July 18, 2007 Global Energy Strategy Sung Yoo (1-212) 834-7045

Now You See It, Now You Dont: What Happened to US Heating Oil Stocks and Why It Doesnt Matter
New Diesel Specs Drive Distillate Stock Shifts US heating oil is not half the refined product it used to be not since the new, lower sulfur Nonroad, Locomotive and Marine (NRLM) diesel fuel specifications effectively reclassified some of it as diesel. While this year's NRLM spec change has not received nearly the publicity of last year's ultra-low sulfur diesel (ULSD) shift, it is having a material impact on the appearance of US distillate inventories. Prior to the implementation of the new NRLM spec, its greater than 500 ppm sulfur content placed it firmly in the heating oil component of the distillate pool, as defined by the Energy Information Administration (EIA). Now, with the allowable sulfur content being cut to less than 500 ppm, NRLM diesel is just that diesel. While the spec change is being phased in over the next several months, the shift is already apparent in refinery production and inventory data. Currently, highway diesel makes up the bulk of the distillate pool at 67%. Nonroad equipment, locomotive, and marine diesel together account for 18% of US distillate demand, and home heating for just 15%. That means that previously some 33% of US distillate was classified as heating oil whereas, once the spec change is fully implemented, only 15% of US distillate demand will fall into the heating oil category. US refiners are the first to grapple with the change, with a mandate to produce NRLM fuel at less than 500 ppm sulfur as of June 1, 2007. Terminals must stock the new spec by August 1, retailers by will sell it by October 1, and end-users take the plunge by December 1. A Look at Current Inventory Levels Following a period of historical highs for both diesel (< 500 ppm sulfur) and heating oil (> 500 ppm sulfur) inventories in the US for the second half of 2006, the new year has seen a dramatic shift in distillate stocks. Diesel inventories (which include ultra-low sulfur as well as low-sulfur diesel) have continued to grow since March of this year from seasonal highs and currently stand at 90 million bbls, 13 million bbls higher than the historic five-year average. Meanwhile, heating oil inventories have slid below the five-year average since March and have continued to fall despite the fact that stocks typically begin to build into the summer. US heating oil inventories are now at 32 million bbls after hitting a new low two weeks earlier current levels are 20 million bbls lower than the historic five-year average. Nonetheless, total distillate inventories remain comfortably above the historic average.

Fuel Ty pe Home Heating Oil Nonroad Diesel Locomotiv e Diesel Marine Diesel Onroad Diesel

Sulfur Content Pre-2007 >500 ppm >500 ppm >500 ppm >500 ppm <15 ppm Post-2007 >500 ppm 15-500 ppm 15-500 ppm 15-500 ppm <15 ppm

EIA Classification Pre-2007 Heating Oil Heating Oil Heating Oil Heating Oil Diesel Post-2007 Heating Oil Diesel Diesel Diesel Diesel

Breakdown of Distillate Fuels

Locomotive 3.5% Marine (<500 ppm)** Home Heating, etc. (>500 ppm) 15% (<500 ppm)** 2.5%

Total Distillate Inventories

Million bbl 158 150 142 134 126 118

Nonroad Equipment (<500 ppm)** 12%

Highw ay Fuel (<15 ppm)* 67%

110 102 94 J F M A M J J A

Fiv e-Year Range Fiv e-Year Av erage 2006 2007 S O N D

Total Covered by NRLM Program: 18%

* As of June 1, 2006. ** As of June 1, 2007. Note: Based on 2003 data Source: JPMorgan Energy Strategy, EPA

Latest month is to-date only, not full-month projection. Source: JPMorgan Energy Strategy, EIA

Global Energy Strategy Sung Yoo (1-212) 834-7045

Refiners Adjust to the New Spec While the past five years have seen US diesel production trend higher, heating oil production has remained relatively flat with the diesel percentage of total distillate production increasing steadily. However, recent months have seen a much sharper decrease in heating oil production, with weekly production numbers indicating that output of greater than 500 ppm distillate fuel by US refiners reached a new low of 449 kbd for the week ending June 22, 2007. The current four-week average for heating oil production is now 468 kbd which compares to a five-year historic average for the same four-week period of over 1 mbd. In addition, imports of greater than 500 ppm sulfur distillate fuels have seen a marked decline in recent months. While total distillate inventory levels remain comfortably within the historic range, the shift towards increased production of lower sulfur distillates increased diesel stocks and taken a bite out of heating oil inventories. Padd I is the exception, and will likely become even more of an island market for heating oil. The vast majority of US home heating oil is consumed in the Northeast, and production there has remained more stable. Sulfur Credits and Small Refiner Provisions NRLM diesel fuel accounts for 18% of total distillate fuel produced in the US in 2006 at 729 kbd. However, due to provisions in the EPAs NRLM program that allow for sulfur credit generation and use, as well as small refiner hardship provisions, actual shifts to lower sulfur spec production will amount to somewhat less than the entire 18% in the first year of the change. Refiners had the option of earning sulfur credits by implementing partial production of the new spec ahead of the EPA dead-

Diesel (ULSD/LSD) Inventories (< 500 ppm)

