This article provides some background into the Natural Gas market and has implications for any investment within this industry.
From Ferdinand E. Banks;
Since the publication of my natural gas book (1987), many changes have taken place in this market. Globally, the growth in the demand for gas may still exceed that of all energy media, except renewables, and until recently gas was often highly recommended as an input for electric power generation. (In both the U.S. and UK, a gigantic infusion of gas-based equipment was planned before the authentic supply-demand situation for gas was identified.)
A main reason for the popularity of gas was the advent of combined cycle gas burning equipment with a very high efficiency. What happens here is that in addition to the gas turbine, there is a secondary turbine producing steam from the waste gases/heat of the gas turbine. The kinetic energy in this steam is transformed to mechanical energy that turns a generator. When compared with earlier equipment, additional electricity could be produced for a given input of gas.
However, as often happens, there are many misconceptions in circulation about natural gas, the most pernicious of which – at least in Europe – have to do with the restructuring (i.e. deregulation/liberalization) of gas markets. Some questions need to be asked as to why and how these misconceptions came into existence, and it appears that the answer has to do with the inability of consumers, and to a certain extent producers, to judge the future availability of gas. For instance, one of the arguments for deregulation turned on the crank belief that more ‘competition’ – to include a greater resort to spot markets and derivatives (i.e. futures and options) – could compensate for the unavoidable depletion of physical resources.
In addition, in some parts of the world, gas producers expressed themselves in such a way as to give the impression that there was virtually an infinite amount of natural gas reserves (in one form or another) that would eventually be available for exploitation, if their transactions were not disturbed by ‘regulators’. Similarly, many gas buyers were almost totally unaware of how supply and demand could develop in the long-run, and instead continued to make plans for a future in which they would have access to all the gas that they would need, at prices that resembled those of the recent past. This might be a good place to note that in Brazil, some starry-eyed deregulators counted on gas-based electric power being cheaper than hydroelectricity and nuclear. As they now admit, this incredibly gauche supposition was completely wrong.
In much of North America, despite propaganda to the contrary, exploration and production have been yielding disappointing results for a long time, and expectations about e.g. the Gulf of Mexico and imports into the U.S. by pipeline from Canada often have an air of unreality about them. In Europe a more rational tale can be deduced on the basis of what happened in Finland. With copious potential gas supplies adjacent to Finland in Russia and Norway, the decision-makers in that country chose nuclear as the best option for additional power. They understood that given the likely future demand for gas in Europe, Asia and North America, in the long-run they might have found themselves relying on imports from very distant sources – e.g, Qatar and Iran.
According to the International Energy Agency [IEA] of the OECD, fossil fuels will account for 90% of the world primary energy mix by 2020. Global gas demand is expected to rise by 2.5-2.7%/y (although in the U.S. this figure will be 2%/y), even though the price has started moving up rapidly. The big consuming area will likely be Asia, where it has been suggested that demand will increase by an average of 3.5%/y between 2001 and 2025. The share of gas in world energy demand could move in that period from 21% to at least 24%. An earlier estimate had the average global gas production increasing by 2.75%/y until at least 2025, and gas quickly overtaking coal in the global energy picture. This no longer sounds right, nor does an absurd forecast the IEA which envisaged the global consumption of oil in 2030 reaching 120mb/d.
World gas prices might already be on an unambiguous upward trend. In picturing world gas prices remaining flat until 2005, the IEA was clearly mistaken, but they are correct in noting that a tightening of U.S. and Canadian gas supplies is unavoidable, and this process could turn out to be very unpleasant for buyers. A wellhead price of $2.5/mBtu (in 1997 prices) for purely conventional U.S. gas in 2020 seemed offbeat to me when it was predicted at the beginning of this century, and unless the global macroeconomy greatly deteriorates, a sustainable gas price of at least $10/Mcf could be experienced before the end of this year, with occasional ‘spikes’ that carried the price well above that figure. Bargain basement oil has gone out of style, and the same is going to happen with gas.
As I explain in my new textbook (2007), if recent changes in the price of gas continue, they will soon restore gas to the position in the electric generation ‘merit order’ that it occupied before the introduction of combined-cycle technology. In case readers are a bit vague on this subject, what this means is that gas will be judged as economically unsuitable for carrying the electric base load, and as a result the many investments made earlier on the basis of a low expected price of gas were ‘sub-optimal’.
In the Mood for Misunderstandings
That brings us to restructuring. The IEA mostly got it wrong on restructuring in the electricity sector, and as a result I see no reason to expect an improvement in their ability to analyse the economics of world gas. However, since even the experts of the IEA are capable of comprehending that major uncertainties exist about the ability to develop and transport the more distant gas reserves, then it might be appropriate to suggest that considerable effort should be made to prevent the cavalcade of unsound ideas about deregulation/liberalisation from getting in the way of sound engineering and managerial practices. I think it useful to stress that the same exaggerated claims made for electric deregulation have also been made for gas, though not so aggressively as a decade ago. The term “exaggerated” may also apply to the future of liquefied natural gas [LNG]. In the U.S. the only place that LNG has been declared welcome is on the Gulf coast – although a friendly reception is no longer certain in e.g. Louisiana. In the Northeast and on the West Coast, pipeline gas is preferred – although where this pipeline gas will originate is something that nobody seems to know.
A main shortcoming of the gas market debate was, initially, the presence of several academic economists without the slightest feel for either the economics or the engineering aspects of the natural gas sector. This includes economists with a modicum of engineering training in their background. The question was therefore raised as to how we should treat the avalanche of misjudgements about this market in order to help prevent expensive, irreversible investments from taking place.
