05.09.2009
Energy Markets in a Turbulent Zone
№3 2009 July/September

Analysts all over the world are anxiously monitoring the impact
of the global crisis on the energy sector. Amid the variety of
tensions of the current developments, few consider the fact that
the energy sphere, ravaged by the crisis, will be facing the main
trials after it is over. The crisis will completely reconfigure the
world energy market.

The new energy order will set much tougher demands for its
participants. That is why it is so important for Russia to discern
through the obscure today an outline of the post-crisis tomorrow,
and be ready for the new reality.

SURPRISES OF THE DEMAND

In the past 30 years, the policy of all world energy market
players has been based on the idea of continuous increase in
consumption. However, this paradigm might not work for many
markets, and not just in the next few years, but also in a more
distant future.

The slow, sometimes controversial and often unsuccessful, yet
steady policy of energy conservation and development of alternative
energy sources, pursued by the developed countries, is gradually
beginning to pay off. Of course, we can hardly expect major
breakthroughs here: what we can see is a gradual change in the
lifestyle which starts with the replacement of a light bulb or
fixing new windows. The countries of the Organization for Economic
Cooperation and Development (OECD) are launching new energy
effectiveness standards. These standards remain in force even if
fuel prices plunge to their lowest level, when all stimuli for
energy conservation seem to be disappearing, and the
competitiveness of alternative energy sources is hardly worth
talking about.

Whereas we might argue about the pace of progress in energy
effectiveness, its result is obvious and inevitable – a decrease in
the energy intensiveness of the economy. This means we might expect
a decrease in the rate of growth (if not a decrease in absolute
volumes) of the demand for fuels in OECD countries in the
foreseeable future. According to estimates, even a partial
fulfillment of Barack Obama’s energy plan and Europe’s 20/20/20
targets may stall the demand for oil and gas in the U.S. and Europe
already in the medium term. Furthermore, both the United States and
Europe view these measures as an important part of their
anti-crisis packages.

Government subsidies for alternative power generation and
energy-conserving technologies can in fact be regarded as a means
to inject money into the economy in order to create competitive
advantages and jobs and increase the load of production
capacities.

If one adds to this the concept of energy supply security, which
became popular at the beginning of this century, the desire of
consumer countries to diversify sources of energy imports, as well
as their efforts to develop their own energy production, it becomes
clear that even after the crisis is over, the volumes of oil/gas
imports by the developed countries will be markedly lower than was
predicted in the past few years.

For example, Obama’s energy plan gives priority to a dramatic
reduction of the United States’ dependence on oil imports by
developing the production of biological fuel, enhancing energy
effectiveness standards for cars, and resuming drilling in “closed”
territories on land and in offshore zones.

The introduction of new standards and technologies will
stabilize the consumption of natural gas in households and the
industrial sector. Moreover, until very recently the demand for gas
was expected to grow in power generation; however, the president,
in his policy statement, named the stabilization of electricity
consumption by 2020 a priority in the new U.S. energy policy. To
this end, the U.S. government will allocate 130 billion dollars in
investments. Another short-term priority is the construction of a
gas pipeline from Alaska with a view to reducing imports of
liquefied natural gas (LNG).

The U.S. has been actively developing new technologies for shale
gas production to improve the country’s self sufficiency. Many
years of investments in these development efforts began to pay off
in 2007 and 2008, boosting aggregate gas production in the U.S. by
14 percent.

According to U.S. Federal Energy Regulatory Commission
estimates, annual shale gas production in the country may reach 200
billion cubic meters in a decade. As a result of all these
measures, the North American LNG market, which exporters regarded
as the most dynamic and attractive just a couple of years ago, is
shrinking dramatically.

Forecasts for gas consumption in Europe have been scaled back,
as well. Estimates of Gas Demand-2020 have been cut by 180 billion
cubic meters over the last decade, and import forecasts have been
revised downwards by 135 billion cubic meters. The reductions are
in line with the EU’s new energy policy aimed at improving the
energy effectiveness of the economy, developing alternative sources
of energy, decreasing the impact on the environment, developing a
competitive market, and improving EU energy security. Benchmarks
for achieving these goals are:

  • increasing energy effectiveness by 20 percent by 2020;
  • reducing CO2 emissions by 20 percent by 2020;
  • increasing the share of renewable energy to 20 percent of
    aggregate energy consumption;
  • ensuring the security of energy supplies (primarily by
    diversifying sources of supply).

