crude oil prices a factor of influencing issues

8/7/2019 crude oil prices a factor of influencing issues

1/12

S I M M O N S & C O M P A N Y

I N T E R N A T I O N A L

Daniel R. Pickering

David A. Pursell

(713) 223-7840

This report is based on information obtained from sources, which Simmons & Company International believesto be reliable, but Simmons & Company International does not represent or warrant its accuracy. The opinions,ratings and estimates contained in this report represent the views of Simmons & Company as of the date of the

report, and may be subject to change without prior notice. For detailed rating information, go tohttp://sciweb01/publicdisclosure. Simmons & Company International may seek compensation for investment

banking services from companies for which research coverage is provided. The firm would expect to receivecompensation for any such services. Research analyst compensation is based upon (among other things) the

firm's general investment banking revenues. Simmons & Company International will not be responsible for theconsequence of reliance upon any opinion or statement contained in this report. This report is confidential andmay not be reproduced in whole or in part without the prior written permission of Simmons & CompanyInternational.

Energy Industry ResearchFebruary 25, 2003

Crude Oil Prices A Discussion Of Influencing Issues

At the publication date of this report, West Texas intermediate crude oil prices are over $36 per barrel. U.S.

natural gas prices are over $7 per mcf. Many investors believe that commodity prices are headed south. A

smaller group believes prices are headed higher. Most are gripped with headline fever and many make the

incorrect assumption that a war with Iraq is the only influencing variable for energy prices.

The reality is that handicapping prices in the current environment requires a multi-variable approach with

influences and outcomes so disparate that we have little confidence in any particular price forecast or

prediction. Multiple opinions even exist within Simmons & Company. This report identifies and examines the

influencing variables of the analysis. As for the forecast..does anyone care to roll the dice?

Inventory Levels

Supply Disruptions

Iraq

Venezuela

Nigeria

Persian Gulf War

Weather

Japanese Nuclear

Decline Curves

Economic Recovery

Natural Gas

Seasonal Demand

Terrorist Activities

Economic Slowdown

Deepwater VolumeAdditions

Robust ProjectEconomics

Gradual Venezuela

Resolution

Strategic Petroleum

Reserve

Speculative Futures Positions

OPEC

Higher Prices Lower Prices


2/12

S I M M O N S & C O M P A N Y I N T E R N A T I O N A L 2

Where Are We Now?

Inventory levels

Both worldwide and U.S. crude oil inventory levels are supportive of strong crude prices. Commodity

markets do not care how a particular inventory situation developed. Whether via normal supply and demand

interaction, war, a political crisis, or an act of God the numbers do not lie. When inventories are tight,

prices tend to respond as illustrated in the charts below.

Recent Crude Oil Price History

20

30

40

Sep-02 Oct-02 Nov-02 Dec-02 Dec-02 Jan-03

WTICru

deOil,$/bbl

Source: Bloomberg and Simmons & Company International.

Crude Oil Price/Inventory Relationship

250

300

350

400

Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

CrudeInventory,mmbbl

5

10

15

20

25

30

35

40

WTICrudePrice,$/

bbl

Note Inverted ScaleCrude Oil Inventory

Inventories

WTI Crude

Price

Source: DOE, Bloomberg and Simmons & Company International.


3/12


Where Are We Now? (continued)

OECD Inventories: According to the IEA, December 2002

OECD crude inventories were 857 million barrels, 6% lower

than the prior year and 5% lower than the five-year average

for this time of year. Over the last half of 2002, inventories

have fallen by 700,000 barrels per day compared to average

seasonal trends of 100,000 barrels per day.

U.S. Inventories: US crude oil inventories are at the lowest

absolute level since 1975. A 1998 study conducted by the

National Petroleum Council pegged minimum operating

levels at 270 million barrels. The most recent DOE estimate

for U.S. crude inventory is 273 million barrels. Although

minimum operating levels are a theoretical estimation, the

ongoing reaction of the U.S. refinery system confirms that

the system simply cannot get much tighter without

substantial operation disruption.

The inventory situation is even more dramatic when one

considers the days supply of inventory (lowest ever) and the

fact that PADD II inventories (where West Texas

Intermediate is priced) are 25% below average.

