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FINANCING THE WORLD

PETROLEUM INDUSTRY
a talk by
John D. Emerson
Chase Bank, New York

Presented at the
1982 OFFSHORE SOUTH EAST
ASIA CONFERENCE

Singapore, February 1982


FINANCING THE WORLD PETROLEUM INDUSTRY

As bankers to the wort~ petroleum industry, Chase naturally has


an interest in the outlook for oil and natural gas. What will
he the demand for oil? How will it be met, and at what price?
And, of course, what will be the future financing needs of the
industrv?

The reoort that ! am Presentinq to vou t~day is by no means the


last word on this subiect. It represents iust one view of the
future, but one that is built around clearlv defined
assumntions. As we make further Progress in modelling the
financial side of the industrv, we will be able to test other
views of the future, which we will present in future rePOrts.

Anv attemPt t~ assess the future financing needs of the


petroleum inoustrv must be set in a soecific framework
reflectina future economic growth, future energy needs and the
outlook for oil supply and demand in particular. These factors
are all linked, althouqh the linkaqe is flexible, not fixed.
For example, it chanqes with chanqes in relative prices, among
oth~r things.
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We believe that the decade of the eighties will see slower


economic growth in the non-communist world than existed between
the end of World War II and the watershed vear of 1973. Rates
of growth will varv in different parts of the world. The
already developed nations on average are likelv to experience
rates of economic growth onlv half as large as the developing
nations. Alwavs assuming, of course, that t1e developing
nations can attract enough investment capital to raise their
Productivitv.

At the risk of oversimplifvinq the issue, economic growth


arises out of the growth of the emploved labor force plus the
qrowth of productivity. We are quite confident that the labor
force will grow more slowly in the eighties than in the
seventies, particularlv in the United States and Europe.
Growth of productivity is harder to predict. The important
inaredients are a skilled labor force and an adequate level of
investment in more efficient industrial processes. During the
Past decade, productivity growth in the United States and
EuroPe has slowed considerably. Correcting this slide will
require that more financial resources be devoted to investment
and less to consumption -- a difficult decision for the
POliticians to make, especiallv in those countries that are
virtual welfare states.
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Our economics department estimates that economic growth during


the eiahties in the non-communist worl~ will average sliqhtly
over 3 percent a vear. The Asian/Pacific area is expected to
oo much better than the average, achieving a rate of growth of
almost 7 percent a year over the decade.

The relat1onshiP of energy use to economic output (Gross


Domestic Pro~uct) reflects a number of factors. Heavy industry
or liaht in~ustrv1 pooulation concentration1 the price ~f

enerqy relative to the other factors of production. It is the


last item that chana~~ so drastically during the seventies.
Prior to the Ar.ah oil embarao in 1973, energy was so cheap that
there was little incentive to invest caoital to use it more
etficientlv. All that chanqed with the quadrupling of o~l

Prices in Januarv 1974, reinforced by a ~rebling of prices


between December 1978 ann January 1981.

The world, and oarticularlv the United States, was caught in


1973 with a caoital stock that was very energy inefficient.

Large cars, poorly insulated homes and industrial processes


that wasted energv. In the vears following 1973, the cost of
energv passed the threshold at which it was cheaper to use more
enerqy than to invest caoital to save energy. Even if energy
costs stabilize, investment in more efficient energy convertors
will continue for the rest of the aecade, at least.
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Among the various sources of energy, oil is the most expensive,


so that in addition to energy conservation a gr9at deal of
substitution is taking place. Oil is being replaced with coal
and natural qas.

~hese two factors, conservation and substitution, will lead to


a fairly flat demand for oil in the eighties. Again, some
reoions will exPerience actual declines, while others, mainly
the develoPing countries, will show a moderate growth in oil
demand. In the non-communist world as a whole, the demand for
oil is forecast to increase from almost 50 million barrels a
nay in 1980, to 51 million a day in 1985 and 52 million a day
in 1990.

