Research Commodities Has the oil market become immune to geopolitics?

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1 Investment Research General Market Conditions 30 October 2014 Research Commodities Has the oil market become immune to geopolitics? Our SVAR decomposition of shocks to the oil price shows that positive supply shocks have been the main driver of oil prices this year. Furthermore its shows that despite the long list of unresolved geopolitical conflicts in major oil producing countries, precautionary oil demand shocks have been absent. We expect this pattern to continue in 2015 and thus see geopolitics as a limited risk factor for the oil market next year. Nevertheless, we expect prices to rise next year from the current low level as OPEC brings back output within its 30mb/d target and global growth increases. We forecast the Brent crude oil price will average USD94/bl next year, jet fuel will average USD880/MT, ULSD will average USD816/MT and 3.5% fuel oil will average USD503/MT. Contents Oil prices plunge, while geopolitical tensions loom... 1 Decomposing shocks to the oil price... 2 Geopolitical conflicts a limited risk in Higher prices await in 2015 but upside risk limited... 3 Oil price forecasts... 4 Overall, our forecasts are below the prices in the forward market and we recommend clients on the consumer side hedge exposure at current low levels. Oil prices plunge, while geopolitical tensions loom Tensions have risen in several important oil exporting countries. The insurgence in Iraq and Syria and the conflict between Russia and Ukraine have drawn the main share of headlines. Other major oil exporting countries are also plagued by an unstable political situation, e.g. Iran is still constrained by sanctions, Barqa rebels in Libya are pressuring for more autonomy and Boko Haram is spreading violence in Nigeria. Despite this so-called geopolitical risk factor being very much present, threatening supplies to the global market, oil prices, including the price of crude oil and major oil products, have fallen to the lowest level since the autumn of During previous instances of geopolitical conflict in the Middle East, including the Iran-Iraq war, the first gulf war, the Kurdish civil war and the Arab spring, the oil price rose % within a couple of months of the conflict beginning. However, this year the oil price has been relatively flat compared with these previous episodes of geopolitical conflicts. Brent has fallen to a multi-year low Source: Macrobond Financial So have oil product prices The oil price has ignored geopolitics this year Source: Macrobond Financial Senior Analyst Jens Nærvig Pedersen jenpe@danskebank.dk Important disclosures and certifications are contained from page 5 of this report.

2 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Research Commodities Decomposing shocks to the oil price Several factors determine oil prices besides geopolitical risks in oil-producing countries, including fundamental supply and demand factors. Thus, we need to decompose changes in the oil price in order to conclude what has driven the oil price. Using the SVAR model described in the box below, we decompose shocks to the crude oil price into three groups: shocks to global oil supply, shocks to global demand for goods and services and shocks to oil demand. A positive supply shock has a negative impact on prices, while a positive global demand or oil demand shock has a positive impact on prices. In the short run (within a given month), geopolitical conflicts may affect global oil supply if they lead to a disruption in supplies, which happened, for example, in Libya during the Arab Spring in Geopolitical conflicts may also affect oil demand if the conflict raises concerns in the market that it may result in a supply disruption. In this case, precautionary demand may increase and the market would start hoarding oil. Structural VAR model for decomposing shocks to the oil price The model used to decompose shocks to the oil price follows Killian (2008): Exogenous oil supply shocks: how big are they and how much do they matter for the US economy?, The Review of Economics and Statistics, MIT Press, vol. 90(2), pages , May. We use a structural VAR model with 24 lags based on monthly data for crude oil production,, where is the monthly percentage change in the seasonally adjusted global is OECD monthly retail sales in volume terms, which is used as an indicator for global economic growth and thus global demand for goods and services and finally, is the real oil price calculated deflating the Brent crude oil price with an index for global consumer prices. The latter two variables are expressed in logarithmic terms. We further consider the structural representation. We postulate that has a recursive structure, so the reduced form errors may be decomposed according to with the following restrictions on : The identification assumptions above allow us to decompose shocks to the oil price into three categories: shocks to global oil supply, arising from, for example, changes to OPEC output or production from non-opec producers, shocks to global demand for goods and services, which tend to increase demand for oil as well and finally shocks to oil specific demand, which may be interpreted as shocks to precautionary oil demand, which may be due to a growing risk of supply disruptions in, for example, producers in the Middle East. Oil supply shocks have weighed on the oil price since Supply shock 12M m.a. Global demand shocks have not had an impact on the oil price in recent years Global demand shock 12M m.a. Precautionary demand shocks have turned negative Oil demand shock 12M m.a. The charts in the margin illustrate the three types of shocks since The results show that the main factor determining the oil price this year has been a positive supply shock, while global demand shocks and precautionary oil demand shocks have not had a significant impact on the oil price. In contrast the oil market was driven by a negative supply shock and a positive precautionary demand shock in early 2011 during the Arab spring. Hence, the results of our SVAR decomposition of shocks to the oil price indicate that the current geopolitical conflicts does not look to have had an impact on the oil price this year October

