IEEJ：November 2015, All Rights Reserved.

The Current and Future State of World Oil Markets
The Institute of Energy Economics , Japan
November 17, 2015

David Knapp
Chief Energy Economist

Powerful Thinking
for the global energy industry

IEEJ：November 2015, All Rights Reserved.

The Current and Future State of Global Oil Markets

Agenda Why did the 2014-15 oil price decline happen?
 How have the roles of key players changed?
 Where are we in the adjustment process?
 The direction of market-based adjustments are clear, the pace is not.

 Where will we be at the end of 2015 and what about 2016 and beyond?
 What is going on in the main US shale areas?
 Which outside and inside factors now have the most influence on oil markets?

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The Current and Future State of Global Oil Markets

Dr. David Knapp Biographyres Dr. David Knapp is Chief Energy Economist and Senior Editor for Global Oil Market
Analysis at Energy Intelligence. He also contributes regularly to several EnergyIntelligence publications including Petroleum Intelligence Weekly, Energy Compass, Oil
Daily, Energy Intelligence Finance and International Oil Daily.
 Before joining Energy Intelligence in late 2000, Dr. Knapp was a senior official with theInternational Energy Agency in Paris and Editor of the IEA’s Monthly Oil Market Reportthrough much of the 1990s. He has analyzed energy markets for more than 45 years in
the international, government, business and financial sectors as Energy Economist andEnergy Team Leader for the Wall Street banking and investment firm of Brown Brothers
Harriman & Co. throughout the 1980s, after starting his career at the Federal Energy
Administration/Department of Energy and then Chase Manhattan Bank’s Energy
Economics Division in the 1970s.
 Dr. Knapp holds a Ph.D. in Economics from the University of California at Santa Barbara
and is a member of numerous professional organizations in the energy area. He was afounder and currently serves as President of the Board of the New York Energy Forum.
He is also a Senior Fellow of the US Association for Energy Economics and is the incoming
VP for Business. He has served on various USAEE committees, as well as being an
appointed Advisor to five recent USAEE Presidents. He is a Charter Member and former
council member of the parent IAEE and is a reviewer for the organization’s Energy
Journal. Dr. Knapp holds the IAEE 2007 Award for Excellence in Written Journalism.
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The Current and Future State of Global Oil Markets

How and Why Did The Price Collapse Happen?

s The prime cause of the oil price collapse was not Opec’s Nov. 27 decision, Opec’s
decision was a reaction to something else.
 The price collapse was the consequence of the birth of the “Shale Era”; changing
the rules oil markets have lived by for decades.
 The Shale Era is more about how geologists think about their job than about thetools and information they have. Technology affected the growth, not the event.
 Source rock as a target, rather than an afterthought, caused the US supply surge, notoil prices, horizontal drilling, multilateral wells or hydraulic fracturing.
 The oil world has been confronted with a new, huge, producible resource base andwas able to produce it economically at prevailing prices.
 Saudi Arabia couldn’t change the resource base, so they have chosen to change theeconomics..

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The Current and Future State of Global Oil Markets

Changing Roles for Key Players: Who is Doing What?
 Saudi Arabia convinced Opec to hold production and allow prices to drop: thealternative of cutting to make room for more non-Opec supply made no sense.
 The rest of Opec went along, because they had to. Without the leverage of Saudi
spare capacity Opec isn’t much of a cartel -- to the extent it ever was.
 Non-Opec has now involuntarily assumed the dreaded “swing producer” role.
Saudi Arabia has been there, and doesn’t want to go back.
 Opec and specifically Saudi Arabia’s new role is chief “sitter and watcher” -- for signs that the“experiment”, as some Opec delegates dubbed it back in November, has succeeded.
What those signs are neither we, nor probably they, know.
 And the US shale industry does not come close to meeting the criteria for swing producer

 The price decline will continue “until it works” shutting in significant/sufficientamounts of non-Opec supply, from Opec’s standpoint preferably from US shaleareas -- the prime source of the glut – but a barrel gone is a barrel gone.
 The answer to an increasing number of queries asking “Are we there yet?” -- as is usually thecase -- is “No.” The similarly cliched response to “When will we get there?” is “When we get there.” But this is far from a car ride with small children, it is a roller coaster ride carrying an entire
industry with it along with fortunes to be made and lost by countries, companies and investors
by coming up with more creative answers.
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The Current and Future State of Global Oil Marketsc