At this point, it is worth noting that the growth of demand for


oil would have slowed durinq the seventies and eighties whether
OPE~ had existed or not. Prior to the 1973 embargo, world oil
~emann was growing at about 5 oercent a year. Had that rate of
orowth continue~, deman~ today would have been 70 million
barrels a nay, and bv 1990 it would have exceeded 100 m:llion
barrels a day.

There is no way on earth that such a quantity of oil could have


been supolied. It was inevitable, therefore, that oil prices
had to rise sufficiently to restrain demand and bring it into
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line with available supply. In the absence of OPEC, oil prices


would still have risen raPidly during the seventies. But they
would have risen in a smooth line, rather than in the two giant
steps that occurre~ for political rather than economic reasons.

Before leaving the demand side, let me reiterate that flat real
oil Prices over the decade would be unlikelv to stimulate
nemanc. Prices are already far above the point where greater
use is more economic than investment in qreater efficiency.
Hiaher real Prices over the decade would reinforce the effort
to use oil more efficientlv, lea~ing to lower overall use.

How will the demand for oil be met? Let us divide the supply
sources between non-OPF.C countries and OPEC cuuncries. The
non-OPEC countries tend to oroduce at their full potential.
T~ejr oil is Priced to move. OPEC countries on the other hand
currentlv have 10 million barrels a day of shut-in production.
Some of this is shut in f.or reasons of government policy and is
likelv to remain so. A sufficiently large potential surplus
will exist ~ver the decade, however, for us to designate OPEC
as the residual supplier. A verv important question, of
course, is whether the OPEC nations as a qroup will be the
residual supPlier or whether that role will be left to Saudi
Arabia alone.
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Let me qive vou some ot the numbers involved. The oil supply
from non-OPEC countries is expected to increase from 21 million
barrels a day in 1980, to 25 million a day in 1985 and 26
million a dav in 1990. Most of the increase will come from the
North Sea and Mexico. Of the non-OPEC supply, just under half
will be produced i~ the United States. I am talking now of
crune oil, natural ~as liquids and svnthetic oil from shale,
coal and tar sanos.

Under this scenario, OPEC production of crude and NGL would be


28 million barrels a day in 1980, 26 million a day in 1985 and
the same quantitv, 26 million barrels a d3V in 1990. Bv 1990,
OPEC will still be willing ana able to produce at least 30
million barrels a day. The choice for OPEC producers will be
either tc compete with each other for markets or adopt a formal
or informal Pro-rationinq mechanism. Which will it be? In the
short run, thouah 1985, we believe that there will be
sufficient competition to Prevent anv increase in real oil
Prices. Bevond 1985, some OPEC producers will be forced to
lower production for technical reasons as their reserves are
depleted. This will take some of the pressure off Saudi Arabia
as the supplier of last resort, should thev choose to accept
that role. During the second half of the decade, only the
Saudis will have the production flexibility to turn a buyers'
market into a sellers•market. It is impossible, at this point
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ln time, to be sure about how thev will perceive their long


term interests, both e~onomic and POlitical. It should not be
taken for aranted, however, that the Saudi's will be willing to
cut their Production sufficientlv to support an increase in
real prices.

To sum up on the price outlook. In terms of the OPEC marker


crude, Saudi Arabian liqht~ we believe that the real price, in
1982 dollars, will not exceed $34 through 1985. In current
dollars, that would be about $43 a barrel. By 1990, the price
in current dollars is estimated to be in the range of $65-75 a
barrel. In a huvers' market, other crudes around the world
will have to be aligned realisticallv, from the refiners' point
of view.

This, then, is the general economic and petroleum background


aqainst which we have evaluated the financial needs of the
world Petroleum industrv. In assessing these needs, we have
tried to take account of differences between the United States
and the rest of the non-communist world and of differences
between sta.te owned and operated companies and investor owned
companies.

~he United States petroleum industry is unique in that it


includes, in addition to the maiors, several thousand
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in~eoendent oroducers who are only involved in that phase of


the business and who frequently have diff~rent financial goals
from the maiors.

