This is exchanges Goldman Sachs, where people from our firm share their incites on developments currently shaping markets. Industries in the global economy, objects, Ewart, Global, had of corporate me patients here at the firm a summer sell off in the commodities markets has seen oil continue its your long fall with base metals now joining in Jeff global head of commodities. Research Goldman Sachs is here today making a second appearance on, I guess. Congratulations, you're, the first repeat, guest gray to be here. we'll talk about competing views on oil and how volatility that China is having an impact on the global marketplace. Jeff walk into the problem. Rigour First, had you on in January, you just put out a research report. The new well order. There for the implications of shale production, the? U S and its impact on global energy markets. Oil was low, then

slower now in your latest, research posits that this low price environment could be around for a while how's your thing evolved on the topic. Since that report was first published later this year, well, when you look The basic until the new oil or one of the key tenants is this idea that capital needs to be sidelined in the rear, and for that is the time to build and shale is far lower than we ve ever seen in any other commodity. And what do I mean by time to build? time to build is the period between when you can make capital and when you get production the large alter deep water projects in Brazil, time to build is roughly eleven years between when you can make capital when you get production iron or its ten we're majors is forty five one. it is in jail. The number is fourteen days this a game changer, because what it means you put capital in production goes up. So for the first time we

the capability to throttle supply up and down based upon capital, Now. Why is this important and how is it shifted? Our thinking recently in January, made the point if prices rise prematurely before the market, rebalancing capital re enter the market. Drilling will increase in push prices back down. We put a piece out this entitled the self defeating rally cause. That's exactly what happened: the higher prices, this opened up equity markets, bond markets, cash flow, turned more normal levels and guess what happened drilling increased tremendously, which brings us to the environment We are now in a greater oversupply than what we were in January, which is why we just reduced our longer term forecast who much lower in two thousand and sixteen forty five dollars a barrel, so you ve talked about some of the. risks in recent research. Their fears that all this oil is being This was surpass storage capacity, which could have Even bigger impact on price has significant risk is that for the industry it is

Creasy substantially, particularly given the larger size of the surplus. By think, let's go back and think about the economics of why this is important and we gotta think of What makes energy different from all other commodity markets in what makes it different is how difficult it is to store it requires expensive infrastructure distort just think about that in the context of metals metal, all you need is a parking lot chain link vans and maybe a guard dog. You can step by step to the moon oil once the storage. Passing is breached by the surplus. You have no choice but to bring supply back in line with demand, because if nothing else to do it, I can't poured out against the side of the world like a kid stack metal. So you have the sea supply brought in line with the man into career balance prices typically spike down to cash costs, which be as low as twenty dollars a barrel and again when we, get how high inventory levels are right now, the probability that happened has increased tremendously. You also

but financial stress, is a key factor for the industry earlier this year. Many shall producers than funding readily available. I talked about this earlier in production, stayed high. as environment changed a little bit since the spring. For that the companies that we were focused on in the spring it has but what's chain. is that group is no longer large enough to rebalance the market, so we think What was our story that we were telling back in winter and spring was at prizes have to stay low enough long enough to create real default risk with the companies with the weak balance sheet so that they really began to throttle back production fact. We estimated back then that forty dollars a barrel for six months woods create significant the vault risk. Now the problem that today, that surplus is so large that this group of companies cannot even come close to be creating that balance. So now the focus here turned to the more financially healthy companies investment grade here when we think about

fought raids in that they're, not as important as managements discipline with capital as well as the equity markets view of these companies. In fact, my focus now has asked he turned to the investor as opposed to the producer, because as long as these companies are funded in the expectation are for a substantial rebounding prices, these companies will have access capital. Inability to continue to increase production is think about what needs to happen and that I will continue to put pressure downloading Jack rises. So when we think about the capacity patient because we think about the investors providing these companies with capital. We go to nineteen? Eighty, eight? Ninety, ninety nine, a fury all that economists had a it, was Her page of the commerce with five dollar oil is here to stay. That created. capitulation in which created the rebounding prizes. We a similar dynamic, has to take place here. If you got us here,. population so that many these companies have funding cut off and we began to seriously rebalancing market. So

