INTRODUCTION TO OIL AND GAS INDUSTRY AND SUSTAINABLE DEVELOPMENT

Prepared by:
Md Akhir Mohd Sharif
Senior Lecturer, Management and Humanities
For lectures on Introduction to Oil and Gas Industry and Sustainable Development dated 9th March and 13th
March 2015.

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The World is in Still in Economic Turmoil
Economy is the branch of knowledge concerned with the production, consumption and
transfer of wealth. It reflects the condition of a region or group as regard to material
prosperity.
The current global economy has become a level playing field for all countries on account of
the domino effect of globalization. Interaction between the developed and the developing
countries in the field of trade and the exchange of technological knowledge has resulted in all
countries being affected by economic fluctuation anywhere in the globe.
Global economic in 2013 saw that it has yet to shake off the fallout from the crisis of 2008/09.
Global growth dropped to almost 3 per cent in 2012, which indicates that about half a
percentage point has been shaved off the long-term trend since the crisis emerged. The
slowing trend will likely to continue. Mature economies are still healing the scars of 2008/09
crisis. The emerging markets did not pick up the slack in 2012 and will not do so in 2013.
Uncertainty across the regions; from the post-election fiscal debate question in the United
States to the Chinese leadership transition and reforms in the Euro Area, will continue to have
global impacts in sluggish trade and tepid foreign direct investment.
In 2007, the US sub-prime crisis caused a financial turmoil in the US which affected the world
over. What happened was in Year 2000 the US effected a low interest rates policy for easy
credit and cheaper loan to create a housing boom. By 2007, the sub-prime crisis led to a credit
crunch causing the housing bubble to burst. Inability to service the housing debt led to a
systematic financial meltdown (where financial asset suddenly lose a large part of their
original value) as credit crisis deepened and spread globally.
The deepening financial turmoil was further aggravated by surging food and commodity
prices and oil prices hike in 2008. The 2007/08 economic environment saw the rising cost of
doing business, declining business sentiment, lower purchasing power and declining
consumer confidence.
The year-on-year downward spiral of the economy resulted in a loss on financial assets, credit
difficulty, rising unemployment, elevated inflation, plunging commodity and oil prices, wealth
and demand destruction, declining corporate earnings, rising bankruptcies and insolvencies,
contraction in gross domestic product (GDP).

The year 2011 has been a roller coaster ride in the world economy. It began with the Arab
Spring which is the power of collective action inspiring a suppressed generation across Arab
nations. Elsewhere, Japan was stricken by successive disasters, the tsunami followed by
earthquake and Fukushima nuclear disaster.
Europe saw the government debt crisis which saw political leaders in Italy and Greece were
ousted from office for failing to adequately manage their nations finances. German
Chancellor Angela Merkel called the crisis Europes worst crisis since the Second World War.
Many doubts have been raised about the future of Chinese economy. Some say the Chinese
housing market is a bubble waiting to burst, while others point out that Chinas inflation and
overdependence on exports would eventually spell doom for its economy.
In 2014, the global economy currently faces a new threat from an old enemy: oil. The jump in
price came with the crisis in Iraq; the worlds second largest producer after Saudi Arabia,
causing oil price to spike. Brent crude, the benchmark for the industry, reached $115/barrel
recently. A strong and sustained recovery seems unlikely as long as oil is above $100/barrel.
The rule of thumb indicates that every $10 increase in the price of a barrel of oil ends up
reducing global growth by two-tenth (20%) of a percentage point.
The World Bank on 10 June 2014, cut its outlook for 2014 global growth to 2.8% from 3.2% in
January 2014. Beyond a certain point, higher oil prices become a major constraint on global
economic activity, particularly if the price reflects supply problems. Energy importers such as
China and Japan would suffer the most from any jump in price, though exporters in the Middle
East would benefit. The Iraq and Ukraine crises most likely add $10 to $15 to the price of a
barrel of crude.
The Importance of Oil
Oil is the raw material that makes possible the functioning of nearly every component of the
worlds economy, directly or indirectly. It provides the greatest power supply to the world,
far more than any other resources. Oil powers industries, heats buildings and provide the raw
material for plastics, paints, textiles and other materials. The world has staked the entire way
of life on this non-renewable resources that is depleting. One would be hard pressed to find
a substance or phenomena in world history that has held a comparable position as that of oil.
Oil economic plays a very significant role to the world economy. Higher oil prices directly
affect the cost of gasoline, home heating, oil, electrical and manufacturing power generation
and practically increase the cost of everything, especially food. That is because a lot of food
costs depends on transportation. High oil prices will ultimately increase inflation if
productivity does not increase. Inflation is a rise in the general level of prices of goods and services
in an economy over a period of time. When the general price level rises, each unit of currency buys
fewer goods and services. Consequently, inflation also reflect an erosion in the purchasing power of
money.

