Market Realities Increase National Interdependencies

September 2014, Vol. 241, No. 9

Adi Karev, Global Head Of Oil And Gas, Deloitte Touche Tohmatsu Limited

The ability to unlock domestic shale formations has been transformational for the United States. However, the ripple effects of this energy boom extend well beyond the North American continent.

As emphasized in the Deloitte Touche Tohmatsu Limited (DTTL)’s “2014 Oil and Gas Reality Check,” the shifting role of the United States from major energy importer to soon-to-be exporter is an international development, the implications of which will be felt across the Middle East, Russia and China.

The report explores how this trend, as well as others, is causing expansion and contraction on a number of fronts: the waxing and waning of dominance among suppliers, the progression into globalization from regionalization in energy markets, the growing shares of some fuels and the declining roles of others in the global energy mix, and the opening and closing of borders in response to geopolitical concerns.

Here is a snapshot of the report’s conclusions across five key areas:

North American Revolution
The United States is positioned to be a net exporter of natural gas by the end of this decade, according to projections from the federal Energy Information Administration (EIA). This growth has been no less astonishing in the oil market.

Access to tight oil, the kind found in shale formations, has increased U.S. production from just over 5 MMbbl/d in 2008 to more than 7.4 MMbbl/d in 2013 — the largest five-year increase in crude production in U.S. history.

Some fear this growing feeling of self-sufficiency will translate into greater isolationism and a reluctance to remain engaged in international affairs. However, the report finds this scenario unlikely as new sources of supply and greater competition for demand, particularly in Asia Pacific, reshape the global geopolitical landscape and create greater, not fewer, interdependencies among nations.

Consider the Middle East, for example. Middle East crude cargoes are anticipating a shift as exports are increasingly being directed eastward toward Asia rather than westward toward the U.S. and Europe. Nonetheless, we believe that predictions of U.S. disengagement from the Middle East are overstated.

Given the fungibility of world oil markets, a disruption in Middle East oil supplies will reverberate to the U.S. domestic market regardless of whether the region remains a major source of crude imports. In addition, the region’s volatility continues as the new normal since the “Arab Spring” protests. With no clear alternative to the U.S. military for maintaining the balance of power in the region and with important allies to protect, the United States will likely remain engaged there for the foreseeable future.

The situation in China underscores a similar trend toward greater interdependency. The EIA predicts China will become the largest importer of crude in the world sometime this year. However, if the United States is now less dependent on Middle Eastern supplies, China has grown more so, and its reliance on supplies from the Middle East and North Africa requires regional stability and steady trading partners.

Notwithstanding the Gulf Cooperation Council’s relative stability since the beginning of the Arab Spring, the region has been wracked by domestic upheavals, revolution, and civil war. All of China’s major crude suppliers in the region are unstable except Saudi Arabia and Kuwait. It remains to be seen whether Russia’s recently constructed East Siberia Ocean (ESPO) pipeline will become a new stable source of significant crude supplies to China.

Since energy is the Achilles heel in China’s economic miracle, some contend the nation will choose to become more directly involved in the Middle East politically, economically, or maybe even militarily. Again, we believe this scenario is unlikely since non-interference in the internal affairs of other countries is a seminal aspect of China’s foreign policy.

Additionally, the nation still has a viable alternative to direct intervention – mainly to quietly continue to reap the benefits of the United States-led international system. As long as the international oil market, protected by U.S. military power, can continue to provide China with the energy it requires, it has little motivation to take a more overt role in international energy affairs.

As for the remaining traditional energy exporter, Russia, the North American energy revolution is complicating its position in world energy markets, and underscoring its reliance upon other nations, even as it attempts to revive its influence in world affairs. Russia relies heavily on European oil and gas demand for its economic security. Although U.S. liquefied natural gas (LNG) exports overseas have yet to begin, the availability of additional supplies, not just from the United States, is giving European buyers greater flexibility in gas contract negotiations.

