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Bridgewater ®Daily Observations March 31, 2016 ©2016 Bridgewater Associates, LP (203) 226-3030 Greg Jensen Atul Narayan Spencer DeSena Thoughts on the Oil Investment Cycle We are in the midst of the fourth major oil investment bust since 1900, and while this cycle is different in some critical ways (particularly the speed at which investment translates into output), the big picture process is the same as in previous cycles. Commodity investment cycles tend to follow a broadly classic process: 1) In the first phase, a pickup in commodity-intensive growth causes a global surge in demand for commodities to outstrip supply. As demand pushes up against capacity limits, prices rise. 2) In the second phase, high prices caused by the supply and demand imbalance induce large amounts of capital expenditure. As prices rise, margins for commodity producers widen and profits increase. These producers, flush with cash and looking at high prices, invest in profitable opportunities to expand production. There is a massive investment boom. This acts as a support to growth and inflation as capital expenditure accelerates. 3) The third phase is typically marked by a slowdown in commodity demand that occurs when the original growth that sparked the cycle fades and high prices incentivize reductions in demand growth, by encouraging substitution and efforts to improve efficiency. Simultaneously, the investment boom begins to bring new supply online, demand/supply imbalances ease, and prices stabilize. Thus, high prices help set in motion the increase in supply and reduction in demand that eventually lead to the turning of the cycle. 4) In the fourth phase, there is a supply glut. The balance between demand and supply swings sharply in the other direction, as production is much greater than demand. This phase is typically characterized by large price declines. 5) As prices fall, margins for commodity producers are squeezed. And, in the fifth phase, producers respond to low prices by slashing investment and in some cases shutting down production permanently. This decline in supply eventually brings the market back into balance, as the low investment deteriorates capacity, sowing the seeds for the next cycle. We are currently in stage 5 of the most recent cycle, where years of investment have left the market oversupplied and prices at the lowest level in a decade. The move in oil prices has resulted, as one would expect, in a collapse in investment that is no longer profitable. For most of 2016, there will likely continue to be a significant spot oil glut, as the lag between production and investment means that cuts will only gradually bite into production. However, unless prices rise significantly, supply will likely fall short of demand some time in 2017, leading to one of the most significant shortages in the history of the oil market soon thereafter. At this point, the forward price of oil does not appear high enough to create the needed investment, and the longer oil prices remain low, the larger the future gap between supply and demand is likely to be. © 2016 Bridgewater Associates, LP. Any publication or other use (including, without limitation, distribution via email or any internet posting) of Bridgewater Daily Observations™ without prior written consent from Bridgewater Associates, LP is prohibited by US and foreign copyright laws. Bridgewater® is a registered service mark of Bridgewater Associates, LP. All rights are reserved. 1 Bridgewater® Daily Observations 3/31/2016 North EM Demand $120 Automobile WWII: Sea. Oil $100 California. most of the world’s investment opportunities are uneconomical. In the near term.4% 140 1. as massive capex cuts from more traditional producers (with longer lag times between investment and production) flow through to supply.6% 3-Yr Fwd 60 40 0. As described above. While there is lots of uncertainty around exactly how long the market will remain out of balance. cuts in shale investment have and will continue to bite into production. The Long-Term Oil Investment Cycle World Oil Capex (%GDP) Real Oil Price (2013 $) $160 1. Global Oil Breakeven Investment Curve World Oil Capex (%GDP) 2016 Est 160 1.2% 20 0 0.9% boom: Texas.3% $20 $0 0. Mideast and Deepwater.2% 120 1. and further cuts of at least 15% are likely this year. we walk through our picture of the current supply and demand dynamics in more depth. If prices remain low. the cause and effect linkages that drive them are the same. we are likely to see capex collapse even further.0% 0% 50% 100% 80 85 90 95 00 05 10 15 20 2 Bridgewater® Daily Observations 3/31/2016 .8% 80 0.4% Spot Oil Price 0. which is necessary to allow supply to catch up with demand.5% $40 0. In the appendix. Below. we describe each of these past booms. The chart below shows the four major oil investment booms since 1900 and the price levels that spurred them.Before we dig into where we stand in the current oil investment cycle.0% 100 0. it is worth offering some perspective on the major oil investment booms and busts over the last 100 years.7% $80 after WWII $60 0. a particularly large reduction in supply could leave the market undersupplied as soon as 2017. and Shale Oklahoma during and 0. While the details of each cycle are different.1% $140 OPEC shocks: Lat Am. and Russian oil Sands. Low Oil Prices Have Led to a