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MAURIZIO LEVI-MINZI:  Good morning.  Welcome to today's Council on Foreign Relations Corporate Program meeting.  I'm Maurizio Levi-Minzi, I'm the co-head of the Energy Practice at Debevoise and Plimpton.

Today it's my pleasure to welcome you to this event and introduce to you Scott Nyquist.  Scott, who co-heads McKinsey Global Energy and Material Practice, has more than 20 years experience supporting clients in the oil and gas industry.  After leading McKinsey European Petroleum Practice in the '90s, Scott moved to Houston where he led for a while the American Petroleum Practice, before assuming his current global responsibilities.  He also has a leadership role in the firm climate change initiative.

Scott is here today to brief us on a timely report prepared by the McKinsey Global Institute entitled "Averting the Next Energy Crisis:  The Demand Challenge."  The report is an examination of the outlook for energy demand across sectors and an attempt to chart the trajectory of energy supply across fuel types.  Given the extraordinary volatility of crude oil prices in recent years and the high degree of uncertainty surrounding both the demand and the supply side of the energy equation during the current global economic downturn, I think that you will find the analytical findings on which Scott will report to be useful intellectual tools to put the energy puzzle in perspective.

Before giving the microphone to Scott, I would like to remind you to please turn off completely any gadget that you might have and also to please remember that this meeting is on the record.  Thank you very much.

Scott, please.

SCOTT NYQUIST:  Thank you very much for inviting me.  We appreciate the opportunity to share our views in this setting.

Before I get into the content of the work, I'll just give a bit of a background on the methodology and how we kind of went about it inside McKinsey.  It just gives you a sense for what the analysis means.

McKinsey has a research arm called the McKinsey Global Institute.  It's funded by the partners of McKinsey & Company, and it's designed to provide independent analysis on economic issues that are of interest to our clients and also provide some nonpartisan views to policymakers.  So this is the think tank for McKinsey.  And that organization, in collaboration with our Energy Practice at McKinsey, who serves energy companies around the world and has access to these executives and their ideas and points of view, together collaborated to put together this report.

And the methodology we used was really a bottoms-up perspective.  We looked at demand from what's going on in transportation in India, what's going on with appliances in China, petrochemicals in the Middle East.  And from this very microeconomic-driven, bottom-up point of view, aggregated that up and said, well, what does that mean for demand of energy around the world and in each region and in each sector?

Then alongside of that, we looked at supply.  What's the resource base?
And as capital flow is moved around the world, how much of that resource base can be exploited, both in the near term and the long term?  And then coupled together these bottom-up views of demand and supply and then come to a conclusion of, what does that mean in terms of the supply-demand balance and the implications for our clients?  So it's a very different point of view than others who take a more top-down macro perspective.

In our work with clients, we were a little frustrated that we couldn't always understand what some of the macro views were saying, so this is why we decided to do this kind of bottoms-up research.

So in my opening remarks, I'll just talk a bit about three areas.  One is just conclusions from the overall energy supply and demand.  Then I'll talk specifically about oil which has some interesting specific issues.  And then briefly talk about some of the policy messages that can come from it.

So before I do that, just some big messages that come out of here, high- level messages.  One is that when you do this bottoms-up view of energy demand, you quickly conclude that when the economy comes back, there is enormous, latent appetite to grow energy demand.  And it grows very rapidly.  And if you unconstrain demand from supply point of view, demand will grow rapidly; 2.3 percent per year from 2010 to 2020, a full percentage point higher than we've had the last five years.  So when the economy comes back -- if the economy comes back, hopefully it will -- then demand for energy will come back very robustly.

We also observed that a full 90 percent of this energy demand growth will come in developing countries.  So despite all the efforts in U.S. and Europe to constrain demand which we think will be largely (successful ?) demand will still grow rapidly as the economies in the developing countries grow.

Third is that we see coal and gas being the main sources of energy to meet this demand growth.  This, of course, means that greenhouse gas emissions, in our analysis, will go up.  Again, we're basing this analysis on existing policies, and we haven't put in any new policies that might come to constrain greenhouse gases.  But when you do this kind of analytic view, you end up concluding that coal and gas will need to be the main providers of energy to 2020.

And the final message is around oil supply and demand.  We see that the impetus for demand leads to demand growth that will be faster than what we think oil supply can match.  Again, this bottoms-up view.  When the economies come back, robust demand growth.  And then we look at all the supply bases around the world, we see that will be difficult for supply to keep up.  Therefore, we can envision the possibility of price shocks in the near and medium term.

So let me first talk some more about overall energy supply and demand and then get into oil.  I said 90 percent of the demand will come in developing countries.  China and India alone will account for some 40 percent of that demand growth between 2006 and 2020.  In five sectors within China, particularly in residential and commercial steel, petrochemical and light-fuel vehicles will account for a full 25 percent of the global-demand growth between now and 2020.  India will also contribute significantly.  Light vehicles, residential and steel sectors will grow rapidly.  

And then the Middle East which will have the fastest growth rate of energy around the world in both its industrial sectors as it uses its low costs of energy to build its industrial systems as well as the consumer side of the automotive, in particular.  As the consumers get wealthier, they'll consume more energy in those areas.  

And we then switch to the developed countries.  We see U.S. demand for fossil fuels essentially flat to 2020.  Demand growth in Japan and Europe will be very, very low.  And in fact, we see demand decline in the light-vehicles sector as the CAFE standards and other countries' approaches to improve vehicle efficiency will reduce demand in those sectors.

