Ole Gunnar Austvik:

Security-of-Gas-Supply; Norway, Russia and the EU

Presentation at the Royal Norwegian Embassy, Berlin
Tuesday June 18 2002.

As the EU Single market is expanded and deepened, substantial economic growth is expected to take place in a number of countries. Without significant technological breakthroughs in the use of energy, this growth must be followed by demand for more energy. Few alternatives are commercial available. If renewable energy sources are not developed in a much larger scale than before, non-renewable fossil fuels (oil, gas and coal) must cover most of the growth. In Europe, natural gas is “the winner”. According to forecasts, European gas demand shall increase some 75 per cent over the next two decades.

The sources for supply that shall meet this demand are limited to a few large production areas and fields, many of them at locations far from the market. Russia is and will remain the key supplier, but Norway will also be important. These two countries will dominate gas exports to Northern Europe. This presentation focuses on gas developments in Norway, Norwegian-Russian energy relations, the liberalization of the European gas market and security-of-supply of natural gas.

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Norwegian natural gas developments

The development of natural gas on the Norwegian continental shelf can be described in terms of three distinct periods (Refvem 2002):

The first period started in 1973 with sales negotiations for gas from the Ekofisk fields to the Continent and from the Frigg field to Great Britain. The group of companies who were licensees of the relevant areas negotiated the contracts. The contracts were of the depletion type (all reserves sold under the same contract). The price clause consisted of a formula with a base price linked to the price development of fuel oils. Since these contracts established the fundamental collateral for investment in field and pipelines, strict take-or-pay (TOP) clauses were established, and there were no clauses of price revisions or renegotiations. These contracts also provided the buyers with an important increase in supply to undertake significant investments in downstream expansions.

The second period started with the US initiative in 1982 to block further increase in natural gas exports from the Soviet Union to buyers in Western Europe. The Afghan invasion in 1980 and the Polish Marshall law in 1981, and the ensuing «evil empire» position taken by President Reagan triggered this intervention. In the late seventies Norway had a rather heated political discussion on depletion policy. The main element was which annual production level to aim for between 50 and 90 million tons of oil equivalents (mtoe), in order to limit the adverse impact of the oil activity on Norway’s economy in general. To the outside observer, this of course indicated considerable room for maneuver, and the US pointed to an acceleration in Norway’s gas production policy as the obvious alternative to make up for the shortfall in further Soviet supplies.

The giant Troll gas field was discovered a couple of years earlier, but as the water depth of 300 meters was at the limit of technological feasibility, the licensees were conducting time consuming studies to establish a viable production concept. Eventually, acceleration of Troll development became an important priority both for Norway and her NATO partners. The Troll contracts concluded in 1986 established a price formula that represented a significant drop in gas prices compared to earlier contracts. For the first time the "supply contract» was introduced in major Norwegian gas sales, whereby a defined volume profile was sold regardless of the field reserves. This was also the start of the system with the Gas Negotiating Committee (GFU, Gassforhandlingsutvalget) whereby the Norwegian Ministry of Petroleum asked the Norwegian oil companies Statoil and Norsk Hydro, and later also Saga, to undertake joint sales negotiations.  It was a period of very rapid development of new gas pipelines to Germany, Belgium and France.

With Troll production capacity as the guarantor of deliveries, a number of smaller fields and associated gas from oil production was also released for sale.  Increasing the recovery of oil from existing reservoirs has always been a prime consideration of Norwegian depletion policy. During this second period the amount of gas reinjected into oil producing formations increased to a level of 40 BCM while the level of gas sales increased from 18 BCM in 1980 to 50 in 2001 with contractual increases up to 65 BCM in 2005. This very active growth period resulted in new combined oil and gas production records up to 230 mtoe, far in excess of the targets considered in the late 70-ies.

The third period started more or less when the EU-Commission issued its "Statement of Objections" regarding the GFU-organization of Norwegian gas exports (June 2001). The issuance of a claim that all Norwegian gas contracts entered into over the last 15 years were established on an illegal basis, formally after 1995 when Norway entered into the EEA-agreement, obviously represented a big surprise to the Norwegians. EU argues that the buyers under these contracts should have the freedom to choose whether they wanted to cancel, renegotiate or maintain these agreements.

At the same time, the integration of EU economies and the need for even competition rules, as well as a desire for more efficient markets and more gas, together with market growth, more pipeline routes and storage capacity makes the market “more liberal” than before. The EU “Gas Directive” is one such step, aiming at opening up the pipelines for Third Party Access (TPA). The removal of barriers to the free movement of gas should improve market efficiency and increase the number of producer-consumer relations, and hence competition.

The reorganization of the Norwegian gas industry needed to adapt to the new situation implies not only that the coordinated gas sales are terminated. It also gives new challenges in the coordination between oil and gas production, resource management and the exploitation of scope benefits in production and transportation of gas. Obviously, in mature parts of the Norwegian shelf this could be dealt with more easily than in undeveloped areas in the Norwegian and Barents Seas.