Oil is both the lifeblood and the poison of the global economy. For all the talk of the green power, it
is the black gold that still drives the economic cycle and the key to prices. A rising oil price is both
deflationary and inflationary at the same time; a poisonous economic mix.
Inflationary is a sustained increase in the general price level of goods and services in an economy over
a period of time. It can be defined as too much money chasing too few goods. When the general price
level rises, each unit of currency buys fewer goods and services. Deflationary is a decrease in the
general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a
negative inflation rate). Deflation increases the real value of money the currency of a national or
regional economy. This allows one to buy more goods with the same amount of money over time.
Ever since the oil price shocks of the Seventies, oil has had an unerring ability to play havoc with the
world economy. This should not entirely surprise, for oil is the basic feedstock, or energy source, for
much of todays economic prosperity and wealth. Without it, we would still be manually drawing
water from well and stream, or riding to market in a horse and cart. For all the well-intentioned talk
of de-carbonization, oil remains the lifeblood of most gainful economic activity. There is no chance of
that changing in the foreseeable future.
Hydrocarbon have become a key driver of the economic cycle itself. If the price goes too high, it will
depress the economy while simultaneously adding to inflation. More money spent on oil means less
money for spending on everything else. The reverse effect is a weakened demand will cause the price
to start falling, at which point oil becomes a powerfully reflationary force. Over the past decades
however, this pattern has changed. Fast growth in emerging market occurred despite economic
stagnation in high income nation with very high oil prices scenario. OPEC has also got better by
manipulating supply to sustain prices.
At $100 a barrel, oil can act as a drag on global growth. Worldwide economic activity was already
weakening in early pre-crisis days in 2008, when oil breached $100 a barrel. Oil then slumped with the
crash but rebounded to $100 in 2011, hampering recovery.

Malaysian Economy How Vulnerable Are We?

The effect of globalization has made economy of any country connected with that of another, both
near and far. Our local grocery store is now affected by economic upheaval in the USA, Europe, Japan
and China. We are no more in silos but interconnected in a global economic web.
Possible downside risks for Malaysia as the economy continues to brace external challenges, political
uncertainty and inflationary pressure include amongst others:

rising inflation e.g. increase food prices

falling commodity prices
declining industrial productions
declining exports
plunging consumer confidence
capital investment flight

Fortunately Malaysia is also an oil producing country and this has had an advantage in sustaining its
economy. However, Malaysia is overly dependent on oil revenues. About 57% of the Governments
revenue is contributed by the petroleum sector (2008). With the depleting hydrocarbon resources,
other form of revenue generating alternatives need to be developed and quickly.

The Malaysian government policy on subsidy also distort the economy and this inhibits the building of
resilience and competitive industry. The inefficient utilization of energy further adds to Malaysias
vulnerability.
Oil Prices: Trends, Key Drivers and Outlook
From the analysis of the global economy and the importance of oil in everyday life, it is clear that oil
economics is critical. The basic foundation of demand and supply determine the oil price. But, it is the
consequence effect of that oil price that can make or break a nations economy.
Crude oil prices measured the spot price of various barrels of oil, mostly either the West Texas
Intermediate (WTI) set at New York Mercantile Exchange or the Brent Blend set at the Intercontinental
Exchange in London or the OPEC Basket, which is an average of the prices achieved in all OPEC
countries and is managed from the OPECs headquarters in Vienna.
WTI crude oil is of very high quality because it is light-weight and has low sulfur content and often
referred to as light, sweet crude oil. In June 2014, WTI is selling at $105 per barrel. Brent Blend is a
combination of crude oil from 15 different oil fields in the North Sea. It is less light and sweet than
WTI. Brent is indexed at $113 per barrel in June 2014. Both are excellence for making gasoline. NYMEX
(New York Mercantile Exchange) is where the major oil trades take place. Oil futures is the value of a
1,000 barrels of oil, usually WTI at some agreed upon time in the future. NYMEX hence gives a forecast
of what oil traders think the WTI spot price will be in the future.
The rest of the worlds oil will be pegged against this marker crude oil. Spot price is the price that is
quoted for immediate delivery, normally one or two business days from trade date. This is in contrast
with the forward price where contract terms (price) are set now, but delivery and payment will occur
at a future date. A barrel of oil is equivalent to 42 gallons or 159 liters (106 bottles of 1.5-liter mineral
water).

How Does Oil Impact the Economy?

