crude oil prices strengthening on the economy, not iran

January 10, 2012

Energy Weekly Commodities Research

Crude oil prices strengthening on the economy, not Iran

Brent crude oil prices jumped $4.75/bbl on the first trading day of 2012, and have traded in a tight

range around $113.00/bbl so far this year. While the rise in crude oil prices has been widely

attributed to escalating tensions between Iran and the West, we find that the market remains

focused on the improving economic outlook rather than on the risk that the Iranian tension

escalates into a severe supply shortage.

There is little evidence of an “Iran premium“ in current oil prices

Net speculative positions increased only modestly through January 3,

suggesting the recent price rally was more of a rebound from the quiet

holiday market. The rise in crude oil prices has also coincided with a

decline in the implied volatility priced in the crude oil options markets. If

the market were truly focused on a potential supply shortfall, we would

expect higher volatility and a sharp call skew. While the call skew has

become less negative in the recent period, it remains negative, unlike

during the loss of Libyan oil when the call skew became sharply positive.

Confidence increasing that impact of the European debt crisis is remaining confined to Europe

The ECB’s recent aggressive action on bank funding suggests that the ECB

is and will continue to do what it takes to prevent an abrupt breakdown in

the European financial and banking system. Further, there are encouraging

signs that the United States and China are proving resilient to the troubles

in Europe, with economic data continuing to surprise to the upside.

Tension between Iran and the West has put downward pressure on oil prices, but risks are becoming more skewed to the upside

Refiners are cutting back on purchases of Iranian oil in response to new US

sanctions and the anticipation of an EU embargo, and increasingly turning

to Saudi Arabia, which is producing at its highest levels in 30 years. The

surplus of oil is putting downward pressure on prices in the physical

markets. Once the EU embargo goes into effect, we expect this downward

pressure to dissipate. We would expect European refineries to replace the

Iranian crude with Saudi barrels, clearing the current surplus, while China

absorbs the surplus of Iranian crude, in part to fill its strategic reserves.

However, OPEC spare capacity is quite low, which leaves the market very

vulnerable to further supply losses, with the potential for further losses

particularly in Iran and Nigeria.

David Greely

(212) 902-2850 [email protected] Goldman, Sachs & Co.

Stefan Wieler, CFA

(212) 357-7486 [email protected] Goldman, Sachs & Co.

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

The Goldman Sachs Group, Inc. Goldman Sachs Global Economics, Commodities and Strategy Research

January 10, 2012

Goldman Sachs Global Economics, Commodities and Strategy Research 2

Hedging and trading recommendations

Petroleum

Hedging recommendations

Consumers: Despite the notable slowdown in global economic growth, we continue to

expect that oil demand will grow well in excess of production capacity growth. In our view,

it is only a matter of time before inventories and OPEC spare capacity become effectively

exhausted, requiring higher oil prices to restrain demand, keeping it in line with available

supply. Further, as tensions between Iran and the West escalate the risk to crude oil prices

is becoming increasingly skewed to the upside. Consequently, we believe that the large put

skew in the crude oil options markets that is still present due to the market’s continuing

focus on the downside risk to prices from the European debt crisis, particularly for longer-

dated maturities, presents an opportunity for commercial hedgers to add incremental

protection on top of their core hedging programs through structures such as zero-cost

collars.

Refiners: US refining margins remain relatively strong as WTI prices remain weak relative

to other crude oils such as Brent and LLS. While forward margins imply a narrowing of the

WTI-Brent spread, we continue to expect longer-dated spreads to narrow even further than

what the market has currently priced in. Consequently, we see current long-dated refinery

margins in 2012 as a selling opportunity for refinery hedgers. Further, for 2H12 and beyond,

we believe that crude will be the bottleneck in the system, rather than refining; this would

squeeze margins from the crude side through a renewed spike in backwardation,

suggesting refiners also look for potential timespread hedges. This dynamic could become

particularly severe should the tension between Iran and the West lead to a more severe

shortage of crude oil.

Producers: While we expect supply-demand balances to continue to move to critically tight

levels in 2H12, making producer hedging less attractive, the ongoing uncertainties over the

European debt situation still pose downside risks. Given the relatively large put skew in the

market, we would recommend put spread structures for oil producers, where incremental

downside protection can be obtained against the impact on crude oil prices of a moderate

slowdown in economic activity by forgoing protection against a more severe downturn.

This would be most beneficial to producers that are able to lower production in the event

of a severe decline in crude oil prices.

