The only function of economic forecasting is to make astrology look respectable. J. K. Galbraith, Canadian/US economist ( )

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2 The only function of economic forecasting is to make astrology look respectable. J. K. Galbraith, Canadian/US economist ( ) 2

3 Why are oil prices still high? in view of the US tight oil revolution, why are oil prices so high? Because costs are high, because the Saudis want to keep them there, because of supply disruptions or speculation, or because the world s spare capacity has been squeezed? What could cause crude oil to get much cheaper? Iraq, Iran and Libya will cause an upset in the oil market this year if their collective production rises by 1.9 mbpd as is possible, under certain conditions and Saudi Arabia (the oil market s swing producer) is unwilling to cut back its output. Why would Saudi Arabia be unwilling to defend the oil price? we know that in recent years the Kingdom has defended $100/bbl oil; what could cause it to abandon this objective? Fears about the impact of high oil prices on the global economy? A desire to make its fellow OPEC members carry part of the burden? Can the marginal cost of production justify current price levels? the cost of producing the marginal barrel is quite a way below current oil prices; perhaps we should look instead at the marginal cost of supplying oil. Why should we worry about rising oil prices? there is clear evidence that oil demand is indeed destroyed by rising oil prices; should we be concerned? Should the Saudis be worried? Should anyone be bothered? We may propose, but geopolitics seem to dispose the oil market seems to be perennially at the mercy of forces beyond its control; why is this so? 3

4 A reminder as to why crude oil prices matter for bunker fuel CorrelaBons between Med fuel oil (with 1% sulphur) and Brent crude prices May 1987 unbl October Mediterranean fuel oil and Brent crude prices ($/tonne, May 1987 to October 2013) May 1987 to Dec Jan 1999 to Dec Jan 2007 to Oct All product prices are driven by the price of crude oil and fuel oil is no exception. The correlation coefficients for Med fuel oil prices and the price of Brent crude oil are high. Since fuel oil is refined from crude and refining is a cost- plus industry, it is hardly surprising to find that fuel oil and crude prices move together. In recent years the correlation between the two has stayed around 97%. Note that Brent crude prices are consistently above the price of fuel oil, because fuel oil is the cheapest product obtained from distilling a barrel of crude oil. The differential between crude oil and fuel oil varies due to underlying refining trends and local market conditions. Sources: EIA and CGES 4

5 '$!" '#!"!"#$%&!'#()$!*+,"-!./0012! '!!" &!" %!" $!" #!" "()*+,"-)./*"012(3"456678" Source: EIA!" Mar-2014 Oct-2013 May-2013 Dec-2012 Jul-2012 Feb-2012 Sep-2011 Apr-2011 Nov-2010 Jun-2010 Jan-2010 Aug-2009 Mar-2009 Oct-2008 May-2008 Dec-2007 Jul-2007 Feb-2007 Sep-2006 Apr-2006 Nov-2005 Jun-2005 Jan-2005 Aug-2004 Mar-2004 Oct-2003 May-2003 Dec-2002 Jul-2002 Feb-2002 Sep-2001 Apr-2001 Nov-2000 Jun-2000 Jan-2000 In comparison with earlier years the price of oil has been remarkably stable lately. The precarious geopolitical situation (the Ukraine, Russia, Syria, Iran and Libya) is causing jitters at a time when the world economy is in recovery mode, while the US shale oil revolution has transformed the supply side of the oil equation. These opposing influences are containing the price of oil within a relatively narrow band, aided by Saudi Arabia s astute price management via judicious use of the amount of oil it pumps into the global market. 5

6 Fundamentals can costs explain high oil prices? CGES estimates of recent fully built up costs of developing oil and gas fields Country, field/project (Reference/Date) Cost $/bbl Brazil subsalt (British Gas, 2011) 14 Canada's oil sands subsurface (CGES, 2012) < 35 Canada's oil sands integrated surface mining & upgrading (Canadian Oil Sands and Suncor Energy, 2011) Norwegian North Sea Avaldsnes-Aldous Major 20 oilfield complex (First Securities 2011) UK North Sea Athena oilfield (Ithaka Energy, 2011) 35 Russia W. Siberia chemical EOR and tight deep reservoir (Shell and Gazprom, 2012) US shale gas in $/bbl oil equivalent (boe, CGES/2012) US shale oil (CGES, 2012) The argument has been put forward many Bmes in recent years that the high oil prices we are experiencing are due to the high costs of developing the so- called marginal barrel. The CGES researches suggest that this is not the case, as the table indicates. The most expensive oil does not cost more than $60/bbl, while hundreds of millions of barrels of oil cosbng not much more than $15/bbl remain shut in. 6

