Opec's Saudi-led strategy of letting the market balance itself is quickly moving from its first phase — maintaining pro-duction to let a growing crude surplus develop — into its second, the absorp-tion of that surplus through rising stor-age levels. But it's the timing of the third phase, the period of actual mar-ket rebalancing, that is of greatest interest to the industry. When will low prices shut in enough high-cost non-Opec supply to allow oil prices to recover? And will production be shut in swiftly enough to prevent storage tanks overflowing, triggering another price collapse? This is uncharted terri-tory for what Mideast Opec delegates openly acknowledge as the group's "experiment," but PIW analysis sug-gests the supply response this year will be limited, with non-Opec supply growth of 1.16 million barrels per day outstripping demand growth of 800,000 b/d.

In the current second phase of the experiment, rising storage levels are being facilitated by steep spot price discounts. Onshore storage is filling up fast, while some volumes are also starting to move into floating storage. Brent crude has already lost $30 per barrel since Opec's Nov. 27 decision not to rein in production, and rising inventory levels are adding to the downward pressure on the price. But a full collapse can be avoided as long as storage is available. Ahead of the expected 2.4 million b/d surplus in the first half of this year, the market had to

deal with a 1.9 million b/d supply over-hang in last year's fourth quarter of 2014. And the more storage tanks fill up, the longer the re-balancing will take, since these massive inventories will eventually have to be drawn down.

Low oil prices seem certain to start affecting non-Opec supply later in the year, but it's countries like Russia that are likely to be most vulnerable, rather than the US' fast-rising light, tight oil supply, which most observers see as the principal intended target of Opec's new strategy. But will this supply response be enough to see some stabi-lization in prices this year, as forecasts by Opec and the International Energy Agency suggest?

The question here is whether the market will run out of storage space before the delayed reaction from non-Opec producers succeeds in slowing global supply. And if prices really col-lapse, how will Opec react? Saudi Arabia has indicated that the producer group has made a permanent change in policy, but dissent among other members, notably Venezuela, is grow-ing. A change in Opec policy seems unlikely before or even at its next meeting in June, however.

The Opec experiment was never likely to be a smooth process, and is not helped by gloomy economic fore-casts for 2015, which undermine any hope that rising demand might ride to the rescue. US tight oil could prove more resilient than expected, while within Opec Iraq continues to hike out-

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February 2015

Slow Oil Supply Response . . . . . . . . . . . 2Oil Price Offers Modest Boost to GDP . . 3Consolidation Is Coming . . . . . . . . . . . . . 4

Inside

The Outlook for Oil in 2015: Supply, Demand and Opec's Big Gamble

put. And as events in Yemen demon-strate, geopolitics remains a real wild card, with potential to both help and hamper the balancing exercise. A nuclear deal with Iran could boost sup-ply significantly, while Libya could go either way. The list of potential hotspots is long, with instability aggra-vated by low prices — as in Venezuela and Nigeria — and some even ques-tioning the potential for disruption in Mideast Gulf monarchies. Moreover, geopolitical disruptions, by their nature, have a habit of springing sur-prises.

US tight oil producers are already cutting capital spending, but are also slashing costs through efficiencies and technology. That may ultimately stop US tight oil acting as the market's new marginal-cost barrel, with other higher-cost sources instead falling vic-tim to the industry's eventual restruc-turing — the logical fourth and final p h a s e o f O p e c ' s ex p e r i m e n t . Investment bank Goldman Sachs sees a new paradigm shaping the industry as US tight oil producers lower costs, and capital shuns high-cost deepwazter, oil sands and other alternative technolo-gies, making the oil industry "more efficient." But this is unlikely to pan out for another year or more, says the bank, which sees Brent at $42/bbl in the second quarter, rising to $64.50/bbl in the fourth and $70/bbl in the first quarter of 2016. n