is the world of forty five to fifty dollars per barrel, roughly a new normal for the industry, and what does the foreign press for telling us today about what the market expects when we think about, where we view the long term price of oil. We put it around fifty dollars a barrel. Think about, whereas the long in the former curve it somewhere in that fifty to fifty five dollars a barrel. So it's not too far off the mark. Think about. Why is a price so load today because we need to have prices below that long term price, to create some financial pain in the industry to start to see, supplies get off the market to be able to create that correction. I think the key here when we think about a long term price of fifty dollars a barrel today, that's a substantial, decline from a long term, priceless saith, four or five years ago. That was closer to a hundred so you ve been reasonably bearish on the market. There are some out there, and some of them are quite vocal one common arguments they make is that OPEC is near maximum capacity production

will inevitably started? Taper off in prices will rise far sooner than your lower for longer thesis projects. How do you for that kind of argument about spare capacity and the lack of spare capacity of OPEC well when we go back to economics, one or one one of the basic. conclusions was that an industry that operated a hundred percent capacity limitation is typically a competitive industry, and that's exact what's happened to oil think about what has shale done. You ve heard the term that is a manufacturing process. It has turned energy into a competitive industry which It very difficult to maintain a cartel, and so we think about OPEC new technologies have neutralize the ability to maintain a cartel. As a result, they need to go to capacity. So this is consists. with the economic theory? And not only will they go to capacity, they will likely start to grow capacity with as we go forward, because market share should really be their primary focus.

In Libya in the Middle EAST in Iraq, there odyssey significant, ongoing conflict that could have a big impact global production. Do those conflicts pose threat one way, the other to your outlook for near term prices. We like to think about this problem is GEO. Political risk has never been higher, but oil, it Risk has never been lore. Why do I say that well, we look at. I ran. They already have a substantial reduction in their exports. Given the sanctions that were imposed on them several years ago? We look Libya, due to the civil war they're on their operating at some around four hundred thousand barrels per day against the potential capacity of one point: four million barrels per day. We look- production in places like Nigeria, Venezuela, it's already been idle back we think about. Where is production growth coming from the say, places like Iraq or Saudi Arabia. The security has and to be more than sufficient? We think about was different about Iraq today than in previous times in history. Is that mostly

direction is done by Davies. This is Wharton, because foreign companies would not put large scale capital work in these countries. If they didn't feel comfortable about the security, times as even their own mercenaries? But the key here we saw this last year. Is ISIS started to move the south of Iraqi could not get down into the Bozrah fields, and so we would argue the places that are standing in terms of increasing production right now are relatively safe and you only potential upside from the other regions that have already cut production back you mention IRAN, how might their return to the markets affect the global price environment as well as sanctions roll off, but when we think what will it do to the long term price? The answers nothing in there. for that is because it has a cost It is well below that of shale, because we think about what determines a long term price of oil is shale shall be the marginal barrel as we

out into the future now that doesn't mean it will create a surplus next year as it began to come on and help keep prices underneath that long term price again and going back to our point, our near term forecasts ranges from thirty eight to forty five over the next year. Despite a long I'm price forecasts of somewhere around fifty nine, because we expect the market continue to remain a surplus in think about what is, I ran, do as they began to come online it'll just amplify that surplus and put more downward pressure on your term prices, but again it doesn't impact, the long term price, because the cost basis is below that of shale. there are some other bulls out there. Who say that? U S, production is actually falling faster than the official statistics show spawned that argument to to go. We had a data observation from the EPA that showed a sharp decline in. U S. Output in May

However, when you dog into the statistics, they actually reported a significant increase in stories levels as well as what we call a balancing term, which is an area which leaves a lot of uncertainty, whether or not that was a true decline. Now we I think it has declined that much for several reasons. One our own models point a relatively flat production. When you actually look at Pipeline data and scrape the pipes and also points to flat production Finally, you look at company guidance. It points to flat production. When third quarter and fourth quarter. So put it all together. We would ask me when the current environment use production is likely flat, not down four hundred thousand barrels per day, as some data points would suggest so much a mere new or order thesis is been about supply. Let's talk a little about the demand side. How has the recent turmoil in China is from the other emerging markets? Brazil affected the demand side in what way like to see a man doesn't matter in the place

