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4-5 April 2012: International Congress on Energy Security

Eight Energy Hurdles for an Olympic Year

Prosperity or doom? Only time will tell; but beyond the energy headlines of 2012, we thought we’d outline some of the core themese that will define the energy world in the year to come. Major price corrections, OPEC pressures, climate slips and Russian gas all have to go into the mix, as do nascent pipelines, unconventional ‘explosions’ and geopolitical gaps emerging between the US and China. We start by sketching some big ticket themes before dropping down into nitty-gritty issues, all while providing some broader pointers for the future. And as this is an Olympic Year, we keep score of the most likely winners and losers in different events – adding some Oylmpic pomp to ‘energy circumstances’. Our bottom line is a disturbing one though; unless more energy players keep pace with global developments, the chances are we won’t have enough medals to go around…

1) Eternal dreams: the quest for certainty
The energy world has been talking about uncertainty pretty much since the Seven Sisters first attempted to control the flow of oil back in the day. It simply never stops. But we believe this time is different. The political debris from 2011 will continue to clog energy markets in 2012. Supply side detritus is scattered across the bulk of MENA producers, all of whom remain vulnerable to political turmoil and new popular demands. The Caspian Streets have scraped the veneer of stability from central Asian strongmen and Venezuela is facing a difficult election year. Non-OPEC heavy weights will have to steer past similar democratic rocks, most notably Russia. The 'Black Swans' of yore have hatched; when it comes to traditional producers, ‘outside the box’ risk events are about as rare as common Canadian Geese. Of course, political risk is also bearing down hard on new Latin American and African plays. With a few rare exceptions, we expect very ‘crude’ coping mechanisms across the board, with both incumbents and insurgents bent on splashing hydrocarbon cash on restive populations.
Add to this the more traditional security threats that loom over the Middle East. The spectre of ever tougher sanctions to curb Iran’s nuclear enthusiasm will continue to rattle traders’ nerves and rock benchmark prices. But Tehran is only too aware that the prospect of a serious oil price shock is an ideal hedge for its nuclear ambitions, and that none of its detractors can afford to call its bluff to ‘block’ the Strait of Hormuz. The resulting stalemate will go on and on, unless of course impatience, a miscalculation of interests or a misreading of intent prompts somebody – our bet is on Tel Aviv – to hazard a resolute if reckless first move. The situation looks just as bad in Iraq, where the US withdrawal has sparked a new round of sectarian strife. Exxon may have bought into Kurdish plays, but the Shia majority haven’t relinquished their claim of centralizing state control over the country’s hydrocarbon assets, and a crackdown against the Sunni insurgency may well dash federalist hopes. Add the regional proxy tussles between Saudi Arabia and Iran currently played out from Syria to Bahrain, stir in the long term problems facing the likes of Yemen, Egypt and Libya, and the MENA supply side picture looks very bleak indeed. Should any one of the major producers in the Gulf go offline, forget trying to even put a price on oil. Stratosphere here we come.
Supply is only half the story of course. Eurozone paralysis will depress global growth deep into 2012, the US dollar will continue to defy fundamentals, all while emerging markets – most notably India and Brazil, and to a lesser extent China –face daunting domestic challenges in order to head off a hard landing. The combined effects of supply side creaks and demand side cracks leave us (roughly) with a $50-150/b outlook for 2012, with swings well beyond this ‘price band’ not just possible but eminently likely. The threat of sharp disruptions ensures that prices will be set by the most dysfunctional expression of the supply-demand equation, rather than by some viable equilibrium. In short, absolutely everything is up for grabs in oil; either upside or downside momentum could easily gather pace. The real question you need to ask for 2012 then is not just whether OPEC would be in a position to moderate prices at the top, but whether western governments can prop-up demand at the bottom, depending on how events conspire. On today’s evidence, the odds are short on either side. Still, some winners are more likely than others. On our scorecard, OPEC gets gold, in a close race against non-OPEC hydrocarbon producers. Emerging Asia snatches a distant bronze, tailed by the US, whereas Europe is far out the metal.

