Two Natural Gas Kings: Russia and QatarProfessor Ferdinand E. Banks
February 11th, 2012
In my forthcoming energy economics textbook (2012), the two natural gas kings are three – Russia, Qatar and Iran – while if I were beginning that book today, I would consider making it a foursome.
The United States (U.S.) might belong with this royalty, assuming that the shale revolution is indisputably authentic and relevant, and not a transient bounty or false impression. Unfortunately we must wait for the verification we need, because the Energy Intelligence Agency (EIA) of the U.S. Department of Energy has apparently reduced its estimate of reserves in the Marcellus shale deposit by 66 percent. This revaluation has created the equivalent of a real option for owners and potential owners of other shale deposits, due to the influence it may have on the reduction of geological uncertainty. Moreover, a little algebra applied to shale deposits in Texas suggests that some investors in that part of the U.S. are running a serious risk of being gravely disappointed as a result of the physical ‘depreciation’ that characterizes those particular resources.
I have been asked to present a short course in energy economics in Spain, and ideally I would wait until I successfully completed my gas lectures, and answered questions raised by sceptical experts, before looking into this matter more thoroughly, but there are a few aspects of the subject that require clarification as soon as possible. For instance, it appears that there might be some friction between Russia and Qatar because of a difference of opinion in how natural gas should be sold. Matthew Hulbert has provided a useful introduction to this topic (2012), and I would like to supplement his observations with some materials from the natural gas portion of my course.
First of all, my long association with economic theory assures me that any friction between Qatar and Russia where the selling of gas is concerned is temporary. As John Maynard (Lord) Keynes once pointed out, “economics is an easy subject that is difficult”, but fortunately for some of us, it is quite straightforward once all the cards are on the table. Any spot pricing of natural gas that Qatar desires to practice in its dealings with European buyers is counter-productive in the real as opposed to the classroom world. If it were otherwise, then the pipelines constructed in the future to bring gas from Russia and possibly North Africa to Western Europe could be grossly under-dimensioned, because the investments required to transport optimal quantities of gas would not be made! As for the long run, do not forget that unless China intends to scrap its gas-burning facilities, it is both ready and able to purchase (via the medium of fixed- term contracts) all the natural gas that Russia is capable of delivering.
Something else is worth considering here. This has to do with the (increasing returns) scale effects of natural gas projects, which very likely exist, because as the late Professor Hollis B. Chenery once pointed out at a workshop in Paris, the maximization of (discounted) inter-temporal profits calls for the construction of pipeline (and compressor) capacity ahead of expected demand. If this rule is valid, then the uncertainty caused by spot trading would prevent the optimizing of pipeline dimensions.
“Spot trade is rapidly growing important, with lower-priced spot supplies increasingly undermining the long term primarily Russian contracts that have traditionally dominated the market.” This is a provocative observation by Matthew Hulbert that may well be true at present, however I believe that it is another example of what Jean-Paul Sartre called “a fire without a tomorrow”. Qatar is a rich country, and the citizens of that country – perhaps a fourth of the total population – are on the average the richest citizens of any country in the world. As a result the government of Qatar can hardly feel a compulsion to sell their finite resources of natural gas at bargain basement prices, regardless of how plentiful those resources might seem to people like Mr Charles Kenney of the Center for Global Development, who measures the abundance of fossil fuels in terms of their Reserve-Production ratio.
Instead, as I once pointed out to my students at the African Institute of Development Planning (Dakar, Senegal), a country like Qatar will concentrate on adding value to exhaustible resources (such as gas and oil) by additional processing. ‘Gas to Liquids’ is one possibility, although one that I occasionally have some problem understanding if economics is the main criteria. Instead, the further processing that I consider relevant for a country like Qatar involves the production of petrochemicals. This makes all the economic sense in the world, unless of course the government of that country has drawn the conclusion that possible large benefits in the distant future are inferior to relatively trivial gains at the present time.
The very long natural gas lecture that I have planned for Spain might contain other items of interest to some readers of this note, but I am especially pleased to have the opportunity to supply a ‘rant’ against the spot pricing of natural gas. The thing to always remember is that spot pricing has been a key element in the strategies for electric deregulation ‘experiments’ that, in one sense or another, have failed almost everywhere. There is no reason to believe that there would be a different outcome for natural gas.
Probably the most important observation on the ambitions of natural gas deregulators was rendered by Professor David Teece of the University of California (1990). According to him, market liberalization in the U.S. has already “jeopardized long-term supply security and created certain inefficiencies.” He also notes that “While more flexible, a series of end-to-end, short-term contracts are not a substitute for vertical integration, since the incentives of the parties are different and contract terms can be renegotiated at the time of contract renewable. There is no guarantee that contracting parties will be dealing with each other over the long term, and that specialized irreversible investments can be efficiently and competitively utilized.”
For this reason I never miss an opportunity to remind my students and colleagues that as far as I am concerned, large and complex gas systems operating in a climate of uncertainty are most efficiently run on an integrated basis that emphasises long-term contracting. This kind of arrangement promotes optimally dimensioned installations, and it is worth mentioning again that if pipeline-compressor-processing systems which fully exploit increasing returns to scale in order to obtain minimum costs are to be readily financed and opportunely constructed, then the kind of uncertainties associated with short to medium term arrangements, to include spot pricing, should be kept to a minimum. The many shortcomings of electric deregulation effectively demonstrates that failing to do so will eventually lead to higher rather than lower prices.
I find it enormously satisfying to note that many energy professionals are coming to their senses where the topics in this paper are concerned, but as icing on the cake, more attention should be paid to some of the claims and conclusions that have surfaced due to the shale gas ‘revolution’. In particular, readers should visit those net forums where issues of the above nature are considered and debated at great length, and here I strongly recommend comments on a contribution by Goodwin (2012). I am sure that all of us on the buy side of natural gas markets hope that shale gas is the real deal, worthy of the attention now being paid it, and we will not be plagued by any unintended consequences associated with exploiting this resource, one of which might be the exorbitant amount of water that may be required. In a book I would like to write some beautiful day, I hope I can say that this kind of gas will buy the time we need to discover and install the optimal energy structure. But for the time being, I am forced to confess that much of what I have heard about shale gas cannot possibly be true or relevant.
Banks, Ferdinand E. (2012). Energy and Economic Theory. London, Singapore and New York: World Scientific Publishing Company. (Forthcoming).
______ . (2007) The Political Economy of World Energy: An Introductory Textbook. London, Singapore and New York: World Scientific.
Goodwin, Richard (2012). ‘Shale gas – friend or foe’. EnergyPulse
Hulbert, Matthew (2012). ‘The vital relationship : Why Russia needs Qatar, (and Qatar could use Russia)’. European Economic Review (19 January)
Lorec, Phillipe et Fabrice Noilhan (2006).’ La stratégie gasière de la Russie et L’Union Européenne’. Géoéconomie (No 38).
Teece, David J. (1990). ‘Structure and organization in the natural gas industry’. The Energy Journal. 11(3):1-35.
Professor Ferdinand E. Banks
February 11th, 2012
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