Oil Primer - Trung

Please refer to important disclaimer at the end before reading the contents of this document.
Oil Industry Primer
January 27, 2016
Trung Nguyen
Credit Analyst
trung.nguyen@lucroranalytics.com

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Contents
Lucror View and Outlook .................................................................................................................................................................... 3
Introduction........................................................................................................................................................................................ 5
History of Oil ....................................................................................................................................................................................... 5
Key Oil Players..................................................................................................................................................................................... 7
OPEC ............................................................................................................................................................................................... 7
Non-OPEC ....................................................................................................................................................................................... 8
Saudi Arabia.................................................................................................................................................................................... 8
The US........................................................................................................................................................................................... 10
Iran ............................................................................................................................................................................................... 11
Fundamentals and Statistics of Today’s Oil Markets ........................................................................................................................ 12
Consumption ................................................................................................................................................................................ 12
No Viable Alternatives to Oil ........................................................................................................................................................ 13
Production.................................................................................................................................................................................... 13
Spare Production Capacity ........................................................................................................................................................... 14
Inventory Surge ............................................................................................................................................................................ 14
Oil Reserves .................................................................................................................................................................................. 15

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Oil Industry Primer
Lucror View and Outlook
The history of oil has registered many dramatic price swings. Capacity has usually been higher than demand, with prices kept
stable by swing producers. Price fluctuations are typically the result of supply shocks (e.g. oil embargo) or intentional flooding of
the market by swing players. Similarly, the current oversupply stems from Saudi Arabia’s decision not to cut production to
balance the increase from non-OPEC producers, particularly in shale oil, and perhaps to counter Iran’s re-entry.
The key fundamental that makes oil unique compared to other commodities is geopolitics. Oil reserves, particularly cheap
reserves, are concentrated primarily in politically unstable locations. Most of these countries are part of OPEC, and mostly in the
Middle East. Historically, this region has and will likely continue to experience various conflicts and unrest. However, the world’s
largest oil producer, Saudi Arabia, has not been exposed to major political unrest in the past few decades. Outside OPEC, Russia,
the third-largest producer (12%+ of global production), is involved in external conflicts and mounting tension with the West.
OPEC together with Russia control almost 80% of the world’s oil reserves. Some 22% of the latter are in the hands of states
subject to US/UN sanctions, according to Institute for the Analysis of Global Security.
Over the long run, demand for oil is expected to remain stable and robust, with no viable alternative in sight. Structural demand
growth continues to be strong, driven by emerging markets, where the population is 4.5 times larger than in OECD countries,
whereas consumption per capita is less than a quarter of the OECD’s.
China is not a key oil player, contrary to popular belief. Oil sold off in the first few weeks of 2016, in line with a plunge in Chinese
equities. In addition, news of China starting large-scale export of diesel suggested that the country was also drowning in oil. This
led the market to believe that the plunge in oil prices was partly due to the apparent weakness in China’s economy and demand
for oil. In our opinion, this is not the case. China only accounts for about 12.5% of global oil consumption, nowhere near the c.
40-50% for other commodities. The country’s oil imports remain very healthy, as seen from the 336 mn bbl of crude imported in
2015, up 8.8% from 2014. In addition, China has always been an exporter of finished products due to overinvestment and
overcapacity in refineries, especially for heavier crudes, possibly due to its overestimation of the country’s diesel consumption.
Moreover, we do not view shale Exploration and Production as the next swing producer. US shale wells are controlled by
hundreds of E&P companies, all of which respond differently to the market. A swing producer has to be a large player that can
cut and add capacity of 1-2 mn bpd, based on supply and demand. The OPEC, possibly 10 times larger than all of US shale oil
combined, also struggles to find a unified voice at times, such as the present situation.
The key macro factors that the market is currently watching for are: [1] OPEC supply; [2] how fast shale oil production decreases;
[3] how quickly Iran’s production rises; and [4] the dollar’s strength. Furthermore, certain technical factors such as US storage
capacity influence oil prices, at least in the short term. That said, beyond these factors and data, the single player that can make
a major impact on prices is Saudi Arabia.
In our opinion, the current oversupply is a result of geopolitical issues, not long-term supply and demand imbalances. The
situation is most reminiscent of the supply glut in 1985, when Saudi Arabia decided to punish other OPEC members by
abandoning its role as a swing producer and started pumping at full capacity. Oil plunged more than 80% from the peak of USD
38/bbl to a low of USD 7/bbl, and remained at USD 10-20/bbl over the next five years. The glut also played a role in bankrupting
the Soviet Union. Now, Saudi Arabia has made its presence felt again, this time mainly in response to non-OPEC members.
There is another theory that the country is pumping as fast as it can to counter Iran’s re-entry. There is no indication that OPEC
will cut quotas for other members to make room for Iran’s output due to the complex geopolitical situation among the Gulf
countries, particularly Saudi Arabia and Iran.
As oil transactions continue to be in USD, the strength of the world’s reserve currency plays a major role in prices. In 1970, the
USD’s value quickly declined after the US pulled out of the Bretton Woods Accord (aka the gold standard), leading OPEC to price
oil in terms of gold. A decade ago, oil prices were surging while the USD was weakening. The opposite is happening now, with
the USD rising sharply against most currencies.