Where Are We in the Process?
 Phase 1 of the “experiment “ was to drive down prices, a process that was wellunderway by the time of the Nov. 27 Opec meeting, but intensified thereafter.
 Phase 2 is the effect of the ongoing surplus on inventories both inadvertent -there is too much oil -- and intentional as contango makes holding oil profitable.
 Phase 3 is occurs when Phase1 works, forward price curves flatten andspeculative stocks reenter the market en masse blunting price recovery.
 If Phase 1 works slowly, and Phase 2 continues for quite a while, there may be
another phase to consider: Phase 2A would occur if and when the world “runs out” of storage. But capacity is a moving
target as onland tanks can be built relatively quickly and there are always more boats, at a price.
 In any case Phase 2A would accelerate the Phase 1 price decline process, as distressed
cargoes begin to show up on tanker markets and force shut-ins at the wellhead.

 Phase now are overlapping with Phase 1 and 2 both ongoing. Phase 2A hasn’t
happened and Phase 3 lies ahead affecting the shape of any price recovery.

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The Current and Future State of Global Oil Markets

Direction of Adjustments is Clear, the Pace and Shape are Not
 It is clear, for oil supply, lower oil prices mean lower supply; for oil demand,
lower prices mean higher demand.
 But there are a number of reason why the process could be quite slow;
 forward momentum for US shale projects is first and foremost, especially in key shale areas like
Eagle Ford and Bakken,
 supply decision have short run and long run components put in other terms operating costs aremuch lower than all-in finding and development costs,
 high sunk cost of major high cost projects like deepwater in Angola, the US Gulf, Brazil suggest
those near completion will be finished despite the price level, demand effects are asymmetric (“you don’t rip out insulation at lower prices”), and like supply
have short term (utilization) and longer-term (equipment choice) components.

 For both supply and demand the long term adjustment components are
generally larger than the short term adjustments – but can be brought forward
by altering near-term effects on price expectations.
 In the “alphabet soup” of oil price recovery trajectories, the basic choices are
V (snapback), U (extended trough) or W (maybe a sequence of Ws with volatility
aborting attempted price recoveries).
 For now what is looking most likely is a long lumpy-bottom U with a weak rightleg, that could turn into an ascending warped-W with a sporadic Phase 3.
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Geopolitics and National Energy Security in the Evolving Sahle Era

Supply-Demand Price Responses are Not the Whole Story

 Absent significant economic events demand is expected to grow by 2.12 million b/d
this year and non-Opec supply increases by 1.81 million b/d assuming delayed
price responses. Inventories continuing to build and prices continuing to decline.
 Opec NGL and other production will see a moderate 200,000 b/d rise again
assuming no extraordinary events and Opec crude adds about 1.5 million b/d.
 These Opec additions assume the financial pressure of the lower oil price on balanceof payments, government budgets don’t spawn production-inhibiting upheavals.
 Iraqi growth especially in KRG, sputtering Libyan recovery and more creative
Iranian sanctions busting are responsible for most of the crude increase.
 Demand responses will be depressed by currency movements in favor of the dollar,
the evolution of subsidies, while supply will vary with fiscal policy changes and themost importantly financial health or lack thereof among producing companies.
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The Current and Future State of Global Oil Markets

US Shale is Not the Only, or even the Major, Supply in Play

 Russia’s flat 2015 and 2016 decline has as much to do with effects of sanction as
prices, while China’s is more about aging, likely over-produced fields, mainly Daqing.
 Five other top 16 non-Opec producers are seen declining this year -- as well as
refinery processing gains -- many unrelated to price, one more than in 2014.
 Growth has been dominated by the US; but 2016 declines elsewhere are muchbigger than US slowing growth, 2015 US slowing nearly matched non-US declines.
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The Current ansd Future State of Global Oil Markets

What to Watch for – The Adjustment Process
 How much oil supply responds will be the main criteria in evaluating the
success of the Opec/Saudi strategy; the strategy is not about a price level; slowing growth in the US, Canada, Brazil and the few other “grower” countries,
 accelerating declines in the China, Russia and several other mature areas, and possible switches from “grower” to “decliner” for places like heavy oil laden Colombia

 Demand growth will play a lesser role next year after a surprisingly good 2015
validating earlier Opec rhetoric and will be in play over the medium term; watch the US, China and India, in particular, and any possible help from lower oil prices forfragile European finances or Japan’s struggling economy, as well as any inter-fuel events that limit supplies or raise prices of competing fuels like coal, nuclear , LNG
or renewables.

