Lighthouse Investment Management

Special Report

Understanding Oil

Special Report - Understanding Oil - May 2015

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Lighthouse Investment Management

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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Executive Summary
Here are the key take-always from this report:

1. Oil, even at $100 per barrel, is incredibly cheap.

2. Demand and supply for oil are price-inelastic. Which guarantees large price
swings.
3. Oil and gas deposits and consumers are millions of miles apart, making
transportation the weakest link.
4. OPEC is not a cartel. But Saudi-Arabia controls the price.
5. The 167th OPEC meeting takes place June 5th in Vienna. Production quota
will not be cut, leading to another fall in oil prices.
6. The USA are generally not interested in a low oil price, unless Russia needs
to be "punished". Non-US oil importers need between $500bn and $1trn US
dollars annually to pay for oil. Global consumers help finance purchases of
US-made weapons by oil-exporting nations, securing employment in the US
and destabilizing the Middle East.

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Incredibly Cheap Commodity
Look at the price of crude oil compared to other liquid consumer products:

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Demand and Supply - Inelastic to Price
Demand is price-inelastic

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

Oil rigs in the Gulf of Mexico. Source: Wikipedia

Supply is price-inelastic

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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Consequence of price-inelastic demand and supply:

Small imbalances between demand and supply can (and will) cause large price swings

Options for producers in case of large drop in oil price

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

If you don't want to sell, you need to store your oil

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.

Oil storage tanks in Cushing, OK

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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Geo-Politics: The Scramble for Energy
At current reserves and production rates global oil reserves will last for another 70 years:

The ten countries with the most oil

reserves make up almost 90% of global
reserves. Only 17% is controlled by
"adversaries" of the United States
(China, Russia, Iran).

New oil discoveries have

been limited to expensive
(deep sea, Venezuela) or
environmentally
questionable (fracking,
US and Canada) sites.

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Oil is not located in the energy-hungry industrialized countries (US, Europe), nor near the fast-growing
centers of population in South-East Asia (China, India). It needs to be transported from areas of
production to areas of consumption.
Global Oil Reserves: Top 10 Countries

Source: Wikipedia, World Map Maker, own calculations. (c) Lighthouse 2014

Per day, an average of 14 tankers

carrying 17 million barrels of oil
have to pass through the Strait of
Hormuz. This represents one
third of the world's seaborne oil
shipments and one fifth of all
global oil consumption.
The Strait of Hormuz, only 20
nautical miles wide, has one
inbound and one outbound
shipping lane (to avoid risk of
collision). Each is only two miles
wide.
Iran, a US foe, borders
immediately to the North.

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In order to ensure continuous flow of oil and gas, US and Russia have deployed military assets all over
the world:
US and Russian Military Presence

Source: Wikipedia, World Map Maker. (c) Lighthouse 2015

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Almost half (45%) of global gas

reserves are in Russia, Iran or China,
not among the best friends of the
United States.

New gas discoveries

are mostly located
outside the sphere of
US influence (with the
exception of Qatar).

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Similar to oil, global gas reserves are located away from large consumers (with the exception of the US):
Global Gas Reserves: Top 10 Countries

Source: Wikipedia, World Map Maker, own calculations. (c) Lighthouse 2014

Natural gas prices vary

significantly by location.
Fracking has led to an
abundance of gas in North
America (and subsequently
low prices). The idling of
nuclear power plants after
Fukushima and demand for
fossil fuel in Japan is keeping
Asian prices at up to ten
times the level in the US.
The US would love to export
its gas to European and Asian
markets, but needs to build
up gas liquefaction plants /
terminals. Abundant Russian
gas could interfere with such
plans.

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Pipelines are, for now, the preferred means of gas transportation:

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German receives about one third of its gas from Russia:

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Russia would like to pipe gas to Western European consumers, preferably avoiding crossing politically
hostile territory (such as Ukraine). Nord Stream is a good example.
The EU foiled Russian plans for South Stream, exerting considerable pressure on Bulgaria, by citing
antitrust concerns (Gazprom wants ownership of pipeline).
Russia quickly recruited Turkey for an alternate solution (Blue Stream, which could avoid Bulgaria by
traversing via Greece towards Italy). However, Turkey is a NATO member and close US ally.

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It is therefore possible the US will let Russia build an expensive pipeline through Turkey, only to cross
those plans later and realize its own ambitions via the Nabucco pipeline.

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Syria has strategic importance for any gas flow from recent discoveries in the Levantine Basin as any
pipelines towards Turkey need to cross its territory (in order to avoid bordering Iraq).

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Russian Ambitions for Euro
Euro-Asian
Asian Economic Powerhouse in Peril
As detailed in the report "Geopolitical
Geopolitical Game of Power in Ukraine" (November
November 2014), the US provoked
Russia to annex Crimea by turning Ukraine "around" towards EU, and
and,, possibly, NATO membership. With
the Russian Navy in Sevastopol and its only access to ice-free water in danger, Russia had little choice
but to act. The US then compelled the EU to join harsh economic sanctions on Russia. However,
H
the
worst pain is inflicted on Russia by sharply lower prices for oil and gas, as its economy is very dependent
on income from energy:

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The Russian Ruble lost more than half of its value against the US Dollar:

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.
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If oil prices are deemed too low, the Saudis will increase the premium at which they are willing to sell oil
to their customers. Customers will then move to other suppliers, causing a tightening of the oil market.
The Saudis will sell less oil, leading to rising prices, but will credibly deny any responsibility.
responsibility
In the opposite case, Saudi Arabia will sell its oil at a discount to global benchmarks. Customers will flock
towards Saudi oil, and Saudi Arabia commits to satisfy any demand at those prices. The global oil market
is being flooded with oil, with predictable effect on oil prices.
This pricing mechanism is rarely mentioned in any publication. But if works, as relatively
elatively small
imbalances of demand and supply have an over-proportional effect on prices (especially in a market
with price-inelastic
inelastic demand and supply).
Squeezing Russia financially
inancially has repercussions for other nations, too. German exports to
t Russia are
down by about one third in the first months of 2015.

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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Saudi Arabia has enough reserves to weather the storm
storm:

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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Any questions or feedback highly welcome.

Alex dot Gloy at LighthouseInvestmentManagement dot com
Twitter: @gloeschi

Alex Gloy

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