April 2008

Stronger signals of weaker oil prices

Edward Morseemorse@lehman.com+1 212 526 3767

Oil market puzzle: high prices now, but weakness ahead

We revised up our 2008 Brent forecast to $93 from $86 primarily because financial demand for oil and commodities has been stronger than anticipated– Current oil market is seasonal and volatile and $50 trading range (i.e. between $70-

120) may repeat itself just as in 2007Although the case for financial demand is compelling, we do not see it as sustainable in the medium termTurning point in oil markets is coming, borne out by leading indicators:– Oil increasing looking less of an effective hedge against the dollar/inflation– Reduced outlook for global demand growth, particularly in US– Growing inventory builds through 2009– Longer term indicators point to upstream and downstream supply response

“New fundamental factors” have buoyed oil prices this year, but physical and financial indicators point to weakness ahead

Lehman Brothers Oil Price Outlook 1Q07A 2Q07A 3Q07A 4Q07A 1Q08E 2Q08E 3Q08E 4Q08E 2006A 2007A 2008E 2009E Brent ($ per barrel) 58.62 68.66 74.61 88.53 96.31 90.00 105.00 80.00 66.15 72.60 93.00 83.00 WTI-Brent differential -0.16 -3.45 0.47 1.98 1.51 -1.00 1.00 -1.00 0.34 -0.29 0.00 0.00

1

Crude Oil Runs (mb/d)

13.5

14.0

14.5

15.0

15.5

16.0

16.5

J F M A M J J A S O N D

Prior 5 Year Range Prior 5 Year Average2007 2008

Principal Product Demand (m b/d)

13.5

14.0

14.5

15.0

15.5

16.0

16.5

17.0

J F M A M J J A S O N DPrior 5 Year Range Prior 5 Year Average2007 2008

Short-term fundamentals have weakened

Weekly statistics show US principal product demand 420k b/d lower y-o-y in 1Q08, half of which is gasoline, distillate and jetRefinery runs depressed in the US, Europe and Asia in large part due to economic run cuts– But despite US runs 140k b/d lower y-o-y in 2008, principal product production is running 10k b/d higherUS/Europe distillate demand drops 500k b/d from February to March and by another 700k b/d from March to April

We have revised down our 2008 US demand growth from flat to -300k b/dWe now see non-OECD growth of 1.2m b/d entirely driving global growth of 1.1m b/d, revised down from 1.5m b/d originally

Lower US and OECD demand leave global consumption growth at only 1.1m b/d

US principal product demand down US crude demand has dropped as well

________________Source: EIA

2

83

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85

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89

Jan-

07Fe

b-07

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-07

Apr-

07M

ay-0

7Ju

n-07

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7Au

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-08

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-08

m b/d

Global Demand Global Supply

Inventory builds and periods of relative price weakness

Stock builds characterize much of the remaining yearUnless OPEC decides to cut output, 2008 inventories should build by 300k b/d

Lehman Brothers monthly oil supply-demand balance

________________Source: Lehman Brothers.

But Q3 prices may still spike with active hurricane season, Middle East summer power needs, and geopolitical tensions in Iraq or Iran bubbling up

3

So, why then revise prices up?

Legitimate demand for oil exists for things other than end use:– For portfolio diversification– As a store of value– As a hedge against inflationWe estimate index flows into energy have totaled about $40 billion YTD, almost equal to flows for all of 2007However, enthusiasm retreated somewhat over past month with tougher margins and profit taking prevailingRemains to be seen if new index investors such as sovereign wealth funds of countries with physical long exposure to oil will remain “double expose” if prices retreat further

Passive fund flows into oil and energy have accelerated this year

YTD fund flows have been strong

020406080

100120140160180

2000 2001 2002 2003 2004 2005 2006 2007 2008(YTD)

WTI Brent Other Energy

$bn

________________Source: Lehman Brothers Estimates

4

WTI performance is only in the middle of the packS&P, which owns the GSCI, has indicated that $40 billion of new money has flowed into commodities since January 1, 2008

Individual Commodity Returns (% from Dec. 31 to Mar 31, 2008)

________________Source: Bloomberg

-30

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0

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40

Nat

ural

Gas

Cop

per

Tin

Alu

min

um

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n

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tinum

Nic

kel

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ladi

um

Silv

er

Coc

oa

Hea

ting

Oil

EU

RU

SD

Gol

d

Sug

ar

Gas

olin

e

Cru

de o

il

Whe

at

Soy

bean

Oil

Cot

ton

Zinc

Lean

Hog

s

Lum

ber

Soy

bean

s

Cof

fee

Soy

bean

Mea

l

Live

Cat

tle

Por

k B

ellie

s

%

5

However, the petroleum complex has performed well since 2007Energy has led returns since the beginning of 2007. We approximate $40bn in all of 2007, equal to new flows in 2008.

