28th October 2014

Ecstrat

Deconstructing Oil
At the turn of the year I had the curious positions of predicting that jihadists would overrun western Iraq1 and the oil price would fall to $90 (Brent).
Unfortunately Iraq has fallen apart and while the oil price spiked as Iraqi violence increased,
but has since fallen below $90, finding some stability at the $85 level ($80 for WTI)
This note considers why oil fell as it did, where it may go from here and broader impact,
with the key takeaways as follows:
1.
2.
3.
4.
5.

Structural issues with Brent have caused pricing abnormalities that are reverting
ISIS has significant regional impact, but is a minimal threat to supply. For now
OPEC largely irrelevant, Saudi Arabian influence also declining on global flow changes
Supply disruptions have likely peaked, particularly in Libya and Iran
Shale is not the swing barrel, lower prices are setting the scene for higher prices

Certain geopolitical developments have been left out due to their sensitivity, better
discussed directly with clients rather than in a note.
My oil model, a hybrid that has been very successful thus far (Fig 1) has flipped back to a
buy for both Brent and WTI, with a target in the next few years of $130 per barrel.
The near-term downside risk is to around $77 level if we see a resumption of the broad risk
asset sell-off, but it is unlikely to stay at these levels, with a band of $90-100 likely next year
(dependent on how bad China gets)
Fig 1. Public model recommendations and the dated Brent oil price (+172% rel)

Source: Bloomberg, Emad, Religare, Noah. Rel performance by going ow or uw oil at position changing points

Business Insider Most Important Charts of the Year December 18th 2013 #1:
http://www.businessinsider.com/most-important-charts-2013-12?op=1
Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Rubbish Models
The fact that our econometric models at the Fed, the best in the world, have been wrong
for fourteen straight quarters does not mean they will not be right in the fifteenth quarter.
Alan Greenspan, 1999 testimony to Congress
Before analyzing how oil prices got to where they are today and where they may end up in
future, it is important to construct a reasonable model and understand the key assumptions
that may influence the price.
As the above quote shows, modelling is terribly difficult and after all the hard work and
effort we put into our models, we do on occasion overstate how great they are, blinded by
their intricate construction to the fact that rubbish in generally still leads to rubbish out.
Indeed, when modelling multivariate real-life situations such as oil, the economy or stocks,
one can assume that any model you build is highly unlikely to give any lasting edge over the
competition unless it is fundamentally different, which is generally a lonely place to be.
Demanding oil
Most oil models tend to be quite similar, based on oil demand. The theory is that one can
extrapolate demand growth from a mixture of GDP growth, demographic trends and
looking where countries are on the oil consumption per capita curve, thus inferring
demand growth, which in turn leads to supply growth to match it.
If one then plots the cost of extracting various types of crude, you can figure out the
marginal barrel for a level of crude and how much that costs and infer the price of spot
crude from there dependent on more bottom-up factors such as inventory levels
Fig 2. Change in Consensus 2014 GDP Forecasts