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We believe that for oil prices to recover, several players have to go out of business, most likely shale oil producers. OPEC claims
that its strategy is working. With prices below USD 30/bbl as of 26 January 2016 while averaging over USD 50/bbl in 2014, a
bloodbath may be expected for US shale players this year. AlixPartners, a consultancy that advises troubled firms, forecasts a
funding gap of USD 102 bn in 2016 between US oil firms’ projected cash flows, and their interest payments and capital spending,
up from USD 83 bn in 2015.
Thus, low oil prices (< USD 30/bbl) could support Saudi Arabia’s intention to remove a significant chunk of supply from the
market. At USD 30/bbl, around 6% of the world’s supply is operating at negative cash cost, and if half went out of business, that
might just be enough to rebalance supply and demand.
Alternatively, major non-OPEC players and OPEC could come together and agree on production quotas, as the latter has stated
that it will not cut production alone.
Lastly, geopolitical tension also could contribute to an increase in oil prices.
In the absence of an oil price recovery, OPEC countries (especially the Arab states) could survive a downturn for a few years,
even with high social costs, and thus significantly longer than shale oil producers. Therefore, the more quickly oil prices fall to
lower levels, the faster high-cost supplies are removed, resulting in a price recovery. Low prices will also result in reduced capex
and exploration (including for alternative fuel sources), while spurring demand. For example, last year the US experienced
record automobile sales, surpassing the prior high set 15 years earlier. Demand was particularly strong for gasoline-guzzling pick-
ups and SUVs.
Source: BP, Lucror Analytics
In January 2016, oil prices almost retreated to the lowest level in more than four decades since 1974 (the first oil shock). The low
point during this period was reached in 1998, triggered by the Asian Financial Crisis.
It is unclear where oil prices will head this year or next, with even OPEC members repeatedly failing to make accurate forecasts.
Our estimate is that oil will be range bound at USD 25-40/bbl for the year, which was the range for inflation-adjusted prices from
1986 to 2003. This range is low enough to make a significant amount of supply uncompetitive, while allowing the Arab states to
survive. We also note that over the last four decades, the social costs for key oil exporters have increased massively, significantly
exceeding inflation. Thus, prices that had been sustainable from 1986 to 2003 for those countries may be unsustainable now.

