Vol. IO, No. 2, pp. in Great Britain
I I I-I
036th5442/85 $3.00 + .OO 0 1985 Peqwnon Press Ltd.
INTRODUCTION: GAS DEVELOPMENT BEGINS
J. E. HARTSHORN Jensen Associates, Inc., 5 rue Pedro Meylan, Geneva, Switzerland (Received October 1983)
Abstract-International trade in natural gas by pipeline and as LNG was the fastest growing element in the world gas business during the last two decades. However, less than 15% of world gas output crosses frontiers, a proportion closer to that of coal (10%) than of oil (50%). Gas, like coal, should be considered a “market locating” fuel, since its transport cost often far exceeds that of other manufacturing inputs. Moreover, gas export projects suffer from heavy front-end investment costs and from uncertain demand growth in the importing countries. For these reasons, developing countries with a potential for natural gas production must seriously consider all opportunities for local gas utilization. In order to maximize the availability of gas for domestic uses, policies which provide adequate incentives for gas development are required. Imaginative formulae to encourage exploration specifically for gas, and imaginative technology to make local gas development commercial on a smaller scale than most developers have considered so far, are the current prerequisites for natural gas in developing countries.
is unusual for an international seminar such as this to be concerned with gas for use at home as well as for trading internationally. International trade in gas has tended to monopolise most seminars and conferences on gas during recent years. This international trade has been the fastest-growing element in the world gas business for about a decade. The projects involved have been the biggest and the most newsworthy. Liquefied natural gas movement by sea, in engineering terms, is at least a remarkable technology, and at times can be economical. Gas pipelines are not technically remarkable; however, international pipelines are nearly always both enormously costly and politically controversial. Moreover, all of the best-publicised gas projects of recent years, as LNG or by pipeline, have been planned to augment the supplies of OECD economies with imports. These have been planned either to meet the shortfalls of local gas supplies (as in the U.S.A. and Western Europe) or to sustain extra use in Japan, where there is no gas and virtually no other energy supply to start with. Nowadays, most natural gas is being discovered outside the OECD economies. But most of the immediately effective demand is still there. Also, the gas is still being discovered mostly by oil companies operating internationally, whose business requires finding and developing for export the only fuel that is really convenient and cheap to transport over long distances internationally. Moreover, most of the heavy capital investment required for gas development, whether for export to OECD or for local utilisation, needs to be financed from or via the international capital markets of OECD. These facts have understandably focused Western public attention on international trade in gas. It is worth remembering that less than 15% of the world natural gas output crosses national frontiers and less than 5% moves inter-regionally. This value should be compared with the 50% or so of world oil production that normally moves in interregional trade. To complete the comparison, one might add that only about 10% of world coal production moves internationally. If both of these competing fuels develop more It
t Based on a paper originally delivered to the EGPC-IEOC International Seminar on Natural Gas and Economic Development, Cairo, 26-27 February 1982. Japan’s LNG consumption was deliberately decided on to diversify imports into an economy lacking any indigenous fuel, and is used to a large extent in power generation: a bilk use taking no advantage of any-of the-inherent “form value” of natural gas except freedom from sulohur. “OPEC and the Develooment of Fourth World Oil,” and inaugural lecture at the School of Oriental Studies, University of London,-February 1977. 111
J. E. HARTSHORN
than oil and reduce the share of oil during the balance of this century, that says something new about world energy trade and perhaps about the developing pattern of the world economy. Gas, like coal, would perhaps ideally be a market-locating fuel. It may be easier to bring the other factors of production to the gas than to move the gas. That is what happened historically with coal. This development will not preclude significant growth in the gas export trade in the coming years or, probably, in the coal export trade as well. When practical, it makes local development of gas reserves discovered in any country an important option for that country to consider; and the assessment of both of these valuable options, export and gas utilisation at home, are highly suitable and balanced subjects for discussion. OIL
