor CDS (OW), as we like theirleverage to oil prices.

US High YieldEnergy

Overweight

2010 should see increased M&A activity, and continued newissue supply.

We estimate that debt/EBITDA likely peaked in 2009 at 4.0x,and forecast a decline to 3.3x this year.

We are Overweight E&P and pipelines, while Market Weightservices and refining. We are Market Weight independent E&Pand Underweight integrateds.

We recommend Hilcorp (OW), Petrohawk (OW), SandRidge(OW) and Targa Resources Partners (OW).

US High Grade

Pipelines

Market Weight

Strong results in 2009 may mean pipelines will have difficultyoutperforming in 2010.

The sector is trading with little spread differentiation.

Midcontinent Express Pipeline has good relative value. Weexpect regulatory approvals to improve leverage metrics.

Boardwalk Pipeline Partners is trading 15-20bp too cheaply.

Buy Energy Transfer Partners, which should get back to a stableoutlook from S&P.

US High Yield

Coal

Underweight

We expect coal credits to underperform the broader highyield market in 2010 as any improvements are alreadyreflected by current spreads.

Sell Peabody Energy bonds, buy BB rated credits, e.g. Arch Coal.

Sell MEE 5y CDS. The current 335bp differential relative to BTUis too wide.

US High GradeUtilities

Market Weight

The best opportunities for outperformance can be foundamong the BBB regulated utilities and electric utility

companies.

Buy Baltimore Gas & Electric Unsecured Notes 5.9% 2016 andJersey Central P&L (OW) Unsecured Notes 7.35% 2019.

Both have low business risk and supportive regulation, offeringattractive relative value at +155bp each.

European High

Grade Utilities

Underweight

We believe there is limited opportunity for outperformanceversus the BCI

We expect financial performance to be stable due to the highlevels of forward sales and effective hedging.

Veolia (OW) has good relative value and is well placed to benefitfrom an economic recovery, having implemented measures to

improve credit metrics.

National Grid (OW) has good relative value, with c.95% of its

revenues being regulated and being well diversifiedgeographically.


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8 February 2010 5

Equities

US Integrated Oil

1-Positive

We remain positive on the medium term oil outlook, however,

the uncertainty has increased.

Until there is more data to establish a clear consensus view onthe pace of recovery and OPEC supply, the risk/reward trade-

off now favours the Majors vs the smaller integrateds.

ExxonMobil (1-OW) trades at 11.2x our 2010 EPS estimate,

compared with the S&P consensus P/E of 14.3x.

Chevron (1-OW) shares are currently trading at 5.6x onEV/2010 EBIDA, versus the group average of 6.6x. Chevron also

has the potential for exceptional production growth.

European

Integrated Oil

2-Neutral

We prefer upstream biased companies. Downstream drag on

corporate profitability may inhibit growth investment plans.

Although we continue to model lower costs for 2010, from

2011 onwards we see inflationary pressures returning.

Eni (1-OW) is under-valued, our sum-of-the-parts analysis

implies 45% upside potential.

US Independent

Refiners

3-Negative

Any margin uptick will be very modest over the next several

years. Our global refining industry stance is 3-Negative.

The Gulf Coast could outperform the Rockies/Mid-Continent

heavy oil refiners over the next 1-2 years.

Valero (1-OW) is our choice for short-term trading given its

geographic diversity and relatively inexpensive valuation.

Sunoco (2-EW) currently offers the cheapest valuation among

the refiners. The shares could be attractive for the long term.

European

Independent

Refiners

3-Negative

Nearly 7mb/d of new capacity will be added by 2012 yet oil

product demand on our forecasts will be around 2007 levels.

With a positive medium term outlook on oil prices, a $10/bl

increase would reduce the realized refining margin by $0.5/bl.

We re-iterate our 3-Negative stance on European refiners. Our

3-Underweights are Petroplus and PKN Orlen.

Our 1-Overweights are Saras, GALP, Hellenic Petroleum and

Motor Oil: these are the most complex and flexible refiners andwill continue to generate positive cash flows.

US Exploration &

Production

2-Neutral

We forecast that production from the five biggest shalesmay be around 50% of total U.S. natural gas production

by the end of 2012.

The oil price will have a dominant effect on E&P share

performance, instead of unhedged gas, which only accountsfor 15% of revenue.

Apache trades at a 19% discount to peers on 2011E debt-adjusted cash flow vs. a historical discount of 8%.

Canadian Natural Resources has a strong long-term record,leverage to Canadian oil sands, and a cheap multiple.

Talisman should perform well as the shift away from low-returnareas towards high-return areas becomes apparent.

US Oil Services &

Drilling

2-Neutral

We believe land rig demand domestically will improve sharplyin 1H10, adding pressure to natural gas prices.

Internationally, we expect 2010 will mark the beginning of along up-cycle in exploration and production spending.

In the nearer term we are worried the group may be in for a

pause, given the OSX has increased 100% since December2008 versus the S&P 500s increase of just 35%.

We emphasize stocks with differentiated international growthprospects, deepwater and subsea exposure, and those geared

towards an increase in exploration activity.

Our favourites among the large-caps are Weatherford,Schlumberger, Transocean, Noble, Cameron and Tidewater. In

the small-to-mid caps, our top picks are ION Geophysical, CoreLabs, Dril-Quip and Dresser-Rand.

European Oil

Services & Drilling

2-Neutral

European service companies face deterioration in earnings as

the lack of work over 2009 hits. However, the first signs of anext up cycle are becoming apparent.

The prospect of a spending upturn has mostly been priced in,and until backlogs begin to move ,we remain 2-Neutral.

Tecnicas Reunidas (1-OW) is trading at a 50% discount to its

2006-08A PE average, yet has seen earnings upgrades and hasincreased backlog by 50%.

Wood Group (1-OW) is trading at 15x 2010F PE versus a sectoraverage of 16x yet 2000-2008 31% pa earnings growth is

expected to continue in the medium-term.

US Natural Gas

2-Neutral

The competitive advantage of using light feedstocks iscreating record and rapidly expanding demand for NGL.

The E&P oriented diversified gas stocks trade at abnormal

discounts to the pure plays.

The three crucial trends affecting comparative results areproduction costs, NGL exposure and MLP structure.

Given the above themes we recommend El Paso, ONEOK,

Questar and Spectra Energy.

US Power

2-Neutral

Our analysis suggests the group has another 12% of relativeunderperformance in the first three quarters of 2010 before a

slow but lengthy period of outperformance.

The Barclays Power Margin Index (BPMI) indicates a

deterioration in future earnings. This is reinforced by theratio of Open EBITDA to forecast EBITDA being less than one.

We are 2-Neutral on US Power and recommend AES Corp.

We like AES for its: 1) contracted project backlog which adds$0.22/share through 2011; 2) $2B of free cash flow in 2012

(25% to equity); 3) upside to EPS driven by weak US$ versus

Brazil/Euro currencies 4) partnership with China InvestmentCorp., which is buying 15% of AES

US Coal

1-Positive1

We believe that higher coal prices and strong financial

performance for equities in 2010 will be a result of improveddomestic demand, stronger Atlantic exports and a gradual

reduction of inventories this should materialize H2 10.

We feel that U.S. coal equities still remain attractively valued

despite the recent bullish run. In particular Peabody has strongexposure to both the attractive Powder River Basin and the

robust Asian market.