3 Geopolitical conflicts a limited risk in 2015 If we compare the current state of the global economy and the oil market to the state of the global economy and the oil market in past episodes of rising geopolitical tension, it becomes further evident why the current geopolitical conflicts have played a minor role in the oil market this year. In particular, three factors are worth highlighting. The US has become less dependent on oil imports. Following a couple of years of a sharp rebound in oil production, the US has now become increasingly self-sufficient in oil and thus can rely less on oil from outside the US. The US dependence on oil imports is currently below what it was during the Iran-Iraq war, the first gulf war, the Kurdish civil war and the Arab Spring. Hence, the US is now less exposed to a supply disruption in the Middle East, which should further limit shocks to precautionary oil demand. Weak global growth. Global economic growth is weak, which weighs on demand for commodities, including oil, arising from rising global economic activity. Global growth is currently lower than it was in the previous four episodes of geopolitical conflict listed above. Hence, the upward pressure on the oil price from rising global growth is less pronounced this year than it has been previously. The less tight market condition should further reduce the risk of precautionary oil demand shocks. High OECD crude oil stocks. Crude oil stocks in the OECD countries are at a relatively high level currently. With plenty of oil in storage, the major oil importing countries are thus more capable of managing a supply disruption. This should further limit shocks to precautionary oil demand. High crude oil stocks US is less dependent on oil import Weak global growth weighs on oil demand The long list of unresolved geopolitical conflicts in major oil exporting countries means the geopolitical risk factor in the oil market will probably be a recurrent theme in the coming year. However, in our view, the oil market currently looks relatively robust, highlighted by the three factors outlined above, and thus less exposed to a disruptive geopolitical conflict. Hence, for now, we view the upside risk to the oil price from the current geopolitical conflicts as less pronounced. In our view, it will either take a significant disruption to the global oil supply, probably much larger than the output swings registered in Iran, Iraq and Libya over the past couple of years, or a significant acceleration in global economic growth, which would tighten the oil market on the back of higher demand. Higher prices await in 2015 but geopolitical risk limited The analysis above concludes that the upside tail risk to the oil price from the current geopolitical conflicts, i.e. a scenario where the oil price increases more than 20% within a couple months following a rise in geopolitical tensions in one or more major oil 3 30 October

4 producing countries, is limited at the moment. That means that the upside risk to oil product prices from geopolitical conflicts is also limited. It holds in particular for the light-end products and middle distillates, which tend to come under pressure more when the crude price spikes. Nevertheless, we expect oil prices to rise over the coming year. The current low level of the crude oil price will not satisfy the public budgets of most producers within OPEC, which require a crude oil price of USD90/bl and above to balance. We thus expect OPEC to counter the low price by bringing its production in line with its 30mb/d target. If downwards pressure on the oil price mounts leading up to 27 November OPEC meeting we could further see OPEC cut its output target by 0.5mb/d to 29.5mb/d. The low oil price is also likely to begin to become a pain for new producers of unconventional oil in, for example, the US, Canada and Brazil, with relatively high marginal costs of production. Hence, if global demand does not improve and add support to oil prices they may have to adjust future production plans. Our forecasts as shown in the latest Commodities Forecast Update: Weakness awaits rest of 2014, 15 October, remain unchanged. Thus, we expect the Brent crude oil price to rise to USD97/bl in Q4 15 and average USD94/bl from the present level around USD87/bl. This would lead to price increases on oil products. Therefore, we forecast jet fuel will average USD880/MT next year from currently USD842/MT, ULSD will average USD816/MT from USD788/MT and 3.5% fuel oil will average USD503/MT from USD459/MT. Overall, our forecasts are below the prices in the forward market. Hence, even though the geopolitical risk factor is less imminent, we recommend clients on the consumer side hedge their exposure at the current low level. Danske Bank s oil price forecasts 29/10/14 14Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q Energy: front month (US$/bbl) NYMEX WTI ICE Brent Oil products: front month (US$/t) NYMEX gasoline Euro-bob Oxy , Jet fuel CIF cargo ULSD 10ppm CIF NWE cargo ICE gasoil ICE Brent % fuel oil FOB NWE cargo % fuel oil FOB ARA barge Crack spread: front month (US$/t) NYMEX gasoline Euro-bob Oxy Jet fuel CIF cargo ULSD 10ppm CIF NWE cargo ICE gasoil % fuel oil FOB NWE cargo % fuel oil FOB ARA barge Source: Macrobond Financial and Danske Bank AVERAGE 4 30 October

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