Navigating the New Energy Equation

John W. McDonald

By John W. McDonald, Vice President Strategic Planning
Chevron Corporation

Henderson, NV, June 12, 2007

We're at a unique point in the oil and gas industry. Our chairman and CEO, Dave O'Reilly, has called it a "new energy equation."

By that, he means we're facing a number of new challenges - rapidly rising demand (especially from emerging giants like China and India), constrained supplies, an uncertain geopolitical environment and shifting societal attitudes about the environmental impact of energy.

Each of these challenges, taken alone, may not be entirely new. But I can't recall a time when we've seen the number of challenges of this magnitude converging on the industry at the same time.

I thought what I'd do today is spend my time discussing three fundamental challenges that will shape our industry over the next decade and their implications.

These are challenges that affect all of us, independent and international oil companies (IOCs) alike - as well as suppliers - so I think there is a lot of common ground here.

The first challenge is that of access.

Slide: Who Owns the World's Oil and Gas Reserves

This slide is a reminder of who controls the world's known reserves of oil and gas. Guess what? It's not IOCs.

IOCs control roughly 6 percent of the world's proved reserves. The vast majority of reserves are controlled by sovereign states and their national oil companies (NOCs). The two big players, by a wide margin, are Saudi Arabia and Iran.

The next group of large owners, in the 100 billion to 160 billion-barrel range are Qatar, United Arab Emirates, Iraq, Russia, Kuwait and Venezuela.

It isn't until you get to the 20 billion to 25 billion-barrel range that we encounter the IOCs - ExxonMobil, Lukoil, BP, Chevron, Shell, Total, ConocoPhillips and ENI.

The implications of this chart are obvious.

Access to oil and gas reserves is not a given, particularly as we're encountering a new wave of resource nationalism in some large producing countries and entrenched barriers in resource countries like Mexico, where the constitution continues to prohibit foreign investment in the oil sector.

Chevron, of course, is proud of the partnerships we have with several major producing countries, such as Saudi Arabia, Nigeria, Angola, Indonesia and others. And producing countries like Libya and Qatar are showing continued interest in foreign upstream investment. But there is clearly a higher barrier to access in the major producing countries, and fewer and more qualified investment opportunities.

Access barriers aren't just limited to NOCs. We also see it here in the United States. While exploration and production continues to be robust in the western Gulf of Mexico, discussion of E&P in 85 percent of the Outer Continental Shelf (OCS) in the United States continues to be a political third rail.

Chevron has been trying to move the political discussion about domestic resources to be more open and fact-based. We believe a case can be made for selective access to promising OCS areas. Because most OCS resource data are decades old, we've suggested that the government conduct a targeted 2-D seismic survey of prospective areas in the OCS to get contemporary data on the resource potential.

Based on that data, we believe we could have a more productive and informed discussion about access to U.S. resources.

The Jack project Chevron worked on with Devon, Schlumberger and other partners is a case in point. When the private sector is allowed to collaborate and invest in a promising resource basin, good things happen. We find the resource and develop ways to produce it economically and responsibly. And global energy markets are better off for it. I will come back to this point in a few minutes.

The second challenge all of us face is the rising cost of doing business.

Slide: Capital Costs Index

This is a complex equation. A primary driver of higher costs is the sustained global economic boom we've experienced over the past five years. As the economy expands, so, generally, do commodity prices. The cost of raw materials, equipment, drill ships, fabrication yards, even talent, are all up.

According to this chart, project costs are up 64 percent on average in the upstream sector just over the past 30 months. The same general trend is also true in the downstream, shipping, LNG facilities, pretty much across the value chain.

The implications here are also very clear. Investment decisions are never easy, but they are even more complex today.

Is this the right time to invest? When does the cost of capital make a project uneconomic? Should I wait for the global economy to cool off, and prices to soften, before making an investment? Capital stewardship becomes much more challenging in the kind of environment we are in today.

For example, major IOCs and independents are expected to account for over 50 percent (38 percent and 15 percent, respectively) of the expected cumulative investment of $3.5 trillion in the oil and gas industry from 2000 to 2010.

And both IOCs and independents are expected to have more than doubled their investments in oil and gas during the decade 2000 to 2010.

Chevron is bullish on capital investment right now. We will deploy almost $20 billion in capital expenditures this year worldwide, almost three-quarters of which will be for upstream projects.

We're committing this level of capital because we have the opportunities to do so - a robust queue of capital projects that will significantly contribute to our production volumes.

These are investments with long time horizons, so we've conducted very thorough due diligence and we're confident in the returns we'll get over the long term.

A third challenge that we'll all face, either directly or indirectly, is a growing worldwide consensus about the need to engage in measures to manage climate change.

Slide: The Carbon Gap 2005-2055

This chart is adapted from some work done by leading climate change researchers at Princeton and is widely used to do scenario planning around climate change.

The top line is the projected growth of carbon emissions under a business-as-usual scenario. The bottom line represents a "flat-path" scenario in which carbon releases are stabilized. The difference between the two curves is about 7 billion tons of carbon.

Fossil fuels are a source of carbon, and reducing carbon emissions by 7 billion tons a year is the equivalent of 140 million barrels of oil a day.

So until we reach some consensus about how the country, and the world, is going to manage our carbon output, the gap between these two lines represents a lot of uncertainty, and potential risk, for our industry.

If, for example, political policy in the developed world takes the form of mandates to significantly increase the production of renewable fuels, what does that mean for our business? How would it affect investment decisions, either in upstream or downstream?