Three major areas of economic consequences arising from oil to the economy are inflation, consumer
spending and auto sales.

Oil Prices History

Like prices of other commodities, the price of crude oil experiences wide price swings in times of
shortage and oversupply. The crude oil price cycle may extend over several years responding to
changes in demand as well as OPEC (Organization of Petroleum Exporting Countries) and non-OPEC
supply. It is also impacted by geopolitical events, supply demand and stocks as well as NYMEX trading
and the economy.
The price of oil has had an unnerving ability to blow up the world economy, and the Middle East has
often provided the spark. The Arab oil embargo in 1973, the Iranian revolution in 1978-79 and Iraqs
invasion of Kuwait in 1990 are all painful reminders of how the regions combustible mix of geopolitics
and geology can wreak havoc. It is the interplay of production among the Arab oil producers that cause
the volatile swing of oil prices since the Middle East and North Africa produce more than one-third of
the worlds oil.

In 2011, Libyas internal crisis flared up oil price of Brent to $120 per barrel until the promise of more
production from Saudi Arabia managed to push down the Brent price to $116. Such a scenario has
two big risks: a serious supply disruption or even the fear of it could send the oil price soaring and
secondly dearer oil could fuel inflation.
Todays oil market has plenty of buffers. Governments have stockpiles. Commercial oil stocks are more
ample than they were when there was the oil crisis in 2008. The Saudi Arabia, the central bank of the
oil market, technically has enough capacity to replace Libya, Algeria and other small producers.
The oil industry is extremely complex: getting the right sort of oil to the right place at the right time is
crucial. Even without a disruption to supply, prices are under pressure from the gradual dwindling of
spare capacity. With the world economy growing strongly, oil demand is far outpacing increases in
readily available supply. So any jitters from the Middle East will accelerate and exaggerate a price.
It is some comfort that the world economy is less vulnerable to damage from higher oil prices than it
was in the 1970s. Global output today is less oil-intensive. But less vulnerable does not mean immune.
The biggest risk in emerging world is inaction. Dearer oil will stoke inflation, especially through higher
food prices. Unfortunate, too many governments in emerging markets have tried to quell inflation and
subsidize the price of food and fuel. This action dull consumers sensitivity to rising prices as well as
costly to the government concern.
From 1958 to 1970, the prices of crude were stable around USD3 per barrel. OPEC was formed in 1960
and instituted price control mechanism through limitations on production. OPEC then through the
unintended consequence of war obtained a glimpse of its power to influence prices.
The first oil price spike was in 1973 following the Yum Kippur War when Israel was attacked by Syria
and Egypt. The reaction on the support of Israel by the United States led to the Arab Oil Embargo
which cut oil supply by 7% and caused oil prices to be around USD12 per barrel.
In 1979 and 1980, events in Iran and Iraq led to another round of crude oil prices increases. In 1979,
the Iranian revolution cut production from Iran to between 2.0 - 2.5 million per day increasing the
price to USD15 per barrel. Then, in September 1980 Iraq invaded Iran and as a consequence,
worldwide crude oil production was down by 10% and price spiked to USD36 per barrel.
OPEC has seldom been effective at controlling prices. Members production quota was not strictly
followed as Member County has individual interest and objective. Saudi Arabia being the biggest oil
produces can act as controller on prices. During the 1979-1980 period of rapidly increasing oil prices.
Saudi Arabia asked for production discipline from OPEC member countries but was not abide by. Oil
consumers began taking reactive initiatives against higher oil prices that resulted in more energy
efficient processes. These factors along with a global recession caused a reduction in demand for oil
which led to lower crude prices from 1990 to 1997.
Higher oil prices in 1970s and 1980s triggered increased exploration and production activities. New
discoveries continued to come online resulting in higher supply in the face of lower demand.
Oversupply, lower demand and failure of OPEC to control price resulted in crude prices to fall.
The price of crude spiked in 1990 with the lower production, uncertainty associated with the Iraqi
invasion of Kuwait and the ensuing Gulf War. The price of oil was then USD27 per barrel.