Individual Commodity Returns (% from Dec. 31, 2007 to Mar 31, 2008)

________________Source: Bloomberg

-40

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Soy

bean

Oil

Whe

at

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s

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tinum

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de o

il

Gas

olin

eS

oybe

an M

eal

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Cor

n

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ural

Gas

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Silv

erC

ocoa

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umC

otto

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arLi

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attle

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mbe

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Nic

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ellie

s

Ora

nge

Juic

eZi

nc

%

6

As oil is used to hedge against dollar/inflation

WTI 1M vs. DXY Index WTI 1M vs. Inflation*

Strengthening rolling correlations between oil/dollar and oil/inflation expectations have created a self-fulfilling prophecy

________________*Inflation compensation as measured by the difference between 10-year treasuries and 10-year TIPSSource: Bloomberg, Lehman Brothers Estimates

-0.8-0.6-0.4-0.20.00.20.40.60.81.0

Jun-

03

Oct

-03

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04

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04

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-04

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05

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08

WTI-10yr Treas/TIPS Breakeven 6-mth rolling correlation

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.81.0

Jun-03

Oct-03

Feb-04

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08WTI-DXY 6-mth rolling correlation

7

But oil versus dollar/inflation hedge likely temporary

US core CPI looks contained

Besides weak historical basis, dollar appreciation and inflationtempering could cause oil prices to sell off

________________Source: Bureau of Labor Statistics and Lehman Brothers US Economics

Lehman Economics see further 2008 rate cuts of 100bp by the Fed, impeding dollar strength for a periodBut, this could give way for the European Central Bank to cut rates by mid-year, and our FX team forecasts the dollar to gain slowly against the EuroOil and gold, raw materials that would show limited pass-through effect to core CPI, should not rise in lockstep with a basket of consumer goods– As investors realize the correlation weakness,

or as inflation threats ebb, usefulness of hedge should wane

Meanwhile:– High commodity prices may add pressures on

the economy and aggravate the US recession and lower physical demand further

– High commodity prices may spur transmission of US economic weakness to the rest of the OECD as well as emerging market economies

0.00.51.01.52.02.53.03.54.04.55.0

Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07

%y-o-yForecasts

Total

Core

8

Beyond flows, volatility to continue for fundamental reasonsTight markets become more volatile as demand runs up against supply limits, then retreats with additions of new capacityOPEC rift is widening, leading to Saudi stealth unilateralismOPEC barrels increasingly are moving east, taking OECD data reporting out of the equation and making both incremental supply and demand difficult to quantify

1M WTI Implied ATM Volatility (30-day rolling average to March 26, 2008)

________________Source: Bloomberg

252729313335373941

Jul-0

7

Aug

-07

Sep

-07

Oct

-07

Nov

-07

Dec

-07

Jan-

08

Feb-

08

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-08

ATM Implied Volatility, WTI 1M, 30-day moving average

%

9

Refinery bottlenecks look to be first to ease

Global refining utilization, 1966-2006 (in k b/d and as a percent)

________________Source: BP Statistical Review of World Energy 2007.

0

20,000

40,000

60,000

80,000

100,000

1966 1971 1976 1981 1986 1991 1996 2001 2006

k b/d

75%

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85%

90%

95%

100%

Global Demand (LHS) Global Refining Capacity (LHS) % Capacity Utilization (RHS)

10

0.0

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0.4

0.6

0.8

1.0

1.2

1.4

1.6

2006 2007 2008 2009 2010 2011 2012

m b/d

China South Asia Middle East Rest of World

0.00.51.01.52.02.53.03.54.04.5

2007 2008 2009 2010 2011 2012

m b/d

Rest of World ChinaSouth Asia Middle EastGlobal demand grow th

Leading indicators suggest longer-term supply reliefSurge in refining construction outpacing global demand growth should bring greater competition to product markets

Refining CDU capacity additions to outpace global demand growth

Upgrading capacity additions strong as well (1)

