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OIL ECONOMICS

By Dr Azrai Abdullah/
Azhan Hasan

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Learning Outline

l The History of Oil


l Demand and Supply
l Oil Market and Case Study
l Global Oil Demand & Global Oil Supply
l OPEC and Its Roles
l Peak Curve
l Phenomenon of the “Perfect Storm”
l Food for Thought – Curse or Windfall
l Causes of High Oil Prices
l Key Assumptions
l Impact and Implication of High Oil Prices
l Key Issues and Challenges

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The History of Oil

l 1859 Titusville (Pennysylvania). First oil well


l 1864-1911 The Standard Oil of J.D. Rockefeller
l 1900-1930 “The long quest for oil, power and money”
l 1928 Achnacarry : The international oil cartel of the
Seven Sisters (1928-1960)
l 1960 The development of the European Oil Companies
l 1960 Creation of OPEC
l 1973 First oil shock. OPEC becomes a price maker
l 1979-80 Second oil shock. OPEC is still a price maker
l 1998 Oil price at 10$/bl
l 1999-2003 OPEC Price range 22-28 $/bl
l A structural change in oil markets
Centre de Géopolitique de l’Énergie et des Matières Premières
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Demand and Supply

l Supply and Demand

l The study of supply and demand inside a


market is known as micro-economics.
l So, let us take a simplified market - it has a
demand curve that looks like this:

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Demand Curve
The x-axis is the price, and the y-axis is the demand.

There is an inverse correlation between price and quantity


demanded.

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Supply Curve

l If the price rises, so will supply.

l In longer-term, higher-prices will feed into firms’ capital


expenditure decisions- new machines will be bought. Higher
prices mean more supply.

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The Meeting of Demand & Supply

l Economists put these two curves together,


the demand and the supply to understand a
market:

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How Market Works

l The market price is the point at which demand


meets supply. That is, there is a price level where
the level of demand is equal to the level of
supply. This point cannot be emphasized
enough: the market will clear.

l An excess of supply, or shortage thereof, is


merely another way of saying that the clearing
price is moving. And markets will clear.

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Oil Supply and Demand

l The market for oil is unusual, because – in the short-term –


both demand and supply are highly inelastic. Irrespective
of what petrol costs, your car cannot easily switch to
another fuel.

l Supply of conventional oil is also relatively inelastic,


although for a different reason. The actual cost of pumping
a marginal barrel of oil is relatively low, once the capital
expenses of prospecting and building an oil rig (and
associated infrastructure) has been put in place. An oilfield
will cost roughly the same to operate whether it is
producing at 50% of capacity or at full capacity.

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Oil Market

l The result of this is that the oil market is one where small
changes to the supply or demand curve cause large
changes to the clearing price.

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Case Study 1 - The Oil Shocks of the
1970s

l This model can be applied to the oil price shocks


of the 1973. Following US support for Israel in
the Yom Kippur war, the newly founded OPEC
announced it would stop selling oil to the US,
and would restrict its overall oil output. Because
OPEC supplied so much of the world’s oil, this
had the effect of changing the shape of the
supply curve. In other words, for any given price
level, there would be less oil supplied as shown
in the next slide.
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The Model [1]

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Explanation on Model

l As can be seen from the chart in the previous slide, this


restricting of supply caused the blue supply curve to move
to the left, and – as the market must clear – the price
rocketed. Dropping out of theory and into practice, we see
that this is exactly what did happen. The price of Saudi
Light oil jumped from under $3 a barrel in 1971 to almost
$40 by 1980.

l It is not only sellers’ cartels that affect the oil price. When
Hurricane Katrina knocked out production in the Gulf of
Mexico it had a similar effect - the supply curve was shifted
to the left and prices rose.

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Case Study 2 - Short-Term Changes to
Supply and Demand Curves

l The rise of emerging markets has also changed the


supply and demand dynamics. As China, India and
the like industrialize, and their emergent middle
classes buy cars, then the demand curve moves to
the right.

l For any given level of price, more oil is demanded.


As the chart in the next slide shows, this has exactly
the same impact on the clearing price of oil as does
reducing supply - the price moves, and sharply.

