Oil: A Perfect Storm Hits Prices OCTOBER 23, 2014

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1 Oil: A Perfect Storm Hits Prices OCTOBER 23, 214 A confluence of excess supplies, weak demand, and a stronger dollar shaved more than 2% off oil prices from recent highs in late June With North American markets continuing to slash crude imports, OPEC producers discounted prices to defend market shares elsewhere The recent rise in volatility in financial markets, reflecting a shift against risk assets, also hit commodities, including oil A firm agreement to cut back production at the upcoming OPEC meeting on November 27 looks unlikely, leaving oil prices without support Prices are likely to remain under pressure through the rest of 214 and into mid-to-late 215, averaging $87/bbl in Q4 and $94/bbl in 215, as downside risks persist Following a period of relative stability above $/bbl for much of the year, oil prices were hit by a combination of factors. Crude supplies from U.S. shale plays continued to surge, Libyan output surprised markets as it rose to nearly.8 mbd by October despite the political turmoil, Iraqi crude exceeded expectations, and Russia and Saudi Arabia sustained high output levels despite a weakening price outlook. At the same time, global growth continued to be revised downward and, together with sustained efficiency in the use of hydrocarbons, slashed demand to half of the levels forecast at the beginning of the year. A strengthening dollar accentuated the fall, which was further aggravated by liquidations in the noncommercial market as sentiment shifted against risk assets. The prospects for the remainder of 214 and for 215 do not augur well for oil producers. OPEC s 214 production to date, at a monthly average of 3.2 mbd, exceeds the demand for its oil, given supplies coming from non-opec sources. Similarly, the bulk of the increase in demand for crude in 215 is likely to be met from outside OPEC, suggesting a need for OPEC to cut its own production to a forecast 28.5 mbd. A credible agreement by OPEC members at the November 27 meeting to cut production and is unlikely. Therefore, pressures on prices will persist. George T. Abed SENIOR COUNSELOR & DIRECTOR gabed@iif.com Hussein Anooshah RESEARCH ASSOCIATE hanooshah@iif.com Paul Ticu DEPUTY DIRECTOR pticu@iif.com Prospects for the remainder of 214 and for 215 do not augur well for oil producers Chart 1 Changes in Monthly Oil Production thousand barrels 4 Jun 14 Jul 14 Aug 14 Sep Iraq Libya U.S. Saudi Iran Russia Arabia Source: Bloomberg. Chart 2 Light Crude Price Differentials to Asian Crude Benchmark Brent-Asia Crude Differential Iranian Light 2 1 Saudi Arabia Light -1 Iraq Light -2-3 Feb 14 Apr 14 Jun 14 Aug 14 Oct 14 Source: Bloomberg.