If we switch to supply, we see renewables in terms of solar and wind and
biofuels being the fastest-growing area of energy supply; however, this started from a very low base.  And when you think about the incremental new supply of energy added to meet this demand growth, it's going to only be about 6 percent of that demand growth that will come from renewables.  Despite all the efforts that we see going on, a very small share of that demand growth.

And if we think about the older forms of clean energy -- nuclear, hydro, traditional biomass -- those will account for a greater share of that total demand growth because they're starting from a larger base, and they'll account for another 15 percent when you add them all up, all the hydro and nuclear.
So if you think about clean energy, maybe 20, 21 percent of the new-energy supply needed to meet demand will come from renewables or clean energy.

Coal, particularly from China and India, will meet some 35 percent of the energy demand growth between 2006 and 2020.  Natural gas will provide some
30 percent of that demand growth and oil about 15 percent.  So you can see this still-heavy dependence on fossil fuels, and that will lead to greenhouse gas emissions growing at about 2 percent per year in our analysis, which will lead to 25 (percent) to 30 percent increase in greenhouse gas emissions between 2006 and 2020.

Now, we did this work in 2006 the first time.  And in that work, we found a big opportunity to improve energy productivity, lots of inefficient use of energy around the world.  And we looked at the opportunities, were we to invest in capital projects that would generate a 10 percent return on capital, what could that do to improve the overall energy efficiency and effectively reduce demand growth?  And we've found a 20 (percent), 25 percent opportunity to reduce 2020 demand through these kinds of energy efficiency investments.  And that was a big opportunity that we saw then.  

And since then, there's been actually quite a lot of action taken around the world to improve energy efficiency.  In the U.S., we had the 2007 Energy Independence and Security Act which put in the CAFE standards, so that reduced our view of energy-demand increases in the U.S. automotive sector.  The EU has put in strict CO2 emission standards, and that is improving the energy productivity and transportation sector.  China and Korea have done something
similar for their light vehicles.  And China has put in this Top-1,000 Energy-
Consuming Enterprises Program designed to reduce by 20 percent the overall
energy intensity, which, again, has affected the way we think about the future of energy consumption.  China has actually reduced it compared to what we
would have had in 2006.

So lots of changes on that side.  And that's reduced the overall opportunity to improve energy productivity.  So we had 20 (percent) to 25 percent improvement opportunity back in 2006, and now we're down to 15 (percent) to 20 percent.  So still lots of opportunity to be more energy efficient around the world, particularly in developing countries, but some progress has been made on that front.

So if we look at the overall energy big picture, lots of energy growth coming as the economy recovers.  All that happening, 90 percent of it happening in developing countries.  The story with current policies is that gas and coal will be the largest providers of that energy source.  Greenhouse gas emissions is likely to go up as a result of those choices.  And still, some significant improvement potential around the world, but we have made some progress in that area.

So let me shift to oil.  On oil, as I said in the introduction, we believe that there is a sniffing of risk of price shock coming.  We see that demand growth is going to grow faster given current policies than what supply is likely to grow.  And again, this is just driven by the bottom-up views of what drives demand and supply.  

Now, when we have debates with our clients and amongst ourselves around what will happen to oil, you quickly get into your views around the economy.
And we have learned over the past two years that when these have a very wide
(prospective ?) of scenarios around what the economy can do since it's highly uncertain.  So we've put in, just for our kind of debate with colleagues and clients, different scenarios.  And we think about what would happen to the oil supply-demand balance under these different scenarios.  So I'll just walk you through a few of them since they give you just a sense for this sensitivity of when oil supply and demand gets tight compared to the various scenarios.

There's the optimistic case where we call it a relatively quick recovery in which the global GDP bottoms out this year and begins coming back in the second half of 2009 and resumes its kind of normal growth trajectory in 2010 around 3 percent per year.  And in that scenario, what happens is is that the supply buffer for oil production capacity we have today quickly gets whittled down, and we can see tightness.  And by tightness, we mean the spare capacity available in the production system going back to levels around 2011 to what they were in 2008.  So we had around 3 million barrels a day of spare capacity roughly in 2008, and if we have a robust economic recovery, we see getting back to those same levels of supply-demand tightness as early as 2011.

This is the Obama optimistic case.  Many of our clients are skeptical that it will be that successful, so we have some other cases.

The second case is the battered-but-resilient case.  And in this scenario, the economy in 2009 continues to slow in the second half of the year but begins coming back in 2010 and resumes what we'll call normal growth in 2011.  And in this case, when you go through all the detailed analysis of oil supply and demand, we get that same tightness of only 3 million barrels a day of spare capacity in the 2012, 2013 time frame, so it delays it a year or two in this batter-but-resilient case.

And by the way, when we've done some surveys with our clients, this is the one that seems to resonate with most of our clients around the world, the battered-but-resilient case.

And we also have more pessimistic cases.  And these are all related to how the credit markets and international trade comes back.  For those who are worried that the credit markets aren't being fixed and that will lead to slow international trade and impact on the real economy, these scenarios are very relevant.

