Analysts all over the world are anxiously monitoring the impact of the global crisis on the energy sector. Amid the variety of tensions of the current developments, few consider the fact that the energy sphere, ravaged by the crisis, will be facing the main trials after it is over. The crisis will completely reconfigure the world energy market.

The new energy order will set much tougher demands for its participants. That is why it is so important for Russia to discern through the obscure today an outline of the post-crisis tomorrow, and be ready for the new reality.

SURPRISES OF THE DEMAND

In the past 30 years, the policy of all world energy market players has been based on the idea of continuous increase in consumption. However, this paradigm might not work for many markets, and not just in the next few years, but also in a more distant future.

The slow, sometimes controversial and often unsuccessful, yet steady policy of energy conservation and development of alternative energy sources, pursued by the developed countries, is gradually beginning to pay off. Of course, we can hardly expect major breakthroughs here: what we can see is a gradual change in the lifestyle which starts with the replacement of a light bulb or fixing new windows. The countries of the Organization for Economic Cooperation and Development (OECD) are launching new energy effectiveness standards. These standards remain in force even if fuel prices plunge to their lowest level, when all stimuli for energy conservation seem to be disappearing, and the competitiveness of alternative energy sources is hardly worth talking about.

Whereas we might argue about the pace of progress in energy effectiveness, its result is obvious and inevitable – a decrease in the energy intensiveness of the economy. This means we might expect a decrease in the rate of growth (if not a decrease in absolute volumes) of the demand for fuels in OECD countries in the foreseeable future. According to estimates, even a partial fulfillment of Barack Obama’s energy plan and Europe’s 20/20/20 targets may stall the demand for oil and gas in the U.S. and Europe already in the medium term. Furthermore, both the United States and Europe view these measures as an important part of their anti-crisis packages.

Government subsidies for alternative power generation and energy-conserving technologies can in fact be regarded as a means to inject money into the economy in order to create competitive advantages and jobs and increase the load of production capacities.

If one adds to this the concept of energy supply security, which became popular at the beginning of this century, the desire of consumer countries to diversify sources of energy imports, as well as their efforts to develop their own energy production, it becomes clear that even after the crisis is over, the volumes of oil/gas imports by the developed countries will be markedly lower than was predicted in the past few years.

For example, Obama’s energy plan gives priority to a dramatic reduction of the United States’ dependence on oil imports by developing the production of biological fuel, enhancing energy effectiveness standards for cars, and resuming drilling in “closed” territories on land and in offshore zones.

The introduction of new standards and technologies will stabilize the consumption of natural gas in households and the industrial sector. Moreover, until very recently the demand for gas was expected to grow in power generation; however, the president, in his policy statement, named the stabilization of electricity consumption by 2020 a priority in the new U.S. energy policy. To this end, the U.S. government will allocate 130 billion dollars in investments. Another short-term priority is the construction of a gas pipeline from Alaska with a view to reducing imports of liquefied natural gas (LNG).

The U.S. has been actively developing new technologies for shale gas production to improve the country’s self sufficiency. Many years of investments in these development efforts began to pay off in 2007 and 2008, boosting aggregate gas production in the U.S. by 14 percent.

According to U.S. Federal Energy Regulatory Commission estimates, annual shale gas production in the country may reach 200 billion cubic meters in a decade. As a result of all these measures, the North American LNG market, which exporters regarded as the most dynamic and attractive just a couple of years ago, is shrinking dramatically.

Forecasts for gas consumption in Europe have been scaled back, as well. Estimates of Gas Demand-2020 have been cut by 180 billion cubic meters over the last decade, and import forecasts have been revised downwards by 135 billion cubic meters. The reductions are in line with the EU’s new energy policy aimed at improving the energy effectiveness of the economy, developing alternative sources of energy, decreasing the impact on the environment, developing a competitive market, and improving EU energy security. Benchmarks for achieving these goals are:

increasing energy effectiveness by 20 percent by 2020;

reducing CO2 emissions by 20 percent by 2020;

increasing the share of renewable energy to 20 percent of aggregate energy consumption;

ensuring the security of energy supplies (primarily by diversifying sources of supply).

