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. Turkey Syria Iran Israel Iraq Saudi Arabia Egypt 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 Abdallah’s 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. 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. 2003 Prices Strong, But Fall As Year Progresses Annual WTI Prices $/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 country’s 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. 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 Non-OPEC Supply Keeps Growing… Absolute and Year-on-Year changes in Non-OPEC Crude Supply kb/d mmb/d

9. 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 Avoids Crisis in 2003… 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. Bush’s New World Order United States: Sole Superpower Military Superiority – Space and Technology MILITARY SPHERE DIPLOMATIC SPHERE ECONOMIC 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 Low Importance High 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. 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 How and When Exports Will Resume? PFC Energy Projected Iraqi Production Return Iraqi Production On A Declining Trend kb/d kb/d

14. US-UN Relations Despite Washington’s reluctance to deal with the UN, the international organization’s 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. Preferred Russian route — central UN role 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. Declining market share for the group—Non-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 Arabia’s unique position as swing producer will leave it with the difficult choice of enduring an untenable price and low production, or crashing the price. Back To Market: In 2004 Moment of Truth 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. 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. 2003 Prices Strong, But Fall As Year Progresses Annual WTI Prices $/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 Sharon’s 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 PNA Isolated, politically neutralized and forced to reform 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 Shi’a- Sunni Nationalist regime US unsuccessful, with Shi’a regime emerging • Washington may use it to dislodge the Al-Sauds • The Saudi public could see the New Iraq as a model • 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 • 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 Riyadh Entente will remain useful for the Saudis The OPEC strategy will be maintained = higher prices Riyadh Entente will be reinforced to oppose US Could the OPEC strategy be maintained? Saudis will use the oil price as a weapon against a strong Iran/Iraq bloc in OPEC and the region

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) Petronas* ExxonMobil 20000 Shell BP 15000 Lukoil* Reserves (mmboe) Yukos ChevronTexaco TFE Petrobras Global Competitors 10000 TNK ENI ConocoPhillips Anadarko Repsol YPF 5000 Regional Majors Oxy Hydro Statoil CNOOC EnCana BG Marathon 0 MOL BHP 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. Rosneft’s reserves estimates are for 2000 and are obtained from IEA’s 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. A B C D The Global Portfolio & Risk Size = Reserves Based on 26 Risk Factors at end-2002 Source: PFC’s 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

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