Given below is an extract from transcript of a Goldman Sachs con call with Mr. Arjun Murti
Goldman Sachs Group, Inc.
Global Oil Research Team Conference Call
June 20, 2008
Moderator:
Good evening Ladies and Gentlemen. I am Rita, the moderator for this conference. Welcome to the Goldman Sachs Conference Call. For the duration of the presentation, all participants’ lines will be in the listen-only mode. After the presentation, the question and answer session will be conducted for participants connected to WebEx International. After that, the question and answer session will be conducted for participants connected in India. I would now like to handover the floor to Mr. Nilesh Banerjee. Thank you and over to you sir.
Nilesh Banerjee:
Thanks. Good morning, good afternoon, and good evening to all. The subject we are going to address here today is something that is touching all our lives in various ways, oil prices, and to share his views with us, please welcome Arjun Murti the heir of Goldman Sachs’ Global Oil Research Team. As you are aware, he was the one who had correctly predicted oil super spike of $105 way back in March 2005, when oil actually was hovering around $40. Recently, he has mentioned oil potentially hitting $200 dollars in the medium term. Without taking any more time, let me handover the floor to Arjun. Here we go Arjun.
Arjun Murti:
Thank you very much Nilesh, and I very much appreciate the opportunity to speak with everyone here dialing in from India. Thank you for the time to speak with you, and I very much look forward to questions you have. I think I am going to go through maybe 15 to 20 minutes of oil price outlook, and then would welcome any questions after that. As Nilesh mentioned, it was really sort of in the 2004-2005 timeframe that we started becoming noticeably more bullish on crude oil. In this by way of some very quick history, my own career began back in 1992 at a small investment bank in Denver, and you know, throughout the 1990s, and I was both in Denver and then on the by-side at a firm in New York, the prevailing wisdom at that time was that oil would be firmly in a $15 to $20 per barrel band in perpetuity, and the basic thought process was if crude oil prices ever got much above $20 a barrel, to say even $21 or $22, we would see a flood of new supply, and then similarly if crude oil prices ever got above, lest to say $25 or $30, the view was it should have a pretty bad global recession, certainly a US recession leading then to a global recession, and that this would then bring down demand, and so either way, to supply or demand, prices were to remain rooted in this $15 to $20 per barrel environment, and as we started getting into the early part of this decade, 2001-2002-2003, both myself and my colleagues around the world, which included analysts in London, another part of Europe, as well as in Asia, we started coming together various approach that looked at non-OPEC supply, and if you look even back at our initial report, we thought non-OPEC supply could grow fairly robustly 3 or 4% a year. Most of my major oil companies that I most closely focused on, companies like Exxon, Chevron, Conoco, and then over in Europe that my colleagues know covered BP, Shell, Total, etc.; all these companies had supply production growth forecasts of 3% to 9% per year. It was always starting next year, but that then production would then grow 3% to 9% per year. I mean, when we look back, the experience was, 2000-2001-2002-2003, we started noticing that the companies were missing these forecasts badly. It was not that they forecast 5% and came in at 4%. In the case like Chevron Texaco, the forecast had positive 3% and came in at negative 3%. Shell was at, you know, various times forecasting 3% to 7% and ended up coming in at negative 3% to 4%. Exxon promised +3, came it at zero, and we started taking a fresh look at our own models and assumptions, and I think one thing that became very apparent was that you had this big boom in the 1970’s that led to a number of major new developments, things like Prudhoe Bay and Alaska, various North Sea fields, and other major producing facilities, and at that time, industry invested a lot of money to build infrastructure and develop these big fields. They then spent most of the 1980’s and 1990’s getting more oil, we call the exploitation phase out of these major developments, and that proved to be very cost effective, so if you only built a big pipeline in Alaska and you have already developed all the major infrastructure, poking a few holes around the edges of the field to extract the remaining oil supply was very, very profitable, and could be done at a very low cost. It was a big trend of declining costs, and there is also this ability to sort of easily add supply from those exploitation or incremental opportunities, and you also had a big demand correction in the early 1980’s, so you had a lot of spare capacity that was built up, primarily in the OPEC countries, and therefore through this combination of low-risk drilling in the non-OPEC areas, and the OPEC countries tapping into their spare capacity, it was very easy to meet demand growth throughout the 1980’s and 1990’s, and it really was not until this sort of early 2000 period that it started to becoming evident that both supply was much more challenging, that the companies were not able to meet their production growth forecasts, and with hindsight, I think, they and many people, both within industry and analyst community had kind of fooled themselves into believing you could always do this very easy exploitation drilling. So, in early 2002-2003, that we started noticing that supply trends were not going to be as robust as we previously thought. I think the big surprise on the demand side that really stuck out was 2004, so for the first time oil had broken through, or first time in the long time $30 dollars a barrel, and despite breaking through $30 and all of this fear of this would cause a big pullback in demand, what we actually observed was an increase in demand, most notably in China, the demand grew 15% in 2004. The United States, a very mature oil country, mature oil prospects, demand grew +3%, a huge number for the United States, and so we thought how can it be that with oil prices having risen so much, we thought 15 to 20, it is now 30 dollars a barrel plus, the demand is actually accelerating, and