There are Megatrends in Energy Industry

PETROLEUM IN THE NEXT CENTURY-3

Kjell Roland
ECON Centre for Economic Analysis
Oslo

There are trends and developments in the energy industry that most observers agree are likely to be around for the long term.

These megatrends are:

Open markets and competition. These began more than 25 years ago and will most likely be extended far into the future.
Technology improvements. These have significantly reduced costs and increased the efficiency of extracting, converting, and utilizing energy. There are solid reasons to believe that continuous improvements, if not in parallel between energy carriers, will go on in the years to come and will significantly affect energy systems as well as the environment.
The environment. Environmental concerns have been high on the energy policy agenda for a long time. The issues at the center of attention have changed over time and priorities differ between countries. This is likely to remain so in the future. However, the environment is possibly the most important force shaping the future of energy industries and markets.

Liberalization and competition

Over the past few decades, energy has increasingly become a commodity traded in competitive markets. This development has not always moved along smoothly, and changes have been made at different times for different energy carriers or parts of the industry. The direction of change, however, is indisputable. While the changes in the 1970s and 1980s were concentrated on the upstream segments of the industry-oil and coal production and trade in particular-the momentum started to move the distribution to final consumers and grid based industries (electricity and gas). Most analysts share the view that what we have seen so far is only the beginning.

From vertical chains to markets

The movement away from vertically structured and self-contained systems controlling physical flows to a market-based system where trade is conducted between independent actors in different segments in the vertical chain, was initiated when OPEC started to nationalize oil production. These national oil companies had access to huge crude production facilities and resources, but with limited refining and practically no downstream outlets, they desperately started to look for trading partners.

In a number of importing countries, state-owned oil companies were established to gain national control of distribution and to squeeze margins that once went to multinational oil companies (Table 1 [101,118 bytes]). Nationalized crude producers and national downstream companies appeared a perfect match. Competitive trading was the obvious way to balance the needs of both parties.

Liquid spot and futures market instruments for all major crude oils developed rapidly in the latter part of the 1970s. This was in response to the price volatility risks experienced by market factors and to the serious imbalance that all major oil companies were experiencing in terms of access to crude production relative to downstream market outlets.

Initially, the majors were hostile to new financial instruments. They thought in terms of vertical chains and physical control. However, most of the major oil companies were short of equity crude after being pushed out of the OPEC countries and most other oil producing regions outside the U.S. (Fig. 1 [46,523 bytes]). OPEC, Mexico, Venezuela, and other countries with national companies were looking for downstream outlets, and national oil companies in importing countries needed crude. Well-organized markets for crude, as well as for all major products gradually did away with the perception that to be well balanced, one needed to control the whole physical chain from wellhead to gas station.

World coal market

The world market for coal received a major push forward as a response to the first oil price hike (Fig. 2 [44,974 bytes]). Large stationary consumers wanted to reduce their dependence on oil and started to move to coal. In response to increasing demand from a number of industrialized countries, the supply side started to respond in a number of low-cost areas of the world.

Increasing demand gradually pushed prices upwards and moved international coal trade away from trade on the margin to balance supply and demand for specific qualities in different regions. Instead, long-term relationships were built between export-oriented producers and consumers reliant on the international market.

Excess production capacity in the Appalachian region of the U.S. East Coast was being used for export, and new low-cost capacity was developed in countries such as Australia, Canada, Bolivia, and South Africa. Increasing volume facilitated a liquid market, and gradually lowered prices (Fig. 3 [46,938 bytes]).

Uneconomic domestic coal production in Europe came under increasing scrutiny. In 1951, the European Coal and Steel Community was put in place to create a European-wide market, but the effect was to establish the institutional framework for government subsidies and maintain national coal markets. Public debt, growth in nuclear power, reduced attention paid to security of supplies, and well-functioning international markets, however, eroded the political will to continue and even increase subsidies for production of domestic coal. Thus, during the 1980s, the gap between production and consumption of coal in Europe widened (Fig. 4 [49,067 bytes]). At the same time, the price for internationally traded coal in Rotterdam was determining the value of coal, even if produced domestically.

The oil crisis in the 1970s influenced the coal market by significantly increasing demand. This helped develop an international coal market which became highly competitive. But prices on the international coal market began undermining the willingness to continue subsidizing domestic coal in Europe. It began the trend towards liberalization and competition.

Natural gas deregulation

Deregulation and restructuring of the natural gas industry started in the U.S. Today, Europe is moving in the same direction.

Deregulation in the U.S. began in 1978 by the adoption of the Natural Gas Policy Act (NGPA). NGPA was made necessary by the failure of an inflexible and bureaucratic regulatory system which hampered normal operations of the gas industry.

In the winter of 1977, schools and factories in New England had to close because gas was not available. Surplus production capacity existed in the Gulf and the Midwest as well as in the transportation system, but the burden of regulation, not the market, effectively kept gas from reaching consumers in the Northeast.

NGPA started a 10-year process of decontrol of wellhead prices and loosening of the bureaucratic grip that regulators had on interstate pipeline companies. Gradually, the services that transmissions companies provided were "debundled" (transportation separated from the gas merchant function).

