Energy strategies in NorthEast Asia: mapping oil pipelines

1
Energy strategiesin North-East Asia mapping
oil pipelines

• First results from the joint Russian-Taiwanese
  project exploring the Russias energy strategy in
  the context of building the oil pipelines in
  North-East Asia(VSTO-1 VSTO-2)

2
Preliminary remarks(relevant for energy
economics)

• According to BP statistics, to the end of 2007,
  Russia had 6,4 of proved world oil reserves,
  25,2 of proved world gas reserves. It may be
  mentioned further that roughly 80 of Siberia
  territory is not explored for hydrocarbon and
  mineral deposits. So, Russia will remain for the
  foreseeable future an important supplier in the
  world primary energy market.
• Dating from 2003, sharply rising world oil prices
  enable Russia to reconsolidate its legacy in oil
  and natural gas business. It is making headways
  globally but with unequal market influences.
• At present, Russia operates well over 230
  thousand km pipeline network but targeted
  predominantly at the markets of the more densely
  populated West Russia and Europe. The pendulum
  began to shift towards East Russia and North-East
  Asia since the early 1990s. And after long
  period of discussions (including Yukos-story) the
  construction of the VSTO pipelines began.

3
Two questions to be answered

• Was it a correct decision of Russian government
  to build VSTO pipeline (or to answer positively
  the to build or not to build - question)?
• Which of the possible VSTO pipeline routes
  (VSTO-1 only, VSTO-2 only, VSTO-1 VSTO-2
  together) is optimal in the eyes of Russia taking
  into account possible lobbying activities that
  could be undertaken by two mayor of the relevant
  oil consumers (China and Japan)?

4
Game theory as a solution approach

• Modern game theory may be said to begin with the
  work of Zermelo (1913), Borel (1921), von Neumann
  (1928), and von Neumann and Morgenstern (1944).
  Much of the appeal and promise of game theory is
  derived from ist position in the mathematical
  foundations of the social sciences.
• Game theorists try to understand conflict and
  cooperation by studying quantitative models and
  hypothetical examples. These examples may be
  unrealistically simple in many aspects, but this
  simplicity may make the fundamental issues of
  conflict and cooperation easier to see in these
  examples than in the vastly more complicated
  situations of real life.

5
Some game theoretic definitions

• In the language of game theory, a game refers to
  any social situation involving two or more
  players (individuals, firms, countries).
• There are two basic assumptions that game
  theorists generally make about players
• The players are rational they make decisions
  consistently in pursuit of their own objectives
  (each players objective is to maximize the
  expected value of his own payoff measured in some
  utility scale)
• Each player in the game is intelligent he knows
  everything that we know about the game and he can
  make any inferences about the situation that we
  can make.

6
Games in extensive form(some of Myersons
assumptions)

• For any positive integer n, an n-person
  extensive-form game ?e, is a rooted tree (a graph
  in which each pair of nodes is connected by
  exactly one path of branches in the graph and in
  which one special node is designed as the root of
  the tree) together with functions that assign
  labels to every node and branch, satisfying the
  following conditions
• Each nonterminal node (a terminal node in a
  rooted tree is a node with no alternatives
  following it) has a player label that is in the
  set ?1,2,,n?. The set ?1,2,,n? represents the
  set of players in the game, and, for each i in
  this set, the nodes with the player-label i are
  decision nodes that are controlled by player i.
• Every node that is controlled by a player has a
  second label that specifies the information state
  that the player would have if the path of play
  reached this node.
• Each alternative at a node that is controlled by
  a player has a move label.
• Each terminal node has a label that specifies a
  vector of n numbers (u1, , un)
  (ui)i??1,2,,n?. For each player i the number ui
  is interpreted as the payoff to player i,
  measured in some utility scale, when this node is
  the outcome of the game.
• When the game is actually played, the path that
  represents the actual sequence of events that
  will occur is called the path of play. The goal
  of game-theoretic analysis is to try to predict
  the path of play.

7
Game without negotiations
8
Games in extensive form to study

• Games with perfect recall ( whenever a player
  moves, he remembers all the information that he
  knew earlier in the game, including all of his
  own past moves)
• Games with no private information ( with
  complete information, with common knowledge a
  fact is common knowledge among the players if
  every player knows it, every player knows that
  every player knows it, and so on)
• Games with perfect information ( whenever a
  player moves, he knows the past moves of all
  other players, as well as his own past moves)
• Solutions in pure strategies (strategy in the
  extensive form game is any rule for determining a
  move at every possible information state in the
  game)
• Solution using the Zermelo-Kuhn algorithm (
  finding the subgame perfect equilibrium) gives
  the unic equilibrium strategies for all players

9
The model

• The first description of the game
• Development of the payoffs
• The flow of the game

10
First description of the game

• Russia begins and decides between four moves
• to build the pipeline only to China (Daqing),
• to build the pipeline to Nakhodka (assume, that
  this pipeline will supply only Japan),
• to build the pipeline together to China and to
  Nakhodka
• to do nothing (decision not to build).
• If Russia decides to build the pipeline together
  to China and Nakhodka (this option is called
  build together), the game ends, because it is
  assumed that no player has then the incentives to
  change the path of the play, so the players enjoy
  their payoffs.
• If Russia decides to build only to China, or to
  build only to Nakhodka, then lobbying patterns
  emerge.