 Inventory levels and the adequacy of storage capacity and particularly the onsetof any distressed cargoes would be major signals.
 Fiscal policy changes being adopted (UK) or considered in a number of place
could prolong the adjustment by improving upstream economics so as to lower
decline rates and maybe justify completion of new projects.
 On the other side of the spectrum geopolitics have not disappeared for oilmarkets, watch in particular, IS in Iraq and Syria (and Libya and maybe
elsewhere). Yemen, the Sudans, Nigeria, Venezuela, Ukraine/Russia….
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The Current ansd Future State of Global Oil Markets

Where Will We Be at Yearend and What’s In Store for 2016?
 “One man’s judgment”: prices will be lower than they are today, forward curves
will still be in contango, inventories will still be building; Saudi Arabia sits tight(King Abdullah’s death and adventures in Yemen notwithstanding) -- why?
 Because there will still be too much oil – supply, demand responses are slow to materialize andhave an unexpected composition -- less early US shale cuts, more cuts almost everywhere else.
 Supply reductions likely come from non-shale US closures of stripper wells and California
Central Valley steam flood operations. Non-US accelerating decline rates account for slightly
more than the net supply growth reduction in the US.
 Storage capacity will be added fast enough to avoid distressed cargoes, while non-OECD
infrastructure expansion will continue to provide a home for some 400,000-700,000 b/d in pipes,
terminal and intermediate tanks, as has been the case for the last few years.
 Strategic reserves will be built further in China and India and perhaps elsewhere in Asia to takeadvantage of the progressively lower oil prices.

 Oil market landscape for 2016: Will see much larger downward supply adjustments, but maybe a bit less demand increase after
a surprising 2015 response led by US; a flattening forward curves causing the emergence of large volumes of stored crude; a slow, wide-bottom U price recovery, bringing back more US shale tilting the right side of the U.

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The Current and Future State of Global Oil Markets

There are an Interesting Range of Supply-Demand Opinions

Sources: Energy Intelligence, Oil Market Intelligence, Sep.15'15; International Energy Agency, Oil Market Report, Sep.11'15;
Opec Monthly Oil Market Report, Sep.14'15; US Energy Information Administration, Short Term Energy Outlook, Sep.9'15.

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Geopolitics and National Energy Security in the Evolving Shale Era

Price Outlook for 2015 -- One Man’s View ()

subject to major changes without notice Since the fundamentals and thegeopolitics are expected to be choppy, so
will the downward price trajectory Much of the work was already done on
prices in 2014, it is now for thefundamentals to catch up Brent should be more volatile than WTI,
since geopolitics have a much bigger Brent
effect and US shale supply changes areseen being less than expected Jan-Feb and Q2 prices bumps, based on
financial side positioning andexpectations, delayed the process but
could be overtaken in the second half.
 Geopolitical events would appear to be
more relevant earlier rather than later for
Nigeria, Venezuela, Iraq, but financialpressures are cumulative

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The Current and Future State of Global Oil Markets

The Evolution of 2015 Prices Has Been Anything But SmoothSource: January - New York Energy Forum, "2015 Oil Market Outlook"; February - CSIS, "Energy Market Impacts of Low
Oil Prices"; March Saudi Aramco Energy Week, "Global Oil Markets in a New Lower Oil Price 'Shale Era"'; April - CERIWorld Oil Conference, "Energy Market Impacts of Low Oil Prices"; May - client presentation in London, Paris and Madrid,"Energy Market Impacts of Low Oil Prices"; June - client presentations in Houston, "Shale Era Challenges Oil Market
Traditional Structures"; July-August - internal estimates. September - client presentations in Europe. All by David Knapp.
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The Current and Future State of Global Oil Markets

Current Supply-Demand Response Only Half the Storyu Some believe Saudi/Opec’s strategy has always had a longer-term component: to assure
oil’s role into the next decade, maybe with it being produced sooner rather than later.
 Arguably the bigger “success” for the strategy is delays and cancellations of the nexttranche of competing non-Opec oil from deepwater and to a lesser extent the Arctic
rather than the immediate reversal of US shale area growth..
 The small surplus from 2014 is expected reach 1.5 million b/d this year and further in
2016. It begins to come down in 2017 and turns modestly negative in 2018. Given thecurrent trends of non-Opec project cancellations, and lack of Opec capacity additions
outside of Iraq, Iran and a couple of Gulf members, the deficits look serious by 2020.
 Accumulated inventories and growing non-OECD Asian SPR give some protection, buthigher price toward the end of the decade are quite likely.
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The Current and Future State of Global Oil Marketsres Focus on US Shale Areas US oil shale area production is reversing a multi-decade decline
 Eagle Ford and Bakken core areas dominate More diverse Permian and Niobrara contributing but most vulnerable
 High-grading is keeping up momentum in sweet spots, at expense of
future performance of marginal areas and secondary shales

