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Breaking the cycle of volatility

Speech given by Simon Henry, Chief Financial Officer, Royal Dutch Shell plc, at the The Global Forum for Energy CFOs in London, on September 23, 2009. This text may differ from the spoken word.

To build a secure and sustainable energy supply, energy companies must make massive investments spread over many decades. Yet the recession has shown that they must do this in the face of strong short-term volatility. In this speech, Royal Dutch Shell’s CFO, Simon Henry, focuses on what governments and the industry can do to develop a financial and regulatory framework that matches the industry’s long-term investment cycle. Priorities include stable capital markets, viable fiscal regimes, and a predictable climate change policy framework. But government intervention must be judicious: fresh regulation in the commodity markets could accentuate, rather than ease, volatility. For their part, energy companies must try to invest through the economic cycle.

Breaking the cycle of volatility

Simon Henry

This morning I would like to address the biggest challenge facing CFOs in the energy industry. 

How can energy companies deliver the long-term, complex investments needed to deliver a secure and sustainable energy supply, and maintain a healthy balance sheet?

And how can energy companies and Governments work together to moderate the short-term volatility that contrasts so sharply with the industry’s investment cycle. 

Let’s start with the big picture.

The global economic outlook has brightened over the summer. The IMF announced that the global recovery is underway. France, Germany and Japan all returned to growth. And the Bank of England believes that the economy is starting to stabilise here in the UK.

Yet dark clouds remain on the horizon. Rising unemployment, weak consumer sentiment and constrained lending all suggest that the global recovery will be fragile. And in the energy industry, we can expect business conditions to remain tough for the next twelve to eighteen months.

This year, we expect global oil demand to fall by over 2 million barrels per day, the steepest drop since 1980. And after thirty years of near-unbroken growth, demand in the EU for natural gas is likely to fall by 5%.

Downstream margins and gas prices are under pressure.

Yet the recession will not halt the long-term increase in global energy demand, as populations and living standards continue to grow especially in Asia. Nor will it lead to a long-term reduction in carbon emissions.

The world will still need more energy at a sharply reduced cost to the environment.

The Investment Challenge

That in turn requires heavy investment in all forms of energy production and low-carbon technology.

The numbers are dazzling. According to the International Energy Agency, energy-supply investment of $26.3 trillion will be needed by 2030, including $5.5 trillion in renewable energy.

Billions more will have to be spent on upgrading electricity transmission networks to handle increased demand and the on-and-off power generated by wind and solar.  

These are complex investments that will have to be sustained over many decades.

From the initial exploration of an oil or gas field, it typically takes between 10 and 12 years before production starts. And, in some cases, production can then be expected to last for up to forty years.   

The Pearl GTL project in Qatar, which Shell is building with Qatar Petroleum, is a vivid example of the scale at which the industry operates.   

When finished, it will be the world’s largest gas to liquids plant.

It will produce enough fuel to fill over 160,000 cars a day and enough synthetic base oil each year to make lubricants for more than 225 million cars.

More than 48,000 workers from more than 50 nations are at work on a building site the size of Hyde Park and Kensington Gardens, making it one of the world’s largest industrial developments.

The GTL plant and equipment require two million tonnes of prefabricated parts from five continents, including 12,200 kilometres of cables and enough steel to make ten Eiffel towers.

Projects of this magnitude have an investment cycle that lasts decades.

Then there’s the technology lifecycle. Historically, it has taken twenty-five years for new primary energy sources to obtain a one per cent share of the global market.

For example, the first LNG plant came on-stream in 1964 in Algeria, using Shell technology. Since then the growth of LNG has been spectacular. But four decades later, the share of LNG in the global energy mix is still only 2%.  

Yet for several reasons, the industry’s investments are only becoming more complex and costly.

One is that the era of easy oil is coming to an end for international oil companies.

Long-term energy demand may be growing, but easily accessible supplies of oil and gas are in decline.

That means the industry must develop the capability to operate in new frontiers, like deep water and the Arctic.

