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EYE ON THE MARKET

S P E C I A L

E D I T I O N

A special edition feature


by Michael Cembalest
Chairman of Market and Investment Strategy
for J.P. Morgan Asset Management

HUBBERT S VALLEY:

Consequences of
an unexpected
oil price decline

EYE ON THE MARKET

J.P. MORGAN

January 2015

Hubberts Valley: the Consequences of an Unexpected Oil Price Decline


The impacts of financial asset and natural resource price declines are often magnified when few investors
or businesses anticipate them. That was the case when fraud preceded US tech and telecom companies
failing in 2001 and 2002; when inadequate disclosure of high-risk exposures and underwriting practices
preceded the conservatorship of US Government-Sponsored Enterprises and the failure of Lehman
Brothers in 2008; and when Greece disclosed in November 2009 that its fiscal deficit was 13%, more
than twice the number it had been publishing. Surprise is a contributing factor to the current oil price
decline, although lack of disclosure is not the issue. Instead, given all the talk about Peak Oil and
Hubberts theory of depleting natural resources that serves as its foundation, a jump in excess oil supply
in 2014 was a surprise to most investors and oil producers/consumers. That part of the supply jump was
increased production by some of the most chaotic countries on earth compounded the surprise further.
This document reviews the economic, financial market and geopolitical implications of the
current oil price decline. While I believe that oil prices will be higher 18-24 months from now (when
some currently operating US shale oil wells are depleted and not replaced), theres a long way to go
before we get there. Now is the time to evaluate the consequences of cheaper oil, assuming prices
below $70 on WTI are sustained. For posterity, this document went to print on Thursday, January 22nd,
2015 when WTI oil prices were around $46 per barrel.
Michael Cembalest
J.P. Morgan Asset Management

Hubberts Peak is a theory of natural resource production that estimates a bell-shaped production
curve. It uses past actual production to produce a fitted curve of both past and future production.
Hubberts original upper-bound estimates that were published in 1956 predicted that US oil production
would peak around the year 1970, after which it would gradually decline at roughly the same pace at
which it rose. As recently as 2008, Hubberts Peak theories were still doing a good job predicting the
peak and subsequent lifecycle of US crude oil production. Horizontal drilling and shale oil production
changed all that, as shown in the chart below.
Defying Hubbert's peak
Million barrels per year, annual US crude production
4,000
3,500
3,000
2,500
2,000
1,500

Hubbert's peak
approximation
Actual US
crude
production

1,000
500
0
1900
1920
1940
1960
1980
2000
2020
Source: Dr. Thomas Huber, Gustavus Adolphus College; EIA;
JPMAM. January 2015.

2040

EYE ON THE MARKET

J.P. MORGAN

January 2015

Table of Contents

Page

Getting started

The current oil price decline: supply factors

The current oil price decline: demand factors

The elasticity of marginal costs of oil production during a period of declining oil prices

10

Equity markets and oil price declines

12

Economic impacts of the oil price decline

15

The oil price decline and high yield bond markets

19

The impact of lower oil prices on the US natural gas industry

22

Geopolitics and oil prices

23

Close-up on Russia

25

A petro-sectarian map of the Middle East

29

Other exhibits: operating costs of current production, real oil price since 1861

30

Acronyms and Disclaimers

31

EYE ON THE MARKET

J.P. MORGAN

January 2015

Getting started
The first thing to keep in mind is that oil is a very volatile commodity. In the span of the few years shown
in the first chart, oil rose from $60 to $140 per barrel, and fell back to $40 before rising again. Oil prices
are highly sensitive to changes in supply and demand, and are more volatile than other energy, industrial
metal, precious metal and agricultural commodities (volatilities from the period 2007 to 2009 are shown in
the table). Price swings of +/- 20% are frequent events, so the notion of sharp oil price changes is not that
abnormal.
Annualized volatility, 2007-2009
Oil
54%
Natural Gas
51%
Gasoline
50%
Lumber
46%
Copper
43%
Corn
38%
Soybeans
33%
Platinum
32%
Zinc
30%
Gold
25%
Aluminum
18%

Oil: 2005 - present


USD per barrel
$160
$140

WTI Crude

$120
$100
$80
$60
$40
$20
$0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bloomberg. January 22, 2015.

Source: Bloomberg.

That said, price declines of 35%-40% are less frequent, and occurred 7 times since 1974. Given where
inventory levels are now, we are not expecting a V-shaped recovery in oil. Thats why it makes sense to
consider the possible implications of oil prices below $70 sustained for a period of 3-4 years.
Oil & gasoline: January 2013 - present
USD per barrel

US crude inventories at highest levels since 1990


USD per gallon

Million barrels of crude oil (ex. Strategic Petroleum Reserve)

$110

$4.00 390

$100

370

$3.50

$90
$80

WTI Crude
$3.00

Gasoline

$70

350
330
310

$60

$2.50 290

$50
$40
Jan-13

Last reported value for each calendar year

270

$2.00 250
Jul-13

Jan-14

Jul-14

Jan-15

Source: Bloomberg. American Automobile Association. January 22, 2015.

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: US Department of Energy. December 2014.

EYE ON THE MARKET

J.P. MORGAN

January 2015

As stated on page 1, the unexpected nature of the oil price decline may magnify its impact. One sign
that a price decline was not anticipated: the large US$1 trillion increase in debt taken on by the worlds
largest energy companies since oil began rising in 2003 from $30 a barrel. A world of Peak Oil is more
of what they had in mind. Even before oil prices began falling in 2014, the number of these companies
with positive free cash flow had fallen sharply, given the rising cost of conventional and unconventional
oil extraction.
Fundamentals of the top 100 global energy companies
USD, billions

Percent
80%

Percentage of
companies with positive
free cash flow

$1,200
$1,000

75%
70%
65%

$800

Total debt

60%

$600
55%
$400
$200
2002

50%
45%
2004

2006

2008

2010

2012

2014

Top 20 Energy Companies by Debt Outstanding


1
2
3
4
5
6
7
8
9
10

Petrobras
PetroChina
Rosneft
Total
China Petroleum
Gazprom
BP
Royal Dutch Shell
Kinder Morgan
Eni

11
12
13
14
15
16
17
18
19
20

Statoil
Enbridge
JX Holdings
Chevron
TransCanada
Exxon Mobil
ConocoPhillips
Williams Cos
Repsol
BG Group

Source: Bloomberg. Q3 2014.

Source: Bloomberg. Q3 2014.

The consequences of large oil price declines can be substantial, particularly when looking at specific oilproducing countries or US regions. In the 1980s, the oil price decline was a major contributing factor to
bank failures in Texas, and to the severity of the US Savings and Loan crisis. As we explain later in the
document, banks appear to have lower oil exposures this time around (leaving the bulk of the problem
with high yield bond investors), but this time capsule helps illustrate what can happen when oil prices fall
suddenly after a debt-fueled capital spending expansion.
Bank failures occurring in Texas vs. the rest of the country
Number of institutions

USD per barrel

600
500

$40
US (ex.
Texas)
Texas

Crude oil

$35

400

$30

300

$25

200

$20

100

$15

$10

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995
Source: Federal Reserve Bank of Dallas, FDIC, EIA, Bloomberg.

EYE ON THE MARKET

J.P. MORGAN

January 2015

The current oil price decline: supply factors


The most significant long-term supply factor has been growth in US shale. As shown in the first chart,
OPEC, non-OPEC ex-US and US conventional production has been roughly flat for several years.
However, the steady rise in US shale oil production brought down marginal costs sharply. The second
chart is an estimate of breakeven costs for new projects, computed each year. By 2014, the next 20
million barrels per day of future production could be obtained at marginal costs of $80 per barrel,
compared to estimates in 2009 that were over $120 per barrel. While not all oil is fungible (light, sweet,
heavy, sour, etc.), US shale radically changed US oil production and imports. Rising US production is
mostly light/sweet and has displaced similar grades imported from Africa (down 90% since 2010).
Apart from US shale, global production flat since 2006
Increase in production since 1998, million barrels per day
6
5
4
3
2
1
0
-1
-2
-3
-4
1998

Shale oil era has reduced estimated future marginal costs


Breakeven cost for new projects, USD per barrel
$120

Non-OPEC
ex-US

2009

2010

2011

2012

2013

2014

$100

US shale

$80

OPEC

2014 with cost


deflation impact

$60
US conventional

$40
Estimated peak cumulative production, mm barrels per day
2000

2002

2004

2006

2008

2010

2012

Source: Energy Information Administration. September 2014.