________________1. Includes coking, thermal cracking, cat cracking, hydrocracking. Source: Lehman estimates

11

And ebbing resource nationalism could attract more investmentRussia, largest producer in world, is lowering taxes to increaseincentives for investment forcing others to follow suit

Russia:– Proposing to cut mineral extraction tax for oil producers by 100 billion rubles ($4.2 billion) by raising non-taxable

threshold from $9.0/bbl to $15.00/bbl; do not renew tax hike on mineral extraction suit– Would reduce tax payments by 8%, includes possible tax holiday for companies exploring offshore areas– Putin promises better investment climate for foreign investors– Foreign investment in Russia last year totalled $121 billion, twice ’06 levels– Plan to double state spending to replace resources ($11.5 billion allocation)– From 2006-2008, Russian state oil company spending up 30+% y-o-y. International service companies up on same order

from a very small base.West Africa:– The worst has already come, stabilizing new tax regimes. Passage of new oil laws.– Algeria lures 64 companies to bid on 15 offshore blocks, signifying changing environmentVenezuela:– Court discharges $12 bn injunction against PDVSA that freezes their assets– Approve new windfall tax that will take advantage of “sudden increase” in prices, taxing exporters at marginal rate of

60% if Brent crude averages above $100 and 50% of marginal rate above $70, will this stand?– But, ONGC spending 450 million in E&P at San Cristobal, acquiring 40% stake– ENI has entered into a joint venture to explore the Orinoco basin, again with 40% stakeResource Nationalism appears to be peaking and competition for capital as Russia

liberalizes could tip the balance.

12

Some have argued higher prices are justified by costs

90

100

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130

140

150

Jan-

02

Apr

-02

Jul-0

2

Oct

-02

Jan-

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3

Oct

-03

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08

Oil Field, Gas Field Machinery (MA) Rotary oil & gas field drilling machinery & parts (MA)Oil field and gas field production machinery (MA) Support activities for oil & gas operation (MA)

________________Source: US Bureau of Labor Statistics

But US PPI Oil Producer Cost Indices are flattening (3-month moving average)

13

US drilling cost rise and fall even more stark

________________Source: US Bureau of Labor Statistics

US Drilling cost PPI (3-month moving average)

80

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260

Jan-

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2

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14

Even deepwater drilling costs are flattening

0

100

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Semisubmersible Dayrates, U.S. GOM, 5,000- to 7,499-Foot Semisubmersible Dayrates, U.S. GOM, 7,500-Foot or MoreSemisubmersible Dayrates, North Sea, 3,000- to 4,999-Foot Drillship Dayrates, GOM, Dynamically Positioned

Avg dayrates in '000 dollars

Deepwater Rig Day-Rates

________________Source: ODS-Petrodata and Lehman Brothers Estimates

15

That costs have flat-lined is a problem for NYMEX WTIHigher US costs appear to explain much of the rise in long-dated WTI prices until the divergence in October 2007.

$91.19

$70.52

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5-year out Dec avg monthy WTI price Predicted 5-yr out WTI based on PPI cost indices

$/bblUS monthly PPI data regressed against average monthly 5-yr out WTI prices

- R2 through Oct-07 is 96% - Divergence worsens: Dec-13 WTI to average $98 in Mar-08

16

What may explain the breakdown?Relationship b/w US costs and WTI held in the past because US costs reflected most of the change in costs globally– Rigs and machinery (and even engineers) are globally integrated marketsHowever, costs of the global marginal producer can go up in ways that are not globalized and thus not reflected in the US PPI– Tax regime changes– Unskilled workers and other locally denominated costsOr long-dated WTI prices may be rising for fundamental reasons unrelated to costs of finding and developing conventional crude– Risks of supply disruption/expropriation in the marginal basin have increased, with

producers requiring a higher hurdle rate of return before they’ll continue to invest there– There may not be enough oil in the marginal conventional basin to satisfy the marginal

barrel demanded at current prices and higher prices may be required to incentivize investment in new higher cost basins / unconventional supplies and substitutes• While those basins are opened up, even higher prices may be needed in the meantime

to curtail demand

17

Non-OPEC supply is not optimisticOPEC dependence will almost certainly grow

Non-crude sources (biofuels, NGLs, processing gains) account for 70% of non-OPEC supply growth in 2008FSU growth of 400k b/d, makes strong crude contribution, but merely offsets declines in the North Sea (-260k b/d) and Mexico (-280k b/d)Deepwater, tar sands crucial as Brazil grows 350k b/d, Canada tar sands 270k b/dOne potential offset: Non-OPEC NGLs/condensates could add another 400-500k b/d of incremental annual growth