Credit Rating System (for a full definition, please see pages 68-69): 1 Sector view is for the wider US Metals & Mining sectorSector Weighting: Overweight, Market Weight, Underweight Credit Rating: OW, MW, UW

Equity Rating System (for a full definition, please see page 71):Sector view: 1-Positive, 2-Neutral, 3-Negative Stock Rating: 1-OW, 2-EW, 3-UW


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8 February 2010 6


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8 February 2010 7

COMMODITIES


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8 February 2010 8

OIL

Bridge of sighs In our view, 2010 is likely to be a bridging year, acting as a transition between the

demand-side weakness of 2009 and supply side tightness in 2011.

We expect OECD demand to stabilize and head for its first year of growth since 2005,and non-OECD demand growth to become more broad-based.

We expect non-OPEC output to revert to negative growth in 2010, as last years largeupswing in Russian and US production will fades.

Oil prices set to strengthen

In our view, 2010 will see a series of continuities being rolled out into every sphere of oil

demand and supply, making it somewhat of a bridge between the demand-side weakness of

2009 and the supply-side tightness likely to re-appear in 2011. Our oil price forecast reflects

this fundamental view. We expect the price of WTI to average $85/bbl in 2010, marking a

large $23 increase from the average of 2009, but still some way off the $99.7/bbl registered in2008. We believe price gains will be skewed towards H2 09 and expect the upward

momentum to continue in 2011, when we forecast the price of WTI to average $97/bbl. On

the demand front, we expect the recovery that started in spring 2009 to continue into 2010.

After an initial phase of patchy demand improvement, we forecast the recovery in oil demand

to become more evenly spread across regions and products. 2009 has been characterized by a

strong dichotomy in performance. At a regional level, non-OECD demand rebounded strongly

from the lows in early 2009, while, on a product basis, gasoline demand greatly outperformed

the rest of the barrel. Into 2010, we expect these divergences to start to close as the recovery

becomes more broad based. We expect global oil demand to grow slightly below trend, rising

by 0.98 mb/d, virtually entirely due to higher non-OECD demand (+0.95mb/d).

Emerging market Asia, led by China, has assumed central stage in the demand recovery that

started in 2009. Chinese oil demand increased by 0.33 mb/d last year, accounting for 60% oftotal incremental consumption across the non-OECD. Demand soared in H2 09, with the y/y

pace of growth exceeding 1 mb/d (~15%) from September onwards, the fastest since the peak

of Chinese oil demand shock in 2004. The demand impetus, alongside a massive expansion in

the domestic refinery system, has fed into much higher crude oil import levels. Chinese crude oil

imports have not fallen below 4 mb/d since May and averaged 4.4 mb/d in H2 09, culminating

Costanza Jacazio

+1 212 526 2161

[email protected]

Amrita Sen

+44 (0) 20 3134 2266

[email protected]

Figure 1: WTI forward prices Figure 2: Refined product prices ($/b)

Far forward oil prices (Dec-17, $bbl)

70

75

80

85

90

95

100

105

Nov-08 Apr-09 Aug-09 Dec-09

0

5

10

15

20

25

30

Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul -09 Dec-09

June 2010 Gasoline crack

June 2010 heating oil crack

Source: NYMEX, Barclays Capital Source: Mimic, Barclays Capital


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8 February 2010 9

at 5 mb/d in December, roughly 800 thousand b/d above 2008 levels. The impressive swing that

Chinese oil demand underwent over 2009 was a major turning point in the market, with respect

to sentiment and fundamental developments, especially for a market that even at mid-year an

outright contraction was treated as a very possible outcome. For 2010, in line with our positive

outlook for the overall pace of the Chinese economy (IMF: +9.0%; BarCap: +9.6%), we expect

Chinese oil demand to continue to grow robustly and remain the single largest contributor to

global oil demand growth. We forecast growth to average 0.38 mb/d, at the higher end of

consensus estimates, which range between +0.31 mb/d (IEA) and +0.4 mb/d (EIA).

The recovery in non-OECD demand has not been confined to China alone. Other smaller Asian

economies have also seen consumption pick up strongly in H2 09, while in the Middle East,

soaring Saudi consumption in the summer, due to high power demand and constrained

natural gas supplies, kept demand from the region growing fairly robustly. Crucially, the three

pillars of non-OECD oil demand growth China, India, and the Middle East have weathered

the 2009 downturn extremely well. Cumulative incremental demand from these three regions

averaged 0.68 mb/d last year, a deceleration of just 0.22 mb/d relative to the pace of growth

registered in 2008. Undoubtedly, in the absence of such supportive demand dynamics, prices

could have fallen much lower. Even within the non-OECD, countries other than China, India

and the Middle East recorded a small demand decline last year (0.12 mb/d), adding to the

sharp demand contraction across the OECD. Moving into 2010, we expect these marked inter-and intraregional differences to soften and other non-OECD countries to account for virtually

all the additional growth from the developing world compared with 2009.

While non-OECD oil demand recovered strongly throughout 2009, the improvement in OECD

consumption was far more modest. OECD demand is on track to decline by 2.1 mb/d in 2009,

the largest contraction since 1981. The latest OECD demand reading available (October 2009)

still places the y/y scale of demand decline for the month in excess of 2 mb/d, indicating that

the region has yet to enter a phase of decisive, concerted demand amelioration. While

progress has been slow, signs of improvement can nonetheless be detected. The drag from

Japan on global oil demand growth is decreasing sharply. After falling by almost 700 thousand

b/d in Q1, Japanese oil demand has showed progressively narrower y/y declines, with the fall

for Q4 through November just 158 thousand b/d. In 2010, we expect the y/y pace of

contraction to stabilise and average 0.13 mb/d. This would be a major improvement relative

to the 0.51 mb/d fall we forecast for 2009. Much of that amelioration stems from the removal

of the unfavourable y/y base effects on fuel oil and direct crude oil burning that increased last

year due to the return of a significant tranche of nuclear capacity. In the US, moderate signs of

demand improvement emerged over the summer. The macroeconomic backdrop for 2010

remains supportive, in our view; we forecast US oil demand to increase by 0.15 mb/d, with

Figure 3: Chinese oil demand growth Figure 4: Non-OECD vs OECD oil demand growth

y/y change in Chinese apparent oil demand (kb/d)

-1000

-500

0

500

1000

1500

Nov-03 Nov-05 Nov-07 Nov-09

-5

-4

-3

-2

-1

0

1

2

3

Feb-08 Sep-08 Apr-09 Nov-09

OECD

Non-OECD Asia

Other non-OECD

y/y change in oil demand, mb/d

Source: China Customs Statistics, Barclays Capital Source: EIA, Barclays Capital


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8 February 2010 10

some upside risk to this projection. This recovery notwithstanding, US demand will likely

remain well below pre-crisis levels, and we expect it to average 0.55 mb/d below 2008 levels.

Contrary to Japan and the US, in Europe the oil demand recovery has yet to begin. Indeed,

Europe stands out as one of the few regions in which demand declines actually look softer in

the rearview mirror than the more recent data suggest. European demand fell by almost 1

mb/d in Q3 09, the largest y/y drop for any quarter since the onset of the crisis, with this

extreme weakness having continued into October. The abnormal path followed by German

heating oil consumer stocks heavily front-loaded in the first part of the year has helped

accentuate this weakening profile across quarters. Yet even allowing for such effects,

European demand has, at best, remained in a bottoming phase. We expect a turning point to

be reached relatively quickly, however, with the advent of cold weather and a steady

improvement in the macroeconomic backdrop making their way into the data. Thus, we

forecast European oil demand to decline by a modest 0.13 mb/d in 2010.

