The Global Oil Market: A Long- Term Perspective

Transcription

1 Report Series The Global Oil Market: A Long- Term Perspective Highlights Although the oil market has been volatile over the last decade, it has shown an underlying trend towards increasing supply tightness in the face of rising demand. This trend is expected to continue, and available projections to 2030 from large energy institutions all point to sustained supply constraints over the long-term. Energy demand is projected to increase by 50 percent though 2030 driven by sustained economic growth and population expansion, especially in emerging markets such as India and China. Oil is expected to meet a sizeable share of this demand growth, particularly for transportation where the scope for increased car ownership in emerging markets is huge. Oil demand growth is expected to outpace non-opec supply resulting in an increased call on OPEC crude. Saudi Arabia, as the largest OPEC producer and potentially the only one likely to maintain significant spare capacity, will continue to exert a substantial influence on the supply, and hence price, of oil. By all indications, oil resources are available to meet the projected increase in demand, with proven reserves sufficient to last years at current production levels. However, uncertainties are likely to continue to surround the timely extraction and delivery of oil given geopolitical risk, increasing exploration and production costs, and capacity constraints. Proven oil reserves are concentrated in a small number of countries (notably Middle Eastern members of OPEC and Russia) which, not being major consumers, have less incentive to invest and raise supply. This tendency is accentuated by the fact that the bulk of global oil resources are under the control of state owned oil companies influenced by national depletion policies that often see oil in the ground as being worth more than money in the bank. Office of the Chief Economist Economics Department Samba Financial Group P.O. Box 833, Riyadh Saudi Arabia Oil prices are notoriously difficult to forecast even in the very short term, let alone over a 20 year horizon. Long-term price scenarios offered by leading sources point to a wide spectrum of possibilities. In general terms, and barring unforeseen technological breakthroughs, the outlook is for market fundamentals to sustain oil prices at relatively high levels, while the concentration of export sources is likely to leave the market exposed to recurrent volatility. Chief.economist@samba.com This and other publications can be Downloaded from

2 Table of Contents Highlights 1 Overview and Prospects 3 Box 1: Key Factors Underpinning the Oil Markets Through Implications for Saudi Arabia 7 Box 2:Saudi Arabian Oil Statistics 9 Long-Term Outlook for Energy Demand 10 Demand for Oil 14 Box 3: Demand Side Risks 14 Oil Supply 14 Box 4: Supply Side Risks 16 Oil Investment Challenges 17 Rising Costs of Production 17 Ownership Structures and Geopolitical Factors 18 Other Factors Affecting Prices 19 Imperfect Information and Markets Perceptions 19 Refinery Capacity 19 Speculation 20 Table: OPEC Oil Production and Spare Capacity 21 2

3 Overview and Prospects Available long term assessments point to a 50 percent increase in energy demand through 2030, and a critical role for crude oil in meeting this demand. Long term forecasts for the oil market are fraught with difficulties, driven as they are by a host of complex factors affecting the outlook for the global economy and world energy demand. Nonetheless, central to any projections are the assumed evolution of demand, supply and prices. Available long term assessments of these fundamentals point to a 50 percent increase in energy demand through 2030, and a critical role for crude oil in meeting this demand, particularly for transportation needs. Projections from the International Energy Association (IEA) show oil demand increasing by around 30 million barrels a day (mb/d) through 2030 to reach about 116 mb/d. World Oil Production (mb/d) Forecast Non-OPEC OPEC Proven oil reserves are sufficient to meet the projected increase in demand. Adequate oil resources are available to meet the projected increase in demand. Proven oil reserves are sufficient to last years at current production level according to BP data. However, ensuring timely extraction and delivery of oil supplies is a challenge, and remains at risk from geopolitical factors, capacity and cost constraints. Such factors have affected recent oil production increases which have lagged rapid demand growth, particularly from emerging market economies. According to the US Government Energy Information Administration (EIA), world oil production stalled at around 84.5 mb/d during , while annual oil demand continued to grow at over 1 mb/d. This imbalance between scarce supply and growing demand, and expectations that it will persist in the future, has put upward pressures on prices during 2008, pushing them to record levels despite evidence that oil production is set to rise during as new projects come on stream. Prices peaked at over $145/b in July 2008, before falling back to around $100/b in September resulting in a year to date average of about $114/b, up from $72/b in