The Asian economic crisis in 1997 further lower oil price to USD12 per barrel. The impact of the
economic crisis in Asia was underestimated by OPEC. OPEC increased its production by 10% despite
the decline in Asian Pacific oil consumption due to Asian economic crisis. The combination of lower
consumption and higher OPEC production sent prices into a downward spiral through 1998.
On March 19, 2003 the United States invaded Iraq. With an improving economy, United States
demand was increasing and Asian demand for crude oil after the Asian crisis was growing at a rapid
rate. The loss in supply from Iraq led to the world facing crude shortage. This increased the oil price
to USD40 per barrel.
Other major factors contributing to higher prices included a weak dollar and the rapid growth in Asian
economies and their petroleum consumptions. The 2005 hurricane Katrina and United States refinery
problems associated with the conversion from MTBE to ethanol as a gasoline additive also contributed
to higher prices to USD65 per barrel.
Speculation in the futures market was certainly a component of price increases over the last decade.
Over the last decade the number of futures contracts on NYMEX increased at over ten times the rate
of increase of world petroleum consumption on all sort of speculative world events. This has resulted
in oil prices going on a free upward spiral breaking the USD100 per barrel mark in January 2008 and
hitting the highest price of USD147 per barrel on 11 July 2008. Most analyst now realize that the
sudden increase in oil price was due to investment by hedge fund and future traders.
Crude oil price plummeted to a low USD30 per barrel by December 2008. This precipitous decline in
oil prices to below USD70 per barrel was primarily due to the demand destruction as a result of the
current global downturn. The oil price will fall in time of recession. It then increased steadily to hover
around USD70 USD80 per barrel until late 2010. Energy Information Administration (EIA) that
oversee energy consumption in the United States recorded prices of USD93 per barrel average in 2011.
The outlook for up to end 2012 is projected for the oil price to rise up to USD99 per barrel.
Key Drivers on Oil Prices
The price of oil does not always feed through the gas stations prices. Buyers of oil for physical delivery
rarely pay the price listed on the WTI index or the Brent crude index. The price of oil is the price of a
commodity different from gasoline that you fill your car with; it is in fact crude oil. Crude oil is the base
product that gets processed into gasoline at the refineries.
Refining capacity, politics, transportation cost, geography, supply shocks, weather and taxes will result
in varying prices of pump price of gasoline regardless of crude prices. Further, deal-making, contract
conditions, side benefits and commercial interest override all other factors when setting the price for
individual oil supply contracts.
A combination of traditional drivers namely geopolitics, supply/demand and environment and new
market fundamentals of financial economics, rising cost and speculation have led to oil prices rally
from 2000 of USD3 per barrel to mid-2008 of above USD100 per barrel.
Continued geopolitical instability and heightened security concerns particularly in major oil and gas
producing countries such as Iran, Iraq, Libya, Kuwait and Nigeria add jitters to the global market. From
the history of oil prices above, the spike in price occurred in the event of geopolitical conflict such as
the Yum Kippur War in 1973, the Iran - Iraq War in 1980, the Gulf War in 2003 and will be worst off if
the countries involved are oil producing countries.

The basic economic foundation of supply and demand determines prices. OPECs spare capacity and
discipline among its member countries on production quotas can play a major impact on the
movement of oil prices through demand and supply mechanism. Unfortunately, OPEC is not very
effective in implementing this mechanism due to differing interest of its members.
Environmental factor that drive oil prices include technology, political relationship, experienced
personnel, environmental protection and economics in the high-risk pursuit for oil.
One new market fundamental that drives oil prices is financial economics namely the hedge fund.
Based on past trend, the USD has a strong inverse relationship with oil price movement. Precipitous
decline in the USD leads financial investors to excessively switch into commodities trading, particularly
crude oil, but as commodity prices fall, the USD exit commodities into safe haven such as treasuries
and bonds which has no or lower risk. The switching between USD and commodities has its effect on
the oil prices.
Rising Cost particularly in upstream activities of exploration and production further drive oil prices.
Exploration now goes to remote areas, deep sea offshore exploration which requires high cost. The
need to maintain the environment in the face of global warming further add to the cost.
Finally, the speculation played by oil market traders who strive on speculative futures trading and
inflates the oil price premium as they leverage on negative sentiment and supply uncertainty. The
share of oil futures contracts controlled by speculators at NYMEX has increased significantly.
Speculation raises a premium of between 40% and 60% to the total crude oil price per barrel. Excessive
and uncontrolled speculation may lead to further price-distortion in the oil markets.
Countries that produce more oil than they consume, like Saudi Arabia and Russia wants the oil price
to go up, while countries that consume more and produce little, like Italy and Japan, like price to go
down. US in the general economic interest would like for oil prices to be low but a low oil price would
damage large American corporation that have invested a lot in influencing the political agenda. The
contradictory need on how oil prices should be causes politics to play a major role in the price of oil.
Petrodollars Curse or Windfall?
The availability of oil reserves to a nation is a blessing. The country will normally thrive on the oil
revenue and has the ability to sustain its economy vis-a-vis the global economy. However, oil revenues
can lead to a curse or windfall depending on how it is being managed.
The Oil Curse is the mismanagement of oil revenues, either for personal gain or lack of transparency
in its utilization. This will lead to deplorable state of economy and society, and may trigger internal
strife and social conflict.
Nigeria is a country where petrodollar is seen as oil curse. Oil exploitations and export revenues have
resulted in conflicts, corruptions, environmental degradation and deepened poverty which lead to the
so-called resources curse.
The Oil Windfall is a proper management and utilization of oil revenue with the utmost accountability
and transparency. Oil revenues are channelled towards development projects, infrastructure and
facilities and other related socio-economic activities that will create a better life for the people and
the nation.

