At the same time I would like to complement my previous work by offering a brief array of disobliging remarks about the proposed comprehensive deregulation of natural gas. This topic was examined at some length in a paper I recently published in ‘Energy and Environment’ (2005), and the core of that discussion is presented below in a shorter and non-technical form. Basically, what I am contending is that electricity deregulation (or restructuring, as it is more correctly labelled) has failed, is failing, or eventually will fail because the increase in risk/uncertainty has a negative effect on investment; and the same thing – or worse – applies to the deregulation of natural gas. It also happens that most deregulation efforts in electricity or gas are contrary to the logic of mainstream economic theory.
Finally, I have a serious set of issues with some opinions presented in a recent paper by the well-known natural gas consultant James T. Jensen (2003). Unfortunately, my energy economics textbook (2000) was not on Mr Jensen’s reading list, however in that work and elsewhere I argued that an increased resort to the kind of short-term arrangements favored by Jensen and many others hardly makes any economic sense at all. It may have appeared to make sense when Jensen’s article was being prepared because at that time a ‘buyer’s market’ was in effect, but playing short-term games in the natural gas market at present or in the foreseeable future is exactly what gas buyers/consumers should make it their business to avoid.
WRONG ABOUT NATURAL GAS
Ad-hoc theories about the abundance of natural gas inevitably begin with the observed size of the existing reserve-production (= R/q) ratio. Just now this is somewhat above 60 years, implying that even if no more gas is discovered, present production can be maintained for more than 6 decades. Similar thoughts prevail for oil (whose R/q ratio is about 40), but in both cases this approach is meaningless. The key thing to focus on in this matter is the estimated date on which output ‘peaks’, and although a prestigious consulting company has just condemned the concept of a global peak, a short appeal to elementary economic theory in the light of various regional experiences makes it clear that peaking is a valid notion. This is true whether we are discussing fields, regions, or the entire world.
Moreover, when we look at the production profile of a major oil or gas region like the United States, what we see is that when peaking takes place (and production sooner or later begins to decline), there is still a huge amount of the resource in the ground, and in addition much of this is immediately extractable. Accordingly, the peak is explained by economics and not geology. More is not extracted – and the peak delayed – because in the interests of profit maximization, the optimal behavior is to extract it later! As explained in Banks (2003, 1987), geology essentially functions as a constraint. This crucial point has never been understood by many observers, and in particular those whose economics educations display the usual shortcomings.
The estimates that I have seen of when the global gas peak will take place range between 20 and 30 years. It may happen however that a really bad gas scene will appear earlier, as Alan Greenspan intimated in his testimony before the Committee on Energy and Commerce of the United States House of Representatives in June 2003. The Federal Reserve Chairman was not thinking in terms of depletion, or an output peak or ‘plateau’, but of price, and as argued below he very definitely had good reason for his distress.
Let’s introduce this matter by noting that 1000 cubic feet (or 28.3 cubic meters) of gas has an average heating value of approximately 1,000,000 British Thermal Units (Btu). (The exact figure is 1,035,000 Btu.) One barrel (b) of oil has an average heating value of 5,800,000 Btu. For a period of several years OPEC expressed the intention to keep the world oil price between $22/b and $28/b, and so we can immediately calculate that this corresponds to an unadjusted gas price of $3.8 dollars per million Btu (= $3.8/mBtu) to $4.8/mBtu. (Why the term “unadjusted”? The reason is that while in theory the gas price could be indexed to the oil price in such a way that it directly follows the oil price, with or without an appreciable ‘lag’, a more loose (or informal) arrangement is probably typical. In any event, there are many indexing schemes/contracts, and perhaps to a limited extent none at all, even if it appears that in 2004 the gas price did follow the oil price to a considerable extent.)
Two weeks before this was written, OPEC ‘unofficially’ raised its price target to more than $50/b, among other things citing a lack of economic damage (to oil buyers) from high prices.