4 Uncertainty about the prospects for oil demand will continue to affect decisions on, and the timing of, new upstream investments Percent Change in World Oil Supply and Demand Supply Demand World oil production rose to an average of 85.7 mb/d in the first seven months of 2008 and is projected by the EIA to exceeded 86 mb/d for the year. However, oversupply risks have emerged as demand growth is expected to slow in line with deteriorating global economic and financial conditions, and this may influence producer decisions and constrain actual supply. Looking further ahead, this inevitable uncertainty about the prospects for oil demand will continue to affect decisions on, and the timing of, new upstream investments, potentially leading to episodic tightness in the oil markets. Without substantial new discoveries, dwindling oil reserves may also weigh on perceptions of market participants in the latter years, especially those concerned with the concept of peak oil. Recent extreme volatility and increasing linkages with financial markets, have made forecasting oil prices hazardous. Any oil price projection is subject to wide margins of error, and the recent extreme volatility and surge to record levels in 2008, together with increasing linkages with financial markets, have made forecasting especially hazardous. The oil market itself is a poor predictor of future spot oil prices. Historically oil futures prices for a given time period are usually well off the actual spot price (see chart). Nymex futures have not been good a predictor of oil prices $/b Futures 45 Feb-06 May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 4

5 Available oil price assumptions for , range from $65 to 113 a barrel in base year prices. Energy institutions such as the IEA, the EIA, and OPEC, traditionally avoid price forecasts, but provide long term assumptions on the level of prices that are thought necessary to generate sufficient investment in supply to meet projected demand. Available price assumptions from these sources for , range from $ a barrel (/b) in base year prices. Their respective low and high-case scenarios expand the range even further to between $57 and $189/b. Nominal and Real Oil Prices $/b Source: BP, Samba Nominal Real - in 2007 $ EIA Oil Price Scenarios (annual average in 2006 $) 160 History Projections High case $/b Reference Low case The graph above shows EIA price scenarios presented in their 2008 International Energy Outlook. For the reference case this indicates an easing in prices (in 2006 dollars) to around $70/b through 2015, before rising to $113/b by This is not far off the IEA reference price assumptions of $65/b (in 2006 dollars) in 2010, rising to $107.6/b by 2030 presented in their 2007 World Energy Outlook. OPEC is more circumspect in making price projections and only mentions a reference price assumption of $70-90/b in nominal terms throughout the projection period in its 2008 World Energy Outlook. It should be noted that these assumptions were mostly made before the rapid spike and subsequent retreat in prices during July-September and the IEA, in particular, is due to release its new 2008 World Energy Outlook in November. 5

6 A possible deep world recession combined with rising spare capacity in 2009, could conceivably push prices back down to around $75-85/b, There are certainly down side risks in the short term. A possible deep world recession combined with rising spare capacity as new projects come on stream in 2009, could conceivably push prices back down to around $75-85/b, which is the estimated production cost of a marginal barrel of oil (Canadian oil sands). However, over the medium to long term, spare capacity effectively all in OPEC is expected to drop back to minimal levels (1-2 mb/d) as demand growth recovers, keeping markets tight and supporting real long-term prices at the higher end of existing assumptions. Mb/d World Oil Demand OECD Non-OECD China Middle East World Supply Non-OPEC OPEC Source: IEA Box 1 Key factors underpinning the oil market through 2030 Projected world economic growth of 3.5 percent a year helps drives global energy demand up by 50 percent. Fossil fuels continue to supply about 85 percent of world energy demand, with oil maintaining a share of about one third. More than 55 percent of new supply will come from non-conventional sources such as NGLs, oil sands and bio fuels, which are more expensive to bring to the market than crude. Oil demand is projected to rise by 30 mb/d to 116 mb/d, with developing countries accounting for most of this rise. Oil demand growth outpaces non-opec supply resulting in an increased call on OPEC crude. Assuming appropriate investments are made, OPEC has the resources to meet the increased demand, but spare capacity is projected to remain relatively low and oil markets tight. Even assuming less robust demand growth, supply side and cost considerations suggest that prices will not fall back below $75-85/b. 6