Norway is a country that has prudent utilization of its oil revenues via the Petroleum Fund which has
made Norway one of the leading examples of the best practices in economic management. It uses the
oil money well and does not face such issues as chronic unemployment, high inflation and huge
national debts.
Another country that has experienced both faces of petrodollar is Angola. Angola is a country that has
been identified as the 7th fastest growing economy in 2011 by the International Monetary Fund (IMF).
Blessed with abundant supply of crude oil, it was able to turn around the petrodollar from being oil
curse to oil windfall. Not long ago, Angola was locked in a civil war but today a complete role reversal
has happened. Backed by Chinese money, more Angolan are returning home, number of companies
in Angola increases with Portuguese immigrant said to have grown exponentially over the past five
years.
The Deepening Global Economic Crisis: Impact and implications
In 2012 emerging economies slowed in growth by 1.3 percentage points on average, partly as a result
of slower export growth and partly because several of them have been growing above trend. The
greatest challenge for the global economy in this slow growth environment is to raise productivity
without losing job opportunities for the millions who are looking for reasonably paid jobs to support
their living standards.
The deepening financial meltdown weighs down heavily on the economy, business and the people
resulting in a recession and synchronized global slowdown.
Business and Industry
declining business sentiment
wealth erosion
demand destruction
higher risk premium
credit and liquidity squeeze
increasing cost of capital
projects become uneconomic
declining corporate earnings and lower margins
bankruptcies and insolvencies
mass exodus of funds from commodities and equities markets into treasuries/bonds (no risk
investments)
mergers and acquisitions intensify
Macro-economy
contracting/declining gross domestic product (GDP) growth
wealth and demand destruction
lower energy, food and commodity cost
easing inflation expectation
rising unemployment
credit and liquidity squeeze
Consumer at Large
lower purchasing power
declining consumer confidence
not spending but savings conscious

Economic Impact on Oil and Gas Industry

The slow economic growth will also impact the oil and gas industry along the value chain of exploration
and production, oil, gas and petrochemical. The four value chain will be affected by:
more industry consolidations via merger and acquisitions (M&A)
Higher risk premium on supply chain and counter-party risks.
Projects become uneconomic with delay and postponement.
tighter lending and borrowing criteria
waning interest in clean technology and unconventional oil development
Oil, gas and petrochemical will also be affected by:
demand destructions
sharp and precipitous decline in prices
margin erosion/squeeze
Oil and petrochemical will further be affected by inventory build-up/tank-top/supply surplus and the
possibility of plant shutdown/scale down operations.
Exploration and production as well as oil will face declining in oil prices, less protectionism, market
liberalization and more access to resources.
Challenges to Oil and Gas Industry
Oil being significant in a nations economy has to overcome all the challenges in the face of global
economic slowdown.
Key issues to oil industry evolve around growth, costs and gaps in technology and skills. It has to
continuously strive for new resources, manage escalating costs, develop human capital and talent and
progress on applying technology as a competitive edge.
Besides, oil and gas industry faces myriads of issues and challenges from many fronts such as
geopolitical where uncertainty and heighten security is of the utmost concerns, environment where
there has been much concern on climate change and global warming, energy versus food security,
capacity constraints which see decline in oil production, reserves depletion and thin spare capacity as
well the need to have enabling technology that can overcome difficult geology, operating
environments and unconventional resources.

Riding Out the Current Economic Crisis

How do oil and gas industry ride the current economic crisis in order to remain relevant as the
backbone of the nations economy?

Adopt a defensive strategy by improving/optimizing cost/margin, review contract and

procurement strategy or protect market share.
prudent and comprehensive risk management and mitigation
Strategize for the coming economic upturn by building and pursuing strategic alliances and
collaborations or through opportunistic mergers and acquisitions.
Operational excellence through facilities reliability and efficiency.

At the corporate industry level, steps must be taken to pursue a highly competitive in an uncertain
business environment. This has to be complemented with the government of the country providing a
conducive environment and the appropriate network globally.

June 2014

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