by Tony Hayward
Group Chief Executive
BP

The member countries of the Organisation for Economic Co-operation and Development (OECD) in the developing world are experiencing the sharpest slowdown in economic growth for many decades. Growth has begun to slow in other countries as well. This is a consequence of both economic cycloid work and the fallout from the ongoing financial crisis.

Up to 2007, we saw the strongest five-year period of global growth since the early 1970s, with an increasing share coming from the world outside the OECD. This helped pull up the prices of commodities, including oil and many other assets. On the back of the boom, the OECD has seen increased growth leveraged into derivative financial instruments. Some of those derivatives were based on sub-prime mortgages taken out by people who could not afford to pay them when the housing bubble burst.

And now, as it always has and always will, the cycle has turned, and we have a financial crisis. This one, however, is much worse than we are used to. This is an international crisis that now raises a threat of widespread defaults or deflation as asset prices come down. The adjustment to a post-bubble world will be painful, but not catastrophic. Governments across the world are taking coordinated action to manage the economic impacts of the financial crisis and to lessen the pain of economic adjustment. I believe that over the next few years, we will see global economic growth recover, driven by continued industrialization in China and the emergence from recession of America and then Europe.

What does this all mean for oil prices? Despite a price decline toward the end of the year, 2008 was the seventh consecutive year in which oil prices increased. We have never seen anything like that. BP has records going back to 1861, the time of the American Civil War, and in all those years, prices have never risen for more than five years in a row. Less than a year ago, in the summer of 2008, people were predicting the price could hit $200 a barrel in the near future. Just a few months later, the price dropped to $50 a barrel.

Three things have happened. First, years of high prices had an impact on oil demand. Oil demand growth in the OECD started to slow down in 2006 and 2007, when prices moved up rapidly, long before anyone was worried about a financial crisis or a global recession. The impact was most clear in the United States. Over the first nine months of 2008, U.S. oil consumption declined by 1.2 million barrels a day, the largest fall since 1980/81.

Second, members of the Organization of the Petroleum Exporting Countries, most notably Saudi Arabia, had increased production significantly in 2008 before implementing new cuts in September and October in the face of falling prices.

Third, the economic slowdown following the financial crisis has started to take hold. This has accelerated the first trend of falling demand, with global growth expected to be below 1 per cent in 2009.

In short, the growth in demand for oil is slowing and cutting deal contracts for 2009.

However, a word of caution: It is always better to look past the short-term fluctuations and keep an eye on the fundamentals. In the long run, the big question is: How tight is the continuing balance between supply and demand?

The balance has not just suddenly changed. We are in the middle of the most significant industrialization in human history as one-third of the world’s population moves from a rural way of life to an urban way of life.

The developing economies will account for all of oil demand growth this year; in recent years they have accounted for 90 per cent of the growth in energy demand. Nearly half a billion people will cross the $5,000 annual income threshold between 2005 and 2020. Half of them will live in China and India. In my lifetime the world’s population has doubled to more than 6 billion people. At the current rate, it will exceed 9 billion people by the year 2050.

The situation in China is, of course, the best example of the speed of change. After 30 years in which the average GDP growth has been 10 per cent, China is already the third-largest economy in the world. Income per head has grown by 27 times in 30 years.

Problem of Supply Is a Human, not Geological, Problem

This growth in oil demand presents a huge problem for supply. Most important, the problem is human, not geological.

It is not true to say that we are running out of hydrocarbons. There are nearly 42 years of proved oil reserves left in the ground and 60 years of natural gas. The world has so far produced 1 trillion barrels of oil. We have reserves of a further trillion barrels, and we know where there are another trillion barrels that we have yet to approve.

On top of all of that, there are vast quantities of unconventional hydrocarbons, including oil sands, heavy oil and unconventional gas. And there are major hydrocarbon basins such as the Arctic which have yet to be explored.

So it is pretty clear that, when it comes to producing more oil, the problems are not below ground, they are above it.

So far, however, the response has not been good enough. Access to something like three-quarters of the world’s resources is constrained for private investment. Resource nationalism is on the rise everywhere.

These are all important facts because it is the oil majors that have some of the best technology for bringing difficult resources on stream across many very different and difficult geological conditions. The technical challenges are formidable. There is a natural decline in many of the mature oil and gas provinces of OECD where there is free access.