Source: Bloomberg

Fig 2 shows how difficult forecasting even GDP growth a year out can be, with other factors
on oil such as energy intensity of usage for even well-known markets such as the USA
similarly opaque and difficult to judge.
Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Thus most forecasts tend to be extrapolations of spot, with current consensus forecasts
moving in line below $100 and even $90 despite no major shifts in expectations of either
demand or supply, a familiar, herd-based pattern in prediction.
It may well be that we overestimate our ability to judge the impact of small moves in
localized factors on the overall oil market, with oil elasticity very strange due to EM
subsidies and developed markets being significantly well off (just about) not adjust.
It seems that the oil price is more influenced by stories and perceptions of reality, from
peak oil to shale oil to the Arab Spring as opposed to more quantifiable data. There are key
levels for consumption and production adjustments and at which the price will react.
It is also worth questioning the quality of data in the market, as it seems that the market
moves more often on sentiment than reality, with 500,000 barrels of oil disappearing from
Sudanese exports of negligible impact versus maintenance on fields with less than 100kbpd.
Figuring out which barrel is more important than another is tough.
My approach is a hybrid of supply and demand-based constraints with elements of
behavioural analysis bolted on. It is not very pretty, but has thus far been effective, with
some of the key elements from it being the approach to understanding how oil pricing
structures may contribute to instability, which is covered in the next section, and how key
market participants may act versus common perceptions.
A Tale of Two Benchmarks
The way that oil and oil-related products are priced has changed in the last few years.
WTI (West Texas Intermediate) crude used to be the center of the oil pricing universe.
Other crudes and derived products would price as differentials to the spot price of WTI
observed at Cushing, Oklahoma based on blend quality, local supply/demand and so on.
The spot price also set the basis for the futures curve that could be used to hedge supply
and demand. 3-5 years out, this approximated the marginal cost of production for oil as
otherwise suppliers or consumers could lock in prices for guaranteed profit.
When the spot price is above future prices (contango), oil is encouraged to come to the
market and when it is below (backwardation), oil goes into storage and production is idled.
As we entered the financial crisis of 2008, WTI became increasingly affected by local factors
as flows from Canadian oil sands and shale led to huge inventory builds.
As such, the center of the oil pricing universe moved to the North Sea and the Brent blend,
also known as BFOE (Brent, Forties, Oseberg and Ekofisk) crude after its four major fields.
Derived products (such as gasoline) and even US coastal blends like LLS started pricing with
Brent as a basis, as can be seen in Fig 3.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Fig 3. Who uses Brent vs WTI, source OEI, ICE

Source: OEI, ICE

However, structural elements of how Brent is calculated combined with investor behavior
may have led to distortions in the oil price that are only now normalizing.
Futures and financialisation
In the mid-noughties, institutions started to allocate huge amounts of money to
commodities via index funds that predominantly used futures contracts, lured by the
promise of endless Emerging Market growth and Malthusian outcomes.
The debate continues on the impact of these financial flows, but the theory was that it
should be minimal as these funds typically invested via futures and didnt hold these
contracts to expiration, meaning spot prices should be determined by the physical market.
This was especially true of the largest component of these indices, WTI, where one had to
take physical deliver on maturation. Thus institutions expressed their commodity bets by
owning futures and rolling them into further out futures before expiration, earning a nice
roll yield as commodity curves tended to be in contango, selling high and buying low.
Brent has a slightly different structure as outlined in Fig 4.
Fig 4. Brent Pricing Structure

Source: ICE

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

This is more complex, but there are three key elements of interest here:
1. You dont need to take physical delivery of Brent but can cash settle, indeed the
physical market is 1,000 times smaller than the futures market in volume
2. Forties is the most important blend as you can settle in any of the four blends an it is
the lowest quality and thus cheapest, making Brent susceptible to Forties availability
3. Many producers dont price off Brent at all due to the small number of players in the
market, but actually price on Brent Weighted Average Futures (BWAVE)
The lack of required physical settlement and price discovery mechanism from the futures
makes Brent more susceptible to certain types of financial flow than its predecessor,
particularly on a curve structure basis.
This may have contributed to a number of distortions in the market such as the Brent-WTI
spot spread and more curiously, the Brent-WTI futures spread (something that guaranteed
supra-normal margins to refiners in defiance of efficient markets).
2008, Peak Peak Oil to 2009, Peak Puke Oil
Looking back historically to get a better understanding of curve dynamics, in 2008 the oil
market shot up across the curve, as can be seen in Fig 5. The exact reason for this
precipitous climb still hotly contested but likely a combination of a number of factors, from
benchmark shifting, to the increased demand for light, sweet crude due to diesel standards,
to the impact of financialization of commodities.
It was at this time that the strong form of the peak oil hypothesis started to gain traction,
with the view that we had reached peak oil production and demand would easily outstrip
supply gaining widespread acceptance.
Fig 5. Brent 1st month and 48th month contracts

