Europe’s Gas Dilemma
By Matthew Hulbert, Valentin Misteli for ISN
The annual release of the International Energy Agency’s World Energy Outlook is normally a painful affair. Snippet details are leaked to the press – some of which are retracted – others of which stick. The headline news for the past few years has generally been something along the lines of ‘World will struggle to meet energy demand unless major investment made.’ Various figures are duly attached. Peak oilers get excited and eagerly await the following years’ report to fulfill the prophecy.
This year has however provided a partial exception: ‘World presides over ten year gas glut’ was the curtain-raising headline. Clearly, this wasn’t exactly what peak oilers wanted to hear, and on the face of it, appears to turn everything the IEA has said for the past few years on its head.
The short term reason for this is simple: Demand for gas has fallen off the edge of a cliff in light of the economic downturn. The IEA now forecasts that overcapacity in gas pipelines and liquefied natural gas (LNG) terminals will rise to at least 250bcm by 2015, more than four times the level of spare capacity in 2007. This is despite the fact that supply side constraints (either through operational difficulties or somewhat blunter political risk) had already started to seriously inhibit new gas being put onto the market from 2006 onward.
Gas has become a buyer’s market as anyone au fait with the non-conventional US gas market would tell you. This raises a number of opportunities, but also risks for consumer states. Nowhere is this more relevant than in Europe where demand has plummeted. This could spell difficulties for securing future supplies should the EU become politically lazy in assuming slackened demand is a structural reality rather than short term blip.
Europe’s demand dilemma
In some respects, the recession has of course proved to be the best energy policy ever imaginable for the EU. Demand has been cut and even more miraculously, emissions have been clipped, something that years of policy tinkering has never gotten close to achieving, More importantly, it has bought valuable time for some governments to get their houses in order where capacity margins would otherwise have been so tight that the lights could easily have gone out. Understandably many in Brussels are rejoicing at this ‘policy hit’ and the fact that structural dependence on Russian gas doesn’t look quite as overwhelming as once thought as greater volumes of LNG provide a little more elasticity of supply. But it still raises serious short-to-medium term problems as to Europe’s credibility in terms of ‘security of demand.’ It could well be that we have jumped out of the frying pan and into the fire.
Here’s why: If Russia, North Africa and indeed Middle Eastern producers such as Yemen and Qatar take the European forecasts seriously, they will need to rise to the challenge of diversifying their export routes and markets away from the EU. Priming the Pacific Basin with LNG is an obvious (and relatively easy) move for Qatar to make given collapsing Atlantic Basin prices – a strategy that would certainly annoy Australia and one that West African producers might follow. The outlook for Iran (which remains a net importer of gas despite sitting on massive reserves) is also now considerably more complex in terms of how, where and when it should bring new gas to the market.
But it’s Russia that will need to make some of the biggest capital investment decisions on further liquefaction facilities and new pipelines between eastern or western markets. Should Russia look east for long-term supply contracts (including LNG contracts which are still predominately brokered on a long-term basis), Europe’s supply problems could grow if Moscow starts to perfect its arbitrage potential.
The bigger short-term problem for the EU is that slumping demand will do little to enhance their prospects of acquiring Central Asia reserves – most notably from Azerbaijan and across the ‘Stans’ in order to fill the nascent Nabucco pipeline. China is clearly now the export market of choice for Central Asian players wanting to break the Soviet export and infrastructure mould. Uncertain European political resolve was one thing for Nabucco, a lack in demand is quite another. This same logic applies to prospective Middle East suppliers.
Pipes still matter – just the wrong ones
But before we go too far, we shouldn’t get overly carried away with the doomsday European supply side scenarios. Pipelines have the great quality of physically hardwiring producers to consumers. Russia and North Africa share a common affinity in this regard to Europe through historical design and political practice. Brussels remains the main game in town for Moscow and Algiers as far as gas is concerned, and will be so for a long time to come. What’s more, it appears that many European governments don’t fully share the IEA’s bearish gas demand forecasts. Berlin, for one, is not convinced.
No sooner than the ink was dry on the IEA report that Angela Merkel (aided by her predecessor) convinced Finland and Sweden to drop their ‘environmental’ opposition to construction of the 55bcm Nord Stream pipeline linking Russia to Germany. The pipeline takes assiduous care to bypass any single inch of Polish territory; the more ‘favorable’ transit terrain across the Baltic Sea is the preferred political option.