Overall, we project OECD demand to remain flat in 2010, with higher North American

consumption offsetting small declines in Europe and Japan. In our view, risks to this forecast

are skewed to the upside; indeed, we see the scale of the recovery in OECD demand as

providing the most likely source of upside surprise to our global balances through 2010.

Alongside that, the composition of growth across various products will also be crucially

important in setting sentiment and prices. 2009 has been characterised by a stark contrastbetween strong gasoline and weak distillates demand, but this divergence, in our view, is set

to fade in 2010. The latest data releases showcase the first signs of a global recovery in

diesel demand. After lagging the acceleration in other products, Chinas diesel demand

growth has decidedly turned the corner since September. Moreover, encouraging signs

have also emerged within the OECD. A blast of cold weather in December has helped prop

up distillates demand in Europe and the US. As a result, the pace of erosion of the distillates

inventory overhang has accelerated substantially. In the US alone, more than a third (13.5

mb) of the existing surplus above the 5-year average has been burnt off since the end of

November. And while data are not yet available, the severity of the winter so far in Europe

and Asia makes us believe that the burning off of global distillate surplus is taking place at

an accelerated pace. This rapid progress towards normalisation has been a clearly positive

factor for sentiment but has thus far been highly dependent on favourable weatherpatterns. The key question, therefore, remains what will happen once the prolonged cold

snap in key consuming areas dissipates. We believe that economic effects will take over

from weather effects in continuing the erosion of the distillates surplus. Barclays Capital

economic forecasts and projections for good inventory dynamics in the US underpin this

view. Our economists expect final goods inventories to reach a tipping point in late Q1 10.

After a severe period of destocking in H1 09, the pace of decline in wholesale inventories

slowed substantially in the latter part of the year. This swing has indeed been significant,

with the $160bn decline in Q2 09 projected to less than halve in Q4 09; however, smaller

declines have yet to turn into sequential increases. When this transition occurs, trucking

mileages should start rising significantly, ensuring sequential growth in middle distillates at

some point in the early part of 2010. In our view, distillates demand is the part of the

demand barrel geared to benefit the most from the recovery path this year, which should

provide some upside price potential to the relative price of distillates, particularly in H2 10.

Similarly, on the supply side, we expect some of the most pronounced discontinuities caused

by the global economic crisis to taper off over the course of 2010. For OPEC liquids, 2009

showed the largest annual contraction since 1982. OPEC-12 crude output averaged 28.6

mb/d last year, 2.66 mb/d below 2008. From its peak hit in August 2008 to its bottom in

February 2009, the contraction in OPEC output reached almost 4 mb/d. While production has

drifted higher thereafter (with estimates for December 2009 placing it at about 29 mb/d), it is

still almost 3 mb/d below pre-crisis levels. The substantial supply-side pressure OPEC is

continuing to exert while immediate price targets have already been achieved is a testament to


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8 February 2010 11

its commitment to defend what it has so painfully gained over the year. Thus, with the oil

balance on the path of normalisation, the $70/bbl level that OPECs policymakers have

signalled as the floor to their desired price range at this stage of the cycle will be very hard to

break, in our view. Where the ceiling of that desired range might lie, however, is much less

clear. So far, the producing group has alluded to $80/bbl as the upper end of its comfortable

range. However, with the recovery consolidating, demand data improving and prices pushing

beyond that threshold, we suspect OPEC will gradually relax this ceiling and their price

aspirations will move higher as the year progress. OPECs degree of acceptance of any

development in upside momentum will be a crucial price setter in 2010, as neither the

recovery in demand nor the weakness in non-OPEC supplies appears strong enough to drive

the market on their own accord. By sitting on a substantial amount of spare production

capacity, key OPEC producers have the ability to curb upside momentum, should they wish to

do so. Overall, we expect any adjustment in policy to be gradual and take the form of subtle

changes in tone, rather than any dramatic shifts in targets. Improving demand and weakening

non-OPEC supplies should leave OPEC with some leeway for further output rises through the

year without putting at risk the rebalancing of the market currently underway.

OPECs supply-side management in 2010 is set to benefit from non-OPECs actual and

projected weakness. From the uniformly downbeat non-OPEC output performance of 2008,

2009 proved more of a mix bag, with pockets of weakness coexisting with pockets ofstrength. Against a backdrop of continued widespread structural weakness, some areas of

upside surprise emerged. Particularly, the return to positive production growth in Russia,

following a dismal performance in 2008, and the strong bounce back in US production (up

0.43 mb/d y/y) after the hurricane-affected year of 2008 offered some breathing room to an

otherwise faltering supply side. Non-OPEC production growth in 2009 totalled a modest 0.22

mb/d, suggesting a significant degree of continuity with the scale of weakness in recent years,

rather than heralding the beginning of a new phase of strength. Ahead, we believe the

prospects for non-OPEC supplies are set to deteriorate. The likelihood of last years strong

production performance from Russia and the US being repeated this year is small, in our view.

In the US, positive y/y effects should fade and potentially revert. Although a bunch of new

projects are scheduled to come on stream in 2010, gross capacity additions are set to fall

short of 2008 and 2009 levels. Similarly, we expect Russian production growth to subside in2010. Fewer new projects are scheduled to commence production, whereas the better

investment climate that developed in 2009 due to tax incentives might not hold as the

governments budget concerns diminish with higher and stabilising oil prices.

The projected fall in non-OPEC supply in 2010 should facilitate OPECs market management,

aided by the prospect for a significant acceleration in the degree of non-OPEC supply

weakness from 2011 onwards. As a potential phase of severe supply-side tightness draws

closer, its effect on sentiment and prompt prices will likely increase. In this context, there is a

limit to how low prices can go, irrespective of how slowly short-term oil market balances re-

adjust. The projected tightness of the medium term is acting as a key bullish factor in the oil

market, propping up short-term prices and reducing the need for OPEC to engineer a much

faster and painful rebalancing of the market. Hence, after the rollercoaster of the past two

years, 2010 is shaping up as a year characterised by much gentler dynamics in fundamentalsand prices. Demand dislocations should progressively correct, the inventory surplus should be

eroded and OPEC output restrictions ease. In such circumstances, extreme price events look

unlikely. We expect prices to remain prone to some volatility but within a relatively constrained

range, as periods of economic optimism alternate with seldom, but remnants, of economic

pessimism. With the potential of fundamentally-led extreme price upside at a minimum, we

believe geopolitical developments are the most likely source of upside price risk in 2010, as a

series of situations involving key oil producing countries remains unresolved and subject to

possible escalation as the year progresses.


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8 February 2010 12

NATURAL GAS

Snow blind

A steep expected drop in US supply and recovery-led demand growth have supporteda recent bullish undercurrent in the North American gas market.

We see incrementally more supply against a stagnant demand outlook in latter H2 2010. We expect Henry Hub prompt-month prices to average $5.25, up somewhat from our

fall 2009 estimate of $5.05.

Excluding weather, the wide range of potential US LNG imports and the uncertaintyover the displacement of coal by gas in 2010 could also swing the market.

Balances for 2010 remain fairly loose

The North American gas market continues to price higher in the forward curve in expectation

of a steep drop in US supply (as a result of a lower rig count) and growth in demand (owing to

the economic recovery). Added to this, several weeks of cold weather have helped spark a

bullish undercurrent in the market, as it is slicing away a chunk of the storage overhang that

characterized the start of winter. While snow and cold weather are understandably boosting

market hopes in the near term, we see the risk of becoming distracted by demand and losing

focus on the supply side of the equation.