2 page 2 OIL SPIGOTS LEFT OPEN OPEC production hit 3.95 mbd in September (about.7 mbd above the average of the preceding 8 months), a level last seen in August 213 when heightened geopolitical risks arising from the Middle East and unrest in Libya pushed prices up to $117/bbl. At that time, Saudi Arabia increased its own production to offset the shortfalls. Since then, however, conditions in the global oil market have changed. Surprisingly, Libyan oil supplies have been climbing steadily, from.2 mbd at the end of 213 to around.8 mbd at present, despite the absence of a competent central government and rising tensions among the armed militias in various parts of the country. Iraq, despite the march of ISIS into a large part of its territory, also sustained production just above 3. mbd. As these OPEC members ramped up their shipments of crude into a weakening market, they began to encroach on other OPEC members market shares which had been built up in response to the unexpected shortfalls in 213 and early 214. Saudi Arabia, traditionally the swing producer and the final arbiter of conditions in the global oil market, also surprised markets by continuing to produce an average of 9.65 mbd, even in the midst of a mid-summer price slump. Instead of scaling back production to support the price, Saudi Arabia began discounting prices to customers in Asia, apparently to protect its market share. These discounts also coincided with discounts offered by other key OPEC producers (Chart 2), thus pulling the floor from underneath the prevailing price level. OPEC production recently reached a level last seen in August 213 when unrest in Libya was at its post-civil war peak Saudi Arabia, coinciding with other key OPEC members, began discounting prices to Asia, pulling the floor from under the Brent benchmark Equally important in all of this has been surging U.S. oil production from shale formations, which rose by.8 mbd by early October to a level of 8.9 mbd. The added supplies from the U.S. displaced an equivalent volume of imports, forcing major light crude producers such as Libya and Nigeria to look for new markets. Other grades of crude exports to the U.S. have also been hit, as U.S. refineries adjust their processing capabilities to accommodate ever-growing domestic supplies of light crudes. With an oversupplied market and the swing producer refraining from cutting quantities, prices began to slump, quickening their downward trajectory as other factors also came into play. DEMAND GROWTH SLOWS The IIF forecast for global growth for 214, as has been the case with forecasts by other institutions (notably the IMF), has been trimmed from 3.% at the start of year to 2.7% most recently, with slower-than-expected growth in the OECD being the main factor in dragging down estimates. Subdued economic growth, coupled with on-going structural efficiencies in the use and substitution of hydrocarbons, continues to crimp oil demand. Income elasticities of demand for crude are not reliable in the short run, but growth slowdowns do provide market signals shaping expectations. Subdued global growth continues to crimp oil demand Demand for oil in the OECD has been on the decline for decades and the principal source of demand growth, especially in the past two decades, has been emerging

3 page 3 markets. Fast-growing Asia has been leading demand growth for commodities generally, including oil. But even emerging Asia has now entered a period of more muted growth while other emerging markets are displaying their own patterns of slowing economic growth. In any event, the growth slowdown across the globe was likely the main factor behind the IEA s revision of its estimates of global demand for oil in 214 from the 1.32 mbd forecast in May to.7 mbd most recently. China s oil demand growth, which has accounted for 4% of the annual oil demand increment over the last decade, has been revised down by 14 kbd for 214 in response to a more muted economic outlook. BULLS RETREAT While changes to the fundamental balance in global oil markets have been the main drivers behind lower prices, the decline was reinforced by a strengthening dollar and the recent reversal of sentiment in financial markets. The 25% drop in oil prices between late June and mid-october coincided with a 6.7% rise in the USD trade weighted currency index. As crude is priced and traded globally using the dollar as currency, a stronger dollar makes crude more expensive to buyers in other currencies. This restrains demand and weakens prices further (Chart 3). More recently, market sentiment also shifted against risk assets. The U.S. Federal Reserve s position of no change to its plans to begin raising the policy rate, together with a recent barrage of negative news ranging from Ebola to weaker Chinese growth and inflation ( as well as more pronounced weakness in Europe, has put pressure on risk assets in general and commodities in particular. Net speculative positioning in Brent (Chart 4) indicates an upward shift in negative sentiment, as the number of combined options and futures positions dropped from almost 24, contracts at the end of June to approximately 46, at present. Lastly, inflation numbers in the U.S. and the Euro Area have remained below the 2% targets weakening the classical rationale of holding crude as an inflation hedge. The decline was reinforced by a strengthening dollar and recent reversal of sentiment in financial markets Chart 3 Chart 4 Co-movement of Brent and Dollar Brent Net Spec Positioning (Futures and Options Combined) index, inverted contracts s 13 Brent Brent Net Position U.S. Dolar Index Oct 11 Apr 12 Oct 12 Apr 13 Oct 13 Apr 14 Oct 14 Source: Bloomberg, IIF. 7 Oct 11 Apr 12 Oct 12 Apr 13 Oct 13 Apr 14 Oct 14 Source: Bloomberg, IIF.

