Natural Gas: The Next Energy Crisis?

The day after President Bush’s State of the Union address on January 31, 2006, the headline in many U.S. newspapers and in the electronic media was: “America Addicted to Oil.” Indeed, a major newsworthy section of the speech was the president’s proposals to break that addiction, especially from suppliers in unstable countries that can affect U.S. national security. He set a goal of replacing more than 75% of oil imports from the Middle East by 2025, largely through technological means.

Whatever one thinks of the president’s policy proposals, he is correct in attributing security implications to the country’s oil addiction. At a minimum, its dependence requires the United States to trim its diplomatic sails when dealing with the major oil-producing countries, costs U.S. taxpayers a substantial premium to ensure access to oil supplies by maintaining a significant military capability in the Middle East, and gives major oil-producing states vast revenues that allow them to support foreign and domestic policies that complicate the security of the United States and its allies. There is also, of course, the undeniable fact that a strong U.S. economy—the backbone of U.S. preeminence in the world—does require, as the president stated, “affordable energy.”

But the president’s contention that the U.S. economy is petroleum-based is not entirely accurate. Although oil makes up approximately 40% of total U.S. energy consumption, coal and natural gas each now supply about 25% of the energy consumed by the United States. So, although oil is a major element in U.S. energy supplies, it is by no means the only significant factor. Disruption of natural gas or coal supplies would pose major problems to the U.S. economy. Moreover, there are increasing signs that in the case of natural gas, the country is headed down a road similar to the one it now faces with oil, with security implications that echo oil’s as well. In short, like addicts the world over who try to free themselves from one addiction only to become hooked on another, Americans may soon find that imported oil is not the only energy-source problem about which they have to worry.

Until recently, the United States was in pretty good shape when it came to natural gas. Prices were low and supplies sufficient. In 2000, for example, North America consumed nearly one-third of the world’s annual output of natural gas. Unlike oil, for which the United States, Canada, and Mexico together produced only 60% of the supplies they consumed, the three countries produced nearly 100% of the natural gas consumed. Bound together by free trade agreements, the continental market for natural gas more than doubled through the 1990s.

If energy experts inside and outside the government are correct, the proportion of total energy consumption accounted for by natural gas is likely to grow substantially during the next decade and a half. If current trend lines and government policies are sustained, about 90% of the projected increase in electricity generation will be fueled by natural gas plants. Between 2000 and 2004, U.S. electricity-generating capacity grew by approximately one-fifth; virtually all of that growth was gas-fired. Analysts predict that by 2020, more than one-third of the country’s electricity will be generated by burning natural gas. The reasons are well understood: Power plants that burn natural gas cost less and are far easier to build than are nuclear power plants, and they create fewer environmental problems than do coal or nuclear plants. With the expanding use of natural gas for homes and its use as the primary feedstock in the manufacturing process for a wide variety of products, demand for natural gas is expected to rise anywhere from 40% to 50% between 2000 and 2020.

The problem is that the available supply of natural gas is not keeping pace with this growing demand. In North America, production from existing wells is declining, and new wells show a more rapid rate of decline than in the past. As natural gas producers themselves have remarked, they have to run harder to stay even, which means digging more numerous but less productive wells.

Compounding the supply problem are two self-imposed impediments. The first is the nearly complete ban on exploring and developing prospective gas fields off the east and west coasts of the United States, off the Gulf Coast of Florida, and in large swaths of Alaska. In addition, federal government restrictions on exploration and drilling in the Rocky Mountain region, similar restrictions on new drilling in Canada, and the government-induced inability of Pemex (Mexico’s state-owned oil company) to afford expanding gas exploration at home have created a situation in which the country is fighting an energy crunch with one hand tied behind its back.

The second major problem lies in the area of delivery infrastructure. Demand requires not only a ready supply of natural gas but also a capacity to deliver that supply to consumers. The two modes for delivering natural gas are by pipeline and ocean-going ships designed to hold and transport vast amounts of liquefied (refrigerated and compressed) natural gas (LNG). In the first instance, state and local governments have made it increasingly difficult to build new pipeline networks. They have also complicated the transportation of LNG. There is plenty of natural gas outside of North America that can be transported to the United States at reasonable prices if there are places to unload and regasify the LNG for transport along an existing pipeline network. However, the United States has only five such sites, four of them built in the 1970s. There are plans to build more, but environmental and post-9/11 safety concerns have caused local communities to push back.