Producers cut drilling to restore market balance, but production is resilient

The expectation of a supply pullback is not misplaced. Producers have heroically slashed

drilling, but, as it turns out, have not cut activity enough, given that demand will slip in 2010.

US natural gas supply is expected to continue to fall through H1 10, a product of 2009s low

rig count, before it plateaus and then grows modestly at the end of 2010. The recent snowy,

cold weather and price rally could blind producers, prompting an even faster rebound in

drilling. We expect 2010 to register a full 2.1 Bcf/d supply drop from 2009 levels. LNG import

growth of 1.9 Bcf/d over 2009 levels mostly offsets the US decline, but a continued slide in

Canadian production and exports causes total US supply to slip 0.9 Bcf/d in 2010.

Muted power demand to offset other demand sectors

Producers actions to rein in supply and thereby reset the market would be successful if

demand would cooperate and had the market not entered 2010 with such a large overhang of

inventory. Aggregate US natural gas demand is expected to fall for a second straight year in

2010. The power sector is the culprit, as the aggressive displacement of coal in 2009 wanes in

2010. The resultant drop in power sector demand for gas overwhelms gains in residential,

commercial and industrial consumption, even when factoring in a cold January 2010. USdemand is expected to fall 0.8 Bcf/d in 2010 after dropping 0.5 Bcf/d in 2009. Demand has

essentially been flat the past 10 years.

Prices starting strongly, but fading through the year

Balances for 2010 remain fairly loose, given our supply outlook. We estimate that the market

will finish the winter of 2009-10 with 1.74 Tcf of gas in storage, which, while not an all-time

record, is nonetheless excess storage. Despite the potential that cold weather could eat away

at the storage surplus, our balance suggests the market will return to strong storage injections

Michael Zenker

+1 415 274 5488

[email protected]


14/76


8 February 2010 13

after the current winter. The cold weather is offset in our balances by stronger supply. End-of-

October storage inventory is expected to reach 3.94 Tcf, another record. While this inventory

is not expected to overly spook the market, it nonetheless again removes much of the winter

price upside. More importantly, when the market realizes that supply is trending higher by late

2010, bearish sentiment will be expressed out on the curve, since it would mean supply is

again outpacing demand. This could prompt another round of drilling cuts.

We believe cold weather will support prices in Q1 10 and, as a result, have raised our

price view for the quarter to $5.50 (from $5.20). This could blind the market to what lies

ahead. Owing to a view that higher coal prices will raise the gas-coal switching floor in

Q2 10 and Q3 10, we have raised our price view for those quarters to $5.00 (from

$4.75). Our fourth quarter estimate is strongly influenced by our October storage

estimate of 3.97 Tcf. We believe this will hold Q4 10 prices in check at $5.50

(unchanged). This results in our forecast for 2010 prices of $5.25.

Dont be distracted by demand

We believe demand will fail to play a role in helping revive prices in 2010, even with cold

weather in January. This is counterintuitive, given that we expect the US and Canadianeconomies to recover. The drop in 2010 US gas demand is driven by an expected reversal of

coals displacement by gas in 2009, which will push 2010 power sector demand low enough

to offset the gains in the other sectors. And the dilemma for the gas industry is that a recovery

of gas prices in 2010 would only exacerbate the situation by further trimming gas-coal

switching, which would eventually halt the upward movement of gas prices.

In 2009, we dismissed concerns that the US would be flooded with LNG, but we do not brush

aside that argument in 2010. Global LNG supply is almost certain to outpace global LNG demand

in 2010, creating an unusually large amount of spot LNG (please refer to the Global LNG section

of this report). The real question is where the surplus LNG will land. Neither the US nor Europe

appear to be short of gas at this point, so spot trade will head to the market with favorable prices.

That is, the trans-Atlantic spread, not absolute prices, will drive the destination of spot cargoes.

While higher levels of US gas production and/or LNG imports are self-correcting in that they

will ultimately weigh on US prices, potentially flipping the trans-Atlantic price advantage back

to Europe, timing is important. The US market is expected to remain supported through

winter, mainly on weather risk. Not until the market shifts its attention to the US injection

season will the impact of supply become a focus for the market, in our view.

Figure 1: US Lower-48 natural gas supply/demand balances and price

Annual average y/y change

2006 2007 2008 2009E 2010E 2007 2008 2009E 2010E

Supply Total (Bcf/d) 59.12 61.61 62.84 64.04 63.15 2.49 1.23 1.20 -0.89

US L-48 Supply 49.47 51.10 54.57 56.50 54.42 1.63 3.46 1.93 -2.07

Canadian Exports to US, net 8.90 9.05 8.19 7.08 6.28 0.15 -0.85 -1.12 -0.80

US Imports of LNG 1.60 2.11 0.96 1.26 3.18 0.51 -1.15 0.30 1.92Exports to Mexico 0.85 0.65 0.88 0.80 0.73 -0.20 0.23 -0.08 -0.07

Demand Total (Bcf/d) 59.49 63.30 63.42 62.87 62.06 3.81 0.12 -0.54 -0.82

Residential & Commercial 19.83 21.35 21.87 21.99 22.02 1.52 0.52 0.12 0.04

Industrial 17.86 18.17 18.09 16.79 17.62 0.32 -0.08 -1.30 0.83

Power 17.01 18.71 18.18 18.73 17.14 1.71 -0.53 0.55 -1.60

Other 4.80 5.06 5.27 5.36 5.28 0.27 0.21 0.09 -0.08Storage Inventories (Tcf)

End of March 1.69 1.60 1.25 1.66 1.74 -0.09 -0.36 0.41 0.08

End of October 3.45 3.57 3.40 3.81 3.94 0.11 -0.17 0.41 0.13Natural gas price ($/MMBtu) $6.98 $7.12 $8.90 $4.16 $5.25

Source: EIA, Barclays Capital


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8 February 2010 14

GLOBAL LNG

Wind of change

Europe absorbed the bulk of excess spot LNG cargoes in 2009 while maintaining asmall price premium to the US.

LNG demand should follow the global recovery, but supply is set to spike. An extended cold spell could offset any oversupply and reset regional price

differences.

Forward price differentials suggest the US is likely to absorb excess volumes in 2010.

Global gas prices are converging

In 2009, weak demand in Asia coincided with growing supply globally to push a large number

of LNG cargoes into the Atlantic Basin. Market watchers in the US worried that US shores would

be flooded with LNG, exacerbating conditions in a market still working off oversupply. But

Europe absorbed the bulk of the excess (Figure 1), as the continent rejected pipeline gas and

took record LNG volumes, all the while maintaining a small but surprisingly durable price

premium to the US. As a result of the global LNG glut, natural gas prices in Europe, the

Americas and Asia converged, representing perhaps the tightest connection of global gas

prices ever.

The global glut occurred despite underperforming supply. Global liquefaction capacity added a

record 5.8 Bcf/d in nameplate capacity in 2009, but much of this came on line in the second

half of the year. Start-up troubles delayed the ramp-up of production from several of the new

trains, and lost production from existing facilities offset much of the new additions.

Consequently, global LNG supply rose by roughly 1 Bcf/d y/y a substantial increase, yet well

below what the market was expecting.

Weather forecasting

For 2010, the rapid growth of LNG supply is more certain. The liquefaction trains that started in

2009 are gaining speed. If all produce at capacity and 2010 plant additions come on line as

planned, global LNG supply would grow by more than 6.0 Bcf/d y/y this year, a staggering 25%

jump. However, given the history of chronic delays and liquefaction plant glitches, this estimate

is likely too high. A more reasonable assumption for incremental LNG production growth in

2010 is 4.5-5.5 Bcf/d, in our view. Still, this would be a large jump that the global market would

be challenged to absorb.

