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NATO Parliamentary Assembly
ECONOMICS AND SECURITY COMMITTEE
Draft General Report*
Jeppe KOFOD (Denmark)
www.nato-pa.int 11 March 2013
* Until this document has been approved by the Economics and Security Committee, it only represents the views of the General Rapporteur.
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065 ESC 13 E
- For a number of years, long-range energy forecasts have included pessimistic warnings about the confluence of rapidly dwindling oil and gas supplies and soaring energy demand. The thinking was that the global economy was going to have to manage supply shortages that would permanently drive up energy prices and trigger a world-wide effort to unearth new sources of energy. This view inspired a global push to include more sustainable sources of power into the energy mix, including solar and wind power. Renewables have the advantages of being both clean and strategically secure although, at least for the moment, they are also relatively expensive. Governments, industry and consumers were also compelled to bolster energy efficiency to get the most power out of the least fuel. The predicted long-term depletion of traditional oil and gas supplies also suggested that coal use would inevitably increase because it would remain both plentiful and relatively cheap although it is also environmentally threatening.
- These pessimistic forecasts pointed to long-term economic difficulties, environmental hazards, and serious strategic vulnerabilities arising out of the growing dependence on oil and gas originating in unstable regions of the world. The Middle East was slated to remain the single most important source of global oil, but the Iraq war and very serious tensions with Iran revealed how fragile this region is and how instability there could threaten global energy supplies and price stability. At the same time, Russia was entrenching itself as the single most important supplier of natural gas to much of Europe, but it was also revealing its propensity to use gas in a heavy handed fashion as a political and diplomatic tool—a practice that caused many in Europe to recognise that overreliance on Russian gas could compromise national security interests and leave European economies theoretically vulnerable to monopoly pricing. Russia’s decision to shut off gas supplies temporarily to Ukraine, and by extension to a number of other Central European countries in January 2009, illustrated the risks of over-dependence on a single supplier. It is precisely incidents like this that have inspired several European countries to build LNG (Liquefied Natural Gas) receiving ports so that gas from elsewhere in the world could be shipped to Europe to help diversify the supply base and thereby reduce the possibility of monopoly pricing and diplomatic pressures. In short, up until several years the global energy security situation seemed slated to worsen, and this was reflected in a number of the IEA (International Energy Agency) global energy assessments. Supplies were tightening, demand was exploding, prices were set to rise permanently, the source countries were problematic and experts claimed that the energy security outlook was growing ever more tenuous for many countries. But then, almost suddenly, these projections were cast aside because technological change had suddenly opened up vast new reservoirs of oil and gas that were previously seen as too expensive and too difficult to tap. Advances in hydraulic fracturing and horizontal drilling techniques suddenly made this vast previously untapped energy accessible at far lower costs at a time when global energy prices were soaring (Krauss).
- The center of this activity has been in North America where both the United States and Canada have unearthed huge reserves of shale oil and gas, coal-bed methane, “tight gas” embedded in sand and rock and in Alberta Canada, oil deposited in bituminous sands all of which were previously thought to be inaccessible at competitive prices. Production of this energy in the United was virtually non-existent in 2000. But because profound technological advances have driven down the cost of accessing these reserves, today it produces roughly 10 billion cubic feet of gas per day (Belfer Center). Unconventional gas production grew at a rate of 48% between 2006-2010. By 2035 the United States will produce 342 billion cubic meters of shale gas or 47% of its total gas production as opposed to 16% in 2009 (Ernst & Young). Current estimates suggest that US shale gas will provide enough gas to supply the United States for the next 90 years (United States Department of Energy). The same hydraulic-fracturing revolution that is drawing gas out of shale formations is now used to extract oil. U.S. oil production is up 20% since 2008 (Casselman and Gold). US oil production grew more in 2012 than in any year in the history of that industry. Daily crude output in 2012 rose by 779,000 barrels a day from the year before and production hit levels that had not been achieved in 15 years. Production in 2013 is slated to increase by another 900,000 barrels a day at a time when slow economic growth and higher fuel efficiency standards have driven down oil demand in the United States. The United States, which forbids crude oil exports, is exporting more surplus diesel and gasoline as a result. At the same time, Alberta’s oil sands alone are estimated to constitute the third largest oil reserve in the world. As a result of these trends, Exxon Mobil corporation predicts that North America will become a net energy exporter by 2025 (Fowler).
- The gas bonanza has dramatically reduced US importing requirements for LNG, slashed domestic gas prices in the United States, totally changed the national energy outlook and is now beginning to recast a range of assumptions about the strategic landscape and US long-term economic prospects. According to the IEA, the United States could eventually overtake Russia as largest gas producer and Saudi Arabia as largest oil producer. By 2017, the United States will produce as much oil as Iraq (OECD-IEA).
- Although Canada and the United States are well ahead of other countries in tapping these reserves, there are also potentially significant shale deposits in many other NATO member countries as well as in Oceana and Asia. Russia, Australia, China, Brazil, Argentina, Germany, the United Kingdom, Italy, Estonia, Sweden France, Luxembourg, Spain, Bulgaria Hungary, Poland, Serbia, Austria, Albania and Romania among many other countries are believed to have potentially significant shale deposits. Most of this potential is not yet under development, but given the rapid change in the US energy outlook and the potential benefits to its economy of cheap and accessible gas, as well as the rapid diffusion of the technology needed to access this energy, it is very likely that many countries will soon embark on exploratory and development projects, although some will need to change regulatory systems that currently prohibit use of new drilling technologies. In any case, this potential is transforming the global energy outlook
- The current price of natural gas in the United States is uncommonly low $3.50 per mBTU (million British Thermal Units). This price is actually below the longer-range marginal cost of shale gas production, which economists estimate at between $4-5 per mBTU. This is because US shale gas production is outstripping US demand. The glut in the US market is pushing energy firms to look for more profitable markets overseas where natural gas prices are significantly higher: $10-12 mBTU in Europe and $15-20 mBTU in Asia. The difficulty and cost of shipping natural gas essentially segments these markets, although conversion to LNG can help unify them to the extent that the export and receiving infrastructure is in place to do so.
