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Energetic Markets: Oil and Gas Will Swing Again
Charles Kohlhaas
THE NATIONAL INTEREST
Special Energy Supplement
Winter 2003/04
The global economy is entering a period in which demand
for oil will exceed supply for the first time. Several
economic and political trends are simultaneously
converging that indicate the international oil and
natural gas markets are about to experience a major
restructuring process. This occurs at the same time that
international political developments are establishing
new objectives for U.S. energy policy and introducing
new geopolitical dimensions to America’s foreign oil and
gas supplies. It is therefore imperative to examine some
of the salient features of these changing conditions.
Not only does the United States remain dependent upon
foreign oil, but North American natural gas production
is declining at a time when demand for natural gas is
rising. The U.S. is set to become a net importer of
natural gas on a significant and sustained basis for the
first time. This is cause for concern, especially
considering that the Middle East, the largest regional
supplier of oil to the international markets, is in
turmoil—even by Middle Eastern standards. Iraq supplies
much less oil to the international markets than before
the war, while widespread adversarial attitudes to the
United States are developing in other Islamic states.
Continuing instability in the Middle East and Southeast
Asia threaten secure access to these regions’ large oil
and gas supplies. Latin America, a major supplier of oil
to the United States, is in political and economic
trouble. The most promise appears to be Russia, the
world’s largest natural gas producer and the second
largest oil producer, which is planning to increase its
production and enter new markets.
Compounding the problem of threatened oil supplies is
rising demand, which creates incentives to develop
sizeable new international supplies of oil and gas in
non-Middle Eastern locations. This process requires
large investments and explicit contracts between
investors and suppliers that establish delivery volumes
and prices. Achieving these contracts will require
America’s concerted diplomatic effort but will have the
effect of solidifying long-term relationships with new
international parties—most importantly, Russia. Such
contracts (and the new relationships that sustain them)
could very well help the United States achieve some of
its emerging geopolitical objectives.
Why Hydrocarbon Prices are Rising
The mechanisms that keep oil and natural gas prices low
are breaking down. In the case of oil, the marginal
pricing system of the New York Mercantile Exchange (nymex),
in which the price of small amounts of a commodity
determines the price of the entire commodity, kept oil
prices at low levels and gave world economies the
benefit of cheap energy for a period of economic
expansion during the 1980s and 1990s, a period of
surplus oil-production capacity.1 Such a price
system is efficient for keeping prices low during
periods of surplus, but it does not offer a return on
sunk costs. It does not, therefore, attract investment.
New sources of oil supplies typically require large
up-front capital investments, which were not forthcoming
during this two-decade period. The domestic oil industry
and overall worldwide activity contracted by about 75
percent in the late-1980s, and new supplies were not
developed. While the large surpluses that were
previously available are now gone, investors have been
driven from the business, and exploration and producing
companies have not generated capital for re-investment
in new fields and sources of supply.
Marginal pricing is also efficient at increasing prices
during periods of shortage, as we are now beginning to
experience in the oil markets. Buyers bid prices up to
the limit they can pay for the oil or gas and still stay
in business. Worldwide demand is growing slowly and will
increase as economic growth resumes. Supply shortages
are thus expected to become more frequent and severe
over the next few years, creating a general trend of
higher prices if new supplies are not developed.
Although prices will trend upward, investors in large
projects will be discouraged by knowledge that new large
supplies will cause price drops and increased
volatility. Without investment, the upward price trend
will accelerate and present an ever-increasing
constraint on economic growth.
Natural gas prices are also rising, but for different
reasons. Because of the difficulty and high cost of
transporting natural gas, it was traditionally used only
in areas where it was produced or could be transported
cheaply by pipeline. The U.S. national pipeline network,
interconnected with Canada’s, allowed for gradual
expansion of natural gas use in North America. Because
gas is a clean-burning fuel, compliance with clean-air
regulations dictates that nearly all new U.S.
electricity-generating plants be gas-fired. In addition,
most new residential and commercial structures now use
gas for heating. But, because environmental
considerations severely restrict gas-well drilling,
declining production and increased demand have thus
combined to cause domestic gas shortages and rapidly
increasing prices.
“Demand destruction” is becoming the mechanism for
balancing gas supply and demand. Residential and
commercial users are not often in a position to switch
to other fuel sources (e. g. coal-fired furnaces or
generators) and so have no option except to pay higher
prices for gas and electricity. Shutting down industrial
activity, with resultant unemployment, is not a
desirable situation for an economy attempting to recover
from a slump. Gas prices are determined by trading on
the commodity market and exhibit the same volatility
and sensitivity to small changes of supply and demand as
oil prices.
