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The Global Energy Challenge

Speakers: Nicholas Butler, group vice president of strategy and policy development, BP, and David G. Victor, director, Center for Environmental Science and policy program on energy and sustainable development, Stanford University; adjunct senior fellow, Council on Foreign Relations
Presider: Vijay V. Vaitheeswaran, global environment and energy correspondent, The Economist
March 11, 2005
Council on Foreign Relations


Corporate Conference
New York, N.Y.

Click here for all transcripts and audio from the 2005 Corporate Conference

VIJAY VAITHEESWARAN: All right, ladies and gentlemen, perhaps we can begin. Thank you very much for joining us for what promises to be quite an exciting and certainly very topical panel on the energy challenge. My name is Vijay Vaitheeswaran, I'm the energy and environment correspondent for The Economist, and I'm delighted and honored to have two very distinguished speakers on the panel today to help us unravel the riddle of the age of energy insecurity, question mark. And I put that to you as a question mark because perhaps my question's ignorantly posed, of course, but on your behalf as a provocateur for the audience will be debunked by the experts here.

To my left is Nick Butler, who is the group vice president of strategy and policy development at BP; and to my right is David Victor, who is head of the energy and sustainable development program at Stanford University. Their full biographies are in your packet, so I won't spend time on those. But I will get the ball rolling a little bit by maybe asking some of the questions that I've just drawn from the headlines, and I'm sure it's some of the reason that some of you are here. Oil, as we know, has gone from $10 a barrel back in 1999 to over $50 of late. We've seen an extraordinary period of volatility on energy markets, natural gas prices in the United States, of course. But beyond that, it seems there is—there are concerns about security of supply, questions about resource nationalism in Russia and many other parts of the world where the resources—especially oil resources—are held. Questions raised about the reserve challenge, will the western oil major, whose developments in places like the North Sea, Gulf of Mexico, these very safe OECD [Organization for economic Cooperation and Development] countries, their reserve bases are entering into a period of very rapid decline, irreversible decline perhaps. Will they be able to replace those reserves?

Because, after all, even though some people see big oil as the enemy of the consumer, I would put to you that, in fact, the western oil majors have been the greatest check on cartel power—on OPEC's [Organization of the Petroleum Exporting Countries] power—in the last 30 years has been the non-OPEC production. Could that begin to decline in the coming years if western majors are unable to replace the reserves or find it more expensive to do so?

Could we see a demand-side shock? Some people argue that this is the world's first demand-led oil shock; pointing chiefly to China, where oil perhaps grew 16 percent in oil consumption, you know, in 2004. But if you look globally, there was also an extraordinarily strong oil demand despite the apparently high price last year. So has the old linkage between oil and GDP [gross domestic product] gone? Are we entering an era of scarcity, "the end of cheap oil," as the chairman of Chevron [Texaco Dave O'Reilly] recently put it, as did the president of Venezuela [Hugo Chavez] used almost exactly the same phrase.

To help us sort through some of this thicket, whether we are indeed entering an age of energy insecurity as distinguished perhaps from the 1990s, which was an era of great optimism, of confidence, of liberalization of market, of the advance of the view that interdependence was really the best way to secure energy security. Are we moving towards an era with greater government intervention and perhaps greater volatility and insecurity? That is the question that I hope to put to our speakers. So, without further ado, let me turn to Nick Butler.

NICK BUTLER: Well, The Economist is always very good at asking a whole range of questions. I'm just going to try and take out of your introduction one or two things that I think are very important from our perspective as a company. The first thing is that we feel that there has to be in this—from the corporate perspective, a real sense of discipline and an understanding of events through time. Oil prices have been over $40 a barrel for just about 12 months. Before that, they were something over $20 a barrel. Through the 1990s, the average was about $18.50. I think it would be a great loss of discipline within the industry if we suddenly decided that $50 was the permanent forward price, and that should therefore create a discipline in what you do with the cash, and also a discipline in what you look at in terms of what you invest in.

The second point is on the question of reserves. There is no shortage of reserves. The challenge is to match investment to where the reserves are. There are at least 40 years of conventional oil supply and much more unconventional supplies beyond that. The challenge is to open up the places where those reserves are available, and that starts with Russia. We've begun to do that. We hope to do more. As you go into a place like Russia, you realize that probably for the last 20 or 30 years, the absence of western technology has really set back what was possible. And as we look at great oil fields, the great field of Samotlor in west Siberia, which was one of the main producing sources of supply during the '70s, '80s, and '90s, and has been declining, we apply a little technology to that, and we now find that under Samotlor is another field. We begin to see now what technology can do—technology, of course, spurred on by these prices—to raise recovery factors.

The recovery factor at Prudo Bay [in Alaska], just in the time I've worked in the industry, which is not that long, has gone up from 40 percent to now over 65 percent, and it's still likely to keep going up. So we shouldn't get into a mindset of thinking that the reserves aren't there. The prices do help to stimulate exploration, technology, the extension of deep-water technology, for instance, in this country and off West Africa. The challenge is the political challenge of matching that technology and the investment capital which is available to the places where the oil and gas can come from.

I think there's—there are two other challenges. One is—and this has partly been resolved by the increase in scale in the industry over the last 10 years of the major players. The ability to spread risk, which comes from being of a substantive size, the ability to invest simultaneously in places like Russia and Angola and the Middle East and the United States all at once, the ability to invest in this new technology and to take a long-term view. The challenge, though, is to work in an environment that is now partly because of prices and people's sense of energy insecurity that you talked about—this is a far more political industry than it was in the 1990s. It's political on both sides.