- The United States is currently engaged in a debate over exporting the surplus natural gas that the shale boom has produced. The US Department of Commerce is charged with issuing export permits. The gas export question was hardly an issue several years ago as the United States then anticipated ever greater gas import requirements, and, indeed, was developing infrastructure to receive rather than export LNG. When the shale boom began, the United States simply lacked the infrastructure to transform this into LNG exports. This has kept the gas largely in the United States, and with no export outlets, demand has simply not kept pace with supply. This has driven down gas and electricity costs in the United States and has been an underreported factor in the US recovery. Lower gas prices are already encouraging more US multinationals to ‘reshore’ operations, build new factories and reinvest in the American economy. This trend will likely expand if energy price differentials persist.
- To compensate for the low gas prices, many shale extraction firms are migrating from dry wells (mainly natural gas) to wet wells (gas deposits of ethane, butane and propane) and ‘tight oil’. The prices for oil, ethane and propane are more linked to global markets than gas. Firms are using shale fracturing techniques to extract ‘tight oil’ previously thought to be unrecoverable (Chazan, Crooks,). Renewed domestic crude oil production from non-traditional sources has also helped partially decouple US oil prices from the global crude price during the past two years (Macintosh). The US Energy Information Administration recently reported that US crude oil production exceeded 7 million barrels per day (bbl/d) in November and December 2012, the highest volume since December 1992 (EIA).
- The disparity in oil and gas prices between the United States and global markets are already being exploited. Arbitragers are deploying trucks, trains and other forms of transport to move oil from the United States to Canada and Mexico for access to global supply chains. Six oil companies, including Royal Dutch Shell, British Petroleum and Vitol, are applying to the US Department of Commerce for crude oil export licenses.
- Natural gas is more expensive to export overseas as it must first be converted to LNG—a very expensive process that adds to the market cost. If the United States develops LNG export facilities, American shale could then reach large markets in Europe and dynamically expanding markets in Asia. Over a dozen underutilised LNG importing facilities constructed in the United States before the shale boom could be converted to exporting centers. But only several of these are slated for such renovation, and the government has granted an export license to only one facility, Sabine Pass in Louisiana. Constructing the liquefaction facilities needed to export LNG is extraordinarily expensive. Facilities that transform from import receiving to exporting gas at least have the pipeline infrastructure, terminals and loading facilities in place. The first LNG exports from Sabine are slated for 2015, at a cost of some $5 billion (“LNG: A Liquid Market”). This will help the United States capitalise on price differentials and it could eventually help bid down gas prices in Europe and Asia.
- US law requires that the Energy Department must determine that such exports are consistent with the “national interest” before it will issue an export license. There is a sharp debate, however, about what constitutes the national interest, with many manufacturing firms supporting export restrictions to keep energy prices low. Environmental groups are also opposed to opening the export market as this would likely trigger even more drilling. Obviously the gas industry would like to be positioned to move gas to the highest price regions of the world. For those unhappy with Russia’s heavy handed use of its powerful market position in Europe, the prospect of greater US LNG exports is welcome because it would lower Russia’s leverage to the benefit of America’s European allies (Levi). It is worth noting here that Australia is investing heavily in LNG export facilities and could surpass Qatar as the world’s largest LNG producer by 2020. This too is good news for those concerned about the security and diversity of supply.
- Exporting crude oil from the United States is currently forbidden under US law and firms interested in exporting new supplies of shale oil are turning instead to refined oil products. Firms extracting crude oil are investing in mini-refineries to export refined product such as diesel, plastic or fertilizer (Olsen, Lee). An intensive lobbying battle is also underway between energy firms seeking to expand their export potential and manufacturing firms enjoying cheap energy and thus supporting current export restrictions. The US Congress seems inclined to approve more natural gas export licenses but will likely continue restricting the export of crude oil.
- There are a range of potential macro-economic benefits to this bonanza. Shale gas and oil production are generating new income for federal and state governments which could eventually help reduce US public debt levels. Falling energy imports are also helping to shrink the US current account deficit while strengthening a weak dollar. The shale industry currently supports 1.7 million jobs in the United States and has added $62 billion to federal and state government revenues. By 2020, the industry will account for 3 million jobs and add $113 billion per year to government coffers (Yergin). The oil and gas industry directly or indirectly employs one in 7 Albertans and accounts for 50% of the provincial economy (Alberta Competitiveness Review). According to the Canadian Energy Research Institute(CERI), Alberta can expect $Ca350 billion in royalties and $Ca122 billion in provincial and municipal tax revenue from the oil sands over the next 25 years. It also suggests that the oil sands alone will create $Ca 444 billion in tax revenue across Canada over the next 25 years, of which $Ca 322 billion will accrue to the federal government (Oil Sands Economic Benefits). Of course these numbers do not reflect the potential environmental costs associated with extracting these resources.
- There are many indications today that the North American Shale bonanza will not be replicated in Europe. There are questions about resource endowments and a range of regulatory barriers to the exploitation of this resource as well as organised resistance to doing so.
- That said Europe currently confronts a range of energy security challenges. The EU today is 80% oil import dependent and 60% gas import dependent (OECD-IEA). Much of its oil is shipped from the Persian Gulf, leaving the continent vulnerable to instability in that region. Russia is a critical gas supplier to many European countries but it has insisted on signing long-term deals that link gas prices to oil prices. Moreover, several of its firms are accused of engaging in anti-competitive practices while its government uses its position as a critical energy supplier to exercise diplomatic suasion over many of the countries it supplies. The gas cut offs in January 2009 to much of Central Europe revealed the risk of over reliance on Russian gas supplies. Russia will remain a crucial energy partner for much of Europe, but there is a compelling strategic and economic rationale for the continent to diversify its supply base. The shale boom could provide an opportunity to do so.