These intentions are largely a political declaration, as most
European experts are skeptical about their feasibility. For
example, Cambridge Energy Research Associates noted in a study,
conducted in early 2009, that the declared goals could only be
attained by 10 percent. Yet even a partial implementation of the
measures within the EU’s 20/20/20 climate and energy package will
result in a dramatic change in the demand for gas – it can stop at
the present level. In the event of complete implementation of the
designated goals, the aggregate gas consumption in the EU-27 will
plunge to the level of the early 1990s, while the demand for
electricity (the major gas consuming sector) may freeze at the
current level.

Furthermore, the EU Energy Security and Solidarity Action Plan:
2nd Strategic Energy Review, published in November 2008, for the
first time officially presented a scenario of a decrease in the
import of natural gas.

The same trend is observed in Asian countries that are OECD
members, above all Japan and South Korea. A decrease in the share
of energy-intensive productions in the economy, and a steady
increase in energy effectiveness standards against the background
of the continuing economic stagnation will reduce the demand even
in absolute terms. In Japan, the demand for petroleum products had
been decreasing for several consecutive years before the crisis.
The trend is so obvious that it is planned to shut down a number of
refineries in the Asian-Pacific region because of the shrinking
market.

The crisis has only intensified these trends, clearly indicating
that the global demand for fuels can decrease, as well. The surplus
of capacities in the oil industry and LNG production keeps growing.
It is not critical and may be short-lived, yet it may bring about
serious upheavals in the conditions of the strong financial
pressure on market participants.

It has suddenly turned out that there is a large surplus of oil
extraction capacity. The fall in demand, caused by the crisis,
coupled with a large-scale commissioning of new oil production
facilities in 2009 (as a result of investments made in the previous
years of high oil prices), have increased excess extraction
capacity in the world from 2.4 million barrels a day in 2008 to 6.4
million barrels a day. This is a record high level since 1988.
Excess extraction capacity now accounts for 8 percent of the total
demand for oil. There is a similar surplus in oil refining.

The LNG market, which has posted the highest growth rates in the
past few years, is showing an even more pronounced surplus of
production capacity versus the demand. In 2009, 19.3 million tons
of liquefaction capacity was commissioned (up 10 percent from
2008), and again, the decisions on investments in these projects
were made several years ago, amidst LNG shortages. In 2010, this
capacity is expected to grow by another 31 million tons (16 percent
more than in 2009, and 30 percent more than in 2010). This will be
the largest increment in capacity in the entire history of the LNG
market.

Despite the inopportune moment for the implementation of these
projects, the owners of the liquefaction facilities will have to
launch them to pay on loans. A considerable part of the new LNG
volumes (over 50 percent) has not been contracted and is likely to
end up in spot markets which are most sensitive to the demand
slowdown. The emergence of such a “gas bubble” on the market with a
diminishing demand will inevitably result in a further price
downfall. In addition, the surplus of cheap gas on the spot market
may prompt consumers to insist on a revision of the price formula
and the “take or pay” terms in long-term contracts, with a view to
reducing the mandatory minimal level of payment.

THE BUYERS’ MARKET AND THE SELLERS’ MARKET

The crisis “cushion” of idling capacities and the falling demand
are re-arranging the already complicated producer-customer
relations, strengthening the positions of the latter. Consumers,
amid the excessive supply, begin to dictate their terms. For
example, buyers in Japan, South Korea and Taiwan already insist
successfully that they tap less gas, even under rigid “take or pay”
contracts. Talks are underway to temporarily ease terms regarding
gas volumes or to re-direct methane carriers to other markets.
Consumers now have a wealth of options. In these conditions, a
supplier who can offer the most attractive prices and flexible
terms gets a competitive edge.

Of course, the domination of consumers will not last forever.
The history of the hydrocarbon market proves that periods of
excessive supply and low prices result in a slump in producers’
investment activity and, eventually, in capacity deficiency. The
fall in hydrocarbon prices has already forced all oil and gas
majors to revise their investment projects.

