Oil the Saudis blinked first

Shipping and the Law 2016 Oil the Saudis blinked first Dr Leo P. Drollas Independent Energy Consultant Napoli 25 th October 2016

A long-run look at oil prices in nominal and real terms 350 300 Oil price based on 2015 prices and exchange rates Oil prices in current US Dollars/bbl Sources: BP, BIS, World Bank and Drollas 250 World recession 200 Change in Saudi policy netbacks 150 100 50 Change in Saudi policy letting prices find their level 0 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 Oil prices in 1980 were almost six times higher than today, after adjusting for global inflation and the changing value of the US Dollar. Note that the average between 1986 and 2004 was $47/bbl in 2015 Dollars. The price collapse in 2015 was the largest in nominal terms since 2009 and the second largest in real terms after the 1986 crash. 2

The current oil situation Oil prices have been weak because the Saudis wanted to reverse the surge in US shale production. This they achieved, but at a very high fiscal cost, which they finally decided was too much for them. The Algiers pact of the 28 th of September marks OPEC s wish to return to output management. The devil, though, lies in the detail of how to determine quotas and how to implement them. Output cuts will ensue, but after initial successes there will be leakages as the crude price rises. The elephant in the room is the very high level of global commercial stock cover, which will take a long time to decline to more normal levels. 3

Saudi Arabia s deteriorating finances Saudi Arabia s fiscal balances 1976 to 2015, with es=mates for 2016 and 2017 160 110 $ bn and $/bbl Saudi fiscal deficits/surpluses ($bn) OPEC basket price ($/bbl) 60 10-40 -90 Sources: SAMA and Drollas Largest Saudi fiscal deficits ever in 2015, 2016 and 2017-140 2016 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 The Kingdom is bleeding cash ($137 bn between Mar-15 and Aug-16) and has issued fresh domestic debt ($26 bn last year). In April 2016, S. Arabia carried out its first international syndicated loan since 1991 by selling $10bn of 5-year paper, following in the footsteps of Abu Dhabi ($5bn) and Qatar ($9bn). The Kingdom still has $554 bn of net foreign assets (end Aug-16), but further depletion of these reserves is almost certain unless oil prices in 2017 rebound to the $75/bbl level, which is highly unlikely; the best that can be hoped for is a level just over $50/bbl. 4

Decline in S. Arabia s net foreign assets 700 Sources: SAMA, EIA and Drollas 70 680 660 640 60 50 620 40 600 580 30 560 S. Arabia's net foreign assets ($bn, lej axis) Brent spot price ($/bbl, right axis) 20 540 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 10 The Saudi government financed its huge fiscal deficit in 2015 [$98bn as announced, but in reality closer to $120bn] primarily by running down its foreign assets. Saudi Arabia s net foreign assets have declined by $137bn in the period March 2015 to August 2016, at an average rate of $8bn per month. Between Feb and May-16 the net foreign assets rate of decline decreased considerably due to the rise in oil prices and the Saudis international sale of $10bn worth of 5-yr bonds in April 2016. However, there were declines of $11bn, $6bn and $1bn in June, July and August 2016. 5

What happens to prices depends on whether OPEC manages to hammer out a plausible and therefore viable quota agreement in Vienna on the 30 th of November (difficult), whether the OPEC member-countries adhere to whatever agreement is forged in Vienna (difficult), whether the inevitable OPEC leakage will be on a small enough scale not to destroy the pact (perhaps), the scale of the response of US shale production to higher crude oil prices (likely to be material), the responsiveness of oil demand to higher oil prices, which also depends on the movement of the trade-weighted US Dollar and global inflation (low), the speed of global economic growth. 6

US crude oil output and WTI spot : Jan-13 to Sep-16 10000 9500 9000 8500 Sources: EIA and Drollas 120 110 100 90 80 8000 70 7500 60 7000 6500 US crude oil produc?on (tbpd, led axis) WTI spot price ($/bbl, right axis) 50 40 30 6000 20 Sep-16 Jul-16 May-16 Mar-16 Jan-16 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 Due to gains in drilling efficiency it took almost a year for US crude oil production to reflect the collapse in oil prices. US oil output started to decline steeply from Apr-16 onwards, but this drop seems to have been arrested in Jul-16, following the price revival. The year-on-year US output drop in July 2016 was at the 700-tbpd level. 7