January 10, 2012


Current trading recommendations

Source: Goldman Sachs Global ECS Research.

Short March 2012 WTI - Brent spread, Long December 12 WTI - Brent spread

Buy March 2012 ICE Brent Crude Oil, Buy December 2012 NYMEX WTI Crude Oil,

Sell March 2012 NYMEX WTI Crude Oil, Sell December 2012 ICE Brent Crude Oil

November 22, 2011 - Energy Weekly $1.79/bbl $3.02/bbl $1.23/bbl

Long Gold

Buy December 2012 COMEX Gold October 11, 2010 - Precious Metals $1,800.5/toz $1,620.5/toz $243.9/tozRolled from a long Dec-11 COMEX Gold future position on 13-Nov-11 with a potential gain of $423.9/toz

Long Brent Crude Oil

Buy July 2012 ICE Brent Crude Oil May 23, 2011 - Energy Watch $105.16/bbl $111.79/bbl $6.63/bblRolled from a long Dec-12 ICE Brent Crude Oil future position on 1-Nov-11 with a potential loss of $1.95/bbl

Long Copper

Buy June 2012 LME Copper December 19, 2011 - Metal Detector $7,274/mt $7,746/mt $472/mt

Long Zinc

Buy December 2012 LME Zinc December 19, 2011 - Metal Detector $1,891/mt $1,981/mt $90/mt

Long UK Natural Gas

Buy Q4 2012 ICE UK NBP Natural Gas April 26, 2011 - Natural Gas Weekly 70.8 p/th 64.1 p/th (6.6 p/th)

¹As of close on January 10, 2012. Inclusive of all previous rolling profits/losses.

Current profit/(loss)1

Current trades First recommended Initial value Current Value

January 10, 2012


Price actions, volatilities and forecasts

units 09 Jan Change Implied2 Change Realized2Change 2Q 10 3Q 10 4Q 10 1Q 11 2Q 11 3Q 11 3m 6m 12m

Energy

3.22

4.95

0.19

0.14

-0.40

-5.81

Industrial Metals4

4

-130

450

-132

Precious Metals

-93

-3.2

Agriculture

48

57

54

4

-4

60

-0.8

0.9

-0.9

1 Monthly change is difference of close on last business day and close a month ago.

2 Monthly volatility change is difference of average volatility over the past month and that of the prior month (3-mo ATM implied volatility, 1-mo realized volatility).3 Price forecasts refer to prompt contract price forecasts in 3-, 6-, and 12-months time.

4 Based on LME three month prices.

3.01 3.022.68 3.102.00 2.22 2.89 3.01-3.18 29.5 -2.9 2.17 RBOB Gasoline $/gal 2.75 35.4