Transmission was opened for third-party access. This allowed more smooth and effective use of existing pipelines. In the old regulatory system, long term secure access to gas resources was high on the policy agenda. Thus, despite complicated wellhead price regulations, gas pipeline and distribution companies in the 1970s were competing for long-term take-or-pay (TOP) contracts. They accepted price clauses and indexation on the premise that the cost could be pushed forwards to consumers in closed vertical chains (Fig. 5 [51,648 bytes]).

Long-term contracts with strict TOP conditions made companies unable to either take or pay for the gas when the recession came in 1981 and gas demand declined sharply. The "gas bubble" was a fact.

In 1984, the U.S. Federal Energy Regulatory Commission (FERC) issued Order 380 which started the deregulation era and exacerbated the take-or-pay problem. After a peak of around 600 bcm, gas demand came down to 473 bcm in 1986. In a situation of surplus capacity, pipelines, desperately struggling with their TOP problems, were persuaded to introduce open access to their facilities by new regulations.

More important, however, is the "final restructuring rule" (Order 636) issued in 1992. This order finalized the process begun in 1986. It required pipelines to separate their merchant function from their transportation service, and had the effect of taking interstate pipelines out of the business of selling gas. It made them transporters of gas without owning it.

End users and distributors now buy gas directly from producers, aggregators, or marketers. The impact of wellhead price decontrol, together with the final restructuring rule, has been to greatly increase the level of competition for most industry participants.

An entirely new and competitive industry emerged that was based on a blend of commercial principles and government regulation. The effect on natural gas prices is shown in Fig. 5.

Competition even in electricity

Only 10 years ago, the electricity industry was the archetype of a utility industry. Electricity was completely monopolized, and the industry structure was designed to mirror the physical chain: vertically integrated from power generator to end consumers. Financially, it was a low-risk, cost-plus kind of operation. Investments were made according to an engineering approach and long-term planning horizon in a highly politicized environment.

Our understanding of what is possible for organizing the power sector has completely changed since reform of the power sector in the U.K., Chile, and New Zealand began in the late 1980s (Fig. 6 [52,226 bytes]).

Debundling of the product for end users and separate accounts between production, transmission, distribution, and trading activities have been introduced in a number of countries. Regulatory systems that open up for third-party access to the grid allow for competition between generators. Pools for electricity trading and innovative financial instruments for hedging and price settings have created new trading practices. In countries like Norway, even individual households have access to the market and shop around between suppliers.

Policy-driven structural change is not limited to industrialized countries, even though the forms are different in the developing world. Restructuring electricity industries in developing countries have largely centered on mobilizing private capital to expand the systems. Regulatory reform has created independent power producers in countries as diverse as China, the Philippines, Tanzania, and Nicaragua.

Transparency and competition

It is hard to see how the present well-organized markets for crude oil, petroleum products, and coal could be undone. In fact, we should expect volumes traded to increase and institutions handling the trading to mature. For oil, what was labeled commoditization in the mid-1980s, and regarded by oil producers as a big threat, is today a fact. Oil is traded like other commodities.

The international coal market is, and will remain, a highly competitive market which, simply due to its pure existence, gradually will undermine domestic protection and subsidies.

Fundamental changes have started and should be expected to deepen in the grid-based energy industries: electricity and gas. Some analysts maintain that even in the power sector the present monopolized and vertically integrated companies will disappear. Debundling of services as seen today in Scandinavia will fundamentally change the rules of the game. Independent actors will appear in all parts of the industry, and small-scale, environment-friendly technologies controlled by the consumer will be favored in many countries.

In the gas industry, the direction of change is very much the same. Contrary to what we see in the power sector, the U.S. is ahead in the gas market. Competition in Europe, however, is likely to follow. And a competitive market for LNG in Asia seems likely in the future.

As in all other industries, there are front runners and laggards. Some countries are already advanced; others have not yet started to change. However, the global trend that we see today towards increasing competition will stay with us in the decades to come.

Globalization

What we see in the energy industries falls well in line with what we see in the economy in general-a trend towards globalization of economic relationships. Economies in different parts of the world are increasingly becoming inter-linked and interdependent. Trade has been growing at twice the rate of the global economy over the last 10 years and the volume of foreign direct investment has grown four times faster than trade. Financial markets have grown even faster.

Economies in transition are being rapidly integrated into world energy and other markets. At the same time as they familiarize themselves with existing international economical and political institutions. In energy as in the economy, the center of gravity is gradually being shifted from industrialized countries toward East Asia.

The oil industry has for decades been a part of the global economy. Over the past decade, even companies involved in electricity generation have developed into global corporations with activities in a large number of countries. Tomorrow, markets for electricity may merge between countries, as is happening in Scandinavia today.

Globalization is likely to go on in energy markets. In 25 years, a much larger share of total energy consumed is likely to be traded internationally or exposed to international competition.

Energy companies, including power and gas companies, are likely to become multinational. Energy industries will increasingly be regarded as "normal" industries with no particular reason to be protected, subsidized, or controlled by governments. Where energy is heading in the next decades compares to the manufacturing industries in the 1960s and 1970s. For this to happen, however, institutions (like the World Trade Organization and European Energy Charter) and common rules and regulations are needed to provide a level playing field.

Among the energy industries, the demand for change is moving to the downstream segments. World oil, gas, and coal industries have experienced dramatic changes in the past, but the challenges and the need for change in the future will move to the utilities and in the relationship between companies and consumers.

The market changes that have altered the upstream energy sector will soon make their way to the utility sector as well.