Prospects for the Future
Only by opening new sources of oil and gas supply can
shortages be alleviated. This, however, will require
large investments in foreign countries, some of which
are neither very stable nor friendly to the United
States. The need to attract this investment will lead to
restructuring of the price and market systems worldwide
for oil and domestically for natural gas. Large new oil
supplies can be offered to customers with long-term
contracts at prices that will offer attractive returns
to investors but less than those currently available
with marginal pricing in the traded markets. The current
marginal pricing system is incompatible with the
investment requirements of the industry. Investor
requirements will dictate that new oil supplies will be
subject to long-term contracted prices similar to
current European gas purchase contracts.
The same is true for Liquefied Natural Gas (lng),
which can be easily transported anywhere in the world
and therefore imported and sold profitably at prices
lower than current U.S. natural gas prices.2
Foreign natural gas can be imported to the United States
as lng at
prices ranging from about $3.00 to $4.00 per million
British Thermal Units, which is roughly equivalent to
the heating value of one thousand standard cubic feet of
natural gas. With recent U.S. gas prices ranging from
$4.50 to $6.00,
lng has become economical to import.
There is still work to be done, however, to make this a
reality. Large up-front capital expenditures are
required for field development, liquefaction plants,
loading facilities, special tankers to transport the
liquefied gas at -260 degrees Fahrenheit, unloading
facilities, plants to gasify the
lng at the
point of import and distribution systems to local
markets. Nonetheless, several companies are
rehabilitating
lng re-gasification plants in the United States
and have announced preliminary plans to expand existing
facilities or build new ones. In addition, several
European countries have recently expanded
lng
imports. The entry of the United States, the largest
user of natural gas with a rapidly increasing demand for
imports, into the world
lng market
will have a profound impact on the
lng supply
system.
As
new supplies are developed, long-term contracts will
quickly displace traded oil and gas in the markets
because of their price advantage. As these contracted
volumes become a larger part of the overall supply they
will become a flywheel on the overall market, damping
volatility and driving out high-cost production. Thus,
marginal prices will be used only for marginal volumes
to adjust supplies for short-term market fluctuations.
Long-term prices (and supplies) of oil and natural gas,
however, will stabilize.
Russia : The Joker in the Deck
Development of additional sources of oil and gas,
however, cannot be expected to proceed smoothly. There
are abundant deposits in places throughout Russia, Latin
America, West Africa and the Middle East. Yet, these
locations are characterized by unattractive fiscal and
contract terms, unsafe and unattractive working
conditions, political turmoil and anti-American
sentiments. Bolivia just cancelled a project to supply
lng to the
west coast of the United States, and its President
resigned in response to anti-American demonstrations.
Other projects in the region are on hold. Promising
reserves in Indonesia are imperiled by political
instability in a country that has had four governments
in five years and where terrorists are becoming more
active. Environmental objections and other permitting
difficulties will delay, possibly defeat and certainly
increase the cost of developing receiving facilities in
the United States for oil and
lng
imports.
Russia, the world’s largest gas producer and second
largest oil producer, is the wild card in any global
re-alignment of political and economic power and in the
oil and gas markets. Its resources rival those of Middle
Eastern countries, and oil and gas production drive
Russian economic growth and political stability. It has
close economic ties to Europe and is seeking to expand
them. (Germany is the largest foreign investor in
Russia, and France is its largest source of foreign
income.) Many Europeans believe that a combination of
European industry, technology and capital with Russian
resources (including military) can create a bloc with
the economic and political strength to rival the United
States. As could be expected, the apparent Bush
Administration disdain for Europe is only serving to
strengthen such designs.
Russian interests, however, extend to areas other than
Europe—the Far East and the Islamic world, for
example—and Russian President Vladimir Putin shows a
preference for maintaining his freedom of action on the
international stage. This helps explain Russia’s growing
interest and desire for participation in the
Asia-Pacific region. Writing in the Wall Street
Journal, Putin outlined his plans for a new energy
structure in the Asia-Pacific region, and above all in
East Asia, through the creation of a system of oil and
natural gas pipelines and tanker deliveries of liquefied
natural gas from the eastern areas of Russia which have
considerable hydrocarbon resources.