The US oil rig count and WTI 1800 1600 1400 1200 Sources: Baker Hughes, EIA and Drollas 120 110 100 90 80 1000 70 800 60 600 400 US rigs targe@ng oil (number, lee axis) WTI spot price ($/bbl, right axis) 50 40 30 200 20 Sep-16 Jul-16 May-16 Mar-16 Jan-16 Nov-15 Sep-15 Jul-15 May-15 Mar-15 Jan-15 Nov-14 Sep-14 Jul-14 May-14 Mar-14 Jan-14 The US oil rig count has become the bellwether of the upstream US oil industry, although soaring rig productivity has distorted the significance of counting rigs. Be that as it may, the rig count seems to follow the price of oil with approximately a six month lag. The oil price rise since Feb-16 pointed to a recovery in the count, which is indeed happening: the count has increased by 30% between May and September. 8

Permian Basin wells drilled & WTI spot : Jan-14 to Aug-16 800 700 600 500 Sources: EIA and Drollas 120 100 80 400 60 300 40 200 100 Wells drilled in the Permian basin (number, lee axis) WTI spot price ($/bbl, right axis) 20-0 Jul-16 May-16 Mar-16 Jan-16 Nov-15 Sep-15 Jul-15 May-15 Mar-15 Jan-15 Nov-14 Sep-14 Jul-14 May-14 Mar-14 Jan-14 The Permian Basin is the largest oil producing region in the United States. It contains conventional and tight oil formations that have yielded around 29bn bbls thus far, with an estimated 43bn bbls left.! Average well productivity in the Permian has risen 5-fold since early 2012.! The Permian is as bountiful as the giant Ghawar field [in S. Arabia] and can expand from 2 mbpd to 5 mbpd even if the price of oil never rises above $55/bbl, says Scott Sheffield, outgoing chief of Pioneer Natural Resources.! 9

Hydraulic fracturing of tight oil the game changer The technique was first tried in 1947 and the first commercially successful application was by Halliburton in March 1949 in Oklahoma and Texas. George P. Mitchell was the first to apply it to shale formations [the Barnett shale gas field in Texas] in the 1980s, eventually using the commercially successful slickwater-fracking process in 1997. Well decline rates over the first 4 months in the Permian basin have dropped from 90% in 2006 to 31% in 2012 and 18% in 2016. Three wells are now routinely drilled from the same rig and sometimes 6 or more. Average well productivity has risen five-fold in the Permian since early 2012. Of the 3,900 drilled but uncompleted wells (DUCs) 90% are profitable at $50/bbl, says Rystad Energy. 10

Changing well productivity in Texas Permian tight oil region The chief characteristic of the US tight oil regions is the rapid rise in well production during the first 3-4 months and then the rapid fall off in productivity subsequently. The great improvement in the efficiency of fracking and tight oilfield management in general has resulted in an almost five-fold increase in well productivity between 2012 and 2015. 11

The game changer : breakeven shale oil prices in the US Sources: Rystad Energy and Drollas 2014 2015 2016 $/bbl $/bbl $/bbl Permian Midland 85 51 38 Permian Delaware 63 47 33 Niobrara 56 43 35 Eagle Ford 75 51 39 Bakken 58 37 32 The Permian oil formations are mainly in Texas and partly in New Mexico. The Niobrara basin is mainly in Colorado and Wyoming, with a small part in Nebraska, while the Eagle Ford formation is entirely in Texas. The Bakken is principally in North Dakota with a small part in neighbouring Montana. 12

Representative fully-built-up costs of developing oil fields (including 6-7% cost of capital) NORWAY Statoil s J. Sverdrup $20/bbl NIGERIA Shell s Bonga South West $27/bbl ANGOLA Total s Kaombo field $42/bbl BRAZIL* Libra sub-salt oilfield $20/bbl US SHALE N. Dakota (Bakken) $32/bbl UK N. SEA Athena oilfield $35/bbl Culzean gas & condensate field $13/bbl CANADA Oil sands (plus upgrading) $50/bbl * The Libra field has 10 billion barrels of recoverable oil and is likely to cost $200 bn over 35 years to develop fully. It is situated 200 km offshore in water 2,000 meters deep. The field lies at a depth of 3,500 meters below the seabed. 13