With the deregulation of the natural gas market in the late 1980s and the creation of a North American free trade region, supplies of natural gas more than kept pace with demand in the 1990s. The result was a decade of gas priced at $1.61 to $2.32 per million British thermal units (Btu). But as ready supplies of natural gas peaked, demand continued to increase, and as cold weather pushed demand even higher, gas prices rose to nearly $10 per million Btu during the 2000–2001 winter. The new average price remains well above that of the salad years of the 1990s, ranging from approximately $4 to $6 per million Btu in recent years, with a high of $14.25 per million Btu in the fall of 2005, in the aftermath of Hurricanes Katrina and Rita.

The implications of the mismatch between stagnant natural gas supplies and growing demand are obvious. If gas prices remain high and susceptible to large spikes in prices, the cost of producing power will rise, and manufacturing companies that rely on natural gas will increasingly think about moving out of the country and closer to their supplies. As former Federal Reserve Chairman Alan Greenspan remarked last year, “Until recently, long-term expectations of oil and gas prices appeared benign. When choosing capital projects, businesses could mostly look through short-term fluctuations in prices to moderate prices over the longer haul. The recent shift in expectations, however, has been substantial enough and persistent enough to influence business investment decisions, especially for facilities that require large quantities of natural gas.” Although power companies can pass along the rising costs to consumers, companies that use natural gas to produce products such as chemicals, fertilizer, and a host of other items will be driven to close plants in the United States and move overseas in an effort to cut costs and stay competitive in the global market.

Another result of the U.S. supply problem is that the gas needed to meet U.S. demand will, by necessity, increasingly come from overseas sources. As with oil, that fact has implications that go beyond the economic health of the United States. Almost two-thirds of the world’s natural gas reserves can be found in five countries: Russia, Iran, Saudi Arabia, Qatar, and the United Arab Emirates. Russia and Iran have almost half of the world’s reserves. The other major sources of reserves are found in West Africa and Latin America. Needless to say, these are not countries or areas marked with strong democratic credentials or close ties to the United States. Higher demand for gas at today’s higher prices will provide vast new revenues for those states and help sustain some very problematic governments. And as the global competition for energy resources heats up, it makes energy importers, such as Japan and most of Europe, more hesitant to challenge those states and their policies. If current trends continue, Russia will be providing more than 50% of Europe’s natural gas supplies by 2020. Even today, Germany imports 40% of its gas from Russia; Italy, 30%; and France, 25%. Central and Eastern Europe are in some cases even more dependent. Slovakia gets all of its gas from Russia; Bulgaria, 94%; Lithuania, 84%; Hungary, 80%; and Austria, 74%. At a minimum, this situation makes it more difficult for the United States to build an international consensus for taking a tougher line toward countries such as Iran and Russia.

The most immediate obstacle to taking a tougher line with Russia, however, is the growing power of Gazprom, the Russian energy company in which the Russian government has a controlling interest. The operator of the world’s largest network of gas pipelines and the world’s largest producer of natural gas, Gazprom is assiduously working to expand its preeminence into a position as close to a monopoly as possible.

Gazprom’s strategy for accomplishing this goal is straightforward. To obtain the resources to develop its energy reserve holdings in Russia and increase production, it has allowed foreign entities to buy its shares and is inviting non-Russian companies to help develop untapped or underdeveloped fields. However, it is doing so in ways that ensure that Moscow still has the controlling interest. Combined with the revenues produced by its pipeline operations and the quasi-liberalization of its rules on stock holdings, Gazprom’s market capitalization stands at approximately $200 billion. Flush with cash, Gazprom is now in the business of trying to buy pipeline networks outside of Russia. In fact, as the European Union pushes its members and prospective members to divest themselves of state-controlled energy companies and to liberalize more generally, Gazprom is moving to buy up pipeline assets or gain a substantial foothold in European energy companies. In short, Brussels’s desire to create a more open market in the energy sector is being used by Moscow as an opportunity to extend its control over the distribution system for natural gas.

Does that matter? Moscow clearly thinks it does. Well before Vladimir Putin appeared on the stage as a possible Russian president, he was writing that the key to Russia “regaining its former might” was its role as a provider of natural resources to the rest of the developed and developing world. As president, Putin halted plans by Kremlin liberals to break up Gazprom’s monopoly inside Russia and instead appointed cronies as the company’s chief operating officers.

