Research Triangle Energy Consortium

On January 7, 2009, Russia shut off the natural gas flowing through the main European pipeline in the Ukraine.  This was a particularly cold winter and 20 European countries encountered serious shortfalls.  Discussed below are the reasons given by all of the players.  But the principal point was, and continues to be, that Russia can use natural gas supplies as a weapon to achieve political objectives.  In late 2008, Russia threatened to form a gas based OPEC (dubbed OGEC) with Iran and Qatar with the express intent of manipulating world gas prices.  Has shale gas dampened their ardor?  More on that below.

Unilateral fuel cut off as an instrument of political will would be essentially not possible with oil.  Oil is more fungible, and alternative supplies can be brought to bear if a major supplier falters, deliberately or otherwise.  It may cost more but you could get it.

Natural gas is a regional commodity.  Bulk transport across land can only be through pipelines, and these are expensive and have long lead times.  Transport across the ocean is feasible only if the gas is liquefied.  For shorter distances there are exceptions, where gas pipelines cross bodies of water, such as in the North Sea.  The liquid product is known as Liquefied Natural Gas (LNG).  This process entails cooling the gas to -160° C into a liquid that is 600 times as dense as free gas.  This is then transported at near-atmospheric pressure.  The low temperatures are maintained by auto-refrigeration by allowing small amounts to boil off, which chills the remaining liquid.  An everyday analog is cooling of our skin by a fan or a breeze causing evaporation of our perspiration.

While LNG is a viable alternative to a domestic gas supply, it can only be delivered to a port location, and in fact only one with a re-gas terminal.  This high capital cost is unlikely to justify a capability merely to be available for upset conditions.  So, as a practical matter withholding of a domestic source is a powerful weapon, LNG alternatives notwithstanding.  Also, LNG is more costly.  Typically the added cost over the price of the gaseous version is about $3-4 per million British Thermal Units (MMBTU).  Transport distance is the determinant of where you are in that range.  As a frame of reference, that is roughly the price of natural gas in the US today.  So, LNG would essentially double that.  This is why cheap shale gas in North America has rendered imported LNG passé.

The sheer distance between producer and user is the reason why natural gas prices are so variable across the world.  The price in Europe is about double that in the U.S., and in Japan, about triple.  This is in part because costly LNG is the marginal cubic foot, and so sets the price.

Russian Use of Gas as Weapon:  Unlike in the Soviet era, Russia can no longer impose its political will through threatened military action.  Russian gas is a significant source for most European countries.  It is the dominant source for nine countries, including Greece, Finland, Hungary and the Czech Republic.  This monopoly allows unilateral action against any one of the countries.  Action against too many would result in loss of needed revenue.  As a parenthetical point, the Arab Oil Embargo in 1973 had a profound and lasting effect on the price of oil, aside from the short-term privation.  But the original political objective was not realized, that of causing a significant shift in support away from Israel.  Interestingly, though, the lasting price escalation that was a direct result of the embargo swelled, producing country coffers.  This allowed financing of politically motivated actions in other countries, including the funding of Islamic schools known as madrasas in Indonesia and other countries.  These are believed by some to be linked to militancy.  In any case, there is little doubt that oil money is behind militant Islamism.

In an odd twist, the embargo driven sustained higher prices opened up exploration in promising but costly areas such as ultra deep water and the Arctic, thus reducing dependency on OPEC.  Since then, Norway and Brazil have become important players, on the backs of deepwater development.

The Russian action in 2009 was allegedly driven by a dispute with the Ukrainians with respect to poaching on the gas line.  While there may have been merit to this, most believe the action was intended to injure the Ukrainian Orange Revolution, which was seen by Russian President Dmitry Medvedev as not commensurate with Russian interests.  That the Revolution was suppressed is not in question.  The temporal connection strongly implies causality with the gas cut off action.  In many ways this act was more effective than would have been a military one.  It also undoubtedly sent a message to other European states.  Even Western Europe was affected, with southern Germany losing about 60% of its imported gas.

Shale Gas Could Change That:  As discussed in a previous chapter, the mechanism by which shale gas accumulates makes it likely to be ubiquitous.  So the likelihood of substantial deposits in Europe is high.  Initial estimates by the Energy Information Administration (EIA) show large deposits in Poland and France, with smaller amounts elsewhere, including the UK and the Ukraine.  Poland is actively exploring and the U.K. is following suit.  France currently has a moratorium on fracturing, but is also not as much in strategic need due to low dependency on coal-based power.  U.S. efforts to produce gas with a minimal environmental impact will be important in widespread exploitation in Europe.  Poland is certainly resolute on the matter.  Furthermore, in the U.S., as exploration proceeds, the resource estimates are bound to increase.  All new hydrocarbon resource plays follow that pattern.

Gazprom, the mammoth Russian company operating gas assets, has publicly expressed concerns regarding the effect of shale gas on future pricing.  The fact that Russia too will have large deposits is irrelevant.  A further increase in their resource base is interesting, but not a factor in the concern regarding domestic sources in client countries.

An interesting possibility is that U.S. shale gas could be exported as LNG.  Until European deposits are developed, U.S. sourced LNG could be a factor in offsetting Russian supply.  If U.S. prices remain low, as is expected, landed LNG in Europe could profitably be at below $9 per MMBTU for some years and closer to $7 today.  From a Russian standpoint, this will not be a pricing concern, but certainly the gas as weapon argument is affected.  Strictly from an economic perspective, the best sources for North American LNG are Alaska and British Columbia gas, and the most logical target customer is Japan.

OGEC is dead:  60% of the conventional gas reserves reside in Russia, Iran and Qatar.  Operating costs are very low, especially in Iran and Qatar.  In late 2008, the three announced an intent to form a gas based OPEC, which was dubbed OGEC.  (Note:  the P in OPEC is Petroleum and by definition, albeit not by common usage, gas is included in the term petroleum, so the acronym OPEC could have applied to gas as well in theory; but with a different cast of characters that would not have made sense.) Alexey Miller, chairman of Russia’s Gazprom, said they were forming a “big gas troika.”  He also predicted an end to the era of cheap hydrocarbons, thus signaling the intent of the gas cartel to raise prices and keep them high.  OPEC accomplishes this despite supplying only about a quarter of the world’s oil.  The Troika would likely have been pretty effective, in part because Russian markets are Europe and China over land, and the other two are much more LNG dependent.  So, unlike current OPEC members, at least the senior partner Russia, will be essentially non-compete with the other two except for LNG relief valves for Russian force majeure, contrived or otherwise.

Shale gas over time will kill attempts at OGEC.  China is expected to have even more shale gas resource than the U.S. and will exploit it quickly.  China National Offshore Oil Corporation (CNOOC) has already taken positions in two U.S. shale gas plays and in the first large one in the U.K.  There is little doubt that part of the intent is to transfer technology to China deposits.  European shale gas will certainly be a factor.  There is reason to believe most of the countries currently importing LNG, including India, have shale gas opportunities.  Finally, there is the specter of U.S. as an LNG export player.  All of this adds up to a world with a lot of gas in consuming countries and more options.  When consumers have options, cartels are ineffective.  Gas has always been harder to manipulate than oil.  Transportation needs can only be met by oil-derived products.  Gas on the other hand can be replaced by coal, wind and solar for power.  OGEC can be pronounced DOA, and we have shale gas to thank for that.