2014

$20
0

10

15

20

25

30

35

Source: Goldman Sachs, "400 projects to change the world", JPMAM. 2014.

US: falling net imports, rising domestic production


Million barrels per day of crude oil
10.5

Net imports
9.5
8.5
7.5
6.5
5.5

Domestic production

4.5
1991

1994

1997

2000

2003

2006

2009

2012

Source: Energy Inf ormation Administration. October 2014.

EYE ON THE MARKET

J.P. MORGAN

January 2015

The most notable short-term supply factor is the unexpected spike in production by OPEC basketcase countries: Libya, Iraq, Iran and Nigeria. To be clear, the military, economic and social backdrop
in most of these countries is terrible, and in some cases, getting worse. However, despite these
conditions, these countries staged a production rebound in late 2014 of a million barrels per day after a
similar y/y production decline during 2013. In the face of growing inventories, Saudi Arabia, Qatar and
the UAE have not supported a quota cut in OPEC production, which accelerated the oil price decline
when announced last November. In our view, there is not much Iran and Venezuela can do on their own
to change the dynamics of oil pricing without cooperation from the Saudis. The table shows the largest
4 prior oil price declines and how Saudi Arabia functioned as the swing producer, a role it is apparently
no longer willing to play.
Production rebound in turbulent OPEC countries
Y/Y production change, thousand barrels per day
2,000
1,500
1,000

Libya
Iraq
Total

OPEC producing more than its quota


Million barrels per day

Iran
Nigeria

32

31

500
0

Production

30

Quota

-500
-1,000

29

-1,500
28

-2,000
Jan-13
Jul-13
Source: Bloomberg. December 2014.

Jan-14

2010

Jul-14

2011

2012

2013

2014

Source: Bloomberg, OPEC, JPMAM. December 2014.

Saudi Arabia refusing swing producer role this time around


Percent decline in the price of oil and output
1996-1999

2000-2002

2006-2007

2008-2009

2014-2015

Oil Price

-61.2%

-48.9%

-34.0%

-74.9%

-59.5%

Saudi Output

-14.1%

-19.2%

-8.8%

-18.1%

-3.3%

OPEC Output

-11.7%

-18.3%

-4.1%

-15.6%

-2.4%

Source: Bloomberg. January 2015.

EYE ON THE MARKET

J.P. MORGAN

January 2015

The current oil price decline: demand factors


Global GDP growth is a substantial driver of oil demand, and both growth and growth surprises outside
the US have been weaker than expected since 2010. The primary culprits: a China slowdown, and the
slowest trend growth in Europe (other than during wartime) in around 100 years. As for the 2010 spike
in oil demand in China, it appears to be a by-product of an unsustainably large fiscal stimulus program
and accumulation of strategic reserves, rather than an organic reflection of Chinese oil demand needs.
Lower GDP growth only explains part of the demand decline
Y/Y % change

Global growth expectations falling with oil prices


USD per barrel

6%

Global GDP
growth

4%

Index

$150

123

Global growth
ex-US
surprise
index

$130
$110

120
117

2%

114
$90

Brent crude

0%

EIA Forecast

Oil demand
-2%

111

$70

108

$50

-4%
2001

2003

2005

2007

2009

2011

2013

2015

$30
2006

105
102
2008

2010

2012

2014

Source: UBS, Bloomberg. January 20, 2015.

Source: EIA, IMF, JPMAM. Q3 2014.

Slowing growth of the "old" China

Annual growth in Chinese crude oil demand

Y/Y real growth, percent

Thousand barrels per day

21%
1,000

19%

Accumulation of strategic
reserves and aftermath of
2009 stimulus program

Industrial production

17%

800

15%
600

13%
11%

400

9%

GDP

200

7%
5%
2004
2006
2008
2010
2012
Source: China National Bureau of Statistics. December 2014.

2014

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: BP, EIA. December 2014.

Remembrance of things past: a return to 19th century stagnation in Europe


6-year percentage change in real GDP; excluding wartime and subsequent rebuilding periods
60%
50%

Italy

France

Spain

40%
30%
20%
10%
0%
-10%
1825 1835 1845 1855 1865 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005
Source: Pre-1950 data f rom "Statistics on World Population, GDP and Per Capita GDP, 1-2008 AD", Angus Maddison.
1950 - present data f rom The Conf erence Board.

EYE ON THE MARKET

J.P. MORGAN

January 2015

Weaker growth outside the US is not the only demand factor at work. Irrespective of economic growth
levels, there have been substantial improvements in oil intensity in many countries. Oil intensity
refers to the barrels of oil needed to produce a given unit of GDP. As shown in the first chart, since
2005, China experienced huge improvements in oil intensity, which declined by almost 35%. Large
intensity improvements have also taken place in the developed world. One contributing factor to
improved oil intensity: the adoption of higher fuel economy standards; historical and future standards are
shown in the second chart.
Decline in oil intensity across economies
Index, 2005=100, barrels of crude oil demand per unit of real GDP

Actual and projected fuel economy for new passenger


vehicles by country, Miles per gallon

100

60

95

55

South Korea
China declining at 4.3% per year

90

50

85

Grc, Neth
Jpn, US, Fra
UK
Ita, Prt, Esp

80
75
70
65
2005

45

EU

US

China
Japan

40
35
30

Tai
2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Bloomberg, BP, national statistical offices, JPMAM. Sept 2014.

25
2000
2005
2010
2015
2020
2025
Source: International Council on Clean Transportation. November 2014.

Transportation is not the only source of improved energy intensity. The EIA also projects energy intensity
improvements in commercial, industrial and residential use. But the oil/transportation benefits are larger
than the electricity intensity benefits estimated by the EIA. Outside the US, oil intensity levels are falling
due to declines in subsidies and price controls in some countries, more conservation, improvements in
internal combustion engines, and fuel-switching among countries that still use petroleum as a material
fuel source for electricity generation.

EYE ON THE MARKET

J.P. MORGAN

January 2015

An additional demand factor is worth mentioning as it relates to the speed and magnitude of the oil
price decline: the impact of hedging unwinds. In early 2014, some industrial consumers of oil (e.g.,
airlines) hedged against increasing oil prices. To understand the impact of what happened when oil fell
instead of rising, consider the following stylized example.
Assume that in January 2014, Airline A wants to hedge against higher oil prices when spot prices are
$92. They buy a call option struck at $110. To finance the call option, they simultaneously sell a put
option on a cash neutral basis (i.e., the premium on the call is equal to the premium on the put). The put
option is struck at $60 1. Everything is fine (oil is ranging around the original spot price), and then oil
starts to plummet in August. The put option the Airline sold is rapidly resulting in a mark-to-market loss,
since oil prices are getting close to the put strike and theres plenty of time value left. Airline A could
wait to see where oil is at expiry, but if so, they could incur a massive loss if oil ends up at $45. So, when
oil hits $70 or so, they decide to close out the short put position.
To whom did they sell the put option? To a broker-dealer that is typically not in the business of taking
long or short views on oil; they would instead attempt to maintain a market-neutral position by deltahedging their exposure. Delta-hedgers typically trade in the opposite direction of the market, so as oil
prices fall, theyre buying to add to their long position. When Airline A closes out the put position (on a
cash basis, probably), the delta-hedging broker-dealer has no further need for the oil exposure they have
been accumulating, and sells it as fast as possible. Thats the options food chain at work, and explains
part of the rapid price decline in the late fall. 2
Hypothetical hedging strategy for oil consumer
USD per barrel
$120

Long Call strike

$110
$100

WTI Crude

$90
$80
$70

Date of hedge
implementation

$60

Forward
reference price
Short Put strike

$50
$40
Jul-12

Jan-13

Jul-13

Jan-14

Jul-14

Jan-15

Source: Bloomberg. January 22, 2015. Assumes cashless hedge structure


executed on January 16, 2014 f or calendar year 2015.

While the spot price is $92 in this example, the forward price is $84. The forward price is roughly equidistant
between the call strike and the put strike, which is why the put and call option premiums are roughly the same.

See disclosure in endnotes.