Significant Russian entry into the economies of the
Asia-Pacific region with development of a new energy
structure can be expected to have significant influence
on worldwide markets. Russia obviously intends to
develop a position as a major oil and gas supplier to
the region as a political tool, as well as to further
its own economic development. The United States should
actively encourage and assist this process, for it is an
opportunity to establish a strong presence in the
Russian economy, the largest market in the region.
The major constraint on the growth of Russian oil and
gas production nationwide is current pipeline export
capacity, and several expansion programs are planned.
Asian Russia currently has almost no export capacity,
although proposals are under review for a system of oil
and natural gas pipelines to Pacific export points. Vast
potential reserves exist just northwest of Lake Baikal
in the Irkutsk and Yakutia regions. These deposits are
at the eastern end of the current Russian pipeline
system, but the most desirable market for oil and gas in
these areas lies farther east with the large and growing
economies of China, Japan, South Korea and the United
States, as well as other Southeast Asian countries.
In
an attempt to expand into these markets, the Russian oil
company yukos
has proposed an oil pipeline to China, and
bp plans a
gas pipeline along the same route. Both could be built
in about two years. But, while both companies have
already committed reserves for transport to the Chinese
market, neither has received Russian government
approval. The government-owned pipeline companies have
proposed lines to the Pacific that would be much longer
and larger, provide more capacity and cost a good deal
more. The private company lines to China would serve one
market. The Pacific lines would put Russian exports in
large quantity into the world market with flexibility as
to destination. Putin’s statements in the Wall Street
Journal (not to mention the recent arrest of
yukos
ceo
Mikhail Khodorkovksy) seem to indicate that the Russian
government will endorse the routes to the Pacific.
The potential reserves in this inland region are
characterized by low per-well production rates,
necessitating hundreds of wells to supply the pipelines.
Because of the high cost for field development and
pipeline construction, the project is very sensitive to
oil and gas prices. These reserves can be developed and
the pipelines constructed only for markets that can
sustain prices at sufficient levels for long enough
periods to justify the investment. Long-term contracts
between supplier and customer must therefore be signed
at prices of $25–30 per barrel.
DROP CAP
The oil and gas markets will undergo a major
re-structuring as the world enters a period of oil
supply shortage and the United States becomes dependent
on the imports of non-North American gas. Introduction
of long-term contracts at moderate, stable prices for
large supplies of oil and gas to the U.S. market would
gradually convert the pricing system for most oil and
gas to such contracts.
Such a fundamental market change would serve multiple
purposes. Large U.S. investment in Russia and continuing
U.S. purchase of Russian oil and gas will balance
growing European influence. Investment in Asian Russia
will be particularly desirable because it will stabilize
access to resources for China, the rest of Asia and the
west coast of the United States.
By
encouraging and assisting efforts to establish long-term
contracts with new suppliers, the United States can
accomplish several desirable geopolitical objectives. It
can become a major investor in Russia and give real
substance to a U.S.-Russia partnership, stimulate
economic development in Latin America and diversify the
West's oil and gas supplies out of the Middle East. Such
accomplishments would be a crucial component to
America’s current war on terrorism and beneficial to its
long-term national interests.
Dr. Charles A. Kohlhaas is a former Professor of
Petroleum Engineering at the Colorado School of Mines
and has worked for, founded, managed, and consults for
major and independent companies in the international oil
and gas industry.
1
Oil production is generally not contracted, earmarked or
otherwise allocated for delivery to certain importing
countries in specified amounts; rather, it is sold by
the producing companies and countries into a worldwide
market system from which refining companies and
importing countries buy as, and when, they need oil.
Particular tanker loads of oil may be bought and sold en
route and re-directed from one destination to another.
This system may be envisioned as a giant pot into which
the producing countries sell their oil and from which
the importing countries buy. The oil price is not
established by the Organization of Petroleum Exporting
Countries (opec),
producing countries or major international oil
companies; it is traded at
nymex in
the form of 1000-barrel contracts for future delivery of
West Texas Intermediate oil (a domestic U.S. grade of
oil). The price is established by traders’ perceptions
of the amount of oil going into the “pot” (supply) and
the amount of oil customers want to buy (demand).
2.
lng is not
a new business or technology.
lng
systems were developed in the 1970s, mainly to supply
Japan and South Korea with gas from Indonesia, but some
lng was
imported to the United States for short times in the
past.
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