we started changing our thinking that it would be old paradigm from the 1970’s that high oil prices are bad for the economy. It was not the right way to be thinking about it. That in fact it was just the opposite, a stronger economy is actually good for oil prices, and that when you look back at the 1970’s, that was driven as much by supply shocks, oil being taken off the market. We have supply shocks that can be bad for demand in the economy, but that is not what we were having this time. We were having an economy, global economic boom-led driven growth in oil demand, and so suddenly our thoughts on this started shifting that A) supply is going to be much more difficult to grow, as we can see from covering all of our oil companies around the world, and by the time we got further into the 2000 built in the analysis from our colleagues in Beijing and Hong Kong at that time, we were covering some of the Chinese Oils that were just emerging as public companies, started looking at some of the Russian Oils, as well as in Europe, and our colleagues there added some analysis, and we started taking a lot more confidence with the supply growth was not going to be robust, and similarly that the demand was going to likely continue. In June of 2004, we published our first report saying quantifying the upside optionality of the super spike, which came out with a very simple view that let us look at what happened in the 1970’s. If the current prices at that time were $30 or $35 dollar a barrel, it was not leading to faster supply growth or lower demand growth, then prices would likely need to be higher, but how high, so we looked back at the 1970’s and 1980’s, when oil prices in real terms were $50 to $80 a barrel. This was in 2003 or 2004 dollars, and we simply used that as our price band. We think there is a potential for oil to go to $50 to $80 a barrel. That report, for better or worse, did not get a lot of media attention, thank goodness, I guess it was such a boring title, but nevertheless, that was our first publication of our super spike view. We then updated that in March of 2005, which Nilesh referenced, which tried to put some analytics behind what price will ration demand back, if we were not going to have supply growth, then we are going to have to have less demand. Bring demand down to the level of available supply, and what we looked at was US gasoline spending as a percent of various economic measures, personal disposable incomes in the US are favorite, and we looked at what was the impact in the late 1970’s or early 1980’s, and therefore we had a corresponding impact this time around, what would be the resulting gasoline price and the resulting crude oil price. The reason we chose to go down the road on this analysis was we had negative demand from 1981 to 1985. It is really the only multi-year period in the history of oil business, 160 years, we had sort of 5 years of sharply declining demand in the US and around the world, and that decline in demand in the early 1980’s coupled with the supply growth that came out of the 1970’s led to the big spare capacity cushion, and then that kind of 15-year period of much lower prices, so we are trying to say what are the conditions that happened in the late 1970’s, early 80’s that led to this decline in demand situation, and the math worked out to somewhere between 6 to 6.5% gasoline spending as a percent of personal disposable income is where we peak. If we apply that in 2005, had various assumptions for marketing margins or refining margins, etc, that would have worked out to somewhere between $80 and $135 oil prices. We actually picked the middle of that band, $105 is sort of our high-end of our super spike band, and it did get a lot of attention. We always thought that $105 was a conservative number, so because in March of 2005, oil was merely $50 dollars a barrel, people thought it was too optimistic to put it kindly. People thought it was too optimistic to come out with $105 high in forecast, but again our analysis actually showed the number could have been as high as $135, and some times going on, 06-07, supply continues to disappoint, demand continues to be resilient, and we have updated this analysis and these numbers several times, including earlier this year, where we upped the band to $150 to $200 based on additional disappointment in supply and the continuation of oil demand growth. Now, people always ask why do you pick the US as the place we have to demand destruction, that seems to be very narrow view of the world, and it actually not meant to be a US-centric view, it is meant to be a global view, and the reason we pick the US is when we look at China, when we look at the Middle East, and when we look at the Latin America, which we call 3 of the core drivers, with China and the Middle East the most important, the prices of course are regulated. In the Middle East, they are subsidized at very lower levels, gasoline prices are of course very inexpensive as an example. In China, they are actually not as inexpensive as I think. Certainly, people in the West perceive them to be. Up until yesterday’s announcement, China, you know, we estimate was paying at equivalent of $90 dollar oil prices, and that is already up sharply from $20 a barrel several years ago, and maybe with today’s price hikes, they are $100 to $105, something like that, but they have steadily increased their price, and one thing we observe is when prices steadily increase, it is far less traumatic for the users of oil than if the price sharply increases. So, we look to the areas of the world that did not have price regulations, that did not have subsidies, and that is basically then the Western World, the OECD countries, but the thing is European oil demand has not grown very much for variety of reasons. Japanese oil demand has been flattered down as well. So, the one country that was growing was the United States, so our view would be that has been that you are going to have to have meaningful demand destruction in the United States before we can talk about the potential for a global oil demand slowdown, and then potentially lower prices. So, if we fast forward to where we are today, and to our most recent series of reports, which is very much an effort of our global team, US of course what might contributes tremendously to these effort as Kelvin Koh in Asia, Michele Della Vigna and