EA-MJOrlando - NAPE Denver slides - 1610

Valuation Assumptions

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● our analyses must include a broad range of considerations

sector - wide (macro) project - specific (micro)- economic considerations - technological

considerations- commercial

considerations<--------------- political considerations ---------->

Oil – recent historyCrude Oil Prices

US EIA, data updated September 2, 2016Economic Advisors, Inc., Denver 3

$/bbl

Oil – recent historyCrude Oil Prices

US EIA, data updated February 2, 2016Economic Advisors, Inc., Denver 4

$/bbl

China

housing slowdown

financial crisis

Great Recession

fraccing

OPEC?

Russia?

Venezuela?

Brazil & PreSal?

ISIS?Syria?Saudi

Arabia?

Mexico liberalization?

Iran?

China?

Agenda:

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Political risks in the market for crude oilCommercial / economic factors driving crude oil

markets

Oil – new conventional wisdom

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The OPEC era is past; they’ve lost control of the market.

The US is the new swing producer.OPEC open-taps strategy is targeting shale oil

producers.Saudi Arabia is in a battle for market share.

Conclusion (preview - … the short story):

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OPEC = Saudi Arabia => dominant firm = price leader = monopolist with competitive fringe deceleration and diversification of energy demand (i.e. China) technological advance in competitive fringe (i.e. fraccing)=> increase in elasticities of D and S => [Price – Cost]

markup=> economic / commercial factors => P ≈ $60 to $80 / bbl

Political Risk per reverbations from Arab Spring (2011) risk to control by traditional elites (political, religious) how long can / will Saudi Arabia ‘pay’ (i.e. Poil < $60/bbl) for

advantage in emerging regional political order? how long can Saudi Arabia afford domestic political order?

Agenda:

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Is OPEC a cartel?

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D: cartel = an association of suppliers who coordinate to maintain high prices and restrict competition

pluralnotice competing objectives here and here

OPEC is Saudi Arabia

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How often do OPEC Member States exceed production quotas?

A: all the timeWho has enough spare capacity to control prices?A:

Source: Medium-Term Oil Market Report 2014, OECD/IEA

Price Leader price setting

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Saudi Arabia is price leader dominant firm monopolist with competitive fringe

Price Leader price setting

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What has changed for Saudi Arabia (the price leader)A: on demand side, slowdown in China 2000 to 2010 – China accounted for 40% of

growth in global demand for energy 2010 to 2015 – growth in China energy demand

moderates from 10.5%/yr to 1%/yr 2015 to 2025 – China energy demand growth est.

= 2%/yr (Source: Exxon) 2016 – China oil demand growth < 2% (though

possibly understated per ‘teapot’ refinery output, Source: Platts)

Price Leader price setting

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What has changed for Saudi Arabia (the price leader)?A: China deceleration => optimal price

What risks were present at +$100/bbl oil? will China industrialize as a oil-intensive

economy? Will China consumer demand for energy be highly

oil-dependent? Or highly diversified? Strategic opportunity to influence path of

development?=> optimal price

quantity

price

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Price Leader price setting

S=MC

D

P

Q

MC

MR

Recall monopoly pricing:

moderation in China demand growth

quantity

price

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Price Leader price setting

S=MC

D

Q

MC

MR

Notice P-MC markup is lower with more elastic demand

P

more diversified demand can increase elasticity

Price Leader price setting

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Saudi Arabia is price leader dominant firm monopolist with competitive fringe

China => P for current slowdown & to encourage oil-intensive industrialization

Elsewhere EM softness (x – India) => P Developed economies softness and drop in

energy intensity => P

Price Leader price setting

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Saudi Arabia is price leader dominant firm monopolist with competitive fringe

What about the supply side? traditional competitive fringe = conventional

development (read large-fixed cost development prospects)

new competitive fringe = shale oil

production

($)

fixed costs

total costs

cost structure of traditional basins = high ratio of fixed costs to variable costs:need high P to justify investment, need low P to continue production => inelastic supply

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Price Leader price setting

production

($)

fixed costs

total costs

cost structure of unconventional shale oil = low ratio of fixed costs to variable costs:production declines rapidly, a broad range of P will justify investment => more elastic supply

Price Leader price setting

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Saudi Arabia = monopolist with competitive fringe Supply Side considerations

P in reaction to more and more-elastic supply Demand Side considerations

P in reaction to global economic weaknessP as strategy to discourage elastic mix in demand

But how low should prices be? Shale oil drilling returns at P > $40/bbl, even if short

term Large-fixed-cost investments require confidence P >

$80/bbl for long (20+ yrs?) term=> commercial / economic considerations => P < $80 / bbl

Saudi Arabia price setting

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Economic / commercial considerations can justify prices as low as $80/bbl (or $70/bbl? Or $60/bbl?)