________________Source: Lehman estimates

A growing role for non-conventionals Non-OPEC supply growth, 2007-2013

-600

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1,000

2007 2008 2009 2010 2011 2012 2013

k b/d

Non-OPEC supply grow th

30,000

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45,000

50,000

55,000

2005 2006 2007 2008 2009 2010 2011 2012 2013

k b/d

Non-OPEC Crude Non-OPEC NGLsBiofuels, CTL, GTL Processing GainTar Sands

2009: Non-OPEC peak?

18

But OPEC capacity to grow faster than demand, for now…

Global production capacity growth vs. global oil demand growth

________________Source: Lehman Brothers estimates

Major upstream producers show response to higher pricesSaudi Arabia’s capacity expansion through 2011-12 should underpin capacity additions outpacing demandFurther upside potential from Russia, deepwater, NGLs could leave non-OPEC supply growth underestimated by 300-500k b/d beyond 2010

-500

0

500

1,000

1,500

2,000

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3,000

3,500

2008 2009 2010 2011 2012

OPEC crude capacity growth OPEC NGL growthNon-OPEC supply growth Global demand growth

k/bd

19

Decoupling thesis to be challenged by 4Q08

Oil prices at $100+ assume demand growth won’t slow in AsiaWhile fundamentals of Asian economies look strong now, they may be approaching a tipping point, esp. if US recession deepensTrade Channel:– Exports make up 55% of Asian GDP, grew 15-20% in 2007 – Multiplier effects on income/capex cannot be ignored– Insofar as US businesses have global supply chains, China

cannot cut prices (or subsidize) to defend against OECD demand drop

If US recession deepens, effect on Asia ex-Japan likely to be non-linear, with growth dropping from 7.5% to 4-5%

Via the trade and financial market channels, a period of extended US weakness could spread to emerging markets by 4Q08

20

50100150200250300350400450500

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Feb-

08

April 2006 = 100

Hang Seng Index Shanghai Composite Index

We expect 340k b/d (4.5%) oil demand growth in 2008, 300k b/d (3.8%) in 200940% of Chinese oil demand is from industry– Another 15-20% moves coal, raw materials, and finished goods to and from industrial plantsChina is vulnerable to an OECD economic slowdown, but lags exist– A weak currency, fixed energy prices and loose loans to industrial firms cause lagsGovernment policy around the Olympics will help to eliminate overcapacities and slow oil demand growth

China net exports as % of production China stock market fall may be weakness signal

-15

-10

-5

0

5

10

15

2002 2003 2004 2005 2006 2007 YTDCement Aluminum Steel

%

________________Source: Bloomberg, China General Administration of Customs, Rosen and Houser, China Strategic Advisory.

As China liberalizes and export markets shrink, oil demand growth should slow in 2008-09

China to turn bearish versus expectations?

21

Supply unknowns and timing may still frustrate

OPEC capacity has robust potential– Capacity may grow 5+m b/d, 2008-12– 80% from Saudi Arabia, Nigeria, Angola

However, capacity downside risk exists– Precarious Nigeria political situation– 1.9m b/d OPEC quota on Angola– Iraq Kirkuk/Basra reversal with violence– Iran/Venezuela declines

And what’s left after completion of Saudi expansion plans in 2012?

Although overarching trends point to 3+ year respite in prices, supply disruptions, politics still remain variables

Spare capacity expansion as decade ends?And who steps up next?