2) False starts: OPEC relays
In a simpler past, weakening Western demand might have prompted OPEC to cut prices to stimulate economic growth. Strong Asian demand means this is no longer the case. Still, the rationale for benchmark prices hitting $127/b last year remains tenuous at best. MENA supply side problems were plain for all to see, but market positions and asset rotation clearly did more to the oil price than the fundamentals in play. Producers got very lucky as a result, with prices averaging well over $100/b for the first time in history. Hence there should be at least some wiggle room for western consumer stimulus, right? Well no actually, wrong.
$100/b for oil is no longer deemed expensive across OPEC ranks, but a necessary price for budgets aimed at securing regime survival without compromising political ambitions. Besides notoriously overstretched patronage states are starting to feel the pinch, after promising unprecedented expansions of social expenditures. The Saudis purportedly need around $90/b to balance their books, which in effect means that the cost of domestic politics is seriously out of kilter with Western growth perspectives. The Saudis may be prepared to open the taps to provide liquidity at current prices. But expecting OPEC to increase quotas to get crude back into a $60-80/b price band to help advanced economies is simply unrealistic.
The extinction of the cartel’s last price moderates does not help. While it’s true that most recessions since the 1970s have been preceded by oil price spikes, OPEC has never been very good at heading the lessons of demand destruction, and with emerging markets dominating the headlines, it is unlikely to do better now. Conversely, if we see prices plunge on the back of weakening Asian fundamentals, prices will almost certainly overshoot on the downside once investors exit positions and release liquidity. Just like in 2008, the kneejerk adjustments will be aimed at keeping investors in the black, not ensuring sustainable global oil production (let alone consistent investment). Most producer states will be caught seriously short if this happens. Russia will be first out of the money, Central Asian budgets will be squeezed and MENA producers will have to make uncomfortable trade-offs. Latin America is in no better shape, no matter whether you look at Venezuela, Bolivia, Ecuador or indeed Brazil, whose bitterly fought over pre-salt wealth remains one of the most capital intensive dreams to date.
We expect that in a back to (conventional) basics scenario, the bulk of OPEC or non-OPEC states would go for volume over price, in the hope that the Saudis will do the heavy lifting and set a viable floor. But even if the Saudis play along, we might experience a novel political paradox, with heightened instability across producer states underpinning prices as panic sets in. Instead of conventional supply restraint negotiated in Vienna, prices might just as well react to supply disruptions caused by unrest. 'Cyclical' could thus take on a whole new meaning as far price and political instability is concerned – the lower the price, the more likely we will see supply disruptions as more vulnerable producers opt for a Libyan or Syrian course. Farfetched perhaps, but we believe that the emergence of a self-correcting 'political risk' mechanism means that the race for OPEC favours will be cancelled. So no medals anyone, and a huge missed opportunity for shaky Western economies.