Biofuels and unconventional oil cannot be scaled up easily. There is a shortage of equipment, costs are escalating and there are too few experienced scientists and engineers.

Twenty-five years of low investment, due to low prices, means production is not coming through fast enough. According to the International Energy Agency, the extraordinary figure of more than $26 trillion will be needed between now and 2030 in order to meet future energy demand, with about half going to the power sector and the other half going to the oil and gas sector.

Investing in Recovery

Over the last few years, many companies have raised their capital expenditure. BP is no exception. We invested $22 billion in 2008, an increase of nearly 15 per cent over 2007, to bring on new production, to upgrade our refineries and to invest in alternative forms of energy.

We are pushing the technical frontiers of the energy business: exploring under the ice in the Arctic, drilling in the ultra-deep water of the Gulf of Mexico and Angola, exploring in heavy oil and tight gas, and pursuing investment into advanced conversion and next-generation of biofuels that do not compete with food crops.

One area with the potential to make a significant difference and contribute materially to incremental oil supply is enhanced oil recovery. The worldwide average recovery factor for conventional oil reservoirs is around 35 per cent of oil in place. If, as an industry, we can raise that by just 5 per cent, it would add more than 170 billion barrels to world reserves, enough for a six-year supply.

The upshot of all these trends, despite temporary prices falls, is that prices will probably settle at a higher level than we have been accustomed to historically. I believe there is a very strong case that says the era of cheap energy is over, at least for the medium term, meaning probably the next five to ten years.

The significance of these trends is not just the prices. Also important is the fact that the big strategic issues are matters of legitimate public interest. Industry faces a huge challenge. How, on the one hand, do we supply secure and affordable energy to fuel economic growth whilst, on the other hand, addressing the issue of climate change?

Energy Security and the Global Market

Let’s take the issue of energy security first. The most important thing we can say is that the best guarantee of energy supplies is the global market. Over the last 30 years it has been an extraordinary success story.

Energy and fossil fuels have increasingly become internationally traded commodities. Crude oil has long been traded in a global market, but coal and gas markets are integrating rapidly.

In fact, the global trade in energy has expanded much more rapidly than growth in underlying energy consumption; the energy world is becoming more interconnected. Maintaining this rate of expansion is crucial to alleviate the pressure on global fuel markets and to allow for a more efficient allocation of resources. This raises issues that should be high on the agenda of all policymakers.

Almost two-thirds of the world’s oil is currently traded across international boundaries. Open markets are crucial. Lower trade barriers and tariffs are both welcome and necessary. So are stable and enduring fiscal and regulatory policies.

This kind of regime will encourage the investment needed, and that is the best guarantee of energy supply that anyone can offer. Where investment is allowed to take place, energy production responds positively.

The evidence is that where markets are allowed to operate, they really do work. This is a real source of hope for the future. Consumers have demonstrated their response to high prices by moderating demand. Consumers are also beginning to embrace energy efficiency. In difficult times, energy security has been maintained, served best by trade and well-integrated global energy markets.

Increased global integration in energy trade is a key foundation for energy security. But it is a fragile process – much in the same way that progress on multilateral trade liberalisation under the World Trade Organization is fragile, and in need of continued support.

Climate Change

The other great challenge is, of course, climate change. Carbon emissions have risen 35 per cent since 1990. The evidence of man’s hand in the change is overwhelming, as the United Nations’ Intergovernmental Panel on Climate Change has found.

There are a number of options for dealing with carbon emissions: energy efficiency at industrial and consumer levels; the use of renewable energy sources, including wind and solar; the development of next-generation biofuels that do not compete with food crops; the use of nuclear power; extending the deployment of clean-coal technology, particularly to China and India, and beginning to use carbon capture and storage.

The role that China now plays in the world, as one of the largest emitters of greenhouse gases, will be crucial. The commitment of the Chinese government to reducing carbon emissions and joining the international abatement effort is very welcome. It is also good to see the efforts the Chinese government is making in seeking to reduce greenhouse gas emissions through improvements to energy efficiency, by increasing the production of renewable energy and through reforestation.

In BP’s particular case, we set a goal in 1998 to reduce emissions 10 per cent below 1990 levels. It was a great opportunity to reduce costs. We calculated that so far we created more than $2 billion of value. BP is also investing about $1 billion a year into biofuels, wind and solar photovoltaics, and we have committed $500 million to the Energy Biosciences Institute to research the next generation of biofuels.

