Chapter 1 Introduction
1.1 Issues
“Within the framework of State sovereignty and sovereign rights over energy resources and in a spirit of political and economic cooperation, (the signatories) undertake to promote the development of an efficient energy market throughout Europe and a better functioning global market, in both cases based on the principle of non-discrimination and on market-oriented price formation, taking due account of environmental concerns.”
Title I (Objectives) of the 1991 Energy Charter, the political declaration that marked the start of the Energy Charter process.
The aim of this study is to investigate the principles of market-oriented price formation both for the global oil market and for gas in a global and regional context, and to look into the evidence of how pricing mechanisms work in an attempt to elaborate on what this means in practice in the case of oil and natural gas. The study focuses on the international aspects, i.e., cross-border trade of oil and gas, and addresses the national level only where the national pricing mechanism forms the basis for internationally traded gas, namely in North America and the UK. The intention is to inform the debate across the Energy Charter constituency on issues related to international energy pricing and pricing mechanisms.
1. Approach
On the basis of a consideration of relevant economic theory and detailed background on the operation of international pricing mechanisms for oil, this report describes and analyses the way that prices for natural gas are formed in different regional gas markets. This analysis looks at the context and characteristics of the respective markets that are relevant for the pricing of international trade, and also addresses the impact of the growing international trade in liquefied natural gas (LNG).
1. Questions Investigated in Detail
Over the last 20 years, the market for crude oil has been developed as a global open and competitive market with all the pricing mechanisms typical of commodity markets. This provides for transparency but does not preclude high prices as a result of an oligopolistic supply structure combined with low elasticity of demand. Gas is closely linked to oil in its production process and can be replaced by oil in most applications. The major question for gas is thus:
Will gas follow oil on the way to a worldwide commodity pricing mechanism? If yes, then how? and if not, why not?
A liquid market for natural gas has so far developed only in North America and to a lesser extent in the UK. To date, these markets have had only limited involvement in international gas trade. In spite
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of reform efforts by the European Union, the development of liquid trading places on the European Continent is still in its infancy, while long-term supply contracts continue to play the dominant role for imports. LNG contracts, which until the 1990s were even less flexible than pipeline contracts, now provide more flexibility with regard to off-take obligations and destination. As costs have decreased, so a larger number of shorter-term LNG deals have developed. However, long-term contracts continue to dominate LNG trade and a global LNG spot market has not yet developed.
The report analyses possible reasons for the differences in the development of gas markets and pricing mechanisms, and whether these differences are linked purely to uneven progress with gas market liberalisation or whether other factors play a role, for example:
geography and geology;
import dependence on a small number of exporting countries who are interested in optimising their rent from natural resources and whose production is concentrated in a few super-giant fields;
long-term entrenched choices for power generation of fuels other than gas (e.g., nuclear power in France);
the impact of and approaches to resource rent optimisation by gas exporting countries.
In relation to long-term contracts for natural gas, the discussion examines:
Import dependence and rent seeking behaviour of resource owning countries as a rationale for concluding long-term contracts;
the core elements of long-term contracts and the room for adapting these contracts to new market developments;
the future role of long-term contracts in energy supply.
For trade in LNG, the report addresses:
the continued predominance of long-term LNG contracts, especially in the Pacific, even as LNG trade has become more flexible;
the impact of the opening of the highly liquid and deep US gas market on the contracting pattern for LNG imports;
the interaction between LNG trade in the Atlantic basin and the markets for natural gas in Europe and North America: what trade patterns for LNG will develop in the Atlantic basin, what will be the role of Henry Hub for LNG prices;
the question of whether arbitrage by LNG will foster a global LNG and ultimately a global gas market.
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5 Box 1: Economic Implications of the Physical Properties of Fossil Fuels
Energy density and composition of fossil fuels
Oil has the highest energy density of all fossil fuels, about 40-45 GJ/t or 35-40 GJ/m3, with some variation due to gravity and sulphur content.
Coal, by contrast, has only about 20-30 GJ/t, varying largely depending on the ash content, which for hard coal can be as high as 40% and even higher for lignite.