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As a saying goes in the commodities market: “The cure for low prices is low prices”.
Introduction
This primer aims to provide a better and deeper understanding of the drivers and nuances of the oil market, beyond headline
supply, demand and inventory numbers. We start with a brief look at the milestones in the history of oil, after which we discuss
key industry players, before ending by covering current statistics.
History of Oil
The history of oil is fascinating and characterised by extreme volatility, and thus the current oil price collapse appears to be par
for the course.
 Up until 1859, light was obtained by burning candles or whale oil. The latter provided the best light and was considered a
luxury product.
 1854: George Bissell, with the help of Professor Benjamin Silliman of Yale University, found that crude oil could be distilled
to produce kerosene, a lamp fuel.
 1857: The Pennsylvania Rock Oil Company, founded by Mr. Bissell and business partners, drilled for and found oil. The first
well was 69 feet deep and produced 15 bbl a day.
 Crude oil was typically stored and transported to refineries in wooden wine barrels, which have become the default
measure till today.
 The distillation process of crude oil also resulted in two main by-products: one was too light, volatile and turned into gas
easily, thus being named gasoline; the other was too dense and smoky to be burned safely as lamp fuel. The latter was
named after Rudolph Diesel, a German who invented the diesel engine in 1892, which could burn diesel as fuel without
spark plugs. Both gasoline and diesel were considered useless and burned/dumped until the emergence of automobiles.
 Crude oil was dubbed black gold, reminiscent of the gold rush in 1849, and prices soared to USD 18/bbl in January 1860 (or
USD 375/bbl today, after adjusting for inflation) as kerosene was replacing the expensive whale oil. However,
overproduction caused the price to slump to just USD 0.16/bbl (USD 2.60, adjusted for inflation) by end-1861.
 John Rockefeller bought the first refinery in 1865 and founded the Standard Oil Company in 1870. By 1890, he controlled
90% of the US market through anti-competitive practices, leading to antitrust legislation.
 In 1911, the Standard Oil Company was forced to split into several firms, which are the predecessors of current oil majors
such as ExxonMobile, BP, Chevron and Royal Dutch Shell.
 In World War I, Winston Churchill (then-commander of the British Navy) replaced coal-fired vessels (with coal storage
bunkers) with those powered by residual oil, hence the name bunker fuel.
 Kerosene became the standard jet fuel as gasoline and diesel were needed for ground vehicles and machinery during WWII.
Kerosene supply was plentiful following the invention and adoption of the electric light bulb. Bitumen, a very heavy
product of oil, was used together with small rocks to make asphalt. Plastics and petrochemicals, by-products of oil, gained
widespread usage from the 1930s onwards.
 In 1928, English and American oil companies sealed the Achnacarry Agreement (or “As-Is Agreement”), under which they
agreed not to compete outside the US. Within the US, they were required to compete due to antitrust legislation.
 In 1930, massive amounts of oil were discovered in Texas, driving prices down by 90% from USD 1/bbl (USD 11/bbl,
adjusted for inflation) to USD 0.10/bbl. The US government then imposed production limits for each state via the Texas
Railroad Commission (“TRC”), with the then-railroad agency becoming the regulator for the oil & gas industry. From the
1930s to 1960s, it largely set world oil prices.
 In 1960, the Organisation of Petroleum Exporting Countries (“OPEC”) was formed. The group did not have any influence
then, as: [1] production in OPEC was by the oil majors via concessions; and [2] the US still had surplus production capacity
and the TRC controlled pricing.
 In the 1970s, the US oil market was dominated by a group of companies known as the Seven Sisters: Standard Oil Company
of New Jersey (which later became Exxon), Standard Oil Company of New York (later becoming Mobil), Standard Oil of

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California (which became Chevron), Texas Company (part of Chevron now), Royal Dutch Shell, Anglo Persian Oil Company
(BP) and Gulf Oil (part of Chevron and BP). These seven have merged into four today: ExxonMobile, Chevron, BP and Royal
Dutch Shell. Today, these four, along with ConocoPhillips and TOTAL, form a group known as the six majors.
 In 1970, oil production in the US peaked and began trending down (until the shale boom), handing over spare production
capacity to OPEC.
 Under the TRC’s pricing mechanism, oil was sold in USD at fixed posted prices set by the majors. The value of the USD
quickly declined after the US pulled out of the Bretton Woods Accord (aka the gold standard), which pegged the USD to the
price of gold, and other currencies to the USD. Thus, oil was getting cheaper as the USD depreciated. In September 1971,
OPEC issued a communique stating that, from then on, it would price oil in terms of a fixed amount of gold. However, the
group was subsequently slow to readjust prices to reflect this depreciation, as it had not developed a pricing mechanism.
From 1947 to 1967, the dollar price of oil had risen by less than 2% annually.
 The 1973 oil embargo was a result of American involvement in the Yom Kippur War. Six days after Egypt and Syria launched
a surprise military campaign against Israel to regain territories lost in the June 1967 Six Day War, the US supplied the
country with arms. In October 1973, OPEC announced an oil embargo against Canada, Japan, the Netherlands, the UK and
the US. The embargo cut global supply by 5-10% overnight. Oil went from USD 3/bbl to USD 12/bbl at the end of the
embargo in March 1974. This was the first and only time that oil has been used as a political weapon.
 In November 1974, the OECD formed the International Energy Agency (“IEA”) in response to the energy crisis. In 1975, the
US established a Strategic Petroleum Reserve (“SPR”) of crude oil for emergency use. The reserve involves crude oil
because refined products are difficult to maintain and degrade quickly.
 The second oil shock: In November 1978, a strike by 37,000 Iranian oil workers led to the Shah being overthrown. The
strike also reduced the country’s production from 6 mn bbl to 1.5 mn bbl (c. 4% of global supply then) in just a month. The
development took the world by surprise, with the supply drop compounded by the start of the Iran-Iraq war in 1980,
cutting Iraq’s output as well. OPEC’s spare capacity could not catch up in time, with oil prices more than doubling by 1980
to over USD 38/bbl (~USD 100/bbl in today’s terms).
 In response to the oil shock, Saudi Arabia, the de facto swing producer, raised production to 10 mn bpd (almost 15% of the
world’s production then). As Iranian production resumed, the Saudis cut production to as low as 2 mn bpd to support oil
prices, which were collapsing. During this period, other OPEC countries had spare production capacity and started cheating
by exceeding their respective quotas.
 Oil glut: In 1985, Saudi Arabia decided to punish other OPEC members by abandoning its role as a swing producer and
started pumping at full capacity, resulting in a huge oil glut. Oil fell as low as USD 7/bbl and remained at USD 10-20 until
1990. The low prices effectively bankrupted the Soviet Union, which was the second-largest producer, and nearly
bankrupted the US oil industry. Kenneth Deffeyes argued in “Beyond Oil” that the US encouraged Saudi Arabia to lower oil
prices to the point that the USSR's hard currency reserves became depleted.
 In 1990, Iraq invaded Kuwait, causing oil prices to more than double from USD 15/bbl to USD 33/bbl within a few days. The
quick conclusion of the war and release of the US SPR caused oil prices to slump to under USD 20/bbl.
 In 1997, oil fell to a low of USD 10/bbl due to the fall in demand amid the Asian Financial Crisis.
 From 2000 to 2008, global oil demand experienced healthy growth. OPEC’s spare capacity shrank from 6 mm bpd to below
1 mn bpd. In addition, Saudi Arabia’s enthusiasm for offshore exploration raised questions about its ability to maintain its
onshore production rate. Many industry experts, perhaps most notably Matthew Simmons in his book “Twilight in the
Desert: The Coming Saudi Oil Shock and the World Economy”, questioned Saudi Arabia’s production capacity and reserves.