If nothing else, Gazprom’s profits provide the Kremlin with an enormous slush fund that is outside the official Russian state budget. This is made even easier by Gazprom’s habit of partnering with shadow companies whose underlying ownership remains opaque but that are suspected of having ties to the Russian mafia and Russian intelligence. Such arrangements also make it possible to feed funds to Russian and non-Russian politicians and government officials alike.

As the past winter’s events have made clear, Putin’s use of Gazprom is not always so subtle. On New Year’s Day, Gazprom cut off Ukraine’s gas supplies. Not long after that, the major gas pipeline feeding Georgia mysteriously blew up. In both cases, two young democracies, both looking to the West, had frustrated Gazprom’s efforts to get control of their pipeline assets. (Ukraine’s pipeline is the main route for transporting gas to Europe, so the cutoff to Ukraine affected Europe’s supplies as well.) Russian officials argued that Ukraine was paying far less than the global market price for the natural gas it took from the pipeline. Moscow, of course, had little to say about the fact that Gazprom was providing Belarus and its pro-Russian leader, Alexander Lukashenko, gas at even lower prices. In the end, facing cutoffs and/or massive price hikes only weeks before elections, Ukraine’s leaders cut a deal that keeps prices for the moment relatively low in exchange for a tangled web of corporate arrangements that gives Moscow a stake in Ukraine’s pipeline system and allows billions of dollars to be siphoned off to a mysterious Swiss company (RosUkrEnergo). To keep the gun to Kiev’s head, the deal also gives Moscow and Gazprom the right to trigger another gas crisis by renegotiating the price Ukraine pays for natural gas after only a few months. Moscow might not have much of a conventional military to threaten its neighbors anymore, but Putin clearly believes he has found another tool to wield influence beyond Russia’s borders.

Reducing Gazprom’s market power

Many in Europe, reacting to rising global demand and the uncertainty of supply exemplified by Gazprom’s hardball approach to Ukraine, appear willing to grant Gazprom concessionary rights on European energy infrastructure and to sign long-term contracts with the company. Although from one perspective this might appear to satisfy Europe’s energy security needs, in the process it further solidifies Russia’s dominant hand in the field. Moreover, it ignores the fact that when Moscow has had a dominant hand to play with its neighbors in the past with oil or gas, it has not been hesitant about playing it. Would it try this with Europe? No one knows. However, since the flare-up over Ukraine, Moscow has done little to reassure European capitals, threatening to take its gas supplies elsewhere—to China—if the Europeans continue to balk about Gazprom acquisitions in Europe and continue to insist that Russia liberalize its own internal energy market. At a minimum, we do know that with Gazprom having this advantage, Moscow will not be any easier to deal with. Nor will it make our European allies eager to challenge Russian misbehavior on other fronts.

There are steps that Europe can take to lessen Gazprom’s market power and, in turn, Moscow’s leverage. First, Russia’s goal of acceding to the World Trade Organization should be explicitly tied to Moscow’s ratifying the 1994 Global Energy Charter for Sustainable Development. The treaty, among other things, would mandate a Russian commitment to promote “an open and competitive” energy market and, in particular, would require Gazprom to open its network of pipelines to independent gas producers. Second, Gazprom’s own oil and gas fields are in decline; most of the gas Gazprom provides to Russian citizens and its European customers comes from non-Russian sources in central Asia. To develop its untapped reserves in Russia, Gazprom will need to draw on the technological and financial resources of the West. The quid pro quo for providing those resources should not simply be an equity share in the revenues generated down the line but a G-8 negotiated and enforced commitment on the part of Moscow to create a truly transparent and market-based energy sector. Finally, European countries should rethink their tendency to sign long-term deals with Gazprom. Instead, they should focus on two initiatives: first, creating new pipeline infrastructure to move central Asian gas to Europe without Russian involvement; and second, adding new LNG facilities to support imports from West Africa and the Middle East. As we have seen in other cases such as the Baku-Tiblisi-Ceyhan oil pipeline, once Moscow is confronted with the fact that it is no longer in a dominant market position, Western companies will find it less difficult to negotiate competitive contracts with Gazprom and the other Russian energy giants.

