The 2010 Outlook For Oil Markets and Impact On Economic Activity New York Energy Forum

William H. Brown III President WHB Energy Research LLC January 13, 2010

Outline of Presentation

    Fundamentals 2010: World oil balance U.S. refinery balance Financials 2010: Non-commercial participation The equity market The dollar Interest rates Price components in a recovery year Broad fundamental view Non-commercial influence Seasonality Overlay all factors into a price forecast Potential price impact on economic growth

Fundamentals 2010

 World oil demand forecast to rise by 1.9% in 2010, assuming real GDP growth of 2.5%-3.0%  OECD oil demand expected to gain by 0.7%  Non-OECD oil demand forecast to rise by 3.2%, paced by China  Refined product demand strength will be derived primarily from middle distillates in both the OECD and non-OECD  Gasoline demand growth is expected to be moderate in the United States, reflecting rising average fleet fuel efficiency

Fundamentals 2010

 Non-OPEC supply forecast to rise by 430 MB/D, with FSU accounting for healthy share of total  OPEC “11” crude oil deliveries expected to average 27.1 MMB/D  Saudi Arabia crude oil deliveries forecast to average 8.3 MMB/D  Iraq oil production expected to average 2.6 MMB/D  Balances imply little net change in global stocks for the year, and thus the market will remain adequately supplied and competitive

Geopolitical Factors Include:



Iran

-We believe an attack by Israel or the United States against Iran nuclear facilities carries odds of less than 50% -There may be greater odds of an internal revolution and attempted overthrow of President Ahmadinejad -If this occurs, there may likely be a greater impact on oil prices than if an outside attack were to occur, i.e. 1979-type scenario -However, we should assume that supply uncertainty could be mitigated via a release of strategic stockpiles and higher Saudi production

Geopolitical Factors Include:



Nigeria

-Despite periodic cease fires and efforts to resolve the Niger Delta disputes and violence, we believe Nigerian oil production in calendar 2010 will average around 2.1 MB/D, below effective capacity -We believe major oil companies will continue to operate in Nigeria, despite the uncertainty

U.S. Refinery Balances 2010

   Crude oil inventory forecast -Runs should remain relatively restrained; excess refining capacity to remain until 2012 -Stocks should build seasonally from here -Peak in the spring should fall well short of 2009 Gasoline inventory forecast -Little growth in 2010 demand -Refiners must continue to micro manage output -Stocks will be more than adequate this year Distillate inventory forecast -A recovery in manufacturing output leads to higher demand -Global demand growth will help moderate import potential -Stock surplus will end by spring

Financials 2010

 Non-commercial participation There is clear evidence of early 2010 allocation of capital to oil, consistent with our thesis. Many funds believe 2010 will be a boom year This was also evident in early 2009, leading us to believe, contrary to the consensus, that WTI would exceed $70.00 per barrel by August  The dollar The greenback has exhibited a tight, not continuous, but periodic inverse correlation with crude oil over the last few years. The reason is the trade periodically “worked” for hedge funds, and not due to any sophisticated fundamental rationale. In 2010 we assume a dollar/euro trading range of $1.40-$1.50

 Interest rates The Fed and central banks will verbally prepare markets for rate hikes down the road. The oil market will discount this phenomenon in 2010.

Financials: Non-Commercial Participation

 CFTC data: one, imperfect way to gauge the influence  The CFTC now provides a long-overdue disaggregation of the weekly Commitments of Traders Report  The categories are: -Producer/Merchant/Processor/User -Swap Dealer -Money Manager -Other Reportables

Financials CFTC Data: Who is What?

    Producer/Merchant/Processor/User -An entity that predominantly engages in the production, processing, packing or handling of a physical commodity and uses the futures market to manage or hedge risks associated with those activities Swap Dealer -An entity that deals primarily in swaps for a commodity and uses the futures market to manage or hedge the risk associated with those swaps transactions. The swap dealer’s counterparties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity Money Manager -A registered commodity trading advisor (CTA), a commodity pool operator (CPO), or an unregistered fund identified by the CFTC (e.g. hedge fund) Other Reportables -Every other reportable trader that is not placed into one of the other three categories is placed into the “other reportables” category

Financials: CFTC Data: Explanatory or Not?

Correlation, Net Position vs. Prompt CL, June 2006-2009 Swap Dealer Money Manager Producer/Merchant Other Reportables 0.28

0.17

0.17

0.14

2007 2008 2009

Financials: CFTC Data: Explanatory or Not?

Correlations: A Look by Year Swap Dealer 0.19

0.38

0.25

Money Manager 0.42

0.41

0.72



Financials: CFTC Data: Explanatory or Not?

Our point with the CFTC disaggregation is the same as we made in the “olden days” pre 2004 when there was only a split between commercials and non-commercials: the non-commercial categories have strong explanatory power regarding NYMEX crude oil, but only during discrete periods within a given year.

Financials: CFTC Data: Explanatory or Not?

