Research: The Geopolitics of Natural Gas

Natural gas is rapidly gaining in geopolitical importance. Gas has grown from a marginal fuel consumed in regionally disconnected markets to a fuel that is transported across great distances for consumption in many different economic sectors. Increasingly, natural gas is the fuel of choice for consumers seeking its relatively low environmental impact, especially for electric power generation. As a result, world gas consumption is projected to more than double over the next three decades, rising from 23% to 28% of world total primary energy demand by 2030 and surpassing coal as the world's number two energy source and potentially overtaking oil's share in many large industrialized economies.[1]

Gas consumption is projected to grow in nearly all world regions, with the largest absolute increases in gas use in North America and Europe and rapid growth in new markets such as China, South Asia and Latin America.[2] It is likely that rising gas consumption in many of these markets will force an increase in imported supplies as low-cost local resources are exhausted. Three countries alone-Russia, Iran, and Qatar-possess 55% of current proved gas reserves.[3] Simultaneously, falling costs for transporting gas-both by pipeline and by ship as liquefied natural gas (LNG)-will continue to improve the viability for these distant suppliers to develop markets outside their borders.

The growing importance of natural gas imports to modern economies will force new thinking about energy security. The relationships that are developing between major gas suppliers and key end use consuming countries will create new geopolitical considerations that will rise to the highest levels of economic and security policy. Already, U.S. Federal Reserve Bank Chairman Alan Greenspan has publicly discussed the implications of rising domestic gas prices and the need for LNG imports to supplement North American gas production. Security agencies have redoubled their attention to gas transportation infrastructures. With the prospect of much greater dependence on foreign supplies of natural gas, the U.S. Department of Energy in December 2003 convened a gathering of the Energy Ministers from current and future major gas exporters to the U.S. to build diplomatic ties to these important suppliers.

The Energy Forum of the James A. Baker III Institute for Public Policy and the Program on Energy and Sustainable Development at the Stanford University Institute for International Studies have begun a major effort to investigate the geopolitical consequences of a major shift to natural gas in world energy markets. The study, to be completed in 2004 culminating with an edited book volume on the subject, is aimed to fill the gap in the academic and business literature on natural gas. Earlier studies have given particular attention to the perspective of investors, with much less attention to the broader consequences of the shift to gas.

A case in point of recent efforts to look at infrastructure development is the recently completed World Bank (ESMAP) study Cross-Border Oil and Gas Pipelines: Problems and Prospects. This study briefly examines twelve cases of cross-border energy infrastructures to identify common challenges and the best practices for mitigating these challenges.[4] The International Energy Agency (IEA) has convened a series of workshops on cross-border gas trade, including policy makers, industry experts and academics and continues to examine issues of gas import security.[5]

There is also a voluminous literature on hypothetical gas transport projects-lines drawn with crayon on maps that represent hundreds of proposed gas lines. Some studies such as the Shell Global Scenarios, have considered gas infrastructure expansion in the broadest social and geopolitical contexts.[6] Still other efforts have focused on the specific economics of hypothetical natural gas pipeline options in particular regions. In 2000 the Asia Pacific Energy Research Center published two reports-one focused on the economics of gas pipeline options in Northeast Asia and a second on gas pipeline options for Southeast Asia.[7] Similarly, the Baker Institute at Rice University has analyzed the pipeline and LNG options for importing gas from the Russian Far East to Japan.[8] The International Institute for Applied Systems Analysis has also conducted a large-scale economic modeling effort to study the routing of Central Asian natural gas to European and Asian markets.[9] Every major commercial enterprise that produces, transports or sells gas across borders enlists models to explore the economics of different projects and scenarios.