7 Implications for Saudi Arabia As the largest oil producer and the only one with significant spare capacity, the investment and production policies of Saudi Arabia will thus continue to exert a substantial influence on the supply, and hence price, of oil. Saudi oil policy has been founded on maintaining a stable oil market at prices that provide a reasonable income, yet not so high as to restrain global economic growth. OPEC countries account for the majority (76 percent) of the world s proven oil reserves, with Saudi Arabia alone accounting for 21.3 percent. Given the positive long term prospects, demand for OPEC oil will remain strong, and OPEC market power is expected to strengthen over the coming decades. As the largest oil producer and the only one with significant spare capacity, the investment and production policies of Saudi Arabia will thus continue to exert a substantial influence on the supply, and hence price, of oil. Estimating the future call on Saudi crude oil production is fraught with difficulties, not least because institutions such as the IEA, OPEC and EIA take different approaches to their long-term supply and demand projections; also, they make different assumptions on the level of non-opec supply as well as the production of natural gas liquids (NGLs) /non-conventional oil production. Nonetheless, rough estimates based on available projections and assumptions on potential production levels in other OPEC producers suggest that Saudi Arabia would need to produce between 16 and 23 mb/d by 2030 to meet projected demand. While the lower estimate appears well within reach given existing plans to expand capacity to 15 mb/d by 2015, the higher end of the potential call on Saudi crude would require large substantial additional investments to expand net capacity in the outer years. In any event, the implied production requirements for Saudi Arabia suggest that the Kingdom s share of global oil production would rise from about 10 percent in 2007 to a range of percent by The rapid run-up in oil prices during 2008 accompanied by extreme price volatility, has been viewed with unease by the Saudi authorities whose publicly stated oil policy has been founded on maintaining a stable oil market at prices that provide a reasonable income, yet not so high as to restrain global economic growth or the needs of developing countries. The kingdom is also concerned that oil prices do not rise so high as to foster heavy investment in alternative energy sources and exacerbate demand destruction that could reduce the value of its large oil reserves. World Crude Oil Reserves Non-OPEC 24% Saudi Arabia 21.3% OPEC excl. Saudi 54.6% 7

8 Neither OPEC nor Saudi Arabia has an officially announced target price. Determining what oil price satisfies these various criteria is difficult. In contrast to the 1980s and most of the 1990s, neither OPEC nor Saudi Arabia has an officially announced target price. Nonetheless, with oil prices approaching $150/b, in June 2008, Saudi Arabia pledged to raise production to 9.7 mb/d at the Jeddah Energy Meeting in an effort to stem rapidly rising price rises and the potential damaging impact on global economic growth. The kingdom also made a conditional commitment to increase longer-term capacity to 15 mb/d, even though it blames much of the record price increase on speculative activities. In addition, despite the September 9th OPEC agreement to abide by its official quotas - which could see Saudi production cut back to 8.9mb/d the kingdom has been quick to reassure markets that it will meet customer demand. With a need to finance ambitious and costly development projects, and to secure time to build up a more diversified economy, it seems likely that Saudi Arabia will maintain a policy of trying to stabilize prices at around $100/b. This will help ensure a healthy revenue stream. 2.5 OPEC Spare Capacity mb/d Increase reflects OPEC production cuts to trim global stocks 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Source:EIA OPEC Total Saudi Arabia Saudi Arabia faces a choice between extracting or preserving oil reserves. In determining and implementing its oil policy the kingdom will be conscious of the fact that oil is an exhaustible resource with a finite revenue stream, and a source of national wealth which presents intergenerational equity issues. Essentially the kingdom faces a choice between extracting or preserving oil reserves. Amongst the many complex and interlinked factors influencing this choice is the rate of return available on reinvesting the proceeds of extracted oil. Saudi Arabia Oil Production mb/d Exports