Source: Bloomberg

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

As markets crashed into 2009, most of the speculative premium was unwound in
commodities as global growth sustainability was questioned, with Brent falling to $40 and
the curve entering significant backwardation (Fig 5).
Unlike prior oil price crashes, such as at the turn of the century when prices touched $10 a
barrel, the swing producers of the Gulf had gone from huge levels of debt to huge net cash
positions during the boom years and were able to cut aggressively to rapidly stabilize the
price, even as excess inventories were dumped. For example, Saudi Arabia cut exports by
2mbpd in 2009.
Large scale expansion projects that would have been suitable at $100 oil were shelved,
removing a significant amount of capacity that was due to come onto the market in the
following years.
Lower oil prices also acted as something of a stabilizer for global growth as lower prices at
the pump fed directly into the pocket of the consumer and industry.
Into the Arab Spring
As the oil price and risk assets bounced from 2009 into 2011, we saw consensus
expectations rise above $100, leading to a sharp increase in the availability of finance for
shale oil drilling. The back end of the curve settled around $90, commonly believed to be
the marginal cost of production for shale oil (although of course this varies).
The Arab Spring surprised the market causing Brent to ramp on supply disruption fears and
the curve to backwardate, pulling more oil to the spot market. Curiously, this slope
remained in place after supply proved resilient as can be seen in the Brent 1st to 12th to
36th month differential in Fig 6. In contrast, WTI largely recoupled across the curve until
Libyan oil started disappearing into 2012 as can be seen in Fig 7.
Fig 6. Brent 1st, 12th and 48th month contracts

Source: Bloomberg

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Fig 7. WTI 1st, 12th and 48th month contracts

Source: Bloomberg

In 2012 a sharply higher chance of an Israel-Iran fracas dominated, driving the front end
back up for both Brent and WTI before both contracts collapsed into the middle of the year
as the nuclear reactors remained in one piece and hot money exited the market in a rush.
The oil price rapidly bounced from here as it entered oversold territory and the impact of
SWIFT sanctions on Iranian output started to bite despite the sharp increase in Saudi
exports.
Oil has remained in a range up to this year, but an extreme level of backwardation ($10-20)
has remained in the curve.
Enter ISIS, a curve clearout
As ISIS swept across Anbar and Ninveh provinces, the oil price spiked, as did speculative
positions per Fig 8.
While we were unsurprised by these developments given the preceding developments in
Iraq as the Shia-led government came to the fore and huge amounts of money and arms
went into Syria. We saw significant supply disruption as unlikely, as while Sunni areas were
quick to fall and Shia-dominated areas such as Baghdad and Basra where the majority of
Iraqs oil is were a different story.
Similarly, the fields of the Kurdish Regional Government, where most international oil
companies have their operations were relatively insulated from ISIS advances thanks to the
size of the Peshmerga, the ethnic makeup of towns in that region and, finally, the
intervention of the US air force shortly after ISIS attempted to attack them.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Fig 8. ICE Brent Managed Money Net Long Contracts

Source: Bloomberg, ICE

The real impact on Iraqi production is likely to be medium to long-term, with Iraq making
up almost half of incremental oil production over the next decade or two per the IEA,
something that will prove difficult with likely continued local disorder.
Similarly, ISIS is now relatively contained, with the real impact being secondary effects in
regional government policy and longer-term in what it evolves into, something we will
return to in a future note.
As the market realized that oil production was stable concerns over global growth and
deflation gained ground (Fig 3), hot money that entered the oil price rapidly exited,
driving down prices as the anticipated spike didnt occur.
This led to the curve flipping entirely, as can be seen in Fig 9, which shows the change in the
Brent futures curve between the recent peak on the 24th of June to the recent low on the
15th of October.
As you can see, the front end fell $30, while the backend remained relatively stable, with
four year Brent falling $6 as the backwardation in the contract flipped to contango as the
structure collapsed.
The Brent curve is already flattening out as any level of contango in a low interest-rate
environment is difficult to sustain as it provides significant incentive to store oil for future
delivery by selling forward and we are likely to see some supply response initially from deep
sea production and then ultimately shale.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

Fig 9. Brent Oil Curve at recent peak and recent trough

Source: Bloomberg

The WTI curve has seen a similar drop of $25 on the front end and four year WTI only falling
$4, although it has intriguingly retained near-term backwardation, with the rest of the
curve relatively flat.
Fig 10. WTI Oil Curve at recent peak and recent trough