In contrast to 2009, global LNG demand should grow this year. Green shoots have blossomed in

many markets, and the global economy is on pace for a healthy recovery in 2010. Yet once again,

the magnitude of the expected expansion in supply threatens to flood the world with LNG

volumes well in excess of the potential increase in demand. Assuming a strong, but not full,

recovery of Asian demand and taking into account new re-gasification facilities coming on line in

capacity-constrained markets, LNG takes in the Pacific Basin and the Middle East could grow by 2

Bcf/d this year, following a 0.5 Bcf/d y/y drop in 2009. South American and Mexican consumers

could contribute a further 0.5-0.7 Bcf/d y/y growth in global demand. Against an estimated 5

Bcf/d y/y increase of global LNG supply next year, this would leave more than 2 Bcf/d of LNG

looking for a home in the US and European markets in 2010.

Biliana Pehlivanova

+1 212 526 2492

[email protected]


16/76


8 February 2010 15

Forward price differentials suggest thatspot Atlantic Basin LNG should flow to the US for most of 2010

Last year, most excess spot LNG sailed to Europe. In 2010, winds of change might shift the

course of Atlantic Basin spot LNG sharply westat least, that is what current forward prices

suggest. On a prompt-month basis, Henry Hub has maintained a premium to UKs NBP for

the past month, and the premium is carrying over across the forward curve for nine months

of 2010, beginning at the prompt February contract. The northeast markets of the US offereven better economics than the Gulf Coast relative to NBP, on both a prompt and a forward

basis. With price differentials favoring US ports, Atlantic basin spot cargoes are increasingly

likely to sail west.

Weather is a key risk to the global gas market

Weather could significantly alter the outlook for global gas (and LNG) markets this year, as

North America, Europe and parts of Asia have all been unusually cold. Most global LNG

consumption is in the northern hemisphere and is, therefore, exposed to the risk of cold

weather in many markets simultaneously. In Europe, UK demand jumped to record daily levels

in January, pushing deliverability infrastructure to its edge and causing shortages in some

cases. China has been struggling to meet the heating load in its northern provinces, as the

country has been hit by an extended period of extreme cold. This cold weather event has

already helped reduce the inventory surplus around the world, although not yet enough to

ensure a balanced market. The cold could prove to be transient, but a continuation of below-

normal temperatures across the globe over the course of the northern hemisphere winter

could have a substantial effect on balances, potentially alleviating much of the oversupply and

resetting regional balances and price differentials. With a good part of the winter still ahead,

weather patterns will be a key variable to watch over the next two months.

LNG is evolving into a dynamic and increasingly nimble marketplace. With spot cargoes now

frequent and given the growing number of market participants seeking to arbitrage regional

price differentials, LNG is connecting the geographically fragmented gas world. In this context,

global gas prices are likely to maintain their newly acquired regional link. With the colder-than-

normal winter weather recently, Asian markets are again leading in spot LNG prices, albeitwith a relatively small premium to the Atlantic Basin. Weather has the potential to clean up

global LNG balances, but short of a major extended cold weather event, the ramp-up of

liquefaction plants and the moderation of heating load as the winter wanes should pressure

spot LNG prices around the world to again trade closely in 2010.

Figure 1: Y/y change in LNG imports by region, Bcf/d

-3

-2

-1

0

1

2

3

4

5

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

US Latin America Europe Asia

Source: Waterborne, Barclays Capital


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8 February 2010 16

COAL

The patient is getting better

We are positive on the outlook for coal, forecasting averages of $90/t, $84/t and$90/t for API 2, API 4 and Newcastle prices, respectively, in 2010.

A broad-based recovery in Asia with continued Chinese and Indian import strengthfor Pacific Coal would support upside momentum.

There has not been much improvement in infrastructural problems at key exportingcountries, causing supply bottlenecks to re-emerge as a major theme.

Market set to strengthen

In 2009, the market was being driven by weak demand in the Atlantic basin, which was

driven by the effect of the deep economic recession across the basin and displacement in

power by gas markets deep in oversupply. The reduction in demand led to a build-up in coal

inventories on both sides of the Atlantic. Coal prices in the weak Atlantic basin were savedfrom deeper reductions by a Pacific coal basin dominated by the remarkable strength in

Chinese and Indian imports. In 2010, we expect more of the same from China and India, which

will likely remain key positive influences on the market. Against expectations for an improving

macro backdrop, we look for a broader-based recovery in demand from other parts of Asia

and, to a lesser extent, the West.

In our view, there are a number of sources of upside. First, supply bottlenecks remain in key

exporting nations such as South Africa and Australia. Rail problems and port congestion

issues have not been resolved, and the recent downturn has been characterised by a lack of

investment in infrastructure to address these problems. As a result, should coal import

demand rise strongly, the export capacity is likely to falter yet again, much like a repeat of

what happened in early 2008. Second, there could well be stronger-than-expected Indian andChinese imports. Despite the strength in Chinese coal demand, we expect coal imports to ease

about 2% y/y, as we see a resolution to the deadlock between producers and utilities that

characterised much of 2009. We forecast Indian imports to rise 20% y/y, even after factoring

in that their ambitious capacity addition plans may not always come to fruition. Nonetheless,

both countries continue to grow extremely strongly, with coal as their preferred fossil fuel for

power generation. As a result, their import requirements could surprise to the upside. The

third factor is disappointments in Indonesian exports. Despite strong growth in production,

uncertainties remain regarding the new mining law. The Indonesian government is expected

to release four implementation regulations in that will hopefully clarify certain clauses in the

mining law and reduce regulatory uncertainty. However, controversial parts of the law remain.

The final source of upside risk is coal gaining back a larger share of demand relative to gas in

power generation in the US and partly in Europe. The very weak gas market in 2009 led to coaldemand falling about 10% y/y on both sides of the Atlantic. With higher gas prices compared

with domestic coal prices (contracts agreed on 2009 levels) in the US, we expect coal to regain

some of its lost market share this year, though to a lesser extent in Europe, as forward gas

prices remain well in the money.

By region, we expect Newcastle to continue to outperform API 4 mainly due to strong Asian

demand and API4 to continue to battle high European stockpiles despite buoyant Indian

demand. That said, more competitively priced Richards Bay coal compared with Newcastle

has drawn Chinese buying into South Africa recently, thereby squeezing the differential

Amrita Sen

+44 (0) 20 3134 2266

[email protected]

Yingxi Yu

+65 6308 3294

[email protected]


18/76


8 February 2010 17

between the two to $5/t by late 2009, from almost $15/t in late November. With China

looking to exploit any arbitrage opportunity that arises, the spread between the two prices

is likely to remain tight, though with Newcastle prices at a premium to API-4. Across the

forward curve, we see strength at the front as bringing about curve flattening, which could

present a risk to the release of stockpiles back into the market. We forecast averages of

$90/t, $84/t and $90/t for the API 2, API 4 and Newcastle, respectively, in 2010.