Anyone who thinks that a sustained oil price above $50/b can be experienced without a high probability of severe economic damage to oil-intensive countries has lost contact with macroeconomic reality. Furthermore, using the figures given above, $50 a barrel for oil corresponds to an unadjusted gas price of almost $9/mBtu. Needless to say, a sustained gas price of this nature is out of the question at the present time (for political or economic reasons that cannot be discussed here), and so regardless of what the usual indexing formulas might indicate, I would like to suggest that for the purposes of the present discussion this $9/mBtu should arbitrarily be reduced to $6/mBtu. As it happens though, in concert with an oil price of $50/b, a price of $6/mBtu for gas is quite sufficient to initiate an international macroeconomic disaster, and Alan Greenspan and his collaborators are well aware of this fact.
I am sure that just about everyone perusing this contribution has heard gas referred to as the “fuel of the future”. In fact I used this expression several times in my energy economics textbook, largely because of gas’ relatively favorable environmental properties, but also because I did not expect that its price would begin to move up as soon as it did.
In addition, I did not pay sufficient attention to gas’ physical fundamentals as compared to oil. Despite the enormous amount of favorable publicity that gas has received, it so happens that even with its environmental deficiencies, oil is a much more valuable energy resource. Reynolds (2000) provides the key arguments for this contention, but aside from the characteristics surveyed by Reynolds, it needs to be appreciated that as energy resources are moved over longer and longer distances from large suppliers to large buyers, gas’ relative inferiority to oil increases. Whether by pipeline or tanker, the unit transport costs of oil are lower than those of gas. For example, in a given volume of pipe, oil contains (on the average) 15 times as much energy as gas, which immediately reflects – negatively – on pipeline investment costs for gas.
It is also the case that moving gas by tanker over very long distances is more expensive than by pipeline, while transporting oil by tanker over the same distances is less expensive than by pipeline. This is one of the reasons why the kind of highly efficient, consumer beneficial gas-on-gas competition that various observers hope or expect will come into existence after enormously expensive LNG investments are carried out, may prove to be a disappointment.
As with electricity, there are plenty of ‘experts’ ready to claim that technology and deregulation will always be able to supply the energy we need at prices that we can afford. Technology enthusiasts are now turning their attention toward the innovations that made it possible to obtain controlled volumes of methane from a hydrate-rich area in North Canada. This hydrate-based gas has been officially classified a viable energy reserve. The same treatment has been given oil in Alberta that is extracted from tar sands, which ostensibly is capable of making Canada an oil producer of the Gulf format. In truth only the richest of these resources is worth exploiting more intensively, unless the oil price is well on the way to the level predicted by Patrick Artus, which is $385/b. The same is probably true of the massive deposits of gas buried beneath various marine and permafrost areas of the globe. (On the basis of published work, Patrick Artus has the right to claim that he is the most productive economist in the world, however I am afraid that since the price he foresees would probably coincide with the beginning of the Third World War, it is unlikely to obtain a great deal of consideration outside the kind of economics seminars that I once attended at Stockholm University, where everyone and everything was treated with a full dose of unctuous respect, even if what was on offer was completely without any scientific value.)
ECONOMICS, ECONOMISTS, AND DEREGULATION
To paraphrase the great physicist Paul Ehrenfest, economics is easy but subtle. Sometimes it is too subtle. When the Federal Energy Regulatory Commission (FERC) was deregulating the US interstate gas market, it claimed that a comprehensive economic analysis provided the justification for its decision. They were promptly sued by the consumer group Citizen Action, whereupon they ‘admitted’ that there had not been any analysis.
The opinion here however is that some sort of formal analysis could not have been avoided, in which case only a charlatan could have come to the conclusion that 'fragmenting' the natural gas industry (and substituting short-term for long-term transactions) was other than a systematic attempt to “bleed consumers”, as the Illinois Commerce Commission maintained. The simple truth of the matter is that large and complex natural gas systems operating in a climate of uncertainty are most efficient when run on an integrated basis that emphasizes long-term contracting. The interior logic of this industry is totally incompatible with the structure of a textbook free market featuring ‘atomistic’ buyers and sellers. The problem here is that textbook free markets are the only kind of markets with which most academic economists and deregulators are acquainted. In their teaching and/or reading, they have ignored more specialized literature, or even the later chapters in economics textbooks, where reality intrudes on half-baked fantasy.
