Desmond King, Managing Director & CEO
Institute of Chartered Accountants in Australia

This speech was adapted from the presentation made to AMCHAM on 8 November 2007.

Is it critical for Australia to retain its oil refining industry because of the importance of petrol and diesel to the Australian economy? Or is oil refining just another Australian manufacturing industry that could exit Australia in the face of global change?

Introduction (Slide 1)

Good morning.

I thank the Institute of Chartered Accountants in Australia for the opportunity to speak today and I thank all of you for taking time to participate in this event.

Energy security and the environment are major long term issues. If you are involved in business or government you will be affected to a greater or lesser extent and you will certainly be affected as an individual.

Petroleum products like petrol, diesel and jet fuel provide 35 per cent of Australia's energy. They are vital to many industries like transport, mining, agriculture, construction and tourism, and everyday commerce. Without them, Australia would literally stop moving.

Already, about a quarter of Australia's petroleum products are imported, three quarters are manufactured in Australia. So I ask the questions:
• Is it critical for Australia to retain its oil refining industry because of the importance of petrol, diesel and jet fuel to the Australian economy?
• Or is oil refining just another Australian manufacturing industry that could exit Australia in the face of global change?

Over the next decades the developing world will have a voracious appetite for petroleum products - there will be fierce international competition to secure those products. That fierce competition has already begun. Without a viable refining industry in Australia, our country will be exposed as the developing world clamours for fuel. Australia has a great future, but only if it can have a dependable fuel supply.

Outline of speech (Slide 2)

To back up my thesis, I will very briefly take you through some of the facts and figures:
• for the world: energy demand growth, oil demand and supply, and refining capacity
• And for Australia: refining, demand growth for fuels, and growing fuel imports.

World energy demand (Slide 3)

Globally, there will be a massive increase in demand for energy and all the services that energy provides - including heating and cooling, cooking, mobility and ultimately employment. This projection from the International Energy Agency shows a 50 per cent increase in energy demand by 2030.

The big news is in share of demand. Developed countries, particularly the United States and the countries of Europe, have essentially flat energy growth. Their share of world energy demand drops from 56 per cent to 40 per cent by 2030. The OECD countries as a whole will, in effect, increase GDP without increasing their energy demand.

China, India and many other developing countries are coming off a lower energy base but growing much faster. Non-OECD countries will increase their energy demand by over 200% by 2030 and their share of world energy demand increases to 60 per cent by that date.

The growth in energy use in the non-OECD is truly daunting, but we in the OECD cannot deny the developing world a better life - and access to energy brings that better life - the life that we in the OECD enjoy today.

World energy supply (Slide 4)

Where will all this energy come from? The International Energy Agency projects that oil dependence will fall, but oil will continue to dominate energy supply, about one third of the total. Gas and coal will continue to supply about one quarter of global energy.

Why is this so? Coal is plentiful and provides electricity, the backbone of industrial development. Oil is quite plentiful and provides mobile energy which is essential throughout the economy. Other energy sources can't be developed fast enough to replace oil and gas by 2030.

Other sources will grow but still supply less than 20 per cent of energy. It will be important to develop a range of new renewable energy sources but these are generally seen as playing a minor role over the next 20 to 30 years. The world desperately needs the development of alternative energy - not to replace fossil fuels over the next 20 to 30 years, but to actually meet the increased overall demand for energy.

Longer term, major changes will be needed in the way energy is produced and consumed. The problem is not really the endowment of resources; it's developing the resources sustainably and delivering them to markets. That is best achieved through competitive markets for investment and trade in energy at the global, regional and domestic levels.

Global oil supply forecasts (Slide 5)

There is a wide range of forecasts for oil supply, as shown on this chart. "Peak oil" forecasters see conventional oil production declining within 10 to 15 years, oil companies are generally more optimistic. Consensus seems unlikely. However, it is most likely the trend will be tighter oil supply and increasing prices, with periods of substantial price volatility.

Even if "peak oil" forecasters are correct, we would be producing about as much oil in 2030 as we do today. Oil is not going away in the next 20 to 30 years as many commentators would have us believe. If peak oil theorists are correct, the challenge is what we need do to supplement conventional oil supply to fill the supply gap.

Resources of oil are extensive but the technological, financial and political challenges of producing enough oil at an acceptable price are daunting.