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Key Oil Players
OPEC
OPEC accounts for about 40% of the world’s production. As of January 2016, the group has 13 members: Algeria, Angola,
Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia (the de facto leader), United Arab Emirates and
Venezuela. Their oil ministers typically meet twice annually to discuss quotas, usually at the Vienna headquarters. Most OPEC
members have decent spare capacity. The group apportions quotas on the basis of population size and reserve estimates. Thus,
there is an incentive for members to inflate reserves or risk having their quota reduced. Despite decades of production, the
reserves of various OPEC countries have either been flat or even increased meaningfully. In addition, details and studies of
reserves are typically closely guarded secrets. As of 2014, approximately three-quarters of the world's “proven” oil reserves
were in OPEC countries. Thus, some industry experts view these reserve estimates as unreliable.
The group does not have a stringent method of verifying compliance with production quotas. Thus, there is an incentive for
members to cheat. The de facto leader is Saudi Arabia, as it is the largest member in terms of production. The country
traditionally maintains control by threatening to flood the market to curb cheating.
When OPEC cuts production, it typically does so for the heaviest grade, which is cheaper than lighter grades. Thus, production
cuts tend to have a bigger impact on residual fuel and the margins of refineries handling heavier crude.
From 2000, OPEC set a nominal price band of USD 22-28/bbl. This was abandoned in January 2005, as demand temporarily
caught up with supply. From 2005 to 2008, oil surged from USD 38/bbl to USD 148/bbl, with the OPEC countries struggling to
keep up with demand. This shows that the group’s spare capacity is limited, despite the current surge in inventory and other
signs of a supply glut. While supply is still greater than demand, this is only a result of all players producing as much as they can.
The group has also been sensible not to use oil as a political weapon (e.g. threatening to hike prices), except for the 1973 oil
embargo, which it quickly reversed after seeing the huge impact. In our opinion, the members are fully aware that their futures
hinge on the world’s dependence on oil. Thus, a loss of trust could spur the introduction of alternative fuel sources and
negatively impact producers.
A key factor influencing OPEC is the demographic explosion over the past four decades in the largest member countries, except
Kuwait and UAE. The population in Saudi Arabia has increased more than 7x since 1960, Iran: 3.5x, Iraq: 5x and Venezuela: more
than 3.5x. This has created a number of issues. Firstly, social costs have surged proportionally. These costs include: healthcare,
education, electricity and water, provided for free or at heavily subsidised prices. Secondly, there is a big need to create
employment for the young demographic. Oil production does not require many workers, and thus the stated production costs in
some OPEC countries may be very low (e.g. Saudi Arabia: USD 5-10 /bbl), but the true costs, including social costs, are
significantly higher. The discovery of oil in these countries has resulted in oil-dominated economies, with uncompetitive non-oil