127.50 Brent Crude Oil $/bbl 113.06 36.5 -1.94 28.5 4.4 79.41 76.96 120.00 120.00

85.24 94.60

87.45 105.52 116.99 112.09

Historical Prices

78.05 76.216.9 123.50102.34 89.54 113.00 115.00

Volatilities (%) and monthly changes2Prices and monthly changes1

WTI Crude Oil $/bbl

Price Forecasts3

101.56 37.0 -2.77 32.8

0.05 25.3 4.7 2.11

2.75 4.254.06 2.90

2.06 2.36 2.82 3.05 3.27 3.46

NYMEX Nat. Gas $/mmBtu 3.06 39.6

2.98 3.26 NYMEX Heating Oil $/gal 3.07 32.5

4.20 4.384.02 32.5 -13.7 4.35

-6.52 21.8 0.2 37.48

4.23 3.98

2400 24002430 2300

42.68 51.74 56.77 58.04 72.30 87.70

LME Aluminum $/mt 2069 27.3

57.03 66.20 UK NBP Nat. Gas p/th 52.87 23.3

2531 26180.60 23.0 -6.9 2122

-0.51 31.7 0.1 7042

2110 2365

19000 2100022037 18500

7278 8614 9629 9163 9000 9500

LME Nickel $/mt 18750 39.9

8993 8000 LME Copper $/mt 7580 38.4

26926 24191-0.17 36.6 -2.7 22431

-0.19 25.4 -9.2 2052

21271 23619

1840 19401704 1785

2043 2333 2414 2271 2200 2400

COMEX Gold $/troy oz 1617 22.9

2247 2050 LME Zinc $/mt 1853 37.8

1388 1508-2.89 25.0 3.7 1197

-3.14 53.9 14.5 18

1228 1370

640 590690 670

19 26 32 38 30.7 32.4

CBOT Wheat Cent/bu 625 33.3

39 29.8 COMEX Silver $/troy oz 29.4 42.4

786 7451.06 27.2 -6.2 467

0.55 19.6 0.3 957

653 707

650 550696 685

1035 1245 1379 1361 1250 1200

CBOT Corn Cent/bu 644 31.2

1356 1220 CBOT Soybean Cent/bu 1190 22.6

670 7311.46 19.9 -3.7 355

n/a 28.1 -2.1 81

422 562

200 175256 235

87 128 179 156 85 85

NYBOT Coffee Cent/bu 222 n/a

106 90 NYBOT Cotton Cent/bu 96 n/a

257 271n/a 26.5 -2.7 140

n/a 45.8 9.6 2987

174 205

22.0 22.029 22.0

2863 2856 3307 3043 2450 2450

NYBOT Sugar Cent/lb 23.3 30.3

2962 2450 NYBOT Cocoa $/mt 2028 n/a

31 240.24 40.4 8.0 16

n/a 14.6 1.4 94

20 29

95.0 95.094 95.0

95 101 111 111 125.0 130.0

CME Lean Hog Cent/lb 83.9 n/a

115 130.0 CME Live Cattle Cent/lb 120.3 n/a

80 71 86 94n/a 18.6 4.7 82

Source: Goldman Sachs Global ECS Research estimates.

January 10, 2012


Crude oil prices strengthening on the economy, not Iran

Brent crude oil prices jumped $4.75/bbl on the first trading day of 2012, and have traded in

a tight range around $113.00/bbl so far this year. While the rise in crude oil prices has been

widely attributed to escalating tensions between Iran and the West, we find that the market

remains focused on the improving economic outlook rather than on the risk that the Iranian

tension escalates into a severe supply shortage. In fact, as oil producers and refiners have

reacted to the new US sanctions against Iran and prepared for the likely implementation of

a European Union embargo of Iranian oil, the escalating tensions between Iran and the

West have likely been exerting a near-term negative influence on crude oil prices.

More specifically, there is strikingly little evidence that any meaningful “Iran premium” is

being embedded in current crude oil prices. Net speculative positions increased modestly

through January 3rd, suggesting a rebound from the low volume holiday markets to reach

levels more consistent with those of early December. Further, the level of positioning is far

below the levels associated with the loss of Libyan crude oil in 2011 (see Exhibit 1). The rise

in crude oil prices has also coincided with a decline in the implied volatility priced in the

crude oil options markets. If the market were truly focused on a potential supply shortfall,

we would expect higher volatility and a sharp call skew. While the call skew has become

less negative in the recent period, it remains negative, unlike during the loss of Libyan oil

when the call skew became sharply positive (see Exhibit 2). More tellingly, the put skew

has also declined in the recent period, suggesting that the reduction in volatility is being

driven more by reduced concerns over an economic contraction, than new concern over a

supply shortage.

Exhibit 1: The recent crude price rally has been more of a

rebound from the quiet holiday market … $/bbl (left axis); million barrels (right axis)

Exhibit 2: … with volatility declining and call skew still

negative, there is little evidence of an Iran “premium” 25-delta call (put) implied vol, 3 month (left axis) ATM implied vol, 3 month (right axis)

Source: ICE, Goldman Sachs Global ECS Research.

Source: NYMEX, Goldman Sachs Global ECS Research.

The concern over an economic contraction has lessened as the market has become more

confident that the major effects of the European debt crisis will remain confined to Europe.

Although we continue to think that economic conditions in the Eurozone will get worse in

the coming months, the ECB’s aggressive action on funding – and the large take-up of the

3-year Long-Term Refinancing Operation (LTRO) suggests that the ECB is and will continue

to do what it takes to prevent an abrupt breakdown in the European financial and banking

system. We continue to believe that if the European debt crisis does not devolve into a

150

200

250

300

350

400

450

90

95

100

105

110

115

120

125

130

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12

Brent Net speculative positions0

0.1

0.2

0.3

0.4

0.5

0.6

-0.08

-0.06

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

Call skew

Put skew

At -the-money volatility

January 10, 2012


second financial crisis, the impact on global economic growth and the oil market will be

limited.