We have a modest-recovery-but-stalled-globalization scenario where this stimulus that's put into the economy actually gets the real economy growing, but we haven't (fundamentally ?) fixed the credit markets and international trade.  So we don't get back to normal levels of growth, and the GDP numbers turn out to be lower than we've had in the past.  And in this case with lower GDP growth after a recovery, it leads to oil supply-demand tightness resuming in 2013, 2014.  So the time frame in which we get this tightness gets deferred another year or two.

And then we have the more depressing scenario, the long-freeze scenario where more like the Japan case where the world doesn't really get its act together in terms of its banking system.  And then we don't see problems of supply and demand for oil for quite some time, beyond 2015 before we really see this tightness.  But it is interesting.  Even in that low-growth case, given the supply system, we do see tightness coming after 2015.

So in all these scenarios, we see a real risk of tightness coming, unlike what happened after the 1980s oil-price shock.  So that's a summary of kind of the views on the tightness.  

Just a couple of comments on some of the drivers of that.  When you go into the details of what drives oil demand, you find that there are some sectors of the economy that use oil.  And when the economy comes back, they are very pro-cyclical in their demand for oil.  So maritime shipping, trucking, petrochemicals, when the economy comes back, these sectors tend to grow quickly.  And their use of oil tends to grow even more quickly.  So oil demand tends to come back very, very quickly in those sectors.  And that's one of the reasons why we see such a rapid response on oil demand when the economy comes back.

And then on the supply side, we've seen a significant decrease in the capital spending as a result of the low oil prices.  We've seen some 18 percent decline in CapEx in 2009 versus 2008.  And that's led to a significant reduction in what we were expecting oil production to be.  So we were hoping that 2009 production, for example, would be a growth of around 1.4 million barrels a day growth in the production system.  And with all the CapEx declines that we've seen, we're now expecting in our battered-but-resilient case of actually 300,000-barrel-a-day decline.  So still a lot of momentum of capital that's coming in to keep production stable, but much lower than what we had expected.  

So you couple a decline in production, the slight decline in production, with the significant decline in demanding we're expecting, depending on the scenarios, anywhere from 2 (million) to 3 million barrels a day of demand reductions in 2009 that leads to this increase in spare capacity.  So a declining production, declining demand leads to increasing spare capacity in the system.  So we had 3 million barrels a day, roughly, spare capacity in 2008, and then we add this increasing spare capacity as a result of declining demand and not too much production, then we end up with 6 million barrels a day, and today it's even maybe 6.5 million barrels a day of average spare capacity in the system.

So with that spare capacity, it will take some years to wear that off.
And as I said before, if the economy comes back quickly, that spare capacity gets whittled down soon.  And then we get tightness as early as 2011 or as late as after 2015.  So that's kind of the short-term view.

If we think a bit longer term, we see that there still is plenty of opportunity to grow oil supply.  We're not a peak-oil firm in the sense that we believe we hit the peak yet.  And it's interesting.  We don't have perfect access to data around the world on what's going on in these oil fields.  But you know, our consultants are working in many of these oil fields around the world, and we're optimistic that there are opportunities to grow production, from their vantage point.  We don't have perfect data, but from their vantage point.  

So we can see that Saudi can grow its production by some 4 million barrels a day.  Iraq has enormous potential grow, which they're going to produce maybe 2 (million), 2.3 million barrels a day this year.  And we think by 2020 that can grow by another 3 to 4 million barrels a day.  Kazakhstan will have growth production.  Brazil, Canada, Qatar also we see significant growth in biofuels.  So when we look at the oil supply system, we do see a potential to increase oil supply.  But as I said, it doesn't grow at the rate at which the demand will grow.

So let me just shift just for a couple of minutes on the policy.  I won't spend too much time on this but just give you some of the highlightable messages.  When you do this kind of analysis and you see this obvious kind of dislocation where letting kind of the demand kind of grow at its own natural rate and the supply its own natural rate, you get this imbalance, you ask the question, where are their market failures and market inefficiencies in the system that governments could take action on?  

And obviously on the supply side there are many governments around the world that inhibit the flow of capital into low-cost production opportunities.
And that's nothing new there.  It's frustrating when you go around the world and see lots of low-cost supply available and you can't access it because of government action.

But we've spent most of our time and our work looking on the demand side.  And we've found similar opportunities to reduce demand growth which could be facilitated by government action.  Examples, as I mentioned before, on energy efficiency, lots of inefficient uses of energy used in light-duty vehicles around the world, lots of inefficient use in buildings, lots of oil used in industrial applications that are not the most energy efficient.  And if you add all this up, the potential could be up to 8 million barrels a day of reduction in demand by 2020.

And the same thing on looking at substitution.  There's lots of opportunities to substitute natural gas, in particular.  In fact, if you look at the oil use for heating applications around the world with some 20 million barrels a day, and some 40 percent of that is in areas where you could use natural gas.  And if you deployed that by 2020, you could reduce 8 million barrels a day there as well.  So lots of opportunities in the system to reduce energy demand.

You can do things like eliminate price subsidies that exist in some countries, the Middle East, India, Brazil, which could reduce demand by 2 (million) or 3 million barrels a day.  So many, many opportunities.

And we think that if there was coordinated government response to eliminate some of the market barriers and market inefficiencies, you could reduce energy demand and lead to a balance, in the long term, of the oil supply and demand.

So let me just stop there and we can open up for discussion.  Just remind you the conclusion is rapid energy-demand growth which will be supplied by coal and gas; oil-price shock risk coming as oil demand will grow fast than supply; opportunities for government, if they choose to, to take policy actions to try to alleviate the supply-and demand imbalance in oil.  Let me stop there.