Total U.S. Crude Oil Inventory (Excluding SPR)2002 2003 Max 1992 - 2002 Avg 1992 - 2002 Min 1992 - 2002

260,000

280,000

300,000

320,000

340,000

360,000

D J F M A M J J A S O N D

('000bbl)

Source: DOE and Simmons & Company International.

Regional U.S. Crude Oil Inventory

15,00711,929

5-Year Avg Current

PADD I67,058

50,262

5-Year Avg Current

PADD II

158,799 146,515

5-Year Avg Current

PADD III

12,794

12,261

5-Year Avg Current

PADD IV

57,967

51,932

5-Year Avg C urren t

PADD V

Source: DOE.


4/12


What Could Pressure Crude Prices Higher?

Although some might scoff at the notion of crude oil trading higher from $36 per barrel, it is far from

impossible. We will examine, in varying levels of detail, some of the influencing factors that could further

tighten an already tight global crude oil market, driving commodity prices even higher.

Supply disruptionsSupply disruptions (and fear of supply disruptions) have been

a significant recent influence on the crude oil market. With

worldwide and U.S. inventory at such low levels, even small

supply disruptions could be quite meaningful on the margin.

The irony is that at a time period when there are more macro

supply disruption possibilities than ever before (Iraqi war,

terrorism, Venezuela, etc.), the market is as vulnerable to

price spikes as it has been in the past decade.

Venezuela: Political upheaval has resulted in dramaticallyreduced Venezuelan production and therefore lower

Venezuelan exports. Current signs indicate a slow recovery

in production is underway. According to the opposition

which we deem as the most credible source on PdVSA

production levels - production has climbed from a mere

200,000 barrels per day in early 2003 to somewhere around

1.4 million barrels per day.

However, the political situation in Venezuela is tenuous at

best. The opposition has been placated with promises of an

August referendum on the Chavez presidency. If a political

tempest were to again manifest (and signs indicate that

trouble is indeed still brewing), it is easy to see how thefledgling production recovery could be derailed, sending

export levels back toward zero.

Iraq: Although most of the focus on Iraq has been on the

probabilities and timing of a military conflict, we should not

forget that Iraq is a significant exporter to the world oil

markets. As shown in the graph below, Iraqi exports are

volatile, but have averaged close to 2 million barrels per day

over the last five months. Ironically, with the advent of the

Venezuela export disruptions, Iraq became the incrementalbarrel. As long as Venezuelan production is relatively

subdued, a military conflict does not have to occur for Iraq to

put upward pressure on crude prices. Imagine the scenario

where Saddam Hussein decides to wage economic war via

shutting off Iraqi exports!

It is impossible to know with any certainty the magnitude of

OPECs excess productive capacity (if any) but it will

certainly be tested if Iraq and Venezuela are simultaneously

off-line.

Iraq Production History

0

1

2

3

4

Dec-00 Dec-01 Dec-02

IraqProduc

tion,mmbpd

Weekly Production (4 wk Average) Average Quarterly Production

Iraqi Internal Consumption:0.6 mmbpd

Source: UN and Simmons & Company International.


5/12


What Could Pressure Crude Prices Higher? (continued)

Nigeria: In the past week, export bureaucrats in Nigeria

threatened to strike and disrupt Nigerian exports. Other

Nigerian oil workers unions quickly indicating their support,

if needed all of which sent a shudder through the crude

markets. In the oil patch, situations of this nature are

commonplace particularly in Nigeria, which boasted bare -

breasted women protestors demanding jobs for their

husbands, sons and brothers. On a worldwide basis (not just

Nigeria), these nuisance strikes take on magnified

significance in the current environment of tight global

supply. It is an opportune environment for workers to

consider taking economic hostages by threatening supply

delays or disruptions.

Iraqi Military Conflict: The Big Kahuna. Will bombs start

falling? What will happen if they do? At a minimum, we

would expect that Iraqi exports would fall by a significant

amount. Any number of additional possible situations could

develop that would reduce Middle Eastern oil supplies:

An Iraqi scorched earth approach creates long-term

damage to Iraqi (and possibly several Kuwaiti)

oilfields. In this scenario, exports could take years

to return to current levels.