There are also encouraging signs that the United States and China are proving resilient to

the troubles in Europe. In China, the PMI reading for December moved back into expansion,

coming in at 50.3 against expectations of 49.1. Further, Chinese monetary policy has been

loosening with loans and the money supply growing faster than expected. In the United

States, the economic data continues to surprise to the upside, with the ISM manufacturing

index for December extending the expansion (53.9 vs. expectations of 53.5) and US non-

farm payrolls increasing by 200 thousand in December, relative to expectations of a 155

thousand increase. The improved US economic data has led our US economics team to

raise their 1Q12 US economic growth forecast to 2.0%, from 0.5%, and gives us stronger

confidence in our forecasted upward trajectory for crude oil prices in 2012.

While the downside from the EU debit crisis has arguably lessened recently, new risks are

being created as the EU prepares to employ more sanctions against Iran, likely including an

embargo of Iranian crude oil. We see the tensions with Iran as currently putting downward

pressure on crude oil prices as refiners cut back on purchases of Iranian oil in response to

new US sanctions and Saudi maintains high production levels in order to supply refiners

and prepare for implementation of a likely EU embargo on Iranian oil. The resulting surplus

of oil in the market is putting downward pressure on prices and timespreads in the physical

markets. Once the EU embargo goes into effect, we would expect this downward pressure

to dissipate. We would expect European refineries to replace the Iranian crude with Saudi

barrels, clearing the current surplus, while China absorbs the surplus of Iranian crude, in

part to fill its strategic reserves.

Consequently, we could simply see a swap of Saudi oil for Iranian by Europe being largely

offset by China filling its strategic reserves with Iranian oil instead of Saudi. However, once

the embargo goes into effect, the risks to crude oil prices will become much more skewed

to the upside. With Saudi producing close to 10.0 mmb/d, OPEC will be operating with a

very thin layer of spare capacity, making the oil market much more vulnerable to additional

disruptions, with supplies from Nigeria being a particular concern. Further, the significant

risk remains that as tensions escalate, brinkmanship in the Persian Gulf could lead to the

closure of the Strait of Hormuz. The Strait of Hormuz, with flows of 17 million b/d is the

world’s most important oil shipping chokepoint, accounting for roughly 35% of all

seaborne traded crude. Iran has threatened to block the Strait and has announced naval

exercises in the region at the end of January.

However, we believe closing the Strait is not in anyone’s interest, including Iran’s. An

attempt to close the Strait would likely be met by a strong military response from the West

to reopen the waterway, and a release of strategic reserves to supply the market in the

interim. This is likely the reason why the crude oil market is not embedding an “Iran

premium” into the price of oil. In fact, in terms of current oil market pricing, we find it more

likely that the negative influence on near-term prices from the tensions between Iran and

the West is likely masking the more positive near-term developments from the better than

expected economic numbers in the United States and China and the reduced risk of

European contagion. Consequently, we expect prices to remain well-supported even if

tensions with Iran subside, and see the risk to oil prices increasingly skewed to the upside

in 2012.

January 10, 2012


Actions and reactions as the tensions between Iran and the West escalate

The tension between Iran and the West over Iran’s nuclear ambitions has intensified in

recent years. The United States and the EU suspect Iran’s nuclear program is aiming to

develop nuclear weapons while Iran insists that the program is for the civilian use of

nuclear power only. On September 12, 2011, Iran commissioned the Busher I reactor, its

first nuclear power plant. Iran has stated that it also operates two enrichments sites and is

capable of creating 20% enriched uranium to feed a research reactor that produces radio

isotopes for medical purposes. The International Atomic Energy Agency (IAEA) has

recently confirmed this capability, which could also be used to create nuclear weapons.

In response to Iran’s continued progress in developing its nuclear program, on December

31, 2011, President Obama signed into law a bill that imposes sanctions on foreign

financial institutions that deal with Iran’s central bank. While the US law allows exemptions

in order to ensure energy market stability, it will likely make it more difficult for Iran to sell

its crude to 3rd party countries as Iran’s central bank is the main entity for Iranian oil sales.

While the United States has not imported any Iranian crude in 20 years, the European

Union has been the largest importer of Iranian oil in recent years. Recently, however, the

European Union has begun to put together a series of sanctions in response to Iran’s

nuclear program. The EU sanctions currently include a ban on joint ventures with Iranian

companies in the oil and gas sector and a ban to export arms and equipment that could

potentially be used in uranium enrichment. According to a Reuter’s news reports, EU

diplomats also reached a preliminary agreement in the first week of January to ban

imports of Iranian crude and the issue will be on the agenda when the EU foreign ministers

meet on January 23, 2012.