3) Outcast triumphs: energy vs. climate economics
Whether we should see Durban as a glass half full or finally shattered can be argued either way. But carbon markets gave a pretty clear answer, with prices plummeting through the floor. Kicking the can down the road to 2015 for a new global agreement that will supposedly materialise around 2020 is hardly the stuff of carbon busting. The inconvenient truth is that emissions reduction will remain a piecemeal affair, driven by national agendas and regional agreements. Canada, Japan and Russia all made a pretty dud call in vocally rejecting any new deals, the whole point of Durban (at least from an Asian perspective) is that this means business as usual. A Beijing-Delhi climate pact might or might not transpire by 2015, but even if it does, don’t expect to have any startling commitments drawn up unless the advanced economies go an extra mile or two. Meanwhile it’s becoming abundantly clear across the Americas that energy earnings will trump climate concerns, especially when it comes to unconventional resources. Efforts to contain the traditional US-China mutual suicide pact have backfired, energy economics is back with a vengeance, while climate economics is badly lagging.
Amid the muddle, it’s only really Europe that pledged to keep following the emissions quest through an awkward blend of policy mandates and market mechanisms, which more often than not, will end work working against each other. Traders have learnt to play carbon markets to good effect while NGOs remain rather happy that the CDM provides fiscal transfers to the developing world on the sly. And to some extent, things are starting to shift. Global green investments reportedly hit $234bn in 2010, but that’s more a reflection of various government tax incentives and subsidies that have inflated green tech bubbles in a barely veiled ideological leap of faith. As soon as government incentives are withdrawn investments typically dry up. This hits on a far bigger unpalatable point for environmentalists to ponder – when it comes to green energy we currently have a tax-payer funded industrial policy that allows smart investors to distil money from government constructs; not a policy framework to reduce global carbon emissions to scientifically advised levels. If we keep continuing to confuse these two issues, serious disappointment will be the least damaging result.
For us, 2012 won’t mark anything particularly revolutionary on the green front. Purely through scale and a ‘portfolio approach’ China will remain the key green growth market, and wind and solar will continue to prosper in certain niche markets. Nuclear will continue on slight upward slope, despite Fukushima and despite the lack of long-term carbon prices, with pretty much the same point applying to CCS technologies: research will continue to garner considerable academic and media attention, albeit without any large scale practical application. Notwithstanding the long list of counter indications, biofuels will probably see the biggest growth, thanks to entrenched subsidies, while the real space to watch for emissions will be the interplay between coal and gas. In theory, this is where the major emissions reductions could be had, but unless global carbon prices are set to wipe coal out from the energy mix, the stuff that fuelled the industrial revolution will remain the ‘fuel of the future’ for much of Asia. That, and the fact that Germany plans to reopen its mothballed coal plants to compensate for the loss of nuclear generating capacity should help to put the global climate debate into a realistic perspective. On our scorecard this gives Europe a pyrrhic gold, with most of the remaining field disqualified, and lingering doubts about irregularities.

4) Crowd favourites: the gas galore
All that said, as part of the emissions narrative, we still think gas will continue to do well into 2012 as a quicker and easier option than renewables. Low prices could make medium term investment decisions a tad tricky, but there is no doubt that the world is going to need gas, and lots of it. Europe needs it to meet its environmental goals, Asia to fill gaps and drive growth, the US to bolster energy independence, and MENA, Sub Saharan Africa and Latin America to meet domestic demand and support economic diversification. Perhaps more importantly, the shale revolution has offered IOCs another bite at the reserves cherry, highlighting the need to revise our definition of ‘Major Reserve Holders’.
Assuming the ‘revolution’ continues to gather pace in multiple jurisdictions, ‘big gas’ might well replace ‘big oil’. One thing is for sure, IOCs aren’t going to let up on this. Asset valuations might become more realistic for what were originally lumps of useless rock and localised environmental concerns will need to be catered for over fracking. Settlements will vary from basin to basin, and it will be up to governments as to how high they want to set the environmental bar relative to prospective economic and political gains. The logic so far has been transparent enough in Europe: The closer you get to the Russian border, the more likely it is that governments want shale to work. In China, supply security and economic opportunity roughly hold the balance, whereas India and Indonesia follow the unconventional suit on purely developmental grounds.
In global market terms, the big plays are obviously elsewhere though. The US will maintain its position as a shale frontrunner, although its global significance derives from the lost Atlantic Basin market rather than from exports. Australia will continue to push CBM developments and – once funding concerns are eased – is poised to surpass Qatar as the LNG champion down the line. The rest of the Middle East will see incremental LNG growth over the next decade, as will West African players, with East African fields promising an Indian Ocean boom.
As suggested above, this might be environmental good news – after all, gas is cleaner than coal, and it just happens to be a relatively quick fix for conversions. But if we are really entering the ‘golden age of gas’, renewables will probable fade back into irrelevance. A massive surge in gas, whether in unconventional or in LNG terms, is thus likely to accelerate the shift in the environmental debate from mitigation towards adaptation. The gas trajectory in 2012 will determine whether governments close the emissions door before the carbon horse has bolted. If political inaction makes gas a structural pillar, rather than a bridging fuel in the international energy landscape, the US is set for gold, with the likes of Qatar and Australia competing for the other places on the podium. Europe will be just out of the money, with Russia licking its wounds.