9 In theory, if these returns are high there is an increasing incentive to produce more oil and transform the proceeds into other forms of wealth which can be enjoyed by future generations. Conversely if returns are low, there is more of an incentive to leave oil in the ground. This issue has become more topical as it touches on the mounting public concern expressed in some OECD countries over the activities of Sovereign Wealth Funds (SWF). Saudi officials have publicly voiced concerns about the potential emergence of restrictions on sovereign investment flows. Saudi officials have publicly voiced concerns about the potential emergence of restrictions on sovereign investment flows. Although the Kingdom has only recently established one small SWF ($5.6 billion), it has large official foreign assets managed by the Saudi Arabian Monetary Authority (SAMA). These are expected to rise from $300 billion in 2007 to around $500 billion by the end of 2008, and it can be argued that any restrictions that prevent the kingdom from maximising returns on these oil receipts could reduce the incentive to raise oil production. Studies from Norway have shown that transferring oil in the ground to a broad portfolio of international equities helps increase the return on government wealth and reduces the associated risk. It would thus make sense for the Kingdom to increasingly diversify its relatively conservatively invested foreign assets. Box 2 Saudi Arabian oil statistics Reserves: billion barrels as of end-2007, equivalent to an estimated 69.5 years of production at current levels, and accounting for 21.3 percent of the world total. Oil production levels: Output rose to 9.55 mb/d in July, less than the 9.7 mb/d pledged at the Jeddah meeting, but consistent with the stated intention to link increased supply with increased demand. Production in 2007 averaged 8.7 mb/d. Production Capacity: Estimated at 10.8 mb/d in Expected to rise to 12.5 mb/d by 2010 on completion of the Manifa and Khurais projects. Latter will add 1.2 mb/d of sweet crude. In addition, the kingdom has recently identified five incremental production increases that could increase capacity further to15 mb/d: raising Zukuf output by 900,000 b/d, Safaniyah by 700,000 b/d, Berri by 300,000 b/d, Khurais by 300,000 b/d and Shaybah by 250,000 b/d. However, investments will only be made if and when a rise in global demand warrant them. Spare capacity: At the July production level of 9.55 mb/d, Saudi spare capacity is estimated at 1.29 mb/d, which represents almost all of OPEC s estimated spare capacity according to EIA data. Assuming production capacity is raised to 12.5 mb/d as planned, and output is raised to 9.7 mb/d in line with the Kingdom s commitment at the June 2008 Jeddah meeting, Saudi s spare capacity could rise to 2.8 mb/d by end This spare capacity will increasingly be in light crudes, with heavy oil projects tied to downstream activities. Looking further ahead, after 2010 rising demand, both at home and abroad, is expected to see an increased call on Saudi crude and a reduction in spare capacity to mb/d. 9

10 Long-term outlook for energy demand World economic growth is projected to average around 3.5 percent a year through 2030 World economic growth is projected to average around 3.5percent a year through 2030, while the world s population is projected to grow by one percent a year. This will translate into energy demand growth of around 1.5 percent a year, and an overall 50 percent increase in demand. However, demand growth is expected to slow in the short-term ( ), reflecting difficult global economic and financial conditions, before recovering. Both population growth and economic growth are key drivers of energy demand. Thus the largest increase in demand is expected to come from the rapidly expanding populations and economies of developing countries. These will account for over 70 percent of the increase in consumption of energy, with China and India being key drivers World Energy Demand Forecast Nuclear Renewable Fossil fuels will continue to satisfy the majority of the world s commercial energy needs quadrillion btu Liquids Natural Gas Coal Fossil fuels oil, gas and coal will continue to satisfy the majority of the world s commercial energy needs, maintaining a share of total supply of around 85 percent. Oil will remain central to this, although its share is expected to dip to around a third. Liquids are expected to remain the dominant energy source given their importance in the transportation and industrial end use sectors, although their role outside the transportation sector continues to be eroded. World Liquids Consumption by end-use (IEA) Quadrillion btus Transportation Industrial Buildings Electric Power 10

11 High prices for oil and natural gas, together with concerns to reduce carbon dioxide emissions, will encourage increasing use of nuclear and renewable fuels. Natural gas is expected to replace oil wherever possible, and will remain a key energy source for industrial sector uses and electricity generation. Overall gas consumption is expected to increase by about 51 percent through The use of coal for power generation is also expected to grow strongly at around 2 percent per annum, despite concerns to limit global greenhouse emissions. Most of this increase (70 percent) will come from China which has large coal resources, while sustained high oil prices will make coal fired generation economically attractive. High prices for oil and natural gas, together with concerns to reduce carbon dioxide emissions, will also encourage increasing use of nuclear and renewable fuels. Electricity generation from nuclear power is projected to increase by about 45 percent, while the consumption of hydroelectricity and other renewable energy sources, particularly wind and biomass, is projected to rise by 2.1 percent per year. Both IEA and EIA projections take into account government policies and measures that have already been adopted by mid-2007 which aim to address climate change and curbing the rapid growth of CO2 emissions. However, it is debatable to what extent new fuel economy standards and targets for bio fuels and renewables will impact long term demand, and OPEC has suggested such activities could reduce the projected call on OPEC oil by 4 mb/d by Key policies include: US Energy Security and Independence Act (2007) this introduces changes to automobile efficiency standards and requires an increasing contribution from alternative energy. EU Energy Action Plan (2007) this includes proposals to address climate change with targets for 2020 including, a 20 percent reduction in greenhouse gas emissions, 20 percent of energy supply to come from renewable sources, including a 10 percent bio fuels target in road transportation. Energy Intensity: primary energy use per dollar of GDP (in 2000 $) Btu per (2000) US$ USA China Saudi Arabia 11

