SIMMONS & C OMPANY Energy Industry Research

INTERNATIONAL February 25, 2003

Crude Oil Prices – A Discussion Of Influencing Issues

At the publication date of this report, West Texas intermediate crude oil prices are over $36 per barrel. U.S.
natural gas prices are over $7 per mcf. Many investors believe that commodity prices are headed south. A
smaller group believes prices are headed higher. Most are gripped with “headline fever” and many make the
incorrect assumption that a war with Iraq is the only influencing variable for energy prices.

The reality is that handicapping prices in the current environment requires a multi-variable approach with
influences and outcomes so disparate that we have little confidence in any particular price forecast or
prediction. Multiple opinions even exist within Simmons & Company. This report identifies and examines the
influencing variables of the analysis. As for the forecast…..does anyone care to roll the dice?

Higher Prices Lower Prices

• Inventory Levels • Seasonal Demand

• Supply Disruptions • Terrorist Activities
– Iraq • Economic Slowdown
– Venezuela • Deepwater Volume
– Nigeria Additions
– Persian Gulf War
• Robust Project
• Weather Economics
• Japanese Nuclear • Gradual Venezuela
• Decline Curves Resolution
• Economic Recovery • Strategic Petroleum
• Natural Gas Reserve

Speculative Futures Positions

OPEC

Daniel R. Pickering This report is based on information obtained from sources, which Simmons & Company International believes
to be reliable, but Simmons & Company International does not represent or warrant its accuracy. The opinions,
ratings and estimates contained in this report represent the views of Simmons & Company as of the date of the
David A. Pursell report, and may be subject to change without prior notice. For detailed rating information, go to
http://sciweb01/publicdisclosure. Simmons & Company International may seek compensation for investment
(713) 223-7840 banking services from companies for which research coverage is provided. The firm would expect to receive
compensation for any such services. Research analyst compensation is based upon (among other things) the
firm's general investment banking revenues. Simmons & Company International will not be responsible for the
consequence of reliance upon any opinion or statement contained in this report. This report is confidential and
may not be reproduced in whole or in part without the prior written permission of Simmons & Company
International.
Where Are We Now?

Inventory levels

Both worldwide and U.S. crude oil inventory levels are supportive of strong crude prices. Commodity
markets do not care how a particular inventory situation developed. Whether via normal supply and demand
interaction, war, a political crisis, or an act of God – the numbers do not lie. When inventories are tight,
prices tend to respond – as illustrated in the charts below.

Recent Crude Oil Price History

40
WTI Crude Oil, $/bbl

30

20
Sep-02 Oct-02 Nov-02 Dec-02 Dec-02 Jan-03

Source: Bloomberg and Simmons & Company International.

Crude Oil Price/Inventory Relationship

250 40
WTI Crude
Note Inverted Scale Price
Crude Oil Inventory 35

30
Crude Inventory, mmbbl

WTI Crude Price, $/bbl

300

25

20
Inventories
350
15

10

400 5
Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

Source: DOE, Bloomberg and Simmons & Company International.

2 SIMMONS & COMPANY INTERNATIONAL

Where Are We Now? (continued)

OECD Inventories: According to the IEA, December 2002 for U.S. crude inventory is 273 million barrels. Although
OECD crude inventories were 857 million barrels, 6% lower minimum operating levels are a theoretical estimation, the
than the prior year and 5% lower than the five-year average ongoing reaction of the U.S. refinery system confirms that
for this time of year. Over the last half of 2002, inventories the system simply cannot get much tighter without
have fallen by 700,000 barrels per day compared to average substantial operation disruption.
seasonal trends of 100,000 barrels per day.
The inventory situation is even more dramatic when one
U.S. Inventories: US crude oil inventories are at the lowest considers the days supply of inventory (lowest ever) and the
absolute level since 1975. A 1998 study conducted by the fact that PADD II inventories (where West Texas
National Petroleum Council pegged “minimum operating Intermediate is priced) are 25% below average.
levels” at 270 million barrels. The most recent DOE estimate

Total U.S. Crude Oil Inventory (Excluding SPR)

2002 2003 Max 1992 - 2002 Avg 1992 - 2002 Min 1992 - 2002

360,000

340,000
('000 bbl)

320,000

300,000

280,000

260,000
D J F M A M J J A S O N D

Source: DOE and Simmons & Company International.