It also means unlocking unconventional oil and gas resources that require heavy investment in all manner of unconventional technologies from oil sands to tight gas.

At the same time, the industry must use enhanced oil recovery techniques to squeeze as many barrels as possible from existing fields.

None of which is easy or cheap.

 Even in OPEC countries, the low-hanging fruit has been picked.

The transition to a low-carbon economy is another game-changer.  This will take place over at least two generations, and will require investment of eye-watering scale and ambition.

For wind-power to contribute 10% of the electricity generated by 2030, the world will need another 1-1.5 million turbines covering an area nearly the size of France.

All this helps to explain why the industry needs confidence in the financial, fiscal and regulatory framework under which it must operate.

And why the current operating environment is so challenging.


Energy companies face a blizzard of short-term pressures that run contrary to our long-term investment cycle.

Most important, the recession has slowed the pace of investment within the industry. The IEA expects upstream oil and gas investment to fall by more than one-fifth in 2009, and spending on renewables to drop by 40%.

That said, at current oil prices the plans of the major oil companies should survive largely intact.

But for many smaller energy companies debt finance has been hard to come by. And project finance, venture capital and private equity have been thin on the ground. 

Moreover, the volatility within the industry has intensified. Over the past year or so, the price of oil has fallen from a high of $147 per barrel to below $40, before recovering to between $60 and $70.

The politics can be equally unpredictable. 

All too often, Governments meet oil price increases with tax hikes, only to leave the higher rate in place when the price weakens. This reinforces volatility within the sector, and deprives businesses of money that could be invested in productive capacity.

Regulatory uncertainty also discourages investment. In addition, there is a high degree of doubt about the likely shape of a global framework to tackle climate change.

All this may be sowing the seeds of a severe supply crunch when demand picks up again, prompting a renewed surge in commodity prices and damping the economic recovery.

The public policy challenge

Given the need for long-term investment, what can be done to ease volatility within the sector?

Much hinges on Governments, regulators and policy-makers of every stripe grasping the realities of the industry’s investment cycle. And having the foresight to take the uncomfortable decisions needed to transform the energy system in the next decades.

 The UK is a potent example.

 The Government has made strong headway on a number of fronts. Its efforts to secure additional funding from the EU for Carbon Capture and Storage technology were critical. And the Climate Change and Planning Acts were bold and necessary items of legislation.

Yet the country’s energy challenge is acute.

 The Economist recently warned that the country faces severe supply disruption within a decade. And the Government itself has calculated that of around 75GW in generating capacity, 20GW will disappear by 2015.

 Moreover, the UK’s renewable energy targets are challenging. Under the EU’s target, renewable energy should supply 15% of the UK’s total energy demand by 2020. Which would mean roughly one-third of the UK’s power generation being drawn from renewable sources.

 But that would require the equivalent of fifty London Array projects to be built between now and 2020. And that is assuming no increase in demand before 2020.  

Where do we go from here?

For policy-makers everywhere, four priorities stand out.

Capital markets

Most urgent, the industry needs a stable base in the capital markets. 

Thanks to the swift and bold action taken by the authorities to support the financial system over the past year the credit markets show signs of stabilization.

Here in the UK, credit conditions across the economy as a whole seem to have eased a little in the past couple of months, with a pick-up in confidence among lenders and borrowers. That, at least, is the story of the CBI’s latest access to finance survey.

Yet many banks’ balance sheets are still under pressure, and confidence in the financial sector remains fragile: July saw a further contraction in Eurozone bank lending. That suggests the authorities may have to underpin liquidity in the system for some time to come.

Even then, difficult questions will remain about when and how to withdraw the vast monetary stimulus pumping through the veins of the economy, as well as how the financial sector is regulated. 

Over the longer-term, stability will depend on the emergence of a smarter global financial system, grounded in a better understanding of risk, stronger international coordination, and more effective governance.

In the meantime, the Ratings Agencies can also exert a steadying influence in the markets. 