Source: Bloomberg

Going forward the key question is what will happen to the backend of the curve, with the
front end still likely susceptible to fears of disruption and thus likely to resume a reasonable
level of backwardation absent significant events such as a major oil producer coming back
online or significant inventory release.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

28th October 2014

Ecstrat

OPEC still impactful, but less flexible

Fig 11 shows that before the recent fall in the oil price, unplanned OPEC disruptions have
actually been running significantly higher than one might expect, with Libya and Iran the
key elements of missing output.
Fig 11. Estimated Unplanned OPEC Crude Oil Production Outages (mbpd)

Source: EIA Short-Term Energy Outlook, July 2014

However, per Fig 12, total OPEC production is actually well above 2010 levels as the Gulf
nations in particular stepped in to replace missing Libyan and then Iranian output in 2011.
OPEC has gradually lost its ability to set prices as it has split into the rich Gulf states and
everyone else. Relatively poorer states such as Venezuela and Iran cannot cut production.
Thus it has become more important to consider what will happen to individual countries
within the cartel rather than the reaction of the whole, as we will now do.
Fig 12. Total OPEC crude Production (kbpd)

Source: Bloomberg, OPEC

Emad Mostaque | John Paul Smith

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28th October 2014

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Saudi myths and legends

There has been significant discussion of the role of Saudi in the oil market during the recent
drop in prices, from nefarious plots designed to put pressure on other oil producers to
bankrupting plucky independent US shale pioneers to questions over its social stability
should oil prices drop below the magical breakeven level.
Fig 13 shows far from flooding the market, Saudi exports actually dropped by 1mbpd
between February and August. This data is from JODI (Joint Organizations Data Initiative),
which typically comes with a few months lag as it is self-reported by contributing members,
but it would not be surprising to see this trend continue.
Fig 13. Saudi Arabian crude exports (kbpd)
8,000
7,500
7,000
6,500
6,000
5,500
5,000
04

05

06

07

08

09

10

11

12

13

14

Source: Ecstrat, JODI

The reason for this despite apparently stable Saudi production, which increased to make up
for Iranian oil leaving the market in 2012 (see the pop in exports) is the increasing internal
consumption of crude for refining as part of Saudi Arabias move to capture more of the
hydrocarbon value chain and diversify its economy through new economic clusters such as
those being developed in Jubail and Yanbu. Internal refinery demand from new plants such
as Satorp targeted at 3.5mbpd by 2016.
With Aramco focusing on gas over oil in the medium term and due to the nature of Saudis
burst spare capacity to 12.5mbpd from current levels, Saudi exports are likely to drop
toward 5mbpd in the next few years.
It is also notable that Saudi crude tends to be heavy crude versus the light crude used by
many refineries in the West. Eastern refineries have adapted to accept heavy crude, but
adjustments in Saudi production are unlikely to affect Western oil balances.
If there is a current glut, it is in light crudes as inventories in Cushing have collapsed and
those in PADD 3 increased in turn, something that also explains the sharp drop in the
differential of Saudi Arab Light to Oman/Dubai and other blends recently and the continued
fall in Saudi exports to the USA.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

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Looking historically, Saudi does not tend to lead in output cuts even when oil fell as in
98/99 and ran deficits for 16 consecutive years from the 1980s as we saw the impact of
oversupply after the oil embargo (to put this in context, OPEC had 10mbpd of spare
capacity). As can be seen by Fig 14 below, the last ten years have been a period of plenty
for Gulf nations, running surpluses even in 2009 when oil prices collapsed (although
average prices were still $60 that year).
Fig 14. Gulf state Current Account % GDP