Oil supply sources (Slide 6)

By 2030, more than half of oil production will have to come from development of existing reserves - a massive capital requirement - and growth in production will have to come from unconventional oil resources and new discoveries.

Large conventional crude oil resources are located in areas that are subject to substantial risk such as the Middle East, Russia, the Caspian region, Venezuela and Nigeria. Other crude oil resources are in difficult environments such as ultradeep water.

Unconventional oil resources are costly and technologically challenging, such as Canadian tar sands, Venezuelan extra heavy oil and US oil shale. Biofuels face major technological challenges to make large scale production sustainable and cost-competitive.

The enormous challenges of finding and developing new supplies of oil today has brought the twentieth century era of cheap oil to an end. As we have seen in the early stages of the twenty first century - the days of US$20 per barrel oil are long gone.

World carbon dioxide emissions (Slide 7)

Supplying oil and other energy to a growing world is a huge challenge - but an even larger challenge is climate change, which requires action to greatly reduce greenhouse gas emissions.

In 1980, global emissions of carbon dioxide were less than 20 billion tonnes, with the developed countries of the OECD accounting for more than half. By 2030, emissions will exceed 40 billion tonnes, with most of the growth in developing countries. However, developed countries will still have much higher emissions per head of population.

The earth may not be able to sustain the increased carbon dioxide emissions from burning fossil fuels - yet it will be reliant on fossil fuels for many years.

That is why carbon capture and storage is so important to climate change policy. While efficiency measures will reduce electricity demand, there can't be a long term future for coal and gas unless power station emissions of carbon dioxide are captured and permanently disposed of.

For oil, action lies more on the demand side, to greatly improve the fuel efficiency of vehicles. In the medium term, diesel engines and petrol or diesel hybrids offer lower grams of carbon dioxide emissions per kilometre. Longer term, low carbon technologies may include plug-in hybrids, hydrogen internal combustion engines, hydrogen fuel cells and pure electric vehicles. Renewable fuels will help cut emissions from the supply side but are likely to play a relatively small role.

While there is no agreed target for reduction in global emissions, a reduction of 50% or more in global emissions by 2050 is commonly suggested, with a greater reduction in developed countries. The changes in energy supply and demand to meet such a target would be - indeed will be - truly radical. We should not underestimate the challenges that are ahead of us.

Global refining capacity to remain tight (Slide 8)

As we have seen, world oil demand and supply will likely continue to grow strongly, even with the challenge of climate change. That means growing demand for refined petroleum products and the refineries to produce them.

New refineries and capacity additions will be constrained by increasing capital costs and tougher environmental requirements for cleaner fuels. As a result, global refining capacity is expected to remain tight. Despite this, there will be strong growth in capacity in developing regions, including the Asia Pacific.

World overview (Slide 9)

To summarise my remarks so far:
• Energy demand will be up 50 per cent by 2030, almost entirely due to growth in non-OECD countries.
• Oil, coal and gas will remain dominant
• Alternatives to conventional crude oil will be required to meet demand growth. Alternatives will not be a net substitute for conventional energy - they will be a much needed addition to conventional energy.
• Oil refinery capacity will remain tight at least in the medium term.

Australian refining industry (Slide 10)

I now want to turn from the world to Australia.

Petroleum products are pervasive throughout the Australian economy. Caltex is in the business of refining crude oil into petroleum products, then distributing and marketing those products at the wholesale and retail levels. We don't explore for oil or gas and we don't produce any. We are an Australian listed company with about half our income coming from refining and half from wholesale and retail marketing.

In 2007 our profit was $444 million on a replacement cost basis. In the case of petrol alone, Caltex's profit after tax was around 1.5 cents a litre compared to the Australian Government's tax at the bowser of approximately 50 cents a litre. Overall, Caltex's has a high volume, low margin business.

Australia's refineries (Slide 11)

Australia has seven major refineries in operation, as shown on this map. In recent times, ExxonMobil closed its refinery in Adelaide and is now importing petrol and diesel mostly from its refinery in Singapore. It also scaled back its refinery in Melbourne to cut the cost of upgrading it to produce cleaner fuels. Caltex has two refineries, one in Sydney and one in Brisbane.

Australian refineries produce about 590 thousand barrels per day of petrol, diesel and jet fuel or about 34 thousand megalitres per year. This is well below Australian demand for these petroleum products, which is about 43 thousand megalitres per year.