- But North American shale is also posing an immediate competitive challenge to Europe. Gas prices in Europe in 2012 were roughly five times greater than in the United States, which have fallen roughly two thirds since 2008. In 2008 US and European gas prices were roughly the same. Japan’s gas prices in 2012 were an astounding 8 times higher than US prices and the Fukushima tragedy will reduce the share of nuclear in that country’s energy mix (OECD-IEA). Gas prices in most of the world have traditionally tracked oil prices, which have remained very high. This tracking phenomena is rooted in the contracts gas consumers sign with suppliers and the fact that gas can act a substitute for oil—albeit an imperfect one. Those contracts reflect the importers needs for security of supply and the producers need for long-term investment horizons to justify the prodigious up front investments that are required for gas exploration and production as well as transport networks. The problem is that oil is a globally traded and fungible commodity and is therefore subject to the law of one price—at least in rough terms. The market for oil is essentially unified by global supply, demand and price conditions. Local deviations in price are quickly arbitraged so that they tend naturally to align with global prices; in more simple terms, if oil is cheap in one market, it will be sold onward to regions where oil is more dear. These transactions essentially create a single global price for oil. This is not currently possible in gas markets.
- Insofar as gas is a substitute for oil, natural gas prices will track oil prices. But natural gas is not a perfect substitute for oil. Moreover, it is not a globally arbitraged commodity. Indeed most natural gas is sold through pipelines and this limits the market for gas produced at a given well. The only way to ship natural gas by tanker is to liquefy it; but LNG processing, shipping and receiving requires massive investments and so only a small share of gas is ever liquefied for global trade. This means that it is more difficult to arbitrage prices globally and local market can thus deviate substantially due to different supply and demand conditions in regional markets. This is precisely what is happening today. While US gasoline prices have jumped more than 125% since the end of 2008 with crude oil prices rising to more than $1 00 a barrel, in the same period, US natural gas prices have fallen by nearly two thirds (Herdon and Swint).
- The United States is beginning to generate a tremendous competitive advantage because the shale glut has driven down energy input prices in manufacturing, conferring very important benefits upon firms positioned to exploit price falls. In essence the fall in gas prices has been an enormous positive stimulus to the economy and this is likely to persist as long as energy price differential do. There is evidence today that some US firms, which had previously off shored manufacturing jobs to Asia are now moving production facilities back to the United States because of low energy prices. Apple and General Electric (GE) have returned some production to the United States and many other firms are likely to follow suit because the energy price differential is making this cost effective. GE has reported that it is now manufacturing at lower cost in Kentucky than in China (Denning). Falling gas and, by extension, electricity prices have made the United States one of the most profitable places in the world to produce chemicals and fertilizer, industries that use oil and gas as both a production input and an energy source. The United States is also undergoing a surge in energy-intensive production in aluminum, steel and glass. Economists have estimated that increased domestic oil and gas production, and the activity that flows from it, would create up to 3.6 million new jobs by 2020 while raising annual economic output by between 2% and 3.3% (Casselman, and Gold). Other analysts have been somewhat less optimistic and put the additional growth at 1%, but that is hardly inconsequential.
- If this price differential persists over time, even greater levels of inward investment would be likely. European manufacturers would then face the twin challenges of competing against low-cost labor in Asia and low cost energy in the United States. Europe also has another potential problem insofar as it has made a major commitment to renewables, which while very clean and very secure, remain, at least for now, costly. Part of this cost is hidden through subsidies. These subsidies are now subject to increased scrutiny in countries with fiscal difficulties so it is not clear how much longer these will stay in place (OECD-IEA). This commitment could become a factor in growing energy price differentials between North America and Europe. That said, it is worth noting that a dramatic price differential is unlikely to persist as the US shale market matures and particularly if it becomes a significant LNG exporter (which would help unify prices). Still it is likely that US gas and electricity prices will remain substantially lower than those in Europe. Europe will need to respond to this differential in order to retain some degree of competitiveness. It has several options, none of which will be easy.
- Firstly, it will likely seek to renegotiate long-term contracts with European gas suppliers and particularly with Gazprom. This has already begun and Europe has gained some leverage because of the North American boom. Indeed, Russian gas producers are starting to feel price pressure arising indirectly out of the shale gas boom in the United States. The United States has essentially stopped importing LNG from countries like Qatar because it no longer needs to import significant amounts of natural gas. Gas suppliers are therefore diverting gas shipments to Europe and driving down gas prices there as well. Spot prices are now significantly below the oil-linked price Gazprom employs in European markets. Now it faces demands made in arbitration to renegotiate prices so that they better reflect lowering spot prices rather than global oil prices (Chazan).
- In 2012 Gazprom renegotiated supply contracts with a number of European customers after receiving complaints that customers were paying too much for gas under long-term, oil-linked contracts, which were significantly above spot gas market levels. These price cuts in some cases approached 10% of previously agreed prices. France's GDF Suez, Wingas of Germany, the Slovakian gas company SPP, ENI in Italy and Botas in Turkey were among the clients that managed to negotiate price adjustments (Platts). In 2012 these concessions totaled $ 2.7 billion and Gazprom is setting aside $ 4.7 billion for negotiated reductions in 2013. Although the share of short-term spot traded gas in the European supply mix has increased in recent years, most gas is pipeline traded and more expensive; this gas will likely remain the dominant factor in European natural gas prices, even if European unconventional gas and LNG imports eventually alters the mix (Ernst & Young).
- Gazprom interestingly has refused to renegotiate prices with its largest foreign customer, Ukraine, and recently called on it to pay $7 billion for gas it never used but for which it had contracted through a controversial “take or pay” contract negotiated in 2009. Gazprom claimed that its rebuff had nothing to do with a landmark $10 billion shale gas exploration deal Ukraine has recently signed with British Petroleum (BP) -a deal which could eventually help wean Ukraine from its dependence on Russian gas. The goal of that project will be to raise domestic energy production, diversify the country’s energy base, drive energy prices down and thus make its industrial base more competitive (Olearchyk and Buckley). Although it could take a number of years before this project begins to yield significant amounts of gas, it is economically and strategically significant.
