Oil prices in 2018 Beyond rebalancing to tightening. JOHN KEMP REUTERS 12 February 2018

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1 Oil prices in 2018 Beyond rebalancing to tightening JOHN KEMP REUTERS 12 February 2018

2 Oil market fundamentals: the cycle goes on Oil industry has always been subject to deep and prolonged cycles of boom and bust and there is no reason to think the future will be any different Cyclical behaviour is the distinguishing characteristic of oil markets and prices and rooted in the industry s structure Low price elasticity of supply and demand Backward-looking expectations and behaviour Positive and negative feedback mechanisms Complex adaptive systems Multiple markets for crude, fuels, refining, services, engineering, construction, drilling, skilled labour, raw materials etc Each market subject to its own feedback mechanisms, operating at different speeds and timescales, with constantly changing balances between supply and demand Balancing the oil market actually means balancing all these markets simultaneously Oil market is never really balanced or in equilibrium except accidentally and not for very long

3 Feedback mechanisms operate in oil markets and can delay as well as accelerate process of adjustment Oil industry is characterised by a multiple feedback loops Initial conditions Outcomes Negative feedback loops dampen impact of an initial change and are therefore stabilising and promote rapid return to equilibrium Positive feedback loops amplify the impact of an initial change and are therefore destabilising and delay return to equilibrium Feedback concept was popularised by communications experts at Bell Telephone Laboratory in the 1920s Long (implicit) history in economics: Adam Smith s invisible hand and David Hume s price-specie-flow mechanism are both instances of negative feedback loops

4 Examples of feedback mechanisms acting on oil supply and demand Positive feedback deepened slump, now accelerating rebound Negative feedback mechanisms (promote return to balance) Positive feedback mechanisms (delay return to balance) Supply-side Capital budgets Cash flow Equity finance Debt finance Producers revenue needs Labour costs Raw material costs Services contract adjustments Fiscal terms (taxes and royalties) Demand-side Fuel switching Fuel efficiency Energy conservation policy GDP impact in oil-consuming countries GDP impact in oil-producing countries Fuel consumption within the oil industry (drilling, refining, transportation) Fuel consumption throughout the oil supply chain (service companies and other suppliers)

5 Long boom, wrenching slump, now recovery

6 Oil market alternates between periods of oversupply and undersupply Calendar spreads cycle between contango to backwardation

7 Spot prices and calendar spreads are part of the same cycle

8 Spot prices and calendar spreads are closely correlated Both currently point to a recovery that is relatively mature

9 Rebalancing and recovery: what do we mean? At least five elements Closer balance between supply & demand (Yes) Normalisation of crude & product stocks (Yes) Forward price curve (Yes) Sustainable flat price (Yes) Sustainable investment (Yes) Market currently shows clear progress on all five elements

10 Brent futures prices have been transitioning from deep contango towards backwardation since January 2015 or January 2016

11 Brent spot price has been on an upward trend since Jan 2016

12 Where are we in the cycle? Mid-expansion Spot prices have been rising for 25 months (compared with 21 and 26 months after previous slumps to reach first major peak) Calendar spreads have been tightening for 37 months (compared with 21 and 34 months to reach first cyclical peak) Excess oil stocks still +109 million bbl over 5-year average Five-year average likely to be too low given the growth in oil demand since 2013 Oil price adjustments are highly non-linear and do not move smoothly to a new equilibrium value

13 Oil prices still feel low compared with the very recent past

14 From longer perspective, prices close to full-cycle average

15 In real terms, annual oil price is now above the average since 1973

16 Brent calendar spread is already in upper half of historic distribution

17 Brent calendar spread in 76th percentile of post-1990 distribution

18 What next? Cyclical recovery likely to continue in 2018/19 Spot prices will rise to moderate consumption growth and encourage faster increases in production Calendar spreads will tighten as crude and products stocks continue to draw down

19 Oil demand outlook for 2018/19 Gasoline-led in 2016/17 becoming diesel-led in 2018/19 Diesel demand mostly from industry and freight movements Diesel demand being driven by synchronised global growth Biggest risk comes from the macroeconomy Oil industry expansion still in mid-phase? U.S. economic expansion in late stage? U.S. expansion will be longest on record by July 2019

