The Geopolitics of Energy

1
The Geopolitics of Energy

• Presentation by
• Fareed Mohamedi
• Chief Economist, PFC Energy
• to
• Energy and Nanotechnology Conference
• Houston, Texas
• May 3, 2003

Strategic Advisors in Global Energy
2
The Geopolitics of Energy

• Introduction
• Focus on oil and gas
• The OPEC system, supply management and prices
• Implications of the US invasion of Iraq
• Longer term issues related to the development of
  adequate oil supplies
• Meeting US gas demand

3
Unprecedented OPEC cohesion
OPEC forged a deal in 1999 that has withstood a
number of challenges

• The deal was underpinned by the following
  developments
• The election of Chavez
• The problems of the Iraq Oil for Food program
• The creation of the Riyadh Entente in the
  mid-1990s
• It provided a means for S. Arabia and Iran to
  work together
• It helped coordinate regional policies vis-à-vis
  Iraq
• It helped coordinate OPEC price and market share
  strategies
• Saudi ruling family used it to show its own
  public plus the rest of the ME that its foreign
  policy was rooted in the region

4
C.P Abdallahs Survival Strategy Key For Riyadh
Entente

• Economic Policy
• Entrepreneurial economy
• State balances books
• FDI for industry

High Priority

• Domestic Politics
• Restore social balance
• Curb subsidies
• Rule by committee

• Foreign Affairs
• American ally
• Strong regional bonds
• Coordination w. Iran

Low Priority
5
2003 Prices Strong, But Fall As Year Progresses
Annual WTI Prices

• Prices will be relatively high for 2003 thanks to
  high 1Q prices in the run-up to war in Iraq.
• The average 2003 price will be about equal to
  those seen in the past two years.
• Despite the loss of the war premium, fundamentals
  remain tight enough to keep current prices in the
  upper-20s.
• However, as inventories rise, prices will be
  pressured downwards.

/b
2003 WTI Prices
/b
6
Last 6 Months Three Supply Shocks

• The market was hit by a triple whammy of supply
  shocks in the past few months
• First from the unexpected Venezuela strike
• Then the predictable but still very significant
  outbreak of war in Iraq
• And finally by losses due to civil strife in
  Nigeria just as refinery demand for the countrys
  gasoline-rich grades was stepping up

Recent Lost Production Due To Supply Shocks
kb/d
7
Last 6 Months OPEC Managed The Challenges

• OPEC has managed by increasing production from
  its other members
• Production outside Venezuela and Iraq increased
  1.7 million b/d between November and March, Saudi
  Arabia accounting for 1.0 million b/d
• Despite much tighter fundamentals than during the
  last Gulf War, daily WTI prices this time peaked
  at only 37.83, compared to 40.42 in 1990
• Saudis also communicated effectively markets
  were reassured additional supplies were on the
  way, OECD members did not release strategic
  inventories

OPEC Crude Production
Saudi Crude Production
mmb/d
kb/d
8
Non-OPEC Supply Keeps Growing

• Every quarter of 2003 except 2Q will see rising
  Non-OPEC Liquids supply, with strongest growth in
  4Q
• On a year-on-year basis, Russia will continue to
  lead the growth at 500,000 b/d
• 2003 Non-OPEC Liquids supply to rise 1.6 million
  b/d, filling much of the 2.7 million b/d rise in
  global crude demand

Absolute and Year-on-Year changes in Non-OPEC
Crude Supply
kb/d
mmb/d
9
OPEC-10 Avoids Crisis in 2003

• Need for inventory replenishment will allow
  OPEC-10 to produce 800,000 b/d more crude than
  2002, but this is weighted to the first half of
  2003
• Increasing Non-OPEC supply and slower demand
  growth point to reduced demand for OPEC crude
  from now on
• Only low inventories and Iraq outage give OPEC-10
  a temporary reprieve

OPEC-10 Crude Supply and Projected Inventory
Change
2003 OPEC production and Quotas
mmb/d
10
Was The Invasion of Iraq An Oil War?