These intentions are largely a political declaration, as most European experts are skeptical about their feasibility. For example, Cambridge Energy Research Associates noted in a study, conducted in early 2009, that the declared goals could only be attained by 10 percent. Yet even a partial implementation of the measures within the EU’s 20/20/20 climate and energy package will result in a dramatic change in the demand for gas – it can stop at the present level. In the event of complete implementation of the designated goals, the aggregate gas consumption in the EU-27 will plunge to the level of the early 1990s, while the demand for electricity (the major gas consuming sector) may freeze at the current level.

Furthermore, the EU Energy Security and Solidarity Action Plan: 2nd Strategic Energy Review, published in November 2008, for the first time officially presented a scenario of a decrease in the import of natural gas.

The same trend is observed in Asian countries that are OECD members, above all Japan and South Korea. A decrease in the share of energy-intensive productions in the economy, and a steady increase in energy effectiveness standards against the background of the continuing economic stagnation will reduce the demand even in absolute terms. In Japan, the demand for petroleum products had been decreasing for several consecutive years before the crisis. The trend is so obvious that it is planned to shut down a number of refineries in the Asian-Pacific region because of the shrinking market.

The crisis has only intensified these trends, clearly indicating that the global demand for fuels can decrease, as well. The surplus of capacities in the oil industry and LNG production keeps growing. It is not critical and may be short-lived, yet it may bring about serious upheavals in the conditions of the strong financial pressure on market participants.

It has suddenly turned out that there is a large surplus of oil extraction capacity. The fall in demand, caused by the crisis, coupled with a large-scale commissioning of new oil production facilities in 2009 (as a result of investments made in the previous years of high oil prices), have increased excess extraction capacity in the world from 2.4 million barrels a day in 2008 to 6.4 million barrels a day. This is a record high level since 1988. Excess extraction capacity now accounts for 8 percent of the total demand for oil. There is a similar surplus in oil refining.

The LNG market, which has posted the highest growth rates in the past few years, is showing an even more pronounced surplus of production capacity versus the demand. In 2009, 19.3 million tons of liquefaction capacity was commissioned (up 10 percent from 2008), and again, the decisions on investments in these projects were made several years ago, amidst LNG shortages. In 2010, this capacity is expected to grow by another 31 million tons (16 percent more than in 2009, and 30 percent more than in 2010). This will be the largest increment in capacity in the entire history of the LNG market.

Despite the inopportune moment for the implementation of these projects, the owners of the liquefaction facilities will have to launch them to pay on loans. A considerable part of the new LNG volumes (over 50 percent) has not been contracted and is likely to end up in spot markets which are most sensitive to the demand slowdown. The emergence of such a “gas bubble” on the market with a diminishing demand will inevitably result in a further price downfall. In addition, the surplus of cheap gas on the spot market may prompt consumers to insist on a revision of the price formula and the “take or pay” terms in long-term contracts, with a view to reducing the mandatory minimal level of payment.

THE BUYERS’ MARKET AND THE SELLERS’ MARKET

The crisis “cushion” of idling capacities and the falling demand are re-arranging the already complicated producer-customer relations, strengthening the positions of the latter. Consumers, amid the excessive supply, begin to dictate their terms. For example, buyers in Japan, South Korea and Taiwan already insist successfully that they tap less gas, even under rigid “take or pay” contracts. Talks are underway to temporarily ease terms regarding gas volumes or to re-direct methane carriers to other markets. Consumers now have a wealth of options. In these conditions, a supplier who can offer the most attractive prices and flexible terms gets a competitive edge.

Of course, the domination of consumers will not last forever. The history of the hydrocarbon market proves that periods of excessive supply and low prices result in a slump in producers’ investment activity and, eventually, in capacity deficiency. The fall in hydrocarbon prices has already forced all oil and gas majors to revise their investment projects.

According to the International Energy Agency, several dozen upstream projects with an aggregate output of 6.247 million barrels of oil a day and 90 million cubic meters of gas a day have been postponed, suspended or cancelled since the middle of 2008. Considering the long investment cycle in the industry, the demand for oil and gas will certainly start growing once the recession gives way to an economic upturn – if not in the OECD (for the reasons stated above) then in developing countries, primarily in Asia. The crisis-induced slump in investment activity will inevitably lead to a new shortage of hydrocarbons and price hikes. Producers and consumers will swap places again.