The snag is that while Finland and Sweden have gone to embarrassing lengths to underline the ‘very limited geopolitical impact’ this pipeline will supposedly have, the idea that Russia would somehow not use this newfound leverage to maximum effect against Ukraine and other former Soviet states either to exact higher gas prices or greater political influence - or indeed, a combination of both - is a strategic reality the EU, and more importantly, individual member-states must face up to. Russia will be banking on EU members to look after their own bilateral energy security interests rather than safeguarding the autonomy of post-Soviet states in future pricing disputes. Nowhere will this be more evident than in countries where Russian cuts can be executed without affecting broader European supplies. What Germany might be offering Russia in ‘security of demand’ it is sorely taking away from Central and Eastern Europe in terms of politically hanging them out to dry on energy related matters.
Get united and get serious
On this basis, ‘security of demand’ is only really viable for Europe if it’s applied across the board. Selective pipelines work well for some, but are politically disastrous for others. Thus, the great challenge for the EU is to secure diversified gas supplies for all, at a time when demand looks highly uncertain. A failure to do so could be catastrophic for Europe once demand rebounds and pressures toward the 2020 emissions targets grow (in real terms this means using more gas, less coal and a couple of wind farms chucked in for aesthetic window dressing). If producers have looked the other way in the interim on the basis that Europe may take a suicidal one way bet on slackening demand, the strategic blunder from Brussels would be on a truly epic scale.
So, what to do? Progressing Nabucco remains important (for political leverage rather than sheer volumes), as does finding the investment for greater storage and LNG capacity. The operationally obvious, but politically tortured move of creating a genuinely integrated and liberalized internal market to increase elasticity of supply and reduce bilateral pressures from key suppliers must also go into the mix. And even if Europe hasn’t got the political cohesion to pull this off, it can at least reassure producers that it has relatively strong commercial clout.
Producers – be they in Russia, Central Asia, North Africa or the Middle East – want nothing more right now than to hear that oil price indexation to prevent gas on gas price competition remains the order of the day in the midst of a gas glut. Although no one is stupid enough to believe that a global spot market for gas is just around the corner, the EU should still give them a reassuring message. The basic rationale would be to tie up long term indexed supply contracts now, to ensure that demand security blips now don’t turn the lights out and put emissions up in a few years. More importantly, it would reduce Europe’s political exposure to producer states that could haunt them in future. Or if we put it in language that economists would like; in “net present value terms,” continuing to play the energy game now will be politically cheaper for Europe than trying to pick it up later.
Taking a punt on oil price indexation today could prove to be a shrewd move compared to betting on gas markets remaining a buyer’s paradise tomorrow. But a word of caution is always needed; although this was a ‘bad’ year for peak oilers, it probably won’t be to long before they have more evidence to shout about.
This year has however provided a partial exception: ‘World presides over ten year gas glut’ was the curtain-raising headline. Clearly, this wasn’t exactly what peak oilers wanted to hear, and on the face of it, appears to turn everything the IEA has said for the past few years on its head.
The short term reason for this is simple: Demand for gas has fallen off the edge of a cliff in light of the economic downturn. The IEA now forecasts that overcapacity in gas pipelines and liquefied natural gas (LNG) terminals will rise to at least 250bcm by 2015, more than four times the level of spare capacity in 2007. This is despite the fact that supply side constraints (either through operational difficulties or somewhat blunter political risk) had already started to seriously inhibit new gas being put onto the market from 2006 onward.
Gas has become a buyer’s market as anyone au fait with the non-conventional US gas market would tell you. This raises a number of opportunities, but also risks for consumer states. Nowhere is this more relevant than in Europe where demand has plummeted. This could spell difficulties for securing future supplies should the EU become politically lazy in assuming slackened demand is a structural reality rather than short term blip.
Europe’s demand dilemma
In some respects, the recession has of course proved to be the best energy policy ever imaginable for the EU. Demand has been cut and even more miraculously, emissions have been clipped, something that years of policy tinkering has never gotten close to achieving, More importantly, it has bought valuable time for some governments to get their houses in order where capacity margins would otherwise have been so tight that the lights could easily have gone out. Understandably many in Brussels are rejoicing at this ‘policy hit’ and the fact that structural dependence on Russian gas doesn’t look quite as overwhelming as once thought as greater volumes of LNG provide a little more elasticity of supply. But it still raises serious short-to-medium term problems as to Europe’s credibility in terms of ‘security of demand.’ It could well be that we have jumped out of the frying pan and into the fire.
Here’s why: If Russia, North Africa and indeed Middle Eastern producers such as Yemen and Qatar take the European forecasts seriously, they will need to rise to the challenge of diversifying their export routes and markets away from the EU. Priming the Pacific Basin with LNG is an obvious (and relatively easy) move for Qatar to make given collapsing Atlantic Basin prices – a strategy that would certainly annoy Australia and one that West African producers might follow. The outlook for Iran (which remains a net importer of gas despite sitting on massive reserves) is also now considerably more complex in terms of how, where and when it should bring new gas to the market.