Source: Ecstrat, JODI

This has allowed Gulf states to accumulate cash reserves of over 100% of GDP on GDPs that
have increased dramatically in this period, for example Saudi Arabia has seen a 50%
increase in nominal GDP in the last five years and a five times increase since the start of the
century. Unlike non-hydrocarbon producers, the governments receive cash directly from
hydrocarbon exports and not a taxation base, so this is real, hard cash in the bank for a
rainy day as opposed to Chinese style reserves that have to be spent abroad.
Given the above factors, it is unlikely that Saudi will adjust oil output absent real local panic
or global economic malaise. Certain characteristics of contracts that they sold in 07/08 also
pushed them to cut production in 09, but even a 1mbpd cut would cause imbalances in the
supply of heavy crude.
We could see a 500kbpd cut easily if other sources come online or we move far lower from
current levels for a reason seen as fundamental. The rest of the Gulf has also increased
production and could contribute another 1mbpd.
We are also unlikely to see Saudi Arabia increase exports due to continued increases
refining needs locally and the need to protect some market share on exports at a time
when global flows are changing markedly. A lower oil price can be sustained by the budget,
with now an ideal time for Saudi to start developing a yield curve for more independent
monetary policy in future and the moves in the Saudi Riyal likely presaging a move to a
basket-based currency system as Kuwait employs in the coming years.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

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Ecstrat

Libya unlikely to kick on in production

Fig 15. Total Libyan Crude Production (kbpd)

Source: OPEC, Bloomberg

After the fall of Qaddafi, the outlook for Libya looked promising, with copious oil wealth
and significant upside potential for an economy that was largely intact2.
Unfortunately, the removal of the existing power structure centered on Qaddafi, a huge
influx of weapons, deep-seated rivalries and influence of external patronage networks have
led to the mess we see today.
While the headlines read Islamist vs non-Islamist, the reality is rather more complex with
competing governments, militias and alliances that are beyond the scope of this piece.
The conclusion is that while we have seen a steady recovery in the oil price as strike action
has subsided and coffers begin to run low, we are unlikely to see production much above
1mbpd over the next year as violence looks set to accelerate, with 120 dead in Benghazi in
the last 10 days alone and external actors becoming more aggressive.
The real danger longer-term is that the two relatively-balanced main factions continue on
the path of resource denial, as occurred in Tripoli airport when Libya Dawn deliberately
targeted Afriqiyah planes when pushing out Zintani militias.
Although hydrocarbon production facilities are relatively well-insulated and remote, the
probability export denial and potential sabotage have increased dramatically and required
investment into aging infrastructure becomes even less likely. This may happen even as the
situation on the ground and in the cities normalizes given the likely territorial split going
forward between the factions and the distance between them, which will take time to
overcome.
2

Re-inventing Libyas economy, Emad Mostaque, August 29th 2011: http://blogs.ft.com/beyondbrics/2011/08/29/guest-post-re-inventing-libyas-economy/

Emad Mostaque | John Paul Smith

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Ecstrat

Iran coming out of the cold

Fig 16. Total Iranian Crude Production (mbpd)

Source: OPEC, Bloomberg

We believe the probability of a nuclear deal being agreed at the end of November is 60-70%
with the chance of the whole thing being called off minimal.
A likely nuclear deal will consist of Iran implementing the IAEA Additional Protocol and
reducing the number of centrifuges from 19,000 to 4,000 or so and agreeing to ship lowenriched Uranium to a third party for enrichment into nuclear fuel plates.
The situation in Iraq and Syria combined with the US pivot toward Asia and adjustment of
relationship with traditional allies makes a deal expedient to ensure a deal even if it
increases Iranian soft power as long as they can ensure no nuclear break-out potential.
On the Iranian side getting to a nuclear deal is a key cornerstone of President Rouhanis
platform, above even domestic issues that, while they have been alleviated this year by
some positive macroeconomic data, are likely to come back to the fore with falling oil prices
unless volumes can be increased.
The likely impact on the oil market would be to remove a key component of the
backwardation in the Brent crude price and introduce around 500kbpd back into the
market of exports, neatly making up for the drop in Saudi heavy oil exports.
Given Irans copious conventional oil and natural gas reserves, there may also be some
pressure at the backend of the curve as the market starts to price in an acceleration of
development of these fields.
Iran is, of course, a tremendously interesting investment opportunity given its profile and
years of being a pariah nation. If you would like more details on how to invest should
sanctions be removed, let us know and we will get you in touch.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

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Ecstrat

Is shale the swing barrel?