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industries and a highly inefficient workforce. The populations are generally young, restless and require a significant amount of
welfare to avoid further “Arab Spring” episodes.
Population of Select Oil Producers
Source: World Bank, Google Public Data
Non-OPEC
About 60% of global oil production stems from countries outside OPEC. Non-OPEC National Oil Companies (“NOCs”) account for
about one-third of non-OPEC production, or one-fifth of global production. Other players include the majors and independent
E&P. The latter account for most (c. 80%) of new fields drilled.
Interestingly, non-OPEC NOCs typically produce at maximum sustainable capacity as long as it is profitable. When oil prices are
lower, these NOCs may have to sell even more to maintain oil revenues for their country or profits. Thus, they typically do not
have spare capacity.
Outside NOCs, there has been a consolidation trend due to the falling rate of discoveries since the 1960s and the increasing
costs of tapping the remaining undiscovered oil fields. Private companies also find it less expensive and less risky to buy reserves
rather than searching for oil themselves.
Saudi Arabia
Source:

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Oil was first discovered in Saudi Arabia in 1938. During the golden age of oil discovery from 1941 to 1965, the country’s
production remained limited. The Kingdom only entered the spotlight in the 1970s, when US oil production peaked. It was the
only producer with spare capacity at a time of rapidly increasing global oil demand. The country seized the opportunity to rise,
increasing its production from 2.5 mm bpd in 1965 to over 8 mn bpd in 1974. Since then, Saudi Arabia has become the world’s
swing producer, adjusting its output according to changes in global demand and claiming to have at least 1.5-2 mn bpd of spare
capacity. In 2014, the Kingdom accounted for 12.9% of global production and 15.7% of the world’s reserves. Of greater
importance is that Saudi Arabia has the lowest production costs (c. USD 5-10/bbl) and the largest economical reserves in the
world at low prices (e.g. if oil falls to USD 20/bbl).
The country also owns some of the world’s largest oil fields. The largest is Ghawar, which spans 280x30 km. It has been in
production since 1951 and accounts for half of Saudi Arabia’s output. However, all the countries super-giant oil fields were
discovered before 1951. Smaller oil fields were still being found up to 1968, with no significant discoveries in the Kingdom since
then.
Some industry experts have questioned Saudi Arabia’s ability to produce more oil. As mentioned above, Matthew Simmons
documented his theory in great technical detail in his 2005 book “Twilight in the Desert: The Coming Saudi Oil Shock and the
World Economy”. Mr. Simmons and other supporters of the peak-oil theory appeared to be vindicated when prices more than
doubled from USD 60/bbl to the USD 148/bbl peak in 2008. While the current low prices and Saudi Arabia’s record production
rate do not seem to support this theory, we cover it briefly:
 Mr. Simmons doubted Saudi Arabia’s reserve figures. Since the country took control of Saudi Aramco (which accounts for
all reserves and production in the Kingdom) in 1979, details of reserves and production have been a closely guarded secret.
 The country’s reserves declined from 149 bn bbl in 1973 to 100 bn bbl in 1977. During this period, Saudi Arabia also
published field-by-field reserves, with Ghawar’s dropping from 63 bn bbl in 1976 to 45.5 bn bbl in 1977. After the country
took over management of Aramco in 1979, it raised the proven reserves from 100 bn bbl to 150 bn bbl, and stopped
releasing field-by-field reserve figures. The amount of reserves was again increased in 1988 to 250 bn bbl, without any
major new discoveries being made. Only a small part of the country has not been explored: the land along the Iraqi border,
the depths of the Red Sea and the bottom of the Empty Quarter.
 Saudi Arabia’s proven reserves remained constant for decades, despite producing 46.5 bn bbl of oil since 1988 (as of 2004,
according to the book). At end-2014 and based on our calculations, the country has extracted 92 bn bbl (current annual
production rate of c. 4.2 bn bbl) since 1998, without any decline in proven reserves.
 Oil production requires the injection of a massive amount of water into oil wells to maintain pressure. Oil fields typically
cannot sustain a decade of peak production, as it is very difficult to maintain pressure with age. As of 2004, the water
required was probably at least 12 mn bbl/a day, 8 mn just for Ghawar. Every major Saudi oil field has been receiving
intensive water injections for over four decades. The book describes the problems in each major oil field in detail.
Oil accounts for over 90% of the country’s budget, 90% of export earnings and over 50% of GDP. Thus, even after budget cuts
last year, Saudi Arabia recorded a whopping budget deficit of 15% of GDP (or over 20% of GDP if not for drastic spending cuts in
the last months of 2015). Its foreign reserves have fallen by USD 100 bn to USD 650 bn.
Further severe spending cuts risk sparking unrest against the backdrop of the recent “Arab Spring” in the region. Even with its
minimal debt, Saudi Arabia’s public finances are unsustainable for more than a few years. When oil prices fell in the 1990s, the
Saudis simply borrowed heavily. They were saved when China’s boom sent commodity prices soaring again in the 2000s. Saudi
Arabia’s external debt now is about one-fifth of GDP.
The country’s geopolitical situation is very uncertain. King Salman is in his 80s, and power is probably now wielded by 30-year-
old Deputy Crown Prince Muhammad bin Salman. It is unclear how the Prince will approach various issues, especially oil.