________________Source: EIA, Lehman estimates

27.028.029.030.031.032.033.034.035.036.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

m b/d

0.0

1.0

2.0

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5.0

6.0

7.0m b/d

OPEC 12 Capacity (lhs)OPEC 12 Spare Capacity (rhs)

22

-100

0

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300

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700

LightEnds

MotorGasoline

MiddleDistillates

Fuel Oil Other

Atlantic Basin Pacif ic Basin Mideast/Eurasia

2008 oil products outlook: Distillate to lead

Recent explosion in heating oil and gasoil cracks might taper off as winter ends…– But downstream bottlenecks, demand pull from non-OECD markets (Southern Cone) and

constricted Middle East exports should strongly support summer cracks Distillates are 50% of global oil demand growth in 2008Diesel specs tighten from 50ppm to 10ppm in Europe 1/1/09, putting further strain on refinersEuropean and US distillate margins to outperform Asian margins in 2008– New refineries East of Suez: Reliance (580k b/d), Rabigh (400k b/d), Qingdao (200k b/d)

________________Source: EIA, Lehman Brothers estimates

Global distillate refinery margins strong, lead oil markets in ‘08

US distillate exports into Atlantic Basin2008 demand growth by product/region

050

100150200250300350400450500

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

k b/d

2004 2005 2006 2007 2008

23

Lehman Brothers Oil Outlook

Lehman Brothers Oil Supply-Demand Balance

Lehman Brothers Oil Price Outlook

________________Source: Lehman estimates; (1) Other includes global processing gains, biofuels outside US, Brazil and Europe, GTL, CTL and unaccounted for new projects

1Q07A 2Q07A 3Q07A 4Q07A 1Q08E 2Q08E 3Q08E 4Q08E 2006A 2007A 2008E 2009E Brent ($ per barrel) 58.62 68.66 74.61 88.53 96.31 90.00 105.00 80.00 66.15 72.60 93.00 83.00 WTI-Brent differential -0.16 -3.45 0.47 1.98 1.51 -1.00 1.00 -1.00 0.34 -0.29 0.00 0.00

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 2006 2007 2008 2009

Global Demand 85.9 84.8 85.3 86.4 86.9 85.8 86.3 87.6 84.4 85.6 86.7 87.6 OECD 49.4 47.9 48.4 49.4 49.4 47.6 48.2 49.4 49.0 48.7 48.6 48.5 USA 20.9 20.7 20.8 20.8 20.5 20.5 20.5 20.7 20.7 20.8 20.5 20.6 Europe 15.2 15.0 15.4 15.6 15.4 15.0 15.5 15.6 15.6 15.3 15.4 15.3 Non-OECD 36.5 37.0 36.9 37.0 37.6 38.2 38.1 38.2 35.5 36.8 38.0 38.9 China 7.4 7.6 7.4 7.6 7.7 8.1 7.7 8.0 7.0 7.5 7.9 8.2 Middle East 6.6 6.7 7.1 6.6 6.9 7.0 7.4 6.9 6.4 6.7 7.1 7.5 Global Supply 84.5 84.5 84.1 85.5 86.2 86.8 86.7 88.3 84.8 84.7 87.0 89.0 Total Non-OPEC 50.5 50.2 49.7 49.9 50.3 50.5 50.6 51.1 49.7 50.1 50.6 51.4 OECD 20.1 19.9 19.5 19.6 19.7 19.6 19.5 19.8 20.0 19.8 19.6 19.6 N. America 14.3 14.3 14.1 13.9 14.0 14.1 14.0 14.1 14.1 14.1 14.1 14.4 Europe 5.3 5.0 4.7 5.0 4.9 4.7 4.6 4.7 5.3 5.0 4.7 4.3 Non-OECD 28.1 28.0 27.9 28.0 28.2 28.5 28.7 28.9 27.5 28.0 28.6 29.1 FSU 12.8 12.7 12.8 12.8 12.9 13.1 13.3 13.6 12.2 12.8 13.2 14.0 Other (1) 2.3 2.3 2.3 2.3 2.4 2.4 2.4 2.5 2.2 2.3 2.4 2.7 OPEC Crude 29.8 30.0 29.9 31.1 31.2 31.7 31.2 31.9 31.0 30.2 31.5 31.8 OPEC NGLs 4.2 4.4 4.4 4.6 4.6 4.6 4.9 5.3 4.1 4.4 4.9 5.8 Inventory Change -1.3 -0.3 -1.2 -0.9 -0.8 1.0 0.5 0.7 0.4 -0.9 0.3 1.4

Call on OPEC 31.1 30.3 31.2 31.9 32.0 30.7 30.8 31.2 30.7 31.1 31.2 30.4

24

Analyst CertificationI, Edward Morse, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

"To the extent that any of the views expressed in this research report are based on the firm's quantitative research model, Lehman Brothers hereby certify (1) that the views expressed in this research report accurately reflect the firm's quantitative research model and (2) that no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report."Important DisclosuresLehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). 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