Economics and Politics of Energy Industries

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www.uh.edu/energyinstitute
UNIVERSITY of HOUSTON
Economics and Politics of Energy Industries
Setting the Stage
BAUER COLLEGE of BUSINESS ADMINISTRATION
ENERGY INSTITUTE
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State of the World

• Energy is necessary for economic growth ?
• Energy resources and industries have been
  considered strategic and/or national
• Energy industries have been vertically integrated
• But, there is now deregulation / restructuring
• Fossil fuels have been the major source for
  generating energy, but
• These resources are increasingly concentrated in
  politically sensitive parts of the world
• Burning of these fuels are increasingly blamed
  for a variety of environmental problems

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State of the World

• So, how do you address environmental concerns in
  a more competitive industry?
• Fossil fuels-based technologies have cost
  advantages to clean alternatives
• Developing economies want to use these
  technologies and their fossil resources
• Developed economies do not want to risk slow-down
  with heavy regulation

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Energy and GDP
Correlation 0.89
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Energy Consumption per dollar of GDP (Btu)
97-Kazakstan
1-Uganda
80-Venezuela
5-Japan
78-Saudi Arabia
94-Russia
12-France
73-Mexico
15-Germany
67-Canada
88-China
22-UK
39-US
29-Bangladesh
86-UAE
70-India
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Energy GDP (low - low)
Morocco
Lithuania
Bangladesh
Bahrain
Slovenia
Nica.
Uganda
Nepal
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Energy GDP (low - middle)
Belarus
Finland
Bulgaria
Denmark
Hong Kong
Peru
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Energy GDP (middle - middle)
Belgium
Venezuela
Czech
Kazak.
Sweden
Switz.
Austria
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Energy GDP (high - high)
Canada
India
UK
France
Italy
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Energy GDP (high - high)
US
China
Germany
Japan
Russia
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Energy Today (primary)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today II (primary)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today IV (primary)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today V (oil)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today VI (oil)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today VII (oil)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today VIII (gas)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today IX (gas)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today X (gas)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today XI (coal)
Source http//www.bp.com/worldenergy/index.htm
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Energy Today XII (coal)
Source http//www.bp.com/worldenergy/index.htm
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Natural Resource Economics
Instead of competitive profit max rule of PMC,
we have PMCOC AB user cost (Hotelling rent)
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Natural Resource Economics

• The behavior of this rent over time is important
  a barrel of oil not produced today will be worth
  something tomorrow.
• What is, then, the profit maximizing resource
  extraction pattern?
• Output will be decreasing over time as the price
  increases over time.
• Hotelling rule the rent will increase at the
  rate of interest (discount rate)

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Natural Resource Economics
Price, Output
Backstop technologies
Price
Output
Time
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Natural Resource Economics
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Reserves to Production Ratios
Source www.bpamoco.com/worldenergy/primary/
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Years of Current Consumption
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World Crude Oil Replenishment (billion barrels)
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World Natural Gas Replenishment(trillion cubic
feet)
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World Coal Replenishment(billion short tons)
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U.S. Crude Oil Replenishment (billion barrels)
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U.S. Natural Gas Replenishment(trillion cubic
feet)
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Canadian Natural Gas Replenishment(trillion
cubic feet)
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Plus Ça Change, Plus Cest la Même Chose
Source www.eia.doe.gov/oiaf/ieo99/highlights.htm
l
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Bermuda Triangle Energy-Economy-Environment

• OPEC or Other Producer Collusion - Price of Oil
  Role of Technology
• Globalization, Liberalization Economic Crises
  (e.g., Asian Crisis of 1998)
• Economic Sanctions - Political Risk
• Environmental Concerns - Global Warming

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Cartels Dont Work
Nominal commodity prices, indexed
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Because an Effective Cartel Requires

• Minimum conditions
• Narrowly defined target
• A good with no easy substitutes
• An entry cost for new producers that is very high
  relative to the marginal cost of cartel producers
• Incentives to cooperate

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BUT
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OPEC (Saudi Arabia) has potential
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A Question of Perspective

• Short-term perspective higher price now is
  better (shared by companies and countries)
• Long-term perspective can live with lower prices
  for a while (should make sense for Saudi Arabia,
  but for companies?)

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Market Shares
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Reactions to High Prices in the 1970s

• Increased non-OPEC production
• Improvements and deployment of new technology
• Increased use of alternatives, especially natural
  gas
• Increased energy efficiency
• Initially, lower D for oil due to economic
  recessions in importing countries caused by high
  prices