- Russia has twice cut off supplies of gas to Ukraine and used Ukrainian energy dependence as a source of political leverage. Ukraine’s economy is one of Europe’s most energy intensive and its gas bill in 2012 was $13 billion. In 2012, its heavy industry has made a great effort to adopt more energy efficient practices and managed to reduce imports by 25%. Russia did negotiate one significant price cut in 2010 but only in exchange for a long extension of Russia’s lease on its naval base in Sevastopol—a perfect illustration of the geo-political uses to which energy can be put. Ukraine still pays very high prices for Russian gas, even more than Western Europe, which is more distant from the source of production. Moscow has told Kyiv that it will see that gas prices are reduced if it joins a customs union that Russia is constructing along the Belarus and Kazakhstan—a deal that would make a closer relationship with the European Union all but impossible. Ukraine’s lacks negotiating leverage and sees shale oil and gas as providing it. Ukraine has every interest in finding other sources of supply and Russian actions have only encouraged this effort (Olearchyk and Buckley). It is estimated that Ukraine holds Europe’s third largest shale gas reserves and could someday be positioned to reduce imports to a minimum. This potential has attracted the attention of key energy companies. In addition to the deal BP has signed, Chevron has won a tender to conduct Shale exploration in Western Ukraine while Exxon and Shell have exploration rights off the Black Sea coast. Doubtless this activity is worrying Russian gas executives and the Kremlin alike and it might only be the tip of the iceberg as other countries in Europe begin to consider developing their own shale potential.
- Russia is not the only exporter with concerns. Norway’s Statoil recently warned that the high level of uncertainty about the future of gas markets in Europe is beginning to impinge on its own investment plans. Statoil has important planned projects in the North Sea and Azerbaijan but is worried about the uncertainties surrounding future gas use in Europe. There are all kinds of mixed signals. Indeed at a time when the United States is switching from coal to gas for electricity generation, a number of European firms are moving in the opposite direction. Because gas prices are relatively high in Europe today, the US switch from coal to shale gas use in electrical generation is currently pushing cheap coal toward Europe. Burning coal is now a less expensive option in Europe and this is creating uncertainty about future gas demand there although gas demand has continued to grow albeit at a slower rate than previously. Uncertainty about future gas demand could also inhibit investment in unconventional gas exploration in Europe (Ernst & Young). It is worth noting that gas fired power stations have been generating losses in Germany, the Netherlands and Belgium. Some electrical utilities are moving toward coal and scrapping plans to build gas powered plants. Heavy subsides for renewables also pose a competitive problem for gas in Europe and these renewables are accorded a priority position in a number of countries and in the European Commission itself (Makan). On the other hand, the uncertain future of nuclear power in the wake of the Fukushima nuclear accident could galvanise demand for gas in countries like Germany which is shutting down older nuclear plants.
- Rapid change in gas markets could also affect pipeline investment in Europe. A number of new supply lines are planned or under construction in Europe today. The Nord Stream gas pipeline under the Baltic is already operational and will mean that Russian gas to Western Europe no longer needs to run through Ukraine and Belarus. Russia is also fully committed to the South Stream project which will bring a very large volume of Russian gas from the Black Sea to Southern and Central European markets. The EU supported Nabucco pipeline is slated to bring gas from the Shah Deniz gas fields in Azerbaijan to Europe. This project’s start date, however, has been pushed back to 2017 due to rising costs. Other proposed lines include the Trans-Adriatic Pipeline (TAP), the Interconnector Turkey-Greece-Italy line (ITGI) and the Trans-Caspian gas pipeline. The problem is that all these projects were planned before the boom in unconventional gas was apparent. If European shale production were to take off, or if global LNG markets dramatically expand and drive down gas prices, some of these projects might no longer be viable.
Another major shock confronted by long-term investors in energy infrastructure has been the collapse of US demand for LNG imports. A number of major infrastructure investments both in the United States and elsewhere were undertaken in anticipation of previously mounting US demands for imported natural gas. The shale gas boom has idled reception facilities in the United States, some of which the industry hopes to convert to export facilities. LNG suppliers have thus had to find other markets for their product and this has helped depress spot prices in Europe. Europe imported 60 million tons of LNG in 2010 and is adding LNG import facilities in Poland, Portugal, Spain and Italy. Poland has signed a 20-year deal with Qatargas that will deliver 1.5 billion cubic meters of gas per year. The gasification terminal in Swinoujscie will be operational by 2014. It will have the capacity to supply 2.5 billion cubic meters of natural gas the equivalent of 15 % of Poland’s gas consumption in 2010. That capacity could potentially expand to 7.5 billion cubic meters (Szalai). Because many current gas contracts are locked in for thirty years and because of very stringent environmental rules, driven in part by population densities in Europe, the direct impact of the shale bonanza will be far slower in Europe than it has been in North America. European gas consumers are likely work to renegotiate these contracts because the shale glut in the United States is pushing down the price of globally traded LNG. Suppliers like Gazprom have shown some flexibility with selected countries like Germany, Italy and Poland, and may be under more continuous pressure to link the prices they charge more closely to spot index prices which an LNG glut today has driven downwards (OECD-IEA). If the United States ever begins to export substantial amounts of LNG, the downward pressure on European gas prices could be significant. Meanwhile Russia itself is looking to diversify its consumer base. It had hoped to export LNG to the United States but that market is now saturated. Russia and China have reached an agreement for Russia to sell natural gas to China by pipeline. This could be the first phase of a broader Russian expansion into Asian markets where prices are high and demand will remain robust. Norway too is looking to Asia now that the American market is sated.