A discussion of energy must start with the price of oil. In assessing the prospects for competing fuels, we became almost resigned, for a time, to sharp increases in that price and to guessing how much further it might rise. However, since early 1982, we have had significant declines in oil prices. First, spot prices fell and undermined official price levels set by OPEC, with the real price in dollars being steadily eroded further by inflation. This development was followed in early 1983 by a cut, even in nominal dollars, in OPEC’s official prices. We are now uncertain whether they may have to slip further before stabilising. This is not a settled prospect for planning natural gas development. But, since 1973, settled prospects in energy have become things of the past. All that is predictable is uncertainty. What has changed recently is something that back in 1978 I suggested to my friends on the OPEC Long-Term Strategy Committee they might eventually have to reckon with. In oil bargaining, the uncertainty has now spread to both sides of the table. This sharp rise followed by a slower fall in oil prices first inflated and then punctured prospects for a whole range of alternative energies. Suddenly, during 1979, they looked economic as well as politically safer than Gulf oil. By mid-1980 and again after 198 1, when oil buyers decided that even a Gulf war need not worry them, these oil prices began to slip. All of these developments have been highly confusing market signals, following one another, for alternative energy developments that depend upon expectations about prices for the later 1980s and after. Natural gas is, of course, not among the way-out unconventional alternative energies that suddenly looked viable and then had the rug pulled from under them again. It is a mature energy source, widely available but, for the most part, remote from developed markets. That makes transport costs critical for its development. The transport technologies are fully established. Nevertheless, natural gas also involves very large, capital-intensive projects and requires commitments from seller and buyer over exceptionally long periods taking effect only several years after the moment of decision. So confusion in price expectations for the late 1980s and 1990s may blur or postpone decisions that could otherwise be made now. That is one reason why confidence in expanding markets for gas is nowhere quite what it was a few years ago. Another reason is that, following the 1970s when demand for gas rose much more than for other energy, there has been a pause. Between 1980 and 1982, natural gas demand has levelled off or hardly fallen, while demand for most other energy and for oil in particular, has fallen significantly more. Gas along with other fuels has been affected by the weakening in energy demand throughout the industrialised market economies of OECD. That has been caused partly by a weakening in economic growth itself, from rates of 4% annually in the decade to 1973 to about 2.5% since, and of not much .better than zero growth from 1979 to 1982. Equally and more importantly, nobody can be sure, have been energy and oil savings in the industrial economies. More of that saving has happened than anybody realised until recently. It seems to have reduced the amount of energy radically that these industrial countries need per unit of economic output. Most forecasters are expecting lower growth than in the seventies, with further energy savings accruing from the two oil price shocks and savings to continue throughout this decade.
Natural gas development begins at home THE
World gas consumption is highly concentrated in the OECD regions (see Table 1). Therefore, its growth could not escape the effects of recession and general energy savings there. Nevertheless, these do not explain the whole of the pause in gas growth. The pause came also partly from the supply side, notably in the interruption of particular projects in the international gas trade. Most important, the Iranian revolution cut off pipeline exports to Russia and planned swap arrangements by which further Iranian gas piped there would have allowed extra Russian gas to be exported to Western and Eastern Europe. Ironically, the Iranian revolution affected gas export volumes much more than it affected the export volumes of Middle East oil. At the same time, existing and planned LNG exports from Algeria to France ran into difficulties in price renegotiation, as projects for the export of LNG to the U.S.A. had already done. The 1979 step change in oil prices made Algeria’s gas negotiators, for a time, yet tougher. Then Algeria cancelled some further contracts for exports to Europe, because it decided that LNG exporting required too much investment upstream which made the option of pipelining the gas across the Mediterranean preferable. Nevertheless, it took a long time also to agree on prices for gas through the only trans-Mediterranean pipeline completed so far, for export to Italy. The transmission of supplies was also delayed until long after the contractual date and the actual completion of the pipeline. The 1979-80 takeoff in oil prices did not create pricing arguments between Algeria and its customers but it sharpened and prolonged them. It temporarily enhanced supply prospects planned for the 1980s. Most of the contracts for the projects had been signed and had been considered viable at contract prices in the late seventies. Higher oil prices, which made gas exporters more ambitious, tended to delay rather than hasten gas deliveries. Even the Russian project for additional gas exports from Siberia to Europe came into being essentially as a replacement of Iranian exports that had been cut off, rather than in response to higher price levels for competing fuels. Perhaps the only major viable gas project (at least temporarily) that was encouraged by oil prices in 1979 was the pipeline planned to move Alaskan gas 4,500 miles south to the markets of the lower 48 states of the U.S.A. The higher level of price expectations following 1979 led to active discussion of LNG export projects that had been in abeyance in Nigeria and Qatar among the OPEC oil exporters and in several non-OPEC countries that have proven or highly probable gas reserves greatly exceeding any volumes they could hope to consume at home. None of these plans have as yet been confirmed by actual contracts. In most areas, the weakening of price expectations since 1982 has caused further delays for reappraisal.