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The Model [2]

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Crude Oil Prices 1947 - May, 2008
Crude Oil Prices 1947 - May, 2008

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Global Oil Demand [1]

l Oil demand as function of income and price


l Oil demand and price usually examined within context of price
elasticity of demand
- Measures relationship between the change in quantity of oil
demanded and change in oil price
l Wide variation in estimates
l Some general observations
- Changes in oil prices have small effect on demand
especially in short run
- Long run price elasticity of demand higher than short one
- Due to substitution and energy conservation but
elasticity still low
- Price elasticity of demand higher in developed countries

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Global Oil Demand [2]

l Relationship between oil demand and GDP growth studied within


context of income elasticity of demand
l Change in quantity of oil demanded and change in income
l Estimates vary widely according to method used, period under
study
l General observations
- Oil demand more responsive to income than prices
- Long run income elasticity for oil demand higher than short
run income elasticity
- Large heterogeneity in estimated income elasticity across
countries and/or regions
- Developing countries exhibit higher income elasticity than
OECD
- Responsiveness of oil demand to income declining over
time especially in OECD countries
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Projections of Oil Demand

l Relationship between oil demand, prices & income


used to project oil demand growth
- Projections highly sensitive to assumptions
made about economic growth scenarios
- Highly sensitive to income and price elasticity
- Highly sensitive to oil price path chosen
- Endogeneity of prices and income bias results
- Ignore potential relationship between oil price
increases and growth
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Projections

Projected Oil Demand (Millions of Barrels per day)


2003 2010 2015 2020 2025 2030
(Actual)

IMF 79.8 92 102.42 113.5 125.5 138.5


EIA 80 92 98 104 111 118
(2006)
IEA 82.5 91.3 99.3 116.3
(2006) (2004)
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Source: IMF (2005), World Economic Outlook, April 2005, Table 4.5; Energy Information Administration (EIA), International Energy Outlook 2006, Figure 26. International
Energy Agency, World Energy Outlook 2006,
Global Oil Supply

Modelling oil supply much more complex

- Issue of reserves
- Behavior of various suppliers
- Distinguish between OPEC and non OPEC non-
- Different and diverse suppliers outside OPEC ranging
from national oil companies, IOCs and independents
- Widely assumed that non OPEC behaves
competitively
- OPEC behavior much more complex
- Many diverse theories in literature ranging
from cartel to competitive behavior.
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Determinants of Non OPEC Oil
Supply

l Two General Approaches:- geophysical and economic

l Geophysical factors determine oil supply


- Production governed by historical cumulative
production and size of ultimately recoverable reserves
(URR)
- Based on specific logistic curve that specifies time
path of cumulative production possible to fit a
symmetrical bell shaped curves for annual rate of
production

l Hubbert’s approach been widely criticized


- Treatment of URR as static variable
22 - Geophysical models overestimate depletion effect
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Oil Reserves Increasing

Oil Reserves and Production Data

1973 1983 1993 2003


World 635 723 1024 1148
Reserves
(billion
barrels)
World Output 59 57 66 77
(million b/d)

World R/P 30 35 42 41
ratio (years)

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Economic Based Models
Economic factors
- real oil prices, costs, regulatory factors play an important
role in determining oil production role

l Various studies attempt to estimate price elasticity for non-OPEC


oil supply

l Response of non-OPEC production to oil prices especially in


short run is close to zero and even negative
- Producers do not necessarily increase production in
face of price rise price
- A decrease in oil prices does not induce producers to
reduce production

l Although long run price elasticity is found to be positive


estimates are quite low but not necessarily in all studies
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Non OPEC Oil Projections

Given the different models and the wide range of elasticity estimates, it is
no surprise that non-OPEC supply projections differ considerably across
studies and over time.

2010 2015 2030


EIA (2006) 54.4 58.6 72.6

EIA (2005) 56.6 61.7 66.2

IEA (2006) 53.4 55.0 57.6

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Supply of Oil: Role of OPEC

l Modelling OPEC supply creates serious challenge for


competitive supply-demand framework

l Describe OPEC as cartel or oligopoly while at same time


use competitive supply-demand framework for analysing
long run behaviour of oil market

l Close the model by considering :


- OPEC acts as swing producer equilibrating demand
and supply with optimal prices/quantity levels
- Treat OPEC supply as a residual (Call on OPEC)
- Hypothetical amount that OPEC needs to
produce to close the gap between oil demand
and non OPEC supply
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OPEC OIL PROJECTION (OPEC CALL)