We're past the age in which producers are going to privatize state companies. We have to work with state companies, and find the right relationships for doing so. And we've also, I think, passed the stage when consuming governments are willing to allow the energy business to be run just on a free-market basis. Energy policy is back on the agenda in every country around the world, including this one. And we have to understand that and work with that, and again find a point of mutual advantage.

And the last challenge, of course, which people try to ignore but I think it's wrong to ignore, is the environment. Renewables and carbon-free energy are really a long way off. For the immediate future, the world is going to rely on oil and gas, and more and more of it. And we have to find ways of producing and using that oil and gas in ways that don't damage the environment.

We've had a lot of rhetoric, a lot of people have waited for other people to do something, waited for Kyoto [Protocol on Climate Change] to be signed. International treaties are important, but they won't solve the problem, and I think we've now got to go and look at what the industry, which will only earn its right to work at the size and with the power that it is seeks to have if it can use that power and the technology and the resources we hold to solve this sort of problem, and we can perhaps get on to that in more detail. But I think let's take a long perspective on what the challenges are about.

VAITHEESWARAN: So don't bet on $50. It would lead to a great loss of discipline that the industry has earned, but you do see some challenges, particularly related to the political aspects of energy policy of the environment. David Victor, can you pick up on that?


VAITHEESWARAN: Perhaps on the environmental aspect and—

VICTOR: OK. Great.

VAITHEESWARAN: —take the argument from there.

VICTOR: Thank you, Vijay. Well, let me—I just want to say three things to open. First, just a brief word on prices, because we're here, because oil is $50—more than $50 a barrel. Nobody holds the panel on the energy challenge when oil is $15 a barrel. They do it when we're [laughter]—and so I just want to say a couple of words about the future price of oil. I think Nick has spot on, on this. 2011, oil is trading in today's dollars at about $40 a barrel. I think there's a reasonable scenario to suggest that that even is overstating the future price of oil.

You know, people are to some degree overreacting right now to the supply challenge and the demand challenge. On the supply side, we've already started to see the industry do what you'd expect them to do as oil prices rise, which is invest more in innovation in new fields, and we've got a lot of new fields and expansions of existing fields coming on line, all—in all kinds of places of the world, including in the Middle East. On the demand side, the big news has been China. Something like a third of the increase in world demand for oil last year was because of China.

The biggest increase in China has been diesel fuel. There's been a 25 percent year on year increase in the consumption of diesel fuel in China, and the bulk of that has gone into generate electric power. So I think what we're seeing in China right now is, over the long term, the rise of an affluent country and automobiles and so on. But over the short term, we see the byproduct of a crisis in their electric power sector. And already, there's a lot of evidence that the influx of capital and building new power plants, especially small plants that burn diesel fuel, that that influx is going to lead to a glut in Chinese power supply in the year 2008 or 2007, and that the big issue in the China power specter in 2007 or 2008 is what do we do with all these extra capacities? So I think to some degree what we've seen is an aberration of the last couple of years. And I think there's even growing evidence that there's kind of a commodity bubble led by oil, but not only by oil. All commodity prices are up, and that we'll see them come back down.

Let me just say in the last two things related to subjects not focused on oil. The first one is the environment. We deal with all kinds of environmental problems related to energy production, and the latest one in the list is, I think, potentially a game change, and that's climate change. If you take seriously the risk of global warming, over the long term you have to move to a low-carbon and then eventually zero-carbon energy system. That doesn't mean necessarily not making useful forms of energy with fossil fuels, but it puts fossil fuels in a difficult spot.

And we've seen already that January of this year the European Union began operation of what's called an emission trading system, where they're trading now credits for carbon dioxide. There's a private system here in North America called the Chicago Climate Exchange. There are all kinds of other markets that are emerging. It's like a new currency, and currencies tend to emerge from the bottom up, rather than the top down. And the division in Kyoto and the Kyoto protocol was that we would have a kind of global trading system that would be imposed top down. And that was never going to work, because the institutions that exist at the global level aren't strong enough to secure value in a currency. Instead, if we think about this as a currency, you have all these different markets, and they're starting to put a price on carbon.

If you just look at the current prices on carbon, they're actually very, very small. They're not going to lead to much change in behavior. What really matters about the current market is that they're sending a signal of credibility. They're sending a signal that over the long term we're going to get serious about carbon: that carbon prices are going to go up, that there'll be markets for trading carbon, that we need to start valuing carbon. And that's produced an amazing array of activity. Folks come into my office all the time. I live and work in Silicon Valley, so we have these people coming in with various kinds of projects that they want to solve the energy problem with zero carbon energy. Some of these projects actually obey the laws of physics and are kind of interesting. [Laughter]

You've got all kinds of inventive activity at the small scale related to dealing with the carbon problem, and then you have also a lot of inventive activity at the large scale, and I want to just highlight two areas to watch very closely.

The first one is coal—the future of coal. Normally, you would expect that if we got serious about carbon dioxide that'd be terrible news for coal because coal is the most carbon-intensive of all the fossil fuels. But it's possible to build a coal-fired power plant in a way that doesn't emit any C02 [carbon dioxide]; that you take the C02, you think of it as a chemical reactor, not as a power engineer's kind of dream world, and you totally redesign the power plant so you end up with a highly concentrated stream of C02, and then you inject that underground. I think you're going to see in the next few years firm orders placed for one or two of these, what are called coal-gassification plants, not with the final step of injecting the C02 underground, at least not in this country. It's a very risky technology, but if you're a coal-fired utility and you want to stay in the coal business, it's your best shot.