- Although prices in North America will begin to rise as the markets move into more of a long-term equilibrium position, an important price differential will persist and this could pose significant competitive challenges for Europe and for countries like Japan which pay even higher energy prices than Europe. Of course, Europe has the potential to develop its own shale oil and gas industry and some countries like Ukraine and Poland are moving quickly to do so. But there is tremendous resistance to the industry, which makes its future very uncertain. Australia and China are also embarking on major development projects which, in itself, could galvanise Europe to do more with its shale potential. China may have the largest shale gas resources in the world with as much as 19% of the total as opposed to the 13% for the United States.
- European countries together account for roughly 10% of the total global shale gas reserves. The petro-physical properties of these deposits, however, differ substantially and each poses unique drilling and collection challenges. It is not yet known how much of these reserves are economically recoverable. The European Commission has suggested that “Shale gas production will not make Europe self-sufficient in natural gas. The best case scenario for shale gas development in Europe is one in which declining conventional production can be replaced and import dependence maintained at a level of around 60%” (Pearson). Different levels of exploration are underway in Austria, Germany, Hungary, Ireland, Poland, Sweden, the United Kingdom and Ukraine. Poland, Ukraine, and France appear to have large potential deposits but France has imposed a moratorium on exploration. The Polish government has awarded a number of exploration concessions to 30 companies covering a territory of 35 thousand square miles or a third of the country (Szalai). Polish officials had initially hoped to begin commercial exploitation by 2014 and to achieve some degree of gas self-sufficiency by 2035. This was very optimistic. Difficult geological conditions, a lack of critical infrastructure and services, and an uncertain regulatory environment have slowed exploration efforts and have led to some concerns about the commercial viability of the industry in that country.
- Indeed, just to establish Poland’s potential will require the drilling of 500-1,000 exploratory wells a year; yet energy firms operating in Poland have only drilled 33 wells over the past three years and have hydraulically fractured only 10. That is not nearly enough to launch this industry and none of the drilled wells have produced encouraging results. There are only 11 drilling rigs in Poland as compared to 2000 in the United States and this too is impeding development. It costs roughly $15 million to drill and fracture a well in Poland as compared to $4 million in the Barnett Shale region of Texas. That is a very serious competitive disadvantage and it reveals the degree to which scale economies matter. Finally, the industry has complained that government intentions to tax the industry at rates akin to Norwegian levies on its highly efficient and developed gas sector threaten to further raise costs and weaken development incentives. These kinds of issues are making it difficult even to assess Poland’s real potential (Kenarov) Poland’s shale challenge could well be emblematic of a greater problem in Europe where very abundant and accessible reserves would be needed to make the sector viable; an array of barriers are making even initial exploration a potentially daunting task.
- In the future, gas is likely to assume greater strategic importance as a result of the technologically driven changes in that market and soaring global demand for energy. It goes without saying that the shale gas and oil boom in the United States will alter the way it looks at the Middle East and particularly the Persian Gulf. Although that region will remain a critical supplier of energy to world markets, its importance to the United States will inevitably diminish as the United States reduces its dependence on imported energy. Although few American leaders speak openly about this eventuality, the strategic community is beginning to think through the implications. It is a worthwhile exercise because a tectonic shift may be underway.
- Roughly one third of US defense spending—or some $200 billion—could be linked to US efforts to keep energy flowing to the global economy (McFarlane and Olah). Even though the United States is not the largest importer of Persian Gulf oil, it has always had a high stake in the flow of that energy simply because global prices are integrated. Now that US gas prices and to a lesser extent oil prices are starting to delink from global oil prices, the United States could eventually begin to lower the strategic priority it accords the Gulf region, even though it will, of course, remain important. It certainly allows it to reassess its vulnerability there. The rising production of oil in North Dakota and Texas, for example, has made it easier to implement oil sanctions on Iran simply because the United States now has a cushion to compensate for the loss of Iranian crude from global markets. The domestic gas and oil boom is beginning to delink the US economy at least partly from those global energy markets. This is happening at a moment when the United States is under very serious fiscal pressures and is likely to cut defense budgets substantially. Moreover, its so-called pivot to the East implies a reduced force presence in Europe and the Middle East. As a result of these trends, the United States is very likely to communicate to its European allies that they will need to do more to keep these lines of communication open. Given Asia’s exploding energy demands, it will have a rising stake in the Persian Gulf and may therefore assume a greater security burden in this regard. This could mark a sea change in the geopolitical alignment in the Persian Gulf.
- This could have implications for NATO over the longer term. The Alliance is premised on the notion of shared security interests and outlooks. One can imagine that a significant divergence in energy security perspectives could begin to erode this foundation. Falling US dependence on imported energy, and particularly imported energy from the Persian Gulf and North Africa, could reinforce the US pivot to Asia. This could happen as Europe’s energy dependence on this region rises. That said, oil markets are fungible and what happens in one market will have an impact on the global market. For this reason, the United States will likely continue to have a strong interest in the Persian Gulf both for reasons of energy security and for general security. But the Alliance will need to conduct a sustained dialogue on these matters in the future.
- Other tectonic shifts are afoot. OPEC itself is likely to lose a degree of global leverage as a result of the unconventional oil and gas boom. The Arab uprisings have generated a high level of concerns in key oil producing countries about domestic stability. A number of OPEC’s member governments have increased domestic spending substantially to quell those concerns, but this, in turn, compels these governments to keep oil prices high to underwrite growing consumption. This is having the unintended effect of opening opportunities throughout the world to unleash the potential of unconventional oil and gas as well as LNG which become competitively priced when oil prices are high. High global energy prices could eventually create opportunities to globalise the trade in shale gas—by creating economic conditions that make it potentially profitable to transform it into liquefied natural gas, compressed methanol, or diesel fuel (Herdon and Swint). Methanol produced from shale could eventually be used in flex fuel engines that produce lower carbon-dioxide emissions without using of carcinogenic additives currently used in more expensive petrol (MIT). All of this will mean that a growing share’ of the world’s energy is produced outside of the OPEC Cartel, and this, by definition, will reduce its leverage over global markets.
