Abstract

This short contribution is an extension of a note that I circulated about a year ago. Although not understood at the time by many readers, a key point in that paper and in my new energy economics textbook (2007) is that the energy situation in Russia is rapidly changing. As with the OPEC countries and oil, Russia is now in position to play a decisive role where the international ‘gas game’ is concerned, thanks largely to the pressures placed on world energy markets by the escalating energy requirements of China and India. These pressures are going to require increased alertness on the part of gas consumers, and this is particularly true in Europe if the pseudo-competitive market favoured by the EU’s Energy Directorate is forced to confront monopolies or strong oligopolies on the supply side. The titles of the sections in this paper are 1. Introduction; 2. In the Line of Fire; 3. Caution: Genius in action; 4. Economics, economists, and deregulation; 5. Concluding remarks.

Key words: Oligopoly, Monopoly, Deregulation, Gazprom, nuclear energy, gas

Introduction

In the twenty years since the publication of my book ‘The Political Economy of Natural Gas’ (1987), natural gas has become the energy medium of choice for many governments and environmental groups. The reason is that since natural gas has been used for decades, its qualities are known and highly valued by both old and potential consumers. Moreover, if we ignore location and intertemporal economic considerations – such as price rises resulting from demand tending to grow more rapidly than supply – it is comparatively plentiful.
As to be expected, Jonathan Stern took issue with my book because I insisted that the more Soviet (i.e. Russian) gas purchased, the better for consumers on the buy side of the market. The economic logic here – which perhaps I should have presented on a more elementary level – was that financing the expensive investments required to greatly expand output would provide an additional incentive for the Soviets to deliver and be paid for the gas stipulated in contracts. By way of contrast though, Professor Stern accepted my claim that the only conceivable attack by Soviet citizens on Western properties during the later stages of the Cold War, would be an attack on the duty free gin and whiskey so prominently displayed at various diplomatic and commercial receptions.
The kingpins of the European Union (EU) recently held a meeting at which the availability of Russian natural gas and oil was reportedly discussed at great length, which led the Financial Times (March 23, 2006) to suggest that the sale of Russian gas to China and Japan might have a negative effect on the energy prospects of Western Europe. By extension, in the long run, this also means North America, because the international gas scene – which includes (or will include) very large amounts of (seaborne) liquefied natural gas (LNG) – has begun to take on some of the features of a mainstream textbook market. Of course, it could never take on all the attributes because – as pointed out in the final chapters of your favourite volume on price theory – a monopoly or strong oligopoly in natural gas has too many special traits to assume the perfectly competitive structure characterizing the fantasies that European Union (EU) energy ‘experts’ have presented their employers for about the last decade.
This last remark needs amplifying. Regardless of appearances and stated intentions, the Russian gas sector today is a state or quasi-state monopoly that features the largest gas company in the world, Gazprom, in addition to a patchwork of oligopolies that are reputedly under some form of private control. As a teacher of economics I have no problem with this, because as Augustin Cournot might have suggested if he were alive today, a monopoly makes more sense for the Russians than a ‘reform’ that creates under-dimensioned ‘competitive’ firms, which together with the camouflage provided by a share market would be hailed by the international business press as a shining example of the free-enterprise system.
The above conclusion about monopoly can also be derived by extending the well know model of Joseph Bertrand – Cournot’s often cited critic – and since Bertrand’s work on oligopolies involved price rather than quantity adjustments (as was the case with Cournot), it turns out that a simple algebraic examination of Betrand’s work leads to the ‘price equals marginal cost’ outcome that typifies perfect competition. But if we continue along this line with the help of elementary game theory, we could infer that some firms might have a cost structure that would enable them to eliminate or merge with all or most of their competitors. As John D. Rockefeller demonstrated with Standard Oil, if the legal system is compliant, it would then be possible to enjoy some lovely profits.
The intricacies of the aforementioned Brussels conclave are unknown to myself, but undoubtedly gas prices and the reliability of delivery were somewhere in the picture. In dealing with the future of the gas price, the price of oil must necessarily be considered, since typically the price of gas is indexed to that of oil; however both the International Energy Agency (IEA) and the United States Department of Energy (USDOE) have assured us that we can forget about our oil anxieties until 2030, which implies that we do not need to worry about gas until an even later date, since the reserve-production ratio for gas is appreciably larger than that for oil. This is the kind of assurance that an intelligent person should make it his or her business to ignore, because the peaking of the global oil production can hardly be delayed past 2020, and when that traumatic event takes place the price of oil and gas could zoom past the top of the Richter scale.
Even if those technological miracles appear that energy corporations have started to emphasize in the millions of dollars worth of advertisements they now plaster over full pages in almost every Sunday supplement in the civilised world, it is impossible to avoid suspecting that some very ugly energy news could appear at any time as an integral part of CNN or Fox News infotainment. The problem here is simple and reduces to numbers rather than economics. The IEA estimates that gas currently supplies about 21% of the global energy supply, and is on its way to 24% of a much larger amount. The latter observation is conveniently played down by that organization because it places a very large question mark next to their earlier (informal) predictions about future energy prices. (Note, energy and not just gas prices!)
According to Claude Mandil, executive director of the IEA, gas import dependence for the 25 EU members will grow from just under 50 percent to 80 percent (which says something about the expected decline of output in the North Sea), while in North America, the present small level of imports will reach 14 percent (FT, 23 March, 2006). Mr Mandil also confirms that the import reliance of Japan and Korea will remain very high, while China and India will emerge as “big gas importers”. How big? This he doesn’t reveal, although I feel sure that his experts have provided him with some guidelines. In case they provided him with the wrong ones, let me suggest that the effective demand of these two giants for energy materials is potentially large enough to place a dangerous strain on the international macroeconomy. (By “effective” I mean that they can pay for any purchases they make with hard currency.) Anyone doubting this should schedule a heart-to-heart chat with the former boss of the Federal Reserve System Alan Greenspan before he loses interest in these matters.