5) Photo finishes: of pipelines and tankers
For oil and gas to be monetised, tankers and pipelines are essential. Whereas oversupply of the latter will cause investors some headaches, 2012 will leave significant marks on the international pipeline diary. Among the projects reaching crunch time, Keystone XL caught most of the headlines at the end of 2011 and will inevitably crop up all the way to the US presidential elections and beyond. But even if Washington signs up for dirtier grades of oil, we expect to see Canada hedge its US bets by developing its Asian plan B. More exotic pipelines such as TAPI and IPI will remain stuck in the political long grass of South Asia, but progress is likely to be made closer to European shores. Baku will have to plump for one of the competing pipeline consortia scrambling for the EU’s Southern Corridor. We put our money on the 10-20bcm Trans Adriatic Pipeline, with outsider chances for ITGI, SEEP and AGRI, as well as a number of rumoured proposals and schemes that have not yet made their public debuts. The European Commission championed Nabucco pipeline is the most likely casualty at this stage, unless of course Brussels stuffs in enough fresh funding to convince the Shah Deniz II consortium to revive the hallucination of European pipeline credibility.
For the Caspian, the real question for 2012 isn’t so much which pipeline will ‘win’ the Southern Corridor race, but whether we’ll see a sequel to the Nabucco saga. If Brussels deems the 10bcm of SDII gas to fall short in elasticity and diversity of supply terms - it will doubtless talk up a bigger and better Southern Corridor narrative with Turkmenistan as a new supplier of choice. Tempting as this may seem on the drafting boards, the mere prospect of another contender in Russia’s immediate backyard will raise the stakes. Not because Moscow is particularly concerned about some new gas making its way into Southern Europe, but because of China’s concurrent efforts to divert major swathes of Turkmen gas and Kazakh oil eastwards. The omens don’t look good for Russia, given that China looks set to source up to 30bcm of Turkmen gas by 2015, with plans to get as much as 65bcm from across the region in the not too distant future. This is where pipeline politics really matter: China’s Caspian hedge will not only cut Russia from potential South Asian markets, but further dent Moscow’s ability to set volumes and prices for the Eastern Siberian production destined to the middle Kingdom. Europe, to some extent, is small fry relative to future Russian future plans and ambitions.
On that note, we think that pricing wars between European utilities and Gazprom over oil indexation will continue to be waged in Stockholm, but that Gazprom can only play for so long before it has to switch to plan B and soak up excess European sport market liquidity. The main game in arbitrage terms though remains Qatar, as the world’s leading LNG producer. Doha has built up an impressive global client portfolio, but its juiciest returns still come from Asia, both in terms of volume and price. To deter Qatar from shifting excess supplies from NBP spot to Asian contracts, Russia will probably have to choke up some economic and political concessions in terms of upstream swaps, supply restraint and a gentleman’s agreement on feeding discreet markets. Whether Moscow will do the required chasing is doubtful, but one way or the other, Russia will have to come off its high hydrocarbon horse and plunge into the complex pricing games that Qatari take-off has brought to Asian markets. The challenge for 2012 will be to dissect the Russian bluster over price collusion in terms of credible actions. The scores here: Qatar takes gold, followed by central Asian producers. China gets bronze, with Russia and Europe still in the warm up phase.