EYE ON THE MARKET

J.P. MORGAN

January 2015

The elasticity of marginal costs of oil production during a period of declining oil prices
Some clients have asked: if marginal costs of production are $80, wouldnt there be an immediate shutdown of production in many parts of the world when prices reach $50? And wouldnt the resulting
supply shortfall propel oil prices higher within a few months?
In thinking about what happens next, we have to look at what happens when oil prices decline sharply.
Yes, horizontal drilling is expensive and complicated, but the oil industry has a track record of forcing
cost reductions through the supply chain when oil prices fall. Consider the period from 1975 to 1985.
Oil prices and production costs rose sharply during a period of high inflation, and then fell during a
double-dip US recession. In fact, the entire 75% increase in real well costs incurred from 1975 to
1982 was erased in a little over 18 months. Massive cost reductions in labor, services and equipment
took place, including those related to casing, drilling, tripping, site preparation, etc.
Cost increases from 1975 to 1982 completely reversed in
real terms by 1984, Index of well costs, 1975 = 100
300

200

USD per barrel


$35

Costs include:
Site preparation
Mobilization and rigging up
Formation evaluation and surveys
Drilling
Tripping operations
Casing placement
Well completion

250

US Crude oil price history, 1975-1985

$30

Nominal
Well Cost

$25
$20
$15
$10

150

Real Well Cost


100
1975

1977

1979

1981

$5

1983

1985

Source: Energy Information Administration. 2008.

$0
1975
1977
1979
1981
1983
Source: Energy Inf ormation Administration. January 2015.

1985

The latest estimates we have seen for the current cycle, now that oil prices have collapsed: ~20%-25%
well cost deflation for E&P shale companies, resulting from a combination of efficiencies, reduced returns
for services companies and lower costs from services suppliers passed to producers. One example: 35%
projected declines in the cost of fracking sand (which can represent 50% of total fracking costs), and
reductions of 30% in day rates for land drilling rigs. We are already seeing a decline in rigs which
we expect to accelerate further.
A slowdown in the number of operating US oil rigs
Number of US oil rigs in operation
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
2009

2010

2011

2012

2013

2014

2015

Source: Baker Hughes. January 23, 2015.

10

EYE ON THE MARKET

J.P. MORGAN

January 2015

Before getting into US shale production and how it might fall with lower oil prices, its important to
highlight two things. First, existing production is less at risk since it only has to cover current
operating costs (which exclude upfront capital costs) and which tend to be below $40 per
barrel. Wells now in operation will probably keep pumping until they are depleted, unless they lose
access to credit markets [a chart on current operating costs appears below, and is explained further on
page 30]. What is at risk is future shale oil production, which has to generate enough profitability to
cover both operating and capital costs. Thats why I expect oil prices to be higher in two years, at which
time some higher cost share locations will be depleted and not replaced. Second, when thinking about
marginal costs and whether prices are high enough to justify production, we look at the forward curve
rather than the spot market; more producers sell in the forward market than in the spot market. The
forward market for oil is shown in the next chart.
Cash costs of current production

WTI crude oil futures curve

Operating cost, USD per barrel

USD per barrel


$105

$60

$95

Operating cost with royalties

$50

6 months ago

$85

Operating cost without royalties

$40

$75

Venezuela

$65

Mexico

$20

Current

$55

UAE
China

Saudi Iraq
Arabia

$10

$45
12

24

36

48

60

Months until delivery


Source: Bloomberg. January 20, 2015.

US
Iran

$0

UK

Canada (exc. oil sands)

$30

1 month ago

Canada oil sands

Russia

Russia
Nigeria
US

China

10
20
30
40
50
60
70
80
Cumulative global oil production, mm barrels per day
Source: Morgan Stanley Commodity Research. December 2014.

90

The bar chart below looks at full-cycle breakeven costs by shale region, as estimated by J.P. Morgan
Securities LLC. Taken at face value, this chart suggests that the lower third of shale locations would
eventually cease future production at $60 oil (based on forward prices). However, as explained on the prior
page, we anticipate cost reductions that could bring breakevens down in some locations.
Breakeven prices by region and formation
Full lifecycle breakevens, $/bbl
Bakken - Sanish
Bakken - Mountrail
Niobrara - HZ
Bakken - Messon
Permian - Bone Spring
Bakken West Nesson
Permian - Wolf camp
Permian - Wolf bone
Permian - Delaware Sands
Permian - Cline
Permian - Wolf berry
Three Forks - Nesson
Niobrara - VT
Utica
Bakken - Dunn County
Eagle Ford
Three Forks - Sanish
Permian - Avalon
Bakken - South McKenzie
Three Forks - Feather Edge
Bakken - North Nesson
Bakken - Divide
Three Forks - Northern
Bakken - Montana
Ulinta
Three Forks - McKenzie

$34

2-year forward

$41
WTI price
$42
$43
$45
$47
$50
$51
$52
$52
$53
$56
$57
$58
$60
$61
$62
$63
$65
$67
$68
$69
$71
$72

$81
$91
$0

$20

$40

$60

$80

$100

Source: J.P. Morgan Securities LLC. December 2014.

11

EYE ON THE MARKET

J.P. MORGAN

January 2015

Equity markets and oil price declines


Since 1974, there have been seven episodes of 35%+ declines in oil within a short period; equity market
behavior was all over the map. When you consider the circumstances behind each occurrence, the
outcomes make more sense. When the primary issue was increased oil production combined with
improvements in oil efficiency, equity markets did well. When the primary issue was a recessionary
decline in demand, equities did poorly. As a rough estimate, the current oil price collapse reflects more of
the former (supply shock and increased efficiency) than the latter (demand decline in Europe and China
due to weak growth). If so, the net impact on US equities should be a mild net positive, which is
what has taken place so far. Historically, there were other factors affecting equity markets at the time
oil prices fell (e.g., in 1987, Black Monday occurred while oil prices were declining). In general, I am not
a huge fan of univariate analyses that look at just one factor (like oil) and extrapolate outcomes for the
entire equity market. But this is the history, and its important to make some distinctions between eras.
Equity markets during rapid 35%+ declines in oil prices
Percent change in the S&P 500 during oil price decline
70%
1986-Supply shock - Saudi Arabia /
OPEC boosts production
1998-increase OPEC production +
Collapse in Asian demand (debt crisis)

50%
30%
10%

1991-Gulf War end relief rally


US shale boom /
demand & intensity decline
1993-Weak demand, rising
OPEC/North Sea production

-10%
-30%
-50%
-80%

1988-second stage of
1980's oil glut
2001-Tech collapse /
2008-2009
Sept. 11th / Recession
Global recession

-60%

-40%

-20%

0%

Source: EIA, Bloomberg. Jan. 22, 2015. Max % drop in oil over 18 months

12

EYE ON THE MARKET

J.P. MORGAN

January 2015

Within the energy sector, there has been some differentiation in terms of stock price declines. Offshore
drillers have fared the worst, while pipeline companies and refiners have held up better. Are energy
stocks cheap enough yet? According to Empirical Research Partners, price-to-free cash flow valuations
for large cap oil and oil service companies were trading at the 15th and 9th percentiles of their historical
valuation range last December (in other words, close to the most inexpensive valuations on record).
However, these valuations were computed based on 12-months trailing free cash flow, a time when oil
averaged around $90 per barrel. As a result, oil stocks are most interesting if oil prices were to rise
again as they did in the late 1980s. The history of oil price rebounds after a large collapse is shown in
the table. V-shaped recoveries do happen (when prices reach the prior peak within 2 years), but
rarely during the first year after the collapse.
Energy down across the board

Oil price behavior after prior 35%+ declines

Percent, performance for energy sub-industries since 2014 oil peak

Price index, trough = 100


Decline
Peak Trough
1984-1986
222
100
1987-1988
164
100
1990-1991
191
100
1992-1994
164
100
1997-1998
201
100
2000-2001
191
100
2008-2009
375
100
2014-Today 214
100

10%

5%

0%

-6%

-9%

-10%

-14%

-22%

-20%

-31%

-34%

-40%

-47%

-30%

Source: Bloomberg. January 22, 2015.

Coal

Equipment &
Services

Crude
Producers

Russell 1000
Energy

Integrateds

Ref iners

Pipelines

Russell
1000

-50%

Of f shore
Drillers

-40%

Y+1
122
158
95
133
275
163
213
N/A

Y+2
102
267
100
147
288
184
254
N/A

Y+3 Recovery
121 U-Shape
190 V-Shape
93
N/A*
168 V-Shape
268 V-Shape
201 V-Shape
319 U-Shape
N/A
N/A

Source: EIA - crude price history, JPMAM. January 2015.