2. In the Line of Fire

One of the items in my gas book that apparently kept it from occupying a prominent position on the favourite bookshelf of Mr Stern was my contention that while the U.S. and most of the states of Western Europe were political allies, they were also economic rivals: they have always been, and they always will be – and this is even more the case now than ever. One person who had some difficulty with this concept was former U.S. president Ronald Reagan, whose advisors informed him that instead of buying gas from the Soviet Union, his European comrades-in-arms should make some effort to obtain the supplies they required from e.g. Africa and Argentina. The reason the chief executive was told this was because he was constitutionally (and intellectually) unable to accept the logical option, which was to immediately contract for the largest possible quantities that could be obtained from the Soviet Union.
I also took the liberty of claiming that the energy rivalry between Europe and the U.S. would be increasingly intense because Japan and other rapidly developing Asian countries would become major players in the great gas game. Now it appears that the chickens have come home to roost. Mr Stern couldn’t possibly have gotten this correct however, because as he enjoyed proclaiming at the energy conferences where he was an honoured guest, he had no background in economics or engineering, and thus could not possibly understand the complex cost-benefit issues that form the basis of a scientific inquiry into this subject.
When I wrote my gas book the ideological commitment of the Soviet Politburo was ostensibly to Marx and Lenin, although I was assured by some very serious persons that it was equally to dollars and deutschmarks, which made executives in the Soviet gas industry prone to discharge their business obligations. If we can assume that there is no change in this posture, then it might be useful to examine the proposals of Claude Mandil to prevent what he views as a potential supply gap whose closing will take “money and time”.
Given that he estimated that it will require only 11 billion dollars per year for adequate investment to take place so that Russian output/export goals to be met, the key matter of contention appears to be time, because it should be possible to obtain the cash involved by just passing the hat at an ad-hoc photo-op arranged for the most presentable billionaires in a recent Forbes listing (March 27, 2006). However in a more recent estimate Daniel Simmons and Isabel Murray (2007) have concluded that an annual investment of 18 billion dollars was more appropriate.
My assumption is that this 11 or 18 billion would actually go to the production and transportation of gas, rather than things like junkets to wonderful Courchevel or glamorous ‘Kitz’ at the height of the skiing season, as Mr Mandil indirectly implied. Personally, I believe that the directors of Gazprom was correct in dismissing this aspersion. They would also be correct in ignoring Mr Mandil’s suggestion that the Russians should provide “real third-party access” to gas pipelines, since by third-party he consciously or otherwise means foreigners interfering with matters whose interior logic they are incapable of understanding.
It has been suggested by some of the Norwegian colleagues that for Russia to live up to expectations about supply, relatively high gas prices will be necessary if investments are to be financed. Something else that will be required is preventing the half-baked deregulation efforts of the European Union from upsetting the delicate relations between gas producers and importers by attempting to impose a market pattern suitable for weekend sales at Hamburger Heaven but not transactions involving billions of dollars. I have also heard it suggested that since a key issue is production capacity, a sensible strategy for the EU – and perhaps other official or semi-official establishments – might be to take steps to furnish Russian suppliers with the loans that they appear to be constantly soliciting these days, providing that repayment would be in gas at a FIXED price. The thing to remember here is that Russia has the largest share of proved reserves in the world (26%), and produces and exports more gas than any country. On the other hand their domestic demand is increasing at perhaps 5% a year, and the natural decline of the major Russian gas deposits is apparently quite high. (A rudimentary explanation of natural decline can be found in my new energy textbook.)
Increasingly the question is raised as to how we are going to make sure that we can avoid being unexpectedly painted into an energy corner. To my way of thinking, there is now an excessive reliance on natural gas, and not enough reliance on nuclear. I would therefore like to see a number of things carefully investigated and widely discussed. For instance, the television audience would have it thoroughly explained to them by seasoned commentators with amenable personalities wardrobes why Finland chose nuclear instead of gas and/or renewables when they decided to increase their electric capacity by 1600 Megawatts (=1600 Mw).
The conclusion that should emerge from such a discussion is that nuclear is less expensive than gas. The reasoning here can be easily obtained by turning to non-technical articles and (especially) comments in the important forum EnergyPulse (www.energypulse.net), while keeping the following in mind. A nuclear plant constructed today could still be going strong in 70 years, while the global output of natural gas will probably have peaked long before that time. Moreover, as pointed out by many persons in that forum, nuclear waste is a potential source of fuel instead of a noxious bother. It also needs to be emphasized that the nuclear reactor has often been called the most important invention of the 20th century, and in a world where energy is clearly becoming more scarce and therefore more expensive, reactors can be made safer, and average capacity factors ( ≈ actual energy output divided by rated energy output) can be increased.


