Challenge of energy security [March 30, 2006]

Dealing with the uncertainty surrounding energy supplies has produced two very different approaches to the problem, writes economics correspondent David Uren
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March 30, 2006
IMPROVING the security of energy supplies has moved to the top of global political priorities, and Australia's gas industry stands to benefit.

It is not just the dark threats from Iran's Interior Minister Mustafa Pourmohammadi to use his nation's oil supplies and control of the Hormuz Strait as a weapon in its tussle with the United States over its nuclear ambitions that has world leaders on edge.

It was weather, not war, that propelled oil above $US70 a barrel in October last year as world markets counted the cost of hurricanes in the Gulf of Mexico.

There are many other threats. Nigeria's exports of 2.5 million barrels a day are jeopardised by ethnic conflict. The Italian oil firm ENI declaring force majeur on its Nigerian contracts last week pushed prices up $2 a barrel.

Two sharply different approaches have developed on how to deal with the gathering uncertainty.









Treasurer Peter Costello spelled out the approach that Australia is pressing before the G-20 finance ministers group, of which Australia is chair, in a speech earlier this year.

"I believe that true energy security is not possible without effective energy markets, strong regional co-operation, and sound policy and regulatory frameworks.

"My vision is the creation of an energy freeway linking energy suppliers and consumers across the Asia-Pacific region for the benefit of all."

China, and to a lesser extent India, have a different approach, trying to secure resources by owning oil fields and cementing strategic relationships with oil-producing countries.

A new Chinese study highlights the fact that behind Saudi Arabia, China's biggest oil suppliers are Oman, Angola, Iran, Russia and Sudan, while imports from some of the nations with the biggest oil reserves, such as Kuwait and United Arab Emirates, are low.

"China is seeking access to energy resources in countries where developed countries, in particular US companies, have less investment," says author, Fan He, director of the Beijing-based Institute of World Economics and Politics.

He adds that several of these are considered "rogue" states by the US, adding strain to bilateral relations between China and the US. China's international energy investments exceed $US40 billion.

Amy Myers Jaffe, from the leading US energy policy think-tank, the Texas-based Baker Institute, says China's strategy is unlikely to succeed. "Hard lessons have been learned in the West about the ineffectiveness of strategic bilateral relationships with key oil exporting countries to safeguard energy supply," Professor Jaffe said.

In the eighties, France pursued aggressive energy diplomacy, supporting the Arab case against Israel, offering sanctuary to the Ayatollah Khomeini and selling advanced weapons and nuclear technology into the region. Professor Jaffe says France then had its industrial contracts with Iran cancelled when Ayatollah Khomeini gained power, and had its oil supply cut during the Iraq-Iran war.

Equity ownership of oil provides no insulation against soaring oil prices and exposes investors to political risk. Bilateral sales agreements count for little in a crisis, when suppliers sell their oil to the highest bidder.

Professor Jaffe's colleague, Peter Hartley, says the threats to security are not as severe as they might at first sight appear.

There are abundant alternative sources of oil if prices are sustained at levels above $US60 a barrel, including gas-to-liquids projects, Canada's Athabascar tar sands (with more contained oil than Saudi Arabia) and resources such as Queensland's oil shale.

He says the real nature of the oil market emerged at a recent conference.

"The oil majors were asking the Saudis what their target price was. The Saudis were asking the oil majors what their cost of alternative supply was. That is the kind of game that is being played.

"OPEC (Organisation of Petroleum Exporting Countries) is restricting supply. There is a lot of evidence they have some kind of target price, but they don't want to trigger the alternative substitutes."

The problem for the oil majors is that they don't want to make the big investments in these projects if the prices is going to fall back below their break-even.

In a tape distributed in late 2004, Osama bin Ladan said oil should be priced at more than $US100 a barrel. Professor Hartley says that in the nightmare scenario of forces friendly to al-Qa'ida toppling the Saudi regime, the market would be swamped by unconventional oil.

Professor Hartley believes the best contribution the G-20 can make to energy security is fostering a spot market for liquefied natural gas (LNG). At the moment, LNG is sold almost exclusively on long-term contracts with prices related to oil. "In a world with more multilateral trade and more abitrage, the smart thing would be to contract up to 85 per cent of your gas long term and leave 15 per cent to be traded opportunistically.

"In that kind of a world, you are less likely to be left short, because a lot of other people are doing the same thing."

He argues that regional isolation of the gas market will be replaced by global interdependence, much like the oil market. "Gas users in Japan will have a vested interest in the stability of South American gas reaching the US west coast."

Modelling by the Baker Institute suggests that Australia's gas production will grow fivefold over the 20 years, by which time it will be second only to that of the US. It will hold its strength in world markets as the second-biggest exporter to world markets after Qatar through to 2040. He says LNG is likely to grow rapidly as an energy source, partly because the capital costs of liquefaction and transport are falling.

"Europeans are talking about how wise it is to become more dependent on Russia. Our analysis is that Europe will get more heavily into LNG, particularly the United Kingdom, but also Ireland, France, Spain and Greece."

Lowy Institute fellow, Mark Thirlwell, says that although market solutions to energy security are important, they will not necessarily prevail. "The complication is that the world isn't run by economists. There are security and strategy people who, when they think about security of supply, say that it matters who owns the asset, it matters how it gets to the well-head and who owns the port. Governments see oil as a national resource that they want to keep tight control over."

In the world of real politics, oil is a weapon, not a commodity. Last week, it emerged that the US had responded to Iran's threat to disrupt oil markets by pressuring Japan to halt work on the development of a major oilfield in Iran. Japan refused. However, it has cut back imports from Iran in case supplies are disrupted. The US showed that its commitment to market-based solutions to oil supply concerns runs only so far, when Congress effectively blocked a Chinese bid for the Californian oil company, Unocal, last year.

The Chinese view of US strategy, according to Fan He, is that its military bases protect its energy supplies.

"US companies dig oil worldwide and then sell to the world market and, therefore, to a great extent control the world market."

Chinese companies by contrast avoid the world market, purchasing drilling rights and shipping oil directly back to China.

"The increasing influence of China in the Middle East, Africa and South America might be viewed as a potential threat for the USA," he says. He suggested that co-operation between China and America in securing shipping lanes could be a path to easing tension, although it is not the energy freeway that Mr Costello has in mind.