7 Most of the US tight oil is produced in two basins the Williston in North Dakota and the Eagle Ford in Texas, with current production of 1.0 and 1.4 mbpd respectively. A further 0.8 mbpd comes from ten other tight oil formations. The N. Dakota Industrial Commission (NDIC) estimates that a typical Bakken well costs $9mn to drill, with initial output of 1,000 bpd and cumulative production of 615,000 bbls over 45 years. Capital and operating costs average $21/bbl and taxes and royalties add another $18/bbl; including a real rate of return of 10% brings the total to around $50/bbl. The same cost structure applies to the Eagle Ford formation, according to the NDIC. Rodgers Oil & Gas Consulting conclude that the average breakeven price for US plays is $64/bbl and $58/bbl for the Canadian formations. Source: N. Dakota Dept of Mineral Resources Tight oil s key problem is the rapid decline in well productivity (see adjacent figure), which requires the repeated drilling of wells in order to maintain production. 7

8 Declining spare capacity a plausible reason for higher prices? The OPEC 10 s capacity since 1998 Sources: BP, IEA and CGES Increment increase Percentage mbpd mbpd mbpd decrease % of total % Saudi Arabia! 10.40! 12.26! 1.86! 16! 38! Iraq! 1.95! 3.52! 1.57! 81! 32! Kuwait! 2.20! 3.08! 0.88! 40! 18! UAE! 2.62! 2.84! 0.22! 8! 4! Algeria! 0.88! 1.21! 0.33! 38! 7! Qatar! 0.71! 0.74! 0.03! 4! 1! Nigeria! 2.36! 2.20! -0.16! -7! 9! Iran! 3.83! 3.28! -0.55! -14! 31! Libya! 1.46! 1.42! -0.04! -3! 2! Venezuela! 3.41! 2.38! -1.03! -36! 58! OPEC 10's capacity Spare capacity World oil demand Spare capacity as % of oil demand! 5.2! 2.7! -2.5! -48 During a period when global oil demand increased by 17.0 mbpd (23%), the OPEC 10 s capacity to produce oil rose by only 3.1 mbpd (11%), resulting in a significant decrease in OPEC s spare capacity as a percentage of world oil demand. Three OPEC countries accounted for 88% of the rises in capacity, while two (Venezuela and Iran) accounted for almost all of the falls (89%). Note that Libya and Venezuela s peak average annual production occurred in 1970, Kuwait s in 1972, Iran s in 1974, Iraq s in 1979 and Saudi Arabia s in 1980 that is, all of the peaks came more than thirty years ago, and two occurred more than forty years in the past. 8

9 The US need for imported oil : 1965 to 2013 Sources: EIA and CGES Sources: BP and CGES Note that we have used finished petroleum product demand as the most appropriate measure of US oil consumption and the one best related to the production of crude oil in the US. This measure of oil product demand excludes natural gas liquids, which are mainly a by- product of natural gas production. The key to understanding the impact of the US shale/tight oil revolution is to examine the amount of oil the US still needs from abroad (the green line) after domestic crude oil production is taken into consideration. Between 1965 and 1985, the amount of oil the US needed was largely determined by oil demand, because its oil production was fairly static, but after 85 US oil output declined steadily, giving extra impetus to the need for additional imported oil due to rising oil consumption. The large run- up in the price of oil since around 2001 caused US oil consumption to flatten at first and then weaken (along with the effect of the recession), driving the amount of oil needed from abroad downwards, which was exacerbated by the sudden surge in US oil production as a result of the tight oil revolution. 9

