31st July 2010

Crude Oil in Medium Term

Based on Fundamentals
The June 2010 International Energy Agencys Medium Term Oil & Gas Market Report is the closest we have as a base for industry forecast, and the picture it paints for the next 6 years is one of global oil supply straining to keep pace with relentless non-OECD demand. Some headline numbers: demand from the non-OECD region is forecast to increase by 23% from 39.3 million barrels/day (BPD) to 48.2 million barrels/day (growing by approximately 1.5 million BPD per year), led by the BRIC economies and, interestingly, Saudi Arabia. Over the same 2009-15 period, supply from the non OPEC world is predicted to grow 2% from 51.5 million barrels/day to 52.5 million BPD. West Texas Intermediate (WTI traded on NYMEX & MCX) crude has settled in a $70-$80 trading range: where can we reasonably expect it to go over the next 5-10 years? Lets first consider oil demand. Between 1950 (11 million BPD) & 1970 (45 million BPD) global crude consumption grew at 2 million BPD / year as Europe, Japan & North America developed into mature economies. In the 40 years since then growth has been 1 million BPD/ year from 45 to approximately 85 million BPD as efficiency has improved & other energy sources have been developed. This period has included 3 meaningful oil shocks: the Arab-Israeli war, the fall of the Shah in Iran, and the recent global financial crisis. If oil demand were ever to be derailed it would have been in the 2007-9 period, during which it fell only 1.8%. What we have to consider is whether demand in the next 5-10 years will grow at 1 million BPD as forecast by the IEA, or whether it could accelerate to the 2 million b/day growth that we saw in the two post war decades. China currently consumes 45% as much oil as the US with a population well over 4 times the size; the Chinese vehicle fleet is 95m versus 255m in the US. The modernization of India, Russia & parts of the Middle East & Latin America will bring additional oil demands, as living conditions, infrastructure & transport all improve. If we use this growth number of 2 million BPD, we see global oil demand reaching 100 million BPD by 2017. Its very unlikely that the world oil supply can keep up with this forecast demand. The non-OPEC world is struggling to grow production, as illustrated by IEA forecast of 0.2 million BPD growth per year over the next 5 years. The list of non-OPEC countries whose production has peaked or is peaking makes situation gloomy: USA, Mexico, UK, Norway, Argentina, Colombia, Egypt, Syria, Oman, Brunei, Gabon, Cameroon, China, Malaysia & Australia. The small growth is expected to derive from Canadian Oil Sands, Brazil, and the Caspian region, and comes against a backdrop of quite sharp natural decline rates & an increasingly sensitive environmental & safety lobby post the BP spill. All of which brings us back to OPEC: it currently produces almost 30 million BPD (including Iraq) & will need to increase production by 5-10 million BPD in the next decade if our demand thesis is correct. Optimists point to Iraqs enormous potential for output growth: skeptics assert that OPEC reserves, especially those of Saudi Arabia, are grossly overstated, and that such growth is a geological impossibility.

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The crude price, which has historically been a result of the supply-demand balance, will increasingly be an input: we expect the medium term oil price to reach a level where it dampens demand, which is likely to be somewhere between $100 & $150 as seen in 2008. OPEC as the producer of much of the new supply will dictate prices more than ever, and will strive to achieve a level which rewards the member countries without restricting global economic growth. We envisage a world in which the average annual oil price moves up $5-$10 per year until it reaches this level.