But NOT P ≈ $40/bbl Assume OPEC gain = +2MBPD, but @ $40/bbl = >

+$80M/day But monopolist incurs loss on pre-existing production=> cost to Saudi Arabia = 10MBPD x ($40-$60/bbl) =

-$200M/dayWhat is Saudi Arabia buying with this cost?

A: signal to large-fixed-cost projects – ‘do not invest’ (e.g. Arctic [Shell, Russia], Canada oil sands, Brazil PreSal, Mexico)

?: but once signal has been received, what are they buying then?

Agenda:

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Gulf States divideSunni vs Shia

Ahl al-Sunnah = ‘People of the Tradition’

632 AD – followers of Abu Bakr, friend and father-in-law to Prophet Muhammad

> 80% of global Muslim pop’n > 90% in Egypt, Saudi

Arabia, Jordan, United Arab Emirates

consideration to literal tradition (e.g. Wahhabiism)

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Gulf States divideSunni vs Shia

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Shiat Ali = ‘the party of Ali’

632 AD – followers of Ali, cousin and son-in-law to Prophet Muhammad

~ 10% of global Muslim pop’n significantly in Iran,

Iraq, Yemen, Lebanonconsider ayatollahs as

agents of spiritual precepts

Gulf States divideSunni vs Shia

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Ahl al-Sunnah = ‘People of the Tradition’

632 AD – followers of Abu Bakr, friend and father-in-law to Prophet Muhammad

> 80% of global Muslim pop’n > 90% in Egypt, Saudi

Arabia, Jordan, United Arab Emirates

consideration to literal tradition (e.g. Wahhabiism)

Shiat Ali = ‘the party of Ali’

632 AD – followers of Ali, cousin and son-in-law to Prophet Muhammad

~ 10% of global Muslim pop’n significantly in Iran,

Iraq, Yemen, Lebanonconsider ayatollahs as

agents of spiritual precepts

Stakeholders in Market for Oil

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domestic poli/econ interests

geo-political interests

Russia (producer / price taker)Iran (producer / price taker)China (consumer / price takerUS (consumer / price taker)Saudi Arabia (producer / price setter)

how will key stakeholders influence oil markets as they pursue domestic political/economic interests and broader geopolitical interests?

Stakeholders in Market for Oil

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domestic poli/econ interests

geo-political interests

Russia (producer / price taker)

- efficiencies of scale- needs for hard currency=> Supply

- influence FSU (Ukraine)- influence in Gulf (Syrian naval base)=> Supply

Iran (producer / price taker)

- rebuild economy=> Supply

- security / prosperity via Shia influence in Gulf pro: Bashar al-Assad, Syria; Yemeni rebels anti: Syrian rebels, ISIS Supply

China (consumer / price taker

- diversify to consumer-driven economy- improve environment=> Demand

- Pacific region influence=> ?Supply, ?Demand

US (consumer / price taker)

- improve economy- increase energy security- improve environment-=> ? (not touching this one)

- Gulf region stability- Pacific region influence- climate change=> ?Supply

Saudi Arabia (producer / price setter)

- maximize net returns to fund state Price to $60 - $80 / bbl Supply

- security / prosperity via Sunni influence in Gulf pro: Syrian rebels, Yemeni gov’t anti: Iranian coalitions maintain US as consumer of Saudi crude Price => Supply

quantity

price

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Geopolitical impact on pricing

Secon&politics

D

P= $60 to $80

Q

MC

MR

P= $40

Q

RussiaIran

US

Saudi Arabia

China

Looking forward - oil:

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Looking forward - oil:

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A: they wouldn’t.

A: they wouldn’t.

A: less critical per capital constraints.

A: Yes / No

A: the emerging priority.

A: long-term objective.

Looking forward - oil:

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Outlook:

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Oil: OPEC will curtail production to raise prices as they

confirm Iran is a manageable riskLarge, fixed-cost investments are discouraged fr non-

OPEC producers (Canadian Oil Sands? Alaska? Brazilian PreSal? Mexico? Russia?)

* But look for Saudi Arabia to limit price increase to < $80/bbl

Questions?

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