The comprehension of the cyclic nature of energy markets’ development and the destructive power of fluctuations for both producers and consumers should help them find new forms of mutual interaction, because this “price swing” and the “built-in” instability of the markets prove to be too costly.

The need for a long-term balance of the interests of market participants is overdue. The existing system of international norms and tacit rules of trade in fuels is so obviously faulty that its replacement is inevitable. The problem is what upheavals will the world energy sector have to face before a new balance is found?

Hydrocarbon pricing is a particularly painful problem. The main paradox of the modern energy market is that prices on the most globalized and highly competitive oil market have lost touch with their basic indicators, while their volatility is disorienting real investors.

Oil prices have become a financial instrument: a mortgage crisis in the U.S. caused investors to seek liquid and reliable assets and they began to invest in oil and gold. Back in 2006, a U.S. Senate report, “The Role of Market Speculation in Rising Oil and Gas Prices,” emphasized that the world price of crude oil was formed irrespective of supply and demand, and that it was controlled by a complex system of the financial market – hedge funds and key banks in the oil sector, such as Goldman Sachs and Morgan Stanley. A major role is also played by international oil exchanges of London and New York. In fact, it was the development of non-regulated international trade in derivatives in the oil futures sector in the past decade that created conditions for the emergence of the speculative oil price bubble.

A probe published in May 2008 by the Commodity Futures Trading Commission (CFTC) showed that in April 2007 up to 70 percent of oil futures on NYMEX were purchased by profiteers, as compared with 37 percent in 2000. The trade in contracts, structured as futures but sold on non-regulated electronic markets – with no restrictions on the number of open positions at the end of the day, has been steadily increasing in the recent years. In addition, starting from 2000, the CFTC has been gradually deregulating over-the-counter trade in oil futures.

In August 2008, after the report’s publication, the CFTC imposed permanent limits on the size of speculative positions that investors may open in exchange trade. The Commission also announced its plans to demand detailed accounts from all foreign exchanges trading in futures for supply of U.S. brands of oil, with the introduction of restrictions on these exchanges, similar to U.S. restrictions.

Major investment funds hurried to withdraw their capitals from the oil market, which provoked a collapse of quotations. Another factor behind the price dynamics was an objective decrease in demand – first, due to exorbitant oil prices at the beginning of the year, and then, starting in the summer of 2008, due to an economic slowdown in the developed countries.

The lack of an effective pricing model gave rise to a manipulative oil pricing system and excessive speculations on the oil market. Current oil prices still reflect the state of financial markets, rather than the actual supply-demand ratio; furthermore, due to the remaining pegging mechanism, the virtual nature of oil prices influences gas prices as well.

Obviously, periods of low prices evoke discontent among producers about the existing pricing system. They would prefer the more attractive “good old” mechanisms, such as direct bilateral relations between producers and consumers, or cost-plus pricing which takes account of the cost of production and transportation, the investment element and a profit margin. This system does not promise super profits when prices grow, yet it protects producers’ money when prices fall, and now it finds increasing support among them. For example, the president of Turkmenistan made a statement to this effect in April.

Multiple reductions in producers’ revenues (for many of them, oil/gas export revenues are a critical part of the national budget) and entry to export markets by suppliers with no contract history with importers (Iran, Turkmenistan and Azerbaijan) may consolidate the established producers outside the OPEC cartel, which has been demonstrating its complete loyalty to consumers in the last six months. For such producers, it is not a matter of profiteering but a matter of survival and social stability in their countries. Of course, this prospect does not add stability to energy markets. But if one keeps ignoring producers’ interests for too long, they will become increasingly assertive. It should be noted that in a crisis economic agents are often unable to work out long-term strategies – their priority is to keep cash flows at any cost.