11
Game without negotiations (without
lobbying1-activities)
12
Development of the payoffs (formulas)
Pi - is the price of oil, i?Ch, Jp,QCh and QJp
- are the quantities of oil transported to China
and to Japan,OpCCh and OpCJp - are Chinas and
Japans opportunity costs of not becoming
Russias oil,L1Ch and L1Jp - are Chinas and
Japans lobbying expenses for the building of the
pipeline itself,L2Ch and L2Jp - are Chinas and
Japans lobbying expenses for the building the
pipeline in the
direction that benefits these countries.
13
Development of the payoffs for Russia (1)

• Sales revenues. For constructing Russias payoffs
  we assume that there are three possibilities
• Exporting 80 million tonnes of oil during next 20
  years on the route only to China (VSTO-1s
  potential throughput capacity could be 80 million
  tonnes a year) brings Russia the price of 500 USD
  per tonne, so 800 billion USD of sales revenues
  are potentially achieved.
• On the same time assume that exporting of 30
  million tonnes of oil during the next 50 years on
  the route only to Nakhodka (VSTO-2s potential
  throughput capacity could be 30 million tonnes a
  year) brings Russia advantages of more
  competition between consumers (and avoid the
  Chinas monopsony), that is the price of 1000 USD
  per tonne, so 1500 billion USD of sales
  revenues are potentially achieved. Actually 1600
  million tonnes (80 million tonnes multiplied by
  20 years) could be exported during 53,333 years,
  but rounded this gives 50 years.
• The exporting of oil to China and Nakhodka
  simultaneously means the yearly transportation of
  50 million tonnes of oil to China (for the price
  of 500 USD per tonne) and of 30 million tonnes of
  oil to Nakhodka (where it could be sold for the
  price of 1000 USD per tonne) during the next 20
  years. That gives Russia the potential of 1100
  billion sales revenues ( 500 billion 600
  billion).

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Development of the payoffs for Russia (2)

• Construction costs. The construction of the
  pipeline is a costly enterprise.
• The costs of the project VSTO-1 to China are as
  high as 12 billion USD.
• The construction of the pipeline to Nakhodka
  VSTO-2 costs again about 15 billion USD.
• However the costs of establishing the vital
  conditions for maintaining the fully operational
  pipelines are much higher and could be estimated
  as twenty times higher (this last guess is taken
  into analysis).
• So, the overall costs of building pipeline only
  to China could be 240 billion USD (1220240),
• the costs of building simultaneously to China and
  Nakhodka could be as much as 540 billion USD
  (12201520540) and
• the costs of building only to Japan equal the
  same 540 billion USD (the pipeline to Nakhodka
  simply uses adding VSTO-2 to VSTO-1)

15
Development of the payoffs for China (1)

• Lobbying the route (lobbying2) . The lobbying
  activities should be introduced into the game.
• According to first expert estimation of Dr.
  Ouyang (letter from 26.06.2008 ) the Chinas
  opportunity costs of not becoming petroleum from
  Russia (50 million tonnes per year) could be up
  to 300 billion USD per annum or 6000 billion USD
  (as sum of 300 billion each year) over 20 year
  period,
• the simple proportion calculations for the
  Chinas opportunity costs of not becoming 80
  million tonnes oil from Russia give 480 billions
  USD per annum or 9600 billion USD over 20 years.
• While constructing the Chinas payoffs assume
  that China will spend up to 5 (the usual agio
  rate in business varies from 0,5 to 5) of the
  minimum opportunity costs over 20 year period
  (that is, 300 billion USD 5 of 6000 billion
  USD) for influencing the decision to build
  pipeline to China.

16
Development of the payoffs for Japan (1)

• Lobbying the route (lobbying2) . The same
  assumptions and calculations are done for Japan,
  however according to first expert estimations of
  Dr. Ouyang and Dr. Popov (letter from 27.06.2008)
  the Japans opportunity costs of not becoming
  petroleum from Russia (30 million tonnes per
  year) could be lower than Chinas.
• Assume that they equal 150 billion USD per annum
  or 7500 billion USD over 50 years (route to
  Nakhodka only)
• Assume that they equal 150 billion USD per annum
  or or 3000 billion over 20 years (root to China
  and to Nakhodka together).
• So, in the constructing the games payoffs we
  assumed that Japan will be ready to spend up to
  375 billion USD (as agio of 5) for lobbying the
  decision build the pipeline only to Nakhodka or
  up to 150 billion USD for lobbying the decision
  build simultaneously to Nakhodka and China.
• As in the case of China we assume that Japan will
  spend the minimum opportunity costs, so Japans
  spending for changing route lobbying activities
  (lobbying2) would be 150 billion USD.