- The implications for Russia are mixed. On the one hand it likely has very large reserves of shale gas, tight gas and oil and has not even begun in earnest to develop this potential. That is not surprising given its extraordinary supplies of conventionally produced natural gas and large infrastructure investments in it. Russian gas firms, however, are showing a rising interestin non-conventional technologies and are beginning to test the waters. This could be a very important supplement to its current reserves and it will undoubtedly extend the life of Russia’s position as a critical energy exporter.
- On the other hand, Russia has reason to be concerned about some of the changes underway. First of all, it had seen the United States as a potentially important customer of Russian LGN. Now it may have to worry about the United States and other shale gas producing countries as an LNG competitor in markets where it has enjoyed a near monopoly. American LNG gas or simply the effect of American production could weaken Russia’s grip on gas markets throughout Europe. These concerns were made evident in its most recent price dispute with Ukraine, which, perhaps not coincidentally began soon after Ukraine announced a large contract to explore for unconventional energy on its territory and waters. Russia has used Ukrainian dependence on its gas to pull it into its orbit and this particular geo-political tool is now threatened. Russia’s hardball tactics have alienated several countries, and there is a growing eagerness in Europe to diversify the energy supply base in order to insulate themselves from Russia’s propensity to employ hard ball tactics with some of its energy clients.
- The unconventional gas boom could also weaken the attractiveness of developing arctic gas fields. Gazprom, for example recently halted plans to develop a range of arctic fields, arguing that it could not justify the investment given uncertainties about the future of the market (Begos, oct. 2012). Publically Russian gas executives express no worry about rising US production and do not see it competing seriously in European market. Still what is happening in the United States has encouraged a number of European countries to renegotiate long-term contracts with Gazprom and this could also be a harbinger of things to come. Because Russia has failed to diversify its industrial and export base, because oil and gas generate 70% of its export earnings and constitute the foundation of state finances, and because its economy is with a range of structural problems including pervasive corruption, it is very vulnerable to a loss of energy market shares. This ultimately could pose a real challenge to the Russian state and its current governing elite which have built their legitimacy on the foundations of the energy industry (Gustafson).
- The extraordinary development of unconventional gas in North America is also changing the environmental landscape. Natural gas emits far lower levels of global warming gasses than coal, gasoline or diesel oil and burning it releases roughly half as much carbon dioxide into the atmosphere as does burning coal (“Frack On”). Between 2006 and 2012, natural gas generated electricity rose from 20% to 25% of total US electricity generation. At the same time, coal generated electricity fell from 50% to an historic low of 42%. Since 2007, the United States has lowered its carbon dioxide emissions by 450 million tons, the largest decline on the planet (The Economist , 14 July 2012). As of 2012 the United States. had achieved approximately 70% of the CO2 emissions reductions targeted under the Kyoto Protocol—an agreement that the Congress never ratified. Shale gas has been critical to these very positive trends although improved energy efficiency and envirionmental standards have also been important factors. The continued displacement and retirement of coal plants will likely lead to further CO2 reductions in the future (Carey). The picture, however is not entirely positive. Hydrofracking poses significant environmental risks if not properly regulated (Haluszczak). The improper storage and disposal of fracking waste water, contamination of water tables, rampant gas flaring in shale oil production, and the use of massive quantities of water all pose weighty environmental and health risks. In some cases oversight and regulation has been woefully inadequate.
- During hydrofracking, corrosive salts, potentially carcinogenic chemicals and even radioactive particles that exist in rock formations are mixed with already polluted water as it is injected underground 3000-8000 feet (915-2440 meters). Roughly 25% of the water is ultimately pushed back to the surface along with these chemicals. Benzene, radium, methane, petroleum distillates and glycol ethers are some of the many harmful substances that have been identified in hydrofracking water (Haluszczak). There is still great uncertainty about the exact amount and variety of contaminants in the waste water as firms have been given permission to withhold this information as trade secrets—something that environmentalists argue violates standard industrial good practices. After it is pressurised into shale rock formations and forced back up by the rising natural gas or oil, waste water is stored in tanks, man-made ponds and other containers. These storage processes are susceptible to spills, leaks and overflows; incidents which gas companies have often failed to report (Wayne).
- Another procedure is to deposit fracking fluid in cavernous underground rock formations. But in Pennsylvania, a sharp increase in hydrofracking wells (36,000 in 2000 compared to over 71,000 in 2011) and a lack of deep deposit wells is posing serious environmental problems (Urbina). Environmental groups have charged that regulators and gas companies were insufficiently prepared to cope with the problem and vast quantities of this waste water ended up water treatment facilities not designed to process these chemicals. Studies have revealed radium, benzene and other carcinogens in a number of streams and rivers. Some rivers used by the sewage treatment plants had radioactivity levels hundreds or even thousands times the amount allowed by federal standards (Urbina). Although the process of hydrofracking often occurs at depths below underground water reservoirs, inadequate well seals can allow contaminated water to leak into water tables. Firms often fail to disclose to regulators that a well has fractured and is seeping chemicals into water tables. Some experts suggest that excess waste water is so contaminated and dangerous that it should be treated in the same manner as medical waste.
