A Free-Market Energy Blog

The Bear Growls a Bit More Softly Now: New Adventures in Pipelinestan

By Donald Hertzmark -- May 7, 2010

In the wake of the BP well blowout in the Gulf of Mexico and the attempted terrorist bombing of New York’s Times Square, the broadcast media have been full of the sackcloth and ashes crowd pronouncing once more the end of the hydrocarbon era and the vital need for the U.S. to “break our oil addiction” ASAP.

Their soundbites start with a half-truth and end with a fallacy.  We are told that “60 percent of U.S. energy supplies still come from oil and gas,” with the implication that (i) all of that is imported; and (ii) the pittance that we produce domestically all comes from offshore facilities.

 It is true that 60 percent (actually 62.5%) of our energy comes from oil and gas.  But the portion that comes from natural gas, about 24% of total U.S. energy supply, is 85 percent domestically sourced.  With oil and liquids, about 45% is domestically sourced.  Sure, we use a lot of oil and gas, and most of it, more than 60%, comes from the U.S.  More than two-thirds of that domestic production comes from onshore production facilities.

The fallacious recommendation that emanates from the incomplete data is that the U.S. has no chance to remain a viable society and economy if we continue to rely on all this foreign (onshore, Alaska, ethanol, Saudi Arabia, Russia, what’s the difference?) and offshore supply.  “Therefore, we have no alternative but to turn to  .   .   .   wind, solar, biomass?”  The agenda pushers never want to let a good crisis go to waste.  But very quietly, mostly out of sight of the energy policy crowd in Washington, we have seen the emergence of major new sources of domestic energy production – natural gas from coalbeds and shale formations.  So great has been the rise in domestic gas production that it has weakened gas prices worldwide, benefitting users in homes and industry.

Moreover, the US example is setting off emulation in Australia, Canada and China, as well as Europe, promising still further major gas production increases.  Without this production the major conventional gas powers – Russia, Qatar, Algeria, Iran, Libya, Nigeria – would be able to garner ever-increasing market share, and with that monopoly rents and political power.

It was just such a calculus that Russia employed in its approach to foreign gas customers in Europe, China and the former USSR.  Ignorance of market forces and developments has severely weakened Russia’s market and political power to use the “gas weapon” (sounds like a Mel Brooks movie) on Europe, China, Japan and the US (though Russia has “taken” Ukraine as a consolation prize. see below).  Following uninformed policy hacks could return the US to those days, but only if we let them lead us there.

In addition to the monetary and political costs of listening to the interventionist voices of doom there are also serious environmental implications.  Producing oil and gas offshore is generally far more benign environmentally than increased shipments of oil in tankers.  And the same people who decry offshore oil platforms would be first in line to oppose siting of LNG regasification plants, the real alternative to domestic gas production.  On the electric power side, the two major contenders, if we “get off gas,” remain coal and nuclear.  But coal is not likely to be nearly as good a citizen as gas for power generation for many years – not until we can mine it with robots and burn it as cleanly and efficiently as we do gas.  As for nuclear, it would take a great leap of faith to think that our political system can deal with this technology in an adult manner, and even then gas-fired electricity is less costly and will remain so for many years.  Politically, rising domestic US gas output promotes a market-oriented energy agenda – private companies investing in output on private land, selling to willing customers -the antithesis of the statist agenda imposed by most recent energy legislation.  If we help ourselves we establish a virtuous circle with financial, economic, fiscal, environmental and political benefits for the US and for the world.

Russia’s Gas Politics – Lessons Unlearned

When last we looked at natural gas politics in Russia and its near abroad, the Russians were planning to surround Ukraine with pipelines, facilitating all manner of selective gas supply strategies to Ukraine and Western Europe.  However, financial reality has caught up with Gazprom, the monopoly gas supplier; spending $40-60 billion to strangle recalcitrant Ukrainians and Poles has proved at bit much, even for Gazprom.  A combination of too much spending and too little productive investment, coming at a time when others were ramping up (shale) gas production and LNG has produced a perfect storm for the Russians: falling gas prices and more competition for EU market share.

Source: http://www.eia.doe.gov/emeu/cabs/Ukraine/images/NGPipestoEurope_Manuel.gif

Lower Natural Gas Prices are Good for the World

Natural gas is the go-to transition fuel for the world.  Clean, easy to use and widely available.  With US domestic gas production up more than 10% in just the last 3 years the world market has been transformed.  This stunning turnaround in US production has led to lower prices, reduced imports, especially LNG, and improved competitiveness for US industries using gas as a feedstock, including the vital petrochemicals industry.

With millions of tonnes of unused import regasification capacity the US has created gas-on-gas competition not only in the Western Hemisphere, but in Europe as well.[i]

So plentiful are shale gas resources in North America that LNG terminal plans are even going in reverse.  In Western Canada there are plans to use a proposed LNG import/regasification terminal to liquefy and export (to China) shale gas from the Horn River formation in British Columbia.

China, naturally, is anxious to obtain as much leverage on its other gas suppliers as possible.  If they can purchase gas that is not indexed directly to oil product prices then they have a tool to push down costs from other suppliers.

Mr. Market Rears His Head and Slaps Down the Gas Cartel

Behind the scenes the major gas-producing countries, hoping to vacuum up rents à la OPEC, have seen their cherished dream, charging higher prices to the world’s natural gas consumers, founder on those pesky gas producers in the US, Canada and Qatar.   While Russia, Iran and Algeria hope to drive gas prices higher, more in line with oil, by withholding supplies, others do not agree.