10 The US need for oil and its imports of crude and oil products, 1965 to 2013 Sources: BP and CGES The Bght oil revolubon in the US has resulted in a decline in its imports of both crude oil and products. Imports of both would have been even lower had relabvely cheap indigenous US crude oil not led to a surge in US exports of oil products, mainly to LaBn America. The drop in US imports of crude oil since 2005 has affected mainly light, sweet crudes from West Africa, which have found replacement buyers in the Far East. 10

11 Pipelines into and out of Cushing, Oklahoma From Canada (tbpd) Keystone 590 From Oklahoma, Kansas, etc (tbpd) Cherokee 18 Blueknight 20 Great Salt Plains 20 White Cliffs 72 N. Cimarron 32 Hawthorn 120 Cashion 100 From West Texas (tbpd) Basin 450 Centurion N. 90 From Illinois (tbpd) Spearhead 190 To Illinois, Indiana (tbpd) Ozark 235 BP1 180 To Oklahoma, Kansas, etc (tbpd) Eagle North 20 Magellan Tulsa 30 Sunoco Tulsa 70 Phillips Borger 59 Coffeyville, Ka 110 Centurion South 60 Kansas Ponca 122 Osage Kansas 150 To the US Gulf (tbpd) Seaway (reversed) 400 Keystone XL 700 Longhorn (reversed) 225 Permian Express I 150 Ho-Ho (TX > Louisiana) 50 Seaway twin line 450 Planned Permian Express II 200 Bridge Tex 300 '#$ &$ #$!&$!'#$!'&$!%#$!%&$!"#$ Brent and WTI prices ($/bbl)!"#$%&'()*!+,-*!,'./(!0.1('()234! :!;-)*<4=>!?3=%@a!*-!b,'%cd!! $()*!+,-./$012/$1,34-$ 536-,-.789$:;<==9>$ Sources: EIA and CGES Aug-2013 Nov-2012 Feb-2012 May-2011 Aug-2010 Nov-2009 Feb-2009 May-2008 Aug-2007 Nov-2006 Feb-2006 May-2005 Aug-2004 Nov-2003 Feb-2003 May-2002 Aug-2001 Nov-2000 Feb-2000 May-1999 Aug-1998 Nov-1997 Feb-1997 May-1996 Aug-1995 Nov-1994 Feb-1994 May-1993 Aug-1992 Nov-1991 Feb-1991 May-1990 Aug-1989 Nov-1988 Feb-1988 May-1987 One unforeseen and unintended consequence of the US Bght oil revolubon and increasing amounts of Canadian crude being shipped to the US is the large price differenbal between WTI and Brent that has opened up in Brent s favour, despite Brent s slightly inferior quality. The unusual and at Bmes large differenbal has persisted because too much crude has been entering the storage hub of Cushing, which is the delivery point for the NYMEX WTI crude futures contract, and not enough oil has been leaving. This imbalance is being recbfied slowly as old pipelines are reversed and new ones built heading towards the Gulf, but a differenbal will persist to a greater or lesser degree as long as restricbons remain on the exportabon of US crude oil. 11

12 Sources: BP and CGES Percentage oil export shares 2005 Percentage oil export shares 2012 going West going East going West going East % % Middle East % % Middle East West Africa West Africa US China India Japan Other Asia from > to % % % % % West Africa na 1 18 Middle East 12 7 na US China India Japan Other Asia 2012 from > to % % % % % West Africa Middle East The decline in US imports due to the tight oil revolution has affected mainly the oil trade with West Africa. Displaced barrels that had been heading to the US from West Africa are now going east to China, India and the rest of the Asia-Pacific region. In 2005, 45% of West African oil exports went to the US and 32% to Asia-Pacific; by 2012 the share to the US had dropped to 19% and that to Asia- Pacific had risen to 46%. It is interesting to note that the share of the Middle East s oil exports going to the US has hardly changed; instead, the share of its oil exports to Europe has declined by 5 percentage points. 12

13 Oil product surpluses and deficits US oil product exports tbpd tbpd EU gasoline 850 1,007 EU middle disbllates US gasoline US middle disbllates US heavy fuel oil L. America gasoline L. America middle dist Sources: ENI and CGES tbpd tbpd Gasoline Jet fuel Gas oil 138 1,007 Residual fuel oil Petroleum coke TOTAL 1,010 2,609 Sources: EIA and CGES The Bght oil revolubon has caused significant changes in the US product surpluses and deficits: its gasoline deficit has all but disappeared and it now has a large surplus in middle disbllates, most of which finds its way to LaBn America, which since 2005 has moved from a surplus to a large deficit in this product category. TradiBonally, a large part of the US deficit in gasoline (which was seasonal) was met by imports from the EU. Since 2005 and the collapse in the US gasoline deficit, this trade has declined dramabcally, while US gasoline exports have increased threefold over the period. 13