The Baker Institute-Stanford University effort will expand on this existing work. In particular, we shall consider the more complex issues of the international security and geopolitical consequences of emerging gas producer-consumer relationships. We will explore the political consequences of integrating what have historically been disconnected regional natural gas markets. The study will allow examination of whether the advent of LNG will create a truly global market for natural gas, as well as the role of likely key gas suppliers in affecting prices and security of supply in that global market. The study will also allow for systematic analysis of many questions that have long been a mainstay of the energy security debate in oil, such as the whether large gas consuming countries will compete to secure uninterrupted access to the world's most prolific natural gas resources.

The study will utilize historical case studies as well as advanced economic modeling to examine the interplay between economic and political factors in the development of natural gas resources; our aim is to shed light on the political challenges that may accompany a shift to a gas-fed world.

Historical Case Studies of Cross-Border Gas Trade Infrastructures

Construction of infrastructure is a major challenge to increased world natural gas consumption. Cumulative investments in the global natural gas supply chain of $3.1 trillion, or $105 billion per year, will be needed to meet rising demand for gas between 2001 and 2030, according to the International Energy Agency (IEA). These case studies (working papers) focus on the special challenges of investing in large-scale, long-distance gas production and transportation infrastructures. These projects, especially pipelines, require dedicating capital resources to projects that are fixed to the ground-immobile, yet requiring decades of operation to recover the initial investment. These studies concentrate on countries that do not have the long histories of cooperation and the stable legal and political environments that are often seen as essential to attracting private investors. The expansion of gas as a global fuel depends in large part on success in attracting investment within such political, institutional and economic environments. The study examines the factors that explain why these projects were built and why alternative viable projects stalled.

The project has developed a detailed research protocol to guide the case study teams.[10] Although each case study examines a complex story in its own right, the protocol ensures comparability across cases on key issues, notably:

1. Creation of demand. In many cases new export projects deliver large quantities of gas to markets that do not already have the infrastructure in place to make use of the new resource. The case studies examine the instruments used to "create" demand-such as facilitating complementary investments in gas-using equipment that are essential to economically viable projects
2. Changing market context. The time and geographic span of the seven case studies allows assessment of how market liberalization and a shift from state projects to an increased role for the private sector affect investment in cross-border gas projects. The studies also allow examination of the impacts due to the shift from oil-indexed gas pricing to gas-on-gas competition.
3. Long-term contracts. Investors and gas suppliers have historically worked under long-term take-or-pay contracts. The shift to more market-oriented arrangements makes the process of contracting more complex, which can slow or impede efforts to finalize projects. Each study looks at the particular roles for such contracts and their enforceability; the studies explore where such contracts have been essential (and why), or whether they serve as a superficial vehicle for securing financing.
4. Transit country risks. Investors and hosts alike have been particularly concerned about the risk that transit countries will extort additional revenues or interrupt supplies. Three of the case studies involve transit countries, allowing for analysis of transit risk and the strategies adopted to mitigate this risk in a range of contexts.
5. The Gas Weapon. Importing countries have long feared that suppliers will withhold gas for economic or political gain. Each case study examines whether this problem has arisen and how such fears were ameliorated.
6. LNG vs. pipeline. In some cases, both LNG and pipeline projects have been available to export gas at comparable cost. In those instances, the case studies will provide insights into the factors, in addition to cost, that affect the choice of gas transport technologies.
7. International Institutions. Theory suggests that pre-existing institutions for economic cooperation would facilitate the completeion of large, sunk-cost investments between countries joined by such agreements. The studies span country pairs that share membership in regional trade agreements, and countries with limited pre-existing formal cooperation. The cases also examine the role of international financial institutions in advancing these projects.

Simultaneous to the analyses of historical case studies, a group of scholars at Rice University is currently developing an economic model of global natural gas markets. The model is being created to simulate the development of global gas markets based on solely commercial considerations of available supply and its development costs, the cost of capital, end-use demand by sector, and fuel competition.[11] Specifically, the dynamic spatial general equilibrium model seeks a level of development of gas resources and consuming markets, and a set of transportation routes such that no trades can be made spatially or temporally to produce a more efficient outcome. Natural gas resources are developed based on their current and future economic rents (a Hotelling-type approach to depletable resource development, but taking account also of changing costs as resources are depleted). Each resource must compete against all other potential resources serving regionally discrete end-use markets. Thus, heterogeneity in development costs and resource size, as well as transportation costs and distance to market, are extremely important factors in determining which resources are used first. Furthermore, the return to capital for different transportation options and associated production facilities (such as liquefaction and re-gasification plants) will determine whether the resource moves by pipeline, LNG tanker, or simply not at all. In fact, it is possible that isolated resources with a low cost of extraction will not be developed due to the cost of transporting them to market.