We need to be realistic about this. Fossil fuels provide the energy that, in most economies, is used to produce clean water, food and shelter. They provide the heat, light and mobility necessary for social progress. And, like it or not, fossil fuels are responsible for nearly 90 per cent of the world’s energy consumption and 60 per cent of the world’s greenhouse gas emissions.

At BP, we talk about going Beyond Petroleum. This means three things to us. One: producing more fossil fuels more efficiently, today. Two: making better use of the fossil fuels we produce. Three: beginning the transition to a low-carbon future.

In China, for example, that means a range of things. BP has invested more than $4.5 billion so far and is one of the leading foreign investors. BP’s business activities include offshore gas production, chemical joint ventures, aviation fuel supply, liquefied petroleum gas import and marketing, oil product and lubricant retailing, solar power installations and manufacturing, and the sales of chemicals technology.

We are working closely with Tsinghua University and the Dalian Institute of Chemical Physics under the Chinese Academy of Sciences on a clean energy program, and we are working with schools to enhance young people’s awareness for environmental protection and climate change.

Environmental Options

Companies do not operate in isolation. Tackling environmental problems requires a sensible partnership with governments. If the costs of greenhouse gases were included in the price we pay for everyday activities like the price of a train ticket or switching on the lights, consumer behaviour would begin to shift.

There are, essentially, three ways this can be done: through a cap-and-trade system, through taxation or through regulation. The cap-and-trade system is, in our view, the best option. A tax on carbon use would offer cost certainty. It would not, however, offer environmental certainty, and that is, after all, what we are after.

For carbon markets to work, we need to place a cap on all greenhouse gas emissions. This can then be divided up into tradable permits.

This kind of cap-and-trade system has gained widespread acceptance – in theory at least – as an efficient method of imposing an economy-wide carbon price. Indeed, it is already running with some success in the EU’s Emissions Trading System.

The question for us now is: How can this work at a global level? Can we seriously expect the 180-odd sovereign governments of the world to agree on the cap? The sheer difficulty of the task is the reason why, against my usual instincts, I think there is a case for transitional incentives to bring forward the development and deployment of low-carbon technology. We need the new technology now. In some cases this will initially require a higher carbon price than that provided by a cap-and-trade system. We need to support the development, deployment and diffusion of new technologies as they start to compete with other fossil fuels.

The purpose of any incentive should be to kick-start the introduction of so-called clean-tech alternative technologies.

Once low-carbon technologies are proven, cheap and accepted, they will be adopted around the world. That is how markets work to disseminate knowledge, from oil exploration to computers and mobile phones. But any incentive regime needs to be strictly temporary. Properly designed incentives, over time, accelerate the cycle of innovation without encouraging inefficiency. You get the new thinking, then you drive down the cost curve.

At BP, the strategic decisions that we make have ramifications far beyond the companies we lead. BP is hugely committed to the idea of being a good corporate citizen. We are well aware that we are embedded in societies, that our actions affect millions of people.

Put like that, it sounds like a burden. In fact, it is an enormous privilege.

In our partnerships, as in any mutual endeavour, we bring our best people, technology and know-how to the table, and our partners bring their resources and in many cases, their own technical expertise. Such partnerships are based on one of the great motivating forces in human affairs: genuine mutual advantage.

Tony Hayward, group chief executive of BP, joined the company in 1982. Following a series of technical and commercial roles in BP exploration in London, Aberdeen, Glasgow, France and China, in 1992 he moved to Colombia as exploration manager. He became president of the BP group in Venezuela in 1995 and two years later returned to London as a director of BP exploration. In 1999, following the merger of BP and Amoco, he became a group vice president and a member of the upstream executive committee.

Mr. Hayward was appointed group treasurer in 2000, where his responsibilities included global treasury operations, corporate finance and mergers and acquisitions. He was appointed an executive vice president in 2002 and became chief executive officer for exploration and production later that year. He succeeded Lord Browne as group chief executive in May 2007.

Mr. Hayward is also a senior independent non-executive director of Corus Group plc and a non-executive director of Tata Steel. He received a Ph.D. in geology from the University of Edinburgh in 1982.

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