Sharp Pullback in Investments At current spot and forward prices. Consistent with this picture. the supply glut phase of the cycle sows the seeds for a price rebound. over 20% of global oil capex was cut in 2015. and the supply issue is amplified going forward. and Alaska boom: 0.1% 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 The current leg down in the commodity investment cycle (and accompanying decline in prices) has severely impacted the medium-term outlook for oil supply. combined with its relatively high cost of production. squeezing service providers. US shale is the main source of oil supply where production has already turned. Additionally. meaning that capex cuts hit production faster in current (and future) cycles than has been the case historically. in large part because companies have managed to focus on only their most productive wells and to tighten their belts in typical cyclical ways (by firing employees.). US shale production is much more responsive to prices than traditional sources of production—high decline rates mean that practically continuous reinvestment is required to maintain production levels. there are limits to how long companies can fight the tide of falling oil prices with this type of cost cutting. The dynamic nature of shale. the positive impact of a price increase on shale production is somewhat muted by the fact that these costs would also increase. rig counts have plummeted to 2010 levels and production started to decline in the second half of last year. ahead of traditional counterparts. etc. Total US Shale Oil Active Rigs US Shale Production (mb/d) $35 (current spot) 1400 Oil as discounted in futures curve 1200 Gradual increase to $60 1000 6 800 600 4 400 2 US shale rigs are now back 200 to 2010 levels 0 0 07 09 11 13 15 07 09 11 13 15 17 19 21 3 Bridgewater® Daily Observations 3/31/2016 . because many of these cost-saving measures are tied to oil prices and associated activity levels. and production is likely to continue to decline over the next year. Potential Shale Investment by Example Well Production Profiles Breakeven (% of Total) 50% Shale Traditional 40% 30% Production 20% 10% 0% $70-$80 $60-$70 <$40 $40-$50 $50-$60 >$90 $80-$90 Time As a result.US Shale Production Has Already Turned and Will Continue to Decline in the Coming Year So far. Declines in shale production thus far have actually been smaller than many expected. However. The time between initial investment and oil extraction is also significantly shorter for shale. makes it particularly vulnerable in today’s price environment. as past investments continue to come online. which will fade over the coming years. OPEC production has actually increased over the past year. increasing the glut 43 38 Decline will accelerate as 41 Boost from Iran 36 capex cuts start to hit coming online over production 39 the next two years 34 37 32 07 09 11 13 15 17 19 21 07 09 11 13 15 17 19 21 While Low Oil Prices Have Led to a Bleak Supply Outlook. Demand Is Expected to Grow at a Moderate Pace Global oil demand will continue to grow at a moderate pace. as the massive cutback in investment over the past year flows through. but OPEC output is otherwise expected to remain flat at high levels over the next few years. 4 Bridgewater® Daily Observations 3/31/2016 .Outside of Shale. driven entirely by the EM world. Non-OPEC supply outside of the US is set to start declining gradually in the coming months. Production Has Not Yet Turned but Will Likely Decline Meaningfully in the Coming Years While investment has been cut across all sources of production. The return of Iranian production following the lifting of nuclear sanctions is expected to provide a near- term boost to production. Non-OPEC ex-US Production (mb/d) OPEC Production (mb/d) Supply Projection Supply Projection 47 42 OPEC ramped up 45 production over the past 40 year. as OPEC stepped away from its role as swing producer and chose instead to produce at nearly full capacity. While oil demand is driven primary by economic growth—which typically accounts for around three-quarters of the change—it is also affected by the oil price itself. against a backdrop of modest global growth. non-shale supply has not yet turned. and we are likely to see a meaningful acceleration in supply declines beyond 2017. Demand has received a boost from this cycle’s price decline. as past investments in chemical plants come online to meet rising EM demand for plastics. especially in power 40 60 40 20 20 0 0 65 75 85 95 05 15 25 65 75 85 95 05 15 25 Below. IEA) 20 18 16 14 12 10 8 6 4 2 0 S. Proposed Efficiency Increase in 2020 of New Passenger Vehicles (mpg. US CAFE standards call for roughly 4% annual efficiency gains in new cars. manifesting in lofty standards for carmakers and penalties for non-compliance. The transportation sector. which accounts for 55% of global oil demand. such as China. the EU. Korea China EU US Canada India Saudi Arabia 5 Bridgewater® Daily Observations 3/31/2016 .From a sector demand perspective. have set similarly aggressive targets. we highlight some of the dynamics affecting transportation sector demand. Rising Fuel Efficiency Standards Will Be a Drag As environmental concerns mount. the transportation and petrochemical sectors are likely to account for the majority of demand growth. though the impact will be fairly small as little oil is used for power