The Iraqi government or military is successful in

damaging the infrastructure or political stability of

its Middle Eastern neighbors. For instance, the

Abqaiq processing center handles all the crude from

Saudis giant Ghawar, Shayba and Abqaiq fields. A

Scud missile into this area would instantaneously

alter the current supply/demand balance for crude.

The Iraqi military succeeds in blocking the Strait of

Hormuz via the sinking of a tanker resulting in

decreased exports from the Middle East for days or

weeks. Over 13 million barrels of crude move

through the Strait each day. Although Iraq was not

successful in closing this shipping lane in the Gulf

War, it only takes one lucky shot to cause a supply

disruption.

There are probably twenty other iterations around

the regional conflict escalation theme as described

above some involving the Middle East, others

involving non-Middle East Islamic countries

(Indonesia, etc.), others involving energy-focused

terrorism. When a war erupts in a region anything

can happen. When terrorists target energy

infrastructure anything can happen. The longer

hostilities are ongoing, the more likely some sort of

destabilizing incident could occur.

A detailed discussion of potential Iraqi military

scenarios can be found in our August 22, 2002

report entitled Iraq Scenario Analysis.

Nigeria Production History Challenging Logistics In The Middle East

1.6

1.65

1.7

1.75

1.8

1.85

1.9

1.95

2

2.05

2.1

Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03

mmb/d

Strait Of Hormuz

SAUDI ARABIA

UNITED ARAB

EMIRATES

IRAN

Source: IEA and Simmons & Company International.


6/12



Weather

Mother Nature can be cruel or kind to the oil markets.

Seasonal demand patterns are unlikely to be dramatically

altered, but extreme weather (a cold winter in particular) can

drive higher domestic demand in many countries, reducing

the supplies available for export. Weather can also intervene

directly just ask the captains of the tankers operating out of

Russias five major ports. Icy conditions due to extreme cold

hampered export loadings. Russian exports essentially

remained flat year-over-year even though production

increased by 11%. Blankets anyone?

Japans Nuclear Situation

Japan has no domestic crude oil production but is the

worlds fourth largest consumer of energy and second largest

energy importer. Nuclear power generates 30% of Japans

electricity, while oil-fired generation comprises 9%. During

2002, a scandal developed within the Japanese nuclear

industry, as executives revealed they had knowingly hidden

cracking and other problems in several nuclear facilities. An

industry-wide inspection campaign was implemented, and a

significant amount of capacity was idled for safety reasons.

In many instances, idle oil-fired capacity was brought on to

offset the lost nuclear capacity. This created incremental

demand for approximately 600,000 barrels per day of crude.

Should the inspection process reveal more widespread

problems with Japans nuclear facilities, the amount of crude

needed to offset nuclear outages could grow, and the

temporary increase in oil demand could potentially become

more permanent.

Decline Curves

20% of worldwide production comes from fields that began

production before the 1960s. Much like these authors, old

fields are not getting any younger. Worldwide (or even

basin-wide) aggregate production decline curves are among

the oil industrys biggest and most important mysteries. It

would be presumptuous to assume that decline curves were

going to be a prime driver in production shortfalls over the

next quarter old reservoirs simply dont react that fast.

However, the point is that a significant portion of the worlds

oil supply is facing relentless downward pressure. The recent

reduction in long-term growth forecasts by several of the

worlds largest oil companies is evidence that base decline

rates are an important factor to consider.

In The Grip of Mother Nature

Source: U.S. Navy.


7/12



Natural Gas Prices

In a report about the influences on crude oil prices, one does

not usually expect a discussion about natural gas. However,

the U.S. natural gas market is extremely tight. Low and

falling inventories, coupled with falling supplies have

generated high prices (sound familiar?!?). High natural gas

prices relative to crude oil prices can create the incentive for

dual-use facilities to switch between fuels. Although

currently near parity, gas market factors could easily cause a

disconnect that would provide incremental demand for crude

oil products witness the gas price spike in recent days. The

magnitude of incremental demand created by switching away

from gas in the winter of 2000/2001 was approximately

500,000 barrels per day. Not a trivial number.

Economic Growth

The slower pace of oil demand growth over the past three

years (0.4% per year) compares with almost 2% per year

during most of the 1990s. Growing economies are generally

energy-hungry. If the world is indeed emerging from a

period of economic malaise, demand growth is likely to

accelerate from the relatively anemic pace of the past few

years.