Qatar, one of the lowest cost producers in the world, and the largest exporter of LNG, has refused to cut output of natural gas.  As much as the Russians might like to play the same role for gas that Saudi Arabia plays for oil, it is not to be; there is simply too much gas bubbling up all over the world and consumers have the luxury of choice among suppliers.

With natural gas production in the US well above levels predicted just a few years ago, excess capacity has built up in the LNG side of the business.  This means that “unclaimed cargoes of LNG are now widely available for those who are able to purchase gas on the market.”  Such spot cargoes of LNG are going for knock-down prices.  Netbacks to producers in Trinidad for delivery to the US are just over $2/mmbtu, and less than $5/mmbtu delivered to the US Gulf Coast.  For those in Europe with functioning gas markets (the UK) LNG cargo prices are more than $4/mmbtu lower than prices in countries locked into oil-equivalent pricing formulas.  This means that the UK gas distribution system can purchase gas from Algeria or Nigeria for about $5.50/mmbtu, while contract customers in Spain pay about $9-10/mmbtu for cargoes from the same sources.

Even India, far from the center of shale gas production, has seen sizable benefits from the changing world gas market.  Recently, an LNG importer in Gujrat state was able to obtain LNG from Trinidad’s Atlantic LNG for $8/mmbtu, cif.  Russia’s gas customers still pay more than that for pipeline supplies.

Maybe Gazprom Does Not Really Understand Markets

Monopolists, especially those with natural resource based industries, often overestimate their market power and underestimate potential competitors.  Russia appears to have done so.  So confident were they of the power conferred by their gas resources, proximity to European markets, and control of pipelines that they missed the change in the correlation of forces in world gas markets.

Once the strict link between oil and gas prices is broken it is difficult to insist that the two products are the same, and that gas should be priced like a liquid, compact and easily transported commodity.  And yet, for many years, Gazprom was able to charge oil-equivalent prices for its gas exports to Europe.

By tying up the available transmission routes from Asia to Europe and by intimidating the transit or competitor countries, Russia believed that they could dictate terms to both Western Europe and Ukraine but also to China.

So focused were the Russians on controlling the transit of gas through Ukraine that they reprised the old line “I liked the company so much that I bought it.”  Only in this case they “bought” Ukraine.  To keep the Ukrainians sweet, and to get naval basing rights at Sevastapol they cut the price of gas to Ukraine from about $10/mmbtu to just under $6/mmbtu.

The Long Arm of the Law of One Price Reaches Out to Gazprom

Surely such discounts will not go unnoticed in Western Europe.  No one wants to pay more for a commodity than they must, and since the Europeans are already reducing their gas take from Russia the next step is to renegotiate the pricing basis of their supply contracts with Gazprom.  The discounts resulting from such renegotiations are likely to cost Russia at least $25 billion in lost revenues per year.

The bad news does not end there for Gazprom.  So focused was the company on its European customers, pipeline investments and new gas supplies that they ignored the major new customer in the East, China.

Fresh from negotiating discounted prices for LNG supplies, China asked Gazprom/Russia, Kazakhstan and Turkmenistan to offer similar discounts for pipeline supplies to Western China.  Its attention elsewhere, and apparently overestimating its market power, Gazprom refused to deal.  The result is the 1,833 km (1,137 mi.) pipeline that will carry 40 bcm (3.9 bcf/d) to China’s Western Region.  Another 10 bcm (~1 bcf/d) of annual production from Kazakhstan will tie into the same transmission project, effectively cutting out Russian suppliers for years.

Shale Gas: Good for the US and Good for the World

As noted at the beginning of this article North American shale gas production has started a massive restructuring of prices and trading patterns throughout the world.  So far the victims include mighty Gazprom, its Russian masters, and, as collateral damage, political freedom in Ukraine.  Others, including Libya, Iran and Algeria, along with Hugo Chavez’s Venezuela and Hugo Morales’s Bolivia will not see their gas cartel wishes or its monopoly rents come to pass anytime soon.

On the winner side are North American gas consumers, domestic gas producers in the US, Australia and Canada and large consumers worldwide who are not lashed to the Gazprom mast.  These include China, Britain, and possibly others in Europe, if they open their gas markets to new suppliers.  The incentives to open up gas markets may now greatly exceed the cost of Gazprom’s wrath.

The threats to this happy state of affairs arise primarily from the US political system. Gas from shale and other unconventional sources will play a critical role in bridging US electricity supplies as coal and nuclear expansions look increasingly problematic.  Gas is likely to be the fuel of choice to supply the electricity as a substitute fuel cycle for the more than 45 proposed coal-fired power plants awaiting (and awaiting) regulatory approvals. Without shale gas, and if coal remains in the penalty box as a future fuel for power generation, US imports of LNG would need to roughly quintuple.  Such a reversal would send gas prices back up to 2008 levels rather quickly and would create their own political problems on siting and transmission.[ii] It is difficult to overstate the siting difficulties that such an expansion of regasification terminals might generate.

We have in our power the ability to create and sustain an efficient, dynamic and responsive market-based natural gas system for much of the world.  On the other hand, we can be small-minded and deliver ourselves into the arms of “GOPEC.”

[i] For a handy conversion from tonnes of LNG to cubic feet per day, just multiply by 130 – e.g., 1 million tonnes/y of LNG <=> 130 mmcfd natural gas.

[ii] For example, if the 45 coal plants were to be replaced by natural gas combined cycle units, as the opponents of coal would prefer, and if shale gas were to succumb to its own environmental foes, then the US would need to import an additional 80 million tonnes of LNG annually to supply those gas-fired power plants.  In contrast, current US imports of LNG are about 11 million tonnes, and the peak in 2006 was just below 18 million tonnes.

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