• The oil companies are not behind this war
• Who are the oil companies?
• What have they become?
• The US oil companies would rather have sanctions
  removed from all major producer countries
• The non-US oil companies used the constraints on
  US companies to make inroads into the Middle East
• The current Administration has not fulfilled the
  few promises it made to the oil patch
• Drilling offshore Florida
• Removing the subsidies for ethanol
• Revoking ILSA
• Alaska is not seen as a real oil play

11
George W. Bushs New World Order
United States Sole Superpower Military
Superiority Space and Technology
ECONOMIC SPHERE
DIPLOMATIC SPHERE
MILITARY SPHERE
Counter Proliferation
American Internationalism
Fix It yourself
First Strike
Lead, Others Will Follow
IMF Systemic WB Poverty
Anti-terrorism
End Treaties, Non Binding
Energy Security Diversity
High Importance
Low Importance
12
Oil Key to New Iraq

• The administration of the Iraqi oil industry will
  be a challenge, particularly in the first year or
  two, and the prospects of a short-term jump in
  production are effectively nil.
• The challenges will be
• To minimize short-term production losses while
  maintaining a reasonably safe operating
  environment
• Create an environment (political, administrative,
  legal) that will allow a very rapid conclusion of
  negotiations for investment in new capacity
• Only then is substantial growth in production is
  possible. In the best case, real growth (from
  2001-2002 peak capacity) will not happen before
  2005.

13
How and When Exports Will Resume?

• Technical issues
• Relatively little damage to fields and
  infrastructure
• Halliburton statement about getting up to
  regional standards (which are quite high) is an
  uncertainty
• Fields are on a declining trend even when they do
  come back
• Political issues
• Need to get revenue flowing means that the US
  will want quick resumption
• But lack of government recognized by UN and
  existing sanctions/OFF regime mean US has to win
  battle at UN before exports can resume

PFC Energy Projected Iraqi Production Return
Iraqi Production On A Declining Trend
kb/d
kb/d
14
US-UN Relations
Despite Washingtons reluctance to deal with the
UN, the international organizations role is
crucial for the economic rehabilitation of Iraq
UN recognized government
Resumed oil exports
Oil negotiations
Oil deals
IMF program
Paris club
London club
Donors meeting
Reparations meeting
15
Battle Over UN Role
A battle is taking place in the UN Security
Council over who has authority in post-war Iraq
Resumed
Complete UN
New resolution
UN/us authority
Oil
-
for
-
Food
weapons
lifting
program
inspections
sanctions
Preferred French route

limited UN role
US
Resumed Oil-for-Food program
US/un authority
Gradual OFF phase-out
Suspended Sanctions
occupation
Preferred US route

marginal UN role
New resolution
US authority
lifting
sanctions
This battle will delay UN recognition of the new
occupation government in Iraq, and will be
crucial for oil sector and financial sector
decisions moving forward
16
Best Case Scenarios
This model assumes that there will be no
commercial or logistical constraints on
companies. In other words, within 12 to 18 months
contracts would be signed and companies would
find the necessary equipment to ramp up
operations in an aggressive manner
17
Back To Market In 2004 Moment of Truth

• Declining market share for the groupNon-OPEC
  plus Iraq will outpace demand growth
• Seasonal demand decline in half of 2004 will
  force OPEC to implement a very large production
  cut from already low levels
• Uneven increase in capacity among OPEC-10 has
  initiated a debate about quota redistribution
  that will heat up when more cuts need to be made
• Saudi Arabias unique position as swing producer
  will leave it with the difficult choice of
  enduring an untenable price and low production,
  or crashing the price.

2003 OPEC production and Quotas
mmb/d
18
Limited Margin of Maneuver for OPEC
In an 18 price environment, Non-OPEC and Iraqi
supply will capture all of the incremental
demand, at least until 2006. This leaves very
little margin for OPEC-10 to increase production
in the next four years.
Non-OPEC Supply and Demand Growth New OPEC-10
Supply Not Needed
Global Demand Growth
Iraq Supply Growth
Non-OPEC Supply Growth
million b/d
19
OPEC Quota and OPEC Capacity
The opening up of the upstream sector in a number
of OPEC countries has started a trend of rising
capacity. Some of these increases might not go
through (Kuwait, Saudi Arabia, Iran), but others
are already underway. This rising excess
capacity, with the potential return of Iraq, will
destabilize OPEC from the inside.
OPEC-10 Quota Potential and Capacity Expansion at
Odds
OPEC-10 Capacity
OPEC-10 Production
OPEC-10 quota
million b/d
20
Quota Reallocations Out of the Closet
As long as demand for OPEC-10 crude has stayed
high, rising production capacity in Algeria,
Nigeria and Libya has not been an issue.
However, as OPEC is forced to cut production,
increasingly large and untenable percentages of
member countries capacity would have to be shut
in to maintain quotas. By 1H 2004, there will be
no way to avoid the quota allocation issue any
longer.
Current OPEC Quotas and 2004 Estimated Capacity
kb/d
21
2003 Prices Strong, But Fall As Year Progresses
Annual WTI Prices

• Prices will be relatively high for 2003 thanks to
  high 1Q prices in the run-up to war in Iraq.
• The average 2003 price will be about equal to
  those seen in the past two years.
• Despite the loss of the war premium, fundamentals
  remain tight enough to keep current prices in the
  upper-20s.
• However, as inventories rise, prices will be
  pressured downwards.