Sample operating and capital costs per barrel in the M. East Cost per peak Capital costs Operating Fully built Capacity daily barrel in costs in up costs mbpd $ $/bbl $/bbl $/bbl SAUDI ARABIA Manifa (offshore) - 2013 0.90 17,500 4.8 3.6 8.4 Khurais (onshore) - 2010 1.20 10,000 2.7 1.4 4.1 QATAR Shaheen (offshore) - 2009 0.29 17,544 5.0 3.4 8.4 ABU DHABI Upper Zakum (offs)-2017 0.25 18,068 5.4 3.5 8.9 Bab expansion (ons) -2003 0.40 3,000 0.8 0.4 1.2 IRAN West Karun fields (ons) - 2019 0.50 40,000 11.0 5.5 16.4 Bangestan (ons) - 2011 0.12 7,500 2.1 1.0 3.1 IRAQ Five-field develop. (ons) - 2012 0.50 5,000 1.4 0.7 2.1 Shaikan (ons) - KRG - 2017 0.45 15,556 4.7 2.1 6.8 KAZAKHSTAN Kashagan (offshore) - 2016 1.50 66,667 16.4 12.8 29.2 US GULF OF MEXICO Jack/St Malo (offshore) - 2014 0.18 42,135 10.7 9.2 20.0 Data for these two fields have been provided for comparison.

OPEC s problem how to accommodate Iran, Libya and Nigeria Annualised gross value of crude output Sep '16 2Q17 Difference $ bn $ bn $ bn Saudi Arabia 172 174 2.0 Iraq 73 74 0.8 Iran 59 72 12.6 Kuwait 47 48 0.5 Neutral Zone U.A.E. 49 49 0.6 Qatar 11 11 0.1 Libya 6 13 6.9 Algeria 18 18 0.2 Nigeria 26 36 9.8 Venezuela 34 35 0.4 Indonesia 12 12 0.1 Angola 29 29 0.3 Ecuador 9 9 0.1 Gabon 3 3 0.04 Total 548 583 35 Assumptions Iran, Libya and Nigeria manage to attain 4, 0.7 and 2 mbpd respectively by 2Q17. The rest of the OPEC member countries produce in 2Q17 according to their output shares in Sep-16, excluding the three mentioned. Aggregate OPEC output in 2Q17 is set at 32.5 mbpd, down from 33.66 mbpd in Sep-16. The OPEC basket price was $44.6/bbl in Sep-16 and it is projected to average $49.1/bbl in 2Q17. Question Is quota allocation worth all the effort if Iran, Libya and Nigeria are excluded from the deliberations. 15

Global commercial stock cover and Brent : Jan-15 to Dec-18 60.00 Sources: Argus, EIA and Drollas 70 58.00 65 56.00 60 54.00 55 52.00 50 50.00 45 48.00 40 46.00 35 44.00 30 42.00 Global commercial stock cover (days, lef axis) Brent spot price ($/bbl, right axis) 25 40.00 20 Nov-18 Sep-18 Jul-18 May-18 Mar-18 Jan-18 Nov-17 Sep-17 Jul-17 May-17 Mar-17 Jan-17 Nov-16 Sep-16 Jul-16 May-16 Mar-16 Jan-16 Nov-15 Sep-15 Jul-15 May-15 Mar-15 Jan-15 Global commercial oil inventory cover has been rising continuously since 1Q14; it is likely to reach a peak in February 2017 if OPEC implements large output cuts (down to 32.5 mbpd, i.e. cuts of over 1 mbpd versus Sep-16) by 2Q17. As commercial inventory cover begins to head downwards oil prices will trend upwards, but cover is expected to decline to only 54 days worth by the end of 2018, which would still be about 9 days more than the normal level of cover. 16