LEVI-MINZI:  Scott, one of the key findings in your report -- that's where you ended up actually -- there is an opportunity to reduce demand by about 8 million barrels.  I think a question that would interest many of us here would be, what is the actual likelihood of that happening?  What are the policy constraints?  And what is your assessment of the likelihood of that happening?

NYQUIST:  Well, I think we're, I would say, pessimistic in the short term and optimistic in the long term in the sense of if you are hopeful that the economy will recover and we'll get to economic growth back to normal, long-term trends, then we'll quickly get to this supply-demand tightness, you know, as early as two, three years.  And this is unlikely that policy action taken now would be enough to solve that problem in that time frame.  So we do see a real risk of the price shock happening, and there's almost little that can be done now to make it happen in a practical sense.

Longer term, we do see many practical actions.  And in fact, another price shock might stimulate governments around the world to act more aggressively to make that happen.  But we don't see a lot of momentum.  There's not much worry right now around oil supply and demand in governments and they're not thinking about.  They have other worries, so they're kind of ignoring this one, which will lead to a problem in the near term.

LEVI-MINZI:  Another, I think, very interesting finding in the report is that developing countries will account for almost 90 percent of the global energy-demand growth through 2020.  And in particular, your report identifies China as being responsible for about 25 percent of overall energy growth.  One of the police questions that, I think, comes to mind is, to the extent that China is so focused on its own economic growth, will they be willing to take steps that may have an impact on their ability to continue the growth that is so important from a political point of view?

NYQUIST:  Yeah.  I think we're relatively optimistic about what China can do.  The Chinese are, you know, very smart when you talk to them about these issues.  They listen carefully and have thought through many aspects of them.  And one of the things that you find is that when you invest in energy efficiency, you can actually demonstrate that you get a positive return on that investment.  So when we've sat down with various policymakers in China and said, if you invest in energy-efficient buildings, here is the positive net-present value of those investments, which they understand.  And they also understand the market failures of why that won't happen unless there is a government role.  And the thing about China is they're quite willing to put top-down government action to make things happen.   There's some debate whether the mayors, the cities will comply with all the actions required by the government.  But in general, we've found a very positive response from them.

And the other thing that we've found is that they have this extraordinary opportunity when they build these new cities.  I mean, you can have a conversation in China, and they'll say, we're going to build a New York over here, how should we do it?  And they'll talk about energy efficiency as part of that overall design of making that happen.  And they'll be very thoughtful in how they make the design.  So we're optimistic that China will do a lot, probably more than other countries, on energy productivity.

That said, you can only do so much energy efficiency because just raw growth of their economy and the growth of people wanting to consume energy- intensive devices will mean energy demand will grow, it will just grow more slowly than it would have been in an unconstrained way.

LEVI-MINZI:  Right.  And in that vain, I think, you sounded a little bit more optimistic than many on the supply side, perhaps on the opportunities to grow the supply side.  Have you seen steps being taken recently by governments that suggest to you that there may be a new trend emerging?  I'm thinking, for example, of the investments that have been made to support, by China particularly, to support the Brazilian oil exploration efforts.

NYQUIST:  Yeah.  Well, I think there's two parts to that question.
The first is, you know, how do others look at the supply equation?  And you get a very wide range of views out there.  There are some who are the peak-oil group that are very skeptical that oil supply can grow at all.  And some are expecting it to decline.  And we don't agree with that as a base case.  We understand the point of view and think it's an important point of view to have because there is a possibility that they could be right.  But our analysis suggests that there are opportunities to grow supply.   

And there are others out there who are much more optimistic than we are on the ability to grow with supply growth.  And that if you believe the numbers that are out there on the size of the resources based in these countries and then if you say, well, if we just opened up those countries to apply capital and technology that we have today, you could say we could grow an oil production supply very, very rapidly.

What we've done in our work is try to combine the political realities of where you can deploy capital with some understanding of what is there in terms of the resource base, although not a perfect understanding.  And then with that judgment of where capital is likely to go, come up with points of view around where supply could come.  And on the basis of that approach, we do believe that supply can grow but, again, not as fast as is needed to meet demand.  So that's the first part of the question.

Then we're very intrigued with, you know, China's actions in the sense of they're being very thoughtful in how they deploy capital to encourage production.  And the Brazil action is a great story where Petrobras and Brazil has this enormous opportunity to increase their production over time.  And with the lower oil prices, you know, their ability of local cash in order to meet that capital growth opportunity which will lead to production growth has put constrains.  And they could have just halted their capital investment plans and they'd decrease it a bit but not too much.  

But instead, to the Brazilian's credit, they're going forward with a very aggressive capital program, extraordinary, 170 billion (dollars), some huge number of capital investments production.  And they've brought in the Chinese to provide some financing, which shows great courage on the Chinese part as well as the Brazilian part to actually make this happen.  So this is a very good example of where the Chinese are using their enormous capital base to provide support to production.  And one has to assume that they're looking at other opportunities around the world to take similar action, which gives you some cause of optimism.  

And frankly, the U.S. role in terms of both its companies and the government isn't providing the same kind of capital that it used to.  And there's some places in the world the U.S. isn't welcome to provide capital.
So China provides a very unique opportunity to go to places in the world, where the U.S. may not be welcome, to help solve the problem.