*Temporary and brief price spike due to the Gulf War.

The underperformance of energy stocks relative to the market is similar to prior oil price drawdowns,
including the severe oil-related selloff in the mid 1980s. Two points of comparison for energy stocks in
the current cycle vs. July 1986:
Price to book value ratios have fallen to 0.5x vs. the overall market, same as July 1986
Relative price to sales ratios are now 0.6x compared to 0.5x in July 1986 (similar as well)
The bottom line is that oil stocks look interesting mostly under scenarios of a return to $75 oil within the
next 2-3 years.

13

EYE ON THE MARKET

J.P. MORGAN

January 2015

The broader sector consequences of prior oil price declines conform to what you would expect.
Consumer Discretionary and to a lesser extent Consumer Staples outperform the markets most often,
looking out six months and one year after the oil price decline.
Since 1970, Consumer Discretionary stocks outperformed the market
most frequently when oil prices declined by 40% [5 occasions]
# of times sector outperforms market over
Sector
Subsequent 6 months Subsequent 1 year
Basic Materials
4
3
Consumer Discretionary
5
5
Consumer Staples
3
3
Energy
3
2
Financials
2
2
Healthcare
1
2
Industrials
2
0
Technology
3
2
Telecom
3
2
Utilities
1
1
Source: Fundstrat. December 2014.

So far, the energy price decline has had a large (negative) impact on projected S&P energy earnings in
2015. However, we have not seen Consumer Discretionary earnings projections pick up yet. The
last chart reiterates the message from the table above: when oil prices fell (from 2000 to 2014, an
admittedly brief review period), consumer sector earnings tended to benefit. But to reiterate, we are not
seeing this trend show up yet in consensus earnings forecasts for 2015. Furthermore, the mass market
retailers best positioned to benefit from increases in disposable income are already trading at P/E multiples
that are well above the market, and close to the largest relative premiums of the last 15 years.
2015 earnings forecast: impact from lower oil

2000-2014: oil price changes and sector earnings

2015 calendar year EPS forecasts, index,12/31/2013 = 100

% response in US earnings growth to a 1% decline in oil prices

105

S&P 500

95

Consumer
Discretionary

85

Consumer
Staples

75
65
55

Energy
45
Dec-13

Mar-14

Jun-14

Source: Deutsche Bank. January 22, 2015.

Sep-14

Dec-14

Cons. Discretion
Cons. Staples
Utilities
Telecom
Total
Financials
Healthcare
Industrials
Materials
IT
Energy
-0.9%
-0.6%
-0.3%
0.0%
0.3%
Source: JPMAM estimates. Notes: based on a model that controls f or the
business cycle, the lead-lag of oil prices on earnings, and extreme swings in
earnings during the f inancial crisis. Analysis period: Q1 2000 - Q3 2014.

14

EYE ON THE MARKET

J.P. MORGAN

January 2015

Economic impacts of the oil price decline


The economic and equity market impacts of an oil price decline can be quite different. The reason: as
shown below, energy has a much larger impact on S&P 500 earnings and market capitalization than it
does on economic measures such as employment and GDP. The US economy is very consumer-sensitive,
while the S&P 500 and Russell 1000 indexes are more impacted by energy and other industrial companies.
Energy is a much larger share of the market than of the
US economy, Energy sector, percent of total
14%

Market Measures

12%
10%
8%
6%
4%

Economic Measures

2%
0%
Employment
GDP
S&P Market Cap S&P Earnings
Source: BLS, BEA, Bloomberg, J.P. Morgan Asset Management. Dec. 2014

Before going into greater detail on economic impacts, its worth considering the transmission mechanism
of lower oil prices. To do so, we use a sources and uses table of primary energy. The majority of
petroleum (around 70%) is used in the US for transportation. Most of the remainder (25%) is used by
industry, either as a fuel or as a feedstock. Oil used for residential/commercial heating and electricity
generation is so small we can ignore it. Looking at the other side of the exhibit, we see the following:
over 90% of transportation fuel is based on petroleum, and industry is split equally in its reliance on
petroleum and natural gas. The bottom line: the benefits of lower oil prices accrue to households
and businesses through reduced outlays on transportation fuel, and feedstock fuel for
industries that have not and/or cannot switch to cheaper natural gas.
Sources and uses of primary energy in the US
Percentage of total
100%

Res. & Commercial


(11%)

Nuclear (8%)
90%

Renewables (10%)

80%
70%

42%
40%

60%
50%

Industrial (22%)

Coal (19%)

34%
Transportation (28%)

Natural Gas (27%)

92%

40%

25%

30%

71%

20%
Petroleum (36%)
10%

Electric Power (39%)

Breakdown by source / use (%)

0%
Sources

Uses

Source: U.S. Energy Information Administration. Data as of year-end 2013.

15

EYE ON THE MARKET

J.P. MORGAN

January 2015

With that framework, what are the economic benefits of lower oil prices? We have to consider the fact
that increases in household and corporate disposable income are offset by declines in oil-related capital
spending. According to Empirical Research Partners, US E&P stocks already announced 2015 capital
spending reductions of 10%-15%.
Our analysis indicates that there will be a modest net positive economic impact in the US from the
oil price decline. Our original estimate range of a 0.1% to 0.4% GDP boost was computed when oil
prices were $65. At oil prices of $40-$45 per barrel for WTI, the net effect on 2015 and 2016 GDP could
be a little larger, by another 0.10%-0.15%.
Estimated effects of $65 oil on US GDP
Consumption Benefit

Capital Spending Drag

0.5% to 0.6%

-0.5% to -0.2%

Capital spending detail

Annual business
spending on
equipment/structures:
$1.5 tn

Net effect
0.1% to 0.4%

11.1%
Oil/gas/mining:
$171 bn

Source: J.P. Morgan Asset Management. December 2014.

How long might it take for such net benefits to materialize? Based on prior oil price declines, 6-7
months for stronger personal consumption; 7-9 months for higher non-energy-related capital spending;
and 10-12 months for stronger employment growth. Since oil started falling last fall, by mid-2015 we
expect the benefits to start showing up in US economic data.

16

EYE ON THE MARKET

J.P. MORGAN

January 2015

Some people are surprised to find out that energy-related jobs have been only 3% of the ~10
million jobs created since February 2010. In North Dakota and Texas, energy-related job gains had a
multiplier effect, such that more energy intensity resulted in greater overall job growth, and not just
more energy jobs. However, in other energy-intensive states we do not see a similar pattern.
Energy jobs are a very small share of recent US job gains

Inconsistent multiplier effect from oil & gas job growth

Millions of jobs added since labor market trough in February 2010


2%
1%

5.0%

Annualized growth rate of total jobs since 2009


North Dakota
4.0%
3.0%
Texas
2.0%

National Colorado
Louisiana
Average

1.0%

97%

0.0%
0.0%

97%

Alaska
New Mexico
1.0%

Oklahoma

Kansas
Wyoming
West Virginia
2.0%

3.0%

4.0%

5.0%

Energy intensity of job market


Source: US Department of Labor. Goldman Sachs. November 2014.

Source: Bureau of Economic Analysis. 2013.

To be sure, there is a big slowdown in energy-related hiring on the horizon; the next chart shows the
tight connection between oil prices and energy jobs. However, given the relatively slow throw-weight
that energy jobs have had in the recovery, we do not think that a hiring slowdown in energy will have a
disproportionately negative impact on a US job market that is now growing at the fastest pace (and with
more job openings) since the year 2000.
Energy companies are likely to begin reducing payrolls

Fastest pace of employment gains since 2000

%, Y/Y Change

Thousands, 6-month moving average

%, Y/Y Change, Adv. 9 months

25%

WTI Crude Prices

20%

Percent
3.5%

150%

200
100%

15%

3.0%

10%
50%

5%
0%

0%

-5%
-10%

Oil Industry
Payrolls

-15%
-20%
1990

-50%

-200
-400
-600

2.5%

Change in
non-farm
payrolls

Job
openings
rate

-100% -800
1994

1998

2002

2006

2010

2014

Source: Bloomberg, Bureau of Labor Statistics. January 2015.

2000

2.0%

1.5%
2002

2004

2006

2008

2010

2012

2014

Source: Bureau of Labor Statistics. December 2014.