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The US
US production had been on a declining trend since 1970, before reversing in 2009, thanks to shale players. Shale oil production
is about 3.8 mn bpd, accounting for about one-third of US output in 2014. OPEC indicated that it did not cut production this time
round due to the shale players. Thus, the supply-demand balance will depend whether shale producers are forced of business or
whether OPEC blinks first. We think the latter scenario is unlikely, considering that most OPEC countries can weather the status
quo longer than shale players, many of which borrowed significantly in the past few years to fund expensive capex.
That said, shale oil production has been far more resilient than most experts expected, given the short cycle and high decline
rates of shale wells (often 70% in the first year). The decrease is not constant over time and tends to reduce in maturing wells.
Hence, production may fall by less than 50% in the second year.
The markets have overestimated the decline of shale players. We analyse below the production of the seven largest shale
producers: EOG, Pioneer Resources, Continental, Marathon, Apache, Anadarko and Whiting. Interestingly, they have not cut
production, with some showing a reverse trend (Pioneer and Continental).
Source: Company filings, Lucror Analytics
There are a few reasons for this:
 The time lag between drilling, completion and initial production. In addition, there are old, drilled but uncompleted wells
that may now be coming online.

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 There has been a substantial improvement in rig productivity, which has more than doubled in recent years. This is on
account of (in order of magnitude): [1] greater knowledge and experience; and [2] oil field service price deflation (20-30%
y-o-y). For example, Anadarko and Pioneer have raised Q4/15 guidance, while maintaining similar capex budgets.
 Oil hedges, which helped cushion the effect of weak oil prices. However, these hedges are all rolling off.
 E&P companies may need to keep drilling to constantly increase or maintain their Proven Developed Reserves. Banks
typically lend based on reserves (reserve-based lending). Thus, shrinking reserves may lead to margin calls.
Bank lending has not reduced as some market participants had predicted. Our analysis of the loan books of some of the largest
banks in the energy space shows that they have actually increased. We also note the rising NPL figures, though they are not yet
at critical levels.
Source: Company filings, Lucror Analytics
Iran
Iran holds c. 9.3% of the world’s reserves (fourth-largest behind Saudi Arabia, Venezuela and Canada), according to BP.