Fig 17. US shale reserves and resources

Source: Bloomberg Visual Data

There is a lot of propaganda spewed about US oil and energy production, from claims of US
energy independence to the inflation and conflation of reserves and resources (eg Fig 17
above showing how bullish shale companies are from Bloomberg).
Shale has had a dramatic impact as can be seen by Fig 18 below, reversing US conventional
oil production decline and causing a step change in the flow structure of the nation.
Fig 18. US oil production (kbpd)

Source: Bloomberg Visual Data

Shale has prospered in the US thanks to easy water availability, solid property rights and
easy access to credit, with high oil prices making these fields feasible to develop.
The high initial production and rapid decline rate of shale wells versus conventional ones is
well known and has led some to speculate that shale is now the swing producer as if oil
prices fall below a breakeven level for shale wells, producers will simply shut off
production, pulling supply from the market until the oil price increases.

Emad Mostaque | John Paul Smith

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This logic is flawed however, as the shale gas experience shows us that producers dont
typically shut in producing wells, but rather cut back on new drilling and exploration.
The nature of the shale oil industry is one where the easy availability of cheap finance has
led to cashflow negative, leveraged companies that need to service their debts and make
back their borrowing in the initial production before making profit on the long decline.
In many cases these producers have also hedged or are forced to drill by lease agreements,
although the latter have been cut back after the shale gas debacle. The selling of leases and
secondary market in shale assets also means that not all shale projects are full capex plays,
reducing the marginal costs in many cases due to sunk costs.
Finally, the behavior of shale players is very different to that of strategic governments as
most shale drillers are independent (although some are rather large). Many IOCs were
burnt by shale gas purchases and the cushion of independents to absorb a halting of
cashflow, particularly when many have listed equities, share options and tradable debt, is
minimal, with shale debt doubling in the last four years while revenue has barely increased.
The lower oil prices fall, the faster the reaction will be from producers, with the size of the
reaction increasing the longer prices stay low. This reaction however is likely to be from
those with the pockets to stay in the game, namely the Gulf and low opex deep water mega
fields from IOCs versus small independent players.
The sharpness of the current fall and rapid sell-off in shale asset prices on traded exchanges
will also make raising financing more difficult for these plays. Further pressure on prices
now that we are below the popular marginal barrel of shale cost of $90 may lead to asset
liquidation to preserve cash flow. This would allow IOCs to step in or, in the case of
defaulters, creditors to take over facilities and continue production to maximize recoveries.
Shale production will continue to increase over the next year or two, but we have now
reached the stage where high quality fields in Bakken and Eagle Ford have been identified
and are being exhausted. This shifts the focus to the exploration phase in new fields such as
those in the Utica shale and Permian basin, which are as yet unproven on a large scale.
The pace of capacity addition will decline unless prices move significantly higher from here
and most estimates have US shale production peaking by the end of the decade near
current levels before falling off, assuming positive outcomes from new basins and resources.
Shale is a useful source of supply at the right price and has adjusted the balance of the US
petrochemical market.
It is not, however, a replacement for swing production and mechanism for near-term price
stabilization, nor is it something that will significantly displace conventional, cheap, mega
fields on a global basis. The US Strategic Petroleum Reserve could act in this capacity given
falls in imports, but only on a limited basis given cavern structure.
Shale gas will also experience some sharp shifts in the next year that will most likely put
paid to expectations of a gas-fuelled fleet future

Emad Mostaque | John Paul Smith

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Oil majors changing their tune

Fig 19. Oil majors field production (crude, mbpd)
18

17

16

15
04

05

06

07

08

09

10

11

12

13

Source: Bloomberg. BP, Chevron, Petrobras, Shell, Total, Statoil, Petrochina, ENI, Repsol, BG, Exxon. BP