Regional U.S. Crude Oil Inventory

PADD IV
12,794
12,261
PADD II PADD I
67,058 15,007
50,262 11,929
5-Year Avg Current

PADD V 5-Year Avg Current

57,967 5-Year Avg Current
51,932

5-Year Avg Current

PADD III
158,799 146,515

5-Year Avg Current

Source: DOE.

SIMMONS & COMPANY INTERNATIONAL 3

What Could Pressure Crude Prices Higher?

Although some might scoff at the notion of crude oil trading higher from $36 per barrel, it is far from
impossible. We will examine, in varying levels of detail, some of the influencing factors that could further
tighten an already tight global crude oil market, driving commodity prices even higher.

Supply disruptions
Supply disruptions (and fear of supply disruptions) have been
a significant recent influence on the crude oil market. With
worldwide and U.S. inventory at such low levels, even small
supply disruptions could be quite meaningful on the margin.
The irony is that at a time period when there are more macro
supply disruption possibilities than ever before (Iraqi war,
terrorism, Venezuela, etc.), the market is as “vulnerable” to
price spikes as it has been in the past decade.
Venezuela: Political upheaval has resulted in dramatically
reduced Venezuelan production – and therefore lower
Venezuelan exports. Current signs indicate a slow recovery
in production is underway. According to the “opposition” –
which we deem as the most credible source on PdVSA
production levels - production has climbed from a mere
200,000 barrels per day in early 2003 to somewhere around
1.4 million barrels per day.
However, the political situation in Venezuela is tenuous at
best. The opposition has been placated with “promises” of an
August referendum on the Chavez presidency. If a political
tempest were to again manifest (and signs indicate that
trouble is indeed still brewing), it is easy to see how the
fledgling production recovery could be derailed, sending
export levels back toward zero.
Iraq: Although most of the focus on Iraq has been on the
probabilities and timing of a military conflict, we should not
forget that Iraq is a significant exporter to the world oil
markets. As shown in the graph below, Iraqi exports are
volatile, but have averaged close to 2 million barrels per day
over the last five months. Ironically, with the advent of the
Venezuela export disruptions, Iraq became the “incremental
barrel.” As long as Venezuelan production is relatively
subdued, a military conflict does not have to occur for Iraq to
put upward pressure on crude prices. Imagine the scenario
where Saddam Hussein decides to wage economic war via
shutting off Iraqi exports!
It is impossible to know with any certainty the magnitude of
OPEC’s excess productive capacity (if any) – but it will
certainly be tested if Iraq and Venezuela are simultaneously
off-line.

Iraq Production History

4

Weekly Production (4 wk Average) Average Quarterly Production

3
Iraq Production, mmbpd

Iraqi Internal Consumption:0.6 mmbpd

0
Dec-00 Dec-01 Dec-02

Source: UN and Simmons & Company International.