Security of supply, prices and taxes

Part of the US intentions (although not the entire reason) behind the attempt to block increases in Soviet gas exports to the west was to limit West-European dependence on fuel supplies from the "enemy". Security-of-supply could be threatened. However, from the start of gas deliveries to Europe in the early seventies, the Soviets and later the Russians have maintained a remarkable stability of supply. First during a period of cold war, then a chaotic transition period with increasing difficulties in the Ukrainian transit conditions. As far as is known, the Russian side has a well-demonstrated respect for the long-term agreements.

Under today’s market liberalization security-of-supply is affected again. One aspect is that it is improved, as access to pipelines is made easier, new pipelines are built and storage facilities expanded. On the other hand, more volatile, uncertain and lower producer prices could lead to a drop in large investment projects and weaken supply security in the long run. This is an experience already made in the American gas market. After the deregulation in the 1980s, prices dropped (the “gas bubble”). While demand for gas increased with economic growth and low prices, capacity was not much expanded. The unused capacity was gradually absorbed, prices increased and, eventually, reached a level higher than in the European market. Only in the past two years capacity has started to increase slowly. Thus, liberalization lead to stop-and-go reactions in long term investment decisions. With the considerable time lags between investment decisions are made and production actually reaches the market, price volatility may increase over time as well as in the short and medium term.

At the same time, an increase in gas excise taxes may become particularly attractive for consuming countries' governments when rent is made available in the gas chain. This is what happened in the oil market over the past 15 years. When crude oil prices dropped in 1986 and 1991, consumers could have derived the benefit from the loss of rent among producers. However, in Europe much more than in the U.S., consuming countries raised oil product taxation, which stabilized end-user prices and to some extent suppressed demand and (delayed?) a potential later price rise on crude oil. As downward trends in crude oil prices and cost-savings in oil exploration and production can be used to increase oil product taxation, an upward trend in oil prices can be used to increase natural gas taxes, as was seen in Italy some 10 years ago. Gas taxes could rather easily be increased if gas prices are dropping, as well.

Because countries with open trade needs rules of minimum levels for taxation and cost-driving regulations, to avoid a “race-to-the-bottom” development; the EU set minimum rules for energy taxation, as well as in a number of other fields. This is an important reason for the pressure towards harmonization of energy taxation. For a large importing country, or a group of countries such as the EU, such taxes may pressure exporting countries’ prices down. In fact, taxes may be orchestrated across borders in a way that maximizes purchasing countries social surplus, in same way an optimal tariff can do for large importing countries, as we know from international trade theory. Thus, national European gas taxes may, deliberately or not, serve much of a similar function as a customs tariff. Because such processes may lead to a pressure on exporting countries’ prices and the distribution of rent among countries, gas taxation may become a major political issue between energy exporting and importing countries. In my opinion, gas taxes should be included in international trade agreements, in the same way as negative taxes, i.e., subsidies, already is today.

Benefits of liberalization

The liberalization of energy markets in Europe is a very important and necessary process. At the same time, we will make a mistake with potential long lasting negative consequences, if we say that liberalization – and particularly the accelerated liberalization decided in Barcelona this spring - is so important that it constitutes "new circumstances" that are not enough to warrant breaking the existing agreements. After all, these are the backbone of the supply and the trust between the parties. It is possible to do both: Liberalize and respect agreements.

If the British model of a big bang-liberalization of electricity and gas market were to be applied to the EU case, resulting in wide renegotiations and years of dramatic market moves, it has to be borne in mind that the British process was essentially a domestic redistribution of income and rent between domestic producers, transporters, customers and the state coffer. In the case of the EU gas liberalization process, a similar "big bang» would have very serious effects for EEA-member Norway and external partners like Russia and Algeria. Russia also sees long-term contract as the logical way to establish long term confidence between parties who need confidence in supply and confidence for irreversible pipeline investments.

In the energy dialogue between EU and Russia there is a growing recognition at the EU-side that long-term contracts may be beneficial and that joint negotiations may be necessary for the parties who will develop large gas field and pipeline systems. It seems that it may be possible to live with the destination clauses in the existing gas contracts, and that one may find solutions to this issue in the case of new contracts that may follow. But it has taken a long time to arrive at these simple understandings, in a period of an historic Russian move to the west. Perhaps, without the events of September 11 2001, the parties would still not sufficiently have recognized the importance of such long term planning in the energy industry.