6) Doping debates: unconventional trumps
2012 is an election year for many, but the race for the White House is sure to snatch the headlines from the Russian restoration, the Chinese succession and the Venezuelan plebiscite. Unless the Republicans get their act together, we expect to see an Obama victory. We also believe that energy will be a significant plot in the election narrative, with all sides heralding yet another dawn of more or less environmentally sustainable ‘energy independence’. Unfortunately, the US will continue to overplay its hand on this. The most exuberant projections pitch US production at up to 19mb/d. From this position, the deficit could be fixed, OPEC would be gone for good and foreign engagements could be scaled down to ensure that oil flows freely and safely across the Americas. The geographical ‘spread’ of independence oil would narrow power projections to the north-south axis running from Canada to Argentina, with the US comfortably in between. In ballpark terms, the 6.5 trillion unconventional American barrels clearly don’t justify the cost of protecting the 1.2 trillion barrels locked in conventional MENA plays.
One problem with this brave new energy scenario is that the lead times for the bulk of unconventional production is 2020ish at best – the inconvenient truth here is that over the next decade or so, OPEC market share will reach historical highs of up to 50% on the physical side, covering over 80% of proven reserves. Another is that OPEC will still provide the cheapest marginal barrels. Last but not least, the US will have to come to terms with the fact that its supposed backyards have no interest in catering to US markets alone. Betting on a single buyer is stupid at the best of times. But given the US’ political and economic woes, Brazil, Argentina, Bolivia, Ecuador, Venezuela, as well as neighbouring Canada and Mexico have an overriding interest in keeping hydrocarbons as a globally traded good. This means loading tankers to feed as many markets as possible and at the best possible price.
Widely misunderstood by the energy independence folks, Beijing has gone overboard to ensure that the Americas remain tied into the global energy markets. Its outsized investments in hydrocarbon plays between Canada and Argentina, as well as in the US, will ensure that the global energy markets can withstand isolationist instincts, but even so, Latin suppliers will leash out at US ambitions – unless Washington tones it down a notch or three. Of course, this isn’t to say that the US can’t garner serious political gains from its new found resources. But instead of jumping up and down about tying the Americas into its energy independence schemes, Washington better use its newfound plenty to keep OPEC on the straight and narrow. What’s more, the continent’s geological windfalls clearly provide Washington with an à la carte option of choosing when and where to outsource geopolitical heavy lifting for others to secure global oil supplies. This should worry European politicians, not least because Washington’s reluctant engagement in Libya told us far more about European deficiencies rather than US preferences. China will have to take on more international responsibility as part of the same equation.
Our scorecard: Canada and Brazil tie for gold, China gets a distant Bronze, the US missed another chance.

7) Medal counts: Chimerican hamstrings
The fact that US no longer have to do all the heavy lifting for global energy supplies will inevitably come with geopolitical implications. The blunt fact to consider is that two-thirds of global oil supplies are sitting on politically shaky ground, and doing so in an increasingly large external power vacuum in the Middle East. The vacuum will get significantly bigger as US power (and interest) ebbs and Chinese oil flows, albeit without overarching political or security guarantees in place. It also had the distinct potential for conflict should Washington and Beijing end up misreading each other’s actions.
The headlines in 2012 will relate more to Asia-Pacific rather than the Middle East given that the US has made a clear stand to stake its future geopolitical credibility containing the regional rise of China. US fingers have already been firmly stuck in Vietnamese and Australian dykes, more digits will be applied across the Pacific Rim and Indian Ocean. Some might say that a bit like running a marathon during rush hour, particularly as Beijing ultimately holds US purse strings and indeed, the economic aces in its own back yard. But as far as MENA states are concerned, few doubt that post-Libya and post-Iraq, US credibility has reached an all-time low. Both Israel and Iran consider the US bark to be far worse than its bite, and despite a heavy troop presence, Gulf States are no longer sure the US will do whatever it takes to safeguard Arab security interests. A break point will eventually come as to whether Beijing can mediate between Saudi Arabia and Iran, but the more the Middle East resembles a ‘Chimerican lake’, the more China will be expected to take up some of the security slack.
China’s predicament is that it knows it can’t keep getting a free energy lunch off the US military table, but that it can’t build up or project its military might without fuelling US paranoia. If anything, 2012 will be marked by variations of this Chimerican dissonance being played out across producer states in Africa, Central Asia, the Middle East, and Latin America. To cut the often rehearsed argument short: everybody knows that US power is on the wane, and that economic 'demand security' (hydrocarbon or otherwise) will increasingly emanate from East Asian shores. The upshot is that resource-rich states are increasingly empowered to play off competing Western and Eastern interests. The downside is that political protection has become more elusive than ever. This also affects Europe. Brussels should be in no doubt that, whatever it does or doesn’t do in order to diversify supplies, it can no longer duck behind US might. The US simply doesn’t see Europe as its geopolitical problem. Since Europe is unlikely to militarily bulk up, this will see losses across the board. With China disqualified, the US takes gold, while Europe, along with most hydrocarbon producers, drops out of the race.