4 SIMMONS & COMPANY INTERNATIONAL

What Could Pressure Crude Prices Higher? (continued)
Nigeria: In the past week, export bureaucrats in Nigeria
threatened to strike and disrupt Nigerian exports. Other
Nigerian oil workers’ unions quickly indicating their support,
if needed – all of which sent a shudder through the crude
markets. In the oil patch, situations of this nature are
commonplace – particularly in Nigeria, which boasted bare-
breasted women protestors demanding jobs for their
husbands, sons and brothers. On a worldwide basis (not just
Nigeria), these “nuisance” strikes take on magnified
significance in the current environment of tight global
supply. It is an opportune environment for workers to
consider taking “economic” hostages by threatening supply
delays or disruptions.
Iraqi Military Conflict: The Big Kahuna. Will bombs start
falling? What will happen if they do? At a minimum, we
would expect that Iraqi exports would fall by a significant
amount. Any number of additional possible situations could
develop that would reduce Middle Eastern oil supplies:
• An Iraqi scorched earth approach creates long-term
damage to Iraqi (and possibly several Kuwaiti)
oilfields. In this scenario, exports could take years
to return to current levels.
Nigeria Production History
2.1
2.05
2
1.95
1.9
mmb/d
1.85
1.8
1.75
1.7
1.65
1.6
Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02
Source: IEA and Simmons & Company International.
SIMMONS & COMPANY INTERNATIONAL
• The Iraqi government or military is successful in
damaging the infrastructure or political stability of
its Middle Eastern neighbors. For instance, the
Abqaiq processing center handles all the crude from
Saudi’s giant Ghawar, Shayba and Abqaiq fields. A
Scud missile into this area would instantaneously
alter the current supply/demand balance for crude.
• The Iraqi military succeeds in blocking the Strait of
Hormuz via the sinking of a tanker resulting in
decreased exports from the Middle East for days or
weeks. Over 13 million barrels of crude move
through the Strait each day. Although Iraq was not
successful in closing this shipping lane in the Gulf
War, it only takes one lucky shot to cause a supply
disruption.
• There are probably twenty other iterations around
the regional conflict escalation theme as described
above – some involving the Middle East, others
involving non-Middle East Islamic countries
(Indonesia, etc.), others involving energy-focused
terrorism. When a war erupts in a region – anything
can happen. When terrorists target energy
infrastructure – anything can happen. The longer
hostilities are ongoing, the more likely some sort of
destabilizing incident could occur.
• A detailed discussion of potential Iraqi military
scenarios can be found in our August 22, 2002
report entitled “Iraq Scenario Analysis.”
Challenging Logistics In The Middle East
Stra it Of Hormuz
IRAN
UNITED ARAB
EMIRATES
SAUDI ARABIA
Oct-02 Jan-03
5
What Could Pressure Crude Prices Higher? (continued)
Weather
Mother Nature can be cruel or kind to the oil markets.
Seasonal demand patterns are unlikely to be dramatically
altered, but extreme weather (a cold winter in particular) can
drive higher domestic demand in many countries, reducing
the supplies available for export. Weather can also intervene
directly – just ask the captains of the tankers operating out of
Russia’s five major ports. Icy conditions due to extreme cold
hampered export loadings. Russian exports essentially
remained flat year-over-year even though production
increased by 11%. Blankets anyone?
Japan’s Nuclear Situation
Japan has no domestic crude oil production – but is the
world’s fourth largest consumer of energy and second largest
energy importer. Nuclear power generates 30% of Japan’s
electricity, while oil-fired generation comprises 9%. During
2002, a scandal developed within the Japanese nuclear
industry, as executives revealed they had knowingly hidden
cracking and other problems in several nuclear facilities. An
industry-wide inspection campaign was implemented, and a
significant amount of capacity was idled for safety reasons.
In many instances, idle oil-fired capacity was brought on to
In The Grip of Mother Nature
Source: U.S. Navy.
6 SIMMONS & COMPANY INTERNATIONAL
offset the lost nuclear capacity. This created incremental
demand for approximately 600,000 barrels per day of crude.
Should the inspection process reveal more widespread
problems with Japan’s nuclear facilities, the amount of crude
needed to offset nuclear outages could grow, and the
temporary increase in oil demand could potentially become
more permanent.
Decline Curves
20% of worldwide production comes from fields that began
production before the 1960s. Much like these authors, old
fields are not getting any younger. Worldwide (or even
basin-wide) aggregate production decline curves are among
the oil industry’s biggest and most important mysteries. It
would be presumptuous to assume that decline curves were
going to be a prime driver in production shortfalls over the
next quarter – old reservoirs simply don’t react that fast.
However, the point is that a significant portion of the world’s
oil supply is facing relentless downward pressure. The recent
reduction in long-term growth forecasts by several of the
world’s largest oil companies is evidence that base decline
rates are an important factor to consider.
What Could Pressure Crude Prices Higher? (continued)

Natural Gas Prices Economic Growth

In a report about the influences on crude oil prices, one does The slower pace of oil demand growth over the past three
not usually expect a discussion about natural gas. However, years (0.4% per year) compares with almost 2% per year
the U.S. natural gas market is extremely tight. Low and during most of the 1990s. Growing economies are generally
falling inventories, coupled with falling supplies have energy-hungry. If the world is indeed emerging from a
generated high prices (sound familiar?!?). High natural gas period of economic malaise, demand growth is likely to
prices relative to crude oil prices can create the incentive for accelerate from the relatively anemic pace of the past few
dual-use facilities to switch between fuels. Although years.
currently near parity, gas market factors could easily cause a
disconnect that would provide incremental demand for crude
oil products – witness the gas price spike in recent days. The
magnitude of incremental demand created by switching away
from gas in the winter of 2000/2001 was approximately
500,000 barrels per day. Not a trivial number.

Historical Gas / Oil Switching Incentives

60
Economics Favored Residual Fuel Oil
(No. 6) Over Natural Gas
50

40
Price ($/boe)

30

20

10 NYMEX Gas

NYC No. 6 Spot

0
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

Source: Bloomberg and Simmons & Company International.