Norway, Russia and the EU

Obviously, the EU processes are influencing the competitive situation for Norway and Russia. Norway must adhere to EU competition laws and regulations. This influences her ability to decide how she wants to organize her gas production, transportation and sales. Russia has, on her side, organized gas production and transmission under one body (Gazprom). There are plans to unbundle and liberalize some Gazprom activities, but not to let Russian companies compete in export markets. Because Russia can maintain such a concentrated structure, and Norway not, Russia will be in a stronger position than Norway in the future in terms of market power. With a faster depletion of Norwegian resources, European dependency on Russian gas will increase over time.

On the other hand, even though Russia is not affected directly by EU gas regulations in the way that she organizes her industry, she will meet the same uncertainty in terms of increased volatility in prices. There will be more short-term contracts and she will run the political risk that gas taxes may suppress EU import prices (Norway’s and Russia’s export prices) as Norway does. This could hamper investments in the large and remote new production fields and transportation infrastructure in Russia, as well.

Because Russia is so important to EU energy supplies, it is possible that the two finds ways to solve this problem. One possibility is that the EU will subsidize some of the investments to compensate for the potentially lower Russian export prices. From a social EU point of view, this will be cheaper than to pay high prices for gas.

An option for Russia is to turn her eyes to the growing Chinese market. If Russia starts to export gas to Asia, we will get a Eurasian gas market, linked through Siberian pipelines. This would change the dominant position of the EU as the most important buyer of Russian gas, and put Russia in an even stronger position as a world energy exporter.

Thus, for economic growth to continue as anticipated, Europe and the world are not only dependent on the continuous flow of oil from the Persian Gulf. Russian gas may become as important for both Europe and Asia. Because energy markets are interlinked, a tight market situation in natural gas will increasingly have the potential of spillover effects into the oil market, and not only the other way around. As gas consumption rises rapidly in Europe and in the rest of the world, a Siberian crisis may in 20 years time have corresponding fundamental effects on world economy as an oil crisis in the Persian Gulf.

Norway’s joint interest with the Russians to maintain prices at a certain level is a new element in her relation to her big nabor in the east, as well as to the EU. In a liberalized market, prices will vary more according to actual supply and demand for gas, and Norway and Russia share the interest in avoiding an oversupply in the market that could make prices fall. This parallel the interests between OPEC countries in the international oil market to maintain prices at a stable, but reasonable high, level the prices of gas in European markets is a common good for Norway and Russia.

In this situation, producers can play an important role in achieving the joint interest in remaining stable and foreseeable suppliers to the European gas market. In order to do this, producers need stable and foreseeable prices as well as the instruments and ability to optimize gas extraction over time. For producers, it is a genuine risk connected to the increased uncertainty and price volatility a more liberal market creates, in general, and of the possibility of increased gas taxation (EU 1997), in particular. It is difficult to see that the EU simultaneously can achieve lower gas prices to consumers, high tax revenues from gas usage, and a growth in both demand and supplies as expected.

One of the biggest problems for producers is that purchasing countries through energy taxes have a political tool that, ex post, can derive (much of) their expected rent. Worst case scenario for exporters occurs when fields and pipelines are "fully" developed. At this stage, most producers' costs are sunk, and producers have no alternative but to continue supplying gas through existing facilities and grids even though prices are well below what was expected.

If the long term stability and growth of the European gas market is to be secured, energy taxes should to a larger extent than today be set to reflect each carrier’s environmental benefits and costs. Taxes on gas should be lower than on other fossil fuels and liberalization should take a form that increases gas consumption. Among fossil fuels, natural gas is the environment's best friend. Low gas taxes would benefit producers through more stable and foreseeable prices, consuming countries through stable and continued increases in supplies as well as it would give us all a better environment.

At the same time, market reform and liberalization should be modified in a way that prices are stabilized over time, to give supply a better chance to grow in line with demand. In this way security of supply is improved, and the chance of a new major energy crisis is less obvious. Germany is in a strategic position with regard to gas relations to both Norway and Russia, while Spain and Italy have a similar position with regard to North Africa. I believe it would be to the benefit of all three parties if a degree of gas diplomacy were re- introduced in the Russian/German/Norwegian triangle.

Austvik, O.G., 2002: "Natural Gas; The Key Source of Energy for Northern Europe" in Structural Change in Europe - New Northern Knowledge. Hagbarth Publications, Germany.
---, 2000: "Norge som storeksportør av gass". Report from ‘Norway in the Geopolitics of Energy’.  Europa-programmet, Oslo. 114 pages.
---, 1991: "Norwegian Energy Policy in an International Context; The U.S. Embargo of Soviet Gas in 1982" in Norwegian Gas in the New Europe, NUPI/Vett & Viten, Norwegian Foreign Policy Studies no.76.
EU, 1997: Restucturing the Community Framework for the Taxation of Energy Products, Proposal for a Council Directive COM (97) 30 Final 97/0111 (CNS)  12.3.1997.
Refvem, Trygve, 2002: Norwegian gas developments, internal note, Europa-programmet.