17

EYE ON THE MARKET

J.P. MORGAN

January 2015

Looking globally, one measure for comparing countries is oil consumption to GDP, net of
domestic production. In that regard, much of Southeast Asia stands to benefit the most when
compared to positive net consumption measures in Europe and Japan. Europe in particular is an
interesting case. The likely benefits from lower oil prices are greatest in countries whose energy
spending as a % of consumption is high; where energy taxes are lower, passing on more of the oil price
decline to consumers; where savings rates are lower, so more of the increase in disposable income gets
spent; and where oil intensity (barrels of oil per unit of GDP) is high. Synthesizing these factors, the oil
price windfall stands a greater chance of being spent in Asia than in Europe.
Lower oil prices benefit most emerging market and developed market countries
Oil consumption less oil production as % of GDP
10%

5%

0%

-10%

-28%
-34%

-5%

Australia
Canada
Norway

US

Spain
Germany
France
UK
Italy

Japan

Thailand
Taiwan
Korea
India
South Af rica
Chile
Greece
Philippines
Poland
Hungary
Czech Rep.
Turkey
Indonesia
China
Peru
Brazil
Malaysia
Egypt
Mexico
Colombia
Russia
UAE
Qatar

-15%

Source: BP, country statistical offices, J.P. Morgan Asset Management. 2013.

18

EYE ON THE MARKET

J.P. MORGAN

January 2015

The oil price decline and high yield bond markets


First, the good news. When compared to prior eras (e.g., the 1980s), US banks are less in the line of fire
from the oil price decline. As shown below, most of the debt taken on by US oil & gas producers this
time around comes from the (ever-generous) high yield bond market, rather than from bank loans. OK,
now the bad news. As the oil boom progressed, energy became a larger and larger portion of the high
yield bond market, rising from 4% in 2000 to almost 20% by 2014.
Growing impact of high yield energy companies

Energy debt mostly sourced from high yield market

Billion USD

Percent of shareholders' equity, short-term and long-term debt


Total debt

60%

$60

50%

$50

40%

$40

30%

Other debt (bonds, commercial paper, etc.)

20%

20%

Bank loans
2002

2004

2006

2008

2010

2012

2014

Source: US Census, Gavekal Research. January 2015.


Note: all mining industries shown (roughly 75%-78% oil & gas extraction).

18%

Energy companies' share of


total annual high yield issuance

16%
14%
12%
10%

$30

8%

$20

10%
0%
2000

Percent

$70

70%

High yield
issuance by
energy companies

$10
$0
1996

6%
4%
2%

1998

2000

2002

2004

2006

2008

2010

2012

2014

Source: J.P. Morgan Securities LLC. 2014 data through November.

That explains why high yield energy spreads have surged since July (we show two measures below; they
differ based on the weighting to E&P vs. midstream/pipelines). Looking back to the mid 1990s, this is as
wide as high yield energy bonds have traded relative to the overall high yield market (second chart). The
only comparable episode was in 1997-1998, when oil prices fell from $22 to $11, prompting The
Economist to publish their (infamously mistimed) cover entitled, Drowning in Oil. Since 1999, high
yield energy bonds have traded much tighter than the market overall, particularly during the collapse of
technology and financial sectors.
Energy high yield pressure points

High Yield under pressure


Spread to worst, basis points

High Yield Energy spreads minus High Yield spreads, basis points

1,100

300

Bloomberg USD
HY Energy

1,000
900
800

200
100

JPM domestic HY

Oil falls from $22 to $11,


Economist "Drowning in
Oil" cover

700

JPM domestic
HY Energy

600

-100

500

-200

400

-300

300
Jan-12

Jul-12

Jan-13

Jul-13

Jan-14

Jul-14

Source: J.P. Morgan Securities LLC, Bloomberg. January 22, 2015.

Jan-15

-400
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: J.P. Morgan Securities LLC. January 22, 2015.

19

EYE ON THE MARKET

J.P. MORGAN

January 2015

Looking at the charts above, it might seem like energy high yield bonds are attractive distressed debt
opportunities for investors. However, consider the following perspective of the default environment
should oil prices remain where they are. Last December, colleagues at J.P. Morgan Securities estimated
the leverage of oil and gas companies, using both $75 and $65 oil, and $3.50 and $2.50 natural gas 3.
They then estimated annual and cumulative default rates for the high yield market under these scenarios.
[As another sign of how unexpected the oil price decline is, they did not run the analysis assuming $50
oil]. Under their more bearish scenario, almost 40% of the high yield energy market defaults
by 2017. If thats the case, investors would need to be careful when looking for value in the high yield
energy sector; looking for oversold non-energy names is a lower-risk (lower-return) endeavor.
High Yield Energy
Estimated Annual
Default Rate
2015
2016
2017
Average
Cumulative

Scenarios
At $75 WTI, At $65 WTI,
$3.50 gas $2.50 gas
3.9%
3.9%
4.7%
20.3%
3.0%
15.1%
3.9%
13.3%
11.6%
39.3%

Source: J.P. Morgan Securities LLC. December 2014.

Energy Outlook and the Impact on US High Grade and High Yield Markets, J.P. Morgan Securities LLC,
December 2014.

20

EYE ON THE MARKET

J.P. MORGAN

January 2015

The entire energy complex is not all in credit free-fall, of course; it depends on each companys cash flow
and debt profile. As shown below, there is a rough symmetry between net debt to cash flow and the
credit spreads of high grade and high yield energy companies. One of the characteristics of high grade
energy companies is a low enough level of debt to be able to ride out periods like this.
Variation in high grade and high yield balance sheets...
Net debt to Q3 EBITDA (annualized)

Credit spread over Treasuries, basis points


1,600
1,400

High grade
High yield

1,200

2,700

High grade
High yield

1,000
800
600
400
200

Source: Bloomberg. Q3 2014.

UPL
HK
MPO
LPI
OAS
EPE
QEP
CXO
NFX
NBL
CHK
DVN
APA
CLR
COG
COP
SWN
EGN
PXD
APC
EOG
OXY
XOM
CVX

UPL
HK
MPO
LPI
OAS
EPE
QEP
CXO
NFX
NBL
CHK
DVN
APA
CLR
COG
COP
SWN
EGN
PXD
APC
EOG
OXY
XOM
CVX

5.0x
4.5x
4.0x
3.5x
3.0x
2.5x
2.0x
1.5x
1.0x
0.5x
0.0x

...leads to difference in credit spreads

Source: Bloomberg. January 14, 2015.

21

EYE ON THE MARKET

J.P. MORGAN

January 2015

The impact of lower oil prices on the US natural gas industry


As oil fell from $108 to $75, natural gas prices held firm. However, once oil fell through $70, gas prices
declined as well. What might the long-term impact of lower oil prices be on shale gas? Will gas users
switch to petroleum products? Not as much as you might think. First, as shown below, hub pricing
for natural gas is still cheaper than propane, a frequently used petroleum-based fuel by industrial users.
Furthermore, in many parts of the energy ecosystem 4, oil and gas do not function as easy substitutes due
to high switching costs and a lack of infrastructure (i.e., the high cost of converting and building natural
gas cars, and residential/commercial areas where natural gas pipelines have not yet been built). Lower oil
and refined product prices could slow both the adoption of CNG cars, and slow the buildout of
additional gas pipelines in areas where they dont exist yet. These factors could slightly dampen the
outlook for future gas demand, but are likely to be negligible regarding current gas demand.
All is not lost for natural gas future, however: the optimistic case rests on electricity generation, the
largest primary energy use and where gas should continue to take share from coal (facing new rules
regarding emissions of mercury, acid gases and toxic metals) and nuclear (rising costs). As shown in the
bar chart, the EIA projects 185 GW of new electricity generation capacity from 2014-2030; 75% is
expected to come from natural gas. Gas production volumes may decline from less spending on shale oil
plays that are rich in gas, and on wet shale gas whose price is linked to oil. And in parts of the US (New
England, Mid-Atlantic), gas is more expensive than Henry Hub, reducing its attractiveness vs. propane.
Even so, electricity generation will still be the primary driver of the US natural gas industry. If so, federal
and localized fracking rules may be a bigger potential obstacle than lower oil prices.
Oil & natural gas: January 2013 - present
USD per barrel

USD per MMBtu

$110

$6.50

$100

$6.00

$90

Even after 40%+ decline in propane/oil, natural gas still


cheaper per mmBTU, Natural gas/propane price ratio [at hub]
1.2x
1.0x

$5.50

WTI Crude

$5.00

$80
$70
$60

Natural gas

$4.50

0.6x

$4.00

0.4x

$3.50

0.2x

$50

$3.00

$40
Jan-13

$2.50
Jul-13

Jan-14

Jul-14

0.8x

Jan-15

Source: Bloomberg. January 22, 2015. Nat gas prices based on Henry Hub.