Much of the impetus for this latest price rally has been weather-related. We see cold

weather in China as a key driver of the strength in API 4 and Newcastle coal. A jump in

Chinas power needs is imposing tremendous stress on its supply system, reflected in fall ing

stocks at power generators across the country; in some cases, shortages have already led to

power rationing. Domestic prices have gone from strength to strength. In early January,

Qinhuangdao (QHD) FOB prices surged above $112/t, and delivered prices in Guangzhou

moved closer towards $130/t, encouraging interest in overseas coal not just in Australia

and Indonesia but also in South Africa. At the same time, a cold snap in the Atlantic is

driving up power demand and gas prices, improving the relative attractiveness of burning

coal. While weather remains the greatest upside risk to our baseline forecasts, other

fundamental factors turned constructive over the course of 2009. The agreement of an

$85/t term price between Tokyo Electric Power and Xstrata (versus a buyers target of$75/t) is telling of underlying concerns about tight supplies beyond the very short term, a

striking contrast with market sentiment this time last year.

Thus, for 2010, we continue to view coal markets constructively and, in our view, despite

being one of worst performing commodities in 2009, prices are set to increase strongly,

with an average increase of 15-20% annually. China remains the key to our global balances,

and with the expectation of a slow but steady recovery in Europe, the supply bottlenecks

that plagued the coal market in early 2008 could well re-emerge this year, given the lack of

investment in export infrastructure to increase flexibility and capacity. The wild movements

in prices at the beginning of this year already serve as a testament to these risks.

Figure 1: Barclays Capital coal supply and demand balance and price forecastsMt 2003 2004 2005 2006 2007 2008 2009E 2010F

Japan 107 118 120 119 126 131 114 1

China 7 10 16 31 41 31 82 88

India 13 15 24 29 35 36 49 59

Europe 167 160 156 169 163 161 144 140

Others 193 217 153 231 250 259 246 265

Total imports 487 521 469 578 616 618 635 665 y/y change (%) 6.9% -9.9% 23.2% 6.6% 0.3% 2.7% 4.8%

Indonesia 88 105 129 183 195 200 215 224

Australia 103 107 107 111 112 125 140 151

China 73 74 61 54 45 36 18 21

Russia 0 0 68 76 74 70 80 74

South Africa 70 67 74 67 67 68 67 70

USA 3 3 19 20 24 21 20 23Colombia 44 51 55 58 65 69 65 67

Others 8 18 32 41 46 40 37 37

Total Exports 389 426 545 611 627 629 642 668 y/y change (%) 9.5% 27.8% 12.2% 2.7% 0.2% 2.1% 4.0%

Global trade balance -98 -94 76 33 11 11 7 3

API 2 (US$/t) 44 72 61 63 87 144 71 90API 4 (US$/t) 31 54 47 50 62 120 66 84

Newcastle (US$/t) 27 53 47 49 66 128 72 90

Source: McCloskeys, Ecowin, Barclays Capital


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8 February 2010 18

POWER

Twilight

Power consumption growth is likely to follow a rebound in the economy in 2010 aftertwo consecutive years of demand losses.

New supply is knocking at the door, primarily via more renewables capacity. Expectations for future power prices have largely moved with gas prices. A longer-term contango for heat rates suggests a recovery in power prices, though it

may lie beyond 2010-11.

Demand shrinks, supply grows

A one-two knockout punch took out power demand in 2009, and any recovery will not be

immediate. The economic recession officially began in December 2007 but became more

harrowing in late 2008, severely constraining power usage. On top of this, extreme temperatures

were largely absent, particularly for the summer, adding another layer of demand weakness. In

aggregate, power consumption fell 3.6% in 2009 versus 2008. Weather contributed about 0.6%of this drop, leaving 3.0% that, in our view, is related to economic weakness.

The past year was one for the record books for power consumption. Average growth had

been 2.4% from 1973 to 2007, and there had been just three years of annual contraction

1974, 1982, and 2001 which correspond to major economic downturns. It is the only

recession to have seen consumption fall for two consecutive years, and it showed the

largest annual contraction at 3.6% since data collection began. As a consequence,

demand for US power is back to 2004-05 levels.

At an end-use level, the pullback in electricity consumption was steepest in the industrial

sector. The magnitude of the recent pullback exceeded the dips in previous recessions,

specifically those of the early 1980s and in 2001. What also separates the recent recession is

the weakness in residential and commercial power use, previously demand stalwarts. In 2009(through October), residential consumption was down 0.9%, commercial usage was down

2.4%, and industrial demand was down a striking 11.6% (Figure 1).

In aggregate, 2010 should show a partial uptick as the economy recovers and temperatures

regain their bite, versus 2009s moderation. It may take several years to reach the 2007

peak, but our forecast for super-normal growth next year (owing to a hastened industrial

recovery and normal growth in residential and commercial) of 3.5% should support prices.

With a few years of demand growth lost in the contraction of 2008-09, the market may

have hoped for a supply contraction to match. Unfortunately, this is a near impossibility in

power markets. With new build uneconomic given the price environment (low forwards),

growth in supply may seem surprising. Coal and wind additions are the most meaningful,

with the former a result of plants under way before the recession and the latter due toincreasing renewables mandates. Coal capacity could grow almost 16 GW in the next four

years, about half of which arrives in gas-dominated regions. Further wind build is more

uncertain. Though we expect similar nameplate growth in wind resources as in coal, these

will operate at a lower capacity factor, and still, there is much risk to future growth in wind.

Pushing and shoving amongst generation fuels

As the top-line in power generation has shrunk, the various fuels in the stack have entered

into competition for share. Total generation shows a 4.4% aggregate decline versus 2008

James Crandell

+1 212 412 2079

[email protected]


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8 February 2010 19

(through September). Virtually all of the total demand loss has been borne by coal-fired

generation. Although petroleum and solar were down about in 2009, the magnitude of the

drop in GWh terms is very small. That wind and natural gas-fired generation were net

winners last year explains why coal generation fell by more than aggregate generation.

Our research has highlighted the high level of coal/gas displacement in the power sector (see

Natural Gas Weekly Kaleidoscope: How will coal surprise in 2010? 1 December 2009). While

low natural gas prices are primarily responsible, changing load profiles and higher contract

coal prices also played a role in the displacement. We estimate that displacement has been on

the order of 20,000 aMW (or 3.0 Bcf/d at a 7.5 MMBtu/MWh heat rate). Next year, we believe

natural gas prices will need to compete with coal for part of the year (about $5.00/MMBtu for

gas), saving gas inventories from becoming too bloated. As a result, we expect a partial

reversal of the relationship between the two fuels in 2010. We project that coal will reclaim

some share, up 10.3% in output from 2009. Natural gas, the marginal fuel in many regions, is

the clear loser, and we forecast gas generation will fall 6% in 2010 (Figure 2).

Prices have rallied with gas

Power prices tend to follow broad moves in the fuels that serve the generation stack,

particularly natural gas, as it is frequently on the margin in most regional power markets.

Gas and coal prices have risen recently, helping power prices to gain footing as well.

Looking at the heat rate (the ratio of power prices to gas prices) is often more instructive

than focusing on power prices. Heat rates were stronger for much of 2009, a result of

operations and maintenance costs claiming a greater share as natural gas prices plunged

and the shift in output between coal and gas-fired units. As gas prices rallied for much of

Q4 09, power prices remained a laggard, and heat rates fell. The ups and downs resulted in

heat rates that were little changed from pre-recession 2008 levels.

While it is true that forward power prices have moved in tandem with forward natural gas

prices, particularly for regions in which gas is on the margin, it is important to note the

differentiation. In most regions, the curve is upward sloping, suggesting that the market is

pricing in a recovery, or tightening, of the power market. Interestingly, the majority of thesecurves are backwardated in the front. While this could simply reflect selling pressure on

power at the front of the curve, it also likely depicts oversupply and a period of fundamental

looseness for power, until higher power prices (relative to gas) are realized. As discussed

above, the pace of demand recovery will be essential for the recovery of the power markets.