12 Over the past three decades, energy use per unit of output has fallen by about a half in the OECD and by one third in non-oecd countries. Over the past three decades, energy use per unit of output has fallen by about a half in the OECD and by one third in non-oecd countries, and this trend is expected to be sustained in the coming years. However, most projections assume behavioural changes in line with those observed in the past, whereas there is an increasing possibility that sustained high energy prices will induce greater conservation and energy efficiency. This could result in significantly slower energy demand growth than currently anticipated. More recently, continuing improvements in US energy efficiency have resulted in declining energy intensity, measured as primary energy use per dollar of GDP, by an average of 2 percent a year since Steady declines have also been recorded in China, although this trend reversed in 2001 as the country s industrialisation accelerated and economy boomed. Interestingly, energy intensity in Saudi Arabia continues to rise steadily in line with the growing economy, but also reflecting the widespread government subsidies on energy consumption GDP growth Vs Oil demand percent Demand for oil World GDP growth (IMF) Oil demand (BP & IEA) According to the IEA, overall oil demand is projected to increase by around 30 mb/d through 2030 to reach 116 mb/d According to the IEA, overall oil demand is projected to increase by around 30 mb/d through 2030 to reach 116 mb/d (OPEC projects 112 mb/d). Key to demand growth for oil is the transportation sector. Worldwide consumption of oil for transport is expected to grow at around 1.7 percent per year, with the fastest growth in developing countries which have the greatest potential for increased vehicle ownership in line with rising incomes and investment in infrastructure. Car ownership levels in developing countries stood at just 31 per 1,000 inhabitants in 2005 according to the International Road Federation, compared with 473 and 427 in North America and Western Europe respectively. In China the figure was just 15 per 1,000, indicating the enormous scope for increased car ownership as the economy develops. Major improvements in fuel economy, and increasing use of bio fuels, is expected to slow the potential growth in demand for gasoline and diesel, but not reverse it. However, it should be noted that higher oil prices are prompting more rapid advances in non-oil fuel technology, such as hydrogen cars, and any major breakthrough in this area could dramatically reduce future oil demand. 12

13 Demand growth in the OECD is expected to be muted at around 0.3 percent per annum, while non-oecd growth averages 3.2 percent, with the largest contributions coming from China, India and the Middle East. While non-oecd oil consumption will outstrip OECD consumption by 2030, average oil consumption per capita will still be about 5 times less than in OECD countries World Marketed Energy Consumption (IEA) Quadrillion btu OECD Non-OECD Much of the projected increase in oil demand rests on the assumption of sustained economic growth in developing countries, especially China and India. Much of the projected increase in oil demand rests on the assumption of sustained economic growth in developing countries, especially China, India and the Middle East. Oil demand from these three sources has been growing rapidly, adding a combined 5 billion b/d to world demand since Such rates of oil demand growth are projected to slow, but remain robust at over 3.5 percent per annum for China and India and around 2 percent for the Middle East. Cumulative oil demand growth since % 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% USA China India Middle East World In the Middle East, Saudi Arabia and Iran are the major sources of growing oil demand. In the Middle East, Saudi Arabia and Iran are the major sources of growing oil demand, with both currently consuming over 1.6 mb/d each, while the Gulf Cooperation Council (GCC) plus Iran now consumes in excess of 4 mb/d. Demand growth in the GCC is anchored on an increasingly affluent population and, particularly in Saudi Arabia, the development of several economic cities. In addition, government subsidies shield consumers from rising prices and add support to robust demand growth. With massive infrastructure, industrial, 13

14 and real estate projects in the pipeline, and expectations of sustained economic expansion, oil demand growth in the regions is projected to continue growing strongly over the long-term. World Oil Consumption 2007 Rest of Asia Pac.14.5% Japan 5.8% North America 28.7% China 9.7% Africa 3.5% S&C America 6.4% Middle East 7.4% Rest of Europe & Eurasia 5.9% EU % Projected energy demand is highly sensitive to underlying assumptions about GDP growth. Box 3: Demand side risks Projected energy demand is highly sensitive to underlying assumptions about GDP growth. There remains a risk that the global economy will fall into a deep and prolonged recession, affecting China and India, and dragging oil demand and prices down with it. Recent record oil prices, and an expectation that they will stay high, may result in further demand destruction in the OECD accentuated by official policies to promote increased fuel efficiency and alternative energy use. In developing countries, high oil prices may push governments into reducing or eliminating increasingly expensive fuel subsidies which could induce a structural change in demand patterns. Government reluctance to pass on higher oil prices to consumers in many emerging markets over the last two years, including in China and India, has been an important factor behind increasing oil demand from these countries. Current projections assume that there is no technological breakthrough in vehicle non-oil fuel technology which is affordable and practical to adopt rapidly. Should this change, oil demand could fall steeply. Oil Supply As noted earlier, world oil resources are considered sufficient to meet projected growth in demand. Given that the majority of theses resources are located in OPEC, these countries will become increasingly important sources of supply, and OPEC s share of the market is expected to grow. 14