0

10

20

30

40

50

60

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

P

rice($/boe)

NYMEX Gas

NYC No. 6 Spot

Economics Favored Residual Fuel Oil(No. 6) Over Natural Gas

Historical Gas / Oil Switching Incentives



8/12


What Could Pressure Crude Prices Lower?

Look out below? We will examine, in varying levels of detail, some of the influencing factors that could drive

commodity prices lower from todays level.

Terrorist Attacks

Although gruesome to ponder, the possibility of additional

terrorist attacks on U.S. or European soil cannot be ignored.

Although perhaps not as debilitating as the 9/11 events, a

period of paralysis could be expected. Theoretically, this

could lower demand for jet fuel and motor gasoline, as well

as spooking commodity markets about the prospect of slower

economic activity (and hence lower energy demand).

Seasonal Demand

Summer follows winter. Due to more moderate temperatures

and reduced space heating demand in the Northern

Hemisphere, worldwide crude oil demand is typically lower

in Q2 and Q3 compared with Q4 and Q1. The IEA forecasts

Q203 demand of 76.6 million barrels per day versus demand

of 78.6 million barrels per day in Q103, a decline of 2.0%.

As we move through 2003, the seasonal sequential decline in

demand could result in softer hydrocarbon prices as could

any weather-related build in inventories above the seasonal

average of 1 million barrels per day.

Resumption Of Venezuelan Production

After rebounding from recent lows, Venezuelan production

still remains roughly 1.5 million barrels below its pre -strike

output. If Chavez is successful in regaining control of

PdVSA and moving the operations toward normalcy, we can

expect much of the currently idle capacity to be returned to

the market. It remains our contention that this process,

assuming no additional unrest, will be slow. However, the

Venezuelan governments thirst for capital to provide

economic momentum in front of the August referendum is a

strong motivation to increase production. If this production

returns, it will have an impact on the market.

Seasonal Demand Change from 2Q to 1Q

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

2001 2002 2003E

Worldwidedemandchangefrom

2Qto1Q


Venezuelan Daily Crude Production

0

0.5

1

1.5

2

2.5

3

3.5

1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 Jan-03 Feb-03

(mmbpd)



9/12


What Could Pressure Crude Prices Lower? (continued)

Deepwater Volume Additions

Over the next 12-18 months, new crude oil supply will be

coming to the market in the form of initial production from a

number of deepwater projects. The land rush and deepwater

exploration drilling boom of the late 1990s is coming to

fruition, particularly in West Africa and, to a lesser extent,the Gulf of Mexico. Roughly 430,000 barrels per day of

incremental deepwater production will enter the marketplace

in 2003. The wild card is how much of this production is

truly incremental versus offsetting declines of existing

production. We will address this topic (and related

deepwater issues) in an updated deepwater report later this

winter.

Robust E&P Cash Flow And Project Economics

The cash pouring into E&P company coffers is undeniable.

Compared to most E&P budget expectations, current cash

flows are the equivalent of a winning lottery ticket. If the

current futures strip holds, 2003 cash flows will increase

75%+ depending on the companys production mix. These

robust cash flows can be used for a number of corporate

purposes dividend payments, stock repurchases, debt

repayment and reinvestment back into the business.

At current commodity price levels, the economics of an oil-

related project are very strong (an understatement). The

chart below highlights a prototype West Texas infill project.

We do not expect West Texas to provide any meaningful

supply increment, but use this example to show the

economics of a marginal oil prospect. Projects in thismature basin are generally considered to be lower quartile

opportunities but strong prices make even these projects

look good.

Obviously, E&P budgets are not based on $30 per barrel

pricing. But history has shown that budget expectations

begin to creep upward during periods of robust prices.

Additionally, strong markets tend to create some rate

acceleration projects that are driven by shorter-term price

expectations. Simply put, high prices encourage incremental

drilling and production activity which results in the potential

for higher supply.

Worldwide Incremental Deepwater Production

Year (mmb/d)

2003 430

2004 150

2005 670

2006 650

Source: Simmons & Company International.