State comoanies have manv different characteristics, but they


have one thing in common. They are either funded directly by
their aovernments or their funding is government guaranteed.
~hev are not subject to the discipline of the financial
marketolace.

Caoital Exoennitures

·As might be exoected, the greater oart of the financial needs


of the industry are the ca~ital exoenditures required to find,
neveloo and produce crude oil and natural gas, and to
transport, refine and market crude oil and refined products.

Before I get into the numbers, let me stress the role that
.
inflation plavs. The level of inflation that the world has
experienced in the seventies and will probably experience in
the eighties has the effect of more than doubling by 1990 the
exoenditures expressed in dollars of 1980 purchasing power. I
am qoina to give vou our estimates in Constant dollars--dollars
of 1980 ourchasing oower. You can factor• in your own estimate
of inflation.
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Let's consider first the downstream expenditures, expenditures


for evervthinq bevond the production phase. The very modest
increase in oil nemand arounn the world and the existing
surplus refining and transportation capacity means that no
additional expenniture by investor owned companies need be
incurred to expand capacitv. This view is reinforced by the
fact that a number of state owned companies, particularly in
t~e Persian Gulf, are actively adding new ref.ining and
petrochemical capacitv.

Despite the existing surplus of refining capacity around the


worln, however, tite investor owned industry will make
substantial expenditures to upgrade some of the existing
plants. Upqrane them from the point of view of increasing the
flexibilitv to handle a wider range of crudes, and to produce
a hiqher proPOrtion of light pronucts. Prom a long range point
of view both of these objectives are important. World crudes
will tend to get heavier and higher in sulphur in the future,
and at the same time the demand for light products will
increase relative to the heavy oils.

In addition to normal downstream activities, we have included


in this section expenditures for investments outside the
Petroleum industrv. Investments in coal reserves, for example,
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or in coal conversion processes to produce gas or liquids. On


the assumption that oil prices will continue to increase in
nominal terms, we believe that investments outside the
petroleum industry will continue to grow.

This increase in expenditures outside the petroleum industry


offsets the decrease in refining, marketing, etc., so that
there is little chanqe in the overall downstream category. In
constant 1980 dollars, it increases from about $30 billion in
1980 to $32 billion in 1990. Remember, these are expenditures
bV investor owned companies. They do not include new projects
funded bv state companies.

These expenditures for downstream activities are quite modest


compared to the surqe in investment required ~o maximize oil
and qas reserve additions. We have not attempted to relate the
expenditures for exploration and development of new reserves to
future demand and production. All producing companies attempt
to maintain an adequate underground inventory which is
reflected in their reserve/production ratio. If this ratio
drops too low, pro~uction will begin to decline, which in turn
will impact their cash flow. So, as one field declines,
companies like to have another ready to put on stream. In this
dav and age, companies are unlikelv to have more reserves than
thev know what to do with, so thev will keep on looking as long
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as adequate incentives, opportunities and funds permit.

An adequate incentive means an adequate price relative to the


costs, included in which, of course, is the local tax
structure. An adequate opportunity means that governments
around the world are willing to lease sufficient geologically
attractive acreage. Adequate funds means that companies are
left with sufficient profits from existing operations to fund
their new ventures. Each of these ingredients must be present,
if exploration and development of new reserves is to be
maximized. Since each of them depends in large measure on
government action, they are essentially unpredictable.

We are optimistic, however, that governments will create the


riqht conditions to encouraqe the development of hydrocarbon
resources since thev have a strong incentive to do so. In a
small countrv, even monest oil production can result in a great
savinq of foreign exchange reserves, and production in e~eess

of domestic needs can earn sufficient foreign exchange to fund


economic development proiects.

In estimating future expenditures for exploration and


development of oil and natural gas we have taken into account
the number of wells drilled and the cost per well in constant
1980 dollaLs. 3oth of these projections are supported by at
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least ten vears of historical data.

