Debt Crisis Scenarios for Oil Prices Rev1

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PJK Research Note:

EU debt crisis, Libya and OECD recession:

What are possible scenarios for oil markets?

Update: September 22nd 2011

PJK International B.V.Sirius 61

4907 CJ OosterhoutTel. +31 (0)162 456 280Fax. +31 (0)162 433862e-mail: [email protected] www.pjk-international.com



PJK International B.V.Sirius 614907 CJ Oosterhout – NLTel. +31 – (0)162 – 456280Fax. +31 – (0)162 – 433862e-mail: [email protected]: www.pjk-international.com

Between demand destruction and supply disruption: likely scenarios22-September-2011 Patrick D. KulsenCopyrights © 2011 PJK International B.V.

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EU debt crisis, Libya and OECD recession: what are possible scenarios for oil markets?

Contents e-paper:

Table of contents

1 Introduction ........................................................................................................................... 3 2 Scenarios.............................................................................................................................. 3

2.1 Current status................................................................................................................. 3 2.2

Good (base-case) scenario

.............................................................................................. 5 2.3 Bad scenario .................................................................................................................. 5 2.4 Ugly scenario ................................................................................................................. 6

3 PJK Market Analysis Services ................................................................................................. 6





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1 IntroductionRecent developments showed the fall of the Gadaffi-regime in Libya, an EU debt crisis seemingly out of control and a possible recession in OECD countries. All these events and their possible implicationshave influenced oil prices. The big question is how oil prices will develop in the future. PJK sketcheslikely and less likely scenarios and its relation to oil markets and oil prices.

2 ScenariosWe shall concentrate on two themes that influence both supply and demand side of the market:

A. Regime switch in LibyaB. Escalating EU debt crisis

Additionally the prospects for world economic growth have been downgraded by organizations like theIMF and OECD. The IEA also lowered its forecasted oil demand growth for 2011 and 2012. Theseprojections are based on a base-case scenario in which eventually the EU manages to solve its debtcrisis. There is great potential downside risk to this base-case scenario due to the possible escalation of the EU debt crisis. In the next subsections such downside risk is discussed in more detail.

Another big uncertainty with respect to oil supply poses the situation in Libya. The Gadaffi-regime hasbeen expelled from Tripoli and what remains are small pockets of resistance. The question is howquickly will the new Libyan government be able to ramp up production? Possible scenarios in thisrespect are also detailed in the next subsections.

OPEC plays a crucial role as ever. How will the cartel respond to increased production from Libya andthe risk of worldwide recession?

The next sections will detail three scenarios and its implications for oil markets:• Good: gradual increase of Libyan production + continued struggle in EU to cope with its debt

crisis (Base-case scenario)• Bad: Strong resistance and sabotage from Gadaffi-loyalists + uncontrolled default of Greece• Ugly: EU debt crisis out of control which leads to split up of EU and Euro-zone.

First however the current status is highlighted.

2.1 Current status

Civil war in LibyaBefore the beginning of the civil war in Libya the country produced around 1.6mb/d. The civil war however reduced export till zero and this event had great influence on oil markets and oil prices.

The civil war has led to the fall of Gadaffi’s regime. With Gadaffi out of Tripoly and a few strongholdsremaining it looks as though the rebels have gained control over the whole of Libya. The cities of Sirteand Bani Walid are amoung the last Gaddafi-loyalist strongholds. Fighting between Gadaffi-loyalists andrebels is under its way and it looks as it is merely a matter of time before these two cities fall into the

hands of the rebels.





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Libyan oil production is however still close to zero at the moment. How quickly oil production will rampup depends on progress by rebelforces, the safety-situation in the country and the damage oilinfrastructure has incured during the civil war.

EU debt crisisThe EU or Euro-zone debt crisis has been going on now for more than one and a half year and still asolution seems out of reach. At the hart of the problems lies the low capitalization of European banks,large economic problems in perhiferial Euro-zone countries and a lack of effective and efficientdecicionmaking processes in the EU.

Deregulation and low capital requirements for European banks led to the situation that these bankswere even more leveraged than US investment banks at the time of the credit crisis. After the creditcrisis and subsequent recession many banks in Europe did not recapitalize. In 2010 new problemsemerged for Europe’s banks. First Greece, then also Ireland and Portugal lose their credibility andaccess to capital markets. These countries eventually got support from Eurozone countries but theprocess looked messy and highlights the EU’s inability to act quickly in crisis situations and to speakwith one voice. In May 2011 the debt-crisis was making headlines again because Greece needs asecond bailout. The resulting EU plan enlarges the powers and size ofg the EFSF and also incorporatesa small “haircut” for banks with a value of around €50 to €100 billion. The plan can only be enforcedafter all parliaments of the seventeen Eurozone countries approve the plan. Financial markets however are not convinced that it is enough and pressure mounted on Spain and Italy. Only because of interventions by the ECB on Spanish and Italian treasury bond markets an acute liquidity crisis wasprevented. Additionally the problems caused by the Finish colleteral deal with Greece also did notimprove confidence in EU’s ability to solve its problems.

At the moment again pressure is mounting on Italy and Spain. Italy’s credibility was downgraded by S&Pthis week and interest rates are again rising for these countries, even though bond buying programs of the ECB is releaving some pressure from the market.