January 26, 2015Petroleum IntellIgence Weekly

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The collapse in oil prices is starting to affect the outlook for US crude output, as producers and their financial backers slash forward price expectations. But most still insist output will rise, even as spend-ing levels dive, given the forward momen-tum in the country's key tight oil plays. According to PIW sister publication Oil Market Intelligence (OMI), US oil produc-tion should, based on current prices, grow in the range of 1.2 million-1.4 million bar-rels per day this year, down from growth of slightly less than 1.6 million b/d in 2014, with the US' Big Three tight oil plays — the Bakken, Eagle Ford and Permian — helping sustain output's higher trajectory. The US growth story also looks likely to remain intact in 2016, albeit at a more modest level (PIW Nov.24'14).

If history is any guide, US onshore stripper wells — those that have pro-duced less than 10 b/d over the past 12 months — and heavy oil wells in the California Central Valley will be the first shut in, while marginal shale plays and fringe areas away from core play "sweet spots" — where break-even prices of as low as the mid-$40s per barrel are not uncommon — will see sharply reduced activity. If low oil prices persist, there is likely to be a sharper deceleration in growth next year, OMI suggests, slowing to around 825,000 b/d as investment declines also hit output growth in core shale areas, queues of already drilled but uncompleted wells are worked through, and stripper well declines accelerate.

The seeds of the anticipated produc-tion growth slowdown are already evi-dent in rig activity, with the start of 2015 witnessing the biggest weekly drop in the number of US onshore rigs targeting oil in more than two decades, according to data from rig firm Baker Hughes. The next few months should, analysts believe, see aggressive efforts by producers to lay down rigs, with eventual declines in ser-vices costs and high-graded drilling pro-grams thereafter putting a floor under rig usage (PIW Dec.8'14).

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Oil-directed rig numbers fell by 61 for the week ending Jan. 9, with the total onshore rig count now down by 180 from the recent peak of 1,930 set in mid-October. The Permian and Bakken areas saw the largest weekly drops among key US basins, down by 28 and eight rigs, respectively. The US onshore rig count is likely to drop by another 450-plus between now and May, ana-lysts at Credit Suisse believe, while Raymond James analysts think the rig count could fall by 850 rigs, or 44%, from peak to trough.

With US tight oil and other high-cost non-Opec supply sources the clear targets of Opec's new strategy, merely slowing US production growth may not be quite the outcome Saudi Arabia and its allies were hoping for. But if oil prices remain around $40-$50 per bar-rel, further pressure on supply growth projections is inevitable as producers contemplate even deeper cuts in spending.

Recent corporate announce-ments already point to reduc-tions of 20%-50% in capital expenditure this year in most cases, even though the indepen-dents which dominate tight oil output have hedged much of this year's production at prices above $85/bbl (PIW Oct.20'14). That hedging means that the bigger impact on output could come if low prices endure into 2016, for which producers have few hedges in place and by when they will have been weakened financially by a tough 2015.

With capital spending levels so closely linked to operating cash flows, any price rebound should, in theory, lead to a rapid revival in activity. That means that a near-term oil price that is low, but not catastrophically so, could have unforeseen consequences for Opec, cre-ating a more resilient US tight oil sector

by encouraging further exploitation of the already tireless work done to lower production costs. Access to capital remains a critical wild card, however, but even that might be addressed if low prices encourage consolidation and take-overs in tight oil plays, and see the entry of bigger and better financed operators.

