Oil prices: where next? Fundamental importance of the cycle. JOHN KEMP REUTERS 14 Nov 2017

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1 Oil prices: where next? Fundamental importance of the cycle JOHN KEMP REUTERS 14 Nov 2017

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 Long boom, wrenching slump, now recovery

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

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

6 Spot prices and calendar spreads are closely correlated

7 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 (No) Sustainable investment (No) Market currently shows significant progress on at least three elements

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

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

10 Where are we in the cycle? Early to mid expansion Spot prices have been rising for 21 months (compared with 21 and 26 months after previous slumps to reach first major peak) Calendar spreads have been tightening for 32 months (compared with 21 and 34 months to reach first cyclical peak) Excess oil stocks down -180 million bbl since start of 2017 but still +160 million bbl over 5-year average Five-year average likely to be too low given the growth in oil demand since 2012 Oil price adjustments are highly non-linear and do not move smoothly to a new equilibrium value Rebalancing process is accelerating according to OPEC

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

12 From longer perspective, prices already close to full-cycle average

13 Annual oil price is now in line with the average since 1973

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

15 Brent calendar spread in 62nd percentile of post-1990 distribution

16 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

17 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 early/middle stages? U.S. economic expansion in middle/late stage? U.S. expansion will be longest on record by July 2019

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

19 Biggest threat to oil expansion comes from macroeconomy

20 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 not really profitable with WTI < $50 Rig activity follows WTI with lag of around 20 weeks Big surge in drilling between May 2016 and July 2017 Rig count has fallen since August Recent rise in WTI prices should stabilise drilling WTI prices above $60 likely to see acceleration of drilling and output

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

22 WTI prices hit a low of $43 per barrel on Jun 23 and have been on rising trend for last 20 weeks. Rig count set to stabilise and rise again?

23 Shale firms under pressure to focus on profits as well as production But hedging currently possibly at almost $57 for calendar 2018

24 Saudi-led OPEC has accelerated rebalancing process OPEC/Saudi production cuts have accelerated a rebalancing process that was already underway Brent prices have doubled from low of $27 in Jan 2016 to $45 at time of OPEC s Nov 2016 meeting and now almost $64 OPEC s formal target is to reduce OECD oil stocks (crude + products) to five-year average Oil surplus down -180 million bbl between Jan and Sep but still +160 million above five-year average Most of the remaining surplus is concentrated in crude rather than products Contango has been replaced by backwardation

25 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 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

26 Record bullish positioning by hedge funds creates reversal risk Hedge funds and other money managers running record or nearrecord bullish positions in crude and especially 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

27 Hedge funds have amassed a record net long position in the five major petroleum contracts equivalent to 1,085 million bbl

28 Hedge funds have amassed record net long position in Brent equivalent to 543 million barrels

29 Hedge funds hold almost 11 bullish long positions for every bearish short position in Brent: imbalance is source of liquidation risk

30 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 Biggest risks come from macroeconomic or trade shock

31 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