3. Caution: Genius in action

One of the things that I enjoy making clear in my work on oil is that the countries of the Middle East do not require technical assistance or money from abroad in order to efficiently exploit their assets of oil and gas. I have heard otherwise, however I prefer to tune out contrary opinions than to pretend ignorance on this point, because every intelligent person who reads the financial and technical press must understand that monetary and technical shortcomings on the part of these countries is a myth. Let me put this another way: I haven’t become inclined to accept a premise that would hardly be accomodated in storefront universities on the South Side of Chicago or the Champs Élysées.
There is also talk about the Russians requiring financial and technical assistance from abroad to optimize their output of oil and gas. Ideas of this sort could only originate in the thought processes of unappreciated genius. I have commented on this in the following way in my oil book (1980): “That the Soviet oil industry is in trouble is well known, but various sectors of the Soviet economy are always in trouble. The point is that time and time again the Soviets have shown that when they concentrate their efforts, they have a remarkable capacity to break bottlenecks and get results. The quantity and quality of Soviet military hardware should make this abundantly clear”. Here I was thinking in particular of the quantity and quality of the equipment in what was then East Germany, and which definitely matched the assets at our disposal in the Western part of that country. On the basis of what we knew about their training, the same was almost certainly true of their infantry and armour personnel.
Two Russian gentlemen who are not buying any of this are Vladimir Kvint, who was/is a frequent contributor to one of the best business publications in the world, Forbes, and Vladimir Milov, president of the Institute of Energy Policy in Moscow. Writing in l990, Mr Kvint informed his audience that “If the capital and expertise of companies like Exxon, Shell and BP could be turned loose on the region (East Siberia), there is no telling how high production could go.” Maybe he couldn’t tell, nor could I at that time, since the Soviet empire was imploding, but I am very definitely capable of carrying out that assignment today. It won’t go much higher than when he was vigorously trying to peddle this bizarre misunderstanding to his admirers in the financial districts of London and New York.
The second Vladimir wants no less than a repudiation of the “desire” to limit foreign investments in Russia’s energy sector. To his way of thinking “we need strategic foreign investors in Russia to ensure development of our new oil and gas fields.” The truth happens to be that just as these investors are not wanted by the Russian government, they are absolutely not needed. President Putin has openly and explicitly called for a limitation of foreign investment in what he calls “strategic sectors” of the economy, because he understands that foreign investors do not necessarily have the best interests of ordinary Russians at heart; and if he doesn’t understand this, a majority of his countrymen may eventually inform him or his successor in very crude language: they seem to be getting tired of domestic resources being put on the block for bargain basement prices. Semi-comatose citizens in some other countries are a bit naïve about the rationality of turning the commanding heights of their economies over to strangers, but it may happen that future events will bring them to their senses.
At the same time that he doesn’t want foreigners tooling about in Siberia and elsewhere in his country, Mr Putin apparently expressed an interest in his constituents obtaining equity positions in foreign enterprises in western Europe. It has been implied that in order to realize this goal, he may be prepared to use the energy weapon – i.e. reduce the availability of oil and gas to large importers of these commodities. There are probably some illusions of grandeur which led him to take this position, because in a rational world he would discern that there is a tremendous amount of work that needs to be done within the boundaries of his own realm, and it is unlikely that this would be expedited by giving some of his best Russian managerial talent the opportunity to purchase their electronics and underwear at the more exclusive outlets in London or Paris.