Also, increasing natural gas production in the United States has largely eliminated its own need for LNG imports, some of which was, until only four or five years ago, expected to come from Russia. With the United States dropping out of the market as a significant buyer, LNG shipments are now more plentiful.

Moreover, such shipments of LNG from abroad and possible future gas pipeline options from Central Asia, the Middle East or North Africa are increasing Europe’s supply options. This heightened competition will likely require Russia to rebalance its oil and gas exports between Europe and Asia to secure vital revenues for its economy in the coming years.

New Sources, Geopolitics
The Organization of Petroleum Exporting Countries (OPEC) and Russia have dominated the oil and gas export environment for over a half century. Today, new suppliers are challenging their supremacy and forcing them to compete more aggressively to maintain their market share and influence.

Between 2012-2035, 72% of the world’s demand growth for liquids is expected to come from Asia Pacific. Countries in Asia Pacific are OPEC’s main customers, purchasing 57% of its crude oil exports in 2012. And the region is poised to become even more important to OPEC since U.S. demand is declining. Beyond OPEC, other exporting nations are also looking to Asia Pacific to absorb additional crude oil supplies from the Americas, Russia and Central Asia.

In terms of natural gas, the region, led by Japan, is the largest importer of the fuel. While demand growth in Japan is expected to slow, China, South Korea and Malaysia are expected to use more natural gas in the coming years.

Exports from Malaysia and Indonesia are expected to decline due to depletion and increasing domestic consumption. However, the current Middle Eastern suppliers to the region – Qatar, Oman, the United Arab Emirates and Nigeria – will face competition not only from new LNG export facilities opening in Australia and East Africa, but potentially from the United States in the second half of the decade.

Russian LNG projects in planning and construction will also aim to capture some of this market. If planned export facilities are completed, the Asia Pacific LNG market will become increasingly crowded and highly competitive.

Complicating the competitive landscape even further, one must not underestimate the sway of China. As the world’s largest net importer of crude oil and other liquids, China largely drives demand dynamics in the region, and is seeking greater supply security through diversification. Accordingly, in recent years, it has been investing in domestic infrastructure projects in a number of its own petroleum producing provinces. In the future, if it needs to, China could increasingly look beyond OPEC and Russia for its oil supplies.

The same applies to natural gas. China is increasingly focused on diversifying its portfolio and is choosing to obtain its supplies from a variety of sources, such as importing piped gas from East Siberia and Central Asian countries.

For example, a new branch of the main Central Asia-China Gas Pipeline is expected to be operational by 2016, which will transport gas from the large Turkmenistan Galkynysh gas field to China. In addition, the speed and magnitude of China’s own shale development efforts will affect its future appetite for natural gas imports.

As Asia Pacific’s market power increases so does its strategic importance. Moving ahead, the region’s ability to absorb new supplies will significantly impact global geopolitics and international trade.

Change In Global Order
The global energy mix is shifting toward cleaner fuels such as natural gas. In North America, natural gas is increasingly being used in power generation, manufacturing and transportation. Meanwhile, Europe is extending its lead in clean fuel consumption. Emissions-free sources comprised 11% of Europe’s energy consumption in 2012, and the region is working toward achieving its target of 20% by 2020.

Japan is also making changes. After the Fukushima Daiichi nuclear accident in March 2011, Japan has diversified its energy mix by importing more natural gas and keeping the proportion of coal in its energy portfolio steady at 25%.

Energy demand among traditional exporting nations will be guided by where each stands on the economic development ladder. Russia’s consumption will remain gas-heavy due to widespread availability, relatively low demand growth, and nascent renewable technologies in the country. The Middle East will increasingly move toward natural gas as well.

Energy demand is expected to rise sharply in this region, driven by population growth, increases in per capita income and modernization, which will lead to higher energy requirements for transportation, industrialization and electrification. This sharp increase in demand at home will cut into the region’s export capacity.