In response to the discussion of these sanctions, Iran performed 10-days of naval exercises

in the Persian Gulf over the holiday period, not coincidentally when President Obama was

signing the new US sanctions into law. These exercises included testing medium-range

missiles and threatening to close the Strait of Hormuz in response to US and EU actions.

Further, on Thursday January 5, one day after headlines announced that European

ministers had agreed in principle on an embargo of Iranian oil, Iran announced it planned

another round of naval exercises on January 27, likely to coincide with the EU foreign

ministers meetings scheduled, at the time for January 30, to discuss implementation of the

sanctions. It was announced that these exercises would include drills on closing the Strait

of Hormuz. In response, the EU meeting was moved to January 23.

While tensions and rhetoric continue to escalate between Iran and the West, the closure of

the Strait of Hormuz would be a massive escalation of the current tensions, and one which

would likely provoke a military response from the West. The Strait of Hormuz is the world’s

most important oil chokepoint, connecting the Persian Gulf with the Gulf of Oman and the

Arabian Sea (see Exhibit 3). According to the DOE, almost 17 million b/d of oil passed

though the strait in 2011, roughly 35% of all seaborne crude. 75% of all the oil shipments

through the Strait of Hormuz go to Asian markets. While the strait is 21 miles wide at its

most narrow point, the shipping lanes are only 2 miles wide on each side due to the

relatively shallow depth – the average depth of the entire Persian Gulf is only 25-40 meters.

A closure of the Strait of Hormuz would require the use of longer alternative routes,

causing delays and potentially bottlenecks and adding costs. A sustained closure of the

Strait would cause a massive spike in crude oil prices. However, given the likelihood of a

Western military response, we believe that the probability Iran attempts to close the Strait

remains low. Further, in the event it is closed, we believe a rapid military response from the

West along with a release of strategic petroleum reserves would likely mitigate the near-

term impact on oil supplies.

January 10, 2012


Exhibit 3: Roughly one-third of all seaborne shipped crude pass the Strait of Hormuz,

making it the world’s most important oil chokepoint

Source: DOE.

An EU embargo would leave few buyers for displaced Iranian crude oil, but China would likely purchase much of it – under the right terms

The European Union has been the largest importer of Iranian crude oil in recent years. It

imported 600 thousand b/d of crude from Iran in 2010 but imports dropped by 65 thousand

b/d year-over-year on average in the first 9 months of 2011. Outside of Europe, Iran sells its

crude oil to a relatively small group of buyers including China, Japan, India, South Korea,

Turkey and South Africa (see Exhibit 4). Most Iranian crude oils require processing in

complex refineries as its grades have a high sulfur content and there were reports by the

IEA in May last year that Iran had problems marketing its crude due to the high-metal

content. This will likely make Iran dependent on the willingness of its current buyers to take

more of its oil in case of a European embargo. However, we believe that few will choose to

do so. While the Obama administration will likely grant waivers to Japan, Korea and

Taiwan in order to allow them to continue to buy Iranian crudes, it will likely require them

to make some reduction in purchases from Iran in return for doing so. Further, a news

report by the Financial Times from December 9, 2011, suggests that Indian refiners have

struggled to buy Iranian crude oil as payment transactions via Turkey’s state-owned

Halkbank have become difficult under tightened US financial sanctions. While Indian

refiners are reportedly (Reuters, January 6, 2012) seeking alternative payment mechanisms

through a Russian bank, India might also ask for the United States for waivers in order to

secure uninterrupted crude oil supplies to their refineries, which would likely require them

to reduce imports of Iranian crude.

This leaves China as the main potential buyer of the displaced Iranian crude. The question

therefore arises whether China is willing and able to buy more Iranian crude. We believe it

can, and ultimately will (see Exhibit 5).

January 10, 2012


Exhibit 4: Iran exports its crude oil only to a handful of

buyers outside Europe Average imports of Iranian crude, January – June 2011

Exhibit 5: China’s imports of Iranian crude continue to

increase at the expense of European imports Thousand b/d

Source: Source: Global Trade Atlas, APEX, EIA, Goldman Sachs Global ECS Research.

Source: IEA, China Customs.