Gas, which has methane as its main component, has only one thousandth of the energy density of oil under atmospheric pressure, i.e., 35-45 MJ/m3, with a lower value depending on the share of inert gases like nitrogen, or a higher value depending on the share of components higher then methane, typically ethane, propane and butane.
It is possible to increase the energy density of natural gas by putting it under pressure, e.g., by a factor of 100 if pressurised to 100 bar, but this still leaves a differential in energy density in the order of 10 compared with oil. It is also possible to liquefy natural gas by cooling it down to minus 162 degrees Celsius. The energy density of liquefied natural gas (LNG) is about half that of oil, but the technology necessary to liquefy, ship and re-gasify LNG is much more costly than that for handling oil.
Noxious components like sulphur, which can occur in all three fossil fuels, need treatment to protect the environment. Handling the ash contained in the coal requires substantial additional equipment for the combustion process and depositing the ash is a costly operation.
The use of coal is so far confined to boilers alone or combined with steam turbines (except for transforming it into a manufactured gas by a process of hydration), while gas and oil are easy to handle and can also be used in internal combustion engines (cars) and in gas turbines.
Oil and coal can be transported and stored in vessels without entailing high specific costs, making it easier to establish marketplaces for oil and coal trading. The high energy density of oil, combined with easy handling, storage and transportation, make it suitable for small applications like cars.
This does not apply for coal and only to a lesser extent for gas. Due to its gaseous aggregate and low energy density, and unless it is transported as LNG, gas requires a fixed pipeline infrastructure for transportation and distribution Establishing a physical trading infrastructure for gas is more difficult because of its high specific costs.
Gas has a substantial advantage on GHG emissions: the CO2 emission factor from burning fuel oil is about 35% higher and, for coal, about 55% higher than for gas. In addition, gas and oil can be used in gas turbines and in CCGTs, where the exhaust heat of a gas turbine process is used to run a steam turbine with a substantially higher electric efficiency (more than 55%) of the combined process than a standard coal-driven steam turbine, which has a maximum electric efficiency of 45%.
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Oil can always replace gas, at the price of a higher CO2 emission factor, while gas can replace oil but is not well suited to fuel individual cars. All three fossil fuels can be used for power generation, gas and gas oil performing similarly, while burning heavy (residual) fuel oil causes more handling problems, and burning coal requires a different treatment and substantial higher investment than for oil or gas.
Character of the deposits of fossil fuels:
Oil and gas fields are subject to hydraulic communication; production from one part of a structure leads to a pressure reduction for all of the structure with repercussions for overall recovery. It is, therefore, common practice to unitise deposits that stretch across the borders of several licences and to have oil or gas fields under a uniform operating regime, even the very large ones. By contrast, large deposits of solid minerals like coal can be produced at several places in parallel, without interference with each other. However, there are usually economies of scope and scale stemming from a coordinated development of large coal deposits.
At large onshore oil fields with good production characteristics the drilling of additional wells to add production capacity is often not very costly. In such cases spare capacity can be kept in reserve or created at relatively short notice. As access to extra oil-tanker capacity is usually possible, large oil producers can react quickly to fluctuations in demand. By contrast, spare production for gas capacity is not expensive for large onshore fields, but the spare infrastructure to bring it to the market is very costly because of the low energy density of gas. For coal, spare production capacity would be costly because of the substantial idle equipment and the need to have enough qualified workforce at hand, while extra shipping capacity may be available on the mass freight-ship market, subject to competition with other users.
The consequence is that oil storage downstream is minimised except for strategic stocks, while, for gas, storage close to the market is usual for seasonal storage to avoid unnecessary capacity in the pipeline, and for coal many power plants have a coal stock close to the plant.
7 Generalised cross-border energy value chains in oil and gas are presented below:
Figure 1: International Oil and Gas Value Chain
ProductionNational pipelineLiquefactionLNGcarrierRe-gasificationNational pipeline (transmission) National pipeline (distribution)
Consumption ProductionPipelineTerminalSeatankerTerminalNational pipelineRefineryConsumption
Storage Oilvaluechain StorageStorageStorage
Internationalpipeline Internationalpipeline
Gasvaluechain
Source: Energy Charter Secretariat