In my new textbook, I did not treat them at all, because I presumed – perhaps incorrectly – that the lack of availability of gas would soon be revealed by its increased price; and unlike the electric deregulation travesty, gas deregulation was a blunder that was never able to get up full steam. One of the reasons for this was that in the U.S., and perhaps elsewhere, some important politicians and industry people, as well as genuine experts from the academic world, took issue with the more bizarre gas deregulation objectives. For instance, they pointed out that the natural gas market in the U.S. is not informationally efficient, which means that gas prices at widely separate localities do not follow each other in a manner which makes it possible to conclude that – when transportation costs are taken into consideration – these venues are in one market. Accordingly, the kind of arbitrage cannot take place which allows consumers faced with high prices to gain by buying elsewhere at lower prices. And not just in the U.S. A former CEO of British Gas went so far as to contend that the “half-baked fracturing” of the gas markets in order to bring about competition is essentially counter-productive. I can add that prospects for an ‘efficient’ global gas market featuring increased spot sales is as much a delusion today as when first touted .
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 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 although it may not be mentioned in your economics textbook, if pipeline-compressor-processing systems which fully exploit increasing returns to scale in order to obtain minimum costs are to be readily financed and expediently constructed, then – as I interpret the evidence – the kind of uncertainties associated with short to medium term arrangements should be kept to a minimum. Failing to do so could cause a reduction in physical investment, and in the long run lead to higher rather than lower prices.
I find it enormously satisfying to note that the majority of energy professionals are coming to their senses where the topics in this paper are concerned, and as icing on the cake, considerably less tolerance is being shown the ravings of flat-earth economists and their adherents where future supplies of gas and oil are concerned. What is happening is that these ladies and gentlemen have started paying closer attention to reality than to the kind of bizarre economic theory that became popular in the U.S. when Professor Milton Friedman proclaimed that the oil price would descend to $5/b. The domestic U.S. gas output has peaked, and more alarmingly the gas rig count in that country also appears to have peaked. This suggests that more than a few important firms now regard North America a hopeless case for large scale investment in the gas sector, even with rising gas prices. Furthermore, as in the U.S., increased drilling in Canada is not raising production by a substantial amount. The situation in both countries can easily be summed up as follows: mature basins, smaller discoveries, and a high rate of natural decline from existing gas wells – which unavoidably translates into higher energy costs if the desire is to increase or even to main output.
In selling electricity and gas deregulation to the voters, among the pseudo-scientific arguments first employed were that increasing returns to scale were a thing of the past. A competent teacher of economics or engineering should be able to expose this myth in a half-hour by employing some secondary-school algebra. Moreover, once increasing returns to scale (or sub-additivity) are recognized, then it should be easy to confirm that any benefits theoretically gained due to competition could be lost. The easiest way to handle this issue though is to ask managers and engineers in the gas (and electricity) industries whether they believe in the non-existence of increasing returns to scale.
Conclusions
In closing, I want to emphasize that until recently there were any number of journalists, academics and assorted paid and unpaid propagandists prepared to inform everyone in their ‘network’ that the high oil and gas prices that have started to appear were irrelevant from a macroeconomic and financial market point of view. Their amateur arguments often claimed that today’s economies are so sophisticated when it comes to energy saving and substitution, that even with oil prices around $100/b, and gas prices that might approach that level, there is no threat to macroeconomic stability.
Since we may encounter this kind of lopsided wisdom arguments again some day, I hope that readers of this paper make it their business to tune out at the first opportunity. In a recent conference of EU movers-and-shakers, it was proposed that the EU countries should formulate a joint strategy for dealing with their energy vulnerabilities, and while I can sympathise with this goal to a certain extent, I fail to see how it conforms with the deregulation nonsense sponsored by the EU Energy Directorate. The commander of the EU Energy Army is a man who believes that ‘peak oil’ (and probably gas) is only a theory, and whose ideas about electric and gas deregulation belong in cloud-cookoo land. He and his colleagues are completely oblivious of what is taking place in real world markets as opposed to those in the fantasy worlds of their advisors and experts. Accordingly, I think that we would all be much better off if we ignore his precious intentions until he absorbs the lessons of economic history and economic theory.
Unless I am mistaken, there are influential persons in Europe and the U.S. who still believe that various deregulatory deficiencies can be ameliorated by greatly ‘thickening’ gas and electricity networks – i.e. thickening them with more pipes and wires. They certainly could be correct, although I suspect that spending serious money in order to facilitate the smooth operation of spot and derivatives markets is at best illogical and a drastic economic mistake. I also have some reservations about the use of the term contestability, and particularly how it was employed by a gentleman in Hong Kong during one of my unfriendly lectures on the subject of electric deregulation. This is a valid and important concept, but for the most part is applicable to activities in which there are low sunk costs. As bad luck would have it though, there are very high sunk costs associated with natural gas networks, and so would-be ‘players’ who enter that particular world thinking that they will gain a reputation for analytical excellence should make sure that there are no gaps in their knowledge of Microeconomics 101.
Finally, what mostly characterizes gas and electricity restructuring up to now is a reduction in economies of scale (due to sub-optimal investment strategies), increased prices, decreased reliability, and perhaps a threat to the security of supply – and all or some of these inexplicable shortcomings are visible in virtually every corner of the globe and as yet show no sign of disappearing..
References
Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. London, Singapore and New York: World Scientific.
‘______ ´(1987) The Political Economy of Natural Gas. London and Sydney: Croom Helm.
Chew, Ken (2003). ‘The world’s gas resources’. Petroleum Economist.
Darley, Julian (2004). High Noon for Natural gas. London: Chelsea Green.
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.