14 Sources: IEA and Argus mbpd mbpd mbpd mbpd Incremental global oil demand less additional non-opec supplies and OPEC's NGLs yields changes in the zero-stock-change call on OPEC less the previous year's change in stocks equals the change in the need for OPEC oil Actual/expected change in OPEC's output Change in global oil stocks % change in Dated Brent Average Brent price ($/bbl) There is a reduced need for OPEC oil both this year and next, because of a surge in non- OPEC supplies (led by US tight oil). Whether OPEC will oblige is another question, especially in view of the expected 0.5- mbpd increase in Iraqi capacity during 2014, the probable return of at least 0.7 mbpd of Libyan oil and the possible lifting of sanctions on Iran from July 14 onwards, boosting its exports by a conservative 0.7 mbpd. Saudi Arabia would have to cut its production heavily to accommodate some of these extra supplies, which we think the Kingdom will do but it is not a foregone conclusion. 14

15 Selected OPEC output volumes Saudi Arabia, Iraq, Iran and Libya (Jan-12 to Apr-14 in tbpd, Argus estimates) $!&!!" '!!!" $!$!!" **!!" *)!!" *#!!" *&!!" *$!!" (*!!" ()!!" (#!!" ":B"43,1C,DE"?7=57="F=15GH"80I",JCEK" "L3,MDE"?7=57="F=15GH"3C9N=",JCEK" "OC16,DE"?7=57="F=15GH"3C9N=",JCEK" "L3,-DE"?7=57="F=15GH"3C9N=",JCEK" 453" 2,3" /01" +,-.$'" A0<" ;<=" :05" 479" +78" +7-" 2,6" 453" 2,3" /01" +,-.$&" A0<" ;<=" :05" 479" +78" +7-" 2,6" 453" 2,3" /01" +,-.$%" &#!!" &!!!" %#!!" %!!!" $#!!" $!!!" #!!"!" Saudi Arabia is always on the look- out for any significant involuntary changes in the output of its OPEC partners, which the Kingdom generally tries to counteract by raising or reducing its own production accordingly. When from Jun- 13 onwards Libyan output started to decline rapidly, Saudi Arabia ramped up its production further, pushing it to the highest levels seen since However, a note of caution is needed when interpreting this move, because Saudi output usually rises significantly in the summer months for seasonal reasons, making it difficult to work out how much of the Saudi production increase actually fed into the international market; moreover, Saudi oil is heavier and sourer than Libyan oil, with ramifications for the product market, especially in the Mediterranean. 15

16 Bullish/bearish factors for oil prices 16

17 Contango and backwardation in the ICE Brent futures market Global commercial inventory cover, Dated Brent and the forward curve (quarterly, 1Q08 2Q14) )!"$ &%#"$ "#$$% Sources: ICE and Drollas *"#$% )'"$ &"#"$,#$$% *)#$% &(#$% )""$ ("$ %%#"$ )#$$% $#$$% &'#$% &&#$% &"#$% &"$!"$ %"#"$ +)#$$% &)#$%!(#$% '"$ "$ Dated Brent ($/bbl, left axis) global commercial stock cover (days, right axis)!%#"$!"#"$ +,#$$% +"#$$% 3rd mnth less 1st mnth ($/bbl, left axis) Global commercial stock cover (days, right axis)!'#$%!&#$%!"#$% )-)!% "-)"% )-)"% "-),% )-),% "-))% )-))% "-)$% )-)$% "-$(% )-$(% "-$.% )-$.% )*)!$ +*)+$ )*)+$ +*)'$ )*)'$ +*))$ )*))$ +*)"$ )*)"$ +*",$ )*",$ +*"($ )*"($ In general, the higher the level of oil inventory cover the wider the contango, if the market happens to be in contango, and the narrower the backwardation, if the market is backwardated. Most of the time the 3rd month versus 1st month spread in the Brent futures market is positively correlated with the level of commercial inventory cover (see the right- hand graph). Occasionally the relationship breaks down, as it seems to have done in 2Q13 and 4Q13. Given the current level of stock cover, the market s backwardation should have been narrower. Now and then the front month acquires a premium seemingly unjustified by the fundamentals. The latest premium is likely to have been driven by market concerns about disruptions to oil supplies (due to continuing turmoil in Libya and worries about the outcome of the talks between the P5+1 group and Iran in Geneva). What is worth remembering is that a premium could be lost as quickly as it was gained (e.g., in 2Q13 and 4Q13). 17