2010 2020 2025 2030

EIA (2006) 32.9 – 37.9 29.3 – 43.3 29.8 – 46.9 30.9 – 51.0
(Upper bound –
Lower bound)
EIA (2005) 30.6 – 32.7 43.5 – 49.2 51.6 – 61.0 61.3 – 74.4
(Upper bound –
Lower bound)
IEA (2006) 35.9 56.3
(Base line
scenario)
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LIMITATIONS

l Calculating OPEC supply as a residual


overcomes problem of modelling OPEC’s
complex behaviour

l But creates two problems:


- Is there Incentive for OPEC to expand
output?
- Will the investment materialize?
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Incentive to Expand Output

l Implicitly assume that OPEC has incentive to increase market share


without any regards to oil prices

l No analysis whether projected output path serves OPEC interests

l Gately (2004) calculates the OPEC’s net present value of profits for
different choices of OPEC’s market share:

- Aggressive expansion plans to expand output can yield lower


payoff than if OPEC decides to maintain its market share
- Increase in discounted expected profit from higher output
more than offset by lower prices as result of rapid output
expansion
- projections made by EIA and IEA of rapid increases in market
share “are likely to be contrary to OPEC’s own best interests”
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The Underinvestment Problem

l Unfavorable geopolitical factors/ sanctions can prevent capacity


expansion

l Relationship between government and national oil company can


result in unfavorable environment for investment

l Relationship between governments and/or national oil companies


and IOCs
- As markets have tightened terms and conditions demanded
by owners have been hardening over time

l For OPEC uncertainty about demand for OPEC oil constitutes a


very important obstacle for investment
- Calls for security of demand

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Limitations of Supply-Demand
Framework
l Using this framework to project oil prices is likely to result i n mistakes
for a number of reasons in
- highly sensitive to assumptions made about income and price
elasticity of demand, the price elasticity of supply, role of
reserves, OPEC behaviour

- Can not capture impact of unexpected shocks:


- Cashin el at al, 1999: “it is incorrect to view shocks to
commodity prices as generally being a temporary phenomenon
that largely reflect short lived variability in supply interacting with
relatively unchanging demand”

- Does not take into account general geopolitical context and


market conditions in which oil prices are determined:
- Supply demand framework analyses oil prices and makes
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‘neutral context’
What is the shape of the peak curve?

- price (demand )
- Geology
- Climate change
(Taxes)
- Political turmoil

- Prices (supply )
- Technology

32 Centre de Géopolitique de l’Énergie et des Matières Premières


10/26/2010
Oil and Gas exporting countries : 43
MB/day at risk

Europe:
13.3MB/ 144M
USA:
Day
13.5M
B/Day China+Japan
Ormuz +India
13MBD 10.3MB/Day

Malacca
10.3MBD
Countries in red
89% of World Oil Reserves
81% of World Gas Reserves
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Investments of the Future 2005-2030

l Closure of some - International Companies


Countries to foreign
Investments (Mexico) - National companies (Pemex-
OIL $4000 BILLION Sonatrach…)
l Political risks (Iraq) GAS $4000 BILLION
POWER $11000 BILLION - New comers (China – India)
l Financial markets
(Profitability)

« Risks are not below the ground, but above the ground »
(Daniel Yergin)

Centre de Géopolitique de l’Énergie et des Matières Premières

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The Origin of Higher Price

l Related to “Perfect Storm”


- A convergence of 3-Dimensional Forces
(economic, social and political) forces
comprising record breaking oil price rally,
surging food (and commodity) prices and
financial turmoil.

Source : CIRU-CPDD, PETRONAS

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A prolonged period of surging FUEL, FOOD and
commodity prices hasten the build up of the
“PERFECT STORM”…

l The unabated crude oil price rally began in 2005 post


hurricane Katrina.

l As an alternative solution to spiraling energy prices, industry


players accelerate the development of alternative energy
sources such as renewable energy and bio-fuels.

l This has led to a direct and increased competition between


fuel and food as more and more grains and oilseed crops are
being diverted towards bio-fuel production resulting in
surging food prices.

l Spillover effects include surging raw material prices for


agriculture and industrial sectors.
Source : IMF International Financial Statistics, May 2008
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… and rising FUEL and FOOD prices on the back of
FINANCIAL markets turmoil unleashed the
“PERFECT STORM”

l The cruncher came in August 2007 as financial markets began to crumble


owing to the US sub-prime crisis.

l Price of houses in the US took a steep dive, further deteriorating the sub-
prime crisis with astronomical financial losses.

l Escalation of the US credit crunch began to grip the global economy.

l The weakening US Dollar worsens the already ‘soft’ global economy which has
already been impacted by rising inflation as a result of higher energy and food
prices.

l The unprecedented convergence of 3-F forces – ‘Fuel, Food & Financial’


created the “PERFECT STORM”.

l In the meanwhile, crude oil prices continue with their record breaking price
rally.