like Brazil has had a significant impact on oil demand, but in places like China has an immense, there's, really important reason. Why hasn't when you listen policymakers in China. There very clear that structural reforms are going to be their focus, and that means turning down the investment side of the economy and turning up the consumer side of the economy? And if we look at commodity demand, it clearly tells you that they're being successful at this, I like commodities and divide them into cap ex commodities. Things iron ore, coking, coal and steel and then up ex commodities things like oil and gas nickel in an aluminum and another way to think about this, is you have to build the building with cutbacks commodities? And then you gotta, heated and cool it with objects, commodities and Sophie the demand for objects, commodities in China there actually up substantially here. Gasoline. The most consumer of consumer fuels is up seventeen

you're over a year, and as we move down that scale from objects towards cap acts and we get the steel which is the most cap ex intensive of all commodities. Its demise and is declining at six point two percent year on year, which really scores. This difference between our backs in cap access. We think about China. We expect demand a hold up last year in going forward for oil. Have I dont want? dismiss what you're saying about. What's going on, Brazil mini commodity? Producing countries, and I'm gonna put Canada, Australia into that group? struggling in the current environment and we're see weaker demand of those regions, but we think about really was can drive demand of the next several years we see in China. India Oecd countries in demand is holding up in those regions so that talk a little bit about the non oil commodities. It some greater length use your big sell off. Some base. Metals have reached six year low prices; they expect that continue given the dynamics you described or

expect to see some levelling up or even increase in some of the Nano commodities see downward pressure lower for longer across almost every commodity right now, in the room, for that is this idea of a negative feedback loop that exists between these commodities demand growth in emerging markets, emerging market ethics, and, let me go in the story little more in depth, there is what we call the three days of macro and these three days our theme things that have been put in place over the last decade: the knock to unwind over the next six months is gonna take five years or so for them for their play up the three these first on is what we call deflation, and again it was ten years in the making due to high howdy prices, we created excess production capacity across every committee with his iron ore, coking, coal, copper, aluminum oil. You pick your commodity, olive, moreover, supplied supply.

Everyone built up capacity, women, the classic cycle. Exactly until we have downward pressure due to the supply side these what we called divergence divert in growth in the United States against the rest of the world. If the? U S hikes rates this year, it will be. The first time in a decade as U S has high grade. In other words, you can say that the U S has had easy monetary policy in place for a decade. This is a huge jump on ass. We think about China is just now getting. The point is trying to ease or Europe are easing into really any significance until two thousand and twelve, so we may about the? U s: it's good three is diverging from the rest of the world, so says you wanna, be long, the? U S dollars and we think about what does that mean in terms Commodities, it means that come currencies like the canadian dollar, the australian dollar chilean peso Brazilian Rio, are all going to be under pressure, as we particular have seen over the course of the last.

I will now what does as due to the cost of producing all those commodities it puts downward pressure in it. Does it through the wage, tell you must take something like copper and chile. Forty percent of the cost of producing copper is labour, and what is that repaid in local wages, which would be Julian pace. So the chilean peso weakens with a stronger dollar, it puts downward pressure The cost structure producing these guys. So that's the second date of the thirty thirty, is DE leveraging again the stories a decade in the making. When we look at the big boom in emerging markets over the last decade, many of these emerging market created significant macro imbalances in large amounts of debt particular in places like China on the credit side, Now what that means going forward is going to have to deliver in the delivery will require, as we ve seen in China, a substantial Rita in an investment in places, a heavy industry which puts downward pressure on the demand for commodities. So, let's take a commodity.

Copper. You can see all three days at work, so you see. deflation excess apply all of the world, putting downward pressure on copper, you see the divergence with a stronger dollar leading to weak or to lay peso putting downward pressure on the cost of producing copper and chile and then five you think about weaker demand coming out China, do the de leveraging reducing the demand for copper out of chilly now, there's an important feedback. Loop take as the real critical story here that exists between these three, in the sense that I say deflation, It puts downward pressure on steel prices in copper, prices which are input into oil, which then reduced also producing oil. A lower oil price strengthens. Europe's economy leads to a stronger. U S dollar, which leads to gradually and pays a weaker australian dollar, lower cost of producing steel and copper, then think of this. As you have a stronger: U S, dollar, rising! U s rate increases the funding.

