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Special Report
Understanding Oil
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Contents
Executive Summary....................................................................................................................................... 3
Incredibly Cheap Commodity........................................................................................................................ 4
Demand and Supply - Inelastic to Price ....................................................................................................... 5
Geo-Politics: The Scramble for Energy........................................................................................................ 10
Russian Ambitions for Euro-Asian Economic Powerhouse in Peril ............................................................. 21
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Do you drive less if gasoline price goes up by 10%? Do you heat less? Do you drive more just
because oil is cheap?
A very large price move is needed to influence oil consumption
Now that most "low hanging fruit" have been harvested, drilling for oil is expensive
Price ranges (new / used) vary from "jack-up" (shallow off-shore, $75-175m), semi-submersible
(deep offshore, $100-400m) to drillship ($300-500m). Daily rent ranges from $100-500m.
Operating an oil rig can cost $50m a year in the Gulf of Mexico, and $360m under harsh
conditions of the North Sea or the Arctic.
Removing an oil rig completely can cost up to $50m
Once a well has been plugged and abandoned it is often difficult and not economical to reopen.
It therefore takes a long time for production to react to changes in the price of oil.
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Small imbalances between demand and supply can (and will) cause large price swings
Stop production. Might be feasible for inexpensive on-shore (but, since this is the cheapest oil, it is
also the last to be cut off). Off-shore oil rigs employ each between 50 and 100 people; that number
doubles to account for rotation of crews. Including support services, a rig might support up to 1,000
people. If you stop production, revenue stops, but costs continue. If you fire all staff, it might be
difficult to re-hire and re-train a complete crew once oil prices recover.
Keep producing and selling oil. At least you cover some of the variable / fixed costs.
Keep producing, then store the oil (possibly locking in a better price by selling oil futures). This
requires for storage to be available.
Oil storage
Monthly storage costs vary from $0.25 per barrel (salt cavern) to $0.50-0.75 (tank) to $0.75-$1.40
(ship). Assuming a $60 oil price and $1 monthly storage cost you would lose 20% of value within a
year!
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Storage capacities usually fill up quickly after a sharp drop in oil prices (see above chart). Prices for
storage increase. In the second half of 2014, 25m barrels of crude were stored in oil tankers. By
March 2015, US storage capacity usage had risen to 70%, the highest since 1935. However, the
delivery location for exchange-traded oil futures is Cushing, Oklahoma (which is land-locked and
hence only accessible by pipeline). Total storage capacity in Cushing is 6.6m barrels, and all tanks are
fully leased through 2015.
Can you see what is going to happen? Producers don't want to sell their oil at low prices ("on the
spot", or at the spot price, for immediate delivery). They want to sell at a higher price in the futures
market (for delivery in, for example, six months). However, they need to find storage. And it only
makes sense to store the oil and sell it at a later date if the futures price is higher than the spot price
and compensates for storage costs. So "spot" oil will have to trade at a discount to futures. This is
called a "contango". The opposite (spot price is higher than futures prices) is called "backwardation".
The oil market moved from backwardation in summer 2014 to contango after OPEC failed to cut
production at their last meeting (November 27th, 2014).
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The above chart shows the price curve for various delivery months (for example: CL3 = delivery in
three months) at different moments. The next chart shows the premium or discount from spot. In
recent weeks, the oil price has recovered significantly, and the steep contango is receding.
Recovering spot prices have made it less attractive to put oil into storage.
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The US Oil Fund ETF (USO) holds 41,461 July 2015 oil futures contracts. Each contract is for 1,000
barrels, so the fund is holding the equivalent of more than 41m barrels of oil. This is an example how
demand from financial investors helps keeping commodities off the market. However, this might
change, and could potentially lead to sharp price movements for oil.
A recovery in oil prices does not necessarily mean a change in the supply and demand balance. It
might merely mirror short covering of futures positions by financial investors, increased storage
capabilities or altered market expectations by producers.
The next OPEC meeting will take place June 5th, 2015 in Vienna. Russian President Putin will meet
with OPEC representatives on June 2-3rd, trying to convince them to agree on production cuts. As
far as I can tell, market participants do not expect a production cut. With economic growth slowing
in China, US and Brazil, the excess supply in the oil market is likely to continue. A further drop in the
oil price would be inevitable. Dollar strength, and, accordingly, Euro weakness could be the
ramifications.
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Source: Wikipedia, World Map Maker, own calculations. (c) Lighthouse 2014
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Source: Wikipedia, World Map Maker, own calculations. (c) Lighthouse 2014
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Mainstream media does not tire to repeat the myth that Saudi Arabia had opened the oil spigot in order
to "defend" market share against US shale oil and gas. Given implications for the oil price (drop by more
than 50%) this seems nonsensical. Why would you lose 50% of your revenue in order to defend a few
percent of market share? Even if some US fracking companies will be driven into bankruptcy, fracking
rigs will return as soon as the oil price recovers (as they are inexpensive, and have a much lower lifetime
anyway).
The recent collapse in oil prices is a repeat of 1986, when Saudi Arabia "lost patience" with noncompliant OPEC members and drove oil prices down to $10/barrel.
Saudi Arabia is a large recipient of US military goods. Without those it would probably not exist. The US
is its guarantor of security. In return, Saudi Arabia receives instruction on what to do with the oil price
from Washington. US rapprochement with Iran might have been merely a ruse to ensure Saudi
compliance with US requests.
Saudi Arabia produces only around 10% of global oil. However, it dominates its price. The Saudis do not
set absolute oil prices; their pricing is usually expressed as a premium or discount to a benchmark price.
Special Report - Understanding Oil - May 2015
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German banks claim not to be exposed, but that would be surprising given economic ties (ex-chancellor
(ex
Schroeder being on the board of Gazprom
Gazprom-owned Nord Stream). According to Citigroup, SoGen alone
has 25bn exposure (or 60% of its tangible eq
equity). Deutsche Bank and Commerzbank
nk reportedly have
EUR 5bn each (Commerzbank had common tier 1 capital, based on Basel III, of EUR 20.7 at the end of Q3
2014).
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Russian $-denominated debt is not so much at the government as at the company level:
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Audi halted car sales in Russia on December 16. Many companies will be affected:
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The estimated excess supply in the oil market is set to continue. What does Washington want to
achieve? Putin will have to agree to withdraw from Eastern Ukraine (excluding Crimea). Battles for
dominance and control of oil and gas flows from the Middle East will continue.
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Alex Gloy
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