- Oil hydrofracking processes also produce large amounts of natural gas. Many US companies dispose of this gas in a process called flaring because the facilities are too remote to put the gas into storage systems or pipelines (Makan, Crooks) The incentives to do so are insufficient due to currently low US natural gas prices. Gas companies operating in remote regions without access to pipelines find it cheaper to burn off the gas rather than commercialise it. North Dakota and Texas, the two hotspots of the shale oil boom, have increased flaring by over 50% just in 2012. Recent night-time satellite photos show that sparsely populated North Dakota is producing almost as much light as the city of Chicago largely as a result of this flaring. North Dakota’s carbon footprint has increased dramatically as a result of this practice and flaring pours noxious pollutants into the atmosphere (Makan, Crooks). This is not simply an environmental and health problem it is squandering a precious and strategic resource. It would be better to cap these oil fields until this gas can be commercialised. It is noteworthy that Western governments have been urging Nigeria to put an end to similar flaring practices which have been environmentally catastrophic in parts of that poor country. A three-year study on flaring generated air pollution found that a number of potentially toxic chemicals in the air surrounding these sites including benzene, xylene and octane (Witter). If drilling sites move closer to communities, these practices could soon have serious health impacts.
- The vast amounts of water required for hydrofracking poses another set of problems. Operating a single well can require 5 million gallons of water over its lifetime. This is consequential particularly in regions where water is scarce. Farmers are increasingly compelled to compete for scarce water with energy companies in the western United States, and extraordinarily dry conditions in recent years have exacerbated tensions between the two industries (Healy). There have also been reports of increased seismic activity in regions where fracturing operations are underway.
- One could argue that one reason the price for unconventional gas is so low is that current prices do not reflect the full range of externalities (generalised costs to society associated with its production but not reflected in the market price). On the one hand, domestically produced gas is more secure than oil imported from unstable regions and therefore its price need not reflect any additional security costs linked with using it, as should, for example, oil imported from the Gulf region. Natural gas also has the environmental benefit of being relatively clean burning and superior to coal insofar as it has a lower carbon footprint. Despite these positive externalities, one could still argue that current prices do not reflect the full environmental costs associated with drilling for this gas. Indeed there are a range of explicit and implicit subsidies to this industry that may be obfuscating the real cost structure of unconventional oil and gas. These subsides can include tax breaks, discounted drilling fees, subsidised water, and government funded clean-up programmes. Exemptions from environmental regulations like the US Clean Water Act and the Resource, Conservation and Recovery Act also constitute a price distorting subsidy that hardly lends itself to best environmental practices.
- This could now be changing as the Obama Administration has begun to tighten up some environmental regulations regarding the industry as have several state governments like that of New York. Other states, including Pennsylvania, have been more lenient in this regard. The Environmental Protection Agency is now insisting that wells for storing waste water must ensure that underground sources of drinking water are not polluted. Improved means of recycling wastewater are clearly needed and there have been a number of disconcerting dumps of this water into rivers and streams (Begos, Sep. 2012). Current natural gas prices in the United States are therefore likely below the real cost of producing this energy. The real marginal cost could actually be $4-5 mBTU rather than the actual price of $3 per mBTU (The Economist , 14 July 2012). The price has been effectively lowered through subsidies, and under regulation which effectively exempts the industry from paying for the environmental degradation associated with the mining process. The potential environmental damage might be even greater insofar as these artificially lower prices make it even more financially difficult to develop cleaner energy sources, and particularly renewables.
- The shale industry also leaves a significantly larger physical footprint than traditional gas drilling. Wells require space to accommodate drilling rig equipment, wastewater ponds, storage and pipeline infrastructure as well as facilities for personnel. Rapid demographic changes linked to the industry can trigger sudden physical as well as social changes in rural communities which can pose daunting policy challenges. Social infrastructure including schools, housing, roads, and police forces are often inadequate and there are reports of significantly increased drug use and crime in some boom towns (Ellis).
- Europe has taken note of these challenges. The EU does not have jurisdiction over state subsoil laws and so regulating this industry will largely be the responsibility of national governments in Europe. This is somewhat similar to the situation in the United States where, until recently, it was the states, rather than the federal government which took the lead in regulating this emerging industry. The challenges to the industry in Europe are more serious because of population density, strong environmental regulation, water shortages in some regions and public resistance. The French government, for example, has imposed a moratorium on the industry and its Minister for Industry recently stated that this will not be lifted until the government is satisfied that the gas can be tapped in an environmentally sustainable fashion. French firms like Total, which holds licenses for exploration, want to explore for gas in Southern France but are now unable to do so. The German government is proposing legislation to allow fracking only where water sources would not be affected. German reserves, however, are not thought to be very large (Natural Gas Europe). The British government has adopted a wait-and-see approach. It is monitoring developments in Poland although a British Parliamentary report suggests that shale gas is not likely to be an energy game changer in that country (Ernst & Young). In Bulgaria, public resistance to a government decision to issue shale exploration licenses has been marked. Public protests against a government concession to Chevron in North East Romania have focused on the incompatibility of the industry with tourism while in Britain, protestors have managed to close down several drill sites (“Frack On”). On the other hand, the public in Poland is very receptive to the industry and recognises both the economic and strategic advantages of developing this domestic energy source.
- The boom in the unconventional oil and gas business is rapidly transforming the global energy outlook. The transformation is most dramatic in North America, but there are already spillover effects on global energy markets and these could grow more substantial if the United States begins to export this gas in LNG form. The global impact today is largely arising out the collapse of American demand for imported LNG and falling demand for coal as American utilities transition into cheaper and far cleaner gas powered generation. This is having spillover effects in Europe and beyond including.
- Europe faces a genuine competitive challenge. Falling gas prices in the United States are driving down manufacturing costs in North America and leading to a relocation of industry back into the American heartland. This process is just starting but it could accelerate if price differentials persist. European gas and electricity prices are much higher and this price divergence is beginning to look like an external economic shock. Europe will have to respond by bringing down energy prices. It can do so by renegotiating gas contracts so that they more closely track spot prices rather than oil prices, find new ways to access ever-expanding LNG markets or they can look to develop their own unconventional oil and gas potential. Russia is also going to need to reassess the structure of its energy sector and the way it uses this sector diplomatically. It will be under increasing pressure to change as competition rises at a time when its public budgets are ever more dependent on this sector. Russia has all the signs of suffering from Dutch disease and the cure will ultimately require the state to free up an over-regulated economy and reform a very burdensome state apparatus. This could provide an opportunity for a new kind of Western relationship with Russia.