Data for the resource base is taken from the United States Geologic Survey's (USGS) World Resource Assessments for natural gas. The model under development will be the first to examine the economic implications of the monumental geological research effort undertaken by the USGS. Data for the estimated costs of developing and extracting those resources was developed under the CRADA between Altos Management Partners and the USGS. Pipeline and LNG value chain costs are taken from multiple sources, which will be outlined in the study.

Demand and supply are characterized regionally, with greater detail in certain areas. For example, North America is divided into more than 50 regions. Russia and the Former Soviet Union are separated into more than 15 regions. Most other demand sinks or supply sources are aggregated to the country level. Remaining exceptions include other producing or consuming countries with substantial natural gas infrastructure, or countries such as China that are expected to play an increasingly important role in world energy markets over the next few decades. Regions with little infrastructure and relatively small potential impact are aggregated in order to reduce the computational burden. In some cases, insufficient data made a disaggregated analysis impossible.

The economic model under development at Rice University also incorporates research on the relationship between energy and economic development, which was acknowledged by the International Association for Energy Economics with its 2001 Best Paper prize. Accordingly, energy intensity is allowed to decline at different rates in each end-use sector as per capita income rises. Demand elasticities with respect to income, own-price, population, weather, and alternative fuel prices are estimated using historical data from the International Energy Agency (IEA). These are used to determine the share of natural gas used in each end-use sector. Thus, economic growth, population growth, and the relative price of competing fuels will determine the extent to which natural gas demand grows in different end-use sectors in different countries throughout the world.

The Rice model will illustrate how global gas markets may develop over the coming 30 years and predict, under certain conditions, the future supply sources for natural gas to various end-use markets. The model can also be constrained to show the consequences of certain political interventions, such as a loss of Russian supply due to bureaucratic inefficiency, the interruption of new project development by the formation of a producer cartel, and other similar events.

The historical case studies and the global economic modeling described above are both valuable stand-alone research. However, the study seeks to push forward to integrate political and institutional insights from the case studies into the economic model of world gas markets. Key factors such the impact of political risk on the pace of project development and the intervention of international financial institutions will be allowed to influence new project development. Such factors often determine which projects are built first; such first moves, in turn, condition the market's future development. This study will break new ground by going beyond the typical economic optimization model framework to incorporate political and institutional realities and a freer range of non-economic possibilities for gas trade development.

Scenarios will be developed from the synthesis of macro-level and regional insights from the case studies. The modeling team and case study authors are now working together to develop various applications of the model that will highlight the interaction of economic and political forces; these will be used to "shock" the base case economic model:

• Politics and Economics: the 1990s. We will calibrate the model to 1990 conditions and then run it for the period 1990 to 2003 using just technoeconomic variables, such as capital and operating costs of projects, gas reserves, and transportation distance. We will then compare the results for the "optimal" run with the real outcomes-the projects actually built in the 1990s. The modeling and case study teams, working together, will aim to explain the differences between the optimal and real outcomes. We will focus on ways to incorporate political, institutional and legal variables into the model so that an embellished model better reflects this wider range of factors at work. We may prepare special runs in which we "layer" these additional variables-for example, adding indicators of political and investor risk to existing cost structures-to explore the sensitivity of outcomes to these factors.
• Making a market: the case of China. The first drafts of the case studies have revealed that some countries have "made" a market for gas with explicit policy interventions. Examples include Japan in the aftermath of the Arab oil embargo and the Soviet Union with the creation of a twenty-year gas policy in the 1950s. The World Bank and national governments have also attempted to create markets for gas in several key South American countries. From these historical examples we are learning about the rates of change and the roles of key projects in "making a market;" these factors tend not to be reflected in existing economic models because they are explicit policy interventions, often pursued as "grand projects" with a governmental hand that does not follow a narrow economic path. China is already attempting to create such a market with the West-East pipeline project and a few LNG projects, but creation of a much larger market requires politically more challenging tasks-bringing gas from Russia (across or around Mongolia), allowing vast imports of LNG from politically unstable countries (e.g., Indonesia), displacing coal (and jobs), etc. Many of the challenges for Chinese policy arise not just from the higher short-term cost of gas (compared with coal) but also Chinese notions of energy security, which are often used to block energy import projects. We are using these insights to develop 2-3 storylines for possible creation of a gas market in China and to explore the consequences for regional and world gas markets with the WGTM.
• Internal Reform: the role of state-owned enterprises. Nearly all the major gas exporting countries have built gas sectors that are dominated by state-owned enterprises (SOEs). This poses possible challenges for technoeconomic models. On the one hand, SOEs are integrated monopolies that can adopt a long-term perspective that is consistent with the long-run optimization framework that is often used in large scale energy models. On the other hand, SOEs are often highly dysfunctional entities-inefficient in their operations and often seized by the state to perform special functions, such as building large (often uneconomic) trophy projects. Often the state seizes large amounts of the SOE's revenues for general budgetary purposes, which leaves the SOE unable to spend on long-term capital projects. (Similar patterns are evident in the electric sector, where Stanford's PESD has devoted much research attention in recent years.) To date, the implications of this internal organization of the gas sector has not been examined in models. We will develop storylines that will explore the implications using one key SOE as the example: Gazprom. We will examine the implications for Western European regional gas markets of alternative pathways in Gazprom reform. One storyline examines the consequences of not reforming Gazprom; a second looks at marginal reforms that create space for outside investors in large projects (e.g., the Yamal peninsula gas fields). A third storyline looks at classic "common carrier" reform that would transform Gazprom into a pipeline company with enforceable open access rules that would encourage other firms to supply large quantities of gas from Turkmenistan and Kazakhstan (and a lesser degree Uzbekistan) as well as prodigious quantities of associated gas from oil operations (most of which is presently not transported from oil fields). In each case, we examine the implications for key markets (e.g., Europe) and for global gas markets (via price formation in LNG markets).

Finally, the case studies and the modeling efforts will help to frame a discussion of the contours of the world gas market over the next three decades and its implications for political relations between nations-especially nations that will be required to build and operate costly, shared gas infrastructures. We also will examine whether key gas suppliers could form a cartel-a "gas OPEC." More broadly, attention will be given an investigation of whether market power will flow to port-accessible buyers or to major producers with spare capacities.

Our goal is not only to explain the past with greater precision but also to look at possible futures in the shift to gas. We aim to develop visions for a future gas economy that are more firmly rooted in a realistic assessment of the political and institutional factors that have a large impact on investment in infrastructures and thus on the pace and character of the unfolding gas revolution. Although we focus on the political and institutional factors that will shape this gas transition, we also aim to speculate on the political consequences of a shift to gas. We expect that the shift to gas will bind nations together more tightly as more countries will be forced to build and operate shared infrastructures.

The study will conclude with two major products. First, the study team will prepare an edited book volume that will integrate the results and present, in one place, all the major findings. (A draft outline for the book is attached.) Second, the team will host a major conference that will bring together policy analysts, industry, and government representatives. We will present results from the study and focus a dialogue on the long-term implications of a gas-intensive world. This capstone conference will be held at Rice University in Houston, Texas on May 26-27, 2004.

Further information on the Geopolitics of Natural Gas study, including meeting notes and presentations of initial results, is available at:http://pesd.stanford.edu/gas.