And the other thing to watch, I think, is nuclear power. First of all, we've seen a dramatic improvement in the performance of U.S. reactors. They're on station more than 90 percent of the time right now. The average was in the 60s only a decade ago, but the really important news is the next wave of nuclear reactors, and there are a lot of interesting designs. This is where China, I think, is going to be very important. If you take the Chinese plans for building their power sector out, by the year 2020, the Chinese will be ordering two new reactors per year in order to build out their electric power sector. Nuclear power is a zero-carbon fuel. It's going to require that we deal with all kinds of challenges like nuclear proliferation and so on. I think I'm the only guy on the planet who hasn't bought nuclear materials from [Pakistani nuclear scientist Dr.] A. Q. Khan. We're going to need to solve that problem [laughter], but those problems, I think, are solvable.

And the last thing I wanted to mention just briefly is natural gas. Natural gas prices in the United States right now are high in part because oil prices are high, and there's a bit of substitution between gas and—gas and oil. But the high price of gas has led to a big investment in liquified natural gas, LNG, imports. This year—last year we imported about 4 percent of our natural gas as LNG. This is tankers that come in from overseas, mainly Trinidad right now and Nigeria, and some North Africa and [inaudible], but it's becoming a global business. And as it happens, natural gas, which used to be a regional activity connected through pipelines that—because pipelines couldn't go long distances, it was not economic to have long-distance pipelines, it was essentially a regional activity. And we're starting to see the emergence of a global natural gas business, and an integration of gas markets. There are already the beginnings of the signs of the integration of the U.S. gas market with the West European natural gas market, which means that we will become eventually integrated with the Russia supplies that are such a big part of the European gas market.

I think all of this is good news. It's good news for the environment, because gas is intrinsically clean. It's good for global warming, because gas emits less C02 than coal. There are some big dangers, though. We're going to focus a lot on the public debate about gas on the risks that we're importing gas from foreign countries that might become destabilized and might cause us trouble; a gas OPEC, if you like. I think that's highly unlikely. The structure of the gas business does not lend itself to that kind of cartel and that kind of volatility.

The really big danger in the gas business right now is that if we don't manage LNG properly, that that option for bringing gas into the North America gas market will be shut off or severely curtailed. One or two big LNG accidents—and this is a well-designed technology. It's, I think, very, very safe, but nothing is 100 percent safe, not even sitting up on this platform. One or two—

VAITHEESWARAN: Especially if you don't step on [inaudible]. [Laughter]

BUTLER: And I'll stop in 20 seconds. One or two accidents could really change the game here, and in this sense, it's a very much—very similar technology to nuclear power. When the Japanese suffered a severe accident in their nuclear reactors a couple of years ago, they had to shut down a third of their entire reactor fleet, because it's a contagion effect. It doesn't—an accident anywhere in the world affects the viability of the technology everywhere, and we need to watch this very, very carefully.

VAITHEESWARAN: Excellent. To pick up on a couple of the themes that have been put forward, my very carefully concocted thesis about a world of insecurity, I think, has been at least partially debunked by our speakers. But I want to come back at them a little bit before I open up the questions to the floor.

In a sense, I'm hearing from both our speakers that the old adage the best cure for high prices is high price. Neither of them seems to believe that, as some people argue—in fact, a growing chorus argues—this is a new era in energy of sustained higher prices, the kinds of arguments that are given both by the Saudi Oil Ministry [inaudible], as well as some people, leaders of oil companies and so on, is that the industry is terribly underinvested. And I wondered if our speakers would comment on this.

The argument goes roughly as follows: We're at a near 20-year low in terms of spare production capacity. We know that that's one of the main reasons the markets were so tense, was a virtual lack of spare capacity in Saudi Arabia and other parts of the OPEC world. But if you look up and down the value chain, if you look at rig towns, if you look at tankers, if you look at refinery capacity, the argument goes this industry has grossly underinvested, perhaps because of prevailing levels of prices, perhaps because of the memory of $10 oil, perhaps because some people say a misguided focus on return on capital, a wrong measure for this industry. Anyway, this argument suggests that the industry needs to invest much more and higher prices are necessary, and that this will have an impact on expectation. If I could maybe turn to Nick: Is the industry underinvested? Do you accept that—


VAITHEESWARAN: —bit that I hear quite often. OK.

BUTLER: No. No, I don't. I think if you look back, the long period of what would now—we've seen as really low prices, sub-$20 prices through the 1990s, probably did discourage upstream investment. But I think since the turn of the century and the decision by OPEC to increase prices in April 2000, you—which took them up to their basket price around $25—you've seen a sustained increase in upstream investment by the industry—15 percent a year increase, $100 billion invested between 2000 and 2004 just by the majors. And that is now coming through.

And one of the reasons why I wouldn't bet on prices staying over $50 is that you will see this year increases in production capacity coming on-stream in the Caspian [inaudible], in Russia, Brazil, and so on, and a whole series of projects by—coming from all the major players around the world, which will increase capacity. And I think you see some of that happening on the OPEC side as well.

Now, that isn't to say that prices will go right back down again. I think the other long-term factor you have to look at is the need for revenue among the people who set the price at the moment for the OPEC states. I just looked at the numbers, and OPEC—the population of the main eight producers within OPEC rose by 75 percent between 1984 and 2004: 75 percent. And that means that most of their population is unproductive. It's under the age of 20, and this is the real driving need for revenue that is setting the lower end of the price envelope.