37 Source : Bloomberg
10/26/2010
A combination of traditional drivers (Geopolitics,
Supply/Demand and Environment) and ‘new market
fundamentals’ (financial economics, rising cost and
speculation) have led to oil prices rally

l Since early 2008 until today, oil prices have increased by


almost 50%.

l The magnitude of the record breaking price spike seems


quite ‘unusual’ as it is being driven by ‘new market
fundamentals’ which are beyond the traditional supply and
demand drivers.

l Coupled with rising food, commodity and raw material


prices, as well as increasing inflationary pressure, the world
economy is seriously bracing the threat of a stagflation
widespread recession if the current record breaking price
rally escalates and does not recede.
Source : AFP & Bloomberg

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Curse Or Windfall?
Food for Thought [1]

l The unabated escalation of oil prices comes at a price


and depending on which context, it can either be
considered a ‘curse’ or ‘windfall’.

l The ‘curse’ of oil has often been referred to a situation


that relates to the mismanagement of oil revenues,
either for personal gain or lack of transparency in its
utilization. As an example, over the past several
decades, we have seen the deplorable economic state
of affairs that ensues when tribal kingdoms,
authoritarian regimes and left-wing dictatorships, to
name a few, lay their hands on national oil revenues.

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Curse Or Windfall?
Food for Thought [2]

l Easy oil cash can lead to corrupt establishments,


discourage sound long-term economic planning and is
almost never channeled in ways that promote
development for the benefit of the masses.

l On the other hand, if oil revenues are being properly


harnessed and managed with the utmost accountability
and transparency, it will be regarded as a ‘windfall’
provided they are channeled towards development
projects, infrastructure and facilities and other related
socio-economic activities that will create a better life for
the people and the nation.
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Curse Or Windfall?
Food for Thought [3]

l From commercial perspective, high oil prices lead to higher


profit for the IOCs/NOCs and potential higher returns for
share/stakeholders. This will also boost the company’s financial
leverage to pursue growth and expansion.

l From consumer perspective, high oil prices will mean higher


cost of doing business, as well as having to brace the rising
inflationary pressure.

l From the Government’s perspective, high oil prices will impact


growth, national development plans, as well as enhance the
burden of subsidy (in the case of countries with subsidized
energy prices such as Malaysia, Indonesia, Egypt, etc.)
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Causes of High Oil Prices – Geopolitics
[1]

l Continued instability and heightened security concerns


in major oil and gas producing countries, particularly in
Iraq, Nigeria and Iran add jitters to the global market.

- Nigeria:
Incessant Niger Delta rebel and militants attacks
wiped off over 1 million bpd of the country’s total oil
production, thus creating future supply uncertainty
in the global oil markets.

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Causes of High Oil Prices –
Geopolitics [2]

- Iran:
Increasing speculation of US-Iran military
confrontation fuels more uncertainty and
heightens the fear of supply disruption that will
send global oil prices to record highs.

- Iraq:
Heightens security concerns owing to protracted
US occupation, as well as threat of sectarian
violence between Sunni and Shia’a.

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Causes of High Oil Prices – Financial
Economics/Markets [1]

l Weakening US Dollar continues to put upward pressure


on oil prices
- Dollar devaluation reduces oil supplies and
increases the demand for oil.
- The result is a steady increase in oil prices. A
prolonged decline in the dollar reduces the
purchasing power of oil producing countries and
increases the costs of international oil companies.
- As a result, the amount of money allocated for
reinvestment in oil production declines.
Source : Global Insight

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Causes of High Oil Prices – Financial
Economics/Markets [2]

l Speculation – Weak US Dollar encourages financial


investors to redirect their capital into commodities,
particularly crude oil, which triggers the crude oil
prices rally
- The root problem is that financial markets have
the leverage to mobilize tens of billions of dollars
for speculative purposes, anytime, any day.
- Speculation heightens a premium between 40%
and 60% to the total crude oil price per barrel.
Source : Financial Times and Bloomberg

