Presentation to NAPE Denver Expo, October 2016, on OPEC pricing strategy and political risks.

2. Valuation Assumptions
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● our analyses must include a broad range of considerations
sector - wide (macro) project - specific (micro)
- economic considerations - technological considerations
- commercial considerations
<--------------- political considerations ---------->

3. Oil – recent history
Crude Oil Prices
US EIA, data updated September 2, 2016
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$/bbl

4. Oil – recent history
Crude Oil Prices
US EIA, data updated February 2, 2016
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$/bbl
China
housing
slowdown
financial
crisis
Great
Recession
fraccing
OPEC?
Russia?
Venezuela?
Brazil &
PreSal?
ISIS?
Syria?
Saudi
Arabia?
Mexico
liberalization?
Iran?
China?

5. Agenda:
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Political risks in the market for crude oil
Commercial / economic factors driving crude oil markets

6. Oil – new conventional wisdom
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The OPEC era is past; they’ve lost control of the market.
The US is the new swing producer.
OPEC open-taps strategy is targeting shale oil producers.
Saudi Arabia is in a battle for market share.

7. Conclusion (preview - … the short story):
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OPEC = Saudi Arabia => dominant firm = price leader =
monopolist with competitive fringe
 deceleration and diversification of energy demand (i.e. China)
 technological advance in competitive fringe (i.e. fraccing)
=> increase in elasticities of D and S =>  [Price – Cost] markup
=> economic / commercial factors => P ≈ $60 to $80 / bbl
Political Risk per reverbations from Arab Spring (2011)
 risk to control by traditional elites (political, religious)
⇒ how long can / will Saudi Arabia ‘pay’ (i.e. Poil < $60/bbl) for
advantage in emerging regional political order?
⇒ how long can Saudi Arabia afford domestic political order?

8. Agenda:
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9. Is OPEC a cartel?
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D: cartel = an association of suppliers who coordinate to
maintain high prices and restrict competition
plural
notice competing objectives here and here

10. OPEC is Saudi Arabia
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How often do OPEC Member States exceed production quotas?
A: all the time
Who has enough spare capacity to control prices?
A:
Source: Medium-Term Oil Market Report 2014, OECD/IEA

11. Price Leader price setting
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Saudi Arabia is
 price leader
 dominant firm
 monopolist with competitive fringe

12. Price Leader price setting
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What has changed for Saudi Arabia (the price leader)
A: on demand side, slowdown in China
 2000 to 2010 – China accounted for 40% of growth in
global demand for energy
 2010 to 2015 – growth in China energy demand moderates
from 10.5%/yr to 1%/yr
 2015 to 2025 – China energy demand growth est. = 2%/yr
(Source: Exxon)
 2016 – China oil demand growth < 2% (though possibly
understated per ‘teapot’ refinery output, Source: Platts)

13. Price Leader price setting
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What has changed for Saudi Arabia (the price leader)?
A: China deceleration => optimal price 
What risks were present at +$100/bbl oil?
 will China industrialize as a oil-intensive economy?
 Will China consumer demand for energy be highly oil-
dependent? Or highly diversified?
 Strategic opportunity to influence path of development?
=> optimal price 

14. quantity
price
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Price Leader price setting
S=MC
D
P
Q
MC
MR
Recall monopoly pricing:
moderation in China
demand growth

15. quantity
price
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Price Leader price setting
S=MC
D
Q
MC
MR
Notice P-MC markup is lower with more elastic demand
P
more diversified demand
can increase elasticity

16. Price Leader price setting
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Saudi Arabia is
 price leader
 dominant firm
 monopolist with competitive fringe
China => P for current slowdown & to encourage oil-
intensive industrialization
Elsewhere
 EM softness (x – India) => P
 Developed economies softness and drop in energy intensity
=> P

17. Price Leader price setting
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Saudi Arabia is
 price leader
 dominant firm
 monopolist with competitive fringe
What about the supply side?
 traditional competitive fringe = conventional development
(read large-fixed cost development prospects)
 new competitive fringe = shale oil

18. production
($)
fixed
costs
total
costs
cost structure of traditional basins
= high ratio of fixed costs to
variable costs:
need high P to justify investment,
need low P to continue production
=> inelastic supply
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Price Leader price setting
production
($)
fixed
costs
total
costs
cost structure of unconventional
shale oil = low ratio of fixed costs to
variable costs:
production declines rapidly, a broad
range of P will justify investment =>
more elastic supply

19. Price Leader price setting
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Saudi Arabia = monopolist with competitive fringe
 Supply Side considerations
P in reaction to more and more-elastic supply
 Demand Side considerations
P in reaction to global economic weakness
P as strategy to discourage elastic mix in demand
But how low should prices be?
 Shale oil drilling returns at P > $40/bbl, even if short term
 Large-fixed-cost investments require confidence P > $80/bbl
for long (20+ yrs?) term
=> commercial / economic considerations => P < $80 / bbl