The agencies should take a balanced view of the energy industry.  In determining credit ratings, they should think through the economic cycle, and apply criteria consistently across the industry.

With global demand for energy set to double by 2050, there are strong grounds for taking an optimistic view of the oil and gas industry’s prospects, particularly over the medium to longer-term.

Commodity Markets

A second point concerns the commodity markets.

We meet in the midst of a heated political debate about how they might be regulated to moderate volatility.

Here, Government intervention might produce the wrong results.

In two areas in particular, I would urge the authorities to proceed with caution.

First, they should resist the temptation to regulate the commodity markets by limiting the role of financial investors. 

The markets reflect an understanding of the fundamentals of the marketplace today and tomorrow.

It’s primarily fiscal and regulatory uncertainty that discourages investment. And it’s inadequate investment that causes the long-term disjunction between supply and demand that leads to such marked price volatility. 

Regulating to limit the role of financial investors in the market would do nothing to address this.

Instead, it is by developing more predictable fiscal and regulatory frameworks that Governments worldwide can ease volatility, and prompt the markets to take a longer-term view.

 A second issue concerns over-the-counter derivatives, which energy companies use to protect against future movements in the price of commodities.

Unlike trades on the commodity exchange, the majority of over-the-counter derivatives are traded privately between energy businesses and banks, without being processed through a central clearing house to safeguard against the risk of default.

In the wake of the financial crisis, policy-makers on both sides of the Atlantic want to increase the transparency of the derivatives market. One proposal is to push OTC transactions onto the public exchanges. Another is to require mandatory clearing of all trades through regulated central counterparties. Both would shrink the derivatives market.

While there is a clear need for tighter regulation in some quarters, governments and regulators must be wary of unintended consequences.

For energy companies like Shell, OTC derivatives are not instruments of financial speculation. Rather, we use them to manage and hedge risks that occur as part of our everyday business activities. As such, they allow us to cope with the sector’s volatility, and increasing complexity.

Take the biofuels market. Here, Shell uses OTC derivatives to manage the risk of fluctuations in the price of biofuel feedstocks, thus protecting retail profit margins.

Scrapping OTC deals, or forcing them all to be cleared centrally, would drive down business investment. To meet exchange collateral requirements, oil and gas companies would have to divert billions of dollars away from investments in new productive capacity and technology. And that would increase, rather than moderate, volatility.   

What would be help to ease volatility is more up-to-date information about the fundamentals of the marketplace. The wild gyrations in the price of oil are exacerbated by incomplete and obsolete market information.

Nobody knows exactly how much oil is produced on a daily basis, just as nobody knows how much oil is in transit around the world. Through no fault of its own, the International Energy Agency can only publish oil statistics with a time lag of more than a year. 

In the absence of up-to-date information, the price of oil sometimes fails to reflect the underlying fundamentals of the marketplace. Looking back to the last price spike, we now know that demand had already begun to decline in the fourth quarter of 2007. Yet in early 2008 analysts still expected global oil demand to continue rising, sending the oil price to a record high in the Summer.

To help develop a more comprehensive picture of the oil market, the International Energy Forum must be encouraged to press on with its Joint Oil Data Initiative.

Viable Fiscal Regime

Tax regimes that are predictable and promote investment are my third priority. With the public finances under pressure in many countries, these will be at a premium in the years ahead.

Yet a coherent and long-term fiscal approach would yield substantial benefits to Governments and industry alike.

North Sea oil and gas is a case in point.

According to Oil and Gas UK, up to 25 billion barrels of oil and gas remain to be recovered from the UK Continental Shelf.

That’s enough to keep the industry humming for years, preserving swathes of valuable jobs and Intellectual Property in the UK. And more than enough to make a serious contribution to the country’s security of supply. 

Like many of your businesses, Shell remains fully committed to the North Sea. Last year, we brought four new North Sea fields on-stream, and we have upgraded the St Fergus and Mossmorran onshore plants, extending their life to 2021. 