Where the ICE futures market thinks Brent is heading 60 55 Actuals The curve on 12/10/16 50 07/12/2015 Actual monthly values of Brent spot 45 40 05/02/2016 23/03/2016 26/04/2016 26/05/2016 27/06/2016 16/08/2016 01/09/2016 The curve on 1/9/16 35 12/10/2016 Sources: ICE and Drollas 30 Dec-17 Nov-17 Oct-17 Sep-17 Aug-17 Jul-17 Jun-17 May-17 Apr-17 Mar-17 Feb-17 Jan-17 Dec-16 Nov-16 Oct-16 Sep-16 Aug-16 Jul-16 Jun-16 May-16 Apr-16 Mar-16 Feb-16 Jan-16 What is obvious from the curves is that they are all heading in the same direction (contangoed) and that between them they vary considerably, both in initial and terminal values. The reason they vary is because of the conditions obtaining in the oil market when they are formed. For example, the difference between the 1/9/16 curve and the 12/10/16 curve is due to OPEC s Algiers pact to limit production. 17

Using the past to predict future W. Med 1% HFO prices 800 Sources: Argus and Drollas 700 600 500 400 300 200 100 Actual W. Med 1% HFO ($/t) Predicted W. Med 1% HFO ($/t) 0 Sep-15 May-15 Jan-15 Sep-14 May-14 Jan-14 Sep-13 May-13 Jan-13 Sep-12 May-12 Jan-12 Sep-11 May-11 Jan-11 Sep-10 May-10 Jan-10 Sep-09 May-09 Jan-09 Sep-08 May-08 Jan-08 Sep-07 May-07 Jan-07 Sep-06 May-06 Jan-06 Sep-05 May-05 Jan-05 Sep-04 May-04 Jan-04 Sep-03 May-03 Jan-03 Sep-02 May-02 Jan-02 Sep-01 May-01 Jan-01 A dynamic monthly model relating changes in W. Mediterranean 1% heavy fuel oil prices to changes in the price of North Sea Dated crude was estimated over the period Jan-10 to Dec-15. The figure above shows actual HFO prices against one-period ahead predicted HFO prices using the model yielded by the estimation. The average error of prediction over the historical period was 4.9%. 18

Prediction of W. Mediterranean 1% HFO prices, $/tn 500 450 400 350 300 250 200 150 100 50 0 Sources: Argus and Drollas Actual W. Med 1% HFO ($/t) Predicted W. Med 1% HFO ($/t) Brent Dated ($/t) Brent forward curve on 12/10/16 ($/t) Nov-18 Sep-18 Jul-18 May-18 Mar-18 Jan-18 Nov-17 Sep-17 Jul-17 May-17 Mar-17 Jan-17 Nov-16 Sep-16 Jul-16 May-16 Mar-16 Jan-16 Nov-15 Sep-15 Jul-15 May-15 Mar-15 Jan-15 500 450 400 350 300 250 200 150 100 50 0 What happens to W. Med 1% heavy fuel oil prices depends very much on the evolution of N. Sea Dated prices and the dynamics of the relationship between the two, as determined by econometric analysis of the past. In this forecast I have assumed that OPEC manages to reduce its output to 32.5 mbpd by 2Q17, but then leaks oil as the price of crude rises. 19

Key longer-term threats to hydrocarbons The drive to cut emissions of CO 2. The EU has pledged to cut its emissions by 40% by 2030 versus 1990 levels and the US by 26% by 2025 versus 2005 levels. Auto innovations may slash oil consumption. McKinsey estimates that hybrids and plug-in electric vehicles will reach 50% of new car sales in China, the EU and the US by 2030. The US EIA disagrees, predicting that hybrid and electric vehicles will make up only 5% of new car and truck sales in the US by 2030. Major conflict in the turbulent Middle East. Intensifying Shia- Sunni enmity could lead to oil (and gas) supply disruptions and high prices, stalling oil (and gas) demand growth and affecting adversely the global economy. The world economy seems to be entering a lower growth phase, led by China s slowdown, demographic stagnation in Europe, excess productive capacity in most regions and the lack of decisive leadership. 20

Concluding remarks The Saudis remain in a difficult position. If they manage to cut output with or without OPEC and others US shale production will take off again. If they continue to fight for market share, they will have to change drastically their spending habits. Fracking has been the game-changer and its production costs have been falling. Growing oil demand could help oil prices higher, but the environmentalists are on a mission to reduce the use of hydrocarbons everywhere. Oil (and gas) prices are not likely to stray far from current levels over the next few years, barring supply disruptions or a significant tightening of OPEC output. 21

! A reminder!!!so we beat on, boats against the current, borne back ceaselessly into the past. F. Scott Fitzgerald concluding line of The Great Gatsby 22