Table 1. World consumption of natural gas, 1970 and 1980, and projected to 1990, in lo6 Bpdoet; data from the World Bank (198 I).’
t Bpdoe = barrels per day of oil equivalent, or 50 X lo7 kcal/yr. $ Industrial market economies include OECD except Greece, Portugal, Spain and Turkey, included in developing countries. 9 Capital surplus oil exporters are Iraq, Kuwait, Libya, Saudi Arabia, Qatar, and the UAE. ll Developing countries include China, four OECD member countries, and seven OPEC member countries.
J. E. HARTSHORN
Both of the two big pipeline projects that were planned for the 1980s to augment OECD supplies, from Alaska and Russia, ran into opposition from American politicians. The Alaskan pipeline project also encountered (and has for the time succumbed to) more practical and severe scrutiny from American banks, which were asked to finance the huge investment (perhaps some $20 X 109) that would have had to be advanced over a period of five to eight years before the line could begin to move its full capacity of some 85 X lo9 cubic metres a year. The project has now been shelved until at least the late 1980s. The Russian pipeline project, which would move up to 35 X lo9 cubic metres of gas a year from the Yamal Peninsula in Siberia to Germany, France, Italy, Austria, and other West European countries, was more robust, though the volumes will be somewhat reduced or delayed. The U.S. government put whatever pressure it could, somewhat ineptly, on its European allies not to carry out the contracts that some of them had already signed, and raised obstacles to the installation in the line of technology involving originally American know-how. Publicly, U.S. opposition was usually voiced in terms of the security of the supply-the fear that if Western Europe became too dependent on Russian gas it would become vulnerable to Russian political pressure. European buyers such as West Germany seem to consider that argument specious. Russian gas looks to them politically no more insecure than Arabian Gulf oil, and at any rate diversifies their energy import risks. More privately, U.S. diplomats argued that Western finance and technology should not be invested to back any major project that might benefit a Soviet economy facing severe difficulties, and hence indirectly make high Soviet defence expenditure more bearable. Neither argument, however, convinced the European gas importers, whose heavy industries probably needed the pipeline construction orders even more than European utilities may need the extra gas. Eventually, the IJ.S. government backed down. American political arguments on this issue tended to ignore one basic commercial consideration. This Russian project offers European utilities gas at prices they believe they can afford. The Russian prices were set and will escalate in relation to product prices in the consuming countries, not to the crude oil prices at OPEC export terminals as Algeria was claiming. Already, the contracts with Russia appear to have influenced later Algerian gas price settlements with France and Italy. The prices agreed upon were distinctly higher than those for the Russian gas and involved some political subsidy by the importing governments, but they were below what Algeria had originally claimed. The Russian contracts brought more commercial reality into the negotiation of other gas export contracts. Prospects for international gas trade indeed depend largely upon such development of the Russian gas reserves, which are by far the world’s largest. Iran, with the secondhighest reserves, has already been removed from the world market by political upheaval. If further Russian gas exports had been halted, even temporarily, by American opposition, then politics would have taken out of the potential world trade perhaps 70% of the reserves that Jensen Associates would rank as the practicable “exportable surplus” of gas. A part of the loss might be made up with additional exports of LNG. But in all probability, gas markets in Europe would simply develop less in total: business would be lost to oil. GAS
Trends in the international gas trade in the 1980s therefore, remain highly uncertain. Most forecasters, my own consultancy among them, are still guessing at growth rates of say 8% annually for this trade through the decade, though that will require considerable acceleration of development by the mid-l 980s. However, even that growth of interregional gas trade would still amount to only about a third of the total growth-say 3% annually-that we expect in world gas consumption. Most of the growth in world demand will continue to be met from gas production within the same regions. Apart from the special case of Japan,? no sizeable market for natural gas has even been developed except on the basis of large-scale indigenous reserves. Today, the U.S.A. remains the secondlargest gas producer, and the largest consumer. Even by the end of the century, it may still be producing some 85% of its needs. North America (including Canada) will remain
begins at home
more than self-sufficient. Europe now produces over 85% of its own needs, and though it may become dependent on exports for 60% of its gas by the year 2000, that will depend partly upon the stretched-out depletion policies of its then major producers, the Netherlands and Norway. The Communist sphere, likely to become the largest region of gas production and consumption during this decade, has developed gas entirely upon the base of the domestic Russian industry, which in 1982 became the world’s largest producer. Within OECD, regionally in deficit except for Australasia, this cannot continue. But in the Communist economies, which will almost certainly account for the biggest volumetric growth in the eighties, Russia can readily supply far more than will be needed. In the developing world, where oil exporters as well as some oil importers may increasingly turn to gas for their local energy needs, this self-sufficient development may take up some 60% of the extra gas production these countries hope