17
Development of the payoffs for China and Japan (1)

• Lobbying the pipeline itself (lobbying1) .
  Assume that the opportunity costs of not having
  the oil pipeline in North-East Asia at all lie
• between 9000 (30006000) billion USD (together)
  or
• 17100 (96007500) billion USD (root to China
  only root to Nakhodka only)
• and that both China and Japan are ready to spend
  for lobbying the construction of pipeline (not
  important to what direction) up to 0,5 of
  minimum opportunity costs (because of insecurity
  of the route).
• In this case 45 billion USD could be spent on
  such activity (this lobbying activity is called
  lobbying1). Rounded it gives 50 billion USD
  from which Japans part would be 20 billion and
  Chinas part is 30 billion USD.
• It is necessary to emphasize here that in the
  developed game exist two kinds of negotiations
  and correspondingly two kinds of lobbying
  activities the first kind are negotiations for
  just building the pipeline (not important to what
  direction, just begin the work on it), this is
  lobbying1, the second kind are negotiations for
  the route of the pipeline, this is lobbying2.

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Development of the payoffs for China and Japan (2)

• Benefits of oil consumers. Let us assume that
  benefits of oil consumers (China and Japan) from
  becoming the oil via pipeline equal to the
  corresponding countries opportunity costs (let
  us take it as a first guess).
• So, the Japans benefits from having all the oil
  from East Siberia over 50 years would equal 7500
  billion USD (15050), the Japans benefits from
  having the part of the oil (the other part goes
  to China) over 20 year period would be as high as
  3000 billion USD (15020).
• Correspondingly, for China the becoming 50
  million tonnes of oil could give benefits as high
  as 300 billion USD per annum or 6000 billion
  (30020), if China becomes all the oil from East
  Siberia over 20 years then its benefits would be
  480 billion USD per annum, or 9600 billion USD
  over 20 years.

19
Game without negotiations (without
lobbying1-activities)
20
Flow of the game (subgame-perfect equilibrium of
the game without negotiations)
21
Results from game without negotiations

• Results

• Game tree

• If this game without extended negotiations
  (without lobbying1-activities) would be the
  whole story, then the game would be easily solved
  and the solution (path of the game) would be
  build to China receive the lobbying2 payments
  from Japan, then change and build to Nakhodka
  with the resulting payoffs 1110 for Russia,
  -6000 for China, and 7350 for Japan.
• However, exactly 11 Nash Equilibria were
  identified in this game, so the
  focal-point-effects could bring the players also
  to the solution build together with the
  resulting payoffs 560 for Russia, 6000 for
  China, and 3000 for Japan.

22
Game with negotiations (no payoffs presented)
23
Flow of the game with negotiations (no payoffs
presented)
24
Game with negotiations (without meet Japan)
25
Results from game with negotiations

• Results

• Game tree

• In this game with negotiations the solution was
  more complex. However the refinement (subgame
  perfect equilibrium according to the
  Zermelo-algorithm) showed that two paths of the
  play could give the same optimal results 1130
  for Russia, 6000 for China, and 7330 for Japan.
  
• The first optimal path identified was Russia
  decides not to build and negotiates with China
  (meets China), China decides not to lobby
  (lobbying1), Russia decides to meet Japan, Japan
  lobbies (lobbying1), then Russia begins to build
  to China, then Japan lobbies again (lobbying2)
  and Russia changes its decision and builds to
  Nakhodka.
• The second optimal path of the play was Russia
  decides not to build and negotiates with Japan
  (meets Japan), Japan lobbies (lobbying1), Russia
  decides to build to China, Japan lobbies again
  (lobbying2), then Russia changes its decision and
  builds the pipeline to Nakhodka.

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Disscussion

• Both models of pipeline game show that Russia
  wants to build the oil pipeline ESPO-VSTO to
  Pacific Ocean (VSTO-2).
• However in the case of building the pipeline only
  to Nakhodka the new questions emerge
• whether the losses of China in the optimal game
  path would be tolerated by China
• what would happen if the influence of USA would
  not be neglected as in the presented games.

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Further research agenda for 2008-10

• Introducing new players (USA, Korea, Taiwan,
  Mongolia, North Korea) in the old game
• Introducing chance player for variation in
  commodity price (oil price)
• Introducing more specific payoffs
• Introducing the private information for players
  (making Bayesian game)
• Introducing many steps and communication

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Conclusions

• The results explain why the process of decision
  making regarding the final route of the VSTO
  pipeline lasted so long.
• The results show the possibilities of
  game-theoretic approach in modern energy economics

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Thank You very much!

• A note of acknowledgement must finish the
  presentation
• I have benefited greatly from conversations with
  Dr. Andrey Bremzen, Dr. Vladimir Sidorenko, Dr.
  Cherng-Shin Ouyang and Dr. Sergey Popov about
  modern game theory and energy economics
• This presentation and related research have been
  supported by joint grant from the Russian
  Foundation of Humanities and Taiwanese National
  Science Council.