Anton Sychev in London and Moscow respectively, and then many of my colleagues in the US, Brian Singer and Chuck Minervino, etc, and our latest global effort in terms of analyzing the situation is a first half of 2008, non-OPEC crude oil supply is actually down. I mean, that is just to me a stunning recognition that we are actually down in crude oil supply this year. We are 8 years into this up cycle. Capital spending has tripled or quadrupled from those companies, and non-OPEC supply is actually slightly down. That gives us a lot of confidence that supply is not on track to grow appreciably going forward, and we think that is very much reflected in long-run crude oil prices which have gone to as high as $130 - $135 a barrel. The market is recognizing that in the absence of the supply growth, you really going to have to focus on the demand side. Now, we do have negative demand in the United States. We are of course likely in recession right now, and with the sharp increase in prices that has seen over the last 4 months, whenever you get a sharp increase, you do tend to get a bit of a demand reaction. We were sort of negative 1% demand growth this year, but as best as we can see outside of the OECD countries, again China, now India, the Middle East, and Latin America, demand still seems to be growing at a fairly healthy quip. There is a lot of concern over the listing or the narrowing of some of the fuel subsidies, and in reference to everyone to a note that Nilesh and Kelvin published a week or two back, and our view is that demand in which these subsidies are being listed is such that it is unlikely to have a material negative impact on the demand in these countries. I will use China as the example. If they completely free floated, their oil price at International level, then maybe, and I use the word maybe we might be somewhat more concerned. The country actually has shortages right now. People in China have been willing to demand more refined products that have been available, and to the extent that the country has had negative refining margins, and whether Sinopec or Petro China, which at least get some subsidies back or more notably some of the teapot refineries, the smaller refineries, that have been unable to run because margins have been negative, well the higher in product prices is likely to leave them to run more crude oil to their refineries and provide more products to China, so somewhat counter-intuitively, you actually get a positive demand reaction, certainly on the crude oil side. The country is likely to demand more crude oil as a result of more robust refining margins. So, we think yesterday’s $5 sell-off was overdone. Now, crude oil prices are very volatile, so you can get pullbacks from time to time, but you know, we continue to be very much in the bullish camp here. I want to stress a couple of things before we open it up for questions. First, we do not believe, we are not subscribers to the peak oil theory. We don’t think the world is “running out of oil,” but the oil is more concentrated in just a few places, so the traditional areas whether it was the US Lower 48, the North City, Alaska, what have you, they are very, very mature, and there is almost no oil price that which is going to grow supply. Then, you got oil in places like Iraq, Iran, Saudi, Russia, Venezuela. All those countries with the exception of Saudi has various geopolitical constraints in developing the oil field, and so to the extent they are not voluntarily investing or bringing in Western companies. Either one would add supply. The supplies are not going to magically bubble out of the ground. Saudi is taking some attempt to grow their supply, but almost none of the others are, and so we are very, very dependent on basically one country to grow their supply, and that therefore keeps us focused on the demand side, but we do not think the issue is peak oil. The issue is really geopolitical constraints with developing oil resources in the number of these countries. The other point I want to make is that we do call it a spike, I think the notion that you can ask, finely balanced supply-demand in a volatile commodity like oil, the meaningful exogenous events like extreme weather, delays in projects just for natural reasons, let alone geopolitical turmoil and geopolitical constraints on growing supply means it is very, very unlikely that you maintain a very fine balance into perpetuity, and that is what we have always thought, the price at some point does go high enough that you not only drag down the OECD, but the key is when does that ever spill over to the rest of the world, and I think one of the key tests that the world has faced this year is, hey, the US is in recession or something that feels more or like recession, yet we still seem to have very robust economic growth, and more importantly for us, oil demand growth in the non-OECD countries, so the question I would ask is when does one believe that the major infrastructure and economic boom going on in China and the Middle East roll over. It is going to be, I think, a very hard thing to predict, but that we call the number one thing we would be looking for in terms of thinking that the cycle can roll over. We do presume it rolls over at some point in time, and Nilesh mentioned our current high-end of our super spike band is $150 to $200. We just yesterday raised our base-case price tag for the next couple of years to $140 and $150 a barrel, and again see if the potential is for further upside there, but our long-term number is $85, and whether it is $85 or $60 or $90 is lest the point, the point is more that if we get into environment where you have enough global demand destruction, even in a flat supply environment, if you can build up the spare capacity, you can begin to unwind, especially some of the cost inflationary aspects of this cycle, oil service day rates do not always have to go up, EMC contracting costs and labor costs don’t always have to go up, but you do have to stop the infrastructure boom if you are to reverse some of those effects. If they reverse, we think you can ultimately then potentially have lower prices for oil. I am going to stop there. Nilesh, I don’t know if you had anything you wanted to add to that. If you did or you didn’t either way, then we are happy to open it up for questions.
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