API President Delivers State of the Industry Speech

The State of the U.S. and Natural Gas Industry 2006
10th Annual Ohio Energy Management & Restructuring Conference
API President and CEO Red Cavaney
Columbus, Ohio
March 1, 2006

I am both honored and delighted to be your lead-off speaker at this 10th Annual Ohio Energy Management & Restructuring Conference. Having appeared in front of you before, I doubly appreciate your inviting me back for a return visit. Clearly, much has happened in the field of energy in the intervening years.

It wasn’t all that long ago that Americans took energy for granted. Following the oil embargo of 1973-74 and the oil supply disruption caused by the Iranian revolution in 1979, the federal government eased its control over portions of the energy business, during a time when our nation possessed sufficient supply and surplus capacity in most energy sources, including oil and natural gas. However, during the late 1980s and 90s, circumstances changed. Our industry was preoccupied with economic survival in the face of heavy government intervention and a dramatically changing international geopolitical landscape. Accordingly, it spent a minimum of time educating key audiences about the industry’s critical needs in providing consumers, both retail and industrial, with a reliable supply of affordable energy into the future. Consequently, we are all paying the price now with government policies that do not reflect their full understanding of the energy world in which we must operate.

During several years of accelerated economic growth in the late 1990s, especially in the “dot.com world,” few considered the energy consequences of this unprecedented growth spurt. In fact, a number of respected political and business leaders claimed that energy demand and economic growth had been decoupled by technology’s ascendancy. Not surprisingly, demand surged; and we entered the 21st Century with very modest amounts of energy flexibility and spare production capacity – a fact little appreciated by the general public and their political leadership.

As energy demand grew and surplus production capacity shrank, we, as a nation, were focused elsewhere – principally on implementing new regimes of government environmental regulations. And while those environmental improvements have served society well, investment dollars were being diverted away, somewhat starving refinery capacity expansion and increased infrastructure flexibility within the energy industry.

The attendant problems being created first became evident in the winter of 2000, when we experienced fuel price spikes and tight home heating oil supplies in the Northeast and upper Midwest. Similar experiences in transportation fuels have become all too commonplace since then.

While improved economic efficiency has reduced reliance on energy for economic growth in recent years, it has not decoupled the two. There is no question today as to the vital relationship between energy and economic growth. Certainly, we can see that relationship in the surging economies of the developing world, especially in China, where the massive new demand for energy has impacted world energy markets, putting significant upward pressure on the availability and price of crude oil.

To appreciate where we are today regarding energy and where our nation needs to go, two fundamental tenets must be understood. First, the energy industry is a long-lead-time, capital-intensive industry. It cannot add capacity or flexibility overnight. And, second, the energy industry cannot function effectively without a constructive partnership with government, at both the federal and state levels.

Unfortunately, today’s view of far too many policy leaders is rooted in a past that no longer exists or inaccurately characterizes the world energy dynamic of today and tomorrow. For the past several decades, following the oil embargo and other supply disruptions of the 1970s and the years that followed, a great number of foreign governments nationalized their oil industries, including their reserves.

Forty years ago, world oil reserves were largely owned by public, investor-owned oil and natural gas companies, most based in the United States. Reserves are a critical measure of a company’s ability to serve its future customers. Today, world oil reserves are 77 percent owned by national oil companies formed during the past 30+ years, while only 6 percent of world-wide reserves are now held by investor-owned oil and natural gas companies.

Consequently, investor-owned oil and natural gas companies elected to scale up to compete within this new world by creating large-scale efficiencies, greater technological and project management prowess, and substantially broader competitive access to capital markets in order to meet the competition from these national oil companies, such as those of Saudi Arabia, Russia, Venezuela, China and others. The value of this scaling up of investor-owned oil and gas companies was largely missed by most observers -- both in and out of government. Some observers, still in the dark on this necessary evolution, now view the industry in exaggerated, negative terms; as too large, too powerful, and not deserving of its earnings.

Obviously, reality is quite different. Would these critics have the investor-owned companies be small and sub-optimal in one of the world’s truly global, commodity markets? Were such the case, would national oil companies then rush to gain share our domestic market? Would that enhance our national and energy security be enhanced by such a development?

Sixty percent of the cost of gasoline is attributable to crude oil. U.S. oil and natural gas companies are crude oil “price-takers,” not “price-makers.” They cannot set the world price of crude oil – the world market does. Roughly half of the oil consumed in the world crosses international borders. The world market is comprised of thousands of buyers and sellers of crude oil from around the world who operate through transparent exchanges in New York, London, Singapore and elsewhere. This world crude price is the single most important factor in determining the U.S. price of gasoline, diesel fuel, heating oil, aviation fuel, and other crude products.