Increasing U.S. supplies

For the time being, the U.S. government should make it a priority to support a tougher, smarter line by its European partners to counter Russia’s attempt to build a monopoly on gas supply and distribution. As for its own energy security, the solution in the short term is straightforward: increase supplies of natural gas and expand the infrastructure to deliver it to consumers. In both cases, however, politics have prevented the United States from moving forward.

The United States has plenty of natural gas reserves. The government’s Energy Information Agency estimates (conservatively) that there are roughly 1,300 trillion cubic feet of recoverable natural gas resources in the United States alone. That is sufficient to take care of U.S. demand for 50 to 75 years, depending on the growth in demand. But by severely restricting or simply banning drilling access to gas fields in the Rockies, the Artic, the eastern Gulf, and the outer continental shelf in both the Atlantic and Pacific Oceans, Washington has artificially created a supply shortage.

Most of the restrictions or bans are tied to environmental concerns. However, in “green” Canada and Norway, new technologies developed for land and offshore drilling have shown that natural gas exploration and extraction need not cause significant environmental problems. If nothing else, the federal government should begin to gradually lift restrictions on new exploration, test the environmental impact, and if negligible, move forward with further development of untapped gas reserves.

Over the long term, however, energy security with respect to natural gas for both the United States and its allies will be tied to the rise of a global market for natural gas. With abundant supplies worldwide, a global competitive market would provide a diversification of supplies that should be the cornerstone of any energy security policy. As then–First Lord of the Admiralty Winston Churchill remarked on the risks involved in his decision to shift the British fleet’s principal fuel from coal to oil: “Safety and certainty in oil lie in variety and variety alone.”

Although a global market in natural gas appears to be on the horizon, we are not there yet. The gas market today consists mainly of three distinct major regional markets—East Asia, Europe, and North America—whose supply chains are also largely distinct from each other. The key to changing this will be an expansion in worldwide LNG tanker carrying capacity, LNG plants, and receiving terminals. As a strictly economic matter, this looks likely. The costs associated with LNG production and transport have dropped by about 30% during the past few years. Once a very costly way of moving and obtaining gas, LNG is now a moneymaker at prices well below today’s current price levels for natural gas. (Some estimates have the United States overtaking Japan as the world’s leader in LNG imports, with some 20% to 25% of U.S. gas consumption being fed by LNG by 2020.) In theory, with an LNG global supply system being the linchpin, the natural gas market could become a commodity market in which prices are kept as low as economically possible in light of actual demand, and in which a diversified set of suppliers reduces the ability of one supplier to manipulate the market over time.

However, for LNG to play its role in helping to develop a global gas market, a significant expansion in LNG port and regasification facilities will be needed, especially in the United States. Although there are proposals to substantially increase the number of regasification terminals in the United States and federal regulators have made it somewhat easier to move these proposals along, there remains strong resistance among local communities and the states to allowing LNG sites. Environmental and post-9/11 security concerns have driven the debate. Although LNG “has a proven safety record with 33,000 carrier voyages covering 60 million miles with no major accidents over a 40-year history,” according to a National Petroleum Council report, the federal government will have to increase public confidence in the safety of natural gas facilities from accidents or terrorist attacks by mandating increased government scrutiny if today’s thin public support for expanding LNG infrastructure is to be overcome.

Finally, although the creation of a global natural gas market would enhance U.S. national security, a just-in-time supply of gas, like the global market for oil, will be vulnerable to spot disruptions either for political reasons (unrest in a supplier country) or environmental causes (such as hurricanes). In the past, long-term contracts from individual suppliers to specific country consumers essentially isolated the problem of dips in supply and price spikes. In a future integrated global market, disruptions or discontinuities in supply or demand will have global effects. As a result, “gas users in Japan, for instance, will have a vested interest in the stability of South American gas reaching the U.S. West Coast . . . and the European Union will be compelled to monitor the political situation in gas-producing regions as remote as the Russian Far-East and Venezuela,” points out a 2005 report from the James A. Baker Institute for Public Policy at Rice University. To mitigate this potential problem, governments will need to store reserves of natural gas, as the United States does oil in its Strategic Petroleum Reserve, in order to provide a margin of safety against severe disruptions in supplies. Taking this and the other steps outlined above should prevent the pending crisis in natural gas supply and improve not only U.S. energy security but its security interests as well.