- The unconventional energy boom has many other strategic implications. It is changing the energy profile of the United States and it will likely do the same for any countries or regions that manage to tap into large gas or oil reserves using technologies that make previously inaccessible gas accessible at low cost. Although it is hard to imagine today, these trends could eventually lower the strategic importance of regions like the Persian Gulf for the United States as it ramps up its unconventional gas and oil potential. Already the United States is shifting from oil to gas in overall energy use with petroleum use increasingly concentrated in transportation and chemical feedstock. Imported oil constituted only 49% of consumed oil in 2010 and will fall to 42% by 2035. More than a third of US oil imports come from Mexico and Canada and only 18% of the total is imported from the Persian Gulf. North America as a whole could be heading towards energy self-sufficiency which might render it ever less concerned with events in the Persian Gulf, even though there are a number of reasons why this is unlikely including the essential fungible nature of oil and the law of one price in that industry. The Persian Gulf will continue to be critical in this sense, even if North America is not importing much energy from the region. If India and China become more dependent on Persian Gulf energy, it is likely that they will need to play a greater role in keeping the sea lines of communication open. The Alliance ought to think through implications of this and, in particular, reflect on how NATO might be able to co-operate with these emerging powers on these matters of shared interest. NATO should conduct a continuous dialogue on energy security matters. Finally, if substantial new energy resources are tapped in Asia, Oceania, Europe and Latin America, the global energy outlook could change substantially, and this will have all manner of strategic and economic implications that are simply difficult to forecast at this juncture.
- But that is a big “if”. Europe, for example, faces a number of problems in tapping into shale gas; it is a densely populated continent where environmental problems can have an immediate impact on surrounding populations. There are a number of open environmental questions surrounding the techniques for drilling for shale gas and oil. Some of the problems have cropped up in United States and have become a source of grave concern in Europe where these environmental problems could have a magnified impact. Well digging and hydraulic fracturing can upset land use patterns, alter regional water use and trigger other political and social problems. Not surprisingly, there is public resistance to this new industry in many European regions. This is slowing down the industry’s development and many countries as well as some in the European Commission are invoking a kind of precautionary principle to study the potential environmental impact thoroughly before making the large investments needed to determine if the industry is indeed viable (DG Environment Newsletter). On the other hand, there is a real possibility to diversify supply sources which Europe ignores at its own peril.
- In several European countries, there are also structural problems including the lack of drilling infrastructure, uncertain regulatory and tax frameworks, insufficient investment capital, and a lack of appropriately skilled energy workers to ramp up this industry quickly. Europe also needs to develop a more integrated continental scale marketplace for energy with appropriate infrastructure to make this possible. These social, structural, institutional and environmental challenges, for the moment, are slowing down the development of unconventional gas and oil industries in Europe. This could ultimately result in a serious competitive disadvantage for those parts of Europe wedded to long-term gas contracts and thus compelled to pay structurally higher electricity prices than in the United States. These complex developments are adding a high degree of uncertainty to the global energy picture and this uncertainty could begin to impinge on long-term investment decisions including investment in critical pipelines.
- Although enormous technological strides have made the emergence of this industry possible, advances are needed to make the industry more environmentally sustainable. Government need to assure that high environmental standards are met even if this adds to the cost of gas. This requires sound regulation and well-trained enforcement staff in sufficient numbers to ensure compliance. Real environmental costs will have to be paid one way or another and under-regulation essentially subsidizes practices that are harmful to the environment.
- Along these lines, local communities and other stakeholders must be engaged from the outset in areas where there is the potential to develop unconventional energy industries. Efforts are needed to minimise disruption of those communities and critical issues like water use must be monitored to ensure that the needs of those communities are respected. Well sites should be as remote as possible from these communities and must be sufficiently deep so as not to threaten critical ground water suppliers. Tighter regulation of flaring at shale oil facilities is essential as the practice is both wasteful and environmentally damaging. Finally the public must be informed when accidental leaks or other environmental accidents occur. This is critical to building trust and ensuring high standards over the long-term (IEA Golden Rules). Only by following these kinds of guidelines will the industry gain wider acceptance among skeptical publics. Indeed, public concerns have been a critical roadblock to the expansion of this burgeoning industry in Europe. There is also a need for full transparency in the industry. Withholding secrets under the rubric of preserving proprietary information cannot be justified when matters of public health and impacts on local environments are at stake. Again, governments have a vital oversight responsibility here and have every right to demand a higher degree of transparency. There is likely to be resistance from industry on these kinds of issues, but frankly transparency is the cost they must pay for doing business. This is the only way to build public confidence in a new and important energy source that can bring enormous economic and security benefits if properly regulated.
- There have been substantial improvements in energy efficiency on both sides of the Atlantic over the past decade. But there is much more that can be done on this front to improve the environmental, security and economic prospects of the trans-Atlantic community. With shale gas driving energy prices down in some markets, it is important not to lose a sense of vigilance about improving energy efficiency. This too requires a degree of regulatory intervention The United States, for example, has made great strides by putting into place more stringent Corporate Average Fuel Economy (CAFE) standards and developing a range of other energy efficiency targets; yet the IEA estimates that it, like most developed countries, can do far more on this front and thereby reap substantial economic, security and environmental benefits.
- Diversification of energy supplies makes strategic sense. It is prudent for government and the private sector to continue to work to ensure that renewables are part of the overall energy mix and that research in that field is advanced. Likewise, governments need to continue to push for efficiency gains. Experts believe that there are enormous gains to be had by adopting sensible energy efficiency standards and the benefits of doing so are economic, environmental and strategic. Those who argue that imposing these standards is too costly or an unwarranted governmental venture into the market, do not understand the nature of externality costs which can only be recouped by government intervention. That said, governments must refrain from over reaching, and standards must be adjusted over time as technology evolves.
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