There has also been considerable misunderstanding and misinformation about the earnings of U.S. oil and natural gas companies. The oil and natural gas industry is among the world's largest industries. Its revenues are large, but so too are its investments and operating costs in providing consumers with the energy they need. Included are the costs of finding and producing oil and natural gas, as well as the costs of refining, distributing and retailing oil and oil products.

The energy Americans consume today is brought to us by massive investments and reinvestments planned and made many years, or even decades, ago. Between 1992 and 2005, for example, the investor-owned oil and gas industry invested more than $1 trillion, on six continents, in a range of long-term energy projects. This trillion-dollar investment exceeded the total net income of all those companies over the same period. To succeed in reliably delivering affordable supplies of fuel to customers, the U.S. oil and natural gas industry must invest large sums, in both good and bad economic times. In this industry, to under-invest over time is to die a slow death.

Contrary to a widely held perception, the industry's earnings are very much in line with those of other industries -- often they are lower. Over the last five years, the oil and natural gas industry's earnings averaged 5.8 cents per dollar of sales compared to an average for all U.S. industry of 5.5 cents for every dollar of sales. Importantly, and for industry-sector comparison over the same five years: banks earned 17.3 cents for every dollar of sales, pharmaceuticals 16.2 cents, and real estate 10.6 cents, to name a few.

For the third quarter of 2005, the oil and natural gas industry earned 8.2 cents for every dollar of sales compared to an average of 6.8 cents for all of U.S. industry. These figures are the latest available for comparative purposes, since not all companies’ earnings reports from the fourth quarter have been filed.

It is also important to understand that those benefiting from these oil and natural gas industry earnings include numerous private and government pension plans, including 401K plans, as well as the direct investment accounts of many hundreds of thousands of individual American investors. While many shares are owned by individual investors, firms, and mutual funds; pension plans, alone, own 41 percent of oil and natural gas company stock.

Unfortunately, just when our nation should be encouraging oil and natural gas exploration, production and refining; punitive tax proposals originating in the U.S. Senate would clearly make it much more difficult for the industry to meet the energy needs of American consumers. A Senate provision to selectively increase the tax on the foreign source income of our nation’s five largest oil and gas companies would make these companies pay taxes twice on foreign income and become less competitive in international markets – at a time when they have been excluded from developing oil and gas resources in vast onshore and offshore areas within our own country. If these companies are marginalized from gaining new exploration rights, do you think this is a “win” for U.S. industrial and retail consumers? I think not.

Also pending is a tax proposal that would impose a financial penalty on these same five companies by forcing them to retroactively change the way they value their inventories for tax purposes. This Senate modification of LIFO (last-in/first-out) accounting procedures is nothing more than a thinly-veiled “windfall profits tax,” which would reduce the capital available for refinery investment – at the very time when public policy leaders of all persuasions are calling for greater investment in U.S. refining capacity.

These harmful tax proposals point up the fact that the most significant obstacle today in meeting U.S. energy challenges is government policies that do not reflect an understanding of the energy world in which we must operate. You can help keep America’s and your own energy costs competitive by urging your senators and representatives in Congress to remove these insidious, punitive energy taxes from the tax reconciliation bill under consideration.

As you will hear later this morning from U.S. Energy Information Administrator Guy Caruso, world energy markets are being radically reshaped by the mushrooming energy demand of China, India, and others. And, these increased world energy demand pressures could well be with us for the better part of the decade – or until worldwide investment provides sufficient capacity to limit, if not eliminate, the price volatility and tight supply/demand situation faced today.

It is worth noting that this price volatility is not limited to the United States, rather it is a worldwide phenomenon. For example, even though European countries tax motor fuels heavily, they too have experienced price increases, though of a lesser percentage change.

How can we meet these challenges here in the United States? For one thing, we cannot any longer afford to revisit energy policy only once every 10 years or so. Energy has become an every-year issue – as changes continue, as markets evolve, and as new technologies come online. We must continue to address our energy policy until we get it right.

As I mentioned earlier and importantly, in meeting U.S. energy challenges, industry cannot do it alone. We cannot meet the energy needs of U.S. consumers without an effective, comprehensive approach by government to energy policy. We can no longer rely on knee-jerk responses, quick-fixes, or wishful thinking alone. The energy legislation signed by the President last year was a good first step, but much remains to be done. Make no mistake about it, government policies do have a huge impact on energy outcomes.

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