Geoqraphicallv, we looked at eight separate regions and in the


United States we considered the maiors and independents
separatelv. The majors are represented by the qroup of
comoanies that Chase reports on each year in a booklet entitled
"Financial Analysis of a Group of Petroleum Companies". The
indeoendents are evervbodv else in the industry.

The recent drilling surge in the United States reflects mainly


tte activitv of the independents. The number of wells drilled
bv this grouo has doubled in five years, reaching about 70,000
in 1981. In contrast, the Chase group of maiors has shown
little increase in the number of wells drilled. tn 1981, they
nrilled about 8,600 wells, just over 10 percent of the u.s.
total.

In our view, and that of several drilling contractors with whom


we have sooken, the independents may be close to a peak. Much
of the increase in recent years has been in-fill drilling
designed to maximize cash flow. With prices stabilizing for a
while, we believe that drilling by independents will plateau at
about 75,000 wells and then drift down to 60,000 by the end of
the decade. This is still a tremendous number of holes in the
ground. Wells drilled by the majors are expec~ea to increase
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moderately, reaching 10,000 by 1990.

Re~lectinq the fact that they drill most of the offshore and
frontier area wells, the maiors cost per well is c~rrently more
t~an ten times that of the independents. And the gap is likely
to widen, as future prospects become more expensive to work.
These conditions lead us to believe that in constant 1980
dollars the maiors' cost per well will increase at 10 percent a
vear and the independents' at 5 percent a year.

Under this scenario, Exploration and Development expenditures


will triple between 1980 an~ 1990, reaching close to $100
billion in the latter year. Unless inflation moderates
considerahlv, the cost in nominal dollars will be more than
twice as large.

Usinq the same methodology, we have estimated total exploration


and development expenditures in Canada, Venezuela, other
western he~~sphere c~untries, Europe, Africa, Middle East and
Far East.

Total wells drilled in those areas are estimated to rise from


14,000 to 1980 to about 17,500 in 1990. The cost per well
drill~d increases at different rates in different regions. The
average cost, in constant 1980 dollars, increases at 8.5
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Percent a year from $1.8 million in 1980 to $4 million in


1990. These two factors vield total expenditures of $25
billion in 1980 and $70 billion in 1990. Not all of this
investment will be made by the investor owned industry. State
controlled compar.ies will play a role which will vary from one
reqion to another and which we est!~ate will total about $7
billion in 1990, leaving $63 billion to be provided by investor
owned companies.

Pulling together the various pieces: total capital expenditures


bv the investor owned industry throughout the non-communist
world rises from t8 billion dollars in 1980 to 190 billion in
1990. Again rememher, these are dollars of 1980 purchasing
power.

This is the big picture. At this point, I would like to focus


on the area of qreatest interest to you--the Far East area.
Before getting into that, however, let me stress that the oil
industry is trulv an international industry. Throughout its
historv, the industry has used earnings from one region to fund
exploration and development in another. It is vital that this
Process continue: it is vital that governments leave industry
with sufficient profits to fund the development of new areas.

As I mentioned, the Far East is one of the regions we examined


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for our projection of E&P expenditures. In our analysis, this


is a verv larqe region, stretching from India and Pakistan
eastward to Jaoan. From a oroduction point of view Indonesia
is the most important country in the region, accounting for
about nO percent of both crude output and the number of wells
drilled. Capital expenditures associated with the exploration
and development phase of the industrv in the Far East amounted
to about $2 billion in 1980. In constant 1980 dollars, they
are expecten to rise to about $10 billion by 1990.