4 page 4 NO AGREEMENT EXPECTED AT THE NOVEMBER OPEC MEETING The scramble for market share among OPEC members, at the expense of price stability, revealed a breakdown of discipline that in the past was the mortar which held the group together. Weakening fundamentals and bearish financial market sentiment have added importance to the upcoming OPEC meeting on November 27. Members most hard-hit and vulnerable to declining oil prices, including Venezuela and Iran, are already facing financial strains that are unrelated to the drop in oil prices. In this respect, so is non- OPEC Russia. These countries fiscal breakeven prices are far in excess of current oil levels (Chart 5) and will suffer even larger fiscal strains and, for Venezuela and Russia, refinancing challenges if prices remain weak. OPEC s current production has run at an average 3.2 mbd when most estimates for the call on OPEC oil is around 28.5 mbd. In the face of this apparent glut, OPEC members will be entering the November 27 meeting in Vienna with no clear strategy to restrain production to lift prices. Three possible scenarios could emerge. One, there will be agreement to take at least about 1.5 mbd off of the market over the coming months, and members agree on a burden sharing formula and commit to adhere to it at least through 215. In this case oil prices will firm up and quickly move towards $/bbl or possibly higher. Two, there will be agreement on the goal but no concrete agreement on the burden sharing formula, nor evident seriousness about compliance. In this case markets will ignore the announcement and proceed on their present course with further possible price declines. OPEC members vulnerable to oil price declines are already facing financial strains OPEC members will be entering the November 27th meeting with no clear strategy to restrain production to support prices A third possibility is that there is no agreement and the meeting ends in acrimony, in which case prices could decline further and remain weak for the medium term. It is clear that the size of the overall cut required to stabilize prices at a higher level tips the likelihood to no agreement at all or at least no convincing agreement that would suggest a fundamental change in current market conditions. In the absence of sufficient Chart 5 Chart Fiscal Breakeven Oil Prices Average Brent Prices $ Libya IIF Forecast Iran Algeria Iraq 15 Venezuela* Oman Russia 95 Saudi Arabia UAE Qatar 85 Kuwait Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 Source: IIF. *Deutsche Bank.. Source: IIF, Bloomberg.

5 page 5 restraint by all other members of OPEC, Saudi Arabia will likely not be willing to shoulder the entire cutback in output. Saudi Arabia and other main GCC members are in a remarkably favorable position to navigate a price slump longer than other OPEC members. Although Saudi Arabia s fiscal breakeven price has risen to about $98/bbl (Kuwait and the UAE have much lower breakeven prices), the country has considerable financial resources to see it through an extended low oil price environment, including over $1 trillion in gross foreign assets with negligible debt, a liquid and stable banking system, high credit ratings, and the ability to borrow at very low rates should it decide to tap capital markets to finance spending needs. Besides, any agreement on production targets is likely to unravel under the weight of fiscal and capital constrained countries and due to the simple fact that Iraq has long been exempt from OPEC targets and Libya is producing at only half of its traditional target of 1.6 mbd both, therefore, can continue to raise output. Saudi Arabia has considerable financial resources to see it through an extended low price environment NEGATIVE OUTLOOK COULD IMPROVE LATE 215 Given likely market conditions, the risks to oil prices are heavily weighted to the downside. In light of a potentially stronger dollar; ample supplies; and continued subdued growth and low inflation, chances are that buyers will delay purchases of Brent in the coming months, putting further pressure on the price through much of next year. In general, we expect prices to bottom out around current levels of $86/bbl (barring a collapse of OPEC consensus as outlined above) and then rise only slowly before picking up steam leading into the final quarter of 215 (Chart 6). Risks to oil prices are heavily weighted to the downside Possible upside catalysts include greater savings than expected for oil importers, which should help draw in additional oil demand, and a pickup in refinery utilization rates coming into the winter season, especially if the winter turns out to be more severe than usual. Less certain is the possible return of geopolitical risk which is always in play, especially in the still volatile countries of Libya and Iraq, where threats to security remain and could unexpectedly spike. Additionally, while most shale projects in the U.S. and tar sands extraction in Canada are still profitable at current prices, and despite widespread hedging, drilling activity could stall if producers project longer-term weakness and trim planned expenditures. This could slow U.S. production growth in the medium to long term, tightening global supply balances and firming up price levels.