The US shale boom was built on a mountain of debt, and banks and bond-holders may be far less willing to extend credit as they become painfully aware of

what lower oil prices mean for highly lever-aged producers. But that financial vulnera-bility could make tight oil players ripe for takeover by the integrated majors, whose track record in tight oil to date has been mixed at best, and who might, notwith-standing investor pressure to rein in capital spending, be tempted by the prospect of adding high-quality tight oil assets at a dis-tressed price. n

January 19, 2015Petroleum IntellIgence Weekly

US Rig Count Declines1,940

1,900

1,860

1,820

1,780

1,740Sep '14 Oct '14 Nov '14 Dec '14 Jan '15Source: Baker Hughes

US Crude Production12,000

10,000

8,000

6,000

4,000

2,000

02007 2008 2009 2010 2011 2012 2013 2014 2015 2016

(‘000 b/d)

Source: OMI estmates and projections

February 2015 | 2

Price Slump Will Slow, Not Stop, US Oil Growth

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Lower oil prices are expected to apply the brakes to non-Opec supply growth this year, but not to the extent that it will be outpaced by relatively modest pro-jected growth in demand. This reflects the growth momentum built up in cer-tain key non-Opec plays over the past few years, and means that the main short-term consequence of Opec's deci-sion to maintain output and let prices fall will be a further fattening of already ample inventories (PIW Jan.19'15).

The latest supply/demand assess-ments by PIW sister publication Oil Market Intelligence (OMI) show an average 2.4 million barrel per day sur-plus in the first half of 2015, dropping to a still hefty 1.32 million b/d in the second half, assuming crude prices stay at current levels. OMI sees non-Opec supply growth this year of 1.16 million b/d, down by around 600,000 b/d from estimated 2014 growth levels, but still comfortably — or uncomfortably, from Opec's perspective — ahead of pro-jected 2015 oil demand growth of just 800,000 b/d. These projections also assume that Opec perseveres with its new strategy and maintains crude out-put at 30 million-30.5 million b/d.

The fall in prices means the drivers for global oil supply have shifted radi-cally from the pattern of the past few years — the focus is no longer on ram-pant non-Opec growth and possible output policy responses from Opec, but instead on how growth rates in areas such as US tight oil might moder-ate and how decline rates in mature areas might accelerate.

Opec's strategy, led by Saudi Arabia, is to sit tight, maintain out-put, and wait for lower prices to rein in high-cost production and re-bal-ance the market. And lower prices will slow non-Opec growth, as pro-ducers respond to reduced cash flow by trimming capital spending, and as investors and lenders similarly lose some appetite for oil sec-tor exposure. Shut-ins of low productivity wells, such as stripper wells in the US, and cancellation or delays to high-cost mega-projects in areas such as the deepwater will grab the headlines, but else-where, significant forward momentum is likely to keep US tight oil plays such the Eagle Ford and the Bakken, and to a lesser extent the Permian Basin, moving forward, albeit at a slower rate.

The hardest hit among non-Opec producers is expected to be Russia, caught by the combination of low prices and Western sanctions, which have in turn spawned a currency crisis and an economic downturn. But there is also expected to be an acceleration in decline rates in mature plays in the North Sea, China, Indonesia, Mexico, Argentina, Azerbaijan, Australia, Egypt and several other smaller producers.

Although the US' output expansion is expected to slow, output should still see growth in the 1.2 million-1.4 mil-lion b/d range this year, down from growth last year of slightly less than

1.6 million b/d. In addition, continued increases from Canada, Brazil and a few others should counter most other non-Opec declines.

Two key countervailing assump-tions underlying the supply outlook are that prices remain at current lev-els rather than moving significantly lower, and that geopolitical disrup-

tions do not take a big chunk out of supply at any stage. Both are of course possible, the former particularly given the additional price pressures created by the build-up in inventories.

The stockbuild is just one result of Opec's strategy, with the weakness in benchmark crude futures leading to a pronounced shift in the forward price curves for both Brent and West Texas Intermediate into deep contango. This creates sufficient incentive to store the crude the market doesn't cur-rently want in both onshore tanks and, at greater cost, in tankers off-shore. But it also creates a major drag on any price recovery when a flatten-ing curve begins to bring that oil back out of storage. n

January 26, 2015Petroleum IntellIgence Weekly

Lower oil prices should be good for the global economy and for oil demand, and if prices remain at current levels, most analysts expect a small additional boost to demand growth throughout 2015 and a bigger one in 2016 as a

global economic recovery takes root. Some early impacts are already visible — US consumers, partly thanks to the low retail fuel taxes they pay, have been first to react, driving more miles and buying bigger cars. But overall, econo-

mists warn that an exuberant demand reaction should not be expected.