15 Demand to outpace non-opec supply mb/d Increase in Non-OPEC supply Increase in world demand Opec share of world supply % Non-OPEC suppliers have struggled to raise production significantly in recent years, and this trend is expected to continue. The assumed call on OPEC supply through 2030 is large, and is projected to reach 60.6 mb/d by the IEA. Non-OPEC suppliers have struggled to raise production significantly in recent years, and this trend is expected to continue. Output is projected to rise only very slowly through 2030, reflecting declining oil field production in the North Sea, the Gulf of Mexico and mainland Mexico. Offsetting these declines will be projected increases in crude and non-conventional oil production from Brazil, Russia and the Caspian region. However, the largest increase will come from the Canadian oil sands, where output is expected to triple to nearly 5 mb/d by Given the lack lustre long-term non-opec supply projections, the assumed call on OPEC supply through 2030 is large, and is projected to reach 60.6 mb/d by the IEA. This implies a need for an additional 25 mb/d of production, with consequent implications for required investment in new capacity. OPEC countries have in place investments to expand upstream capacity by as much as 5 mb/d by 2012 over 2007 levels. And, as noted earlier, Saudi Arabia has indicated sources of an additional 2.45 mb/d of supply to bring capacity to 15mb/d (see Box 2). World Oil Supply mb/d Non-OPEC OPEC NGLs/non-conventional OPEC crude 15

16 It should be noted that IEA demand projections tend to be overstated, while OPEC believe that world production of non-conventional supplies, such as NGLs, will be much higher than the IEA assume. A lower projected call on OPEC crude is thus a plausible projection. This adds weight to assumptions that the combination of increased supply and a slowdown in demand will lead to increased OPEC spare capacity over the next 2-3 years. However, there is a general agreement that this will subsequently fall back to minimal levels of around 1-2 mb/d as demand growth picks up, keeping the market tight. Around 27 percent of global reserves are located in three OPEC countries (Iran, Iraq, and Venezuela) currently prone to political unrest, and/or dominated by state owned oil companies. It is also noteworthy that around 27 percent of global reserves are located in three OPEC countries (Iran, Iraq, and Venezuela) currently prone to political unrest, and/or dominated by state owned oil companies with poor investment records. Oil production in these countries has fluctuated in recent years, and it will be a challenge to secure the production increases needed to meet rising world demand in the long-term. Iran, Iraq, Venezuela: Oil Production mb/d Iran Iraq Venezuela Box 4 Supply side risks Decline rates from fields currently in production are uncertain, and may turn out to be higher than current IEA estimates of 3.7 percent per year, implying a need for larger gross capacity additions. The potential for supply disruptions remains significant, particularly in Nigeria and Iraq, while lack of investment in the state owned Venezuelan oil sector may see production levels decline. More generally, capacity constraints, increasing costs, and less accessible oil fields may act to slow new investment and the bringing on stream of new capacity. On the positive side, large oil reserves exist in the Artic (recently estimated at 90 billion barrels) and US offshore deepwater. Technological and/or political breakthroughs may act to bring these on stream in the future. 16