We would see that probably being at about $30 a barrel, and I think it is interesting, particularly since there has actually been no supply crisis over the last year. No one has actually cut off supplies. No one's been denied supplies. No part of the market has failed. I think it's interesting to wonder how much of the current price is pure speculation by people who are trading in derivatives and other instruments, rather than trading in the product itself. But we continue to plan our business on $20 a barrel, rather than $50.

VAITHEESWARAN: And Victor, what do you think of this idea that there is an investment challenge that may either require higher prices or be thwarted by low prices? And you talk a lot about coal, about the power sector. I know your work at Stanford focuses quite a bit in developing countries in this area. The best estimates I've seen from the International Energy Agency suggests that to meet the anticipated requirements demand, especially from the booming third world, we're likely to see an extraordinary sum of money that needs to be invested; in the trillions over the next 20 or 25 years. Will it happen, or will we see the cycle of boom and bust essentially depriving some of the world's poorest people from the energy that they [inaudible]; the things that we have, like the light, the heat, the mobility that we enjoy?

VICTOR: Yeah. I think I agree with Nick. I don't see any investment crisis in the oil and gas business, but I think in the electric power business, a good case can be made that there really is an important—there's a major problem here. Electricity is crucial for modern society. It's not just because we need to be able to see a light and to hear the microphones, but because wealthy societies live in cities. Cities are the epicenter of our culture, our economic activity, and so on. We could have a country place in Vermont, but people are always drawn back to the city. And in cities you need to have essentially zero emission energy carriers, and that means today, electricity principally. In the United States, 40 percent of all the primary energy—the original—the primal energy is converted into electricity before it's used to work, like to light a room or lift an elevator. And that has not stopped rising. The same is going to happen in China, in India, and so on.

The Chinese and the Indians and essentially every other developing country has not figured out a way to send credible long-term signals to invest in the electric power sector. Right now, China for example, they've had rolling blackouts in the latest crisis with their electric power system. That is going to continue for the next few years. In India, 25 percent of the capacity to generate electricity in India is actually privately-owned small plants that are located on the premises of the factory, because nobody can afford to operate without electricity. And that's because the Indian government has just systematically failed in creating incentives for mainly the private sector to invest in electric-powered generating and transmission facilities.

This problem is essentially unsolved, and the solution over most of the last century has been in most countries, except for the United States—has been to have a state-owned company just provide electricity, but those state-owned companies are incredibly inefficient and dysfunctional. And that's why the Indian government is in such trouble right now. That's why China is in trouble right now. They do not deploy capital efficiently. This is the big investment crisis in the energy business.

VAITHEESWARAN: Could it extend beyond? Going back to your arguments about gas, the gas resources in the world are generally more dispersed than oil, but with one exception: Russia, of course, where the concentration of the world's gases are even greater than the 25 percent share of conventional oil that Saudi Arabia has. And we know, of course, that in Russia Gazprom is the state entity that controls that and it may, depending on how politics in Russia go, end up controlling the oil sector one way or another. We're seeing the emergence in a very clumsy way of a new state actor—a giant. And likewise, we're seeing resource nationalism around the world. Venezuela is another good example.

Is there reason to think that this is—perhaps might argue for something like less than perfect market development, suboptimal levels that might create some problems for the companies that seek resources, but also for consumers around the world that want them at a reasonable price?

VICTOR: Well, I think Nick alluded to this already. When they look at places to invest, systematically they're looking at partnerships with state companies or various kinds of hybrid companies, and there's not much in the world right now in terms of attractive resources that are not one way or another locked up by a state company or a company that behaves a little bit like a state company.

I think the talk about resource nationalism is a little bit hyperbolic. This is the result of high energy prices, and when energy prices are high, and you have a lot of energy on the ground, you can get away with resource nationalism because the incredible rents that come from these energy resources tend to paper over all of the inefficiencies. And so it's not, I think, accidental that the Russian talk about resource nationalism is rising right now when they can afford to do this, because the biggest problem is, where are you going to put all the money that comes in oil and gas exports?

But when prices come down, the resource nationalism will—it won't evaporate, but it will defuse. It might stay in places like Venezuela or Mexico—it's actually written into the constitution. But over the long term, this is bad news. To use the Russia example again, the dominance of Gazprom in the Russia gas industry is not good news for investments in Russia. Russia is an amazingly inefficient country. For every cubic meter of gas they consume, the Russian economy produces 85 cents of value added. You might think, well, that's because it's cold and they need a lot of gas to stay warm and so on, but if you go to other cold countries like Canada, Canadians produce $8 of value added for every cubic meter of gas that they consume. Finland produces, I think, $35 of value added. Some of that is Nokia, but [laughter] not a lot of gas used in cell phones.

But my point is that these systemic inefficiencies from the state-owned companies are—will spill over and are spilling over the investment side, and it's very, very hard to do business in that environment where you don't have the rule of law. It's very hard to enforce contracts over long-time horizons, and electricity and gas projects, even more so than most oil projects, require reasonably stable, predictable investment forms.

VAITHEESWARAN: So as prices come down, the ability for governments to get away with sort of inefficient resource nationalism will fade?

VICTOR: I think that's a safe prediction.

VAITHEESWARAN: Nick Butler, I want to pick up on some of the comments on environmental issues that you made, and maybe pick up David's point as well.

BUTLER: If I could—

VAITHEESWARAN: Sure, if you want to come back on that.

BUTLER: I'd like to come back on Russia, because I think it's the most interesting issue in the global energy scene.