As the International Monetary Fund said in October when it downgraded global economic growth for 2015 to

Oil Price Offers Modest Boost to Global GDP

Continued on p4

February 2015 | 3

Slow Oil Supply Response Points to Big Stockbuild

2015 Quarterly Oil Market Balances Chg. vs.(million b/d) Q1 Q2 Q3 Q4 2015 2014Demand 92 .81 92 .72 94 .32 95 .12 93 .75 +0 .80OECD 45 .43 44 .92 45 .93 46 .13 45 .61 -0 .06Non-OECD 47 .37 47 .80 48 .39 48 .99 48 .14 +0 .86Supply 95 .41 94 .94 95 .15 96 .93 95 .35 +1 .40Non-Opec 58 .63 58 .27 58 .21 59 .93 58 .67 +1 .16Opec NGLs & Other 6 .57 6 .44 6 .67 6 .84 6 .65 +0 .14Call on Opec Crude 27 .60 28 .01 29 .44 28 .35 28 .36 -0 .54Opec Crude 30 .20 30 .22 30 .26 30 .16 30 .04 +0 .10Implied Stock Chg . +2 .60 +2 .21 +0 .83 +1 .81 +1 .60 —

Source: Energy Intelligence's Oil Market Intelligence

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3.8% from the 4% predicted last July, the recovery remains "brittle, uneven and beset by risks." The historically less bullish World Bank sees a low oil price adding just one-tenth of a percentage point to global GDP growth this year, and with an eye on the sputtering euro-zone, Japan, and China's economic gear-shift, forecasts growth in the global economy in 2015 at 3%. It sees some support from the oil price and the US economy, but also the risk of a new financial crisis, especially if investors exit Asia as and when Western banks start raising interest rates. "The global economy is running on a single engine [the US]," says World Bank Chief Economist Kaushik Basu. "This does not make for a rosy outlook."

A number of factors — taxation, subsidies, currencies and the availabil-ity of alternative energy sources — complicate how lower oil prices are passed on to consumers, economists warn, noting that the elasticity of oil demand is greater when prices rise

then when prices fall. "You don't get as much demand back as you lost from prices going up," one market-watcher says. "You don't rip out your insulation." Much like their counterparts in the US, consumers in Asia are enjoying lower fuel prices, but in countries like China, India and Indonesia, the simple transla-tion of cheaper crude into cheaper pump prices is complicated by recent subsidy and tax changes and shaky cur-rencies that make oil more expensive in local money (PIW Jan.12'15).

Oil demand growth should be bet-ter supported from this year on by a sustained and even recovery in the world economy, but that demand growth will continue to be heavily con-centrated in non-OECD economies, buoyed by some additional buying from China and India for their strategic stockpiles. Despite modest GDP growth, OECDs economies are expected to con-tinue to cut back on oil use. Overall, PIW estimates point to limited annual demand growth this year of 800,000

barrels per day, up from growth of 720,000 b/d in 2014.

There could be surprises to the upside, if Asia's smaller economies take off, or in the US, which could easily add 100,000 b/d to that total as more jobs are created, net of likely oil job losses in producing states like Texas and North Dakota. Africa could also deliver more demand growth than anticipated from a low base, but some trends will remain intact despite lower oil prices. China ceased to be such a big engine of oil demand growth as of 2013, and is expected to see demand growth of just 200,000 b/d this year, while possibly substantial structural declines in demand are set to continue in Japan and Europe. Oil demand may also be affected by a tightening of environmen-tal regulations, while policies aimed at improving energy efficiency in vehicles will also blunt any demand increase. n

January 19, 2015Petroleum IntellIgence Weekly

Low oil prices will likely spur a big wave of industry consolidation this year, but it could take some time to develop. Oil companies traditionally use mergers and acquisitions as a way to unlock value during periods of low oil prices, with the strong preying on the weak. All indications suggest the current downturn will be no different. But before widespread deal-making can happen, oil price volatility must subside so that companies can find common ground on asset values.