A new factor will enter the Far East international oil picture
this vear - China. Since relations between China and the west
were normalized in the late-seventies, a great deal has been
learned about oil in China and there has been much speculation
about the future.
I would like to stress the word "international" because oil
oroduction in China is not new. there is a field in Szechuan
Province, in the interior of the country, that was producing
oil and natural gas over 2000 vears aqo, and it is still
oroducinq. Anv estimate of future oil ?reduction, however,
should start with an assessment of the resource base. Such
assessments have a habit of changing over time. Back in the
twenties, geologists wrote China off completely, but then in
those davs, it was said that no oil would ever be found in
Saudi Arabia.
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It is now recognized that China probably has a verv large


Detroleum resource base. Preciselv how large will not be known
for some time, since relative to the size of the country,
little exploration has been done. Using the u.s. style prov~n

reserves concept, China's oil reserves are currently estimat.ed


to be about 39 billion barrels onshore and a similar amount
offshore. The Chinese claim over 100 billion barrels, but
these may include less definitive categories of reserves. When
adequate exploratory work has been done, particularly in the
vast sedimentary basins of western China, the resource base may
turn out to be as hiQh as in Saudi Arabia.

At the Dresent time, crude oil production in China is all from


onshore fielos, althouqh most of them are quite close to
coastal areas. Output has grown ra~idly from about 400
thousand barrels dailv in 1973 to two million barrels a day in
1980. The rate of increase has been slowing in recent years
however, and production may remain flat until offshore
production commences arounn 1985.
Half of the current oil production comes from the Taching field
in the northeast corner of China. The field was discovered in
1959 and for various reasons has been developed very ~lowly.

Pressure maintenance systems were installed early on to


lengthen the life of the field and to enhance ultimate reco,pery
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of the oil in place. Production is from a shallow zone-about


3000 feet-althouqh new drilling is planned to explore the
possibilitY of tapping new reserves at greater depths (10,000
ft) •

Most of the remaininq production comes from the same general


oart of the countrv, but closer to water on the Bohai Gulf.
The Shenqli and ~akanq fields are in this area. Each of these
fields is considered to have reserves on a par with Taching.

All of the oil producen in this northeastern region is hard to


sell on the world market. Although low in sulphur content, it
is verv waxy and has a high pour point such that it solidifies
at normal temperature. These quality problems, however, will
recede if, as seems ~robable, the supply of light crudes
diminishes over time.

Onlv about five t;>erc:ent of China's current product ion comes


from the vast sedimentary basins of western China, but the
Potential is enormous. ~n oil discovery was reported a few
vea:s ago in the Tar.im basin, an area as large as the state of
Texas. As frequently occurs in the world of oil, the area
involved is verv remote and undeveloped, and a 2500 mile
pipeline would be required to bring the oil to the refining and
marketing areas in the east.
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At the present time, there is no offshore production in China,


and little is expected before the mid-eighties. But it could
increase rapidlv thereafter, eQentuallv matching onshore
prod~~tion.

So far, about 70 test wells hav~ been drilled offshore by the


Chinese, and some light oil has oeen discovered off Hainan
istano in the Gulf of Tonkin. ThE~ first offshore area to start
production, however, is expected to be the Bohai Gulf, close to
the Shengli and Takanq fields in the north~ast. The waters
there are shallow and calm.

~he recent seismic work carried out bv the international oil


inoustrv along the Chinese Coast from the Bohai Gulf to the
Gulf of Tonkin has identified 140 structures, some of them very
lar9e. The Chinese government has indicated that it will start
awarding exploration an~ development contracts this sprin9.
This suggests that oil production will start early in the
second half of the decade, reaching one to two million barrels
a dav bv 1990.

On the demand side, China's economy has traditionally been


fueled with coal, but the use of oil is increasing, and it
should continue to grow as part of the modernization pro9ram.
Ten vears ago, the oil sharP. of total energy use was 10
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percent. It is now estimated to be about 20 percent.

A verv rough balance would indicate that the internal use of


oil will reach 2.5 - 3.0 million barrels a day by 1990, leaving
about one million barrels a day for exports. More rapid
increases in production, or a deliberate sacrificing of
internal use could lead to much hiqher exports. Since exports
of oil will play a major role in funding the modernization
Proqram, the Chinese can be expected to maximize them,
consistent with internal needs.

To assist in the nevelopment of their oil industry, the Chinese


have decided to elicit the cooperation of foreign companies.
Two seParate aopro~ches are under way.

(i) Develo~ent of reserves al~eady found: a deal has


alreadv been made with Japan National Oil Company
involving a long-term loan and technical assistanc~.