generation at this point. twice the rate we’ve seen over the past decade. normalized to CAFE. World Oil Demand (mb/d) World Oil Demand by Sector (mb/d) OECD Transportation Petrochemicals Non-OECD Power Generation Other 120 EM will drive the global oil demand Petrochemicals and growth as developed world demand 100 transportation will continue to 60 continues to decline grow. and Korea. Other regions. as pressure from rising fuel efficiency regulations (such as CAFE standards in the US) is somewhat offset by continued vehicle fleet growth in the EM world. Oil is also expected to continue to lose market share to renewables and other sources of energy in the power sector. Feedstock demand from the petrochemical sector is expected to be strong. governments across the globe have made a big push to increase fuel efficiency. as shown below. is likely to grow at a modestly slower pace in coming years. while use declines 80 gradually in other sectors. For example. standards are competing with low fuel prices.To illustrate the point. such as China and India. Most of the demand growth within the transportation sector is likely to come from EM economies. In addition. though it is equally valid for light trucks and heavy vehicles as well. The stated regulations appear to be a high target (and could change in upcoming reviews if the goal winds up being too lofty). these countries are expected to see a rapid increase in vehicle penetration off of very low levels. The charts below illustrate this dynamic for cars.. which are seeing growing middle classes. current CAFE standards call for more sustained and faster improvement than we’ve seen at any point over the past 35 years. Wood Mac) US Germany Japan 300 China India . That said. Car Ownership per Thousand (Wood Mac) Increase in Global Car Stock from 2014 to 2035 (Mln cars. the impact has the potential to be meaningful for global demand... If other countries follow a similar pattern. Past increases in fuel efficiency have been accompanied by large increases in oil prices—in this instance. 2 No gains assuming 60% compliance 8 ahead of standards 20 as oil prices rise 1 10 7 65 70 75 80 85 90 95 00 05 10 15 20 25 85 90 95 00 05 10 15 20 25 But Rising Vehicle Penetration in Emerging Markets Is Exerting Upward Pressure on Demand Increasing demand for vehicles from emerging market consumers is likely to somewhat offset the downward pressure from rising efficiency standards.. it’s hard to know to what extent companies will actually adhere to standards if consumer preferences are at odds with policy objectives.5 mb/d by 2020. The chart on the left below lends some historical perspective to the case at hand. 0 95 00 05 10 15 20 25 30 6 Bridgewater® Daily Observations 3/31/2016 . full adherence to CAFE standards in the US would result in a reduction of oil demand by about 0. US New Passenger Vehicle Fuel US Road Transport Oil Demand (mb/d) Efficiency Standards (mpg) Assuming Trend Efficiency Gains Oil Price (log) Full Compliance with CAFE US Passenger Car CAFE Standards (mpg) 60% Compliance with CAFE Actual CAFE Fuel Economy (mpg) 12 5 60 Rising efficiency following 11 oil shocks as standards put 50 4 into place 10 40 3 ~0.5mb/d drag from 9 30 efficiency gains by 2020 Rising efficiency. In particular.which means that they 250 800 will see a massive 200 increase in car stock over the coming decades 150 600 100 400 50 India and China are expected to see a sharp increase in car 0 Iran Mexico Indonesia India China Thailand Saudi Arabia Turkey Brazil US Rest of World ownership rates from low 200 levels. only 0..2-0. Inventories % of Demand (Y/Y) Oil Contango (12M .7 0. 0. Over the past year and a half.0 10 15 20 25 10 12 14 16 18 20 22 24 26 Inventories Are Helping to Bridge the Gap.And the Impact from Fuel Switching Will Be Limited in the Next Few Years Disruptive technologies like electric.. OECD Comm. the necessary battery technology to incentivize mass adoption is likely at least a few years away. infrastructure bottlenecks (e. the steep oil futures curve has incentivized a rapid build in oil inventories. World EV Sales (% of Total) World Displaced Oil Demand from Goldman Sachs Electric Vehicle Sales (mb/d) Barclays Goldman Sachs Barclays Goldman Upside Goldman Upside 16% 0.g.1 0% 0. For this mechanism to work.2 0.impact on oil demand Even under some 0.Spot) $15 12% Steep contango has been incentivizing inventory builds $10 7% $5 2% $0 -3% -$5 -8% -$10 -13% -$15 1995 2000 2005 2010 2015 7 Bridgewater® Daily Observations 3/31/2016 . because they can sell at a future date for a price where they make a profit. In the case of natural gas vehicles. high upfront costs (which are only slowly improving). but current economics are unfavorable and logistical bottlenecks stand in the way of near-term mass adoption.3 mb/d of oil are expected to be displaced over the next five years. the lag between investment in battery factories and production is sufficiently long (and the current investment level is sufficiently low) to make expectations of mass adoption within the next five years impractical. market participants have to be willing and able to buy oil today and pay the costs associated with storing it.4 growth will be limited of the most bullish 8% expectations.. Inventories today are helping to smooth an oversupplied market. For electric vehicles.5 . Additionally. and the current limited