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The Current and Future State of Global Oil Markets

A Reconfigured US Oil Production Landscape

Sahle Era

The US was an aging oil province, now reinvigorated by oil shale North Dakota has moved into the #2 position
behind Texas, surging ahead of declining
Alaska and California.
 Alaska has dropped behind California and is
at barely more than a quarter of its peak.
 The country as a whole is not much morethan half its 1971 peak, while Texas is fastclosing on a new state record..
 But besides North Dakota, New Mexico andColorado are making new peaks and are
expected to do so for several more years.
 Some small producer states are also at orclose to records; South Dakota, Missouri
and Utah.
 Many states are at less than 10% of theirpeaks, but a few of them have some shale
exposure. For all states, declines in thevery mature conventional areas are being
accelerated by low prices.
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The Current and Future State of Global Oil Markets

The US Light, Tight Oil Surge Has Changed the Global Oil Market
The US shale liquids are dominated by North Dakota and Texas
 More than half of expected 2015 crude
oil growth comes from North Dakota
and onshore Texas which are also
major contributors to another 242,000 b/dof growth in US natural gas liquids.
 Shale-based increases in crude oil,condensates and NGLs is even larger assome of the increases go to offsetting
declines in conventional oil and NGL
output from other parts of Texas andNorth Dakota.
 Nationally, several states without
significant shale development continue todecline, noticeably Alaska, California
and Louisiana and shallow water Gulf
of Mexico.
 But New Mexico’s Permian Basin
exposure and Colorado’s Denver-Julesburg Basin Niobrara sand have madesignificant contributions to rising US
supplies. Montana Bakken not so much
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The Current and Future State of Global Oil Markets

Understanding the Bakken “Shale” Oil Area
Key US growth area
 Geographically, the Bakken area is a part of the larger
Williston Basin that contains a number of other productive
sands but nothing close to the productivity of the
Bakken/Three Forks.
 Bakken output, primarily using the same method as shaleareas, now represents over 98% of state output.
 With Bakken’s remote location/short pipeline capacity., rail
costs have become more important than production costs.
Harsh climate and small population are additional
disadvantages putting the Bakken on the front lines of
price-induced production cuts..
 Reliance on rail transport comes with difficult crude oil
quality standards and shut in of some oil as have flaring
restriction and lacking gas off-take capacity.
 Producers are cutting spending but continue to exercise
drilling options to hold leases but not completing somewells . Some already-completed wells are not hooked up
yet for lack offtake space.

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The Current and Future State of Global Oil Markets

The Texas Eagle Ford the “True Shale Play”
Location and developed infrastructure give it an advantage over the Bakken
 Bakken is conventional oil in a shaleenvironment, Permian is a mixed
shale/non-shale play with the non-shale
portion dominant.
 Shale zones account for most of the Eagle
Ford area liquids under 23 counties ineastern and southern Texas, 12 fields
currently produce liquids often from undermultiple countries. Output now exceeds 1.5
million. Infrastructure is highly developed,
political environment is strongly positive The Eagleville field is by far the mostproductive responsible for more than 75%of the liquids output of the Eagle Ford,other fields include Briscoe Ranch, DeWitt,
Sugarkane.
 Supply logistics are highly developed
skilled labor is of the highest order and the
local communities are exceedingly
receptive. Nearby refineries are readycustomers and exports are even possible.
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The Current and Future State of Global Oil Markets