20. Saudi Arabia price setting
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Economic / commercial considerations can justify prices as
low as $80/bbl (or $70/bbl? Or $60/bbl?)
But NOT P ≈ $40/bbl
 Assume OPEC gain = +2MBPD, but @ $40/bbl = > +$80M/day
 But monopolist incurs loss on pre-existing production
=> cost to Saudi Arabia = 10MBPD x ($40-$60/bbl) = -$200M/day
What is Saudi Arabia buying with this cost?
A: signal to large-fixed-cost projects – ‘do not invest’ (e.g. Arctic
[Shell, Russia], Canada oil sands, Brazil PreSal, Mexico)
?: but once signal has been received, what are they buying then?

21. Agenda:
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22. Gulf States divide
Sunni vs Shia
Ahl al-Sunnah = ‘People of
theTradition’
632 AD – followers of Abu
Bakr, friend and father-in-law
to Prophet Muhammad
> 80% of global Muslim pop’n
 > 90% in Egypt, Saudi Arabia,
Jordan, United Arab
Emirates
consideration to literal
tradition (e.g.Wahhabiism)
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23. Gulf States divide
Sunni vs Shia
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Shiat Ali = ‘the party of Ali’
632 AD – followers of Ali,
cousin and son-in-law to
Prophet Muhammad
~ 10% of global Muslim pop’n
 significantly in Iran, Iraq,
Yemen, Lebanon
consider ayatollahs as agents
of spiritual precepts

24. Gulf States divide
Sunni vs Shia
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Ahl al-Sunnah = ‘People of
theTradition’
632 AD – followers of Abu
Bakr, friend and father-in-law
to Prophet Muhammad
> 80% of global Muslim pop’n
 > 90% in Egypt, Saudi
Arabia, Jordan, United Arab
Emirates
consideration to literal
tradition (e.g.Wahhabiism)
Shiat Ali = ‘the party of Ali’
632 AD – followers of Ali,
cousin and son-in-law to
Prophet Muhammad
~ 10% of global Muslim pop’n
 significantly in Iran, Iraq,
Yemen, Lebanon
consider ayatollahs as agents
of spiritual precepts

25. Stakeholders in Market for Oil
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domestic poli/econ interests geo-political interests
Russia (producer / price
taker)
Iran (producer / price
taker)
China (consumer / price
taker
US (consumer / price
taker)
Saudi Arabia
(producer / price setter)
how will key stakeholders influence oil markets as they
pursue domestic political/economic interests and broader
geopolitical interests?

26. Stakeholders in Market for Oil
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domestic poli/econ interests geo-political interests
Russia (producer / price
taker)
- efficiencies of scale
- needs for hard currency
=> Supply
- influence FSU (Ukraine)
- influence in Gulf (Syrian naval base)
=>  Supply
Iran (producer / price
taker)
- rebuild economy
=> Supply
- security / prosperity via Shia influence in Gulf
⇒ pro: Bashar al-Assad, Syria; Yemeni rebels
⇒ anti: Syrian rebels, ISIS
⇒ Supply
China (consumer / price
taker
- diversify to consumer-driven
economy
- improve environment
=> Demand
- Pacific region influence
=> ?Supply, ?Demand
US (consumer / price
taker)
- improve economy
- increase energy security
- improve environment
-=> ? (not touching this one)
- Gulf region stability
- Pacific region influence
- climate change
=> ?Supply
Saudi Arabia
(producer / price setter)
- maximize net returns to fund state
⇒ Price to $60 - $80 / bbl
⇒ Supply
- security / prosperity via Sunni influence in Gulf
⇒ pro: Syrian rebels, Yemeni gov’t
⇒ anti: Iranian coalitions
⇒ maintain US as consumer of Saudi crude
⇒ Price => Supply

27. quantity
price
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Geopolitical impact on pricing
Secon&politics
D
P= $60 to $80
Q
MC
MR
P= $40
Q
Russia
Iran
US
Saudi Arabia
China

28. Looking forward - oil:
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29. Looking forward - oil:
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A: they wouldn’t.
A: they wouldn’t.
A: less critical per capital constraints.
A: Yes / No
A: the emerging priority.
A: long-term objective.

30. Looking forward - oil:
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31. Outlook:
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Oil:
 OPEC will curtail production to raise prices as they confirm
Iran is a manageable risk
Large, fixed-cost investments are discouraged fr non-OPEC producers
(Canadian Oil Sands? Alaska? Brazilian PreSal? Mexico? Russia?)
* But look for Saudi Arabia to limit price increase to < $80/bbl

32. Questions?
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