LEVI-MINZI:  That's terrific.  Well, I don't want to hog you, so at this time I'd like to invite the members to join our conversation.  And please wait for the microphone to come around and speak directly into it.  Please stand, state your name and affiliation if you would like to participate.

QUESTIONER:  John (sp) Watts, Sequel Energy.  Scott, what did you assume, pardon me if I missed it, but in the likelihood and the impact of a global, coordinated limit on greenhouse gas production?  And what do you think the scope for changing some of your demand projections are if it were to follow, as some of the optimists about the Kyoto process would hope, and end up moving toward a 50 (dollars) to $100-a-ton price on carbon?

NYQUIST:  Well, in the analysis that we've kind of published in this paper, we've kept the policies as they are today.  So Europe has something going on that will affect demand, but the rest of the world didn't, and that leads to this very rapid growth in what we included in our paper for greenhouse gas emissions and heavy use of coal and gas.

Now, we have done cases where if Copenhagen is successful and we do get various regulations, either in the form of mandates or in terms of a carbon price, to drive it down, and that, of course, could shift the mix significantly and also can reduce demand growth as well because we find it affects both areas.

But we do agree with your kind of (impatience ?) that it requires a carbon price of, you know 50 (dollars) to $100 to make the kind of change.  We find that if we put carbon price in our models up to (4050 ?) it just doesn't make a dent in greenhouse gas emissions.  It does require a significant price, and it needs to be now, or else it won't get anything by 2020.

So when we've done other work with clients on this thing, we end up going through a judgment around the political process of, what's likely to be a carbon price and all of the other regulations?  And you end up concluding that you might get some reduction by 2020, but most of that actually will happen after 2020.  You know, if we had $100 today, it would be a real jolt to the system, and you might change capital investment programs, which could have an impact by 2020.  But if you kind of have a gradual ramp-up, you know, it takes a long time before the system shifts.

QUESTIONER:  (Name and affiliation inaudible.)  One of the biggest potential sources of energy is nuclear.  And as you said, China is increasing the demand.  But at the same time, China and India are very eager to produce a lot of the nuclear reactors.  At the same time in the United States, President Obama does not exclude nuclear as one of the options but hasn't been clear that there are real directions.  So how do you think the impact of the nuclear in the overall demand of supply for energy in the future?

NYQUIST:  I agree with what you said about the U.S., which, in practical sense, means that nuclear will grow very slowly in the U.S. under the current kind of administration.  I'm not sure they're going to block it, but they will make it more difficult to grow.  In other parts of the world, we see it growing much more rapidly, particularly in China.

So again, if you think about a 2020 time frame, it's almost too short a timeframe for nuclear to make a significant kind of dent in it if we had 1.5 percent growth of nuclear supply between now and 2020.  And the real debate is, what happens after 2020 to 2030?  And you kind of take the U.S. out a bit.
There will be some growth but, you know, the administration is not pushing very hard to make nuclear work in the U.S.  And if you don't very hard top down and break through all the permitting barriers and all that, it will just, you know, slow down on its own.  So I think most of our clients are pessimistic on growth of nuclear in the U.S.

However, we're optimistic that in Asia in particular there could be some significant growth and China could even be higher growth than what we expected.  So we can see more nuclear growth in the 2020 to 2030 time frame but still quite pessimistic, I guess, relative to overall energy supply and what could happen between now and 2020.

QUESTIONER:  Yes, thank you so much.  Carole Brookins, former U.S. director at the World Bank, on the board at the World Bank.  It seems to me that what you're saying is we're in this paradigm shift, and we're kind of in the middle of it where we have the existing energy economy, hydrocarbon based pretty much, plus nuclear, plus a little bit of older biofuels.  We have these emerging technologies, and we have an emerging policy that is not yet clear, a global policy in terms of what is going to happen in terms of achieving carbon caps, how it's going to be done, et cetera.  Does this, in a sense, during this 10-year period or five-year period, create the kind of confusion that actually slows exploration for hydrocarbons and investment in hydrocarbon pipelines and the supply chain simply because of this other uncertainty coming in and different type of government mandates?  Does the problem get exaggerated short term?  Is this an overlay?

NYQUIST:  Well, I think there's a few aspects to that.  I think, you know, it gets exacerbated in governments around the world who are saying,
well, maybe we shouldn't work hard to open up oil fields for new production since it's no longer going to be an important fuel of the future.  So there's less pressure on them to open up that, and the U.S. is a good example where there's lot of oil resources available but there's not much movement right now with low oil prices and this transition to a new economy to really kind of exploit the resource base.

But I would say, in general, that most countries around the world that have oil supplies are very eager to produce them.  And they see enormous revenue potentials for their governments.  And they're eager to find ways to produce them, and they're just looking for capital to produce them.  If you just go around the world, the Venezuelans would love to find ways to increase production, and they're not very worried about greenhouse gases.  The Iranians would love to increase production, but they're unable to get capital and technology to increase it.  Iraq is desperate and going to be working very hard to increase production.

So when we look at those kinds of countries that have a lot of the resources, they're not so worried about this transition.  They want to find ways to get capital, to get technology and produce the oil that is possible.