0.0x
2002

2004

2006

2008

2010

2012

2014

Source: Bloomberg, EIA. January 22, 2015. Note: natural gas based on
Henry Hub pricing; propane based on Mont Belvieu hub pricing

2000 marked the beginning of the natural gas century in the United States
Gigawatts, electricity generating capacity additions [Source: EIA, 2013]
60

60

30

Other renewables
Solar
Wind
Natural gas
Nuclear
Hydropower/other
Coal

20

nuclear era ends

50
40

EIA Forecasts
debt fueled
natural gas
boom-bust

50

40

subsidy-fueled
wind power
expansion

wind subsidies
lapse
As per the EIA, the
future is mostly about
natural gas

30

20

10

10

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

2018

2021

2024

2027

2030

As shown in the sources and uses chart on page 15, industrial users are in practice the only part of the energy
ecosystem where both oil and gas could be used interchangeably. Electricity generation does not rely on oil, nor
does residential and commercial heating to any material degree.

22

EYE ON THE MARKET

J.P. MORGAN

January 2015

Geopolitics and oil prices


Theres a lot of discussion about consequences of the oil price decline on oil-exporting nations in the
Middle East, Latin America and Central Asia. Standard measures used to assess such risks: break-even oil
prices needed to balance the fiscal account (budget deficit), and the external account (trade deficit). As
shown in the chart 5, oil prices have fallen well below fiscal breakevens for all countries except Kuwait and
Qatar, and below most external account breakevens. The table looks at the impact of a $40 oil price
decline on fiscal and current accounts for a slightly different group. The usual suspects shown up at the
top of the list; by the time you get to Mexico 6 and Malaysia, the impacts are smaller. While Brazil has a
lot of problems right now with Petrobras and the overall commodity price collapse, its overall economic
sensitivity to an oil price decline is not large enough to show up in the table. At first glance, this data
suggests that many oil-exporting countries will have difficulty balancing budgets, selling domestic and
external debt, managing currencies and maintaining domestic subsidies to their constituents.
Impact of a decline in oil from $80 to $40

Breakeven oil prices are interesting, but don't forget


about benefits of commodity stabilization funds

Country

Fiscal breakeven, USD per barrel


$180

With size of Sov. Wealth Fund, $ bn


YEM, N/A

$160
$140

VEN, $1

$120

$60
$40

IRAQ, $18

UAE, $1,079

AZB, $37

Current Brent
price
QTR, $256
KUW, $548
$20

$40

$60

$80

($189, $317)
LIB, $66
2014 peak
Brent crude
price

SAUD, $757

$100
$80

ALG, $77

IRAN, $62

KAZ, $157
$100

$120

$140

External breakeven, USD per barrel


Source: National sources, IMF, JPMS LLC. 2014 projections. January 2015.

Azerbaijan
Venezuela
Kazakhstan
Russia
Iraq
Bolivia
Nigeria
Ecuador
Colombia
Malaysia
Mexico

Fiscal balance
(% of GDP)
-9.6
-6.0
-5.6
-4.4
-3.6
-3.6
-0.9
-2.8
-2.0
-2.1
-0.8

Current account
(% of GDP)
-14.5
-11.2
-8.9
-7.6
-7.9
-5.0
-7.0
-3.2
-3.2
-1.7
-0.4

Source: J.P. Morgan Securities LLC. December 18, 2014.

However, the concept of oil break-evens ignores commodity reserve funds created for just this
purpose: to be able to ride out commodity price declines and smooth out any macroeconomic
adjustments. In the chart above, the size of each countrys sovereign wealth fund accompanies each
dot. The Saudis, the UAE, Kuwait and Qatar are prime examples, with sovereign wealth funds in
aggregate over US$2 trillion. The bigger challenges: countries like Venezuela, whose economic situation
7
was arguably in shambles even before oil prices declined, and Russia, a country we focus on in more
detail in the next section.

The universe of countries shown in the chart is a subset of those analyzed by the IMF in its October 2014
Regional Economic Outlook for the Middle East and Central Asia. We were able to add Venezuela based on
our own estimates. The IMF has not published (as far as we can tell) similar estimates for Russia.
6

Mexico has 2 problems: (a) modest fiscal and external account sensitivity to oil prices, and (b) the risk of
substantially curtailed interest in the privatization of some of its oil and natural gas blocks, which now may have to
be postponed to future years. The second problem may be a bigger issue for investors than the first one.

Venezuela is a good example of a country suffering from a natural resource curse. Despite having 18% of the
worlds proven oil reserves, the country is a mismanaged, inflationary, recessionary, crime-infested mess. Its citizens
are confronted with shortages of bread and toilet paper (and a proposed limit of 2 shopping days per week),
inflation of ~80%, being #6 on the World Banks list of homicides per capita, and last place finishes in the World
Economic Forums assessment of legal and judicial systems, goods market efficiency and innovation across 144
countries. Its external debt is trading at 35 to 45 cents on the dollar. Its best prospects may eventually involve a
massive fiscal and political adjustment, combined with IMF and World Bank assistance. An Iranian-sponsored
Marshall Plan seems less likely to happen, or to work.

23

EYE ON THE MARKET

J.P. MORGAN

January 2015

Saudi Arabia is an interesting case, since oil receipts account for 85%-90% of total government
revenues, and it spends a lot of money on defense and social programs. How long can they afford to
spend if oil prices remain where they are? The answer: for a longer period of time than fiscal
breakeven prices suggest. Saudi Arabia is often described as having a $750 billion sovereign wealth
fund, but the reality is a little more complicated. The Saudi Arabian Monetary Agency (SAMA) has 2.8
trillion Riyals of mostly liquid assets (cash and foreign securities), which is equivalent to US $750 billion.
SAMA liabilities include 1.7 trillion Riyals of government deposits, and 1.1 trillion of liabilities to banks,
other entities and money in circulation. So, strictly speaking, the Saudi government has 1.7 trillion Riyals
(US$450 billion) of liquidity that it could draw upon if needed. Before the oil price decline, Saudi Arabian
government oil receipts were higher than spending. This year, the gap will be negative and is projected
at ~10% of GDP. What would happen if the government financed such gaps by drawing down on its
deposits at SAMA? The second chart shows 4 scenarios from the IMF regarding Saudi deposits at SAMA.
Assuming no change in spending and $65 oil, its deposit account would fall to zero by 2018. A modest
fiscal adjustment (3% of GDP) would push the full depletion date to around 2021.
Billion 2012 Saudi Riyals

Impact of government spending and oil prices on


government deposits at SAMA, Billion Saudi Riyals

180

2,000

Saudi Arabia government expenditures

$90 oil, 3% fiscal adjustment

160
1,500

140

$90 oil, no
adjustment

120
1,000

100

Defense

80

Health

500

$65 oil,
3% fiscal adjustment

60
40

Education

Housing

$65 oil,
no adjustment

20
0
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010
Source: Saudi Arabian Monetary Agency, IMF. 2012.

-500
2013

2014

2015

2016

2017

2018

2019

Source: IMF Article IV Consultation. September 2014. *Oil is Brent Crude

As a result, if oil averages $65, the Saudis will probably have to cut spending to prevent a sharp decline
in their SAMA deposit account. However, there are 2 release valves they could draw upon to smooth
things out. First, the Saudi government could issue debt. In the wake of the 1991 Gulf War, Saudi
Arabia issued debt, which it has now mostly paid down (its debt/GDP ratio is only 2%). Secondly, the
Saudi government has access to all of the assets of SAMA if needed, and not just its deposit account. In
other words, they have the ability to jump ahead of other SAMA creditors in an emergency. As a result,
we believe the Saudis will continue to spend large sums to maintain political, sectarian and
social stability, although perhaps not as much as in 2014. A petro-sectarian map on page 29 helps
explain the importance of government subsidies, oil deposits and sectarian issues in more detail.

