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Drivers of Demand for Capital in Global Energy Randall S. Wade Managing Director and COO December 2010 Sector Attributes • Energy is a building block of economic growth • Benefits from long-term demographic trends that drive demand • Demand largely caught up with supply in last five years; supply will struggle to keep pace with demand going forward • Energy supply is comprised of several heterogeneous markets, each with distinct sub-sectors and underlying fundamentals • Negative correlation with traditional investment classes such as equities, fixed income • Commodities provide a natural hedge against inflation • Long-lived, hard assets • Inherent volatility in commodity prices World GDP by Sector Source: EIA, CIA World Fact Book, World Health Organization, Bloomberg 2 Sector Attributes Technically complex Complex and interpretive resource evaluation, and sophisticated engineering required for success One off, purpose specific design Project cost risk typically carried by owner (not EPC) Capital intensive Very large capital investment required throughout lifecycle. Ability to ‘protect’ or follow initial investment is crucial Investment decision heavily reliant on commodity price forecast Commodity price volatility Oil prices in 2002 were sub $20/bbl, reached a high of ~$147/bbl in July 2008, and hit a low of ~$34/bbl in December 2008 Financial flows increasing volatility Cyclicality GDP growth drives underlying demand Significant lag in investment cycle, leading to boom-bust profile Complex demand-supply position Energy markets are complex and intertwined (e.g. upstream importance to gas transmission, gas price on spark spread) Structural change driven by: - Decline of OPEC spare capacity, and rise of NOCs - Development of unconventional resources - Impact of the rise of Asia on demand 3 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 4 1) Industrialization of the Developing World is Driving Demand • World population has more than doubled since 1950 • Urbanization increases demand for energy • In 2009, for the first time in history, the world’s urban population overtook the rural population Actual Source: Historical data from World Bank (GDP), BP Statistical Review 2009 (Energy), US Census Bureau (Population). Forecasts per EIA International Energy Outlook 2009, IEA World Energy Outlook 2009, World Bank HNP Stats. 5 Forecast 1) Industrialization of the Developing World is Driving Demand Oil Consumption China 67.6% Middle East 39.6% India 27.9% Total World 10.9% US (1.4)% Source: BP Statistical Review 2009 6 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 7 2) Depletion of Aging “Elephant” Fields • There are ~70,000 oil fields in the world • Bulk of production comes from a small number of very prolific fields, mostly giants and super giants – World’s 10 largest fields produced 20% of world’s production – 20 largest fields produced 25%; 16 are post-peak – Ghawar’s 5.1 million bpd equaled 7% of world total • Most of the largest fields have been in production for years, and in some cases several decades Production at World’s Largest Oil Fields The aggregate production decline (from peak output) at the world’s six largest oil fields equates to 6.6 million barrels per day. Source: IEA World Energy Outlook 2008; Cantarell production updated for 2009 per CERA 8 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 9 3) Replacement Costs are Increasing as Source of Supply Shifts • Exploration spending increased by 21% in 2008, and has doubled since 2005 • However replacement rates fell to 88% of production (first year since 2004 in which production was not replaced) • Finding and development costs soared 66% to $25.50/bbl • Competition for unconventional resources increased sharply Expected Costs of Production Source: IEA World Energy Outlook 2008 (left); EIA Annual Energy Outlook 2009 (right); 2009 Global Upstream Performance Review, IHS Herold/ Harrison Lovegrove US Natural Gas Production by Source 10 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long pay-back periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 11 4) Under-Investment in Infrastructure • Infrastructure investment depends on stable political, regulatory, and fiscal regimes • Energy sector is huge consumer of infrastructure and collectively accounts for 43% of global infrastructure investment • Energy companies affected by global recession – Demand growth uncertain, credit constrained, balance sheets stretched – Deleveraging, postponement/cancelation of major projects – Global upstream oil and gas budgets cut by 19% in 2009, or ~$90 billion • Near-term fall in energy investment likely to lead to a medium-term shortfall in supply due to development lag Expected Sector Distribution Expected Geographic Distribution Source: Amundi PEF 12 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 13 5) Climate Change and Price Mechanisms for Carbon • Atmosphere currently contains ~455 ppm of CO2-equivalent greenhouse gases (“GHG”) • IEA analyzed one scenario (“450 Scenario”) in which countries take coordinated actions to stabilize GHG at 450 ppm • A low carbon future requires a