/b
2003 WTI Prices
/b
22
Can Saudi Arabia Take Lower Prices?
The Capital Account of the Balance of Payments
Billion US
Asset Flows
Debt Flows
Current Account Balance
23
Can Saudi Arabia Take Lower Prices?
Saudi Arabia Assets and Liabilities
Billion US
External and Domestic Liabilities
ExternalAssets
24
Can Iran Take Lower Prices?
Iran Capital Account
Asset Flows
Billion US
Debt Flows
Current Account Balance
25
Can Iran Take Lower Prices?
Iran External Assets and Liabilities
Billion US
ExternalAssets
External Liabilities
26
The Other Wild Card The Neo-Con Agenda

• Has the neo-con agenda peaked, or will new phases
  unfold over the next few years?
• Create a Pax Americana in the Middle East
• Win the peace in Iraq
• Succeed in creating a viable democracy
• Convince the Middle East to abandon Palestinian
  state
• Answering the North Korean challenge in Asia
• Containment or regime change?
• Induce China to cooperate and accept US agenda in
  the region
• Downgrading the UN and Bretton Woods institutions
  
• Contain the French and Russian challenge
• Institutionalize American Internationalism

27
The Neo-Con Agenda in The Middle East

• The Neo-Conservative agenda sees regime change in
  Iraq as the first step towards fundamentally
  altering regional dynamics
• Consolidate US and Israeli interests in the
  region
• Create appropriate conditions in the Levant for
  quick solution to Israeli-Palestinian conflict on
  Sharons terms
• Force change in neighboring states and the Gulf

Pax Americana
Short Term
Medium term
Authoritarian leader/popular revolution in Syria
peace deal
Secular reformist take over in Iran
Turkey
Syria
Iran
Israel
Weakening Syrian power
Egypt
Political isolation and threats
Lebanon
PNA
PNA
Iraq
Saudi Arabia
Isolated, politically neutralized and forced to
reform
PNA
Leadership reform and peace deal
Iraq
28
How Will Saudi Arabia Respond?
It will largely depend on the US success in Iraq
Successful US, with pro-US regime in Baghdad
US unsuccessful, with Shia regime emerging
US unsuccessful, with Shia- Sunni Nationalist
regime

• Washington may use it to dislodge the Al-Sauds
• The Saudi public could see the New Iraq as a model

• Iran could emerge as a major influence over Iraq
  weakening the rationale for its alliance with
  Saudi Arabia
• The US would be opposed to an Iranian backed
  Iraqi govt. and use the Saudis to offset this
  growing power

• For Iran an insular, domestically preoccupied
  Iraq could pose less of a threat and a model
• The Al-Sauds could see this as an opportunity to
  have some influence

Riyadh Entente will remain useful for the Saudis
The OPEC strategy will be maintained higher
prices
Saudis will use the oil price as a weapon against
a strong Iran/Iraq bloc in OPEC and the region
Riyadh Entente will be reinforced to oppose
US Could the OPEC strategy be maintained?
29
What is Happening in the Oil Industry?
Changing Competition Reserves vs. Production 2002
PDVSA (1,340 102,499)
25000
Pemex (1,574 51,655)
Rosneft (152 27,915)
ExxonMobil
Petronas
20000
Shell
BP
15000
Lukoil
Reserves (mmboe)
Yukos
ChevronTexaco
TFE
Petrobras
Global Competitors
10000
TNK
ConocoPhillips
ENI
Anadarko
Repsol YPF
5000
Regional Majors
Oxy
Hydro
Statoil
CNOOC
EnCana
BG
Marathon
0
BHP
MOL
0
600
1200
1800
Focus Players
Production (mmboe)
Note 1 2002 reserves and production for all
companies are PFC estimates. 2002 production is
based on 1H2002 data. Reserve Estimates are
primarily based on a 110 reserve replacement
rate. Data for BHP, CNOOC, PDVSA, Pemex, Yukos,
and MOL represents 2001 data. Data for
Petronas and Lukoil pertains to 2000. Data for
TNK pertains to 1999. Rosnefts reserves
estimates are for 2000 and are obtained from
IEAs Russia report. Note 2 PDVSA (1,340
102,499), Rosneft (152 27,915) and Pemex
(1,574 51,655) excluded for scaling reasons.
30
Replacing Core Areas