West Texas Oil Project Economics

Imputed IRR Sensitivity

Initial Production (bpd)

50 75 100 125 150

12 -14% -13% -13% -12% -12%

15 -7% -4% -1% 2% 4%

18 -2% 3% 8% 12% 17%

21 3% 10% 16% 22% 29%

24 7% 16% 24% 32% 41%

27 12% 22% 32% 42% 53%

30 16% 28% 40% 53% 66%WTINYMEX($/bbl)

Source: Simmo ns & Company International.


10/12


What Could Pressure Crude Prices Lower? (continued)

Economic Slowdown / Demand Destruction

Energy-hungry growth regions such as China and Southeast

Asia have been very resilient to increased crude oil prices.

The economic growth in these regions has allowed them to

absorb higher raw material costs oil demand grew even

during the Asian Contagion events of 1997/1998. Slower-

growing, more-developed economies have not been as lucky

in recent years. OECD oil demand remained essentially flat

from 1998-2001, a period of relatively high oil prices and

relatively low economic growth. If the current worldwide

economic recovery stalls and demand growth remains

anemic, todays oil prices could be at risk.

Release From the Strategic Petroleum Reserve

Details regarding the Strategic Petroleum Reserve (SPR) can

be found in our February 6, 2003 report aptly entitled The

Strategic Petroleum Reserve. Although unlikely to be used

unless a war develops in the Middle East, the SPR contains

approximately 600 million barrels of crude oil and has a rated

maximum withdrawal rate of 4.4 million barrels per day.

The purpose of the reserve is not to influence price but rather

to ensure the availability of supply. We would expect any

SPR release to have a moderating (although not necessarily

negative) impact on oil prices.

Asia Pacific and Chinese Oil Consumption vs. Yearly Demand Change

16,000

17,000

18,000

19,000

20,000

21,000

22,000

1995 1996 1997 1998 1999 2000 2001 2002

('000barrelsperday)

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

Oil Consumption

Yearly Demand Change


OECD Oil Consumption vs. Yearly Demand Change

44000

44500

45000

45500

46000

46500

47000

47500

48000

48500

1995 1996 1997 1998 1999 2000 2001 2002

('000barrelsperday)

-1%

0%

1%

2%

3%

Oil Consumption

Yearly Demand Change



11/12


What Could Swing Prices in Either Direction?

Speculative Commodity Positions

Changes in speculative positions can have a meaningful

impact on oil price. Typically, commercial players are

usually not interested in making directional bets on

commodity price via the financial markets. Thus, non-

commercial or speculative positions tend to exert more price

influence. Currently, the speculative open interest in crude

futures is near five-year highs (the NYMEX rolling three

week average open interest is shown in the chart below).

Interestingly, the bets being made by non-commercial

players are almost evenly balanced between long positions

and short positions (89,000 long, 97,000 short as of Friday,

February 21, 2003). Profit-taking by the longs could hurt

prices. A short squeeze could drive prices higher. Who will

blink first depends on the outcomes of the events previously

discussed. If recent natural gas price behavior is anyexample, the speculative game of chicken can be very

violent.

OPEC

The past several years have seen the cartel operate with more

cohesion than ever before. Should OPEC be able to maintain

its discipline or choose to remove crude oil barrels from a

tight market, prices could be pressured higher. Inadvertently,

OPEC could also be a driver of higher prices if it turns out

that their excess production capacity is less than expected

depriving a tight market of expected barrels. Conversely,

OPEC cheating during lull demand periods or a perceived

breakdown of OPEC discipline could result in lower prices.

This risk grows in a post-Iraq war scenario when cartel

members must give up existing quotas to allow for higher

Iraqi output

NYMEX Crude Non-Commerical Open Interest

0

20,000

40,000

60,000

80,000

100,000

120,000

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02


Conclusions

Where do oil prices go from here? Higher, lower or sideways? What today is considered outlandish could become the consensus

thinking of tomorrow. Issues unforeseen in this report could become significant factors. Six months ago, who would have thought

that Venezuela would be just as important to the energy markets as Iraq?

When it comes to the current outlook for oil prices, the only certainty is uncertainty.


12/12

Simmons & Company International

Institutional Securities Group

www.simmonsco-intl.com

Houston, Texas

Research Department Institutional Sales

Local (713) 223-7840 Local (713) 223-7840

Toll Free (800) 856-5508 Toll Free (800) 856-5508

Trading International Watts

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crude oil prices a factor of influencing issues