I think on the coal side, it's a slightly different story where there -- people are worried about the transition.  If we invest heavily in new kind of coal-fired power generation, you know, will new regulation come in five year's time that will require us to pay a tax on that?  And there's some concern of that, particularly in developed countries.  But that's not slowing down China or India.  They're going, you know, full steam ahead on the coal side, which is why we see this big growth.  But it certainly is a big impact on the U.S.  It would be very difficult to invest in a new coal plant without deep concerns of what the impact of carbon legislation will be on that coal plant in the future.  Very hard to get it permitted anyways today, but even if you could, you'd be very worried about the economics.

But I think you're right.  It's a transition time, it affects different parts of the world in different ways.  I think the developed countries probably are more cognizant and worried about the impact on their economics than would be the developing-world country.

QUESTIONER:  Ted Kamman, Jones Day.  I'd be interested in your comments on the politics of this all, perhaps two dimensions.  One is there's a kind of famous Dutch disease and lots of discussion about petrocracies and how oil-based economies seem to have relatively corrupt governments.  And the second aspect is U.S. policy in the Middle East and kind of the impact on the United States of governments, petrocracies being a major source of supply.

NYQUIST:  Well, big topics.  On the Dutch disease case, it's, I guess, long history of countries that have had a resource base that enabled them to create a huge amount of wealth that was then squandered by the people in power.  Long stories of that.  And we've talked to many of these countries and oil companies around the world about that issue.  And what's interesting is is the Norwegians have kind of created a kind of case example of actually how to do this.  And they've been playing this service of talking to countries around the world that, look, when you're creating wealth, putting it into some kind of sovereign fund that will, you know, pay for your future generations and separating that from the cash that would flow into the economy, you can avoid, at least mitigate, some of the Dutch disease issues.  

So I have one example of a country that actually can make this work, has really helped the country, and that's led to, you know, even in Saudi Arabia they've been very thoughtful around how they manage their economy through the peaks and valleys compared to the past.  Malaysia has been very thoughtful.  Venezuela, less thoughtful, I would say, on it.  So there's been a change in mind-set on this thing.  And Russia's example where, again, they understand this very well but, again, when you have the money and you're a dictator in control, you behave differently than when you have a democratic system.

So I think this is going to be less of a problem than it had been in the past where virtually no matter what country you were when you had this wealth, you would lead to, you know, overheating your economy which would then lead to a collapse.  I think now we've had some new ideas out there that kind of mitigate that going forward.  But it will still be, you know, part of the equation.

Your second question was?

QUESTIONER:  (Off mike.)  Impact on U.S. foreign policy -- (inaudible) -- supply issues.

NYQUIST:  Yeah, yeah.  Well, on that, we have this debate going on, which is, you know, we can alleviate oil dependence by accelerating this transition to the new economy in terms of more green energy, more use of natural gas and natural-gas-fired vehicles, electric cars.  That is a big part of the solution that will reduce our dependence on the Middle East and other sources of oil.  And that thinking is one big part of it.

Then there's this other part of the equation, which is the environmental side that comes in when you put a tax of some form, a price of greenhouse gas emissions that actually helps from an economic point of view shift the supplies away from the oil side.

And what I haven't seen happen yet is that if you were really worried about the Middle East, you would say, we need to take a full, comprehensive look at total energy supply potentials to get us to be independent.  And you know, what you would do then is you would not just use supply factors or demand factors, you use all the supply-and-demand factors.  So the previous administration really focused on supply and (diversity ?) of supply.  This administration is more focused on new energy.  And in my view, if you actually focused on both at the same time, you could actually make real progress to that.  

So when we do our analysis of how do you kind of become independent, both in terms of price and in terms of volume from risky sources of oil, you end up saying, we have to do a lot of everything.  We have to do a lot more on the supply side, open up fields in the U.S. and around the world.  We have to do a lot in the demand side to reduce energy demand through energy-efficiency standards.  We've got to create new sources of supply, including nuclear, including wind, including solar.  If you do all this, then the power that the cartel has on the oil side is something that could be mitigated over time.

QUESTIONER:  Alex Posnik (ph) of Lukoil Americas.  I want to explore the supply squeeze that you are predicting, if and not when that at some point it's going to happen, you're saying.  Is the effect of it in any way predicted or explored in your report?  And is it going to cause another slowdown like we're experiencing right now?  What are the effects that you include here?

NYQUIST:  Well, we haven't done any kind of fundamental work on that issue, so we just would speculate like everyone else on it.  Lots of people have looked at, what's the impact of high prices on the economy?  And you can go research those studies, and you do see, when prices fly up, it leads to kind of economic growth.  And we haven't looked at this, but we speculate that when history is written around what happened in 2008, part of this story will be that the high oil prices led to a slowdown in the economy, and that will get quantified and sorted out, and that was part of the reason why we're in such a deep recession.  Hopefully, we'll be able to understand that better by the time the next price spike comes, so there is this link that's there.  So we don't have a clear view on that.

And the other part of it is is that we also wonder, if we do get a price spike, how high will it go?  And we don't have any great models to predict that.  What's interesting about 2008 was when we were in 2008 doing the same analysis, what we were thinking and telling our clients is that as long as the economy keeps growing, demand will grow and the oil price has to go up because we can't see supply meeting it.  And so you were in this world of just economic growth automatically leading to demand, particularly for things like diesel and aviation fuel where there's no alternatives, and prices going up and up.

And we said, how high will they go?  And when you're in that short-term price spike, you know, the answer is you don't know.  Now, we did some analysis that said if prices stayed about 125 (dollars), $150 a barrel, there is enormous demand response that will happen over time, both in terms of people changing their lifestyles but also substitution coming in -- biofuels, electric cars.  The economics of these things working much better at 125 (dollars) to $150 a barrel than they do at 50 (dollars).