We believe that the displaced Iranian crude oil will likely be purchased by China, under the right terms, and could serve to fill its expanding strategic reserves

China has become the second largest importer of Iranian oil after Europe in recent years,

and its imports exceeded those of the EU in 1H11, averaging roughly 550 thousand b/d in

the January-November 2011 period. While we believe it is unlikely that China increases its

Iranian imports at the expense of imports from other suppliers such as Saudi Arabia, we

believe that it has the means to absorb additional crude oil by importing it into its strategic

petroleum reserves (SPR). Unfortunately, the Chinese government doesn’t provide data on

its strategic stockpile program and the available information is sometimes contradictory.

The problem is aggravated by the fact that the boundaries between strategic government

stockpiles and industry inventories is often blurred as the three companies that are

building the strategic reserve capacity for the government, Petrochina, Sinopec and

CNOOC, are also building tank farms for their own use, often at the same locations.

Nevertheless, the available information provided by news reports and industry publications

suggest that Chinese SPR and commercial inventory filling will create substantial demand

in 2012.

More specifically, according to the China National Petroleum Corp (CNPC), China plans to

build at least 500 million barrels of strategic reserves by 2020, and more recent reports by

the China Economic Weekly suggest that it could be up to 621 million barrels (85 million

tonnes). The program will be built in three stages: The first phase with 102 million barrels

was completed and filled by early 2009 (see Exhibit 6). The second phase, currently under

construction, will add 170 million barrels (see Exhibit 7). However, a Reuter’s news report

(January 25, 2011) suggests that actual capacity may exceed this planned amount as local

governments have lobbied for more projects. While some sites were completed and filled

in 2010 and 2011, the bulk of these projects will either be commissioned in coming months

or have just been completed and are ready to be filled. We estimate that China can add

between 90 and 110 million barrels of oil to its strategic reserves. While there may be some

constraints on the rate of fill, this suggests that China’s strategic reserves could absorb 550

thousand b/d of Iranian crude displaced from the EU for 160-210 days. Including the need

% of Iran's exports

Total volume of

crude imported

from Iran, thousand

b/d

Iran as % of total

crude imported

European Union 18 450

Italy 7 183 13

Spain 6 137 13

France 2 49 4

Greece 1 20 14

Germany 1 17 1

UK 0 11 1

Netherlands 1 33 2

Japan 14 341 10

India 13 328 11

South Korea 10 244 10

Turkey 7 182 51

South Africa 4 98 25

Sri Lanka 2 39 100

Taiwan 1 33 4

China 22 543 11

Total 91 22580

200

400

600

800

1000

1200

2004 2005 2006 2007 2008 2009 2010 2011

European Union

China

January 10, 2012


to fill China’s new commercial storage capacity would extend the ability to absorb displace

Iranian crude oil by another 30 days.

However, China has announced that it halved its crude imports from Iran in January and

will do so again in February as the two countries remain divided over payment terms.

While according to Reuter’s (January 4, 2012) the two parties are mainly negotiating over

the length of the credit period – China insist on a 90 days payment mode while Iran is

asking for 60 days – this underlines Chinas strong negotiating position at the moment. On

net, we believe that China will likely be able to absorb a large amount of the Iranian crude if

the EU implements an import ban, but that China will likely do so only after securing very

favorable terms.

Exhibit 6: Phase I China SPR sites 2004-2009

Exhibit 7: Potential Phase II China SPR sites


Source: Reuters, OGJ, Goldman Sachs Global ECS Research.

Saudi Arabia continues to produce near 10 million b/d as Iranian shortfall looms

While China could absorb a large amount of the displaced Iranian crude oil, preventing a

surplus of Iranian crude from forming in the market and potentially pushing down prices

for crude oil, we expect refiners that are no longer able to source Iranian crude oil to turn to

Saudi Arabia for additional barrels. Saudi has been producing close to 10.0 million b/d,

which suggests that it is producing at a high level as refiners anticipate a coming EU

embargo on Iranian crude oil, and are lining up alternative suppliers.

While Saudi production could offset a near-term shortage for refiners under the embargo –

preventing a sharp increase in crude oil prices – this would require a significant loss in the

amount of OPEC spare capacity available, which would leave the market very vulnerable to

additional losses of crude oil supplies, including a further loss of Iranian crude supplies.