According to DeVany and Walls (1995), the facilities that should have been constructed in countries where there were large demands for gas were prevented from coming into existence by regulation: “regulation blocked the formation of a connected network”, was the way they put it.
The things blocking the formation of “connected” networks in the situations discussed in their book were the laws of engineering and economics. They also said that deregulation in the US was sparked by “chaos and crisis”. This may well have been true, however it is one thing to pass the baton from regulators to markets, and quite another to get the latter to run in the right direction. This is why what often is called deregulation is actually reregulation!
What those scholars and other members of the deregulation booster club have done is to consciously or otherwise misrepresent the scope for increased competitiveness, because they underestimate the difficulty of forming efficiency (i.e. scarcity) prices in the presence of increasing returns to scale, ‘lumpy’ investments, uncertainty, etc. What we have in their work is a plain and simple unfamiliarity with the physical constraints that characterize actual as compared to make-believe natural gas networks. It is also easy to prove that those derivatives (e.g. futures) that have functioned so well for oil and various financial assets have meant trouble to many transactors in natural gas and electricity ‘paper’ markets.
This might be a good place to mention an observation of Professor David Teece (1990) of the University of California. “While more flexible, a series of end-to-end (i.e. 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 time of contract renewal. There is, therefore, 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.”
One of the colleagues who played an important role in the early Scandinavian deregulation debate once informed me that regulation is based on dead ideas from (theoretical) welfare economics, but as far as I can tell, the driving force behind deregulation/reregulation is ‘dead presidents’ – i.e. those gentlemen whose pictures are featured on US currency.
As Berg and Tschirhart (1995) wisely note, “Because regulation is a political game, there are tugs of war, and economists can be found at both ends of the rope.” There were physicists at both ends of the relativity rope also, but those at the wrong end were soon made to feel their inadequacy – if only because the conference invitations stopped coming. By way of contrast, many of the scholars at the wrong end of the regulation/deregulation rope may never have to face the embarrassing fact that they have completely missed the point, because where this very important issue is concerned, there is usually a tidy satisfaction in continuing to be wrong – the kind of satisfaction against which a check can be cashed.
It could happen that natural gas pipelines and storage facilities in many regions might eventually be so extensive that something approaching a far-reaching deregulation makes sense. But just now, particularly in Europe, the theory supporting natural gas and electricity deregulation is internally inconsistent, mostly unrelated to reality, amateurish (at least in the case of Sweden), and probably hazardous to the incomes and net worth of innocent and deserving teachers like myself. Admittedly, some of the present regulatory structure might be ineffective, but it can hardly be a candidate for the scrap heap when the arguments attacking it make a practice of ignoring important theoretical and empirical evidence.
A SO-CALLED LNG REVOLUTION
In a long and detailed article of considerable pedagogical value (2003), James T. Jensen has argued at great length for the rapid expansion of the liquefied natural gas (LNG) trade. This is already happening to a certain extent, and he attempts to explain this phenomenon – or “revolution”, as he calls it – by the actual or proposed deregulation/liberalization of various gas markets.
The real reason for the expansion of the LNG trade is a shortage of natural gas in or near large consuming countries that cannot be compensated for by more intensive domestic exploration and production, or imports from nearby regions! Global gas demand might double in the next 20 years, but to help satisfy this demand the manager of the Royal Dutch/Shell Group has said that there will be a fivefold increase in LNG.
Moreover, the ‘balance of resources’ has changed in such a way that it may be is more economical to ship LNG into the Gulf of Mexico from the other side of the world than to drill for the gas (or oil) that may still be somewhere in that expansive body of water in fairly large amounts. Energy-deficient Japan remains the largest importer of LNG, but in 5 years the relatively energy-rich US will probably be first in the LNG import league; and even if no changes in the structure of the gas market were taking place, this transition is inevitable. In fact it might be moving more rapidly, because there would be less discussion about the desirability of ‘spot’ or short-term transactions, when obviously long-term transactions are still optimal if the required amount of physical investment in shipping and liquefying/deliquefying facilities is to take place as rapidly as possible.