VAITHEESWARAN: And of course, BP has a unique presence there—

BUTLER: We have a small investment there. [Laughter]

VAITHEESWARAN: —BP [inaudible]. Very small, indeed. [Laughter]

BUTLER: I think, again, we need to see it in perspective, and your question was exactly right. This is an area where some degree of insecurity could occur if we don't get things right. It's just 20 years this spring since [former Soviet President Mikhail] Gorbachev launched glasnost and perestroika, and Russia has been through a—is on an unfinished journey towards what would be recognized here as an open democratic society. It's actually made a great deal of progress, and I think if you compare it to the progress made by other countries, which started from a comparable position and a comparable challenge, we should celebrate and note the extent of the progress that has been achieved, but it's not finished. And I think the Yukos affair is an example of that. It is an isolated example because alongside that very problematic issue, we and other people find that Russia is an excellent place in which to invest. We have invested. We are able to operate there to western standards of corporate governance and transparency. We're able to apply technology, as I mentioned earlier, and we're able to repatriate profits. You wouldn't be able to do that everywhere in the world, but it is not—the process of change has not yet reached Gazprom and all the organs of the state.

And the challenge I think is not just a commercial one. It is a process of change that neither we nor any other international major can bring about on our own. It is a matter for governments, for the European Union and the U.S. and China, all of which in different ways will be dependent on Russian supplies in the decades ahead, to be engaged there, rather than just throwing bricks. And I think that that could achieve a very great deal.

We do have a little time, and we have time in the gas market because there are other sources of gas supplies, which can meet the needs of this country and Europe and China over the next two decades before we become really dependent on Russia, and those come from Indonesia, from Trinidad, through LNG, and the obvious urgent need to make sure the infrastructure is there to receive those supplies, and because the U.S. is very fortunate from Alaska, too. I think you'll soon see very major supplies of gas coming from Alaska, which will help the energy balance here. But Russia is important for the medium and longer term, and it needs public as well as private engagements to get it right.

VAITHEESWARAN: Do you think that—you mentioned China in talking about Russia. An extraordinary amount of attention has been focused on the politics of energy for Asia, particularly China, but also competition from Japan and Korea for Russia's resources, pipeline politics, where will its LNG from [the Russian island] Sakhalin go? Some people even, to use the phrase that David has coined in the past, talk of a new "axis of oil" with, you know, Russia the extraordinary supplier and China the world's largest new incremental guzzler of energy, and posit that this might be a threat. This might be a threat to certainly western economies' need for oil, but also the old geopolitical axis of the United States and Saudi Arabia, the security guarantee that has existed for six decades since [former U.S. President] FDR [Franklin D. Roosevelt] met on a U.S. battleship with [Saudi Arabia's] King Ibn-Saud after the [post-World War II] Yalta conference.

That central axis of oil geopolitics is under threat, argue some, and in particular because of the rise of China and the Asian powers. Do you see this from your company's perspective being the largest oil company in—with a foreign presence in Russia?

BUTLER: I think we're—again, if you take this very long perspective, what you can begin to see that the Yalta and the Bretton Woods institutions [regulating international political economy] and the settlement at the end of the Second World War was not the end of history. Things have moved on. The economic development of the world has moved to the east, and that will change the whole pattern of geopolitical relationships. I think the flows of energy from Russia in both directions are just one part of that. East Siberia is the next real frontier of the industry worldwide, and I don't see it as a threat. I see it as a source of supply to the new center of economic activity in the East that is absolutely essential if the global balance is always going to be maintained.

If it weren't developed, and if China were drawing simply on the Middle East, then that would reduce the size available to Europe and the U.S. It is a whole—you have to take a holistic view of it, and that's why the development of Russia is so important for the medium-term future of the energy business that you started off by talking about.

VAITHEESWARAN: David, do you take a similar view or a relaxed view that oil markets are fungible and—or, any oil that Russia sends to China is merely displacing the oil that would have gone somewhere else, that it's not a zero-sum game, as it were? Or as some people argue—maybe if you look at the Indian and Chinese state-owned companies—state-controlled companies—they see it very differently. They want equity oil. They're running all over the world in a fierce scramble for assets in Sudan and Ecuador and anywhere they can get their hands on it, the majors, it is believed, and block them out of the Caspian, made sure that the Chinese didn't get into that region. And so there seems to be a difference of opinion on how to think about energy security and the rise of Asia.

VICTOR: Right. Well, I think they weren't in the Caspian, and they weren't in a lot of places, because they didn't have the capital and the technology to be in those places, and those are the fundamentals. I agree with Nick completely. The core of this business is going to be a globally fungible commodity business where we look to a variety of different frontier sources of supply. It may be that around that core there's some fringe of bilateral arrangements like what we see now happening with Kazakhstan and the oil pipeline that's going to be built from Kazakhstan east into China so that they lock up the Kazakh supply, or the Sudan kinds of arrangements where you have Chinese companies developing in Sudan or in Iran and a few other places, especially dedicated oil supplies.

I think, though, the Chinese logic of energy security, which has been animating a lot of this where the idea is that if you own the oil on the ground—if you have an equity stake in the oil, that that's somehow more secure and makes your government less vulnerable to price swings or supply interruptions, is not sustainable over the long term because it's not in any way consistent with the way the oil markets actually operate.

And so, as China becomes an ever-larger importer of oil, I predict that that scheme will become unraveled, and they will instead shift to the kind of coordinated system that we have and most other major oil consumers have, which—whereby we hold oil stockpiles, and we coordinate the use of those stockpiles in case of some kind of strategic emergency.

It's sobering to look at the Japanese experience. The Japanese had a state company that did the same thing. They ran around the world investing in projects, and it was a complete disaster. And I predict the same thing will happen with the Chinese and the Indian projects.

