A one-sided fight, for now By Derek Brower, Journalist High oil prices in the last four years have have brought producer governments wealth and power. The most obvious example of this is Russia, where Putin’s successful domestic campaign to regain control of the commanding heights of Russia’s economy (by, for example, crushing Yukos), has consolidated economic power in the Kremlin’s hands. Beyond her borders, however, that power is being brought to bear on Russia’s neighbours. But the oil and gas sector is cyclical. And today’s energy nationalists should use their power and wealth wisely, because there remain many risks to the present ascendancy of the National Oil (and Gas) Companies. That is the thrust of a speech Derek Brower gave in Dubai last week (at an event hosted by Marsh, the insurance group), cautioning executives from National Oil Companies to use their new power carefully, and not to abuse it. Below is an excerpt. For the full speech, go here.
The best example of this shift in power – away from Western notions of the open market to policies in producer countries that put their political needs ahead of those of the consumer’s – is Russia and its National Gas Company, Gazprom. […] The free-market vision of Russia, the one in which many in the West placed their hopes after 1991, was of a country whose political and economic transition from communism to capitalism would bring its wealth of oil and gas resources to consumers in the West. On one level, Russia has become rampantly – and often brutally – capitalist, as anyone who has lived there, as I have, can tell you. But for many Russians, the attempt in the 1990s to move to market capitalism brought political and personal chaos. Under Vladimir Putin, the market principles have been overtaken by a political ambition to transform Russia’s hydrocarbon wealth in the ground into political capital that can be spent on the world stage. How Russia has gone about doing that has become a model for other countries that might wish to do the same. Moscow’s first step was to consolidate its energy sector in the hands of the state. Rival economic powers within Russia have either been destroyed, or are being destroyed. In 2003, the Kremlin began a campaign to crush Yukos, then the most transparent – and most successful – company in Russia. Its assets were transferred to the state-controlled company Rosneft, in a sale that was anything but transparent, and anything but run on market principles. A handful of companies are still picking over Yukos’ bones, with Gazprom likely in the next few months to buy up what remains of Khodorkovsky’s company. Yukos’ biggest political crime was to have offered a stake in the company to ExxonMobil and ChevronTexaco in 2003. The market would have loved that; politics, however, could not allow such a large share of Russia’s oil and gas to fall into Western hands. The Kremlin’s gaze is now on the foreign companies operating in Russia’s upstream. The production-sharing agreements that a handful of foreign oil companies signed in the 1990s have been deemed politically unacceptable. A clearly political campaign against the Shell-led consortium developing LNG on Sakhalin Island brought Gazprom into that project as the main shareholder in December. Japan and other Asian countries that plan to buy LNG from Sakhalin don’t know whether to laugh or cry: Gazprom’s involvement makes the project a politically-favoured one, and therefore certain to go ahead; but at the same time, they now have the Kremlin’s hands on yet another source of their gas. But it is good news for the ever-strengthening Gazprom, which will now get crucial experience of developing an LNG plant. And now TNK-BP’s gasfield in Kovykta is facing the same pressure. Spurious charges claiming that the company has not developed the field as it promised are being used to force it to give Gazprom the controlling stake it wants. Gazprom will get its controlling stake, probably by the end of this year 2007. Total, another PSA holder in Russia, will soon also come under the same pressure. Production-sharing agreements are good for cash-strapped producers when the oil price is low; but when the price of oil – and other commodities – is high they want control over how soon that project can come on stream. It all adds up to an assault on market principles in Russia. Markets rely on free-access to infrastructure, competition, transparency, and the sanctity of contracts. None truly exists in Russia’s risky energy sector. That isn’t a complaint for me. I’m a neutral observer. For anyone who handles risk, however, the triumph in Russia of politics over the market is making the job much more complicated. For some, the risks are worth the rewards – and financial investors have, after all, rewarded the Kremlin’s policy. Rosneft successfully launched an initial public offering (IPO) in London last summer, raising $10bn – all