Iran is OPEC’s second largest producer, producing 3.7 million b/d of crude oil and 550

thousand b/d of NGLs in 2010. While Iran’s export capabilities have declined in recent years

as its domestic consumption increased sharply (see Exhibit 8), the country still exports 2.2

million b/d of crude. In addition, a large part of Iranian NGL production is exported

indirectly in the form of petrochemical products. Consequently, a complete shortfall of

Iranian petroleum exports would have a significant impact on oil prices. As for comparison,

when Libya’s exports of 1.5 million b/d of crude oil stopped in spring last year, Brent crude

oil prices increased from $100/bbl by the end of January 2011 to more than $125/bbl by the

end of April, despite the fact that the crude oil market was much better supplied. More

specifically:

Site ProvinceStrategic Storage

Commercial Storage

Total Investment

Completion date

Mln bbl Mln bbl Rmb

Zhenhai Zhejiang 32.3 19.9 5.2 Sep-06Huangdao Shandong 19.9 Dec-07Dalian Liaoning 18.7 Nov-08Zhoushan Zhejiang 31.1 37.3 4 Dec-08

Total Storage Capacity 102 57.2

Site Location Company Completion date

Size mn bbl

Comm. mn bbl

Investm. (bn Yuan)

Shanshan Phase I Xinjiang Petrochina early 2009 6.3 6500Shanshan Phase II Xinjiang Petrochina end 2010 5.0Shanshan Phase III Xinjiang Petrochina N/A 39.0Tieling Liaoning Petrochina 2010 7.3Dushanzhi Xinjiang Petrochina Sep-11 18.9 12.6 2650Lanzhou Gansu Petrochina Nov-11 18.9 6.3 2378Caofeidian Sinopec 2H2011 32.7Jinzhou Petrochina 2011-2012 18.9 2260Tianjin* Sinopec 1H2012 20.1 3500Huizhou CNOOC 2012 25.2Shangdong Qingdao Sinopec 2012-13 18.9 2200Jiangsu Jintan Petrochina 2012-13 15.7Zhangjiang Guangdong Sinopec 2012-13 44.0Hubei Yingcheng Sinopec 2012-13 18.9Yangpu Hainan Sinopec N/A 31.4Cezi Island Zhejian Sinopec Oct-11 0 9.0

* According to OGJ, Reuters reports the size of Tianjin at 40.2 milion barrels

January 10, 2012


OPEC spare capacity was around 2.6 million b/d before the Libyan war started and

due to the fact that Libyan product demand collapsed as well, OPEC spare capacity

remained well over 1 million b/d when Libyan supplies dried up. In contrast, we

believe OPEC spare capacity is currently only around 1 million b/d.

The situation is further exacerbated by the fact that global inventories are much

lower now than they were at the beginning of 2011. In January 2011, global crude

stocks remained 125 million barrels above the 10-year average. According to the

latest IEA data, inventories had dropped to 21 million barrels below the 10-year

average by October 2011.

While the return of more Libyan production could help to restore some OPEC spare

capacity over the coming months, spare capacity will remain much lower than before the

Libyan war and hence a shortfall of all Iranian exports would likely have a much more

significant impact on prices. This creates greater upside risk from current prices as we see

little evidence that a significant “Iran premium” is currently priced into the oil market. The

risks come not only from Iran. Nigeria’s production has slowed materially and Shell has

again declared force majeure on their Bonny Light production as crude theft caused a leak

in the Nembe Creek trunk line. With mass protests now taking place in Nigeria in response

to the removal of the gasoline subsidy, further losses of crude oil production are possible,

highlighting the upward risk to oil prices from operating with such a small amount of spare

production capacity, as Saudi produces at its highest levels in over 30 years (see Exhibit 9).

Exhibit 8: Iran’s ability to export has declined materially

over the past years as domestic consumption increased Thousand b/d, production (left axis); net exports (right axis)

Exhibit 9: According to their own statement, Saudi

Arabia’s output was close to all-time highs in NovemberThousand b/d

Source: IEA, Goldman Sachs Global ECS Research.

Source: IEA, BP and Goldman Sachs Global ECS Research

1500

1700

1900

2100

2300

2500

2700

2900

3000

3250

3500

3750

4000

4250

4500

1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11

Crude & NGL production

Net exports

0

2000

4000

6000

8000

10000

12000

1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

Saudi Arabia producing 10.05 milion b/d in November 2011

January 10, 2012


WTI market monitor WTI – Brent forward curve

$/bbl

The WTI-Brent spread narrowed further following the

announcement of the Seaway pipeline reversal. We expect

that more crude oil will flow from the US Midwest to Cushing

in anticipation of the reversal of the Seaway in 2Q12, leading

to a build in Cushing inventories. While near-dated

differentials are now close to the levels necessary to attract

crude back into Cushing , longer-dated differentials still

imply that large volumes of crude have to be shipped on

barges on the Mississippi by the end of 2012 which is

inconsistent with the significant pipeline and rail capacity

that will be online by then. We therefore believe that longer-

dated WTI-Brent spreads have more room to narrow towards

our 12-month target.