 Let’s look at an example where there were too few data points to statistically verify, but where the relationship appeared fairly “tight” based on observation: September 29, 2009 through January 5, 2010    Over this time period prompt NYMEX CL on a settlement basis rose from $66.71 to $81.77 per barrel Over the same period net length held by money managers rose from 60,002 contracts to 154,775 contracts, implying a $1.59 per barrel price gain for each 10,000 contract rise in net length Purely hypothetically, based on the most recent relationships, if money managers went “flat” crude oil, all else equal prompt NYMEX crude oil would be trading at around $57.00 per barrel

Financials: The Equity Market

 Correlation, S&P 500 vs. NYMEX CL: 2004-2009 2004 2005 2006 2007 2008 2009 0.18

0.00

0.25

0.40

0.15

0.66

0.76

Financials: The Dollar

 Correlation, Dollar/Euro vs. NYMEX CL: 2004-2009 2004 2005 2006 2007 2008 2009 0.60

0.04

0.43

0.02

0.93

0.73

0.87

Financials: Interest Rates



Fed Funds vs. Prompt NYMEX CL

-It is clear that cheap money has helped fuel the commodity boom over the last few years -There have been periods since 2004 where there has been a close inverse correlation between Fed Funds and prompt NYMEX CL -However, eventually the relationship obviously breaks down because money does not get any “cheaper” but oil prices continue to rise.

-We therefore can only make a judgment as to the impact on crude oil prices of higher rates. We suggest it will periodically has limit gains under the expectations of more moderate economic growth, but not directly and adversely impact oil prices as a hedge fund “trade”, like the dollar

 

Price Components in a Recovery Year: Seasonality

With very few exceptions, crude oil prices tend to rise in the second quarter from a first quarter trough Factors include: In Q1, lower refiner demand for crude in Atlantic Basin In Q1, market discounts end of winter Consensus invariably “mis-correlates” the first to second quarter downturn in global refined product demand with crude oil prices In Q2, refiner crude oil demand recovers In Q2, North Sea production begins to fall seasonally In Q2, funds buy gasoline, always believing the U.S. gasoline season will be strong

Price Components in the Recovery Year: Seasonality

January February March April May June July August September October November December

Monthly Crude Oil Price Seasonality Since 2004: Year=1.00

2004 0.83

0.84

0.88

0.89

0.97

0.91

1.00

1.08

1.12

1.27

1.15

1.04

2005 0.83

0.85

0.97

0.94

0.88

1.00

1.04

1.15

1.15

1.10

1.03

1.05

2006

0.99

0.93

0.95

1.06

1.07

1.07

1.12

1.10

0.96

0.89

0.90

0.94

2007 0.75

0.83

0.84

0.88

0.88

0.94

1.03

1.00

1.10

1.19

1.31

1.27

2008 0.93

0.95

1.05

1.13

1.25

1.34

1.34

1.17

0.98

0.78

0.58

0.42

2004 2008 0.87

0.88

0.94

0.98

1.01

1.05

1.11

1.10

1.06

1.05

0.99

0.94

2009

0.68

0.64

0.78

0.81

0.96

1.13

1.04

1.15

1.12

1.23

1.26

1.21

 

Price Components in the Recovery Year 2010: Adding It All Up

2010 NYMEX crude oil prices will once again be determined by a combination of fundamental and financial variables: Fundamental factors: Growth in world oil demand -Growth in non-OPEC supply -Geopolitical influences on supply Global days supply of crude oil and product inventories influenced by: -Excess refining capacity -Excess producing capacity, primarily Arabian Gulf sour grades Financial factors: Need/desire by financial institutions to diversify invested assets Global equity market strength/weakness -Value of the dollar -Interest rates and interest rate expectations

Price Components in the Recovery Year 2010: Adding It All Up

   Fundamental factors are “straightforward”, but there is a critical need to appreciate the importance of the financial factors and the “non-commercial” price influence Ever since 2004, the non-commercial influence on crude oil prices has been increasing, and has had a major impact, even during the global recession. We have tried various approaches to quantify the impact for the last four years. In our view, those who argued that fundamentals were primarily, if not exclusively, responsible for the price run up were guilty of the logical fallacy: Argumentum ad ignorantiam Non-commercial participation in oil will continue in 2010 and beyond. This is fact of life, there is no one to “blame”, and Wall Street should not be afraid or paranoid. Short of banning ETFs and prohibiting OTC activity, there is little the Obama Administration can or will do to limit “speculation”

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Year

Price Components in the Recovery Year

potential monthly price path for prompt NYMEX crude oil:

2010: Laying It All Out

Adding up fundamentals, financials, early-2010 asset allocation impacts, overall non-commercial influence, and seasonality yield this However, the potential second half fundamental response to higher prices in a recovery year and the potential for rate hikes suggests a greater weakening off the summer peak: $80.00

$81.35

$86.80

$88.70

$90.75

$94.30

$97.20

$97.65

$96.30

$96.90

$91.75

$87.15

$90.75

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Year $80.00

$81.35

$86.80

$88.70

$90.75

$94.30

$97.20

$97.65

$92.50

$88.50

$84.25

$78.50

$88.35

   

Price Components in the Recovery Year 2010: Conclusions

The overall fundamental global balance should remain competitive in 2010 with excess producing and refining capacity suggesting much lower prices than $80.00 per barrel However, early 2010 market behavior and anecdotal evidence suggests funds and other non-commercials are intent upon allocating more capital to oil this year, given bullish economic expectations Thus, a higher price “bar” has been established from which prices will rise seasonally as we move through the next couple quarters Price elasticity of demand still “exists”, however, suggesting that crude oil price strength in 2010 will be “front loaded” in the first half of the year. Later on, fundamentals and the prospect of higher rates will exert a sufficient influence so as to weaken prices more than the “normalized” seasonal pattern would imply, setting the stage for 2011