Yet 2009 is likely to be the third successive year in which overall investment in the North Sea falls. The remaining oilfields in the North Sea are small and harder to tap, making it a costly and difficult operating environment. 

Only deep and urgent cuts in the rate at which new investments are taxed will reverse the trend.     

The Government made a start in the budget, and has since signaled that it may go further. But the global marketplace is increasingly unforgiving. And the window of opportunity for the North Sea is small and shrinking. 

All this leads onto my fourth and final public policy priority.

Climate change framework

Just as the industry needs a viable fiscal structure, so it needs a robust and predictable climate change policy framework.

 The lack of a hard price for carbon dioxide hinders long-term planning, and discourages investment on the scale needed to build a sustainable energy supply.

At Copenhagen in December, negotiators will have the chance to lay some of the groundwork for a global cap and trade scheme.

Yet the development of a global carbon market depends heavily on the swift implementation of domestic cap and trade schemes across the developed world. So far, progress has been limited, and Governments must pick up the pace here.    

In all these ways, politicians and regulators can help to give the industry greater certainty about the regulatory regime under which it is expected to operate, and ease volatility.

The industry’s contribution

What should we, as energy companies, do?

For all that the current economic headwinds are brutal, the industry must keep one eye on life beyond the recession.  And our focus should be three-fold.

First, with fossil fuels likely to account for more than half of the world’s energy needs in 2050, the industry must continue to make the most of the world’s hydro-carbon resources.

A second goal must be to reduce the carbon dioxide intensity of fossil fuels. That calls for a relentless focus on energy efficiency across our own operations, and rapid advances in Carbon Capture and Storage Technology. 

Last month, Shell announced its decision to join ScottishPower’s consortium to deliver the UK’s first commercial CCS system operating from a coal-fired power station.

A third task for the industry is to help broaden the world’s energy mix.

At Shell, we are growing our natural gas business. We expect that by 2012 it will account for around half of our production.

Natural gas is the cleanest burning fossil fuel, emitting half the carbon dioxide of coal when burned for power generation, for example.

In the area of alternative energy, biofuels will be Shell’s prime focus in the years ahead. We’ve been active in formulating standards for the more sustainable sourcing of fuels. And with partner companies and universities in the US and Europe, we are striving to develop fuels that also use non-food biomass and crop residue.

By maintaining investment in these three areas, energy companies can help to moderate volatility within the sector, and build a path to a secure and sustainable energy future.

Shell’s strategy

Shell has, over the past five years, sustained one of the most ambitious investment programmes in the industry.    

As economic conditions deteriorated, we stuck to a robust and consistent strategy, resisting calls for more share buy-backs in late 2008 in order to preserve a strong balance sheet for the tough end of the business cycle.

We will invest some $32 billion in capital projects this year, and around $28 billion in 2010.

All told, we are investing in long-life projects that will grow our production by 2-3% a year to 2012.

To finance our programme, we have prudently increased our debt levels, issuing some $18 billion of debt so far this year. Gearing has risen, standing at 12.6% at the end of the second quarter. We expect that figure to be in the low-twenties by the end of the year, still within the 20% to 30% long-term average that we regard as acceptable.

We have retained our confidence in the future, and have increased our dividends payments by 5% this year.

Alongside this, we recently announced a major reorganization of the company to increase accountability, sharpen delivery and cut costs.

That’s our strategy. 

And we believe that our investments will carry us into a period of strong growth in 2011-2012, alongside a portfolio containing options for growth until 2020.

More broadly, they will put us front and centre in the transformation of the global energy system.


Yet neither Shell nor the rest of the industry can do the job alone.

Energy companies desperately need a robust financial and regulatory platform from which to make the massive investments that will deliver a secure and sustainable global supply of energy. 

At the moment, the short-term volatility that has intensified during the recession is discouraging investment.

Industry and Government must work together to break the cycle of volatility.  

Throughout the financial crisis, the authorities have shown themselves willing to take bold and difficult decisions on an astonishing scale.

Transforming the world’s energy supply will require policy-makers to take some equally courageous decisions.