VAITHEESWARAN: Indeed, I think just in the last few days, they've officially dismantled the Japanese state-owned oil company. Right. I think we've gotten off to a good start. I'm going to ask for your help. Please put some questions to the audience. I will ask you for a few things, however. Please, identify yourself clearly: your name and your affiliation. Please wait for the microphone and till I identify you. And please, make it a question, rather than a very long rambling comment. [Laughter] That's my right as the [inaudible]. All right. Let's start with this gentleman who had his hand up first. And please, towards the end of this question, throw up your hands and I'll point up another question.

QUESTIONER: My name is Bob Waggoner. I'm with Burrelle's Information Services. My question is really directed to David. You mentioned 40 percent of energy, I believe, is consumed as electricity, and I would assume most of the balance is for transportation. And I'd be curious as to your appraisal as to the science and the economics of fuel cells—hydrogen-powered fuel cells, which could be hydrogen produced from nuclear sources. This has been posited by a number of people, including one of the members of the Council, Jessie Ausubel from Rockefeller University. And I wondered at a $20 BP market future price or a $50 price as today, is this something that's economically rentable and scientifically making sense?

VICTOR: Well, this is next [inaudible]—to think about different time scales, and he's absolutely right. This is a long-term possibility. If oil were $200 a barrel sustained, I don't think we'd be using fuel cells. It's just way too expensive right now, but over the long term, this is one possibility. But it's really important that we think carefully about why we would want to do that. And the only coherent reason right now for going to a fuel-cell-based automobile system is if we're so worried about carbon dioxide causing global warming that we want to dramatically reduce consumption of carbon dioxide.

Right now today at the margin, the much cheaper way of doing that is to just buy more efficient cars. The new [Toyota] Prius gets 55 miles per gallon. That's more than a Humvee. [Laughter] The new—and that's just starting to touch the surface. For example, diesel cars, which has essentially been out of the U.S. market—diesel cars are poised to make a comeback in the United States, and diesel hybrids are unbelievably efficient, and if people really focus on this, we could easily have a 100-mile-an-hour—a 100-mile-per-gallon car.

VAITHEESWARAN: But David, just to challenge you on that, I take your point that it's really the greenhouse gas benefits that would be the long-term goal from moving from a hydrogen-based economy, especially in transport. The internal combustion engine has shown that it's quite good at tackling local pollution, and to the point where you can hardly measure the parts per million. I mean, it's—in terms of conventional pollutants. But gasoline and the internal combustion engine will never be able to meet California C02 requirements, for example, or other very rigorous greenhouse gas tests that hydrogen if made from, say, renewables or nuclear, as the gentleman posited, might be able to.

But isn't there one other reason it might make sense in the long term? That is, if one is concerned about the geopolitical externalities of oil use; that is, the fact that two-thirds of the world's conventional oil resources are in the hands of five countries in the Middle East, a quarter of them in Saudi Arabia, that if you're concerned, over the next 20 years, Middle East OPEC share is likely to increase, and that this may lead to instability. If you were to factor in the geopolitics of things, hydrogen has the benefit that it can be made by any country anywhere from a variety of sources of energy, forget the economics for the moment, that has a certain kind of a geopolitical benefit that some people may find attractive.

VICTOR: I mean, we should invest some, as we are now, and private companies are and Nick's company's investing in this as well, and see where that goes. But I don't think we can forget the economics completely, because at the margin, what we're trying to do if we're worried about importing oil from the Middle East or being exposed to a global market that is subject to the vagaries of the Middle East or Venezuela or Russia or wherever else, what we care about is reducing oil consumption. And at the margin, I'll spend my dollars on energy efficiency before I spend a nickel on fuel cells, at least in the next 20 years.

VAITHEESWARAN: Excellent. The gentleman there.

QUESTIONER: [Inaudible] from Barclays Capital. I just want to ask—I just wanted to ask a question about—I just wanted to ask—

VAITHEESWARAN: Let's try the other mike, please.

QUESTIONER: I just wanted to ask a question about unconventional reserves and how real is the potential for the Canadian tar sands [reserves], and what actual type of infrastructure will it take to really tap into that?

VAITHEESWARAN: Something you want to tackle, Nick? I know historically, your company has not been impressed by Canadian tar sand reserves, as some of your rivals have. Could you offer a view?

BUTLER: I think we've been impressed by the reserves. I'm not so sure we've been impressed until recently by the economics of producing and refining them. Now that is beginning to change, and one of the reasons I wouldn't be terribly confident of prices staying at $50 a barrel is that if people begin to get the idea that they really are going to stay above $30 a barrel, the economics of a number of substitution technologies really start to look quite attractive, and tar sands is one of those that would involve both production facilities, pipelines, and adaptation of the refineries. And I think to do that, it would need some confidence that prices were going to stay at that sort of level, and probably—to go back to your last question, Vijay—some element of some investor within the market putting a premium on energy security. And if you had the two together, that might just make them a viable proposition. They're certainly there. They're certainly in place and the technology has moved on.

VAITHEESWARAN: When you say "putting a premium," you're talking about energy policy? Not a private—

BUTLER: Policy, yes. Policy that shifts the curve—


BUTLER: —by, say, $4 or $5 a barrel.


BUTLER: People are prepared to put a price on security by owning that sort of [inaudible].

VAITHEESWARAN: Whether it's through externalities, taxing, or subsidies, or some other kind of price support?

BUTLER: Many ways of doing it.

VAITHEESWARAN: Many ways of doing it, right.

VICTOR: And there's an honesty that—

VAITHEESWARAN: I'm sorry, David.