The shortfall in refining capacity means imports make up about a quarter of Australian demand for petrol, diesel and jet fuel¹. Diesel is the product in shortest supply, with imports making up about one third of all diesel consumed in Australia.

Petroleum product demand and imports (Slide 12)

Over the next decade, demand for petrol is projected to be fairly flat but demand for diesel and jet fuel is projected to grow strongly at 3 to 4 per cent per annum. Petrol demand growth is reduced by increased fuel efficiency and penetration of biofuels. Diesel demand is closely linked to economic growth and jet fuel to tourism. In 2007, for example, diesel demand in Australia increased by over 6 per cent due to strong growth in the industrial, mining and transport sectors.

Strong growth in demand for diesel and jet fuels means that imports will grow as no new refineries will be built in Australia and capacity increases at existing refineries will be much less than demand growth. One or two less efficient refineries may even close over the next decade.

Imports in 2015 could equal 30 to 40 per cent of demand for petrol, diesel and jet fuel. By 2030 imports could be 50 to 70 per cent of demand².

Regional supply and demand remains tight in medium term (Slide 13)

Economic growth, particularly in Asia, is driving global demand for petroleum products, particularly diesel, and keeping prices for diesel high. It wasn't always like this.

As you can see from the chart, there was excess capacity in Asia in the late 1990s, particularly for petrol. Financial returns were unsustainably low and oil refining in Australia was in dire straits. Since about 2003, Asian demand has been very strong, particularly in China, and refining capacity has been scrambling to catch up.

Despite this, business cycles have not been eliminated and demand will not keep growing forever at a high rate. On the supply side, the prospect of higher returns has induced new investment and by about 2009 it is projected that enough refining capacity will have been added in Asia to bring Asian supply and demand back into balance.

Jamnagar refinery, India (Slide 14)

The new Reliance Petroleum oil refinery at Jamnagar in north-west India will be on stream in late 2008 making petrol, diesel and jet fuel for the export market. Its capacity of about 600 thousand barrels per day will be similar to the total capacity of Australia's seven oil refineries. The new refinery will complement the existing Reliance Industries refinery at Jamnagar, making a total capacity of 1.2 million barrels per day.

Large modern Asian refineries have economies of scale that mean lower unit costs than Australian refineries and higher energy efficiency. Apart from India, there are large oil refineries in Singapore and other refineries throughout Asia and in the Middle East with products for export to Australia.

So how can refineries in Australia compete?

Refining location advantage US$2.88 barrel (Slide 15)

The economics of refining are basically simple. Crude oil is imported in large ships - up to 200,000 tonnes. Petroleum products are imported in much smaller ships - up to 45,000 tonnes.

The key question for refinery viability is whether the landed cost of crude oil in Australia plus refining costs is less than the landed cost of petroleum products. The higher cost of freight for product imports provides a location advantage for Australian refiners.

In 2007, the freight difference between small product ships and large crude oil tankers was US$2.88 per barrel. A barrel is 159 litres. However, this natural protection is eroded by the higher cost of refining in Australia which results from smaller scale, higher capital costs, and better wages. So Australian refining is vulnerable to additional costs not faced by our international competitors.

How do we stay competitive? Not through protection - Australian oil refining has no tariff protection and we don't propose any. Not through subsidies - unlike many industries we don't seek and don't receive financial assistance. Not through regulation - we want a level playing field, not regulatory distortions in our favour.

Staying competitive requires strenuous efforts to improve efficiency and cut costs. It also requires all governments to avoid imposing costs that cumulatively could kill refining in Australia.

Let me give you some examples.

Australian greenhouse gas emissions (Slide 16)

Firstly carbon cost. Total Australian greenhouse gas emissions in 2005 were 559 million tonnes of carbon dioxide equivalent. Of this about 8 per cent was from use of petrol, 8 per cent from diesel and 4 per cent from jet fuel and other fuels. To manufacture these fuels, oil refineries produced about 1 per cent of Australia's emissions.

Under the emission trading scheme proposed for Australia, permits to emit greenhouse gases in a particular year will be auctioned, with the revenue going to the government. Emitters must surrender permits each year equal to their emissions.