Figure 1: Annual growth in end-use consumption Figure 2: Annual % change in generation

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

Residential CommercialIndustrial Total

-20%

-10%

0%

10%

20%

30%

40%

Coal

Petroleum

Natural

Gas

Nuclear

Hydro

W,W,&G

Solar

Wind

Total

2009 through September 2010E

Source: EIA, Barclays Capital Source: EIA, Barclays Capital


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8 February 2010 20

CARBON

This is a low

Out to 2012, the market is long EUAs by some 224 Mt, and 2013 is a net short of 170 Mt. We expect 2010 to trade similar to 2009, but some better price support in the latter

half of the year.

We look for prices to average about 15 /t over the second half of 2010. Average EUA prices should continue to increase in 2011 and 2012, rising to 18 /t in

2011 and 24 /t in 2012 as 2013 short positions are increasingly priced in.

Market remains long

2009 was a hard year all around, with difficult economic conditions matched by a challenging

political environment in which to advance climate change policy. The carbon market fared

moderately well it recovered from a very weak Q1 09 to trade largely within 13-15 /t for the

remainder of the year. The Dec 09 contract traded at an average price of 13.37, a 40% reductionon the average 2008 price (22.35 /t), reflecting the sustained effect that the economic recession

has had on prices. We are forecasting that industrial output across the EU-27 will be 15% down

y/y, although this hides some of the big y/y reductions in some sub-sectors such as steel, which

had a 37% fall in output y/y over the first 10 months of the year. Such industrial length has

weighed heavily on the carbon markets all year.

For the power sector, 2009 was a year of low emissions. EU-27 power demand was down an

estimated 8.5% y/y. Within that, thermal generation also fell, given better hydro and wind

availability in most regions, with the exception of the Nordic countries, which actually had a fall

in hydro. In the thermal generation sector, the very weak gas market led the Dec 09 NBP

contract to shed 50% of its value over the year, and, as a result, gas generation remained in the

money for most of the year. The weak gas market was driven by low European demand and acounter-cyclical increase in supply due to a significant increase in LNG regasification capacity in

the UK. Consequently, gas generation tended to be used more than coal in terms of y/y

reductions, providing a further reduction in European emissions.

The curtailment in economic activity and the falls in power sector emissions have shifted

market expectations to persistent length. As the year closes, we expect 2009 to be 129 Mt long

(with allocations exceeding emissions) and the phase to be 224 Mt long. The fact that the

expected annual and phase length did not completely collapse the market was testament to the

importance of utility hedging patterns against some reluctance from industrials to sell. In terms

of utilities, the fact that they remain short of allowances in aggregate and that they hedge a

number of years in advance means that the buy side of the market has been fairly good this

year. On the sell side, the reluctance of industrials to sell at lower prices has been driven byexpectations of post-2012 shorts, the ability to bank surplus allowances and an improvement in

underlying credit markets. Given these combined factors, prices remained fairly rangebound

during the year with few excursions outside of 13-15 /t. When prices started to fall below that

level, the sell side started to evaporate, and when they rose, it helped to bring some more of

that industrial length into the market.

The market outlook: Weakness in Q1 but then better

While the economic outlook has shown signs of moderate improvement in the EU, economic

activity in 2010 will still likely be down on 2008 levels, recovering only about 1.6% against a 2009

Trevor Sikorski

+44 (0) 20 313 40160

[email protected]


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contraction of 3.9%. Given this, our forecast for the phase sees a long market out to 2012, with

the competing factor of an improvement in economic outlook being more than offset by bigger-

than-expected reductions from the power sector. We are forecasting that:

Out to 2012, the market is long EUAs by some 224 Mt a slight reduction from ourprevious report (238 Mt). 2013 is a net short of 170 Mt. The estimates of market

balance for the phase are sensitive to the levels of economic growth assumed and the

speed of recovery in Europe during the coming three years. Our estimates are for a very

moderate pace of recovery over the coming years.

Although emissions begin to increase in 2010, due to moderate economic growth, therelatively low level of industrial output will keep this in check. The net long position in

the market increases in that year due to the increase assumed in the cap, with more NER

being allocated to new power sector installations.

Figure 1: EU ETS phase 2 supply and demand balance

Phase 1 2008 2009 2010 2011 2012 Phase 2

EUA Allocation (cap) 2107 2003 2065 2083 2099 2490 10741

Emissions 2071 2119 1937 1988 2037 2437 10517Emissions cap -36 116 -129 -96 -62 -54 -224

Note: phase 1 = annual average, 2007 emissions = 2165 Mt. Source: CITL, Barclays Capital

The Q1 10 price story is now one of industrial length versus utility buying, driven by the much

colder-than-expected start to the new year. We continue to expect some industrial selling finally

manifesting itself in Q1 10, although even here there are two opposing dynamics. One, the credit

position of the industrials has improved drastically, while order books are having modest

improvement (still down on last year). The underlying conservative nature of the smaller industrial

participants, and the free nature of the EUAs that are often maintained on the balance sheet at zero

value, may lead to passive banking and may conspire to keep this length off the market. This

would be price sensitive and we would think any price movements up towards the 15 /t areawould be met with some additional industrial volumes coming for sale. Two, the industrials

certainly have more length, with industrial output some 17% down on last year, and while credit is

much better, it is still not where it was before the financial crisis of last September. As such, in a bad

year for underlying business performance, the ability to boost bottom lines and profitability will

likely still be there to stimulate some selling.

The big issue here is whether long industrials look at any weakness in current prices (sub-14 /t)

and decide that they may be too low to tempt them to cash in current volumes to de-hedge, in

effect. If there is a real concern that cashing in today at the low is going to mean having to buy more

at much higher prices in a few years time, the keeping off the market of the significant length we still

think is out there could provide better price support than we have been expecting.

The cold start to 2010 is the other factor that should provide price support. The cold weather

increases power demand for any space heating done through electrical heaters, increasing the

need for thermal generation, and has a strong effect on the price of gas, making coal more

competitive and increasing the emissions levels from the total level of thermal generation. Both of

these bring the utilities into the buy side and should help provide some greater price support to

absorb some of the industrial length.

Given these competing features, our price forecast for Q1 10 is 12.0 /t, while for H2 10 it is 15 /t.


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GEOPOLITICS

Year of living dangerously

The internal politics of Nigeria continue to cause concern and present a significant riskfor the oil market.

The stand-off over Irans nuclear programme looks as if it will heat up in 2010, with someof the starker options still under discussion.

Iraqi parliamentary elections could have some important implications for oil output in theregion.