VICTOR: Of the Chinese companies.


VICTOR: They're crawling all over the place looking for these tar sand reserves.

VAITHEESWARAN: Yeah. The gentleman here had a question. And then next, we'll come here to this gentleman.

QUESTIONER: Jim Jones of Manatt Jones Global. Two investments in the energy business are refineries and LNG re-gasification facilities. I don't believe there's been a new refinery built in this country for at least a quarter of a century. And on LNG facilities, in order to meet the—what we think will be our demand for LNG, we're going to have to build the re-gasification plants.

Question on refineries: what kind of practical policy or moves can be made to permit more refineries—more efficient refineries to be built in this country or does it matter, whether we have refinery capacity in this country? And No. 2, what can be done practically to open the way for more re-gasification plants to handle LNG?

VICTOR: You want to—

BUTLER: I think on refineries, there's no shortage. And I think the last 20 years have seen a remarkable advance in the technology of refineries that have allowed them to adapt to the changing [inaudible], and I assume that that will continue. I think the demand for refineries worldwide will be in Asia, and we have to make sure that the balance globally is maintained at the right level. I think on re-gasification, I would defer to people here who understand local American politics, because it seems to me that it isn't a matter of economics or of the industry they have clearly needed. The supplies are clearly available, and the problem is just getting them in place. But there are other—I'm sure there are other people here who understand those local politics better than I would.

VAITHEESWARAN: David, do you want to follow up?

VICTOR: Let me just briefly on that LNG re-gasification facilities. I think the sense of crisis about this has been overstated. A lot of proposals have been made. We're only going to build four or five of them in the next seven or eight years, maybe more. I think it's like any large industrial facility. It's hard to site and you're absolutely right. There's all kinds of local political problems, and the industry is getting smarter about what kind of deals would get made with local communities in order to accept these facilities. There's going to be some places where it's really hard to build it. I don't think you're going to build one in San Francisco harbor. I think that's highly unlikely. So I don't see that there's a major issue there.

There is one big problem that I think is going to come to the fore, which is the way this has been treated as a regulatory issue in the United States, [which] has been to say we've got a crisis. We need to create rules that encourage anybody to invest in a LNG re-gasification facility. That works in the Gulf Coast where there's a lot of other gas, and you can own a private LNG facility and not be able to manipulate the market using the LNG facility. If you're at the end of the pipeline network, which would be the northeastern United States or California, the situation is different. And I think you should watch in the next year or two that California might actually try to change the FERC rules—the Federal Energy Regulatory Commission—[which] signals about the way these classification facilities are treated for, out of concern that somebody who owns 100 percent of this facility and also owns part of a pipeline will be able to manipulate the market. Remember that California's electricity crisis was first and foremost a crisis about manipulation of the gas market before it was an electricity crisis.

VAITHEESWARAN: One other thought I'd offer is that with the kind of price signals we're seeing now, you'll find creative solutions. David mentioned California. Of course, if you can't build an LNG re-gas terminal in California, what do you do? You build it in Baja California [Norte], [Mexico], which is what [inaudible] and Shell are doing, and piping it in across the border. And I think we'll see more solutions like that, whether it be re-gasification on board or some other kinds of solutions as well.

If you look at the technology innovation on refineries, the number of refineries has come down in the U.S. A nameplate capacity might have remained the same, but because of extraordinary advances in catalysts and other kinds of processes, we actually have an extraordinary rise in throughput, and people in the business tell me there's much more scope for innovation along those lines, without needing to go through the hassle of [inaudible] it a new refinery. So I would say the price signals would work. Another question. I think I saw—the gentleman back there, please.

QUESTIONER: I'm Harold Tanner. We have a lot of talk about an energy policy in this country and the lack thereof. And I'd like to ask Dr. Victor if he might comment on what some of the elements of an energy policy might be that he would consider, including CAFE [corporate average fuel economy] standards.

VICTOR: Well, let me—I'm actually incredibly enthusiastic we don't have an energy policy, because I can—especially given the gridlock in Washington today with—and there's a demonstrable rise in the inability of Congress to pass major legislation since the early 1970s. The idea that they could come up with something that's not totally whacky is, I think, a problem. [Laughter]

So, I think we do have an energy policy that is broadly in the right direction; namely, we let markets work in almost every aspect of the energy system. Where there are market failures, especially related to the investment in long-term research and development, we provide incentives, the R&D [research and development] tax credit, which is not only for energy, for other sources of R&D investments. The Department of Energy is not the most functional organization on the planet, but it also invests in long-term energy technologies. So I think we have bits and pieces of an energy policy that is broadly a pro-market energy policy, and I can't imagine us doing a whole lot better than that.

VAITHEESWARAN: In praise of U.S. energy policy. You heard it here, folks.

VICTOR: In praise of the absence of [laughter].

VAITHEESWARAN: Yeah. Important word. A question here, please.

QUESTIONER: Karen Parker, Wellington Management. One of the interesting features about this rise in price as relative to previous ones has been often noted is that elongated [inaudible] prices have risen more in proportion to the short dates, and people have concluded from that, that something fundamental has changed, and changed in the long-term kind of imbalance. And I think this is really striking, because it was only a few years ago before the Iraq conflict that everybody thought with all this supply command [inaudible] prices were going to decline into the low $20 region. Apart from the outcome in Iraq, is there anything else that you can conceive [of] that might have changed fundamentally. And if not, what would explain this different pattern in long and short-term prices?