So again, we don't believe that oil prices above, you know, 200 (dollars) or 300 (dollars) or 400 (dollars) would be sustained for long periods of time because we think there would be this demand response and substitution response.  But when you're in a price fly-up or a price spike, you know, it's very hard to predict what will happen when we get into that situation.

QUESTIONER:  Yes, Bernadette Kilroy (ph) from Clarium Capital Management.  If I may, I have two questions.  I understood that your report assumes status quo policies.  I wonder, does it also assume status quo technologies?  And if not, how do you account for that?  And then secondly, you also spoke a bit about how certain sectors are very sensitive to economic growth, and that was a part of your analysis of the drivers of oil.  And if you may pardon the pun, could you drill down on that a little bit more?  (Laughs.)

NYQUIST:  So on technology, we're using a view of existing technologies that could be deployed in the time frame between now and 2020.  And electric cars is a good example.  We do have some significant growth of electric cars toward the 2015 to 2020 time frame, both in the U.S. and Europe.  And it gets to be significant growth.  However, when you look at the overall vehicle stock that will be in place in 2020 and the share of electric cars, it just doesn't matter in terms of it's a rounding error in analysis.

Now, if you roll that ahead to 2020 to 2030, these existing technologies that can be deployed become much more significant.  But it's a bit demoralizing when you look at the energy system just how long it takes for a new technology to come in, work its way through the system and then make a fundamental difference on global energy supply and demand.

Now, on your second point around these specific areas, I mean, this is something that was kind of counterintuitive to us when we began.  And let's talk about diesel just kind of a detailed example of this.  Now, the whole refining system was built around the world effectively to make gasoline as the U.S. was the engine of petroleum demand and everything was meant to make gasoline.  And so for years in the '80s and '90s, there was almost this diesel that was kind of a byproduct that no one knew what to do with.

And then the Europeans said, well, let's take advantage of this thing because it's actually more energy efficient and it has less damage to the environment.  So they put in policies to accelerate the use of diesel.  And that kind of worked its way through in the '90s.

And then what happened is is that as the developing countries began to grow, we found that diesel use became a much larger share of demand.  It gets used in many applications.  For example, diesel gets used in trucks to transport goods and services.  And so when you have lots of trade, you have lots of trucking.  And there's no substitution yet for diesel and trucking.

It also gets used on coastal ships to move from location to another.  Another middle-distillate part is aviation fuel.  And it turns out that as the economy is booming, aviation fuel demand grows very, very rapidly as well.

So inadvertently, we created these areas of very rapid demand growth for petroleum products that have no substitutions.  There's no substitution for aviation fuel for airplanes.  There's no substitution for diesel in trucks at the moment and diesel in cars at the moment.

And then when we reacted to putting in biofuels into cars, we actually created a mechanism to substitute there, and now we're talking about electric cars as well.  And we put in CAFE standards to make cars more efficient.  So all of a sudden, the refining system which was designed to produce gasoline no longer needs to produce gasoline, it needs to produce diesel.  And so in 2008, we had this huge shift where everything was being designed to produce diesel, and gasoline prices were lower than diesel, and the whole system was kind of backwards.

Now, when the economy crashed, all that diesel demand disappeared because it was so dependent on the economy.  And even things like power generators for building construction that were using diesel and all the ships that were moving products around coasts could no longer do that because we were in an economic crisis.  So then we had this huge diesel demand that happened in 2008 just disappeared overnight along with aviation fuel demand.  And all of a sudden, we're back to the world where gasoline is now the driver again.  So this is an example of how the product prices and the different demands, you know, swing the system. 

But what we see coming back, going forward, when the economy recovers, we think that diesel and middle-distillate demand will grow much more rapidly than gasoline.  It will be in the system again where that's going to be putting pressure on the overall (product ?) system.  And so we're advising our clients, build (hydro ?) crackers, build cokers to help, you know, meet this future diesel demand problem that we'll have.

QUESTIONER:  Elizabeth Bramwell, Bramwell Capital.  I was struck by the fact that 90 percent of the oil use going forward is going to come from emerging markets.  So now we have these proposals on cap and trade and higher carbon taxes.  Does it really make any difference when we have so little control over emissions in China and India?  And essentially, I think, in general, I think we've implied that cheap energy is important to GDP growth.  And so, you know, if China is going to clip along here at 7 or 8 percent and we stall out at zero, is this really good policy?

NYQUIST:  Well, there's two views on this.  (Laughter.)  One view is that the U.S. has to lead, and so we can't have a kind of credible story in Copenhagen, where this debate will happen, unless we actually have these policies in place.  And once we have them, we'll be able to persuade the rest of the world, Chinese and Indians, to kind of join in.  And then we'll be able to, you know, create a global solution and have a level playing field. 

The other point of view is is that, you know, that's not going to happen.  We'll put this in place, and the Chinese and Indians will say, thank you very much, and in 15 years we'll talk about what we'll do to reduce greenhouse gas emissions.  And the Chinese could argue that this is not a flow issue, it's not an emissions issue, it's a stock issue.  So U.S. and Europe, as soon as you reduce the carbon emissions that you put in the last 150 years, then we'll talk about what we need to do to mitigate our share.  But in the mean time, we're going to try to grow our share of the total stock in there because we're way behind you guys.  So there's a very difficult negotiation, I think, that is effectively going on on that issue, and it has big economic implications.