Since Russia is an extremely large country, it is easy to argue that enormous amounts of exploitable oil and gas will be located in the not too distant future, particularly in Eastern Siberia or the Barents Sea. Observe: “enormous” as compared to merely large! This is the kind of eccentric idea that a certain professor in the UK attempted (with some success) to foist on the unwary for years, despite the fact that he knew – or should have known – that in the executive suites of the oil majors so dear to the heart of Mr Kvint, contrary beliefs were accepted for many years. If we look at North America, for instance, we see that the best technology in the world never uncovered any supergiant deposits of conventional oil in Canada, which is a country at least as large as Eastern Siberia; nor was it able to reverse the U.S. production decline, although most of the oil produced in that country in the last century was extracted from only a miniscule portion of the total surface area of the lower ’48 and Alaska.
Milov also wants “Moscow” to repudiate what he calls the “gas supply blackmail” now being practiced by his government. He could have called it the “oil supply blackmail”, given the direction in which a new large Russian oil pipeline will ostensibly run: a 1.6 mb/d installation from the Irkutsk region to somewhere on the Pacific coast opposite Japan. However let me emphasize that while that scholar may call it “blackmail”, in the MBA lectures at Harvard and Stanford it’s called business, and what it amounts to is making it clear to potential customers that if they can’t match the offers of other buyers, they will have to obtain their requirements elsewhere.
According to the chief of the Russian pipeline ‘Transneft’, Russia should cut supplies to “overfed” Europe, because according to him “economics manuals” clearly indicate that “excessive supplies depress prices”. Low energy prices seem to have no place in his latest 5 year plan. The part about supply and demand is correct, but unfortunately he and his colleagues should have participated, in the late l990s, in the Russian equivalent of Econ 101. According to the logic in that and similar courses, he might have been able to deduce the theoretically correct conclusion that his country was producing too much oil. Not only would a higher price have provided Russia with a larger export income, but it would have sent a valuable signal to oil users that there was probably less of that commodity in the crust of the earth than they were being led to believe.
With all due respect, I think that it might be an excellent idea if our political masters and their advisors attempt to understand exactly what Russia and other states will or will not be able to offer when, or if, oil and gas demand suddenly lunges ahead of supply, and the gap might have to be closed by some traumatic price escalations. What I do not suggest though is that extra attention should be given a recent “Special Report” on oil in the Economist (April 22, 2006). Among other things this odd contribution quoted Professor Kenneth Rogoff of Harvard University – formerly chief economist of the International Monetary Fund (IMF) – who calls our attention to “long-dated futures going out five to seven years”, which therefore might make it possible to lock in present oil prices until 2012 or thereabouts. In making this ridiculous claim he is more off-the-wall than Professor Henrik Houthakker of the same institution, who some years ago cited oil futures with maturities of three years as being available to hedge price risk, and at the same time referred to options.
Bunkum of this type has also found its way into discussions dealing with natural gas and electricity. There is a chapter in my new energy economics textbook that deals with these matters, and so I will merely state here that liquidity shortages in a long-dated market of the kind posited by Rogoff (and also Houthakker) could severely punish transactors who open a position anywhere in the vicinity of the maturities mentioned by these two scholars. Something else to focus on is that in reality it would be difficult to find a long-dated contract for energy futures of any type that ‘went out’ more than 5 to 7 months, if that. I can note that in New York, 1,420,734 futures contracts were traded in one day in the middle of April, 2006, thereby exceeding the previous record of 1,383,616. There was a great deal of nervousness behind these figures, and average maturities were probably in weeks rather than months.