18 Brent price forecasts for 2014 and 2015 Sources: Argus, ICE and Drollas 140! Brent price forecasts ($/bbl, November 2013 to December 2014) 130! 120! 110! 100! 90! 80! Actual! Interpolated/Base Case! OPEC's output maintained at 30 mbpd in 2014! OPEC raises output in 2H14 by 0.5 mbpd! ICE Brent futures on 16/05/14! 70! Nov-15! Sep-15! Jul-15! May-15! Mar-15! Jan-15! Nov-14! Sep-14! Jul-14! May-14! Mar-14! Jan-14! Nov-13! Sep-13! Jul-13! May-13! Mar-13! Jan-13! Despite a number of geopolitical upheavals, the oil market has been remarkably stable since last autumn, in large part due to Saudi Arabia s astute management of its oil output. There is no reason to believe that this will not continue to be the case, with or without S. Arabia s fellow members of OPEC. The main challenge the Kingdom faces is how to cope with large possible production increases in Libya, Iraq and Iran between now and the end of Well in excess of 1.5 mbpd might become available from these three countries, which would send Brent down below $90/bbl by Mar- 15 unless S. Arabia takes the initiative. On the other hand, if OPEC s output stays around 30 mbpd, Brent will rise well above $120/bbl by next summer, damaging the global economy. 18

19 Why worry about rising real oil prices? The impact of changing real oil prices on the demand for oil in the market economies Oil demand in the former NCW without the OPEC countries ( ) Oil demand in the European Union ( ) Sources: BP Stats and CGES Sources: BP Stats and CGES Oil demand in the market economies is affected by rising oil prices in real terms. Between 1985 and 1998 the real price of oil declined and oil demand in the non- centrally planned economies (minus the OPEC countries) rose at a steady trend rate of growth. When the real price of oil started rising strongly ager 1998, the rate of increase in the demand for oil slowed considerably, with oil consumpbon barely growing in the last few years. The picture in the European Union is similar unbl 2006, but very different thereager due to the prolonged recession, the sovereign debt crisis in the Eurozone and the adopbon of policies to reduce CO 2 emissions. 19

20 Can the world continue to afford expensive oil? Indices of nominal global GDP and oil costs per head (2000=1.0) Sources: IMF, IEA and CGES The following example of recent gasoline prices shows the distorbng effect of subsidies Global GDP per capita has doubled during the last thirteen years (5.3% p.a.), whereas oil costs per head have trebled (8.5% a year) over the same period. This measure of oil costs includes transportation, refining, and distribution & marketing costs, plus taxes. In many parts of the developing world subsidies help to reduce the impact of rising oil costs (see the table on the right), but as you can imagine these subsidies are a huge drain on the public finances. 20

21 Sources: BP and CGES The vertical axis refers to the % change in emissions from the base year; e.g., +0.4 represents a 40% increase and +1 a 100% rise (i.e. a doubling). The UK s CO 2 emissions in 2012 were 16% lower than the base level, while the EU s as a whole were 12% lower and the US 6% higher, as were Japan s (19% higher). The sharp rise in Japan s emissions in 2012 was due to more oil- and gasbased power generation after the Fukushima nuclear disaster. The UK s rise in emissions in 2012 was due to more coal-based power generation before the planned decommissioning of certain coal-fired power stations.

22 Concluding remarks 22

23 You are a philosopher Dr. Johnson. I have tried in my time to be a philosopher, but, I don t know how, the cheerfulness was always breaking through. Oliver Edwards (a solicitor) talking to Dr. Johnson 23