• Many core areas in maturity phase
• Business going to Non-OECD basins
• Strategy depends on region (e.g., Petrobras,
  Repsol YPF, and PDVSA in Latin America and
  Petronas in Asia-Pacific)
• Selected oil cores transiting to gas
• With the exception of deepwater plays, major
  companies are not creating new core areas through
  exploration, but through production deals
• Production deals create new challenges -- new
  risks
• Core transitions from oil risk to gas risk --
  e.g. technical to commercial

31
Global Competitors Must Replace Maturing Legacy
Assets
of Upstream Net Income from N. America and
Europe

• Replacement of earnings from historical assets
• Growing earnings in areas where Regional Majors
  Governments control

North America Europe of Worldwide Total

2000-2002 Average Upstream Net Income From North
America Europe
Reported and PFC estimates.
32
Access to Oil Gas Reserves Constrained
NOC reserves(equity access)
Reserves held by Russian companies
Full IOC accessreserves
113 / 6
140 / 7
324 / 17
1,354 / 70
NOC Reserves (no equity access)
Source PFC Upstream Competition Service BP
reserve figures are conventional billion boe, 2001
33
Industry Shift

• Divestiture in mature areas
• Majors withdrawing from non-strategic areas
• Independents moving in and aggregating positions
• New independents likely to be created to capture
  opportunities unattractive to large independents

34
National Oil Companies

• NOCs growing importance in the industry
• Generally more commercial and some privatizing
• But NOCs can be threat to state especially if
  political leadership is from different background
  from NOC managers
• Distrust of IOCs falling even among populist or
  leftist governments
• States looking for production deals to attract
  capital and technology
• What States want is evolving so IOC access issue
  is a very dynamic and at times confusing one for
  IOCs

35
State Types and Implications For NOCs/IOCs
Government
NOC
IOC Role
Entrepreneurial Capitalist
Privatized Competitive
Open Competition
Social Democratic Capitalist
Public Entrepreneurs
Limited Opening
Driving Forces
Increased Opportunities
Authoritarian Globalizer
Entrepreneurial Bureaucracy
Oligopoly
Populist Development
Statist Bureaucracy
Traditional Monopoly
Rentier State
Façade/No Institution
Excluded
36
The Global Portfolio Risk
Size Reserves
Based on 26 Risk Factors at end-2002
Source PFCs Petroleum Risk Manager
37
US Nat. Gas Supply A Pressing Issue

• Energy security also means natural gas supply
  security
• Defined as reliable supply at a reasonable cost
• Demand encouraged, but supply shrinking
• Washington encouraged the growing consumption of
  gas but has actively discouraged production
• In 2002, gas supply has declined by 5.6 in
  continental US, forcing the suppression of
  industrial demand
• In the next few months, up to 4 bcf of industrial
  demand need to be suppressed to allow storage to
  refill for next winter
• Industries and jobs lost in the US

38
US Nat. Gas Supply A Political Question?

• Continental supply is extremely difficult to grow
  quickly -- no matter how high the price
• Basin exhaustion a fact of life in a mature asset
  base
• Accelerating decline rates creating treadmill
  effect
• Regulatory hurdles for areas now open to
  exploration
• Access to federal land practically closed
• Offshore Florida, California and East Coast
  closed
• LNG siting issues, so little help in the
  foreseeable future
• Alaskan/MacKenzie Delta pipelines Right Answer,
  wrong decade

39
US Has No Surplus Gas Supply
Excess Pipeline Gas Supply Capability in the
US (I.e., as a Share of US Gas Consumption,
annualized)
Sources PFC estimates. Includes Canadian
imports, EIA.
40
Canadian Pipeline Imports Nearly Tapped New LNG
Supply of Increasing Importance
41
Abnormally Large Gas Storage Draws Lead to
Increased Price Volatility
42
Market Tightness is Driving up U.S. Gas Prices --
Floor Price is Rising
9.13
8.72
43
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Strategic Advisors in Global Energy