The oil majors are quite different to shale producers as their focus is on finding and
developing the so-called elephant fields, large fields of typically over 400mb of recoverable
reserves that are becoming increasingly hard to find but would really move the needle.
This has started to show in production, with Fig 19 showing a listed selection of these oil
majors, a mixture of National Oil Companies (NOCs) and International Oil Companies (IOCs),
with production peaking before the 08 crash.
While NOCs continue to spend largely ignoring minority interests and pose a governance
hazard, IOCs have found it increasingly difficult as NOCs become more sophisticated and no
longer need their help, or in the case of Iraq, were too stingy to give out production sharing
agreements, paying only dollars per barrel. This meant that their niche became these large,
complex, expensive projects, particularly deep and ultradeep sea production.
Productivity of capex has fallen by a factor of 5 since 2000 by some estimates and continues
to decline by over 5% per annum, with costs outpacing revenues and margins solidly down
despite oil prices over the last few years higher than many expected (indeed, returns on
equity peaked in 05 when oil was at $50 a barrel)
The onus is now (in some cases explicitly) on quarterly cashflow versus production
increases, with the focus on dividends and near-term shareholder and option value gains
versus long-term growth. Solidly negative free-cash-flow looked to be turning the corner,
but with the recent oil price volatility, spending may be reigned in further.
With the sharp increase in capex per barrel costs over the last decade, oil and gas spending
has become an increasingly important part of US capex and fixed asset investment, over
20% from levels of under 5% at the turn of the decade. A slowdown in capex by majors in
favour of divestment of non-core assets and spending bodes ill for future replacement
production as well as a capex-led recovery in the US and sustainably low oil prices.

Emad Mostaque | John Paul Smith

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Conclusion: Could drop to $70s, next year $90-100, $130 in a few years
In Dantes Inferno, Canto XX, Dante and Vergil encounter the soothsayers, doomed to walk
with their heads forever facing backwards.
Prediction is a dicey game and while there is significant uncertainty around a changing oil
market, there are some key overarching factors that the market may not be properly
discounting.
The main one of these is the end of the super-cheap, mega-field era and the continuing
decline in capex from multinational oil companies and state oil companies worried about
low oil and finding an increasingly difficult financing and political environment. The focus of
IOCs on cashflow and dividend payments is also undermining long-term gains.
Small, independent shale oil companies are flourishing, but can only add so much capacity
and are targeting the sweet spots now. These too are likely to find financing more difficult.
Absent significant technological leaps or a sharp slowdown in the global economy, the
backend of the curve is likely to move higher as a result of low prices and the sharp increase
in volatility we have seen.
The likely continuation of low rate policies by major central banks globally and continued
geopolitical flare ups and issues with pricing structures are likely to keep Brent in a level of
backwardation and it would be surprising to see Brent-WTI spreads gap out again given the
sharp decrease in inventories and infrastructure now in place there.
By 2017/18 we should see continued conventional declines (particularly from Russia, a
topic for another day) and a peak in tight oil lead to a very tight market, even if Chinese
growth has subsided to 4% and Iran has come online, likely pushing oil prices toward $130.
Lower oil prices may be tempered by a stronger dollar, but the tendency for them to be
below their recent averages may well provide a boost to global growth, with sharp moves
down such as the one we have seen now leading to rapid consumption responses from the
Chinese already. It is notable that total energy spending in the US at $1.3tr is barely lower
than the 2008 peak.
In the near-term, our concerns on China, a potential Iran deal and my personal concern
over US profit margins and potential fall in risk assets means that liquidations could take us
down to the mid $70s for a brief period into 1Q, with $77 (Brent) a level that the Gulf will
consider cutting back production.
It is not the time to buy energy-related companies yet, although we may well see a decent
counter-trend bounce now given a level of stabilization and sharp switch in positioning in
contracts that are more susceptible to sentiment swings.
On oil I am a buyer of both Brent and WTI, although Id prefer 2018/2019 oil to spot and
would average in. Below the mid $70 level Id be a straight out buyer of oil and oil-related
securities, which would likely be decimated at these levels.

Emad Mostaque | John Paul Smith

emad@ecstrat.com | jp@ecstrat.com

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