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Adversity is the Mother of Invention
Offshore below 10,000ft? Virtual environments?
Laser drilling?
Cumulative U.S. oil production
4-d seismic, offshore below 5,000ft
3-d seismic, horizontal drilling,
measurement while drilling, offshore below 1,000ft
Directional drilling, offshore below 250ft water
depth
Long-line pipe transmission
Advances in drilling, early seismic, shallow
offshore EP
Oil and gas discovered in U.S. (Titusville, 1859
Spindletop, 1901)
Romanian oil production from hand-dug wells (1854)
Mainframes Minis Micros
Work Stations ?
1859 1870 1935 1938 1947 54
78 83 85 90 92 98 2000
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The Core Belief System...Shell Interdisciplinary
Scholars Program
(Hypothesis)
Tendency Toward Energy Sector Reform
HIGH
LOW
Energy products are commodities
Energy products are strategic materials
Small resource base
Large resource base
Strong imperatives
Weak imperatives
Weak institutional setting
Strong institutional setting
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Dictates Energy Sector Organization...Shell
Interdisciplinary Scholars Program
(Hypothesis)
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and Relative Strength of the StateShell
Interdisciplinary Scholars Program
(Hypothesis)
Trade Laws
Pressure from Trade Flows
Regulation
Strength of State Ownership/ Control
Open Access
Jurisdictional Boundary
Diminishing Monopoly Power
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But Whose Core Belief System Is It?

• Notable examples of backpedaling on energy sector
  reform are found
• in Russia and other NIS
• in Latin America
• in Western Europe (natural gas)
• in the U.S. and Canada (electricity)
• Where energy is considered a free good, the
  transition is more tenuous

Plan for disruptions in development scenarios!
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Motivation Can Move MountainsShell
Interdisciplinary Scholars Program
(Hypothesis)
Oil and Gas Reserves
High
Low
Favorable
Strong
E. Canada
Argentina, Texas
Angola, Norway
Government Policies
Government Motivation
Colombia
China?
Brazil?
Venezuela
Russia, Other NIS
India
Saudi Arabia, Mexico
Weak
Unfavorable
Low
High
GG, Engineering Risk
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Its a Tough Neighborhood...
Worldwide Oil and Gas Reserves
R/D Shell (16.8), Exxon (13.7), BP (8.3), Mobil
(6.4), Chevron (6.0), Amoco (5.5), Total (4.2),
ARCO (3.8), Texaco (3.7), Elf (3.5)
2,642 billion barrels oil equivalent
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but its an Even TOUGHER Neighborhood

• Countries slated for major oil and gas
  transportation projects
• Central Asia
• Azerbaijan and Georgia
• Afghanistan and Pakistan
• Myanmar
• Colombia and Bolivia

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Sanctions Dont Workbut the Market Will

• The debate Does investment lead to better
  country behavior? No clear evidence
• Are there market incentives for good country
  behavior? Better evidence
• New, highly publicized corruption ratings
• Credit ratings reflect country behavior
• Foreign direct investment flows
• Market incentives also drive corporate behavior

Sanctioned countries are higher risks regardless!
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Market Failure -Natural Monopoly
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Possible Solutions

• A, natural monopoly outcome, is what we want to
  avoid
• B (PMC) is equivalent to perfect competition,
  but negative profits
• C yields zero economic profit ? no incentive to
  maintain service quality
• D provides a positive return cost-of-service
  (or, rate-of-return regulation)

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Deregulation
ISO Gridco Transco
Pool / Exchange
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• New System
• Unbundled because competitive efficiencies in
  supply retail are expected to surpass benefits
  of VI
• TD remain natural monopolies with regulated open
  access

• Old System
• Vertically integrated because of economies of
  scale
• Regulated (or national) monopoly
• Cost-of-service (rate-of-return) regulation

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Why Does Deregulation Happen?

• Profit incentive for new firms to enter the
  marketplace
• Technology drives industry economics drives
  policy
• New technologies facilitate the rise of
  competition
• Contestability and the limits to monopoly
• The threat of potential competition

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Technical Change Shifts the Production Function
Technology Industry Economics Policy
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Market Failure - Externality
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Private Outcome (Pe,Qe)

• Total social benefits (consumer and producer
  surpluses) OEAQe
• Total social costs OCRHQe
• Net social benefits CEBR - BHA

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Socially efficient outcome (P,Q)

• Total social benefits OEBQ
• Total social costs OCRBQ
• Net social benefits CEBR
• Difference between the two BHA, welfare loss due
  to externality

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Solutions to externality

• No government
• Government
• Moral suasion
• Government production
• Command control
• Market incentives

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Pigovian tax

• Set a tax equal to the difference between MSC and
  MPC at the socially optimum level of output,
  i.e., BV
• But, there are problems
• How to calculate MSC?
• Who bears the burden of tax?

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Global Warming

• Global warming as a scientific event
• Rational objective analysis to confirm or refute
• Policy prescriptives realistically debated
• Timing based on evidence
• Adjust accordingly

• Global warming as a political event
• No consensus on scientific basis or approach
• Policy prescriptives politically debated
• Timing based on public opinion
• Adjust accordingly

Both views can lead to market-based solutions!
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Clean Energy

• AFVs
• Nuclear Power
• Renewable Power Technologies
• Regional/Economic Differences
• Deregulation of Power Industry
• New Sources of Energy hydrogen?

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Energy TomorrowFood for Thought

• New era in energy Competitive Electricity
• Consumers of oil are now more powerful choices
• Last line of defense for oil, transportation, is
  under attack
• Low price of oil may help (or, not!)
• Oil Co. ? Energy Co. ? Utility Co. (Enron as a
  water utility!)