SocGen's Three Scenarios For Oil See Crude Price Between $110 And $200

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After Nomura released a report two weeks back predicting oil could rise to $220 if the MENA situation escalates, this morning SocGen's Michael Wittner has released his own scenario analysis on the possible outcomes of the 2011 revolutions. His three cases see oil within the following escalating thresholds: $110-$125; $125-$150; and $150-$200. We are fairly confident that the worst case, which as expected involves all sorts of bad things happening in Saudi Arabia, is missing an extra zero somewhere. Some key observations from the report (attached below): "The forward curve for Brent, the better indicator of global oil market fundamentals, is currently in backwardation (nearby premium, forward discount) for the next 5 years, reflecting concerns over growing physical tightness in the crude markets. The oil markets are pricing in an extended Libyan shutdown of crude exports (see below). Even on the WTI forward curve, where prices are still under pressure from local mid-continent US market conditions, the contango has eased and now only extends through 2011; from 2012 through 2015, WTI is also in backwardation. As the Libyan crisis has escalated, the latest US CFTC data show that non-commercial net length for NYMEX WTI futures has reached an all time high. This is a key indicator that a new wave of investor flows is now moving strongly into WTI and the oil complex in general. With the widespread unrest in the Middle East and North Africa (MENA) region expected to continue, and the oil markets worried about further supply disruptions, the attractiveness of commodities and oil to investors has been underscored. With oil prices driving heightened concerns over inflation, oil itself is seen as a good hedge against inflation." In summary, SocGen sees about $15/bbl risk premium built into current prices, which could jump to as much as $110.

Full SocGen Oil Market Scorecard:

Scenario highlights:

Geopolitical Scenario 1: Libya shutdown, plus widespread unrest in the Middle East and North Africa. Brent price range of $110-125/bbl

This is the scenario that we are in right now. Current shut-in Libya crude production - lost supply - is roughly estimated at around 1.0 Mb/d by the IEA. This leaves crude output of around 600-650 kb/d, compared to normal crude production of 1.65 Mb/d.

Crude exports were estimated at 500-600 kb/d in the past week by the IEA, compared to normal crude exports of 1.30-1.35 Mb/d.

With refinery operations disrupted, almost all crude supply was exported, though the export figures also include crude drawn from inventory at operating export terminals.

Will the shut-in volumes go higher? The answer is "yes". As the conflict drags on, it is entirely possible, and maybe even probable, that Libyan oil production and exports will drop all the way to zero, without foreign personnel from oil and oilfield service companies.

So far, in response to the loss of 1 Mb/d of Libyan crude, Saudi Arabia has reportedly increased production by 0.4 Mb/d to 9.0 Mb/d; the Saudis are probably in the process of increasing output further. As we have previously noted, the Saudis can make up the volumes but they cannot make up the quality. In contrast to high quality light sweet Libyan crude, most Saudi spare capacity is medium sour. The Saudis have said that they have some spare crude capacity that is comparable to Libyan grades, but it is unclear how much, and there is market skepticism about these claims.

Importantly, before the Libyan crisis, according to the IEA, Saudi Arabia had spare crude production capacity of 3.5 Mb/d (crude output of 8.6, compared to capacity of 12.1 Mb/d). But now, after increasing output by 0.4 Mb/d, Saudi spare capacity is down to 3.1 Mb/d. As they increase production, Saudi spare capacity will go lower. If Libyan exports go to zero and the Saudis make up for the entire 1.5 Mb/d by themselves, Saudi spare capacity will fall to 2 Mb/d.

Aside from "how big will the Libyan shut-ins get"?, another critical question for the oil markets is: "how long will the shut-ins last"? This is a huge wildcard - a "known unknown"  - and it depends on whether and when Gaddafi steps down or is forced out, and how long the developing civil war lasts.

Judging by elevated price levels across the crude forward curves, as well as the backwardation, the oil markets appear to be pricing in an extended Libyan shutdown, lasting several months. The markets are also pricing in continuing widespread unrest in MENA, but are not assuming actual oil disruptions in other countries.

Brent price range for Scenario 1: $110-125/bbl

Bullish factor: Saudi spare capacity declines, possibly all the way to 2 Mb/d.

Offsetting bearish factors: none. This scenario would not cause significant downgrades to global GDP growth or global oil demand growth. There is no chance of a release of IEA emergency strategic reserves in this scenario.

What if the situation in Libya is resolved and goes back to normal quickly? It would still take months for oil production and exports to get back to normal. Oil workers would need to return to Libya, and they would need to assess the condition of the oil fields.

Possible issues include reservoir damage and looting or sabotage of equipment at oilfields, pipelines, and terminals.

In addition, sanctions and legal restrictions recently imposed on Libya could complicate a return to normal trade and commerce.

Also, if there is a change in the state oil company due to a change in government, there could be contractual issues to deal with.