OPEC’s response to Libyan and EU crisisBefore the uprising Libya was exporting 1.7mb/d of crude mostly to France, Italy and Germany. Saudi-

Arabia and other OPEC countries have volunteered to increase production in order to bridge the gap inworld oil supply. That did not prevent oil prices from rising through February, March and the beginning of April till prices peaked on 8th of April above $126/barrel for Brent crude. From this peak oil pricesdropped because there were signs the world economy couldn’t handle such high oil prices. Also fiscalproblems in the US and Europe dimmed economic growth prospects and pressured oil prices. At themoment oil prices are still in a downward trend but considering the collapse of stock indexes oil priceshave maintained much of their value.

Because oil prices remained rather stable OPEC has no real reason to change its policy at this moment.The next (ordinary) OPEC meeting is scheduled on December 14th 2011, so until this time quota willstay unchanged.





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2.2 Good (base-case) scenario

This scenario is what policy makers and organizations like IMF and IEA are expecting to happen. Withrespect to oil production in Libya the IEA is expecting production to reach 25% (0.4mb/d) of pre-civil war levels by the end of 2011 and to reach 66% (1.0mb/d) by the end of 2012. Return to full capacity(1.6mb/d) is expected to take at least two to three years. This scenario assumes political stability andenough security on the ground to let the mostly foreign oil workers return to production sites. Also itassumes minimal damage to oil infrastructure.

With respect to the Eurozone debt crisis the base-case scenario is a continuation of what has happenedfrom the start of this crisis: at the last moment EU politicians manage to prevent the crisis frommaterializing and a (half) solution to problems emerges. Eventually this process leads to step-by-stepadjustment of the EU’s stability pact and enlargement of the EFSF. Furthermore policies for stimulatinglong-term growth are adopted and European banks are recapitalized. Altogether this increasesconfidence and credibility in the Eurozone and means eventually the end of the debt crisis.

Oil prices remain in its downward trend but, as has been the case recently, prices do not decrease veryfast. The gradual increase in oil supply due to Libya and the remaining downside risks to economicgrowth in the EU and US cause the downward trend in oil prices. OPEC is expected not to lower quotain response to such a slow decline in oil prices because this would endanger economic growth and oildemand. Brent crude prices of between $95/bbl. and $85/bbl. are envisaged here for end 2011 begin

2012.2.3 Bad scenario

This scenario is less likely but has more bad implications for economic growth. First of all Libyan oilproduction ramp up is halted due to fierce resistance and sabotage of Gadaffi-loyalists. Because of continued fighting ground personnel of oil companies are not deployed. An added dimension could bethe crumbling of the rebel alliance into separate tribes and that these tribes begin to fight against eachother. There were some reports of tensions between various tribes that form the rebel alliance. If thesetensions escalate then oil production will suffer even more.

A bad scenario for the Eurozone crisis compared to the base-case would be an uncontrolled default of

Greece. Many players are speculating on such an event because the debt to GDP ratio has increasedsignificantly the last couple of years and because austerity measures of the government have either only increased problems or are not implemented. The uncontrolled default of Greece would hit banks inEurope. First of all banks in Greece and Cyprus would go bankrupt and Cyprus would also need to getfunds from the EFSF. Secondly, many banks in France and Germany have a large exposure to Greekdebt and may find it hard to cover those losses. A credit crunch would develop because banks wouldstop lending to each other. Most likely a new round of bailouts for banks would be needed as was thecase at the end of 2008. However, let’s assume that Spain and Italy do not lose access to the sovereigndebt market because the ECB starts buying their debt. In that case losses for European banks would belarge but there would still be a good chance the Eurozone would survive such a crisis.

In this scenario financial markets would react in a similar way as in the credit crisis. Brent crude oilfutures prices dropped from $140 till $36.20/bbl. in a few months. A worldwide recession would follow





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which would lower oil demand. OPEC would most likely respond by cutting its quota but it is inevitablethat oil prices would drop to low levels like in the beginning of 2009, say around $55/bbl. to $45bbl.

2.4 Ugly scenario

This is the doom scenario and less likely. It is similar to the bad scenario but differs in the fact that alsoSpain and Italy lose access to sovereign debt markets because of political divisions between Northernand Southern Europe. Neither the ECB nor the EFSF are allowed to intervene. As a result of the size of both economies these two countries are too big to bail out and a disorderly default would result. Thiswould increase losses for European banks tremendously and would most likely result in a ‘everybody-for-himself’ strategy: Germany, France, Netherlands and other triple-A Eurozone countries might

manage to bail out their banks but other countries like Spain and Italy would not be able to do that.

When the dust settles the world would plunge into a deep depression hitting both the OECD as well asthe emerging markets. Oil demand would drop as would oil prices. Similar price levels for Brent as in2009 would be possible: $36/bbl.

Patrick D. Kulsen, MSc. BA.

3 PJK Market Analysis ServicesSpecifically for oil traders PJK offers market intelligence and analysis services. These services aim toimprove understanding, decision-making and risk management associated with oil markets withincustomer’s organization. For more information please contact PJK or visit our website. Details can befound below:

PJK International B.V.Sirius 614907 CJ OosterhoutTel. +31-(0)[email protected] www.pjk-international.com

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Debt Crisis Scenarios for Oil Prices Rev1