To my way of thinking, Jensen’s provocative paper would be even more useful if he recognized the comparative weaknesses of natural gas derivatives market, and if he were not so attached to the idea of a “buyer’s market” in natural gas.
As with electricity, if derivatives market does not function in an ideal manner, the risks inherent in deregulation cannot be efficiently hedged. The electricity derivatives markets have not performed particularly well, and on the best known and largest derivatives market in the world, NYMEX (in New York), several electricity and gas contracts were withdrawn a few years ago (although they may be reinstated). Moreover, I can assure readers that if they open their favorite finance textbooks, and particularly those dealing with derivatives, they would be fortunate to find more than a page or two about electricity and gas. It also happens to be true that extensive price manipulation has taken place on or in association with the Nordic Electricity Exchange (Nordpool), and similar behavior would be facilitated by a widespread exchange trading and pricing for gas.
As for this matter of a buyer’s market, it is interesting to examine a short paper by Professor Kang Hyun Oh (2004), who is the chairman, president and CEO of the Korea Gas Corporation. He too is aware of the buyer’s market in gas that existed until several years ago, however he realizes that this is no longer the case. In a buyer’s market the prevailing logic is that buyers prefer contracts with short maturities, because they believe that the chances are good that these can be renegotiated at lower prices. It is now clear however that sellers of gas are in a much more favorable position than they were just a few years ago, and as a result are much less accommodating. I would therefore be very surprised if buyers remain quite so insistent on short-term arrangements.
Professor Oh mentions gas-on-gas and interfuel competition. Informally, interfuel competition is far less relevant today than in the past, because for environmental reasons, coal – which is the most relevant alternative fuel – is a much less popular alternative to gas. As for nuclear energy, the planning-production process could easily take 6 or 7 years, which limits the meaning of the term ‘competition’. Gas markets should soon be returning to their normal condition, where instead of being coy with suppliers, and pretending that eventually it will be possible to leisurely bid for spot cargos being randomly freighted from one ocean to another by footloose suppliers, buyers will once again be willing to pay premium prices for LNG, and if possible to sign long-term contracts for very large amounts.
Both Jensen and Oh seem to believe that if more LNG carriers become available without being dedicated to specific long-term contracts, market liquidity will improve. This is possibly correct, however it is not easy to envisage a large increase in the supply of LNG shipping tonnage if spot and short-term arrangements become the standard rather than the exception. As alluded to above, the financing of investments would become more complicated. Technological improvements have reduced costs in all links of the LNG chain, but not to an extent that it has become advisable to think in terms of selling the contents of LNG carriers like ice cream from freezer trucks. At the present time spot and short-term trading amounts to almost 9 percent of the total LNG trade, but unlike Jensen I can see no reason why it should go appreciably higher. In fact it might decline, because spot transactions require hedging capacities that exist more in fancy advertisements and brochures than in real life, and soon this will be apparent to all players in the gas market.
Professor Oh deals sums up this topic as follows: “I have to admit that the central question is how LNG suppliers and buyers can find common ground to fill the gap of conflicting interests. In other words, this is the question of how the suppliers’ acceptable return can be effectively reconciled with buyers’ new requirements.”
My answer here is that the best way to find it is through conventional markets where, hopefully, governments are not tempted to suppress or amend the laws of economics and engineering; and where heads of state choose to operate like General Dwight Eisenhower (one of the most conservative American presidents), and openly recognize the importance of natural gas in the lives of ordinary citizens.
The decision to give market forces more latitude on the global gas scene is probably correct in some respects, and incorrect in others. More flexibility is definitely warranted. But flexibility should not mean fragmenting and reregulating at random because of a strange belief that this kind of behavior will always enhance efficiency. Certainly, such a departure would never be recommended in an economics textbook in which such things as returns to scale and uncertainty are taken seriously. Put another way, economic and political agendas which insist on ignoring engineering rationality and optimality are best left in the seminar room.
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