based on the main asset, Yuganskneftegaz, that it had appropriated from Yukos. Other Russian companies, like Transneft, the state pipeline firm, also want to launch IPOs, trusting that Western investors have seen the power shift and decided that it works, provided you invest in the right way, backing companies whose control remains in Moscow’s hands. Jeroen van der Veer, Shell’s chief executive, pretended in Moscow at the end of December that he welcomed Gazprom’s takeover of control on Sakhalin. He had no choice. And Robert Dudley, the head of TNK-BP, has been making the same conciliatory noises. If one wishes to stay in Russia, it is understood that one must play by the new rules. For others, though, the risks have become greater. That is particularly true for consumers of Russian hydrocarbons – especially natural gas – where politics are perceived to have weakened the reliability of those supplies. For Europe, the shocks of the Ukraine gas war with Russia in 2006, when Gazprom shut off exports to its neighbour for just over a day, and the similar spat with Belarus earlier this year were taken to be clear evidence of Moscow putting its political interests ahead of the market. That, at least, is the way Brussels, and many others including the US and Nato, saw it. Moscow says that its hardball with the transit countries on its borders was all about markets, and its desire to put its supplies to those consumers on an international market footing. There is some truth to that. After all, one of the conditions the EU stipulated for Russia’s entry to the WTO was that Gazprom raise the price of its natural gas. So Brussels’ complaints were baffling to many in Moscow. But where the conflict between politics and the market really bites is in Europe’s dependency on Russian natural gas. First of all, Europe is realising that such dependence weakens its political clout vis-à-vis Russia. President Chirac acknowledged that fact a couple months ago when he claimed that when dealing with Russia, Europe has to separate “political” from “economic” relations. In other words, don’t antagonise Russia or she might turn off the taps. Second, the dependency is undermining Europe’s attempts to create a genuine common energy market in the EU. Gazprom knows that, and is playing a very good hand. Highly liberalised markets like the one Brussels wants will not be good for Gazprom and the political ambitions of its masters in the Kremlin. They want secure, long-term contracts with big companies – not risky liquid markets in which small downstream firms are competing to buy capacity from Gazprom. And so, to undermine Europe’s liberalisation goal, Gazprom has successfully targeted Germany as a “hub country” for its gas exports by negotiating bilaterally with Berlin to arrange long-term supply contracts. It is trying to do the same with Hungary. Italy, France and the Netherlands have also negotiated bilaterally with Gazprom for long supply contracts. Such contracts may or may not enhance Europe’s security of energy supplies. But they definitely render its attempts to create a liberalised energy market more difficult – and less realistic. It all demonstrates that a company with a political – and not necessarily economic – rationale behind it now has the advantage in a world where reserves bring power. And Gazprom is able to do to Western companies in Central Asia and the Caucasus exactly what Chinese companies are doing to their Western counterparts in Africa: put political strategy ahead of any real market motive, to sew up countries that it considers important to Moscow’s political ambitions. Gazprom acts like a chess player in Central Asia and the Caucasus, capturing transit countries to ensure that rival gas producers, like Iran and Turkmenistan, cannot compete with the Russian company in supplying Europe with natural gas. In Armenia recent deals with Gazprom – totally political, without any commercial value –have handed that country’s energy sector over to Russia. Why does Moscow want control of such a small market as Armenia? Because Iran could have transited gas to Ukraine and Georgia (and onward to Europe) through Armenia. Now it cannot. Russia is doing the same thing with Turkey, expanding export capacity to a country that has insufficient demand to support it – all to ensure that that key transit hub for European energy remains in Russian hands. It is a sound strategy for Gazprom – but it is making the EU’s attempts to diversify gas supplies very difficult indeed. It boils down to this: the NOC – or National Gas Company in Gazprom’s case – can make political decisions that are out of the remit of a company operating in a genuine market. While Gazprom is able to act, companies like Austria’s OMV, which is leading a consortium to build a new gas pipeline into Europe, have to wait for the right market conditions to appear. Unlike Gazprom, if OMV – or any