At present, the bid-ask spread for potential deals is too wide, as pro-spective sellers have not reconciled themselves to the new price realities after Brent's 50% fall since June to less than $50 per barrel. The price slide has brought M&A activity to a standstill over the past three months and has resulted in some agreed deals being aborted, including United Arab

Emirates-based Dragon Oil's $800 million bid for Irish independent Petroceltic, and some assets being pulled off the market, such as US inde-pendent Newfield's interests in China. The big exception has been the $13 billion takeover of troubled Canadian independent Talisman Energy announced last month by Repsol, for which the Spanish major has been accused of overpaying (PIW Dec.22'14).

The Western majors have a big decision to make about whether to pursue acquisitions. They are commit-ted to capital discipline, having sacri-ficed growth to protect cash flow, and most are in fact looking to sell assets to help cover expected cash-flow defi-cits this year. At the same time, sanc-tions against Russia have deprived them of access to key long-term growth assets — a portfolio void that

could be addressed opportunistically via M&A (PIW Jul.28'14).

Large acquisitions would draw intense scrutiny from investors, who were already fed up with majors' profligate spending and weak returns even before the collapse in oil prices. Still, the majors boast strong enough balance sheets to handle big pur-chases. Exxon Mobil has been linked with bids for BG and Anadarko Petroleum, but says "bolt-on" asset-level deals in US shale are more likely. Holding treasury shares worth some $350 billion, Exxon can entertain almost any deal. Few believe the majors will actually double down on the failed "supermajor" strategy, how-ever, so any deals will have to offer a compelling mix of cash flows and flex-ible capital spending requirements — in addition to growth.

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Consolidation Is Coming, But May Take Time

February 2015 | 4

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(NOCs) from Asia and Middle East are more likely to lead the way, as overseas M&A targets suddenly look more obtainable. After refraining from major deals in 2014 amid China's corruption probes, Sinopec and PetroChina look ready to make a big splash in M&A markets this year, as do some expan-sion-minded Southeast Asian NOCs such as Thailand's PTT Exploration & Production and Indonesia's Pertamina.

China's NOCs spent roughly $20 billion on upstream M&A in 2013, but just $3 billion last year. Sinopec has cash available after divesting 30% of its retail business for around $17.5 billion and is reportedly looking for new acquisitions. PetroChina is also evaluating new M&A opportunities,

while China National Offshore Oil Corp. is likely to refrain from large acquisitions after its 2012 purchase of Canadian independent Nexen. PTTEP has a $3.5 billion war chest with which it is expected to target entry into US shale. UAE-backed firms Mubadala Petroleum and Taqa may also be looking to fill gaps in their portfolios, with Energy Minister Suhail al-Mazrouei saying periods of low prices historically "create the best value" for buyers.

M&A opportunities are expected to grow over the course of the year as low prices increase the cash-flow pressures on some firms, particularly smaller, weaker independents. The US independent sector, which has been

heavily financed by high-yield "junk" bonds in recent years, will likely see the most M&A action, but there will be no shortage of targets worldwide.

Iraq's semiautonomous northern region of Kurdistan, Brazil and East Africa also offer substantial growth opportunities and could become active hubs for deals. In the US, there are junk credit ratings on roughly 100 E&P companies with production of some 4.5 million barrels of oil equiva-lent per day (PIW Nov.24'14). Despite capital expenditure cuts, the sector is expected to outspend cash flow by 60% this year, pointing to worsening debt metrics. n

January 26, 2015 Petroleum Petroleum IntellIgence Weekly

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