availability of natural gas/LNG shipping in many regions present major near-term roadblocks. the charts below show a range of possible paths for electric vehicle demand—in even the most bullish scenarios.6 12% 0. The price of oil will reflect how these net out...and natural gas-powered vehicles have the potential to displace a significant amount of oil demand in the longer term. but Limited Cheap Storage Capacity May Be a Downward Pressure on Prices in the Near Term Oil supply can be met by demand or stored as inventory. fueling stations). barring a technological breakthrough in the production process. For example.3 4% 0. as they move supply from today into the future. Reported OECD inventories are at record highs.0 2007 2009 2011 2013 2015 2017 2019 2021 8 Bridgewater® Daily Observations 3/31/2016 .5 in early 2017 86. given the prices prevailing in forward markets. If the price move to change the investment comes too late. Crude Inventories (Mln barrels) barrels) 3100 Estimated US Capacity 3000 700 At record highs 2900 600 2800 Very high capacity utilization 500 2700 2600 400 2500 300 2400 2300 200 90 95 00 05 10 15 90 95 00 05 10 15 Barring a Significant Price Increase. The following chart shows what we expect for oil supply and demand. Oil Markets Will Likely Shift to Undersupply by 2017 Overall.5 81. the price moves could be large and disruptive. Crude Inventories (Mln US Comm. which would be a downward pressure on oil prices and likely require even lower prices than are discounted for the upcoming year OECD Comm. there is a risk that this storage capacity fills and oil has to be increasingly stored in more expensive offshore tankers or even shut in. While it’s difficult to know precisely how close we are to actual capacity limits. unless prices change.0 98.5 91. and US commercial storage (especially Cushing) is operating at close to 90% utilization rates. we expect the oil glut to lead to a major shortage starting at some point in 2017.0 We could move into undersupply 88.0 93.0 83.5 96. World Oil Supply and Demand (mb/d) Supply Demand 101. doubling in real terms over the course of the decade. in combination with a slowdown in demand growth resulting from the US recession in the early 1960s. with prices falling by 50%. Oklahoma. in order to provide some perspective on the current cycle and what we might see going forward. crude oil production was initially developed as an alternative lighting fuel to whale oil. and the market had to work through significant oversupply. led to a boom in investment in novel resources in Alaska. in combination with the discovery of the massive East Texas oilfield (the largest in the US).000 residents in 1900 to 87 by 1920—and oil prices rose with it. 9 Bridgewater® Daily Observations 3/31/2016 . World Oil Production (mb/d) US OPEC Russia Europe Lat Am Other Beginning of Investment Booms 100 90 80 Each boom diversified where the world got its 70 oil from 60 50 40 30 20 10 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 There have been four major investment cycles in the oil market. California. and Louisiana. the real price of oil declined by a third in the 1960s. the dominant source of the day. coupled with a flood of liquidity in the wake of the Bretton Woods breakup. However. which limited the degree of overheating and overinvestment. in particular the USSR and the Mideast. Starting in WWII. kicked off an investment boom that lasted decades. Russia. whose price escalated as the result of decades of overfishing. where high prices have incentivized investment that eventually unlocked new sources of supply. the US share of global production halved. we walk through some historical examples of oil cycles to show how oil investment cycles have played out over time. • Demand growth from WWII. • The OPEC price shocks (in ’72 and ’79). During this time. as supply came online from these new regions. During and after WWII. where governments had not only pushed to invest in new sources of oil but had taken on foreign borrowing to finance this investment. pushed the market into surplus.Appendix: A Brief History of Oil Investment Cycles Below. Each oil boom brought on new supply to the market. moderated production in order to sustain flat nominal pricing.1 vehicles per 1. this boom saw the development of new sources of production in the emerging world. Each cycle brought online new sources of production and diversified where the world got its oil from. and the North Sea. either from the discovery of new fields or from tapping known fields that previously weren’t economically or technologically feasible. This dynamic incentivized a wave of investment that unlocked new fields in Texas. The surge in demand was dramatic—US motor vehicle registrations rose from 0. While the US. • The first real investment cycle in oil occurred in the 1910s. demand waned in the face of skyrocketing prices. and prices fell by more than 70% in the early 1930s. led by Texas. Higher-cost producers cut investment spending in the face of compressed margins and deteriorating balance sheets. as the automobile age ushered in a new source of demand for oil. the price of oil was largely government regulated. and credit problems emerged in Latin America. in the same way that high oil prices have unlocked unconventional oil sources in the most recent boom. 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