Streetwise Professor

Some weeks ago I opined that it was foolish for Poland to lock itself into a very long term contract with Gazprom (going out to 2037) given the prospects for shale gas.  I did a little digging (or should it be drilling?) for information on shale gas prospects in Poland, Ukraine, and elsewhere in Europe, but other things (e.g., life) intervened and I didn’t follow up.  Fortunately, Deutsche Welle recently ran a piece on the subject that contains some interesting data and commentary:

The largest deposits of shale gas in Europe are assumed to be located on Polish territory. New technology from the United States could make it possible to exploit these gas reserves. Test drillings are planned all across the country.

According to geologists, Poland could become the largest gas supplier in Europe after Norway and Russia. It would make the eastern European country rich – much richer than previously assumed, said energy expert Pawel Nierada from the Sobieski Institute in Warsaw.

“Conservative estimates already show that Poland could suddenly become a serious exporter on the European gas market,” Nierada said. “The reserves exceed our country’s consumption many times over. It’s hard to imagine what it would be like if the more optimistic estimates of the US government were to turn out to be true. Then, here in Poland, we would have more gas than Norway.”

Specifically, estimates are that Poland has 3 trillion cubic meters of recoverable gas.  This is a small quantity compared to Russian reserves, but (a) it’s relatively large compared to Polish consumption, and consumption in adjoining countries, (b) it’s close to market, rather than locked in forbidding locations in northern Russia, and (c) it’s not in the tentacles of the gas octopus, and hence not in the clutches of one of Poland’s historical enemies.

There are skeptics, of course:

But many people are skeptical about this procedure, Nierada said.

“There are also critical voices which say that the technology is still in its infancy – the experts from the Russian gas company Gazprom, for example,” he said.

Gazprom, expressing skepticism?  Go on.  Tell me another one.

In fact, the company has acknowledged in word and deed that the shale revolution in the US has already derailed some big plans, and the extension of that revolution could truly rock Gazprom’s world, and not in a good way.  So the company has every incentive to play skeptic in the hope that this will slow down the shale juggernaut–and every sentient being should discount its skepticism as heavily as the market discounts its stock price.  Indeed, Gazprom is actively looking to get into shale plays in the US.  At the very least, this indicates that it (quite sensibly) wants to learn more about the details of the technology and the performance of shale plays so that it can plan accordingly.  Alternatively, it could indicate that the company knows very well that shale is for real, and wants to get into the game.  Either way, it belies its skeptical public statements.

Yes, there are uncertainties about shale.  The environmental concerns, from what I have learned, seem over-hyped: and there are firms out there who have every incentive to try to hype fears in order to impede shale gas as a competitive force.  More substantial questions relate to the production profile of shale wells, specifically, that production tends to fall more rapidly from shale wells than traditional ones.  But this is an evolving technology, so the possibility that additional innovations will mitigate that problem.

But as I wrote in my earlier post, the very fact that there is considerable uncertainty with an appreciable upside potential means that it is wise to avoid locking into long term commitments until that uncertainty is resolved.  Poland specifically, and Europe generally, are in the very early days of the shale experiment.  There is some uncertainty about how the technology that has worked in the US will perform in European formations, in addition to the technological and production uncertainties just mentioned.  But the US experience, in which shale has completely demolished the conventional wisdom about the future of the North American gas market in a period of less than 4 years, and which has made earlier major investment plans based on this conventional wisdom costly failures (e.g., LNG import terminals in the US–shed a tear for Cheniere; Gazprom’s abortive plans to export LNG to the US), should make everybody everywhere extremely chary about entering into expensive long term commitments.  There is a real option value here–a value to waiting–and greater uncertainty actually makes that option to wait more valuable.

But I guess “everybody” doesn’t include the Poles, and “everywhere” doesn’t include Poland.  For they tweaked their deal with Gazprom to meet EU objections, and leapt into a long term commitment with Gazprom.  This was incredibly foolish.

The impression of foolishness is only reinforced by some of the rationales advanced by Polish officials:

Production in Poland could begin in ten years at the earliest, gas companies said. But experts think it could start earlier. Then, the country could fulfill a dream it has had for hundreds of years: to be economically – and therefore also politically – independent from Russia.

In spite of that, though, politicians across the spectrum have been slamming on the brakes, such as economics minister Waldemar Pawlak.

“Up till now, shale gas has been more of a media phenomenon,” Pawlak said. “We still don’t know how difficult it will be to produce in Poland. It will also be more expensive than gas from conventional sources, because more drilling is necessary for the same amount of output.”

Poland’s president Bronislaw Komorowski has been skeptical, too. He said that all those production towers across the country would be an eyesore.

Economic factors drive skepticism

Even if there are factual reasons for the skepticism, experts have long criticized Polish politicians for being too passive. For years, Poland has relied on imports from Russia without even considering the exploitation at least of conventional gas resources in the country. This was mainly due to the monopoly of the state-owned gas firm PGNiG.

“The company was never interested in producing gas itself,” Nierada said. “It earned its money very easily, after all, by buying gas from Russia and simply adding its margin. The company didn’t care about how high the final price was.”

An economics lesson for Economics Minister Pawlak (there’s a joke in there somewhere):  “We don’t know” is a reason to avoid long term commitments until you find out: that’s the implications of real options theory, in a nutshell.  Moreover, even if it takes more wells in Poland to produce the same gas that could be produced in the frozen wastes of Russia, costs (to Polish consumers) could well be lower because (a) it’s a damn site more expensive to explore, drill, and produce in many of the godforsaken places Gazprom will go to produce gas to meet its contractual obligations, (b) it’s expensive to transport gas from godforsaken places in the frozen north to Poland, and (c) Gazprom is likely to exercise considerable market power if unconstrained by competition from Polish or European sources.

And I would add, Mr. Pawlak: $4-$5 gas is not a media phenomenon.  It’s the real deal.  Yes, declining demand resulting from the financial crisis has had something to do with the cratering of the price of gas in the US.  But that’s not the whole story.  Increased production has had a very huge impact.

As for President Komorowski.  Please.  You’re embarrassing yourself.  Visit DFW some time.  Hell, I can see oil wells from my office in Houston.  And production towers go up, and then they come down, and producing wells are barely noticeable.  It’s no big deal.  Really.

Indeed these objections from Polish officials are so pathetic that it raises darker suspicions.  Such as: they have been, er, suborned by Gazprom/Russia.  The alternative explanation is cluelessness.  Not a happy choice.

But Poland has made its bed, and will have to lie in it.  Maybe shale gas will prove to be a flash in the pan.  But maybe not.  And the fact that the “maybes” are so divergent means that Poland’s hasty decision to betroth itself to Gazprom for the next decades was unwise, and extremely so.