We're already starting to grapple with these questions in California, which is in the process of implementing some major new low-carbon regulations that I'll address in a moment.

Will we be facing new tax schemes intended to reduce emissions and force low-carbon alternatives into the marketplace, or will we develop true market-based solutions?

No one knows right now, but we can be certain that whatever the outcomes, they will have an impact on our business.

At Chevron, we believe that the best way to address climate change policies is through national frameworks that stress global engagement, transparency, efficiency, accelerated technology and other fundamental market-oriented principles.

We also believe that as a global economy, we don't have the luxury of making a wholesale shift to non-carbon energy sources. Sustained economic growth means that we'll require all the energy we can develop, a portfolio of energy, if you will, of conventional, unconventional and next-generation sources.

There are other challenges facing our industry, of course, but these three - access, rising costs and the environment - are the dominant ones.

So what are the appropriate responses on our part to these issues?

Slide: Responding to the Challenges

On the issue of access, we need to make the case that the United States - indeed, the world - needs all the energy we can develop - including U.S. energy sources like oil, gas and coal, renewed investment in nuclear and the sensible, economic development of alternatives and renewables.

Alternatives are important, but we have to put them in perspective and educate the American public and policy-makers about their practical limitations - as well as their potential.

For example, Chevron is a major investor in a biodiesel plant that just came on line in Galveston, Texas. At its peak, the plant will produce about 100 million gallons of soybean-based diesel fuel each year. That's about the same amount of transportation fuel that our Pascagoula refinery produces in a little over a week and a half.

Biofuels will play an increasingly important role in the transportation fuel portfolio. But conventional hydrocarbons will continue to be the leading source of fuels for decades to come because they are so economic and efficient - and because of the enormous investment we've already made in the infrastructure needed to refine, transport and market these fuels.

In the near-term, one of the biggest steps we can take toward energy security would be wider access to U.S. oil and gas supplies, as well as access to oil and gas in producing countries. The industry can help make that happen by continuing to demonstrate technological leadership - exploring and producing oil and gas safely, efficiently and responsibly.

Doing so can help remove a major psychological barrier to federal and state government sanctions to expand acreage in the Gulf and in promising areas of the OCS - the lingering perception that oil and gas production is damaging to the environment.

As we know, it is not oil production, per se, that is damaging, but how production is carried out. And the technology we have in hand today, and are continuing to develop, has reduced our environmental impact tremendously.

By way of example, since 2003, Chevron's shipping fleet has transported more than 650 million barrels of oil and petroleum products worldwide. In that time, less than 25 gallons have been spilled.

When hurricanes Rita and Katrina ripped through the Gulf of Mexico two years ago, they caused major damage to drilling platforms. But due to advanced technology like subsurface shutoff systems, there were no major offshore oil spills.

When Chevron and its partners drilled the Jack well test in the Gulf, it set a half-dozen records for pressure, depth and duration in deepwater. And it did so without a single environmental or operating failure.

Our industry has greatly elevated our ability to recover resources without adverse environmental impacts due to continual advancements in technology. And demonstrating technological leadership and innovation also creates a powerful value proposition for potential business partners.

At the same time, it's incumbent on the U.S. government to create the right kind of investment climate to maintain adequate production of oil and gas, both here in the United Sates and abroad.

Several political proposals now under consideration would do the opposite. Windfall profit taxes, unrealistic mandates to increase ethanol production and other measures would discourage investments all along the energy value chain.

Chevron is working with Capitol Hill - individually and with the American Petroleum Institute - to raise the issue of access to create pragmatic solutions.

At the same time, we're fighting legislation we regard as punitive and politically driven in order to protect our franchise and our ability to deliver affordable, reliable energy supplies to the marketplace on an economic basis.

Finally, let me offer some thoughts on the issue of climate change. It's an issue that has the potential to impact all of us, regardless of size.

The science on climate change is still developing. But to a great extent, popular opinion and political sentiment is pretty much set on the need to take a variety of actions to mitigate human activities that create harmful carbon emissions.

Our home state of California has exported a lot of things to the rest of the country - fashion, technology, entertainment. If climate change regulations follow the same path, we may be in for some disruptive change.

California recently passed a comprehensive global warming bill, AB 32, that would require greenhouse gas emissions in California to be rolled back to 1990 levels by the year 2020.

To reach that goal, the state is authorized to adopt market-based compliance mechanisms, such as cap and trade, or to execute specific mandates, such as a 10 percent reduction in the carbon content of all passenger vehicle fuel sold in the state.

The potential impact of these regulations on our business is significant. We're working closely with the governor and his administration to make sure this legislation is implemented in a rational, cost-effective and equitable way.

We're also attempting to shape ongoing political discussions about climate change to ensure we take a rational path forward that balances economic and environmental needs.

We've captured our point of view on climate change in seven basic principles we believe should guide policy-making, and I've provided a document for each of you today that explains those principles and why we believe they are so important.

Slide: 7 Principles for Addressing Climate Change

I've outlined several significant challenges facing our industry. While they can seem overwhelming, I'm always encouraged when I look back on our history and realize that no matter how big the challenge was, our industry has not just endured - we've prevailed. So despite all of the challenges, I'm optimistic about the future and confident that with the right policies in place, our industry has the capability to provide affordable energy to a world that needs it, and to do so safely and reliably.

Thanks for your attention.

Published: June 2007