According to the International Energy Agency, several dozen
upstream projects with an aggregate output of 6.247 million barrels
of oil a day and 90 million cubic meters of gas a day have been
postponed, suspended or cancelled since the middle of 2008.
Considering the long investment cycle in the industry, the demand
for oil and gas will certainly start growing once the recession
gives way to an economic upturn – if not in the OECD (for the
reasons stated above) then in developing countries, primarily in
Asia. The crisis-induced slump in investment activity will
inevitably lead to a new shortage of hydrocarbons and price hikes.
Producers and consumers will swap places again.

The comprehension of the cyclic nature of energy markets’
development and the destructive power of fluctuations for both
producers and consumers should help them find new forms of mutual
interaction, because this “price swing” and the “built-in”
instability of the markets prove to be too costly.

The need for a long-term balance of the interests of market
participants is overdue. The existing system of international norms
and tacit rules of trade in fuels is so obviously faulty that its
replacement is inevitable. The problem is what upheavals will the
world energy sector have to face before a new balance is found?

Hydrocarbon pricing is a particularly painful problem. The main
paradox of the modern energy market is that prices on the most
globalized and highly competitive oil market have lost touch with
their basic indicators, while their volatility is disorienting real
investors.

Oil prices have become a financial instrument: a mortgage crisis
in the U.S. caused investors to seek liquid and reliable assets and
they began to invest in oil and gold. Back in 2006, a U.S. Senate
report, “The Role of Market Speculation in Rising Oil and Gas
Prices,” emphasized that the world price of crude oil was formed
irrespective of supply and demand, and that it was controlled by a
complex system of the financial market – hedge funds and key banks
in the oil sector, such as Goldman Sachs and Morgan Stanley. A
major role is also played by international oil exchanges of London
and New York. In fact, it was the development of non-regulated
international trade in derivatives in the oil futures sector in the
past decade that created conditions for the emergence of the
speculative oil price bubble.

A probe published in May 2008 by the Commodity Futures Trading
Commission (CFTC) showed that in April 2007 up to 70 percent of oil
futures on NYMEX were purchased by profiteers, as compared with 37
percent in 2000. The trade in contracts, structured as futures but
sold on non-regulated electronic markets – with no restrictions on
the number of open positions at the end of the day, has been
steadily increasing in the recent years. In addition, starting from
2000, the CFTC has been gradually deregulating over-the-counter
trade in oil futures.

In August 2008, after the report’s publication, the CFTC imposed
permanent limits on the size of speculative positions that
investors may open in exchange trade. The Commission also announced
its plans to demand detailed accounts from all foreign exchanges
trading in futures for supply of U.S. brands of oil, with the
introduction of restrictions on these exchanges, similar to U.S.
restrictions.

Major investment funds hurried to withdraw their capitals from
the oil market, which provoked a collapse of quotations. Another
factor behind the price dynamics was an objective decrease in
demand – first, due to exorbitant oil prices at the beginning of
the year, and then, starting in the summer of 2008, due to an
economic slowdown in the developed countries.

The lack of an effective pricing model gave rise to a
manipulative oil pricing system and excessive speculations on the
oil market. Current oil prices still reflect the state of financial
markets, rather than the actual supply-demand ratio; furthermore,
due to the remaining pegging mechanism, the virtual nature of oil
prices influences gas prices as well.

Obviously, periods of low prices evoke discontent among
producers about the existing pricing system. They would prefer the
more attractive “good old” mechanisms, such as direct bilateral
relations between producers and consumers, or cost-plus pricing
which takes account of the cost of production and transportation,
the investment element and a profit margin. This system does not
promise super profits when prices grow, yet it protects producers’
money when prices fall, and now it finds increasing support among
them. For example, the president of Turkmenistan made a statement
to this effect in April.

Multiple reductions in producers’ revenues (for many of them,
oil/gas export revenues are a critical part of the national budget)
and entry to export markets by suppliers with no contract history
with importers (Iran, Turkmenistan and Azerbaijan) may consolidate
the established producers outside the OPEC cartel, which has been
demonstrating its complete loyalty to consumers in the last six
months. For such producers, it is not a matter of profiteering but
a matter of survival and social stability in their countries. Of
course, this prospect does not add stability to energy markets. But
if one keeps ignoring producers’ interests for too long, they will
become increasingly assertive. It should be noted that in a crisis
economic agents are often unable to work out long-term strategies –
their priority is to keep cash flows at any cost.

