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could
now
occur
before
the
end
of
Q1
2016
some
three
months
earlier
than
originally
anticipated.
No
one
knows
exactly
how
much
Iran
will
be
able
to
increase
its
exports
but
if
it
is
500,000
bpd,
as
the
Iranians
claim,
then
the
earlier
lifting
of
sanctions
will
add
on
average
125,000
S&P
GSCI
TOTAL
RETURN
INDEX
12000
Source:
Bloomberg
[2.2] [Investor Letter 12-15.PDF] [Page 1 of 7]
1
bpd
of
additional
supply
in
2016.
There
again,
the
latest
reports
from
official
Iranian
news
sources
say
Iran
will
only
add
to
supplies
at
a
rate
that
the
market
can
absorb
without
unduly
impacting
prices.
In
previous
letters
we
have
argued
that
to
correct
a
short
term
imbalance
in
the
market,
oil
prices
are
being
pushed
to
a
level
that
is
unsustainable
in
the
longer
term.
Furthermore,
because
the
adjustment
to
supply
is
being
made
through
drastic
cuts
to
capital
expenditure
which
cannot
be
quickly
reversed,
the
stage
is
being
set
for
a
supply
shortfall
in
the
future.
Prices
will
eventually
have
to
move
to
a
level
that
creates
supply
rather
than
destroys
it.
We
(and
most
other
observers)
believe
that
price
to
be
well
above
current
levels.
Yet,
remarkably,
the
5
year
forward
price
for
Brent
crude
oil
has
fallen
dollar
for
dollar
with
the
spot
price
over
the
course
of
the
past
year.
Likewise,
in
the
leg
down
seen
last
month,
which
was
provoked
by
a
higher
(see
first
box)
setting
the
stage
for
implausibly
high
inventory
decline
rates
in
2017.
What
are
the
risks
to
this
analysis?
Obviously
supply
could
again
prove
more
resilient
than
expected.
However,
conditions
for
the
oil
industry
have
deteriorated
dramatically
in
the
past
five
months.
Rig
counts
have
resumed
their
decline
and
productivity
gains
appear
to
have
come
to
an
end.
Rising
interest
rates
and
widening
credit
spreads
are
making
it
much
harder
for
indebted
oil
producers
to
fund
their
activities.
Outside
of
the
U.S.,
it
is
unlikely
that
2016
will
see
the
sort
of
upside
surprises
witnessed
in
2015.
The
oil
industry
cannot
function
with
$50
oil,
let
alone
sub
$40
oil.
Another
downside
risk
is
that
Libya
sees
some
sort
of
accommodation
between
its
feuding
factions
and
suppresses
IS
allowing
it
to
increase
oil
production.
This
could
add
perhaps
500,000
bpd
of
additional
supply.
Against
that,
however,
should
be
weighed
the
risks
to
supply
from
other
fraught
countries
-
be
they
Iraq,
Nigeria,
Venezuela
or
for
that
matter
any
of
the
oil
exporting
countries,
all
of
which
are
now
wrestling
with
severely
depressed
oil
revenues
and
the
impact
of
this
on
restive
populations.
The
escalating
sectarian
faceoff
between
Saudi
Arabia
and
Iran
as
they
jockey
for
regional
dominance
also
adds
a
significant
tail
risk
to
the
upside.
While
the
recent
news
that
Saudi
Arabia
(and
Bahrain)
has
severed
diplomatic
relations
with
Iran
has
no
immediate
impact
on
oil
supply,
it
further
raises
tensions
in
the
heart
of
the
world's
largest
oil
exporting
region.
Finally,
there
is
the
risk
that
a
slowing
global
economy
would
also
slow
the
rebalancing
process
by
reducing
growth
in
demand
for
oil.
However,
our
assumption
of
1.3
million
bpd
growth
for
2016
is
already
quite
conservative
other
forecasters
are
assuming
higher
growth
rates.
PIRA
for
example
is
currently
forecasting
growth
at
1.9
million
bpd
for
2016.
The
simple
fact
is
that
the
accepted
oil
narrative
has
become
uniformly
negative:
the
glass
is
totally
empty
and
lies
shattered
on
the
floor.
The
consensus
view
is
that
we
are
in
a
period
similar
to
the
late
1980s
and
1990s
which
followed
the
previous
Saudi
decision
in
1985/86
to
defend
market
share
and
which
resulted
in
a
long
period
of
depressed
prices
(although
not
as
depressed
-
relatively
speaking
-
as
today).