other publicly listed company – wants to make a strategic decision, it has to satisfy its shareholders and investors first. Gazprom, whose majority shareholder is the Russian state, needs simply the order from the Kremlin. That, in short, is the crux of Europe’s energy security problem: Brussels has no Gazprom that it can instruct to carry out its foreign energy strategy. It must rely on the invisible hand of the market. And in the new era of energy geopolitics, the market confers no strategic advantages. The market’s purpose is the market. Politics’ purpose is power. I’ve painted a fairly bleak picture for consumers of energy, who seem to be holding the short straw while producers carry a big stick. And it looks like a happy picture for NOCs, which have the power. But there are some reasons why this picture needn’t be so black for consumers – or positive for producers. The first is that, ultimately, the attempts by producers and exporters to monopolise the power might bring short-term benefits. But it will also lead to long-term problems. The perceived contempt for contracts in Russia means that the next time the oil price is low, and Moscow goes begging for foreign companies to invest as it did in the 1990s, it will be forced into a weaker negotiating position – one that takes account of the risk associated with doing business there. Good investors have long memories. And sometimes the majors collaborate to defend their collective interests. In Mexico, for example, the government’s invitation to oil majors to develop the country’s deepwater in the Gulf of Mexico, by signing service agreements, has met a coordinated lack of interest from the majors. It is likely that Mexico will have to change its constitution before those companies – who have the technology and know-how that Mexico’s state company, Pemex, needs – agree to invest. That kind of example of Western majors working together to defend their interests is a risk for NOCs. The second is that markets remain the most efficient means of producing the energy that the world needs and bringing it to market. Russia’s efficiency as a producer since Yukos was crushed is illustrated on this graph from the OECD, which shows a clear and rapid decline, starting in the summer of 2003, when the attacks on Yukos began. And, as the International Energy Agency points out, while Gazprom has been buying newspapers, chicken farms and foreign countries, it hasn’t been spending enough in its upstream. That remains the real threat for the company, its consumers, and any other NOC that follows the same model: what happens when that lack of investment hits its output capacity, and Gazprom, in this instance, is unable to meet its supply commitments, domestically and internationally. It could happen as early as 2012, according to Petroleum Economist’s predictions. The third reason is that sensible producers have long memories, too. They know that these power shifts can be cyclical, and they don’t want to hasten the end of the one that presently puts them in the ascendancy by being too greedy. They are unlikely to push for total power and control over energy markets. That is why the latest talk about a “gas Opec”, for example, is just that – talk. It won’t work, for the following reasons. Natural gas is not yet a liquid market, like oil’s is. Contracts are long-term and regional. And cartels need free-markets, which they can then attack. If the oil market weren’t a genuine market, then Opec wouldn’t have the ability to influence prices around the world. So any ambition to create a gas Opec would require the ambition first to create a natural gas market. That would be good news for consumers who want liquidity in their supplies. Second, the problem that could soon plague Russia (and which I mentioned a minute ago) has already undermined Iran, with the second largest gas reserves in the world: its investment in the gas sector has not been sufficient to bring it influence as an exporter. To become an influential member of any natural gas cartel, Iran would first have to bring foreign companies and capital into its gas sector, to develop real export capacity. That would bring more gas on stream and serve to diversify the world’s sources of energy. But aside from the question of whether Iran and Russia would cooperate in a gas sector in which they will, eventually, be long-term rivals for contracts, there is a yet more fundamental reason why a gas Opec will not happen. Such a cartel would finally push consumer countries to make genuine political changes of their own – reducing consumption, genuinely diversifying their energy imports, and breaking the dependence on the main suppliers. A cartel would be suicidal for Russia’s present energy foreign policy. And it would be a gift for those pressing the West to change its patterns of consumption away from hydrocarbons. In short, it would be another risk for the NOC.