Million bbl 100 95 90 85 80 75 70 65 60 J F M A M J J A S O N D Fiv e-Year Range 2006 Fiv e-Year Av erage 2007

Heating Oil Production (Past 12 Months)

Million b/d 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 23-Jun-06 24-Oct-06 24-Feb-07 27-Jun-07 Heating Oil Production

Latest month is to-date only, not full-month projection. Source: JPMorgan Energy Strategy, EIA

Source: JPMorgan Energy Strategy, EIA

Heating Oil Inventories (> 500 ppm)

Million bbl 65 60 55 50 45 40 35 30 J F M A M J J A S Fiv e-Year Range Fiv e-Year Av erage 2006 2007 O N D

Diesel & Heating Oil Production

Million b/d 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 21-Jun-00 21-Oct-02 Diesel Production Heating Oil Production

19-Feb-05

21-Jun-07

Latest month is to-date only, not full-month projection. Source: JPMorgan Energy Strategy, EIA

Source: JPMorgan Energy Strategy, EIA

Global Energy Strategy Sung Yoo (1-212) 834-7045

line. A recent EPA survey of refiners indicates that 70 kbd of accumulated sulfur credits will be used in 2007 and 46 kbd from 2008-2010 (see Appendix for more details on sulfur credits). In addition, approximately 35 kbd of NRLM production will remain in the greater than 500 kbd category until 2010 due to approved small refiners choosing Option 1 of the small refinery hardship provisions (see Appendix for more details on small refiner hardship provisions). The combination of sulfur credit use and small hardship provisions is expected to account for 105 kbd of NRLM distillate fuel that will continue to be produced at greater than ppm sulfur by US refiners, thus remaining in the EIAs heating oil category. That said, 624 kbd of NRLM diesel fuel is expected to be outputted at less than 500 ppm sulfur and classified as diesel fuel with on-highway ULSD and LSD fuels. Lag Time for Transition While diesel and heating oil inventories continue to diverge from their historic ranges, in terms of days of demands cover, levels are returning to seasonal norms as demand begins to reflect the new spec changes. That said, the transition period has seen some erratic behavior in both implied heating oil and diesel demand. While the EIA does not breakdown distillate demand in its weekly data, our calculations of apparent heating oil and diesel demand indicate some irregularities in the EIAs distillate data. The large fluctuations in demand for heating oil and diesel witnessed in recent weekly data likely reflect some difficulty in

properly classifying the two fuels as demand is an implied function of storage levels. Hefty increases in demand for one fuel were often offset by comparable declines in the other corrected by a reversal in the following week. While refiners began producing NRLM diesel fuel at less than 500 ppm ahead of the June 1 deadline, the staggered timeline gives segments of the distribution channel ample time to purge the higher sulfur NRLM diesel from the system. Therefore, some time will be necessary for demand to normalize with production as consumption of the less than 500 ppm sulfur NRLM fuel reflects actual production. Plenty of Heating Oil, But Who Will Trade It? The increase in US diesel inventories and decrease in heating oil stocks lately while dramatic is mainly due to the effective reclassification of NRLM from heating oil to diesel in the EIA data, and we are not inclined to read much into the shift in terms of market implications. On a days of demand cover basis, heating oil inventories dont look radically tight. More importantly, the spec change means that heating oil is now, more than ever, a regional product with less and less relevance to the national distillate picture outside of PADD I. The marginalization of heating oil and rising importance of diesel as a US refined product raises questions about how NYMEX heating oil will be traded going forward. Nymex heating oil has historically been traded as a proxy benchmark for US distillate. Now, as heating oil and diesel fundamentals diverge and heating oil is relegated to the East Coast, the NYMEX contract is an increasingly inappropriate proxy for diesel.

Diesel Fuel Days of Demand Cover (> 500 ppm)

In day s of forw ard cov er 90 80 70 60 50 40 30 20 J F M A M J J Fiv e-Year Range Fiv e-Year Av erage 2006 2007 A S O N

Heating Oil Days of Demand Cover (> 500 ppm)

In day s of forw ard cov er 32 30 28 26 24 22 20 Fiv e-Year Range Fiv e-Year Av erage 2006 2007

Latest month is to-date only, not full-month projection. Source: JPMorgan Energy Strategy, EIA

Latest month is to-date only, not full-month projection. Source: JPMorgan Energy Strategy, EIA