to develop (see Table 2). Most developing countries wherein gas is discovered will find it worthwhile to consider gas exports, and a few may decide to commit all their reserves (for example Cameroon, following the example of Brunei). Some may find it geographically convenient to import gas in one area and export it in another (for example, Argentina). But for the most part one can expect countries where significant amounts of accessible natural gas are discovered to use some of it internally, whether they also export gas or not. Large proportions of this extra gas production in developing countries will be associated gas which up to now has been flared, unavoidably wasted because of the oil production with which it has to be produced. Most of the OPEC exporters in the Gulf have invested heavily to reduce the flaring of this valuable energy, using it for industrial development at home while exporting some of the gas liquids that can be extracted from it. Such industrial development will probably give those OPEC countries a significant foothold-profitable or not-in the world petrochemicals trade. Also, the gas liquids will increase their exportable liquid hydrocarbons per barrel of crude produced. For all gas operations in countries that export oil, the economics of gas development, for export or home use, are complex. Utilising gas at home and freeing extra oil for export may well improve profits and petroleum revenues. Gas costs about twice as much as oil per unit of energy moved through a pipeline, and about seven times as much exported as LNG by tanker. Up to the present, no gas export operation appears to have offered the producer profits per BTU of energy exported comparable to the economic rents now obtainable on energy exported as oil. On the other hand, local gas markets are not easy to create rapidly, and gas supplies usually become available, in relatively large quantities, very suddenly. The transport facilities needed to move them, even within the home economy, involve heavy front-end investments and need to be used to full capacity as soon as possible. Gas, we are continually assured, is a noble fuel that deserves to be used only in premium markets. Unfortunately, premium markets often involve costly distribution
Table 2. Annual
growth in natural gas consumption. the World Bank (1981).’
Industrial Market Economies
Oil Exporters Oil Importers
t See notes accompanying
data are from
J. E. HARTSHORN
facilities and generally have low load factors. Very few significant markets for natural gas have been built up without bulk, high load factor sales (for example, to power stations) to absorb the initial surge of supplies. Later, enthusiasts generally deplore this, or try to divert the gas from such ignoble uses to premium customers. But without the initial bulk sales, the local market might never have been developed at all. My American colleagues in Jensen Associates spend much time analysing the peculiar intricacies of the U.S. gas market, not all of which are readily translatable even into the gas market economics of other OECD countries. My own experience has been more with gas in developing countries, but gas developed for export as LNG. So I am glad to leave to other speakers the prognosis of local gas market possibilities within developing economies. The choices between local use and exports, and how much gas one might reasonably reserve for local use later, depend largely on particular countries’ circumstances. They are associated with the cost of waiting, that social discount rate of time preference which is so easy to define in theory and so hard to quantify in practice. The passage of time is not neutral between countries. Its cost depends upon each one’s resources and opportunities. The world’s gas reserves are not far short of total proven oil reserves (see Table 3) and they have been found, for the most part, as a by-product of exploration for oil. Since production of gas is small in comparison with that of oil, the reserves/production ratios in gas are far higher. But R/P ratios hardly matter in the gas industry outside North America and Western Europe. Everywhere else, the constraints to gas development arise not from reserves, but from project economics. For individual countries, however, finding or adding to one’s reserves of natural gas becomes distinctly important, particularly for countries on the brink of developing local gas use or opportunities for export. INCENTIVES
Most gas has been found by accident, and most petroleum legislation makes it hardly worth looking for gas on purpose. No petroleum exploration and development agreements in existence anywhere were designed primarily for gas. That was true of the former oil concessions. It has remained true in the various metamorphoses that have followed them, such as production-sharing agreements, which have tended to establish government ownership of the resource and to increase greatly the share that the government gets out of resource development. But the petroleum resource in mind was virtually always oil. Almost all the clauses that define performance and rewards for both sides in petroleum agreements define these in terms of oil. There is usually a gas clause of two possible kinds. One kind is an agreement to agree later if gas is found: in effect, convenient because meaningless. The other simply rules that any gas found shall belong to the
Table 3. World
and reserves/production from Cedigaz ( 1983).2
ratios for natural
gas ( IO9 ml); data
Natural gas development begins at home