The unprecedented scope of market globalization aggravates the instability of the situation: the extended chain of suppliers boosts the role of the transit of fuels, which has become an area of high risks capable of negating bona fide efforts of other participants. As the number of countries involved in any chain of energy supplies is growing, the reliability of these supplies increasingly depends not so much on technical but on institutional factors, above all on market regulation in individual states. Therefore, the bipolar model of producer-consumer relationships must be supplemented with a third – and highly problematic – link, namely transit countries.  During crises, these states seek to raise transit fees, preferring short-term increases in revenues to long-term financial advantages.

The collision between these fundamentally different outlooks must produce a system of new international norms and rules for regulating the energy sector. Importantly, the formation of such a system is of critical importance not only to the industry itself but also to all economic and political agents. The case in point is not so much the adoption of preventive measures or local accords on certain aspects of fuel transportation, as the development of an entirely new, universal model and instruments of interaction in the global energy space. The old patterns that took shape three decades ago will fail to meet the new challenges.

RUSSIA IN NEED OF RESETTING

The world energy sector has entered a high turbulence zone: we will be facing serious upheavals and changes in rules of the game on this complex market at least during the next decade. The world should be readying for mounting confrontation between consumers and producers, who will have nothing to lose in this struggle. A revision of pricing models and a fundamental change of the legal and regulatory framework are quite likely. The geography of the demand will change too, causing a rerouting of supplies. The stagnating energy consumption will inevitably increase competition between producers – both at the level of countries and companies.

A new redivision of energy markets is very possible. Major transnational oil/gas companies, which earned big money during the “fat years” and which do not bear the burden of social commitments, will seek to reclaim the positions that they have yielded to national companies with high state shares in the past seven to ten years. This is just a shortlist of the new conditions in which all market participants will find themselves, including Russia, one of the key players.

Considering the heavy dependence of the Russian economy on energy exports, it is difficult to overestimate the importance of adapting the external energy policy to the ongoing changes. Also, given the duration of the investment cycle in the energy sector and the need to create a transport infrastructure in advance, decisions have to be made today, in the conditions of tough budget cuts and frustrating uncertainty of the international situation.

A constant monitoring of the dynamics of the demand for fuels in major consumer regions remains critically important. It is necessary to watch for changes in their energy policies, especially in energy effectiveness, and develop alternative scenarios for the export of Russian fuels, while taking into account possible stagnation of the demand among the largest consumers.

The anti-crisis strategy is universal for all sectors of the economy – the main emphasis is placed on reducing costs. This is particularly important for the Russian oil and gas industry. The short respite given by the ruble devaluation is drawing to a close. Companies now have to take crucial organizational and technological measures to bring down costs in all the links of the chain of supply. Simultaneously, they need to re-evaluate and select the most effective investment projects and discard the rest.

Another imperative is to win clients’ loyalty. Russia will have to build its relations anew on the traditional European market, where Russia has been cast in the role of a “dangerous” supplier of late. One can talk at length about the reasons behind this attitude, but it is more important to find ways to change the negative attitude towards Russia’s “energy superpower” brand, at least to elevate it to the level of reasonable confidence. A considerate approach to clients, discounts, more attractive terms of contracts, and active marketing and trade will help preserve the market niche during the crisis. Since the guarantees of sales assume special significance, partnerships with companies with strong positions in the downstream sector are becoming highly useful (although it is obvious that in exchange, we will have to offer them really attractive assets or projects in Russia).

New markets can be gained through various exchange operations with other producer companies (swap deals), which will help optimize transportation costs.

In crises, the main competitive advantage is effectiveness, flexibility and adaptability. Russian companies that operate abroad will have to quickly adapt to changes in regulation and, if necessary, to rebuild their organizational structure to meet legislative requirements.

Considering the geographic shift in demand, Russia will have to learn to work effectively in the Asian region, with its peculiar pricing system. It has other price targets, and one should not expect profits there to be as high as in Europe. However, one can learn to derive reasonable profits on this market and, having gained a foothold on it, benefit in the future from large exports and a variety of supply routes.

In other words, Russia needs a comprehensive program to overcome the crisis in the energy sphere, which will enable it to fit into the new energy matrix naturally, using the main advantage of the crisis – the emergence of a certain timeframe to win new positions.