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Iran’s production was cut by about one-third due to sanctions by the US and EU. The most severe sanctions were imposed in
2012 and targeted the country’s oil production, suspending all exports to the EU and cutting output by almost 1 mn bpd. After
the sanctions were put in place, China accounted for c. 45% of Iran’s oil exports and India for 15%, followed by Korea, Japan and
Turkey, according to Bloomberg.
Oil and condensates (total of c. 45 mn bbl as of July 2015) have been put in floating storage and are finding their way back to the
market. While the amount of Iranian condensates in floating storage has remained stable, the amount of Iranian crude oil in
floating storage has trended down from 20 mn bbl in July 2015 to about 8 mn bbl as of October 2015.
The sanctions were lifted on 16 January 2016, unfreezing USD 100 bn of assets. Iran will likely be eyeing its lost markets,
particularly Europe and South Africa. Moreover, the country will aim to return to its pre-sanction production level of c. 3.7-3.8
mn bpd, or 14-15% of OPEC’s output, similar to Iraq. Specifically, Iran targets to increase production by 500 k bpd within weeks
(buyers are already lined up) and to reach pre-sanction levels by end-2016 (+1 mn bpd).
Analysts are more sceptical. A Bloomberg survey in August 2015 among 120 market participants showed that only 10% believe
Iran can raise its output by 1 mn bpd, 62% between 0.5 to 1 mn bpd, and 28% <0.5 bpd. One reason is that increasing production
is very capital intensive and the country is a particularly difficult place to do business. It was ranked 152 out of 181 in the Ease of
Doing Business index in 2012 and 2013, albeit improving to 130 last year (still very high, e.g. Saudi Arabia is ranked 82, and it
takes c. 500 days to enforce a contract in Iran). In addition, low oil prices make it even more unattractive for oil companies to
invest in the country. It is estimated that increasing crude production by 2 mn bpd and condensate by 1 mn bpd will cost c. USD
20-30 bn.
It can be argued that, as Iran has been able to produce more in the past, it is simply a matter of returning to its previous
production level. Conversely, underinvestment in oil fields while sanctions were in place may have reduced the total amount of
oil recoverable. For example, badly-managed water injection (which requires capital) can damage a field’s long-term potential.
Without water injection, only 30% of the oil in a reservoir can typically be extracted, while well-managed water injection can
raise this to 60%.
Geopolitical tensions between Iran and Saudi Arabia have escalated recently, with Saudi Arabia executing a prominent Shi’ite
cleric on January 2
nd
. In response, Iranians attacked the Saudi Embassy in Tehran, with the Saudis cutting diplomatic, trade and
air links to the country. These latest developments reduce the chances of the two nations reaching an agreement over
production quotas.
Fundamentals and Statistics of Today’s Oil Markets
Consumption
Oil is essential to the modern way of life and demand is inelastic. Global demand has steadily increased year-on-year since the
industry’s nascent stages and is highly correlated to the global population growth of about 2% annually.
It is noteworthy that demand growth has been very stable, with negative y-o-y growth in only four periods since 1965: 1974-
1975 (due to the 1973 oil embargo), 1980-1983 (the second oil shock, caused by the Iranian Revolution), 1993 (Gulf War) and
2008-2009 (Global Financial Crisis).
Demand growth is driven by emerging markets, which offset a demand decline in OECD countries. In the latter, vehicles are
becoming more fuel efficient and require less fuel to travel the same distance. OECD countries had consumed two-thirds of oil in
2000, but the developing world now consumes more. That said, oil consumption per capita in emerging markets is so low that
structural demand growth will likely be maintained. Based on BP’s oil consumption data and the World Bank’s population data,
we estimate that oil consumption per capita for OECD countries was 13.1 bbl/year (as of 2014). Conversely, oil consumption per
capita for non-OECD countries was only 3 bbl/year. Given the OECD’s population of about 1.25 bn and that of non-OECD
countries of 5.75 bn, the impact would be massive if per capita oil consumption for the latter were to double to 6 bbl/year.
Recent history provides an indication of the possible effect of car ownership becoming widespread in emerging countries. For
instance, oil demand more than doubled from 20 mn bpd in 1960 to 50 mn bpd in 1970, a span of just 10 years, driven by the

13
sweeping increase in car usage in the developed world. Similarly, between 2000 and 2010, Chinese petrol consumption more
than doubled, and now the country is the world’s largest car market. Thus, long-term oil demand should remain robust,
supported by structural demand growth from large populations in emerging markets.
In the World Oil Outlook 2015 published last October, OPEC stated that the impact of the recent oil price decline on demand
would be most visible in the short term, reducing over the medium term. The long-term oil outlook has been less affected.
No Viable Alternatives to Oil
To date, no globally viable alternative to oil has been discovered, in our opinion. The two major obstacles to finding a
replacement are energy storage and sourcing energy to store. As about 70% of oil usage is for transportation, the alternative
would have to be lightweight and safely fit into vehicles. It is very challenging to find a replacement as energy-dense as liquid oil,
given that hydrogen is hard to compress.
Electric vehicles are still not a threat to oil consumption, despite their recent material growth, not least thanks to the support of
green governments. As of mid-September, cumulative sales of plug-in electric vehicles worldwide remained less than 0.1% of the
world’s stock of motor vehicles. That said, demand has already caused lithium prices to more than double last year from USD
6,000/tonne to USD 14,000/tonne. According to Bill Gates, the entire world’s battery capacity — every battery everywhere —
can power just 10 minutes of current global energy usage. Transportation accounts for about 30% of energy use, with the whole
world’s battery capacity able to power just c. 30 minutes of current usage.
In addition, the scale of oil consumption is massive. To provide a comparison, we consider arguably the next best non-carbon
source, nuclear power. To produce sufficient energy to completely offset modern oil use, the world would need an additional c.
4,000, 1.5 GW nuclear power stations, 20 times the combined capacity of existing nuclear power plants. These additional plants
would deplete uranium reserves in 10 years. Wind and solar do not have the same scale as nuclear energy yet to power
something as massive as transportation usage.
Production
Oil production output has been more volatile than demand. That said, there is plenty of crude oil in storage to compensate for
volatility. Historically, production capacity has typically been higher than demand. In order to maintain oil prices at levels
enabling a decent return on capital, some large players assuming the role of swing producers would withhold part of their
production from the market. First, it was Rockefeller’s Standard Oil from 1870 to 1911. From 1931 to 1971, it was the oil majors
under the TRC. And from 1971 onwards, it was OPEC.
Global oil production has significantly outpaced consumption in recent years. Most of the growth stemmed from non-OPEC
countries, particularly the US, with the largest increase on record. The country added 1.6 mn bbl in 2014, or three-quarters of
the global increase. OPEC production was essentially flat, with declines among African OPEC producers offset by rising Middle
Eastern output. Every two years over the past decade, oil production in the US has risen by 2 mn bpd, the equivalent of
Norway’s production, owing to increased shale supply. As a result, oil supplies are surpassing demand by 1-2 mn bbl.