20 World trade volumes growing at fastest rate since 2011 Almost all freight relies on high-powered diesel engines

21 Freight movements growing strongly after a pause in 2015/16 (freight cycle is partly driven by commodity cycle)

22 U.S. freight volumes are growing at some of fastest rates this decade Freight movements are main driver of diesel demand

23 U.S. businesses have finally got inventories under control Freight recovery has strong momentum going into 2018

24 Biggest threat to oil expansion comes from macroeconomy U.S. expansion shows increasing signs of maturity

25 U.S. shale production will continue to grow in 2018/19 Shale producers costs are pro-cyclical Cost deflation during 2014/2016 slump Breakeven prices remain in dispute Most shale firms profitable with WTI>$60 Rig activity follows WTI with lag of around 20 weeks Recent rise in WTI prices should increase drilling WTI prices above $60 likely to see acceleration of drilling and output

26 U.S. oil rig count generally follows WTI with a lag of weeks

27 WTI prices hit a low of $43 per barrel on Jun 23 and have been on rising trend for last 32 weeks. Rig count now close to its end-aug high

28 U.S. crude output generally follows changes in the rig count with a lag of around 6 months (and WTI with a total lag of 6-12 months)

29 U.S. crude output has topped 10 million b/d and now highest for 47 years Further increases likely in 2018/19

30 U.S. shale oil production costs are cyclical and rising with recovery Rising costs will push breakeven prices higher in 2018/19

31 Saudi-led OPEC has accelerated rebalancing process OPEC/Saudi production cuts have accelerated a rebalancing process that was already underway Brent prices have risen from low of $27 in Jan 2016 to $45 at time of OPEC s Nov 2016 meeting and now $67 OPEC s formal target is to reduce OECD oil stocks (crude + products) to five-year average (ministers have recently suggested it could change) Oil surplus down to just +109 million bbl over five-year average Most of the remaining surplus is concentrated in crude rather than products Contango has been replaced by backwardation

32 OPEC will continue to tighten oil market in 2018 What is the price target? OPEC sources have said they want to see $60 price floor in 2018 Real target may be closer to $70 as an annual average for 2018 IMF estimates that $70 needed to balance Saudi government budget Aramco part-privatisation remains scheduled for end of 2018 or 2019 OPEC is notoriously slow to respond to changes in supply/demand conditions OPEC allowed prices to overshoot during both the previous recoveries after 1997/99 and 2008/2009 price slumps

33 Record bullish positioning by hedge funds creates reversal risk Hedge funds and other money managers running record or nearrecord bullish positions in crude and refined fuels Positioning creates downside risk if and when fund managers attempt to realise some profits after the rally but pull back might be limited Crude and products markets are nonetheless tightening and the cyclical trend is probably higher in 2018

34 Hedge funds have amassed a record net long position in the six major petroleum contracts equivalent to 1,421 million bbl

35 Hedge funds hold more than 11 long positions for every short across the petroleum complex: imbalance is a source of liquidation risk

36 Conclusions Cyclical recovery is underway and set to continue in 2018/19 Spot prices will continue trending higher Calendar spreads will continue tightening Crude and products stocks will continue to draw down OPEC will allow the market to tighten too much rather than risk not tightening enough Shale output will continue to grow as prices rise above $60 Hedge fund positioning poses risk of a sharp correction OPEC restraint will become self-defeating if continued too long Biggest risks come from macroeconomic or trade shock

37 Oil price outlook survey

38 Most energy professionals expect Brent price to average around $65 in 2018, rising to $65-70 in 2019 and $70 in 2020

39 Forecast Brent prices for 2018 have moved slightly higher from around $60 in 2016 to $65 in 2018

40 Forecast Brent prices for the end of the decade have changed little since 2016 and remain anchored around $70

41 Final warning from Rex Predictions notoriously unreliable, better to focus on coping strategies Former Exxon Mobil Chief Executive Rex Tillerson (2 March 2016): We ve never been any good at predicting these [price] cycles, neither when they occur nor their duration. We don t spend a lot of time even trying. How the future is going to look, we take no particular view on it, other than to recognize that whatever it is today it will be different sometime in the future, and after that it will be different again. In my nearly 41 years [with Exxon], that s been my experience. I didn t learn anything about my ability to foresee that. I learned a lot about how you deal with it