But it’s Russia that will need to make some of the biggest capital investment decisions on further liquefaction facilities and new pipelines between eastern or western markets. Should Russia look east for long-term supply contracts (including LNG contracts which are still predominately brokered on a long-term basis), Europe’s supply problems could grow if Moscow starts to perfect its arbitrage potential.
The bigger short-term problem for the EU is that slumping demand will do little to enhance their prospects of acquiring Central Asia reserves – most notably from Azerbaijan and across the ‘Stans’ in order to fill the nascent Nabucco pipeline. China is clearly now the export market of choice for Central Asian players wanting to break the Soviet export and infrastructure mould. Uncertain European political resolve was one thing for Nabucco, a lack in demand is quite another. This same logic applies to prospective Middle East suppliers.
Pipes still matter – just the wrong ones
But before we go too far, we shouldn’t get overly carried away with the doomsday European supply side scenarios. Pipelines have the great quality of physically hardwiring producers to consumers. Russia and North Africa share a common affinity in this regard to Europe through historical design and political practice. Brussels remains the main game in town for Moscow and Algiers as far as gas is concerned, and will be so for a long time to come. What’s more, it appears that many European governments don’t fully share the IEA’s bearish gas demand forecasts. Berlin, for one, is not convinced.
No sooner than the ink was dry on the IEA report that Angela Merkel (aided by her predecessor) convinced Finland and Sweden to drop their ‘environmental’ opposition to construction of the 55bcm Nord Stream pipeline linking Russia to Germany. The pipeline takes assiduous care to bypass any single inch of Polish territory; the more ‘favorable’ transit terrain across the Baltic Sea is the preferred political option.
The snag is that while Finland and Sweden have gone to embarrassing lengths to underline the ‘very limited geopolitical impact’ this pipeline will supposedly have, the idea that Russia would somehow not use this newfound leverage to maximum effect against Ukraine and other former Soviet states either to exact higher gas prices or greater political influence - or indeed, a combination of both - is a strategic reality the EU, and more importantly, individual member-states must face up to. Russia will be banking on EU members to look after their own bilateral energy security interests rather than safeguarding the autonomy of post-Soviet states in future pricing disputes. Nowhere will this be more evident than in countries where Russian cuts can be executed without affecting broader European supplies. What Germany might be offering Russia in ‘security of demand’ it is sorely taking away from Central and Eastern Europe in terms of politically hanging them out to dry on energy related matters.
Get united and get serious
On this basis, ‘security of demand’ is only really viable for Europe if it’s applied across the board. Selective pipelines work well for some, but are politically disastrous for others. Thus, the great challenge for the EU is to secure diversified gas supplies for all, at a time when demand looks highly uncertain. A failure to do so could be catastrophic for Europe once demand rebounds and pressures toward the 2020 emissions targets grow (in real terms this means using more gas, less coal and a couple of wind farms chucked in for aesthetic window dressing). If producers have looked the other way in the interim on the basis that Europe may take a suicidal one way bet on slackening demand, the strategic blunder from Brussels would be on a truly epic scale.
So, what to do? Progressing Nabucco remains important (for political leverage rather than sheer volumes), as does finding the investment for greater storage and LNG capacity. The operationally obvious, but politically tortured move of creating a genuinely integrated and liberalized internal market to increase elasticity of supply and reduce bilateral pressures from key suppliers must also go into the mix. And even if Europe hasn’t got the political cohesion to pull this off, it can at least reassure producers that it has relatively strong commercial clout.
Producers – be they in Russia, Central Asia, North Africa or the Middle East – want nothing more right now than to hear that oil price indexation to prevent gas on gas price competition remains the order of the day in the midst of a gas glut. Although no one is stupid enough to believe that a global spot market for gas is just around the corner, the EU should still give them a reassuring message. The basic rationale would be to tie up long term indexed supply contracts now, to ensure that demand security blips now don’t turn the lights out and put emissions up in a few years. More importantly, it would reduce Europe’s political exposure to producer states that could haunt them in future. Or if we put it in language that economists would like; in “net present value terms,” continuing to play the energy game now will be politically cheaper for Europe than trying to pick it up later.
Taking a punt on oil price indexation today could prove to be a shrewd move compared to betting on gas markets remaining a buyer’s paradise tomorrow. But a word of caution is always needed; although this was a ‘bad’ year for peak oilers, it probably won’t be to long before they have more evidence to shout about.