14
Spare Production Capacity
The amount of spare production capacity is often used as an indicator of the tightness in global oil markets. The EIA defines
spare capacity as the volume of production that can be brought online within 30 days and sustained for at least 90 days. Saudi
Arabia has historically had the greatest spare capacity of 1.5-2 mn bpd on hand for market management. OPEC’s current spare
capacity is less than 2 mn bpd. A figure under 2.5 mn bpd indicates a tight market, according to the EIA.
Source: EIA, Lucror Analytics
Saudi Arabia’s spare production capacity is currently about 1.1 mn bpd, according to Rystad Energy. However, it has been as low
as 0.1 mn bpd in 2012. The Kingdom was slow to rebuild spare capacity thereafter, increasing levels to 0.4 mn bpd in 2013 and
0.8 mn bpd in 2014.
The tight spare production capacity clearly shows that the current oversupply is due to unwillingness to cut back production, or
basically overproduction. Even though the world is drowning in oil, according to the IEA’s latest report in January 2016, it is also
susceptible to a supply shock due to tight spare production capacity. For example, the Iraq War and demand growth in China
and India resulted in the “demand shock” that hit the global oil market in 2004-2008.
Inventory Surge
Source: Bloomberg, Lucror Analytics
Oversupply has caused inventories in OECD countries to surge to unprecedented levels since 2014. Storage facilities at Cushing
in the US state of Oklahoma, which can hold 73 mn bbl, are registering record highs of 64 mn bbl. In response, the US finally
lifted its oil export ban (which had been put in place for energy security purposes) in December 2015. Global stocks soared in
Q4/15 by a record 1.8 mn bbl a day, according to the IEA, though they usually decline in winter. The IEA expects inventory to rise
by 385 mn bbl in 2016, which may cause overflow as there is insufficient storage worldwide. The US can possibly store another
100 mn bbl, with the rest of the world adding 230 mn bbl of storage capacity this year.

15
Oil Reserves
According to BP, the world’s proven oil reserves were c. 1,700 bn bbl at end-2014, or 52.5 years of current production. OPEC
countries accounted for the majority (71.6%) of global reserves. Over the past decade, worldwide proven reserves rose by 24%,
or more than 330 bn bbl.
Canadian oil sands, one-third of non-OPEC reserves, are extremely thick and do not flow at normal temperatures. Thus, they
have to be heated or diluted with light crude oil or natural gas condensate. Oil sands have only recently been considered part of
the world's oil reserves, as higher oil prices at the time and new technology enabled profitable extraction and processing.
The chart below shows the impact of various oil prices on the largest producers’ reserves. The key takeaway is how small the
economically viable reserves are when oil prices fall below USD 20/bbl or USD 40/bbl. At USD 20/bbl, economically viable
reserves worldwide drop from over 1,700 bn bbl to 339 bn bbl (10 years of production), of which only 13 bn bbl are outside
OPEC and the Middle East. At USD 40/bbl, non-OPEC reserves jump 10 times to 110 bn bbl, with global reserves of 561 bn bbl or
c. 17 years of production.

16
Source: The Economist, Rystad Energy, Quandl, Lucror Analytics
According to consultancy Wood Mackenzie, with Brent at USD 40/bbl, oil fields with a combined capacity of only 1.5 mn bpd (c.
1.7% of global supply) would be cash negative. These largely involve Canadian oil sands, followed by the US and then Colombia.
Even at USD 30/bbl, only 6% of global production fails to cover operating costs. While it may be uneconomic to drill new
deepwater wells at under USD 60/bbl, it may still make economic sense to keep existing ones running at prices well below that.
Operators may prefer to continue producing oil at a slight operating loss rather than shutting-down and re-opening wells, which
generally requires drilling rigs and is expensive. The costs of stopping and starting may be even larger than the short-term
impact of negative operating cash costs.
Source: IMF, Rystad Energy, Lucror Analytics

17
Most oil states depend so heavily on oil revenue to balance their budget that their fiscal break-even costs are extremely high.
That said, we believe these costs are quite meaningless in the short term, given that countries could cut spending for a few years
before suffering structural damage to their societies. While some view such costs as a driver for long-term oil prices, we do not
share this opinion.
*OPEC members
Source: Citi, Lucror Analytics

18
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