SIMMONS & COMPANY INTERNATIONAL 7

What Could Pressure Crude Prices Lower?

Look out below? We will examine, in varying levels of detail, some of the influencing factors that could drive
commodity prices lower from today’s level.

Terrorist Attacks demand could result in softer hydrocarbon prices – as could

Although gruesome to ponder, the possibility of additional
terrorist attacks on U.S. or European soil cannot be ignored.
Although perhaps not as debilitating as the 9/11 events, a
period of paralysis could be expected. Theoretically, this
could lower demand for jet fuel and motor gasoline, as well
as spooking commodity markets about the prospect of slower
economic activity (and hence lower energy demand).
Seasonal Demand
Summer follows winter. Due to more moderate temperatures
and reduced space heating demand in the Northern
Hemisphere, worldwide crude oil demand is typically lower
in Q2 and Q3 compared with Q4 and Q1. The IEA forecasts
Q2’03 demand of 76.6 million barrels per day versus demand
of 78.6 million barrels per day in Q1’03, a decline of 2.0%.
As we move through 2003, the seasonal sequential decline in
any weather-related build in inventories above the seasonal
average of 1 million barrels per day.
Resumption Of Venezuelan Production
After rebounding from recent lows, Venezuelan production
still remains roughly 1.5 million barrels below its pre-strike
output. If Chavez is successful in regaining control of
PdVSA and moving the operations toward normalcy, we can
expect much of the currently idle capacity to be returned to
the market. It remains our contention that this process,
assuming no additional unrest, will be slow. However, the
Venezuelan government’s thirst for capital to provide
economic momentum in front of the August referendum is a
strong motivation to increase production. If this production
returns, it will have an impact on the market.

Seasonal Demand Change from 2Q to 1Q

0.0%
Worldwide demand change from 2Q to 1Q

2001 2002 2003E

-0.5%

-1.0%

-1.5%

-2.0%

-2.5%

-3.0%

Source: IEA and Simmons & Company International.

Venezuelan Daily Crude Production

3.5
3
2.5
(mmbpd)

2
1.5
1
0.5
0
1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 Jan-03 Feb-03

Source: IEA and Simmons & Company International.

8 SIMMONS & COMPANY INTERNATIONAL

What Could Pressure Crude Prices Lower? (continued)

Deepwater Volume Additions
Over the next 12-18 months, new crude oil supply will be
coming to the market in the form of initial production from a
number of deepwater projects. The land rush and deepwater
exploration drilling boom of the late 1990s is coming to
fruition, particularly in West Africa and, to a lesser extent,
the Gulf of Mexico. Roughly 430,000 barrels per day of
incremental deepwater production will enter the marketplace
in 2003. The wild card is how much of this production is
truly incremental versus offsetting declines of existing
production. We will address this topic (and related
deepwater issues) in an updated deepwater report later this
winter.
Robust E&P Cash Flow And Project Economics
The cash pouring into E&P company coffers is undeniable.
Compared to most E&P budget expectations, current cash
flows are the equivalent of a winning lottery ticket. If the
current futures strip holds, 2003 cash flows will increase
75%+ depending on the company’s production mix. These
robust cash flows can be used for a number of corporate
purposes – dividend payments, stock repurchases, debt
repayment and reinvestment back into the business.
At current commodity price levels, the economics of an oil-
related project are very strong (an understatement). The
chart below highlights a prototype West Texas infill project.
We do not expect West Texas to provide any meaningful
supply increment, but use this examp le to show the
economics of a “marginal” oil prospect. Projects in this
mature basin are generally considered to be lower quartile
opportunities – but strong prices make even these projects
look good.
Obviously, E&P budgets are not based on $30 per barrel
pricing. But history has shown that budget expectations
begin to creep upward during periods of robust prices.
Additionally, strong markets tend to create some rate
acceleration projects that are driven by shorter-term price
expectations. Simply put, high prices encourage incremental
drilling and production activity which results in the potential
for higher supply.

Worldwide “Incremental” Deepwater Production

Year (mmb/d)
2003 430
2004 150
2005 670
2006 650
Source: Simmons & Company International.