Source: NYMEX, ICE, GS Global ECS Research.

Crude oil price differentials

$/bbl

Historical crude oil price differentials

$/bbl

Source: NYMEX, ICE, Platts, GS Global ECS Research.

Source: NYMEX, ICE, Platts, GS Global ECS Research.

Flows from US Midwest to Midcontinent vs. spread

$/bbl (left axis); thousand b/d (right axis, inverted)

Flows from US Midwest to US Gulf Coast vs. spread

$/bbl (left axis), thousand b/d (right axis)

Source: Genscape, NYMEX, Platts, GS Global ECS Research.

Source: Genscape, NYMEX, Platts, GS Global ECS Research.

-14.00

-12.00

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

1M 5M 9M 13M 17M 21M 25M 29M 33M 37M

01/09/12 01/02/12 12/10/11

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

WTI - MSW MSW - LLS LLS - BRT WTI - BRT

12/07/11 12/29/11 01/06/12

-35.00

-30.00

-25.00

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-1

WTI - MSW MSW - LLS LLS - BRT WTI - BRT

-180

-160

-140

-120

-100

-80

-60

-40

-20

0

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00


WTI - MSW (one month prior) Spearhead - Ozark

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00


LLS - MSW (1 month prior) Barge Movements

January 10, 2012


US oil stocks

Million barrels

US crude oil stocks

Million barrels

Source: DOE.

Source: DOE.

US total hydrocarbon stocks

Million barrels

US distillate stocks

Million barrels

Source: DOE.

Source: DOE.

US motor gasoline stocks

Million barrels

US residual fuel stocks

Million barrels

Source: DOE.

Source: DOE.

Product 30-Dec-11 2-Dec-11 31-Dec-10 4Wk Year

Total Petrol 1044.3 1054.0 1063.7 -9.7 -19.4

Crude Oil 329.7 336.1 335.3 -6.4 -5.6

Total Product 714.6 717.9 728.4 -3.3 -13.8

Mogas 220.2 215.0 218.1 5.2 2.0

Jet Fuel 41.4 42.2 44.1 -0.7 -2.7

Distillate 143.6 141.0 162.1 2.6 -18.5

Resid 36.4 38.6 38.9 -2.2 -2.5

Other 199.9 203.5 195.7 -3.6 4.2

ChangeEnd-of-Week

260

280

300

320

340

360

380

400

Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec

2008

20092010

2011

800

850

900

950

1000

1050

1100

1150

1200


2008

2011

2009

2010

80

90

100

110

120

130

140

150

160

170

180


2008

2011

2009

2010

175

185

195

205

215

225

235

245


2008

2011

2009

2010

25

30

35

40

45

50


20112008

2009

2010

January 10, 2012


WTI forward curve

US$/bbl

WTI-Brent forward curve

US$/bbl



Historical realized WTI volatility

Percentage

Historical WTI prices

US$/bbl



321 NYMEX forward curve

US$/bbl

NYMEX heating oil crack forward curve

US$/bbl



75.00

80.00

85.00

90.00

95.00

100.00

105.00

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13

06Jan12 30Dec11 07Dec11

-12.00

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14

06Jan12 30Dec11 07Dec11

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

Jan 00 Apr 01 Jul 02 Oct 03 Jan 05 Apr 06 Jul 07 Oct 08 Jan 10 Apr 1115.00

35.00

55.00

75.00

95.00

115.00

135.00

155.00

Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11

0.00

5.00

10.00

15.00

20.00

25.00


06Jan12 30Dec11 07Dec11

15.00

17.00

19.00

21.00

23.00

25.00

27.00

29.00


06Jan12 30Dec11 07Dec11

January 10, 2012


Historical NYMEX heating oil crack prices

US$/bbl

RBOB crack forward curve

US$/bbl



Historical RBOB crack prices

US$/bbl

USGC 1.0 percent fuel oil crack forward curve

US$/bbl



-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11

0.00

5.00

10.00

15.00

20.00

25.00

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13

06Jan12 30Dec11 07Dec11

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

January 10, 2012


Disclosure Appendix

Reg AC

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crude oil prices strengthening on the economy, not iran

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