4. 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 its decision. They were promptly sued by the consumer group Citizen Action, wherupon 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 economic truth 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 source of the gross misunderstanding 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 or failed to comprehend the more specialized literature, or even those chapters in mainstream textbooks where reality intrudes on unprofessional fantasy.
Fragmentation has also come into the picture for Gazprom, the ‘flagship’ of the Russian gas sector. That enterprise produces about 85% of Russian output, and is owned by the Russian state (with about 38% of equity holdings) and Gazprom with about 13%. (There is also a small ‘competitive’ fringe that produces about 15% of Russian gas, although they apparently own 30% of reserves.) There are influential people in Russia who are desperate to see Gazprom broken up, but President Putin probably understands that this makes even less political and economic sense in Russia than it does elsewhere, given the low price of gas in a Russia where large industries and small businesses (as well as consumers) have started to experience real economic progress, and where things are as good as they can get for a gas monopoly selling to foreign buyers. (Russia supplies about a quarter of the gas consumed in the OECD.)
In the paper by Eirik Lund and Marina Tsygankova on Russian gas exports (2006), I detected a sympathetic approach to putative Russian efforts to reduce the role of long term contracts in favour of more “flexible” short-term arrangements and spot trade. This may certainly happen some day, although it seems weird in the light of the European gas supply deficiency once predicted by (Germany’s) Ruhrgas, and which is certain to appear unless expected gas prices are sufficiently high to encourage investment. A sizable expansion of short term arrangements and spot trade means increased price uncertainty, and thus is not the way to obtain more investment in Russia or anywhere else.
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 naive 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 U.S. was initiated 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. Electric deregulation in the U.S. is a malicious farce!
What those pseudo savants 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 real as compared to make-believe natural gas networks. There is also plenty of evidence that those derivatives (e.g. futures and options) 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 U.S. 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 awkward fact that they are completely in error, because where this very important issue is concerned, there is often 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 of economics and international finance 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 crucial theoretical and empirical evidence.


5. Concluding remarks

In the conference of EU movers-and-shakers referred to above, it was proposed that the EU countries should formulate a joint strategy for dealing with their energy vulnerabilities.
I can sympathise with this to a certain extent, although unfortunately this proposal is somewhat unrealistic in the light of the deregulation agenda that has been launched by the EU Energy Directorate. I can also note that while Hannibal was the commander of a multinational army that defeated many foes, these outcomes might have been different if the same army had been commanded by his wine steward, or the gentleman who held his horse. In fact I think that Hannibal would have taught himself enough economics to recognize that when a monopoly goes head-to-head with a troupe of perfect competition wannabes, the latter usually takes a beating. If monopolies intend to humiliate or take advantage of adversaries whose flexibility is limited by what a former director of British Gas called “half-baked” rules in order to bring about ‘competition’, then why waste valuable time suffering the excruciating babble about ‘ level playing fields’ that passes in deregulation circles as sophisticated economic theory.
In the case of Europe, one of the few significant “virtues” that might be afforded by optimal integration is that large European firms would be able to negotiate with the same authority as monopolistic or oligopolistic external suppliers – to include the kind of suppliers that former Governor Gray Davis of California described as “out-of-the-state criminals”. One hopes that the present governor of California is capable of such insights, although it is possible that he prefers the so-called wisdom of Mr Joe Roeber, who in an almost hysterical article in the Energy Journal (1996), told his readers that “…big gas interests in continental Europe…will do their best to stop it happening…and you may be sure that they will fail.” By “it” he specifically means deregulation, and spot or short-term markets becoming the centerpiece of European gas markets, and thus the possible replication of a California electricity-market situation where, as Professor Darwin Hall (of California State University at Long Beach) informed me in a private communication, four new governmental agencies had to be established, and the State’s budget was ruined. Exactly what the ruining of a State budget would mean in the U.S. is a mystery to me, but in Sweden it would be another step on the road to a world where things like high-quality health care and personal security continue their Brussels-sponsored journey into the welfare sunset.
Let me add the following. The commander of the EU Energy Army at the present time is a man who believes that ‘peak oil’ is only a theory, and even worse, has announced that electric and gas deregulation makes good sense. Accordingly, I think that we would all be better off if we pretend that the above mentioned high-flown and dispensable conference with its bogus deliberations and intense press coverage never took place, and future calls for a joint energy strategy under EU supervision are either pointedly ignored or ridiculed.


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* University of Uppsala, Sweden, and Asian Institute of Technology, Bangkok.