24

EYE ON THE MARKET

J.P. MORGAN

January 2015

Close-up on Russia: bad things come in threes


The oil price decline has resurfaced memories of the 1980s when the Soviet Union disintegrated. As
shown in the first chart, right before the Soviet collapse, Russian oil exports to the West fell in half. A
fascinating paper on the subject drew parallels to the end of Spains control over the Iberian Peninsula in
the 1500s, which also coincided with a loss of commodity inflows. However, as the second chart
demonstrates, the disastrous economic performance of the Soviet Union was well underway even before
the 1980s began. Instead of oil prices being seen as the catalyst for its collapse, it might make more
sense to see it as the last straw for a colossally inefficient economic system, one which dedicated 40% of
budget revenues and 20% of GDP to the military.
Economic collapse of the Soviet Union

Commodity declines and the end of empires


Pesos, millions
35
30
25

USD, billions

By the end of the eras shown,


Spain lost control of Portugal,
1981
Aragon and Catalonia, and
Russia lost control of E. Eur

1983

1985

1979

20

Russian oil
exports to
capitalist
countries

Gold inflows
to Spain (bars) 1977

30
25
20

1987
1989

15

15
1975

10

10

1973
5

5 1971

0
0
1525 1535 1545 1555 1565 1575 1585 1595 1605 1615 1625 1635 1645

Source: "The Soviet Collapse: Grain and Oil", Yegor Gaidar, April 2007.

Rate of return on invested capital


0.50
0.45
0.40
0.35
0.30
Total economy
0.25
0.20
0.15
Industry
0.10
0.05
0.00
1950 1954 1958 1962 1966 1970 1974 1978 1982
Source: "The Soviet Economic Decline: Historical and Republican Data",
Easterly and Fischer, May 1994.

What about this time? Russia is again suffering hardships due to an oil price collapse, since 54% of its
exports are crude oil and other petroleum products; another 14% relates to natural gas. Russia might
have been able to handle the oil price decline if that were the only problem it faced. However, sanctions
(which have sharply curtailed reduced Russian bond and loan issuance in foreign currency) and capital
flight are compounding the problem. These three factors (oil, sanctions and capital flight) have
resulted in a 50% decline in the Ruble despite the government spending $100 billion to defend
it. Central bank policy rates are 17% (the highest since Russias default in 1998), and inflation jumped
to 11% in December 2014. Lower hard currency revenues will make it harder for Russia to deliver the
pension and public sector salary increases that have been the hallmarks of Putins presidency. The notion
put forth by Russian policymakers that lower oil prices have a silver lining (it will force restructuring and
productivity improvements) doesnt sound very convincing. Making Russias economy more productive
would require weakening the power and influence of its oligarchs, and allow for the development of a
truly independent class of small and medium-sized businesses. Dont hold your breath.
Impact of sanctions on Russian corporate debt issuance

Another episode of a falling Ruble and rising inflation

Billion USD, trailing 6 months

Y/Y% change (both axes)


-40%
-30%

16% $50

Weaker
Ruble

Inflation

-20%

Trade-weighted
Ruble index
(inverted)

14%

$45
$40

12% $35
10% $30

-10%

$25

0%

8%

$20

6%

$15

10%

4%

20%
2006

2%
2008

2010

2012

2014

Source: Russian Federal Statistics Office, J.P. Morgan. December 2014.

Loan Issuance

$10
$5
$0
2002

Bond Issuance
2004

2006

2008

2010

2012

2014

Source: BondRadar, Reuters, J.P. Morgan Securities LLC. 2014.

25

EYE ON THE MARKET

J.P. MORGAN

January 2015

Even after a failed currency defense, Russia still has almost $400 billion in foreign exchange reserves
(more than enough to cover 2015 sovereign and corporate debt maturities of $130 billion), and also has
among the worlds largest proven natural gas reserves. Even so, the situation is worse than in 20082009, when reserves exceeded $600 billion and Russian sovereign and corporate debt levels were lower.
Russian international reserves

Proven natural gas reserves in the top 15 countries

Billion USD

Iran
Russia
Qatar
Turkmenistan
United States
Saudi Arabia
UAE
Venezuela
Nigeria
Algeria
Australia
Iraq
China
Indonesia
Norway

$600
$500
$400
$300
$200
$100
$0

200

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

400
600
800
Trillion Cubic Feet

Source: The Central Bank of the Russian Federation. January 2015.

Source: BP Statistical Review of World Energy. 2013.

The 1998 Russian default

Russia's 1998 exchange rate collapse

Billion USD
$30

1,200

Rubles per dollar


Non-resident holdings of
short-term Russian bonds

Russian FX
Reserves

$25

1,000

0
5

$20

10

$15
$10

15

$5

20

$0

Net foreign liabilities of Russian banks

-$5
4Q

1996

1Q

2Q

3Q

4Q

1997

Source: Ariel Cohen, Heritage Foundation. June 1999.

1Q

2Q

1998

25
Jan-96

Jul-96

Jan-97

Jul-97

Jan-98

Jul-98

Source: Wall Street Journal, Haver Analytics.

The bottom line is that if oil remains at $50-$60, Russia is looking at something like a 5-6%
recession in 2015, and another smaller recession in 2016. Russia has FX reserve ammunition to
try and ride this out a bit longer (a lot more than it did during the 1990s, when its reserves fell
below its short-term foreign liabilities), but at some point, will probably have to put in capital
controls to prevent losing too many foreign exchange reserves. Some Russian companies will
end up defaulting, in part due solely to lack of access to foreign exchange. Im not sure that
this is the stuff of regime change; more likely, just another in a historical line of long, cold,
depressing Russian winters of deprivation for many of its citizens.
What about a relaxation of sanctions? Anything is possible (and countries like Austria, Hungary
and France would like to lift sanctions now), but as of the time of this writing (January 20, 2015), the
fighting in the Ukraine is getting worse. Both Russia and Crimean separatists have been bringing in
reinforcements and equipment to the battle at the Donetsk Airport. Furthermore, Russia announced a
cessation of natural gas exports to and through the Ukraine. Six other countries are affected: Greece,
Bulgaria, Macedonia, Croatia, Romania and Turkey.

26

EYE ON THE MARKET

J.P. MORGAN

January 2015

As economic conditions in Russia deteriorate, whos in the line of fire? Italian, Turkish and Austrian
banks stand out as having the largest exposures as a % of their overall foreign lending. However, in the
rest of the world, Russian exposure is generally less than 1% of total foreign claims, and outside Eastern
Europe, exports to Russia as a % of GDP are less than 0.4% (0.1% for the US). Furthermore, as
emerging markets crises go, Russia is at the low end regarding its external debt relative to exports
(second chart). Most of the data we have seen suggests that the global banking system could
handle an increase in Russian corporate defaults without too much damage.
Lending to Russia as a % of foreign claims
Foreign claims on ultimate risk basis, percent of total foreign claims

Russia's external position is less extreme than historical


crises, External debt as % of exports
500%

Belgium
UK
Switzerland
Japan
Germany
US
Europe
Sweden
Neth
India
France
Korea
Italy
Turkey
Austria

400%
300%
200%
100%
0%

0%

1%

2%

3%

4%

1994

1997

1998

1999

2000

2001

MEX

THA

IDN

BRA

TUR

ARG

1998

2014

Russia

Source: Institute of International Finance. October 2014.

Source: BIS consolidated statistics, Q2 2014.

While the global banking system might be able to handle it, there will be some disappointed long-term
investors in Russian assets. Since 1990, Russia has been the 3rd largest foreign direct investment
destination after China and Brazil. Investors in public equity markets have been cautious on Russia for
some time. As shown below, Russian P/Es are by far the lowest in the EM world, even when computed
on a sector-neutral basis (which adjusts for the fact that Russia has an overweight to energy).
Russia 3rd largest EM investment destination after China
and Brazil, Share of DM investment in EM (ex-China) since 1990
18%
16%
14%
12%
10%
8%
6%
4%
2%
BRZ

RUS

KOR

MEX

IND

TUR

IDR

PLD

SAF

TLD

MAL

CHI

TAI

HUN

CZK

PER

PHP

0%

Source: Bridgewater. November 5, 2014.

The Russian equity discount


P/E multiples for MSCI equity indexes, sector neutral, 12-mo fwd
22x
19x

India
Taiwan
Mexico
South Africa
Brazil
Korea
China
Russia

16x
13x
10x
7x
4x
2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: MSCI. J.P. Morgan Securities. November 2014.