A similar situation is developing in Africa. Here, electricity consumption is expected to grow the fastest due to population growth and urbanization, which will enlarge the proportion of natural gas and renewables in the region’s energy mix.

The emerging economies of China and India tell a different story. Despite strong growth in natural gas and renewables, the energy mix in these nations is not expected to change significantly over the next few years, and it will still be dominated by coal, which is abundant, cheap and readily accessible. Accordingly, estimates from leading analysts and market participants suggest coal will continue to account for about 45-60% of the region’s energy portfolio.

Overall, changing supply-demand patterns are rearranging the order of fuels in the global energy mix in favor of natural gas. This will significantly affect energy industry participants, as it has implications for commodity prices, trade, policies and technology.

Project Strategies
Oil and gas megaproject reserves, those holding more than 1 billion barrels of oil equivalent, can be broadly grouped into three categories: traditional, new-age and unconventionals. Traditional projects comprise onshore, shallow water, and heavy oil; new-age projects encompass LNG, gas-to-liquids (GTL), deepwater, and Arctic; and unconventional projects refer to shale, tight oil and oil sands in Canada.

Limited growth prospects with traditional reserves and the economic boom of the early 2000s moved capital expenditures toward new-age projects, but a series of delays and cost overruns deflated the industry’s enthusiasm for these efforts. The U.S. shale boom and the rapid growth of unconventionals further slowed the pace of new-age project development. Nonetheless, new-age projects will continue to remain an integral part of the oil and gas industry’s growth strategy over the long-term as conventional fields decline and shale growth moderates.

Modern project management strategies will increasingly be required if oil and gas companies are to reap the benefits of new-age projects. While there is no “one size fits all” solution, leading industry practices suggest modern megaproject strategies should, at a minimum, include: enhanced upfront engineering and planning, an agile project monitoring and evaluation methodology, increased integration and collaboration between project participants, and a system of emerging technologies, tools and experiential knowledge to promote operational excellence.

Energy Nationalism
Resource nationalism essentially results from a tug-of-war among three basic human drives: the desire for wealth as resources are monetized (greed); the desire for energy security since modern societies are dependent on energy (fear); and the desire to maintain national sovereignty over one’s resources for purposes of national development (pride).

Every country wrestles with these opposing and conflicting agendas at some point, reflecting changing national endowments, local development objectives and national priorities.

Three macrofactors are shaping a new kind of energy nationalism and rebalancing the drivers of greed, fear and pride:

• Technology, the great equalizer, has helped to unlock new sources of hydrocarbons that were formerly viewed as inaccessible.

• Improvements in energy efficiency and changing lifestyles are affecting the demand for petroleum products in developed countries.

• The demographically driven rise of the Asian economies is altering a global demand pattern that has been in place for four generations.

Collectively, these factors are giving rise to a modern version of resource nationalism that in some ways is not as strict and in other ways is stricter.

A major characteristic of this type of resource nationalism is a new openness to joint ventures, technology transfers, research and development, and cooperative agreements behind borders that were previously closed. Access to technology and know-how are critical to expanding petroleum production in the unconventional resource plays, as well as to improving recoveries from mature basins.

Cross-border arrangements will be necessary in order to access this technology and to help some nations reduce their net import balances. Oilfield services companies, in particular, should benefit from new opportunities to take technologies into new markets.

As the industry reaches into previously inaccessible areas, the demand for infrastructure, such as pipelines, processing and storage will also increase, especially in countries not accustomed to such growth.

The oil and gas industry has historically taken a global approach to its behavior and outlook, and the years ahead suggest it will do more of the same, generating ever-increasing levels of connectedness and interdependence. And presumably, the world will be a safer place for it.

Author: Adi Karev leads Deloitte’s Global Oil & Gas practice with more than 20 years of advisory experience, encompassing many years in Asia, as well as multi-national advisory work with international Energy & Resources clients.

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