government. That may fortify or enhance national rights. Whether it will mean anything or nothing to the country will depend on how much gas is found where, and whether there seems anything sensible to do with it. Neither kind of clause gives explorers any real incentive actually to look for gas-to drill, for example, where the geological indications imply a greater likelihood of the occurrence of gas than of oil. Thus, the explorers come looking for oil. The host government, quite reasonably, usually stipulates that it should have prior rights to any gas found coincidentally. This approach prevails mainly but not exclusively in non-OPEC developing countries, where the price of imported oil for some and the need to get the best out of their known petroleum opportunities for others (such as Egypt) make gas very well worth looking for in the national interest. In the foreign explorer’s private interest, it may not be. In my own view, as a consultant practised in the design and the modification of petroleum agreements, gas is one extremely important example of a new range of problems arising between international companies and host governments. A related problem occurs when a host country wants foreign explorers to find petroleum but later may choose in the national interest to develop the petroleum differently from the way in which the explorers would have chosen to develop it. Often, the difference arises over the pace of development and production. Time is certainly not neutral between governments looking to long-run national interests and companies whose development plans must reasonably be influenced by commercial pay-out periods and discount rates. As regards gas, this difference in rates of time preference is often complicated further by the “setaside” stipulations that host governments usually make. They want to defer any exports of gas until enough reserves have been accumulated from discoveries to cover the amount of local gas sales that they believe may eventually be developed in some chosen period. The Canadian “set aside,” often taken as a pattern, is 30 years’ consumption at current rates. For a country just starting to develop gas markets locally, choosing a sensible period (and hence the amount of reserves to defer) is not easy. In the meantime, until that much gas may be found, it may be left in the ground for years. If so, and if the discoverer gets nothing in the meanwhile, why should an explorer look for gas at all? REWARDS
The Egyptian government and a number of companies exploring in and offshore the Nile Delta, led by IEOC (the Egyptian subsidiary of Italy’s EN1 group) are now experimenting with a new gas clause in production-sharing agreements which is specifically designed to address this problem. An interesting aspect of this principle is that, if an explorer discovers significant reserves of gas which he is not immediately able to exploit because these must be dedicated to the reserves deferred for local use, then there is provision for some reward simply for having discovered it, as a multiple of his expenditures laid out on the exploration. This is a principle that I raised for discussion some years ago, but which I think has hardly been introduced into recent petroleum exploration agreements anywhere else. It is a principle that may have particular application to exploration for gas. More generally, host governments might be interested in the fact that it fits another neglected feature of all petroleum exploration. In exploration the risks are extraordinarily high, but the expenditure need not be enormous. Once the petroleum is found, the risks are much lower but the expenditures are far higher. For finding a nation’s oil or gas, the discoverer deserves a very high rate of return on his very risky gamble. For developing petroleum, he and the host government need an equity return, covering normal commercial risk, on a far higher capital investment. Both, of course, may be able to obtain institutional finance for this second stage from commercial or international banks. Development may in any case be deferred, as with gas, or carried out with a time profile of depletion representing the noncommercial national interests of the country. If so, formulae are needed that can reward the explorer for his exploration risk, as distinct from a normal return on development outlays, if further exploration is to be encouraged at all. Egypt and the companies introducing this unusual feature in petroleum formulae (which have other unusual features such as joint commitments involving parties to several
different agreements) deserve good luck with it. The principle of “the finder’s prize” has a long and honourable history in mining legislation for solid minerals. Discovery under the mining legislation of the “Code Napoleon,” for example, did not confer an automatic right to develop the find. The finder could be rewarded in money. It may not be generally appreciated that one of the world’s greatest gas fields, at Groningen in the Netherlands, was discovered under just such a “Code Napoleon” Dutch mining law. Most petroleum agreements, and many petroleum companies and governments, have so far assumed that exploration and discovery should confer an automatic right to develop. They have ignored the possibilities that nowadays development may have to be deferred, or carried out according to national depletion preferences, not commercial considerations. Egypt, which several years ago borrowed and improved the production-sharing system originated by Indonesia, seems to me to be introducing or reintroducing a valuable principle here that can strengthen one of the weaker links in the whole chain of petroleum development by offering a real incentive in newly prospective acreage to explore specifically for gas. This is one promising approach to the first major problem of developing gas resources in the Third World during the 1980s and 1990s. The second problem is the need to focus imagination down from the grandiose schemes that have characterised most development in the gas industry in recent years onto smaller-scale local opportunities to make use of modest gas finds which international gas developers might not bother with but which poor countries desperately need help to utilise. REFERENCES 1. World Bank, World Development Report 1981, The World Bank, Washington, D.C. (1981). 2. Centre International d’Information, sur le Gaz Nature1 et tous Hydrocarbures Gazeux (CEDIGAZ), Le Gaz Nature1 Dans Le Monde 1982, CEDIGAZ, Rueil Malmaison, France (1983).