major transformation of the sector (both in terms of sources of energy and required infrastructure) Source: IEA World Energy Outlook 2009 14 5) Climate Change and Price Mechanisms for Carbon Renewables depend on government subsidies in order to compete against fossil fuel generation US Renewable Generating Capacity Source: EIA Annual Energy Outlook, April 2009 Update (left); California Energy Commission (right) Generation Cost by Fuel Source 15 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 16 6) Resource Nationalism • International Oil Companies (“IOCs”) only own 7% of the world’s oil reserves • National Oil Companies (“NOCs”) operate as an extension of the government (e.g. Saudi Aramco, Pemex, PDVSA), or as autonomous entities that concurrently support government objectives (e.g. Petrobras, Statoil) – Activities of NOCs are frequently inefficient and/or not market-oriented • NOCs produce the majority of the world’s oil and hold most of the world’s proven reserves • IOCs are increasingly relegated to exploring in high-risk areas in order to secure reserves (Arctic, ultra-deep water, unconventional) World Proved Oil Reserves, 2008 World Oil Production, 2008 in million bpd Source: BP Statistical Review 2009 17 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 18 7) Geopolitical Considerations Geopolitical influence on sector evident at an increasing rate in the daily news 19 Drivers of Demand Beginning around 2005, EIG believes the world began a 15-20 year secular trend in energy and energy-related infrastructure requiring massive amounts of investment. Underlying Factors that Drive Demand 1) Developing world continues to industrialize, coupled with population growth and demographic trends 2) Depletion of aging “elephant” fields that have underpinned global supply for decades 3) Higher replacement costs as conventional supplies began to be replaced with higher cost “unconventional” supplies 4) Chronic under-investment in infrastructure caused by the inherent volatility of the sector and the need for long payback periods 5) Concerns about climate change and the introduction of price mechanisms for carbon 11) Assertion of market clout by national oil companies and other state actors and the resulting resource nationalism as energy independence takes on increased political importance 12) Security of supply as an enhanced geopolitical consideration as key supply states use energy as an economic weapon to leverage consumer states 13) Market distortions caused by increased government intervention through mandates, subsidies, taxes, and regulation 14) Fragility of the energy supply network and susceptibility to disruption by terrorist activity 15) Increased price volatility due to low reserve margins, correlation to U.S. dollar, and inflation expectations 20 10) Oil vs. US Dollar and Inflation • Oil has been a strong hedge against inflation (0.86 correlation) • Oil has provided a similarly strong hedge against the US dollar (-0.80 correlation) Source: EIA, Bloomberg 21 Drivers of Demand $26 Trillion of Investment Required Through 2030 Source: IEA World Energy Outlook 2009 22 Capturing the Market Opportunity Investment demand is growing across the entire energy value chain on a global basis Upstream Infrastructure Reserve-based Development Production Payments Forward Oil Sales Midstream Gas to Liquids Pipeline Gathering Systems Processing Facilities Gas Storage Bunkering Production Platforms Drill Ships FPSOs Drilling Rigs Transportation LNG Tankers Specialty Tankers VLCC Vessels LNG Synfuels Processed Gas (methanol, fertilizer, DME) 23 Gas to Electrons Renewables Wind Solar Biofuels Geothermal LNG Regasification Terminals Gas Sales, Pipelines, Gas-Fired Power Plants, Electricity T&D Capturing the Market Opportunity Opportunity Current Dynamic EIG Portfolio Examples Energy-related Infrastructure • Pipelines, gathering systems, compression, processing, and rigs for energy companies looking for growth capital or to recycle capital currently tied-up on their balance sheet Oil versus Gas • Onshore and offshore primary and tertiary oil recovery plays recognizing the relative value of oil versus gas on a BTU equivalent basis in the current market Renewable Energy • Wind, geothermal, solar, and biofuels primarily in the US and Europe in response to the implementation of carbon regimes Recapitalization of Mature Assets • Operating assets with significant existing cash flow as a source of liquidity for large energy companies in a credit constrained environment China/Asia Energy Demands • Enhanced activity in existing EIG Austral-Asian platform recognizing continuing resource nationalism and demand for energy and resources 24 ~ ~ Impact of the Credit Crisis • Contraction in global GDP took pressure off near-term supply/demand fundamentals and caused one to two year “time out” in the otherwise dominant secular trends in the industry • Two key impacts of the credit crisis: – Re-pricing of risk across the credit spectrum, particularly for illiquid assets – Contraction in suppliers of capital: “survivors” continue to be price makers, not takers US Corporate Bonds, B-rated Source: Bloomberg (Merrill Lynch data) 25