Streetwise Professor

June 24, 2008

A Gas Cartel?

Filed under: Energy,Politics,Russia — The Professor @ 10:38 am

Edward Lucas and Bob Amsterdam both offer recent comments on the potential for an OPEC-like cartel for natural gas.

In a book review in the WSJ, Edward writes:

[Marshall Goldman] also sees no danger of an international natural-gas cartel forming along the lines of the Organization of Petroleum Exporting Countries, one that would presumably include Turkmenistan, Venezuela and Trinidad.

Russia would never let its decision-making be affected by others, Mr. Goldman says. That may be true in the case of price-setting (where the economics are quite different from the oil market, because oil is traded on the spot market, whereas the international gas business is mainly based on long-term contracts). But a possible Organization of Gas Exporting Countries could still help bolster Russia’s position by consolidating producer power in exploration, pipeline routes and the market for liquefied natural gas.

Yes, oil is currently traded on a spot market–but it wasn’t always so. The spot oil market began during the second oil shock of 1979, with the abrogation of equity agreements between Mideast producers and the “seven sisters” oil companies. Contracts are made to be broken, and something similar could well occur in LNG if producing nations found it to be in their interest.

Moreover, contracting choices are endogenous. Long term contracting makes sense when there are relatively few potential consumers and producers of LNG. Under these circumstances, individual buyers and sellers are locked into bilateral relationships characterized by huge investments in specific assets. As more LNG production facilities and ports are created, however, the lock in problem is mitigated. Put differently, the market is “thicker”–and thick markets can support spot contracting.

Indeed, the spot market for LNG is developing apace, and the flexibility of spot market contracting is increasingly recognized as an important source of value for producers. Thus, although it is correct to say as a historical observation that LNG is bought and sold under long term contracts, this is unlikely to be an accurate forecast of how the market will look even 5 years hence. A cartel could effectively control such a spot market for LNG, and affect pricing for all natural gas, even that delivered by traditional pipelines.

Robert writes:

Such a cartel would not function in the same manner as OPEC – and this is the most frequent sticking point for critics who say there is nothing to worry about. Given the regional nature of natural gas (LNG is still not produced in high enough quantities to generate a spot market), it is unlikely that cooperating exporters could ever achieve production quotas in order to put supply pressures on price.

As I just noted, this statement is becoming increasingly obsolete. Natural gas is becoming less and less a regional market. And what’s important to remember is that prices are set on the margin–and for most major consuming regions LNG is, or will soon become, the marginal fuel. Even if a particular market receives the bulk of its gas from a traditional pipeline, its marginal source, and the only alternative source for major supply increases, is or will soon be LNG. The price of this marginal/alternative source will limit the price that the traditional supplier–Gazprom, say–can charge.

Hence, even if LNG volumes are smaller than volumes delivered through traditional pipes, it is becoming sufficiently important to be a major determinant of the profitability of traditional operators like Gazprom. That firm’s market power will depend in large part on the potential competition from LNG. Hence, the firm has a tremendous incentive to take actions–most importantly, the formation of a gas cartel–that would reduce competition from this source.

Britain is a case in point. At the UH-GEMI energy trading conference in March, Davis Thames from Cheniere (which ran into some financial problems in May) noted that Britain is building LNG capacity that is (if memory serves) about 9 times what its LNG imports are likely to be in the near to medium term. Why would this possibly make sense? If the LNG market is competitive, this excess capacity would sharply constrain the ability of a traditional pipeline supplier to hold up Britain for a higher price. In other words, the capacity would greatly increase British negotiating leverage–if the LNG market is sufficiently competitive and liquid.

But if it is not . . . the traditional suppliers–most notably Gazprom–would have tremendous market power despite the consumer investment in LNG ports. Hence, throttling competition in LNG is essential to Gazprom as a means of maintaining its market dominance.

When appraising the prospects for a gas cartel, I therefore take very little solace in differences between the market for oil and the market for LNG. The oil market once looked not too different from the LNG market; the oil spot market only blossomed during the second oil shock, and with the increasing diversity of LNG supply sources and demand sinks, the LNG spot market is developing and will continue to mature and grow. Since LNG is becoming, and will almost certainly be, the marginal, price setting source of gas for most consumers, it is the most important competitor for traditional pipe-in-the-ground (or under-the-sea) operators, most notably Gazprom. Gazprom therefore has a tremendous incentive to facilitate formation of a gas cartel, and exporters of LNG could profit from its formation. Hence, in my view, such a cartel is a matter of serious concern. Unfortunately, as seen too often in Central Asia, major consumers in Europe and the US don’t seem to be taking the threat seriously, and are running the risk that OGEC will do to the gas market what OPEC did for oil.

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