"MARKET UPDATE"
CALIFORNIA PETROLEUM CONFERENCE
BACARA, GOLETA, CALIFORNIA, JUNE 23, 2008

We are a very popular industry at the moment. It used to take me 20 minutes a day to read all the articles on the industry every day. I couldn't even get through all the Wall Street Journal articles this morning in 2 hours.

Historically, we've had 6 recessions since 1970. The average length of recession was 11 months, the longest was 16 months but the shortest was 8 months. Textbooks will tell you that a recession is two quarters of negative GDP growth. An official recession is not just GDP: it is when the government says there is one. My definition is like pornography: I know it when I feel it. And it feels like a recession right now.

Most of our driving today is commuting, driving to and from work. Unemployment rates are most associated with gasoline demand changes. It's different in the regions you live in. In the Northeast, most commuting is by mass transit. In the West, there is very little mass transit, so we are more sensitive to unemployment data.

The unemployment rate is now 5.5%. It jumped up a full half percentage point in one month, though, so it's something to watch. The California unemployment rate is higher than the rest of the nation — it's over 6% today. Part of that is due to the housing market. It's a very, very large part of the California economy. It appears like we're in another bust cycle in the real estate market. Gasoline demand growth is negative in California.

California isn't one single market when it comes to unemployment. In Southern California, it is between 5 and 6 percent. In Northern California, they're approaching 10% in places like Visalia, Fresno, and Stockton. If you live in Northern Californa, you probably already feel this.

I think we're in recession. We're in a mode of cutting back on expenditures. In spite of all the bad news, on a historical basis, it is a fairly mild recession.

This is an election year. The government is interested in us having a smooth rest of the year for election purposes.

What the heck is going on with diesel? Historically, gasoline margins have been 25-30 cents versus crude. Lately, it's been at around 10 cents. The opposite is true for diesel. They are now up around 70 cents over crude.

The answer for what is going on with diesel prices is not what is going on in the U.S. Gasoline demand in the United States was down in the first quarter and it hasn't gone up much since then.

We used to average 200,000 bpd of diesel exports. They are at almost 400,000 bpd of diesel, double the historical average. Where are they going? Primarily to South America. There is a little growth in our exports to Europe. The real picture is what's going on in South America. It's primarily to generate electricity with diesel generators.

South America has had rapid growth which has overwhelmed the electrical grid and the natural gas supply grid. They have had a drought, so they have not been able to get the electricity they need from hydroelectric sources. There has been a spike in the price of minerals. It has created a surge in mining activity which has created a surge in demand for electricity which can only be met by diesel generators.

China has been stockpiling diesel but it looks like they are about done with doing that. And it looks like there may be rain in South America, so that may help solve that problem.

What drives crude prices?

• Market fundamentals. Saudi supply, Nigerian unrest — this is the stuff you see in the paper every day.
• Goverment financial policy.
• Flow of investor funds.

The last two are linked and I think they are responsible for what I've seen in the last few years.

The government controls interest rates. The Federal Funds rate — the rate where banks can borrow from each other — is the one where all the action happens. If that's moving, pay attention.

If they lower the interest rates, which the government has been doing, it creates cheap money. It increases inflation — that is the definition of inflation, cheap money. And it can devalue the dollar.

It tells people that the United States isn't a good place to invest. It causes investors to do things that you may not want them to do.

Investors see lower interest rates. They think there is going to be a recession. They know there is a potential for inflation. What do they do when they see this? They get out of bonds. If you're afraid of inflation, you're going to get out of stocks. You're going to get into commodities. It's a Catch 22 on this inflation/commodity cycle. If you move money out of stocks because you're afraid of inflation, what does it do? It raises prices. And that creates inflation. So you move more money into commodities because you're worried about inflation. It's true of WTI crude. It's true of gold, copper, any commodity.

5 years ago, under $20 billion was invested in commodity funds. Last year, it was $140 billion in commodity funds. That is a lot of money being taken out of stocks and bonds and other investments.

It's not fundamentals. It's the financial market.

It's not just the dollars. A lot of people have started to use the commodities market who have never used them before. In 2000, non-commercial contracts were 13% of the volume. As of March of this year, they are 30% of the volume on the crude futures market. The number of companies participating has gone from 100 companies to 400 companies — and that is just the big players. At the same time, the number of commercial players has been static at about 250. This has been a big shift in who is using the commercial market. It used to be us. We would use it for hedging, which is what the market was designed for. We used to trade about the amount of crude in the world. That makes sense. Deals should equal about crude production. Now we're trading 5X the amount of crude that is produced in the world. That tells you who is involved. It's not us. It's the financial institutions.

Should we do anything about it? After all, they are investors looking for a return. This is a free economy. I try to live by the adage: when in doubt, don't regulate it. But if this is creating a bubble, this is not good. It is hurting everybody. Let's stay tuned. Our Congress is fully engaged in this.

We're all going to change our behavior as much as we can at $4.00 per gallon. We all have incentive to change our behavior.

The turnover rate in the American population is 13 years. Even if you made every new car today fuel efficient, it would take 13 years for it to roll through and give benefit. I think the only thing you could do in a 5 year time-frame is change fuel — for example, move to diesel — or change driving patterns.

We're used to being US-centric. We believe we drive demand. We don't any more.

If crude prices are going to come down, they should come down in the next 4-5 months. We are at the low demand time for crude — most goes to heating. Saudis are putting more physical crude on the market; that should hit around August. We are seeing a decline in demand because of these high prices. If it doesn't come down, then we are seeing something fundamentally wrong. They should come down to the cost of finding future supply and that is around $80-90 per barrel.

The rapidity at which funds can flow into commodities is the same speed they can flow out. It wouldn't take much for the herd mentality in the investment community to say 'I've had a nice run and I'm out of here.'

If we increase the cost of doing business as a refiner, inevitably that gets passed on along the chain. There is no doubt that, like the 1990 Clean Air Act, what they do on global warming is going to set the stage for what they do for the next 30 years. I urge you to get involved. They are talking about some things that, if they are passed, are going to be incredibly expensive. It's an election year, so Congress isn't going to do much from August through the rest of they year. But with the start of next year, I think they are going to come back and climate change is going to be incredibly strong. It can do nothing but change prices.

It is a little embarrassing when you go to Saudi Arabia and yell at them for not producing crude oil when we have billions of gallons of crude oil here that we are not producing. There is a credibility issue coming into play.

It's very tough to turn around that regulatory train. The greenhouse effects of corn-based ethanol are worse than conventional gasoline. If you talk to Air Quality Districts, they know that. But if you ask them to change the requirements, they say there is a federal mandate level that will kick in and require 10% ethanol. We're paying to raise the level of greenhouse gases and then we're going to pay to bring them back down again. If you recognize that ethanol creates greenhouse gases and you want to lower them, cut the ethanol.

I think we're still living in a very volatile world, even with the extra crude on the market.