17 Oil Investment Challenges There are widespread concerns that current investment in developing oil supply is inadequate, and likely to remain so in the foreseeable future. While it is generally agreed that adequate oil resources are available in the ground, the willingness and ability of international oil companies (IOCs) and national oil companies (NOCs), to deliver the necessary investment in capacity expansion to extract the oil is less certain. There are widespread concerns that current investment in developing oil supply is inadequate, and likely to remain so in the foreseeable future. This suggests that future supply weakness is a real possibility, and that it will be a challenge to secure the necessary increases in oil production presented in available long-term forecasts. A number of factors will continue to provide a dampening influence on investment activity, including the rising costs of production, the ownership structure of oil resources and geopolitical risk issues. Rising costs of production The marginal cost of finding and developing the most expensive barrel of oil has more than tripled to an estimated $75-85/b. A significant factor influencing the economics of upstream projects is the rapid run up in costs. Projects currently underway or announced have seen their costs revised sharply upwards reflecting rising prices for rigs, pipelines, storage facilities, and for skilled human resources. According to Cambridge Energy Research Associates, upstream costs have more than doubled since 2000, with 76 percent of the increase occurring in the last three years. At the same time available oil resources are increasingly found in less accessible locations, such as deep offshore or in oil sands, which are inherently more costly to extract. Overall the marginal cost of finding and developing the most expensive barrel of oil has more than tripled to an estimated $75-85/b. The increasing costs, combined with uncertainties on likely returns to necessarily large capital investments, are making oil project economics less attractive with potentially adverse implications for capacity expansions. 220 Upstream Capital Cost Index (2000=100) Source: CERA 17

18 Ownership Structures and Geopolitical Factors Oil reserves are increasingly concentrated in a small number of countries. Political opposition to foreign investment has curtailed IOCs ability to access low cost reserves Other factors likely to influence investment and production prospects are the location and ownership of oil reserves. Oil reserves are increasingly concentrated in a small number of countries (notably Middle Eastern members of OPEC and Russia) which, not being major consumers, have less incentive to invest and raise supply. This tendency is accentuated by the fact that the majority of global oil resources are in the control of NOCs influenced by national depletion policies that often see oil in the ground as being worth more than money in the bank. Further, even if willing to invest, NOCs ability to do so is often constrained by inefficiencies, high operational costs, and difficulties in accessing finance. Meanwhile political opposition to foreign investment has curtailed IOCs ability to access low cost reserves. While rising costs, combined with shareholder demands, are making it less attractive for IOCs to invest in extracting higher cost oil reserves. More generally, the concentration of oil reserves in a few countries increases the risk of geopolitical disruptions to oil supplies and capacity expansions. These risks range from possible physical destruction of oil assets due to conflict in countries like Nigeria and Iraq, to political interference in the oil sector which reduces the rate of growth, such as has occurred in Venezuela and Russia. From the consuming country side, especially large oil importers such as China and India, the current oil ownership structures, also poses a potential threat to their energy-security. National Oil Companies Control Proven Oil Reserves NOC Oil reserves (equity access) 11% 6% 6% Full IOC access Oil reserves held by new Russian companies 77% NOC oil reserves (limited equity access) Source: PFC Energy, BP World's Top 10 Oil Reserves Oil Producers Oil Exporters Share of Total mb/d Jun-08 mb/d 2007 Saudi Arabia 21.3% Russia 9.8 Saudi Arabia 8.53 Iran 11.2% Saudi Arabia 9.7 Russia 6.86 Iraq 9.3% USA 8.7 UAE 2.56 Kuwait 8.2% China 3.9 Norway 2.55 UAE 7.9% Iran 3.8 Iran 2.47 Venezuela 7.0% Canada 3.5 Kuwait 2.34 Russia 6.4% Mexico 3.2 Venezuela 2.13 Libya 3.3% UAE 2.6 Nigeria 2.13 Kazakhstan 3.2% Kuwait 2.6 Algeria 1.84 Nigeria 2.9% Iraq 2.5 Mexico 1.71 Source: BP Source: EIA Source: EIA 18

19 Lack of reliable and timely data mean that short-term prices are driven by general perceptions of supply and demand balancess. Other factors affecting prices Imperfect information and market perceptions While the oil market is driven in the long run by the underlying fundamentals of supply and demand, lack of reliable and timely data on these factors mean that short-term prices are in fact driven by the general perception of these fundamentals. Oil prices thus react to news of potential supply disruptions including; geopolitical risk affecting countries such as Iraq and Nigeria, hurricanes in the Gulf of Mexico, or of possible OPEC production cuts, as well as to evolving perceptions of demand growth. Most recently market participants were worried that demand may be growing faster than supply, driven mainly by rapid growth in developing countries such as China and India. However, as news emerges pointing to slowing world economic growth, particularly in the OECD, this perception is shifting, promoting a more bearish outlook on prices, at least for the short term. Countering this short-term sentiment is the view that over the coming decades oil will be priced for what it is irreplaceable and that we will soon reach peak oil i.e. the point from which global oil supplies decrease and never rise again. Determining when such a peak will be reached is difficult, even existing proven reserves data is debatable. Nonetheless a number of geophysicists have predicted that it will occur by 2015 and, in the absence of major new oil finds, such views may increasingly influence future oil prices. The surge in oil prices has focused attention on the critical role played by the refining sector. Refinery capacity The surge in oil prices has focused attention on the critical role played by the refining sector. Lack of investment in new refineries, reflecting poor margins or cracks, has led to tightness in the refined products markets, and this has been a source of upward pressure on oil prices. Changing patterns of product demand, in particular a surge in diesel demand, have led to severe bottlenecks in the refining sector in a number of countries in recent years. Global Oil Refining Capacity b/d OECD

