TeXLive 2011: pdfLaTeX does not convert eps to pdf for eps files in subdirectories

Add the option -shell-escape to your compilation options.

Alternatively, instead of having the EPS images in a folder at the same level (but in a different subdirectory), you could just place it in a subdirectory of your root .tex file. Then pdflatex will not complain about the conversion and inclusion of EPS files.