The Role of Speculation in Energy Markets January

The Role of Speculation in Energy Markets January 25, 2007 Kyle Dickard Managing Director, Global Commodity Analysis 1

Overview Quotes on Speculation Market Manipulation Defined Benefits of Speculation in the Energy Markets Hedgers, Speculators and Investors Speculation and Volatility Potential Impacts of Speculation on Price Other Drivers of Price Movements Market Responses to Price and Shape of the Curve Changes in Historical Relationships Conclusion 2

Quotes on Speculation “Overwhelmingly, academic research has shown that speculation actually reduces price volatility and that speculation increases availability of market information. Recent CFTC data supports the research by showing that physical commodity futures markets with higher non-commercial participation have lower overall volatility. ” “Our bill would give regulators the information needed to expose oil traders engaging in market speculation or manipulation. ” 3

Market Manipulation “Any planned operation, transaction, or practice that causes or maintains an artificial price. Specific types include corners and squeezes as well as unusually large purchases or sales of a commodity or security in a short period of time in order to distort prices and putting out false information in order to distort prices. ” CFTC 4

Benefits of Speculation in the Energy Markets n Counterparty for Hedgers n Accept Risk n Add Volume n Provide Broad Market Information n Create Liquidity n Reduce Volatility 5

Hedgers, Speculators and Investors n n New Participants • Pension Funds • University Endowments • Hedge Fund Investors • Financial Institutions Commodities as an Asset Class 6

Speculation and Volatility Crude Oil Futures and Options Commercial and Non Commercial Positions 1995 - Current 7

Potential Impacts of Speculation on Price n Estimated $100 B from investors enters markets n 40% allocated to crude oil n Incremental demand of 1 MM barrels per day n Strong uptrend in prices 8

Potential Impacts of Speculation on Price NYMEX Crude Oil Prices and Total Open Interest Positions 1995 - Current 9

Other Drivers of Price Movements n Lack of investment in energy infrastructure n Asian and North American demand n Lack of investment in exploration and production n Limited potential for OPEC swing production n Threat of disruption in producing regions n Terrorism premium n North American natural gas fundamentals 10

Market Responses to Price and Shape of the Curve n Stimulate additional production of both natural gas and crude oil n Increase in inventories n Scale back of consumption n Finance production and storage to meet future demand Oil Rigs and NYMEX WTI Price Natural Gas Rigs and NYMEX Nat. Gas Price 11

Changes in Historical Relationships n Traditionally, there was an inverse relationship between crude oil price and inventory n High inventories meant low prices and vice versa n Recently, we have seen high inventories AND high prices 12

Changes in Historical Relationships n Relationship between crude oil inventory and price appears to have changed in 2004 n Gulf War points illustrate price increase on PERCEPTION of future supply disruption 13

Changes in Historical Relationships n Relationship between crude oil inventory and shape of the curve remains relatively unchanged n Strongest incentive to store when inventories are the highest and vice versa 14

Market Responses to Price and Shape of the Curve n Global demand outpaces supply n Spare refining capacity declines over time Global Spare Refining Capacity (Capacity – Refinery Runs) 15

Market Responses to Price and Shape of the Curve n Contango shape of the forward curve n Adequate supplies in the near term n Supply concerns in the future 16

Conclusion Speculators are Necessary n Meet the needs of hedgers n Provide liquidity n Reduce volatility Potential Causes of Price Movements n Investors enter energy markets n Lack of investment in energy infrastructure Crude Oil Futures and Options Commercial and Non Commercial Positions 1995 - Current 17

Disclaimer Merrill Lynch prohibits (a) employees from, directly or indirectly, offering a favorable research rating or specific price target, or offering to change such rating or price target, as consideration or inducement for the receipt of business or for compensation, and (b) Research Analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investor clients. This proposal is confidential, for your private use only, and may not be shared with others (other than your advisors) without Merrill Lynch's written permission, except that you (and each of your employees, representatives or other agents) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the proposal and all materials of any kind (including opinions or other tax analyses) that are provided to you relating to such tax treatment and tax structure. For purposes of the preceding sentence, tax refers to U. S. federal and state tax. This proposal is for discussion purposes only. Merrill Lynch is not an expert on, and does not render opinions regarding, legal, accounting, regulatory or tax matters. You should consult with your advisors concerning these matters before undertaking the proposed transaction. 18