BUTLER: Well, I think the first thing to understand is that markets aren't always right and I don't happen to think that they're right on this long-term forecast. I think what might have changed are a number of things. First of all, the rapid growth of China in particular and the sense that there is a new consumer in the marketplace. Secondly, the fact that people see now on the numbers that are readily available and widely discussed that in 10 years' time, most of world trade, in oil in particular, will come from a very limited number of regions. Thirdly, the sense of conflict between the West and the Islamic world which followed 9/11.

Now, I think actually if you go beyond those headlines, you can see that the market is working, that people are investing, that demand does adjust, that substitution will come in. It won't be neat and orderly, but I still don't think that we're going to see $50 or anything like it as a long-term price for oil.

QUESTIONER: [Inaudible] rapidly.

BUTLER: I think—

QUESTIONER: [Inaudible] I mean, it's true, but it—I don't know why it would have been seen as news.

BUTLER: I think it is the pace of change. I mean, the Chinese economy grew by 49 percent between 1999 and the end of 2004. And that was a much greater quantum, an actual amount. It became noticeable in the world market, and if you look at the figures for oil imports, they had previously been quite low. They've really gone up over the last five years. I think they will now somewhat tail off. They won't—they increased last year 990,000 barrels a day extra import demand from China. It looks more like half a million barrels a day this year, which is still a pressure on the market, but not quite such a dramatic pressure, so the pace of China has changed. The growth—the percentage growth—9 percent a year growth on something that's quite small, is still quite a small amount. Nine percent a year on the size of the Chinese economy now is quite a material event, so that's what I think has changed perception.

VAITHEESWARAN: I'm going to add one more thing, and maybe it's just a mechanism as to how it's happening. Concerns about reserves, in part because of the troubles at Shell, which are corporate reserve bookings, and in part because of questions that have been raised about Saudi wells and their performance, which are about really the hydrocarbons in the ground and performance of those reservoirs. In my view, I've argued on the page [inaudible] by and large, these concerns are misplaced, but nonetheless, among people in the marketplace, especially a lot of the new investors who've piled in of late—there's been a lot of speculative activity as the [inaudible] data shows—and there's an extraordinary amount of pension fund activity, which may explain some of the extraordinary rise in prices. When you say, "Show me," you can't prove that Saudi Arabia has all this oil and all its reservoirs are in tiptop shape, and so I think there's a—people perhaps holding large asset positions, which might be hurt by $100 oil, say, "Here's an inexpensive hedge." As for lack in $40 oil ten years down the road, some people argue now that there's actually a bubble in the making, but that's a conversation for another time.

BUTLER: Well, just to add a word on the reserves point, I don't think it is just a problem of any one. People do have problems, but I think there is a wider problem that we don't have a common international standard of measuring what reserves are. And I think that if you have reserves both judged by individual companies, and then you have reserves judged by different regulatory authorities in different countries, investors and governments and the public generally are going to get very confused. And I hope that we can move to a common standard, which takes this issue off the table.

And I think, if we move to a common and sensible standard, and the [inaudible] report we just published a couple weeks ago is a very good step in that direction, you would find that all the companies—all the majors certainly—had more reserves than they're allowed to book certainly in this country under rather obscure rulings than that apply at the moment.

VAITHEESWARAN: I think we have time for probably one more question. I think I see a gentleman with a hand back there, so you have the honor of the last question.

QUESTIONER: Jeff Shafer from CitiGroup. Traders tell me that no matter how far ahead you look, there is zero elasticity of supply fossil fuel of hydrocarbons to the price, which I find very dubious. But I'd like to know what your estimates—what's the difference between $25 and $50 oil over five years or 10 years in terms of the supply of energy?

VAITHEESWARAN: David, do you want to take a shot?

VICTOR: If your traders believe that, they're about to lose a ton of money for you. That is just so unbelievably wrong that I don't know where to begin. I don't know how to make an estimate of the difference between $25 and $50, because I think something Nick has alluded to already, the major companies are already doing a responsible thing, which is they're using internal prices of $20 to $25 a barrel for their long-term investment, because prices go up and down. And so maybe if oil got to stay at an incredibly high level, we would see some of this elasticity, but I think already we're seeing that the companies aren't looking at that—the market price, and although they're being forced to do that for the way they book reserves, which is a bizarre way to have a reserves accounting system.

VAITHEESWARAN: You want to comment on it?

BUTLER: Yeah. I think. Well, I agree with David on—you've probably got the wrong trader. I think that just—it is difficult to work out the exact correlation between price and the impacts on either reserve volumes or production. It—there are so many other factors involved, but just because it's difficult doesn't mean that there isn't some correlation. The one we would quote, I think, is the reserves recovery. If you look at Prudo Bay in Alaska, that's the oil we were supposed to—started—and it started producing in the 1970s. It was supposed to have been closed down more than 10 years ago. It is still producing, and it will be a very expensive final barrel of oil to produce that, and I think prices will encourage technology to be applied for people to look at the next incremental technology to get that last barrel out, and that's where it impacts on us.

VAITHEESWARAN: I want to [inaudible] you know, your trader isn't entirely crazy. We have seen $50 oil—a seemingly shocking price—with China growing at 10 percent, a record world growth, certainly the highest growth rate of global GDP in many years. Some people do argue the old GDP-oil linkage is broken or doesn't exist, but in fact, I think if you look a little closer at the statistics, what you find is that, what with inflation, an adjusted term $50 is nowhere near the previous peaks that we saw 25 years ago, which were above $80. I think the punch line is that 50 bucks just ain't what it used to be. I want to thank you for coming, and [inaudible] David Victor, Nick Butler. [Applause]






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