One thing I would say is that when we've done these analysis around how much trade really gets affected and what impact it has on trade flows, it actually isn't as big as one would think.  The higher electricity prices that will come from this in the U.S., you know, affects consumers but it doesn't affect trade flows as much as one would think, at least in the analysis we've done.  But it is a drag on the economy, and it is a drag on consumers, so it affects that more than it affects trade.

QUESTIONER:  Thank you.  (Name and affiliation inaudible.)  Looking at the supply side, it looks like a lot of production is going to come from OPEC.  Particularly interested in what your thoughts are on the Matt Simmons thesis on Saudi Arabian production.  And with the sort of lack of disclosure, is it even possible to prove or disprove Saudi Arabian production decline going forward?  And maybe if you could elaborate on that and maybe touch a bit on what the price projections you have would change if such declines were to happen.

NYQUIST:  Well, I know Matt Simmons very well and have great admiration for the role he has played in kind of raising this issue.  And he has gone in and tried to do a fairly detailed look at the geology of the various fields in Saudi and based on external information and made some judgments around, you know, what could be produced from those fields and concludes that there is a much more difficult production environment than what Saudis are saying.  So that's his thesis, and he wrote a book on it based on some, you know, detailed analysis that says, they're going to go in decline.

Now, when you talk with the Saudis and you look at where they're deploying capital, you say, well, they're new fields they're finding.  And when you look at the structure of those fields and investments you could put in existing fields to stop production declines, you think that we ought to be able to do the same things we've done in other oil fields around the world to slow decline.  And then you see the actual evidence that they've done that and, you know, put in capitalist fields (enhanced oil coverage ?) to slow the decline.  That gives you a point of view that, well, maybe there's more that can be done there to grow production.

But I will say is that it's not transparent, you know.  And you know, we talked to them, the Saudis, and we listened to what they had to say, and we watch what they do, and that gives you some basis for optimism.  And they're not foolish people at all.  I don't fully understand why they don't want to disclose it, but they have their reasons.  So we end up coming up with a different point of view than Matt, that says that we think we can grow production through new fields and maintaining the decline rates in the existing fields in Saudi Arabia.

But what I like about Matt's point of view is is that, you know, that is a scenario, and it's a scenario that our clients and policymakers need to consider and be prepared for because, you know, he could be right on this thing. 

And so your second question is, you know, what happens if he is right?
And then we end up in a world, I think, where we end up having prices rise and the oil shock that we were talking about before happening, say it comes in 2011, 2012.  And then if we're in the world and we see that the oil fields are in peak and they are declining, that would put enormous kind of price pressure into the system.

And then our view of what happens then is there will be a big demand response.  And when we've done our analysis on this thing, we think that you can get fundamental shifts of oil demand, you know, at prices somewhere between 125 (dollars) and 175 (dollars) a barrel where you can get lots of substitution, the rate of bringing in electric cars, the rate of biofuels coming in will be much faster.  People will use natural gas faster as a substitute for oil in heating applications.  It will just accelerate government action to break down the barriers that are in the way.

So we do think prices will be more, you know, will be above $120 a barrel in that world, but it's not going to be 500 (dollars) or 800 (dollars) sustained because the demand response will be quite significant.

And if you're an environmentalist, you might say this is a great thing because it will force us to get off oil sooner.  If you're an economist, you say that's a terrible thing because it will be ugly in 10 years when we try to respond to that huge shift in a shock mode.

QUESTIONER:  Just to follow up on that idea, what probabilities would you put on the Simmons scenario versus the different scenarios that you outlined initially?

NYQUIST:  Well, I'll say 20 percent.  A way to think about it is is that if we have a 50 percent case in our outlook, there are some more optimistic scenarios where supply can go back even higher and we can see 5 (million) to 8 million barrels a day higher.  And then we can have, you know, 5 (million) to 8 million lower, you know, by 2020 as well.  So if you put a number on it, I'll put 20 percent.

QUESTIONER:  (Off mike.)  (Inaudible.)

NYQUIST:  Yeah.  So I talk about GDP scenarios that drive the demand side.  Then we have a whole range of scenarios that I didn't talk about on supply.  And we have scenarios where, you know, our outlook on supply is wrong and the rocks just aren't working and we go down into steep decline.  You know, just to give you a detail, when we look at most fields in the world, they have decline rates anywhere from 6 percent to 15 percent without investment.  So they just kind of go down very rapidly. 

In the Middle East, there are more 3 (percent) to 5 percent decline rates.  And then you put in capital to do -- (inaudible) -- drilling and enhanced oil recovery and crude oil recovery, and that will kind of slow that decline.  And as well, we're watching all the time is, what signals are there where more and more oil fields are in the high decline rates, the 15 percent decline rates?  And if we start seeing that happen, that puts us in the scenario where we actually do get more into peak oil.  But so far, we're not seeing that.  Again, our judgment is when we look around at all these oil fields that we can understand, we think there's enough investment you can put in to keep the supply system growing, at least in the medium term.

LEVI-MINZI:  Well, at this time we have reached the fateful hour.
So I want to thank you, Scott, again for a very interesting presentation and thank everyone for coming. 

NYQUIST:  Thank you.

(Applause.)

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