20 Meanwhile, environmental standards, cost inflation and stringent laws and regulations, have tightened refinery margins and constrained operations. This has been accentuated by a mismatch between the quality of fuel supplied and the demand for lighted products. This was particularly noticeable during the second quarter of 2008 when Saudi Arabia offered to sell more of their heavy crude, but this was not taken up as their pricing policy was unattractive to refiners. How refining capacity evolves over the next two decades will be an important factor in oil prices. How refining capacity evolves over the next two decades will thus be an important factor in oil prices, with the quality of future crude supplies also having a bearing. According to OPEC, new refining capacity coming on stream through 2015, notably in Saudi Arabia, India and China should be sufficient to meet projected refining requirements. However, as with investments in upstream capacity, given future demand growth uncertainties, the challenge will be to make appropriate refinery investments to meet requirements through Speculation Oil price movements have shown increasing correlation with developments in global financial markets. Oil price movements have shown increasing correlation with developments in global financial markets. As part of the general growth in derivative financial instruments there has been a surge in oil derivatives, and tremendous growth in oil-index linked products. This has led to a massive increase in open interest on exchange traded commodities futures such as Nymex oil. Financial institutions and hedge funds now account for over 70 percent of trades, and data released by the US Commodity Futures Trading Commission (CFTC) show that at one point in July this year a single firm controlled 11 percent of the Nymex oil futures contracts. As part of these developments, and in the wake of sustained weakness in the US dollar during , financial institutions have started to trade in oil as a hedge against the US dollar. From January 2007 to August 2008, the dollar-euro exchange rates and the price of WTI showed a 90 percent correlation in a daily time series. Oil price Vs $/Euro Exchange rate $/b WTI $/Euro /01/07 26/09/07 04/06/ Oil Price $/Euro 20

21 It is hard not to see a role for speculation in the apparent detachment in oil prices from underlying fundamentals. The impact of such speculative activity on the recent surge in oil prices has been subject of much debate. The Integrated Task Force on Commodity markets, chaired by the CFTC, concluded in July that speculation was not driving prices, although this is still disputed. It is hard not to see a role for speculation in the apparent detachment in oil prices from underlying fundamentals during the first half of 2008 when they soared to $147/b, despite repeated downward revisions to world growth by the IMF, and to world oil demand by the IEA. In addition, daily price movements by $10/b, do not seem to fit with a fundamentals driven market, and even former Federal Reserve chairman, Alan Greenspan, has publicly stated that speculation was importantly responsible for the rapid increase in prices. What does appear clear is that speculative activities have led to much greater volatility in the oil market. These activities also add a further complicating factor in trying to predict oil prices - what is the outlook for the US dollar and its potential impact on oil prices, and when will this relationship break down? Not so long ago a weakening dollar would have been a sign of weakness in the US economy which would have had adverse implications for oil demand and prices. OPEC Oil Production (mb/d EIA data) Algeria Angola Ecuador Indonesia Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates Venezuela OPEC Total Spare Capacity Algeria Angola Ecuador Indonesia Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates Venezuela OPEC Total

22 Howard Handy Chief Economist Keith Savard Director Economic Research James Reeve Senior Economist Andrew B. Gilmour Senior Economist Raza A. Agha Research Economist Touheed Ahmed Management Associate Disclaimer This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, SAMBA is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be place upon the information it contains. Additionally, the information and opinions contained herein: 1. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations; 2. Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or 3. Are not intended to constitute a guarantee of future performance. Accordingly, no representation or warranty is made or implied, in fact or in law, including but not limited to the implied warranties of merchantability and fitness for a particular purpose notwithstanding the form (e.g., contract, negligence or otherwise), in which any legal or equitable action may be brought against SAMBA. Samba Financial Group P.O. Box 833, Riyadh Saudi Arabia