8) Torch bearers: the IEA and global governance
The turbulent outlook holds major opportunities and risks for the International Energy Agency. Opinion remains sharply divided as to the sagacity of strategic stock release back in June 2011 – market calls have been made either way as to what would have counterfactually happened without the intervention. But what was not lost on analysts was the absence of China and India from the IEA podium. Finding ways to bring Beijing and Delhi into the energy mould is going to be crucial to foster consumer cooperation in the future - even if that means bending to some of China’s idiosyncratic ‘market’ rules. Truth be told, these rules are hardly less principled than the deals made by Socal on the Arabian Peninsula, the Anglo-Iranian Oil Company in the Persian Gulf or, more recently, elf in Françafrique. China is at the epicentre of demand growth, emissions growth and global M&A, whether bureaucrats in Paris like this or not. Working out how the changing energy landscape can be made to benefit economic growth without alienating producers is simply not possible without including emerging core stakeholders in the debate.
Since the time for co-option has passed, the IEA needs to work towards and with China, rather than trying to dictate how things should play out. We don’t think there is time for an incremental approach. For China to make the shift towards IEA strictures, we would have to see a significant global shock to get the Asian ball rolling. Rather than hoping for a disaster too ugly to contemplate, the IEA should make a bold first move and make Beijing an offer they cannot resist. This means giving the Chinese a hydrocarbon deal that is as least as good as the Indo-US nuclear deal, and then some. Amid the parlous make believe institutions that have come to define global governance, the IEA has the stuff to become a genuine trail blazer for effective East-West cooperation. To succeed, it must broker serious concessions and compromise all round, starting with clipping OECD energy subsidies. It really doesn’t do to preach what one doesn’t practice. But start getting things right with China, and the IEA could soon find itself opening previously barricaded doors – be it with the BRICS, the GCC, SCO or ASEAN. Such connections will be crucial if the shocks and storms of 2012 prove to be as vivid as we think they will be. If they play out, there won’t be enough medals to go round. Laggards will lose, and lose big.

Matthew Hulbert and Christian Brütsch

Matthew Hulbert
Matthew Hulbert works as a consultant for various institutions and governments, most notably for the Netherlands Institute for International Relations (Clingendael) as Senior Research Fellow in The Hague, writing their flagship book for them in 2011, Age of Paradox, Exploring the Uncertain Energy World 2000-2020. He was previously Senior Fellow at the Center for Security Studies, ETH Zurich, leading its work on energy security and political risk. He previously worked in the City of London advising on energy markets and political risk as Senior Energy Analyst at Datamonitor for leading global utilities, and headed up the Global Issues Desk at Control Risks Group, specializing in political risk, geopolitics and security analysis for

multinational companies (FTSE 100), governments and institutional investors. Prior to this, he held political consulting positions at Weber Shandwick Worldwide advising multinational companies on political risks and governments on public diplomacy, including speech writing for various governments at the World Economic Forum, Davos. He has published widely across international policy journals on energy and been quoted in leading international media including The Times of London, The International Herald Tribune, Le Monde, South China Morning Post, Forbes Magazine, and Foreign Policy Magazine amongst others. Matthew is Executive Contributor to The Globalist (Washington DC) a Lead Columnist for Europe’s foremost online energy platform, European Energy Review (Amsterdam) and contributing writer for World Politics Review (New York). Matthew will complete a major book study in early 2012 entitled Mastery of Oil: China, the West and the New Energy World Order. He holds an MPhil International Relations (Distinction) Cambridge and BA History & Politics, (Double First) Durham.