This
analogy
however
ignores
the
fact
that
back
then
OPEC
spare
capacity
and
surplus
supply
were
together
approaching
20
percent
of
global
consumption.
Today,
excess
supply
and
spare
capacity
represent
perhaps
as
little
as
1
percent
of
current
global
oil
consumption.
Yet,
because
of
a
universally
pessimistic
outlook,
cuts
to
capital
expenditure
by
the
industry
in
2015
and
2016
will
-
remarkably
-
almost
certainly
exceed
those
made
during
that
earlier
era
of
much
greater
imbalance.
Skeptics
will
answer
that
this
capital
expenditure
is
not
required,
and
go
on
to
argue
that
the
supply
void
created
by
the
cancellation
of
high
cost
oil
sands,
deep-
water
and
Arctic
production
projects
will
readily
be
filled
by
light
tight
oil
(LTO)
production
in
the
U.S.
and
ultimately
elsewhere
as
costs
continue
to
decline.
However,
it's
clear
that
based
on
various
independent
analyses,
for
U.S.
LTO
production
to
recover
to
growth
rates
commensurate
with
balancing
the
global
oil
market
it
would
require
WTI
prices
to
be
above
$75/bbl
(see
nearby
box).
Moreover,
it
seems
probable
that
many
of
the
cost
savings
seen
over
the
past
year
will
be
temporary.
Service
providers
are
operating
at
a
loss
which
is
resulting
in
bankruptcies
and
industry
consolidation.
Any
upturn
will
see
a
firming
in
service
prices
and
therefore
higher
costs
for
oil
producers.
LTO
production
elsewhere
in
the
world,
where
conditions
are
much
less
conducive
to
its
development
for
reasons
we
have
discussed
in
detail
previously,
will
not
make
a
meaningful
contribution
to
supply
for
at
least
a
decade,
if
ever.
But
then
some
might
retort
that
demand
for
oil
is
approaching
terminal
decline
because
of
the
wide
scale
adoption
of
renewable
energy,
electric
vehicles
(EVs)
and
the
phasing
out
of
fossil
fuels.
Yet
even
the
most
optimistic
forecasts
see
EVs
capturing
only
5-6
percent
of
the
world
auto
fleet
by
2025
by
which
time
the
fleet
will
have
grown
50
percent.
Demand
growth
for
gasoline
has
been
extraordinarily
strong
during
the
past
year
with
the
U.S.,
China
and
India
leading
the
way.
The
latest
data
show
gasoline
demand
in
the
U.S.
running
at
more
than
5
percent
above
year
ago
levels
(1).
During
2015
apparent
oil
consumption
in
the
U.S.
grew
at
a
faster
rate
than
GDP.
If
intensity
of
oil
usage
can
move
higher
in
America
then
why
not
elsewhere
in
the
world
following
a
60-70
percent
decline
in
prices?
It
remains
our
view
that
the
current
extreme
pessimism
is
setting
the
stage
for
a
significant
future
supply
shortfall
and
that
the
risk
of
this
rises
the
longer
that
prices
stay
depressed
and
capital
expenditure
in
future
production
is
further
reduced.
To
be
sure,
we
have
learned
that
the
supply
response
to
falling
prices
is
slower
than
we
and
most
observers
expected.
However,
by
the
same
token,
it
follows
that
the
supply
response
to
higher
prices
will
also
likely
be
slower
than
generally
assumed.
For
a
start,
oil
companies
and
their
backers
will
want
evidence
that
higher
prices
are
going
to
be
sustained
and
are
not
just
a
blip.
Secondly,
producers
are
likely
to
use
higher
revenues
to
repair
weakened
balance
sheets,
at
least
initially.
They
will
also
want
to
execute
hedges
which
will
be
difficult
with
depressed
deferred
prices
as
the
market
inevitably
swings
from
a
contango
structure
to
backwardation
as
inventories
start
to
be
drawn
down.
Finally,
many
of
the
mechanisms
that
delayed
production
decline
will
go
into
reverse
when
prices
do
recover.
Rig
efficiencies
will
fall
as
companies
move
beyond
their
core
sweet
spots.
Service
costs
will
rise
along
with
demand:
some
250,000
people
have
been
laid
off
in
the
oil
and
oilfield
service
industry.
In
a
tight
job
market
it
will
not
be
so
easy
to
attract
those
workers
back.
If
for
these
reasons
the
supply
response
to
higher
prices
is
delayed,
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