Two Other States Are Contributing to the Shale Revolution
New Mexico and Colorado have seen localized but significant gains
 Virtually all of New Mexico’s oil output
comes from two counties, Lea andEddy, with only small amounts from
Chavez county all n the southeast
corner of the state. Northeast corner isa gas area.
 Five of Texas’ Delaware Basin Permiansands cross the border into New
Mexico and are being exploited by anumber of small and medium sizedcompanies.
 Water resources are an issue but thestate is generally seen, like Texas andNorth Dakota remains “development
friendly.” Shale growth dominates
declines from non-shale areas.
 Colorado has a much larger number of basins, but only the Denver-Julesburg (DJ) in the northeast part ofthe state is a significant shale liquids area, primarily Niobrara shale in the Wattenberg field ..
 Colorado’s other large conventional field Rangely in the Piceance Basin has been in decline for a numberof years. The state is decidedly split and is a battleground on hydraulic fracturing.
 A number of D-J fields have potential to contribute and there are a couple of other untapped Niobrarabasins like the North Park Basin in the north central part of the state and some of the western basins.
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The Current and Future State of Global Oil Marketsres No Oil Market is an Island The advent of paper markets brings with it asset allocation influences
 Physical market interactions have also become more intense Oil also lives in a world of inter-fuel and inter-factor competition Headline driven oil price movements are increasingly financial
 But classic geopolitics still can paly a supporting (or depressing) role
 One great irony of the current oil market is Middle East geopolitics
being more threatening than ever while oil production makes records

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The Current and Future State of Global Oil Markets“Outside” Influences on Oil Markets and Prices
Financial drivers, geopolitics, domestic policies and regulation all play a role
 Physical balances and supply logistics, are not
only affected by the physical market but
interact in a dynamic way with financial drivers.
 Correlations between factors that affect oil
prices are very sporadic flipping from very tightto virtually zero from year to year or month tomonth, tightening and loosening. But ingeneral physical market factors currently
dominate the trend.
 But financial factors and the market sentiment
they reflect still matter in variations around thetrend; i.e. the recent “dead cat bounce”
 Oil pricing in dollars enters currency a into oil prices with a physical market as products and laborcosts relate to local currencies, as seen in the regular monthly Oil Market Intelligence chart above.
 For a net oil importing economy like the US, stock prices (the S&P) should be negatively affected byhigher prices, but to the extent economic optimism or pessimism drive prices of both share and oil, acounterintuitive positive correlation can result.
 Even if oil-dollar or S&P-oil correlations are flawed, if trading strategies are based on the perceived
correlation, the relationship becomes a self-fulfilling prophesy—until it doesn’t.
 Public policy similarly will push prices around, with economic stimulus, variations in price subsidies
common examples. US state and local hydraulic fracturing rules are another.
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The Current and Future State of Global Oil Marketsres Physical Markets Have Become More Complex, Higher Velocity
 Inside the physical oil market interactions between the Atlantic Basinand East of Suez markets interaction is complex, with gluts in both.
 Light-sweet & heavy-sour differentials are swinging cross-regionalflows.
 Linkages between crude markets and product markets are dynamic
as pricing power ebbs and flows.
 Refiners sit in the middle with their own external influences includingtransport logistic for crude and product and continuing environmental.
 Oil is also only one fuel choice in energy markets and energy is only
one factor of production.
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The Current and Future State of Global Oil Markets

 Financial Market Drivers Dominate Physical Drivers More Often
 The advent of paper markets brings with it asset allocation influences Events in stock markets, currencies, bond markets now can affect oil
 Interactions are complex -- what affects banks, affects oil lending China’s stock market crash, strong dollar, QE2; “the new geopolitics”
 But old style geopolitics is “alive and unwell”

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The Current and Future State of Global Oil Market

Geopolitical Hotspots Support For Oil Prices Has Waned
And cooling tensions could soften prices where additional oil is forthcoming Focus has shifted from geopolitical supply interruptions to market surpluses But there remains a long list of hotspots including Iranian nuclear deal as well as Ukraine-Russia
and related sanctions.
 The most visible concerns surround Islamic State in Iraq, Syria and its a growing presence in
Libya joining supply crippling internal factional conflicts.
 Yemen and Sudan are currently “hot” but like Syria and, to a lesser extent, even Iraq have more
upside than downside for supply prospects. But Nigeria still has more to lose than gain.
 Low oil prices are exacerbating Venezuela’s already disabling economic and oil production
problem with social unrest appearing to be growing. Ecuador faces similar difficulties despite
improved performance and prospects.
 Colombia faces some internal political problems, but its oil production problems are more market
related due to the preponderance of heavy oil facing stern competition in the key US market from
Canadian oil sands supplies. Brazilian scandals look more relevant beyond the near term.
 The effects of low oil prices on the geopolitics of the Mideast Gulf are very different, but Iran’sinternal and external political context will have a material role in oil market developments beyond
direct market developments.
 Similarly Iraq represents both the largest potential upside production potential and the largest
potential losses from internal conflict between the Federal and KRG governments and the external
threats not only from ISIL but also complicated interrelationships involving Iran and Turkey. .

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