27

EYE ON THE MARKET

J.P. MORGAN

January 2015

The oil price decline is important to watch as it relates to Russias planned re-militarization. As
shown below, Europe has gradually been disarming. NATO capabilities have degraded, as evidenced by
NATO difficulties in Libya with strategic airlift and air-to-air refueling operations. In 2012, only 3 of 28
member states (other than the US) reached NATOs targeted 2% of GDP spending on defense. One
quote on the subject: We are moving toward a Europe that is a combination of the unable and the
unwilling. [Camille Grand, Fondation pour la Recherche Stratgique]. The US now shoulders 75% of the
NATO budget, up from 50% during the Cold War. A European Defense Agency report indicates that
European countries spent half of their defense budgets on personnel vs. less than one third in the US,
creating an even greater gap from a military equipment perspective.
Defense spending changes since 2008 financial crisis

Military spending

Index, 2008 = 100

Percent of GDP, with 2013 spending in 2011 USD


5.0%

150

4.5%

140

4.0%

130

3.5%

Rus

120
Russia, ($85 bn)

3.0%

90

Brl, Jpn
Ind
US, Fra
Ger
UK

80

Ita

110

United States, ($619 bn)

2.5%

100

2.0%

Europe, ($278 bn)

1.5%
1.0%
1992

Chi

1995

1998

2001

2004

2007

2010

Source: Stockholm International Peace Research Institute. 2013.

2013

70
2008

2009

2010

2011

2012

2013

Source: "The Military Balance 2014", IISS, February 2014.

What is Russias military up to? In October 2008, the Russian-Georgia war exposed serious defects in
Russian military preparedness, after which Moscow initiated a sweeping set of reforms. Recent
indications: Russia reinstated long-range bomber patrols, stationed Iskander cruise missiles in Kaliningrad
(between Poland and Lithuania on the Baltic Sea), is upgrading its nuclear submarines, tanks, military
satellites and MIRVs, intends to replace 70% of its air force over the next few years, plans to build a
long-range stealth bomber and targets one million active duty personnel by 2020. In other words,
Putins Russia is planning to re-arm 8, a process which appears to have already begun; see chart
above (right) on defense spending increases since 2008. However, low oil prices will almost
surely make Russias military re-modernization more difficult, compounding challenges Russias
9
military already faces .

Russian military spending is just 14% of US levels in dollar terms, but dollar comparisons may understate some of
Russias military strengths. Russia does not spend the huge sums that the US spends on aircraft carriers, transport
planes/helicopters (lift capacity), unmanned drones and naval cruisers, destroyers and amphibious assault ships.
However, Russias fleets of bomber aircraft, infantry fighting vehicles, main battle tanks, artillery units and guided
missile submarines are not that different from the US, at least in number.
9

Russias military already faces a number of other hurdles that are worth noting:
Demographics: the number of male eighteen-year-olds is projected to decline by 35% from 2007 to 2017,
making it harder to reach conscription targets; more than 20% of all military posts are unfilled.
Russia is aiming to improve the technical proficiency of its weaponry by a factor of 7 by 2020, which will require
more innovation and productivity than it has displayed recently. Only 15%-20% of procurement projects planned
for the first half of 2013 were completed on time.
Russias nuclear arsenal still consumes an estimated 40% of its military budget, reducing the amount left for
everything else.
A Russian military prosecutor estimated that 20% of the defense budget is embezzled each year.

28

EYE ON THE MARKET

J.P. MORGAN

January 2015

A petro-sectarian map of the Middle East, with a focus on Saudi Arabia


Why are Saudi health, housing and education subsidies so important? Because some of them are paid to
its Shia population in the Eastern Province, where the oil is (see box on map). Saudi oil is primarily found
in Shia inhabited districts of Hasa, Qatif and Hofuf, and in the continental shelf extending from the
Eastern Province into the Persian Gulf.

Some recent subsidy history: following the collapse of Mubaraks regime in Egypt, Saudi Arabia announced
a social welfare package for citizens worth $10.7 billion, featuring pay raises for government employees,
new jobs and loan forgiveness schemes. By the end of the month, the payments totaled $37 billion. The
trend continued, as King Abdullah announced an additional $93 billion in social spending ($66.7 billion on
500,000 housing units, $4.3 billion on more medical facilities, and an additional 2 months' wages for all
government workers and two extra payments for university students worth around $500).

29

EYE ON THE MARKET

J.P. MORGAN

January 2015

Other exhibits: cash costs of current production, and some oil history dating back to 1861
As it relates to future production, analysts typically compare the forward price of oil to total costs of
production, including cash costs, capital costs, financing costs, etc. The reason future production and
marginal cost dominate most analyses: oil fields are constantly depleting, so any assessment of the future
needs to take into account how high oil prices have to be to incent future exploration and production of
new wells. The marginal cost chart on page 5 is an example of this kind of analysis.
However, when considering whether existing wells have an incentive to keep producing, we
need to consider cash costs only, since capital and financing costs are already sunk. The first
chart below shows cash costs of production. The blue line shows on-site operational costs only, while
the brown line includes mineral rights/land royalty payments to private sector owners or governments,
payments which are often structured as a % of revenues. The royalty payments below were estimated
last November when oil prices were around $75. Since oil has fallen further since then, total cash costs
may now be 10%-30% lower across the middle section of the curve. As a result, with spot prices
around $45-$50 and forward prices closer to $60, most existing wells in the world will keep
producing.
Real oil prices: industrial revolution to today

Cash costs of current production

2012 USD

Operating cost, USD per barrel

$140

$60
Operating cost with royalties

$50

$120

Operating cost without royalties

$40

Canada oil sands

$100

Venezuela
UK

Canada (exc. oil sands)

$30

Mexico

$20

China

Saudi Iraq
Arabia

$10

US
Iran

$0
0

$80

UAE

Russia

$60

Russia
Nigeria
US

$40

China

10
20
30
40
50
60
70
80
Cumulative global oil production, mm barrels per day
Source: Morgan Stanley Commodity Research. December 2014.

$20

90

$0
1860

1884

1908

1932

1956

1980

2004

Source: BP, Bloomberg, BLS. January 22, 2015.

The final chart shows the real price of oil (adjusted for inflation) since 1861. The latest correction still
leaves oil priced more expensively in real terms than it was a decade ago.

30

EYE ON THE MARKET

J.P. MORGAN

January 2015

Acronyms
BEA: Bureau of Economic Analysis; BIS: Bank of International Settlements; BLS: Bureau of Labor Statistics;
BTU: British thermal unit; CNG: Compressed natural gas; E&P: Exploration & production; EBITDA: Earnings
before interest, taxes, depreciation and amortization; EIA: Energy Information Administration;
EPS: Earnings per share; FDIC: Federal Deposit Insurance Corporation; FX: Foreign exchange;
GW: Gigawatt; HY: High yield; IMF: International Monetary Fund; JPMAM: J.P. Morgan Asset
Management; MIRV: Multiple independently targetable reentry vehicle; NATO: North Atlantic Treaty
Organization; OPEC: Organization of Petroleum Exporting Countries; P/E: Price-to-earnings; SAMA: Saudi
Arabian Monetary Agency; WTI: West Texas Intermediate
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31

EYE ON THE MARKET SPECIAL EDITION

JANUARY 2015

MICHAEL CEMBALEST is Chairman of Market and Investment Strategy for J.P. Morgan
Asset Management, a global leader in investment management and private banking
with $1.6 trillion of client assets under management worldwide (as of December 31,
2013). He is responsible for leading the strategic market and investment insights across
the firms Institutional, Funds and Private Banking businesses.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment
Committee and a member of the Investment Committee for the J.P. Morgan Retirement
Plan for the firms more than 250,000 employees.
Mr. Cembalest was most recently Chief Investment Officer for the firms Global Private
Bank, a role he held for eight years. He was previously head of a fixed income division
of Investment Management, with responsibility for high grade, high yield, emerging
markets and municipal bonds.
Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging
Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in
1987 as a member of the firms Corporate Finance division.
Mr. Cembalest earned an M.A. from the Columbia School of International and Public
Affairs in 1986 and a B.A. from Tufts University in 1984.

AMERICAS

ASIA

EUROPE

Brazil
Chile
Colombia
Mexico
Peru
United States

Hong Kong
Singapore

France
Dubai
Germany
Italy
Spain
Switzerland
United Kingdom

MIDDLE EAST

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