As for the emerging markets, which exacerbates the de leveraging problem, which then further we The demand for these commands- you can see, is a negative feedback. Loop just continue to reinforce lower commodity, Ices this'll be that for so. So I think it's really important to think about this. This broader macro contacts in that's why they cycles are so correlated so give A dynamic and three d: dynamic: wouldn't call it. What places are most vulnerable around the world right now, the big commodity producers, but it's not as obvious is that so? Obviously the community producers to be places like Canada, Austria, Chile, Brazil and even pay. Actually the Middle EAST, but it's important to distinguish the key. trees that are getting investment versus the countries that are not getting investment. If you take a country like Brazil, it's getting On both sides is not getting significant investment in the say, its iron or sectors, but also getting a terms. Trade shock and consumption is also going to us, was getting hit on both investment and consumption site. Same thing with Chile. However, it

Saudi Arabia to very interesting case you're, in a significant increase investment. Going back to your question early, what's going on with OPEC, there taken the production up to capacity taken capacity up. There is a real good number of rigour in the field and Saudi Arabia right now, so, in other words, you say there get an investment boom is just not happiness in Sarajevo with most of the lower costs. Producers around the world are attracting capital right now, because there a safer place to put money in an invite at which we have much lower commodity prices. So again, I think the point in point here is distinguish between countries that are getting investments in countries that are not when you think about this for This thesis, What are the unknown on nodes? What was uncertainty? This forecast? What can really change the outlook in a dramatic way, ironically, it would be the: U S, economy, faltering, and the reason why I say that it was a would likely force the Federal Reserve to return too much more accommodative monetary policy and potentially ink

in Cuba again, and why is this important because it through a lifeline to the emerging markets. Predicary places like Brazil in the other emerging markets would then create more demand for committees, but also what it will do. Is it weaken the dollar again making the argument before and the three days with the negative feedback loop. It would reverse it in dollar would begin to weaken and put up pressure on the cost of producing commodities around the World in writing. I was visiting a client recently in Houston and they asked me the same question and the Clyde whose a producer of oil in Houston responded to me back. So you're telling me that the? U economy weakens the our business will do much better. I go yes. What I'm telling you, but that's truism going clear back to the pole, tire post war era, the higher oil prices user associated with it you're? U S economy and stronger in p prospects.

ever what difference is that were tell him the causative very differently than what we have historically said here, we're saying the? U S. Economy causes the wheel prize as opposed to the oil price, causing the? U S, economy. I think the point here is. We know these correlation exist. They ve gone back over decades. However, the one thing that I am baffled by is what actually causes these cause out is. The only thing we know for sure is that these super cycles there's one in the fifties after work, Two, there was one in the seventies after a period of war, and then we had the one of the two thousands after the Iraq war is the possibility that you actually have production capacity reduced, stance. We do these events, which then creates a rising commodity prices, leading to a weaker. U S dollar still certainly my thinking, but I think it does really underscore the importance of this negative feedback loop and as core nation that exists between commodities affects emerge, market demand, so

all doom and gloom for the producers, at least in the short term. What do you think could eventually led to rebalancing the market? This was a decade in the making will take a decade to our work itself out, I dont want say it all gloom and doom for thee. but he's in the countries that are low on the costs curve. Things are still doing relatively well form, but if terms, I think about how this market resolve itself. ill rebalance itself from a barrel or metric tonnes perspective within the next several years?. but the real imbalance in these markets is on the capital side. There still way too much capital chase in these markets, under the belief that oil, apart back up to a hundred two hundred and fifty dollars a barrel in the very near future and eventually that will drive in the anything that will dry up that capital is a substantial reduction in the expectations of a rebound and price. Once people it's too late and throw in the towel and think it hey. Prices are lower for longer than that.

Would likely leave, and then you can make the arguments for rebounding longer term prices. But let's go back to the last cycle. Oil prices collapse nineteen. Eighty six, though rebalance by one thousand nine hundred and eighty eight and prices pop back up to they went from ten dollars to twenty dollars a barrel, but it took until a key. Ninety eight for those capital markets, rebounds with the creation of the super majors. There was a lot of consolidation that happened. That created companies, like on mobile, you had p, shall told how so it took twelve years. I don't think he's gonna take that long in the current environment, but it's not up in the next year to excellent. Thank you. Jeff It is good to have you once again. That concludes this episode of exchange. The Goldman Sachs objects seaward thanks for listening this spot

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