Oil and business the coming challenges

Energy affects everyone. Its use is so pervasive we barely think about it until we pull up at the pump or pay the electricity bill. But energy consumption in the form of fossil fuels is a large part of the climate change problem.

We all face threats from climate change with scenarios that vary from serious to disastrous. We must all be part of a global solution that reduces emissions while maximising economic growth.

Another major factor affects our future – limited oil supply. We are likely to experience a shortfall in conventional crude oil supply versus the trend in oil demand some time in the next two decades. Carbon pricing and other regulatory interventions to address climate change will also fundamentally reshape energy supply and demand.

See chart 1 – Oil prices. As this chart reminds us, we recently experienced unprecedented high oil prices. The data is from a few months ago and there has been a large drop in prices since then. However we can’t ignore what the market has been telling us: to reduce our reliance on crude oil.

See chart 2 – Energy by source. The world is heavily dependent on fossil fuels for energy supply in the form of coal, oil and gas. This dependence will be difficult to change because of rapid growth in the developing world and the current cost of switching to alternative energy sources such as nuclear and renewables.

Growth in developing countries has serious consequences for greenhouse emissions, which makes global agreement on reducing them imperative.

World oil consumption is changing. Oil use per unit of GDP in the US, Australia and Japan has flattened off. China and India have much lower incomes and lower oil use per unit of GDP. If these countries tried to increase their use of oil to the level of developed countries, the supply would not be available.

It seems likely there will be global agreement by 2010 on reducing growth in greenhouse emissions, even though imperfect and differentiated between countries. Australia and other developed countries will commit to substantive action.

This raises the question: should Australia be planning an emission trading scheme in a global economic crisis and possible recession? Our view is a scheme should be put in place as soon as it can be properly designed, but implementation should take account of economic conditions and international climate change negotiations.

Australia can take an international leadership position in policies to reduce emissions but until there is global commitment to emission reduction our trajectory should be modest and ensure a low carbon price initially.

A scheme with a fixed price could be an alternative to a market-determined price while an international agreement is negotiated, then implemented, to provide a level playing field.

Australia can’t go it alone. Even if we massively reduced our greenhouse emissions there would be no discernable change in global concentrations of emissions, global warming or rising sea levels. All the world’s major emitters need to take substantial action to reduce emissions or reduce their growth in them.

If Australia is to meet its target of a 60 per cent reduction in emissions by 2050 relative to year 2000, radical changes in energy supply and demand will be necessary. A 60 per cent reduction relative to year 2000 is a 77 per cent reduction relative to business-as-usual emissions in 2050.

That’s the good news. The bad news is Professor Garnaut has advised we need a 90 per cent reduction of greenhouse emissions in 2050 relative to business as usual.

Australian energy supply and greenhouse emissions

Leaving aside nuclear power, the only way Australia can meet its 2050 target is through heavy reliance on low-carbon electricity and biofuels. Both climate change and the oil market are driving us in the same direction: greater efficiency in use of liquid fuels and diversification of supply.

Caltex recently participated in the Future Fuels Forum led by CSIRO, which generated a number of scenarios of fuel supply through to 2050. There are many sources of low carbon electricity including solar thermal, wind, geothermal, wave, biomass, photovoltaic and hydro that should be allowed to compete for market position. Coal and natural gas with carbon capture and storage will play an important transitional role until stringent targets and high carbon costs reduce their viability.

See chart 3 – Distance travelled by engine type. However, internal combustion engines will be around for a long time yet. They may use petrol or diesel with some proportion of biofuels, and may become more efficient through use of hybrid technology. Pure electric vehicles or plug-in hybrids will remain relatively expensive over the next few decades.

See chart 4 – Australian transport fuel consumption. Beyond fuel for transport, there is fuel growth in other sectors, notably diesel for mining. Biofuels like ethanol and biodiesel will be important in transport applications where electricity is impractical.

As an oil company Caltex has a focus on the future of liquid fuels, the core of our business. But Caltex is also the largest convenience store retailer in Australia. This is a growing part of our operations which will continue to evolve. To retain our position as the leading fuel marketer we will likely be greatly increasing the amount of biofuels we sell.

Oil refineries will continue to provide substantial volumes of conventional liquid fuels, even in 2050. In the CSIRO scenarios, these fuels are blended with ethanol and biodiesel and net petrol and diesel consumption remains high.

The long-term outlook for fuels is consistent with Caltex’s outlook for Australian demand growth through 2020. While petrol demand will be flat, we see diesel increasing at about four per cent per year and jet fuel at three to four per cent per year.

Alternative liquid fuels with a smaller carbon footprint will play a role, and will include biofuels from sustainable feedstocks, synthetic petrol and diesel and hydrogen. Natural gas and LPG are already used as transport fuels.

The key to success is the ability to adapt. Refining is a tough business. Competitive pressures could mean some Australian refineries will close but many, perhaps all, could be competitive in the long run.

We have been building our marketing operations for a number of years now. The marketing-focused model is part of our business evolution. It keeps us aligned with a world in which carbon prices, oil prices and demand-side technologies are all changing within the timeframes of current investments. Caltex is investing in new and upgraded terminals around Australia to increase flexibility and meet increased diesel demand from Australia’s resource industries and other customers. We have also acquired wholesale operations that fit our marketing objectives.

Caltex is also diversifying its fuels portfolio with investments in terminals and service stations to sell biofuels blends to retail and commercial customers. Biofuels can have much lower life-cycle greenhouse gas emissions than petrol or diesel but the challenge is to produce them sustainably from non-food crops.

Because Caltex’s refinery production is significantly less than its sales of petroleum products, a reduction in demand for refined petroleum products translates into lower imports, not lower refinery production for Caltex.

Climate change policy issues

No discussion on climate change can be complete without mentioning Australia’s Carbon Pollution Reduction Scheme (CPRS). Its potential impacts on emissions-intensive, trade-exposed industries like oil refining are significant.

Oil refining operates on small margins on average over the business cycle and, given the capital-intensive nature of the business, faces very high carbon mitigation costs expressed as dollars per tonne of emissions abated. High costs for carbon emission permits would threaten the viability of the Australian refining industry.

A scenario based on gross refiner margins since 2000 shows carbon costs would reduce refining earnings before interest and tax (EBIT) by one third. In the bottom half of a business cycle, carbon costs for refining could consume 100 per cent of EBIT. That would be a formula for shutting down operations. Many industries face similar outcomes.

We believe all revenue from the sale of permits should be recycled to households and businesses, not diverted to other uses.

Emissions-intensive trade-exposed (EITE) industries, will contribute about 40 per cent of permit revenue, excluding agriculture. By their nature, as trade exposed, EITE industries can’t pass on price increases due to carbon costs so they don’t have an impact on households or other businesses.

However, the green paper proposes only 20 per cent of permits would be allocated free to EITE industries – that’s just half of the permits they’re required to hold for their emissions.

This shortfall in EITE assistance appears to constitute to a $2-billion per annum redistribution from EITE industries to the rest of the economy.

In conclusion:

• Climate change and oil supply and demand will fundamentally change the long-term business environment.
• Caltex’s business continues to evolve.
• Sound climate change policy decisions are critical for the viability of Australian industries.

Australia can’t solve the global climate change problem alone. However, climate change is a good example where, with the right scheme, we can help lead the world to a better future without disadvantaging the economy.

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