Global Energy Strategy Sung Yoo (1-212) 834-7045

Appendix: The EPAs Nonroad Diesel Program The EPAs nonroad diesel program is aimed at ultimately reducing NRLM diesel fuel sulfur limits to 15 ppm from previously unregulated levels. The first phase requires refiners and importers to produce or import NRLM diesel fuel with a 500 ppm maximum by a June 1, 2007, deadline. By June 1, 2010 NR (nonroad) diesel fuel from refiners and importers will have to meet a 15 ppm standard, while LM (locomotive and marine) diesel has a deadline of June 1, 2012, to meet the ULSD standard. Sulfur Credits The program allows refiners and importers to generate credits for early compliance with NRLM sulfur reduction rules. Refiners and importers were given the opportunity to earn high sulfur credits for early production of NRLM diesel at 500 ppm from June 1, 2006 to June 1, 2007. In addition, 500 ppm credits will be granted for 15 ppm NRLM diesel produced from June 1, 2009 to June 1, 2010. The earned credits can be used to comply with sulfur specifications at later dates. High sulfur credits can be used to comply with the 500 ppm NRLM standard from June 1, 2007, and 500 ppm credits can be used to comply with the 15 ppm NR (nonroad) standards starting from June 1, 2010, and the 15 ppm LM (locomotive, marine) standard which begins on June 1, 2012. The provision also permits unused high sulfur credits to be converted into 500 ppm credits for use after 2010. Unlike highway diesel credits, NRLM credits may be transferred nationwide. Five small refineries applied and were approved for this option for a total of 48 kbd. A recent EPA survey indicates that 23 refineries generated a total of 263 kbd high sulfur credits in 2006. Nine refineries are expected to use 70 kbd of sulfur credits in 2007 and seven refiners plan to use 46 kbd from 2008-2010. Small Refiner Hardship Provisions Additional provisions are included in the nonroad diesel rule that provided small refiners with additional options if they met EPA guidelines and filed for small refiner status by December 31, 2004. A small refiner is defined as a refiner that: 1) processes NRLM diesel fuel from crude oil; 2) has a maximum of 1,500 employees on average for all pay periods from January 1, 2002, to January 1, 2003; and, 3) has a corporate crude oil capacity of less than or equal to 155,000 bpd for 2002. The small refiner provisions allow additional time for compliance to the new regulations, and for those who comply with NRLM standards earlier than required grants the option to generate diesel sulfur credits or receive limited easing of Tier 2/Gasoline Sulfur standards. The options are as follows: 1) Delay 500 ppm NRLM production from June 1, 2007, to June 1, 2010. Production of high sulfur NRLM diesel fuel from June 1, 2007, to June 1, 2010, must not be greater than 105% of refinerys average NRLM diesel fuel production from 2003 through 2005. Six small refineries applied and were approved for this option for a total of 35 kbd. 2) Delay 15 ppm NRLM production to June 1, 2014, in lieu of 15 ppm NR deadline of June 1, 2010 and June 1, 2012, for LM. Production of 500 ppm NRLM diesel fuel from June 1, 2010, to June 1, 2014 must not be greater than 105% of refinerys average NRLM diesel fuel production from 2006 through 2008. Options 1 and 2 are not mutually exclusive. Six small refineries applied and were approved for this option for a total of 24 kbd.

NRLM Diesel Fuel Standards

Who Covered Fuel Highway Diesel Fuel Large Refiner & Importer Large Refiner & Importer NR LM NRLM with Credits (Not in NE or AK) Small Refiner Transmix Processor & In-use Transmix Processor & In-use NRLM (Not in NE, w/ approval in AK) NR (Not in NE or AK) LM (Not in NE or AK) 2006 2007 2008 2009 2010 2011 2012 2013 2014 80% 15 ppm / 20% 500 ppm 500 500 HS HS HS HS 500 500 HS HS HS HS 500 500 HS HS HS HS 100% 15 pm (including small refinery fuel) 15 500 500 500 500 500 15 500 500 500 500 500 15 15 500 500 500 500 15 15 500 500 500 500 15 15 15 15 15 500

Note: Dates are June 1 at refinery, August 1 at terminal, October 1 at retailer, and December 1 for in-use. Source: JPMorgan Energy Strategy, EPA

Global Energy Strategy Sung Yoo (1-212) 834-7045

Sulfur Credit Generation and Use

2006 2007 Refineries generating high sulfur credits Refineries using high sulfur credits High sulfur credit generation (kbd) High sulfur credit usage (kbd)
Source: JPMorgan Energy Strategy, EPA

2008 3 7 4 46

2009 3 7 4 46

2010 2 7 3 46

23

23 9

263

105 70

3) NRLM Credit Option allows approved small refiners to earn tradeable nonroad diesel sulfur credits for early production of compliant NRLM diesel fuel. High sulfur credits producing 500 ppm NRLM diesel before June 1, 2010, and 500 ppm credits for producing 15 ppm NRLM diesel fuel prior to June 1, 2014. This may be used in conjunction with the NRLM Delay Option. Six small refineries applied and were approved for this option for a total of 24 kbd. 4) NRLM Diesel/Gasoline Compliance Option small refiners who produce more that 95% of their NRLM diesel fuel at the 15 ppm standard by June 1, 2006, and opt not use the NRLM Credit Option will receive a relaxing of their interim gasoline sulfur standards beginning in January 1, 2004 (20% increase in the small refiner annual average and per-gallon cap for the length of the interim program 2010 if 15 ppm highway diesel was produced by June 1, 2006, or 2007 if not).

Small Refiners Hardship Options

Option Description 1 2 3 4 Delay 500 ppm NRLM Production Delay 15 ppm NRLM Production NRLM Credit Option NRLM Diesel/Gasoline Compliance Option Number of Refineries 6 6 6 5 2003 High Sulfur Distillate Fuel Production 35 24 24 48

Source: JPMorgan Energy Strategy, EPA

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