That said, our main concerns revolve around the oil fields themselves. The bottom line is that if the Libyan crisis ends, prices would fall, but not all the way to the pre-Egypt levels of $95-100 Brent, and not all at once. Prices would decline gradually, as flows are restored. However, the wider MENA unrest would still cause a residual risk premium in oil prices of perhaps $5.

Geopolitical Scenario 3: Unrest spreads to Saudi Arabia and threatens Saudi crude exports and any remaining spare capacity. Brent price range of $150-200/bbl.

In this most extreme, worst-case scenario for the oil markets, serious unrest spreads to Saudi Arabia. In this case, it does not really matter if Libya or any other producers are shut down or not. Saudi Arabia is OPEC's biggest producer and the world's biggest current holder of spare capacity. If production and exports are

Geopolitical Scenario 2: Libya shutdown, plus another shutdown in a medium-size producer, plus widespread unrest in the Middle East and North Africa. Brent price range of $125-150/bbl.

In the oil markets, there is a lot of concern and talk about more extreme geopolitical scenarios, although these are not explicitly priced in. One such scenario involves another supply disruption in another medium-size producer, while the Libya shutdown continues, and widespread MENA unrest also continues.

An example of this would be a supply disruption in Algeria, which exports 0.9 Mb/d of crude and NGLs and another 0.5 Mb/d of products. In total, this makes Algerian exports of 1.4 Mb/d very similar to Libyan exports of 1.5 Mb/d.

We must emphasize that we choose Algeria as an example here simply because of its export volumes. We do not believe that there is a high probability of unrest in Algeria, but will leave the geopolitical analysis of this country for another time. The purpose of this scenario exercise is to frame up broad price ranges and key market dynamics that need to be taken into account.

If Saudi Arabia starts with 2 Mb/d of spare capacity, because they are alone making up for a full Libyan shutdown, then they have enough left to make up for another 1.4 Mb/d of Algerian crude and product exports; we assume that Saudi crude will, in effect, substitute for Algerian product exports, and will be processed in spare refining capacity in Europe and elsewhere.

This would leave the Saudis with only 0.6 Mb/d of spare capacity. For oil market participants, this would be considered so low as to be "basically nothing left". This is especially true because in this scenario, we continue to have unrest and perceived threats to production elsewhere in MENA.

Also, remember that estimates of capacity in Saudi Arabia and elsewhere are not precise, and there is a range of uncertainty around the figures. There is no official source with "the right number". For the time being, we continue to use the IEA's capacity estimates; however, we note that we are in the process of reviewing our capacity estimates for OPEC countries.

Brent price range for Scenario 2: $125-150/bbl

Bullish factor: Saudi spare capacity declines to almost zero.

Offsetting bearish factors: yes, they increasingly start to come into play. In this scenario, with prices reaching the highs seen in July 2008, there would be significant downgrades to global GDP growth and to global oil demand growth. The "demand destruction" would be focused on the US, as was the case in 2007 and H1 2008. Because of the low tax burden on end-users in the US, consumers and businesses quickly feel the full brunt of higher market prices.

Another key bearish factor would come into play. In this scenario, there is a good chance of a release of IEA emergency strategic reserves, with the probability increasing as Saudi spare capacity dwindles. See the chart above for the maximum drawdown rates of IEA strategic crude and product reserves.

Geopolitical Scenario 3: Unrest spreads to Saudi Arabia and threatens Saudi crude exports and any remaining spare capacity. Brent price range of $150-200/bbl.

In this most extreme, worst-case scenario for the oil markets, serious unrest spreads to Saudi Arabia. In this case, it does not really matter if Libya or any other producers are shut down or not.

Saudi Arabia is OPEC's biggest producer and the world's biggest current holder of spare capacity. If production and exports are affected, or even perceived to be seriously threatened, the impact on the oil markets would be dramatic, to say the least.

As with Scenario 2, we must emphasize that we consider serious Saudi unrest or a Saudi disruption a very low probability
scenario. We include it here because, in the current tense environment in MENA, and with severe and occasionally violent protest ongoing in Bahrain, Saudi Arabia's neighbor, oil market participants are discussing "what if the worst-case actually happens"? Again, we will leave the geopolitical analysis of this country for another time. Here, we simply try to estimate broad price ranges and key market dynamics.

Brent price range for Scenario 3: $150-200/bbl

Bullish factor: Saudi production and exports are reduced or are under perceived imminent threat, and any spare capacity is
rendered irrelevant.

Offsetting bearish factors: yes, they become major drivers in the oil markets. The higher the price spike, the more important they become. In this scenario, there would be large downgrades to global GDP growth and large downgrades to global oil demand growth ("demand destruction").

In this scenario, there is an absolute certainty of a release of IEA emergency strategic reserves. In addition, IEA "demand side management" measures, such as fuel rationing, would probably be imposed, as part of a full-fledged emergency response mechanism.