The unprecedented scope of market globalization aggravates the
instability of the situation: the extended chain of suppliers
boosts the role of the transit of fuels, which has become an area
of high risks capable of negating bona fide efforts of other
participants. As the number of countries involved in any chain of
energy supplies is growing, the reliability of these supplies
increasingly depends not so much on technical but on institutional
factors, above all on market regulation in individual states.
Therefore, the bipolar model of producer-consumer relationships
must be supplemented with a third – and highly problematic – link,
namely transit countries.  During crises, these states seek to
raise transit fees, preferring short-term increases in revenues to
long-term financial advantages.

The collision between these fundamentally different outlooks
must produce a system of new international norms and rules for
regulating the energy sector. Importantly, the formation of such a
system is of critical importance not only to the industry itself
but also to all economic and political agents. The case in point is
not so much the adoption of preventive measures or local accords on
certain aspects of fuel transportation, as the development of an
entirely new, universal model and instruments of interaction in the
global energy space. The old patterns that took shape three decades
ago will fail to meet the new challenges.

RUSSIA IN NEED OF RESETTING

The world energy sector has entered a high turbulence zone: we
will be facing serious upheavals and changes in rules of the game
on this complex market at least during the next decade. The world
should be readying for mounting confrontation between consumers and
producers, who will have nothing to lose in this struggle. A
revision of pricing models and a fundamental change of the legal
and regulatory framework are quite likely. The geography of the
demand will change too, causing a rerouting of supplies. The
stagnating energy consumption will inevitably increase competition
between producers – both at the level of countries and
companies.

A new redivision of energy markets is very possible. Major
transnational oil/gas companies, which earned big money during the
“fat years” and which do not bear the burden of social commitments,
will seek to reclaim the positions that they have yielded to
national companies with high state shares in the past seven to ten
years. This is just a shortlist of the new conditions in which all
market participants will find themselves, including Russia, one of
the key players.

Considering the heavy dependence of the Russian economy on
energy exports, it is difficult to overestimate the importance of
adapting the external energy policy to the ongoing changes. Also,
given the duration of the investment cycle in the energy sector and
the need to create a transport infrastructure in advance, decisions
have to be made today, in the conditions of tough budget cuts and
frustrating uncertainty of the international situation.

A constant monitoring of the dynamics of the demand for fuels in
major consumer regions remains critically important. It is
necessary to watch for changes in their energy policies, especially
in energy effectiveness, and develop alternative scenarios for the
export of Russian fuels, while taking into account possible
stagnation of the demand among the largest consumers.

The anti-crisis strategy is universal for all sectors of the
economy – the main emphasis is placed on reducing costs. This is
particularly important for the Russian oil and gas industry. The
short respite given by the ruble devaluation is drawing to a close.
Companies now have to take crucial organizational and technological
measures to bring down costs in all the links of the chain of
supply. Simultaneously, they need to re-evaluate and select the
most effective investment projects and discard the rest.

Another imperative is to win clients’ loyalty. Russia will have
to build its relations anew on the traditional European market,
where Russia has been cast in the role of a “dangerous” supplier of
late. One can talk at length about the reasons behind this
attitude, but it is more important to find ways to change the
negative attitude towards Russia’s “energy superpower” brand, at
least to elevate it to the level of reasonable confidence. A
considerate approach to clients, discounts, more attractive terms
of contracts, and active marketing and trade will help preserve the
market niche during the crisis. Since the guarantees of sales
assume special significance, partnerships with companies with
strong positions in the downstream sector are becoming highly
useful (although it is obvious that in exchange, we will have to
offer them really attractive assets or projects in Russia).

New markets can be gained through various exchange operations
with other producer companies (swap deals), which will help
optimize transportation costs.

In crises, the main competitive advantage is effectiveness,
flexibility and adaptability. Russian companies that operate abroad
will have to quickly adapt to changes in regulation and, if
necessary, to rebuild their organizational structure to meet
legislative requirements.

Considering the geographic shift in demand, Russia will have to
learn to work effectively in the Asian region, with its peculiar
pricing system. It has other price targets, and one should not
expect profits there to be as high as in Europe. However, one can
learn to derive reasonable profits on this market and, having
gained a foothold on it, benefit in the future from large exports
and a variety of supply routes.

In other words, Russia needs a comprehensive program to overcome
the crisis in the energy sphere, which will enable it to fit into
the new energy matrix naturally, using the main advantage of the
crisis – the emergence of a certain timeframe to win new
positions.