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Key Assumptions [1]
l Major geopolitical issues such as heightened security concerns in
Iraq and Nigeria, and possible US-Iran military confrontation
continue to remain uncertain and unresolved over the medium term
(3 to 5 years).

l Oil prices are expected to remain high at above $100 per barrel for
the rest of 2008 if the supply/demand imbalance, geopolitical tension
and financial markets turmoil persist.

l Oil prices for 2008 fell to its lowest level of $91.49 on September can
be seen as a temporary correction as oil prices continue to remain
on a ‘high plateau’ where oil is still trading at least than 80% above
the 2005 price.
Source : CIRU-CPDD PETRONAS

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Key Assumptions [2]

l For oil price to escalate beyond $150 towards $200 per barrel, there
have to be major or sudden supply disruption/shocks from the top
oil producing countries, or serious distortion to the markets via
excessive and uncontrolled speculation.

l Demand for energy, particularly oil, from China and India remains
robust over a longer period, which is in line with their respective
strong growth projection.

l Spare capacity will remain marginal at below or almost 2 million


bpd in the medium term that will further squeeze global oil supply.

Source : CIRU-CPDD PETRONAS

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Key Assumptions [3]

l Investment in new capacity will continue to lag


behind and eclipse by higher demand from emerging
and developing economies.

l Prolonged ‘resource nationalism’ policy in


hydrocarbon-rich countries in Latin America, Africa,
Russia and Middle East that continues to serve as
barrier for IOCs and NOCs to access the resources.
Source : CIRU-CPDD PETRONAS

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Impact and Implication of High Oil
Prices [1]

l Global Economy
- Prolonged high oil price may lower GDP growth
owing to increasing cost of doing business.
- Rising inflation.
- Asia’s export-oriented economies are vulnerable
to higher oil prices.
- Developed countries will accelerate the
development of alternative fuels.

Source : CIRU-CPDD PETRONAS

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Impact and Implication of High Oil
Prices [2]

l Socio-Political
- Widespread protests against oil price spike
across the major economies (US, France,
Spain, China, India, etc).
- Socio-political upheaval that may impact
political stability.
- Drastic change in consumer habits – becoming
more calculative, efficient and prudent in energy
consumption.

Source : CIRU-SPDD PETRONAS

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Impact and Implication of High Oil
Prices [3]

l Malaysian Economy
- Higher revenues for the government (from CITA, PITA,
royalties, dividends and duties).
- Increasing inflationary pressure. Bank Negara stated that the
inflation will increase to more than 6%.
- Energy intensive sector will be burdened with higher cost of
doing business.
- Exports will soften due to declining demand from trading
partners such as US and EU.
- Increased unemployment due to slower economic growth.
- The amount of subsidy to be provided by the government for
2008-09 will be much higher.
Source : CIRU-CPDD PETRONAS

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Impact and Implication of High Oil
Prices [4]

l PETRONAS
- Sustained high oil price will lead to higher revenue
and profit for PETRONAS.
- E&P investment in domestic deepwater, small
marginal fields and EOR projects become more
attractive.
- Better incentives to develop and monetize our oil and
gas reserves in Africa and Turkmenistan.
- Drilling, seismic, fabrications, raw materials and other
upstream-related services may cost higher.
- Potential development in alternative energy as one of
the sustainable solutions to high energy costs.
Source : CIRU-CPDD PETRONAS

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Key Issues/Challenges [1]

l Key issues/challenges for PETRONAS evolve around


growth, costs and gaps in technology and skills:
- Access to resources in view of rising geopolitical
uncertainty & resource nationalism.
- Escalating costs & changing fiscal terms raise
concerns on margins & viability of existing and
future investment portfolio.
- Human capital and talent development to manage
domestic operations and international expansion.
- Technology as a competitive edge – How have we
progressed?
Source : CIRU-CPDD PETRONAS

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Key Issues/Challenges [2]

l The oil & gas industry faces myriad of issues/challenges from many fronts:
- Geopolitics - Uncertainty and heighten security concerns enhance the risk
premium and costs of doing business.

- Environment - Increasing concerns on climate change and global


warming make it imperative to pursue growth via innovation and breakthrough
technology.

- Energy vs. food security - direct and increased confrontation & competition
between food and fuel.

- Capacity constraints - oil production decline, reserves depletion,


marginal spare capacity.

- Enabling technology - difficult geology, harsh operating environments,


unconventional sources (extra heavy oil, tar sands, etc), EOR, etc

Source : CIRU-CPDD PETRONAS

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