This type of deal, however, would not suit the private


international companies.

(ii) The Private companies are more likely to be involved


in the exploration and development of new reserves,
Particularly in offshore areas where their technical
skills are in qreatest demand. The specific fo~~ of
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association will need to provide adequate profit


incentives for the companies, suitably disguised to
overcome Chinese idealogical problems. While there
mav be some exceptions, we would expect the caoital
an~ technoloav bur~ens to be assumed by foreigners,
while orovininq the Chinese with opportunities to
learn.

However the deals are financed, we would certainly expect that


exploration and production offshore China will provide work for
service comoanies thouah the nineteen eiqhties and beyond.

I would like to return now to the World Picture. We have


co~sidered in some detail the forecast capital expenditures of
the investor-owned industrv. While these represent the bulk of
the industrv's financial needs, they are not the onlv ones.

Dividends plav an essential role in an investor owned industry,


and in estimatina the quantitv of funds in•rolved, we have
assumed a oavout of 30 percent of net income as dividends. In
the United States, this payout rate, it should be remembered,
is an average of the verv different policies of major companies
a,d indeoendents.

With the rapid increase in recent years in the industry's


- 21 -

recourse to external financing, mostly in the form of debt,


recavment of debt is a significant item in the use of funds.
We have estimated that the in~ustry's outstanding lor.g-term
debt worldwide at the end of 1979 was about $90 billion.
During the oeriod ending in 1990, as much ~s six times this
amount mav be adned in the form of new debt of varying
maturities expressed in constant 1980 dollars. We have assumed
for an~lvtical purooses that one sixth of the debt outstanding
at the end of each vear will be recaid in the following year.

Finallv, with the dollar size of the industrv, as represented


hv the total caoital em~loved, qrowing at more than 8 percent a
vear, regular and sizeable a~ditions to working cacital are
necessarv.
In total, to satisfv the oil production and consumption volumes
alreadv discussed and to develop reserves to maintain
oronuction in the vears following 1990, t~e funds required by
the investor owned petroleum industrv worldwide increase from
about $100 billion in 1980 to 250 billion in 1990. Again,
these are dollars of 1980 purchasing power.

These financial needs are met bv a combination of internal and


external funds, and there is an optimum relationship between
the two. If reliance on debt financing grows too fast, the
rising debt equitv ratio siqnals the financial markets to
- 22 -

downgrade the innustry's credit rating and increase the cost of


borrow1ng. If, on the other hand, the industry avoids
borrowing, it mav needlesslv- raise its cost of capital
. and lose
the OPPOrtunity to make profitable investments.

In our analvsis, we have assumed that the level of capital


investments that I have presented to you will actually be
made, and we have calculated the impact on the industry's
debt/equitv ratio ot two different rates of net income growth.
To Provide some perspective, the Chase group of Companies

worlnwide net income growth in the ten years ending in 1978


amounted to 8.9 percent a year, about equal to the rate of
inflation. In other words, there was no real growth of
earninqs. In 1979 and 1980, earnings surged, of course, under
the influence of hiqher prices.

The first real net income growth that we assumed was 1.5
Percent a vear worldwide. This leans to a level of debt in
1990 hiqher than the industry's equity - in our judgment, an

untenable situation and one that would require a scaling down


of the capital investment program.

At 10 percent a vear -real earnings' growth in the United States


.

and 6 percent a year overseas, the industry's debt/equity ratio


would ~e no higher in 1990 than in 1980, indicating some slack
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in the industrv's financing caoabilitv. Based on the


assumotion's made in this reoort, therefore, it is our
conclusion that to finance the investment proq~am of the
investor-owned industrv that we have postulated and still
maintain orudent debt/equitv ratios will require annual
increases in real net income of around 5 percent.

In an environment of little demand growth and fairly flat real


orices, the industrv will face a real challenge, and
aovernments must stand readv to help if they want their oil and
aas resources to be develooed as raoidly as possible.

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