Three key risks

Nigeria remains, in our view, the biggest near-term supply disruption risk. Militia violence in the

restive Niger Delta has reduced its output by nearly one-third since 2007, but a recent presidential

amnesty plan and development initiative for the oil region had raised some hopes that there could be

an incremental return of some lost production. In October, most of the major militia groups agreed

to a temporary cease fire. However, President Yar Aduas severe health problems, which have kept

him out of the country since November and produced a political vacuum in the capital, effectively

halted progress on the peace process, and there has been an uptick in attacks on the countrys oil

infrastructure since late December. In addition, under the terms of the constitution, Vice President

Goodluck Jonathan, who hails from the Niger Delta, would automatically assume the presidency if

Yar Adua could not continue in office. This development, however, would violate the unwritten

agreement that the presidency must rotate between the Christian south and the Muslim north and

that, therefore, a northerner must occupy the office until 2015. Any attempt to prevent Jonathan

from becoming president would likely outrage the residents of the Niger Delta, which produces

nearly all the wealth for the country and has never held the presidency, and could turn what has

been a low level insurgency into a much broader armed conflict. Finally, violence could increase in

the Niger Delta as preparations for the 2011 elections commence. In the 2003 and 2007 election

cycles, powerful politicians in the oil region armed local militia members to intimidate their politicalrivals and prevent people from voting. Attacks on the nations energy infrastructure increased

dramatically in the period leading up to the polls. There is nothing so far to suggest the link between

armed militancy and Nigerian electoral politics has been broken; thus, we expect a significant rise in

attacks again by H2 10 at the latest as the campaign begins to kick into high gear. There are already

media reports of weapons shipments arriving in the country, sparking fears that election-related

violence could commence earlier this time around.

The stand-off over Irans nuclear program could heat up in 2010 and raise fresh fears about a

potential military confrontation that could threaten the security of the Strait of Hormuz and Gulf

energy suppliers. The US and its European allies are preparing to impose punitive sanctions on Iran

following Tehrans failure to meet President Obamas end-of-December deadline for progress in the

nuclear negotiations. The White House is likely to focus initially on targeting dozens of Iranian

Revolutionary Guard (IRGC) front companies. The guards role in the Iranian economy has expanded

dramatically during President Ahmadinejads tenure in office. In September, the IRGC bought a

controlling stake in the Telecommunication Company of Iran, and members of the infamous security

organization acquired large interests in oil and gas fields, airports, health clinics and engineering and

construction firms.

The US Congress is also moving ahead with its own sanctions legislation. In December, the House of

Representatives passed legislation that authorizes President Obama to impose sanctions on

companies that supply Iran with gasoline, assist in the construction of refineries in the country and

Helima Croft

+1 212 526 0764

[email protected]


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8 February 2010 23

provide the insurance and shipping services that enable Iran to import refined petroleum products.

The Israeli government is working closely with the US Congress to shape the legislation. At a lunch at

Barclays Capital last month, Moshe Yaalon, Israels Vice Prime Minister and Minister for Strategic

Affairs, said he was very optimistic that tough economic sanctions could change the Iranian

regimes behaviour, given the unprecedented domestic opposition it is facing in the wake of the

disputed June elections. In late December, thousands of demonstrators again took to the streets of

Tehran and other cities to demand the ousting of the government. The governments inability toquash the protest movement has led some leading Iran analysts to suggest the country may be

witnessing a nascent velvet revolution similar to that which swept communist regimes from power

in Eastern Europe in 1989.

Despite the rising domestic discontent in Iran, sanctions may still not alter the regimes nuclear

calculus. Even if Congressional legislation forces European and Indian companies to stop

supplying refined petroleum products, Iran will still be able to obtain the products from the spot

market in the Gulf. While this will undoubtedly be more expensive and increase the pain in a

country with double-digit inflation and unemployment, it might not be as effective as US

lawmakers would hope. Iran already appears to be stockpiling gasoline in anticipation of new

sanctions. Its January gasoline imports are expected to jump 23% from the previous month. If

sanctions do not force the Iranian government to change course, the Obama Administration

will likely face pressure at the end of 2010 to opt either for a containment strategy similar to

the one the US pursued in relation to the USSR in the cold war or to pursue a military strike

against the nuclear facilit ies. Obama's senior military advisors have publicly stated on numerous

occasions that a military strike would likely only set the Iranian nuclear program back two to

three years and could cause additional unrest in the Middle East.

Iraq is facing an important transition year in 2010, with parliamentary elections scheduled for March

and the US preparing to withdraw all combat troops by the end of August. Both events could have

important implications for the governments ambitious efforts to triple oil output by the middle of

the next decade. The Maliki government held two oil licensing rounds in 2009 and is close to

concluding service contracts with international oil companies to develop nearly a dozen fields,

including the giant Rumalia, Majnoon and West Qurna fields. However, the 7 March elections could

lead to a shift in the governments energy policies if Maliki does not prevail. In October, the head of

the parliamentary oil committee warned that a new government could revise or even cancel the

contracts, insisting that there are no guarantees for the oil companies that the new government will

follow the same path in dealing with them. Prime Minister Maliki pulled out of the ruling United Iraqi

Alliance in September, citing a desire to build a more broad-based political movement. His State of

Law coalition, which includes several Sunni parties, will now face the Iraqi National Alliance, which

includes some of the most prominent Shiite political parties such as the Islamic Supreme Council of

Iraq (ISCI) and Moqtada al-Sadrs Sadrist Trend party. It should be noted that ISCI has a different oil

policy than Maliki and has called for greater regional autonomy for the South and more oil revenue

to remain in the region.

Senior US commanders in Iraq have warned that the months following the polls could be particularly

tense as the various parties engage in protracted horse-trading to form a new government. It also isunclear when the oil laws which cover issues such as revenue allocation; contract terms; foreign

access to the fields; and the role of local, regional and the central government in setting oil policy

will be passed. Kurdish members of parliament are currently blocking the legislation to force the

government to recognize the legality of the two dozen oil contracts signed by the Kurdistan regional

government and to secure a favourable resolution to the Kirkuk impasse. Finally, despite the steady

decline in violence since the peak of the civil war, a series of car bomb attacks in December and

January targeted government institutions in central Baghdad, similar to the coordinated bombings

there in August and October. Therefore, the security situation remains fragile and could imperil

investment in the country.


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CREDIT


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US HIGH GRADE ENERGY

Value is elusive in 2010

Oil field service and refining remain the cheapest sub-sectors, but we think only oilfield service is poised to outperform.

Both the independent E&P and integrated sectors are rich versus U.S. corporates.

Summary of investment view

The overall energy category is trading rich to its 10y average differential relative to the U.S.

Corporate Index but cheap to its 10y average differential to the broad industrials bucket. In

2009, it outperformed the U.S. Credit Index by 721bp, with sub-sector results versus U.S.

Credit as follows: 1,188bp for independent E&P; 258bp for integrateds; 920bp for oil field

service; and 1,554bp for refining.

Oil field service and refining remain the cheapest sub-sectors, but we think only oil field

service is poised to outperform. Although the North American oil services industry appearsto be working through a trough that is likely to persist for much of 2010, we believe activity

levels have bottomed and service-intensive shale activity will remain robust. For refining,

wide spreads may offer room for outperformance in early 2010, but we remain

Underweight, given our long-term bearish call on the sector and our view that 2010

consensus estimates remain too high. The refining industry is still interesting from a trading

standpoint, but we recommend that buy-and-hold, long-term investors avoid it. We are

Overweight the oil field service sector and Underweight the refining category.

Both the independent E&P and integrated sectors are rich versus U.S. corporates. In light of

our strategy teams view that financial spreads will continue to normalize in 2010, we

expect the independent E&P sector to perform in line with the market and the integrated

sector to again lag the broader index. Within the independent E&P and integrated buckets,we prefer companies with leverage to oil rather than natural gas, given the challenging

supply/demand dynamics of the latter. We are Market Weight the independent E&P sector

and Underweight the integrated category.

Investment recommendations

Buy Nexen cash (OW); Sell Suncor CDS (OW). Although execution issues at NexensLong Lake will remain a concern in 2010, we find the company well positioned, given its

leverage to oil prices

Documents

Barcap Global Energy Outlook Feb 2010