West Texas Oil Project Economics

Imputed IRR Sensitivity

Initial Production (bpd)
50 75 100 125 150
12 -14% -13% -13% -12% -12%
WTI NYMEX ($/bbl)

15 -7% -4% -1% 2% 4%

18 -2% 3% 8% 12% 17%
21 3% 10% 16% 22% 29%
24 7% 16% 24% 32% 41%
27 12% 22% 32% 42% 53%
30 16% 28% 40% 53% 66%
Source: Simmo ns & Company International.

SIMMONS & COMPANY INTERNATIONAL 9

What Could Pressure Crude Prices Lower? (continued)

Economic Slowdown / Demand Destruction
Energy-hungry growth regions such as China and Southeast
Asia have been very resilient to increased crude oil prices.
The economic growth in these regions has allowed them to
absorb higher raw material costs – oil demand grew even
during the Asian Contagion events of 1997/1998. Slower-
growing, more-developed economies have not been as lucky
in recent years. OECD oil demand remained essentially flat
from 1998-2001, a period of relatively high oil prices and
relatively low economic growth. If the current worldwide
economic recovery stalls and demand growth remains
anemic, today’s oil prices could be at risk.
Release From the Strategic Petroleum Reserve
Details regarding the Strategic Petroleum Reserve (SPR) can
be found in our February 6, 2003 report aptly entitled “The
Strategic Petroleum Reserve.” Although unlikely to be used
unless a war develops in the Middle East, the SPR contains
approximately 600 million barrels of crude oil and has a rated
maximum withdrawal rate of 4.4 million barrels per day.
The purpose of the reserve is not to influence price but rather
to ensure the availability of supply. We would expect any
SPR release to have a moderating (although not necessarily
negative) impact on oil prices.

Asia Pacific and Chinese Oil Consumption vs. Yearly Demand Change
22,000 6%

5%
21,000
4%
('000 barrels per day)

20,000 Oil Consumption

3%
Yearly Demand Change

19,000 2%

1%
18,000
0%
17,000
-1%

16,000 -2%
1995 1996 1997 1998 1999 2000 2001 2002

Source: IEA and Simmons & Company International.

OECD Oil Consumption vs. Yearly Demand Change

48500 3%

48000

47500
2%
('000 barrels per day)

47000 Oil Consumption

Yearly Demand Change

46500
1%
46000

45500
0%
45000

44500

44000 -1%
1995 1996 1997 1998 1999 2000 2001 2002

Source: IEA and Simmons & Company International.

10 SIMMONS & COMPANY INTERNATIONAL

What Could Swing Prices in Either Direction?

Speculative Commodity Positions OPEC

Changes in speculative positions can have a meaningful
impact on oil price. Typically, commercial players are
usually not interested in making directional “bets” on
commodity price via the financial markets. Thus, non-
commercial or speculative positions tend to exert more price
influence. Currently, the speculative open interest in crude
futures is near five-year highs (the NYMEX rolling three
week average open interest is shown in the chart below).
Interestingly, the “bets” being made by non-commercial
players are almost evenly balanced between long positions
and short positions (89,000 long, 97,000 short as of Friday,
February 21, 2003). Profit-taking by the longs could hurt
prices. A short squeeze could drive prices higher. Who will
blink first depends on the outcomes of the events previously
discussed. If recent natural gas price behavior is any
example, the speculative game of chicken can be very
violent.
The past several years have seen the cartel operate with more
cohesion than ever before. Should OPEC be able to maintain
its discipline – or choose to remove crude oil barrels from a
tight market, prices could be pressured higher. Inadvertently,
OPEC could also be a driver of higher prices if it turns out
that their excess production capacity is less than expected –
depriving a tight market of “expected” barrels. Conversely,
OPEC cheating during lull demand periods or a perceived
breakdown of OPEC discipline could result in lower prices.
This risk grows in a post-Iraq war scenario when cartel
members must give up existing quotas to allow for higher
Iraqi output

NYMEX Crude Non-Commerical Open Interest

120,000

100,000

80,000

60,000

40,000

20,000

0
Dec-98

Dec-99

Dec-00

Dec-01

Dec-02
Jun-99

Jun-00

Jun-01

Jun-02

Source: Bloomberg and Simmons & Company International.

Conclusions

Where do oil prices go from here? Higher, lower or sideways? What today is considered outlandish could become the consensus
thinking of tomorrow. Issues unforeseen in this report could become significant factors. Six months ago, who would have thought
that Venezuela would be just as important to the energy markets as Iraq?

When it comes to the current outlook for oil prices, the only certainty is uncertainty.

SIMMONS & COMPANY INTERNATIONAL 11

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