However, companies that face import competition from countries that do not impose carbon costs may be classified as "emissions intensive trade exposed" and receive free permits. As Singapore and Indian refineries will bear no carbon costs, Caltex should receive a free allocation of permits for its refinery emissions.

Unless this occurs, up to $1 per barrel of the $2.88 per barrel freight advantage could be eroded. This level of carbon cost would probably make all of Australia's refineries uneconomic and shift production to Singapore, India and other countries that will not bear any carbon costs.

Also under emission trading, the government proposes that Caltex should be responsible not only for our own emissions but also our customers' emissions. At a carbon cost of A$40 per tonne of carbon dioxide, Caltex would have to purchase $1.4 billion in permits annually - then have to increase fuel prices by about 10 cents per litre to try and recover the money. This system would impose a huge financial risk on Caltex far out of proportion to our earnings and financial capability.

Other regulatory issues (Slide 17)

Biofuels. Caltex supports the development of biofuels like ethanol and biodiesel as they may play a significant role in future fuel supply and energy security if costs can be reduced and sustainability issues can be overcome. However, we are concerned at government policies and legislation to mandate the supply and use of biofuels.

Biofuels need R&D for new feedstocks and advanced technology and may warrant some additional transitional financial assistance. However, a sustainable biofuels industry can't be built behind protective barriers.

Environmental requirements. Air pollution is still a major issue and Caltex has invested $500 million to produce cleaner fuels to cut air pollution. Over the period 2007 to 2009 we will spend about $1 billion on various capital projects to improve safety, reliability and production capability and to maintain our refineries. We support expenditure to reduce the impact of our refineries on the air, water and land but such expenditure has to be realistic and spread over a reasonable period - we just can't afford to do everything over a short timeframe.

Fuel price regulation. From time to time, various politicians, organisations and media engage in oil company bashing as a cheap way of gaining public support. Such attacks and proposals for regulation undermine confidence in the industry and ultimately call into question the desirability of investment. Price regulation is also bad for consumers. False perceptions of excessive profits and market power can also constrain political and regulatory ability to rationalise the industry or impose unreasonable conditions on such rationalisation.

Does oil refining really matter? (Slide 18)

Let me wrap up.

• Energy security is an emerging strategic issue for all Australian industry. The energy outlook we face should be a source of concern to everyone. It is essential to Australia's productivity and competitiveness that we build and maintain our energy supply capability all the way along the supply chain from source to end user. Retaining a substantial oil refining capability is essential to Australia's energy security.

• Petroleum product imports are increasing - what level is the "tipping point" for insecurity - 30 per cent, 50 per cent, 70 per cent? Oil will play a critical role in Australia's energy mix for many years. Oil refining is a crucial link in the supply chain and relying on overseas refineries for our petroleum products would expose all industries and private consumers to unnecessary risk. There is a strong case that oil refining in Australia does matter and policies and attitudes need to recognise its vital strategic role in the Australian economy.

• Liquid fuel security can be achieved - but we have to recognise the problem and take it into account when decisions are made on many different regulatory issues. Oil refining is a tough, competitive business and so are distribution, wholesaling and retailing. Shareholders will only continue to support companies that have good short and longer term prospects. These prospects depend at least in part on whether governments and the community at large recognise the importance of the Australian refining industry to our economy.

As I said at the beginning, over the next decades the developing world will have a voracious appetite for petroleum products - there will be fierce international competition to secure those products. That fierce competition has already begun. Without a viable refining industry in Australia, our country will be exposed as the developing world clamours for fuel.

Australia has a great future, but only if it can have a dependable fuel supply to fuel our economy. I believe that if Australian governments ensure that there is a level playing field for Australian refineries to compete against their overseas competition, Australia can achieve a satisfactory level of liquid fuel energy security for the long term. Given a level playing field, Australian refining can play a vital role in fuelling Australia's economy for many years to come.

Oil refining in Australia truly does matter.

Thank you. I would be pleased to take questions.

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¹2006-7 demand of petrol, diesel and jet fuels equals total of sales of 42091 ML plus exports of 1169 ML. Imports of 9565 ML were 22 per cent of demand. Refinery production of petrol, diesel and jet fuel was 34120 ML.
²Demand growth is extrapolated at 0.2%, 4% and 3.5% pa for petrol, diesel and jet fuel. The higher numbers assume one notional refinery closure by 2015 and 2 refinery closures by 2030. These are scenarios, not predictions.