Some weighty disproportions, underestimated interconnections and risks that were not embraced by an in-depth analysis or were simply hushed up have come to the surface. The crisis makes it easier to rethink the situation, as the dominant paradigm, which could scarcely be called into question in conditions of economic growth, is getting weaker.
The structure of economic ties that took shape in the past decades has serious inherent inconsistencies. The widespread conviction that the expanding global economy is stable by virtue of its scale and diversification of the participants’ interests is creaking at the seams. The towering imbalances of world trade and U.S. deficits aggravate the general situation, but market participants cannot assess the situation adequately or counteract to it using the available instruments (hence the abrupt fluctuations of exchange rates). As a result, market participants often act relying on feelings (sometimes strange even for professional market analysts) that easily grow into panic.
This uncertainty has objective reasons, as various sectors of today’ s financial and economic system are interconnected and, more often than not, the same players drift from one sector to another – together with their capital. Many macroeconomic indicators have become unpredictable, aggravating the risks of projects with long payoff periods. The entire situation forces even long-term investors to shift the focus onto short-term positions in a bid to compensate for their losses (real or anticipated).
It is only now that market players are becoming aware of the scale of the risks, as until very recently risks could be hedged by a variety of inexpensive tools. Offers of such tools came not only from private investors but also from the government, as one saw in the case of real estate market mechanisms. The crisis as such was largely a result of underrated risks.
Thus, any investor who moves to the short-term market and becomes a purely financial speculative player there (even including pension funds) expects to get short-term profits. A market of this kind generates many financial instruments, but the abundance of financial instruments does not guarantee large profits anymore, as the number of players and the resources drawn have grown several-fold in recent years.
Shares are the simplest of all instruments, and the inflow of money to that market began to be felt about ten years ago, as a result of which the stock market started moving in a steady upward trend. However, its integral growth at rates considerably higher than those of economic growth could not continue forever. Slow growth irritated professional market traders, who had become accustomed to windfall profits.
Naturally, points of growth do exist, but a search for them entails the difficult task of looking for objects of capital investment and serious risks. The desire to make life easier first brought about an influx of investment in hi-tech companies, however that sector later crashed. Then the sizable growth of the Chinese and Indian economies bolstered by unbalanced exports of their products – to the U.S. in the first place – raised the efficiency of many companies and pushed their stock prices up, but this growth had petered out by 2006 and 2007 as well, and the oil market turned out to be a good sector for investment.
Objective uncertainty stemming from insufficient data on proven reserves in major oil-producing countries – especially in Saudi Arabia – and a sharp overall decrease in exploring for new deposits amid a steady demand for oil fueled fears that a shortage of oil was already possible in the foreseeable future. This facilitated the rise of a long-term tendency for growth in oil prices and a steep increase in the activity of financial investors in the oil exchange instruments sector.
Thus a new bubble – an oil-related one this time – formed. In the less than two years that preceded the peak of oil prices in the summer of 2008, the presence of financial investors on the oil market had grown several-fold and they accounted for 80 percent of all transactions. These investors did not need oil as a commodity and did not have it themselves. They carried out transactions with what is known as “ paper oil” – with the aid of exchange instruments linked to the oil market. Remarkably, claims were made that the considerable dominance of paper deals over real transactions with oil was a sign of a mature market and that it provided the necessary liquidity and an objective price for this commodity.
However, life does not support these theses. In reality, the market is volatile and this fully conforms to the interests of the vast majority of players. Moreover, market participants are interested in keeping this volatility at a high level. (It should be noted, though, that volatility per se does not guarantee a victory. A more favorable situation is when the market is moving in a direction that can be predicted by the market participant.) The modern information society has mechanisms that allow it to push masses of players towards supporting a certain trend. The list includes well-targeted rumors, ignoring some information (“ the market has swallowed it already”) and over-emphasizing other information, as well as proliferation (usually under the aegis of respectable institutions – more often than not, financial ones) of ostensible forecasts, which, in fact, are indicators of the predominant vector in market development.
If this vector is clear to a majority of players, then the market is ready to move in this direction and investors are ready to get revenues from it, even though the movement may overstep the boundaries of long-term assessments and fundamental indicators. This is how bubbles are formed.
Assessments of a financial agent’ s success are based entirely on short-term indicators, so the agents assess the items for their investments against short-term indicators as well. Since the problem of uncertainty persists, investors have to assume higher risks camouflaged as market instruments.
The crisis has pushed the risks still higher. Previously there was an obvious global tendency (“ the main line”) suggesting that as markets grew, consumption also increased. This was bolstered by the relevant instruments of growth, such as large-scale inexpensive loans and equally inexpensive insurance schemes.
Yet commercial forecasting becomes impossible when the number of risks rises above a crucial point. This triggers a sharp decline in activity and prolongs the crisis. Imagine that acute and conspicuous elements of the crisis have been eliminated. What is to be done with the vagueness surrounding the price of credit resources, exchange rates and, last but not least, the market demand for commodities? The latter has begun to influence even traditional mass commodities like oil and gas.
How does one subdue entropy? In the first place, we must analyze specific markets, mechanisms and interests of the participants, and if the analysis reveals that a given market does not correspond to the tasks it is expected to resolve, then we must modernize that market.
The main criterion of market analysis is the availability of stabilization mechanisms. If the tasks are long-term, then we must have mechanisms capable of overcoming the propensity for short-term deals and short-lived benefits, gregariousness, timidity, and other deficiencies of existing markets.
Let us look at some concrete examples.
THE CRUDE OIL MARKET
The history of the crude oil market is reviewed in detail in an array of publications (see, for instance, “ Putting a Price on Energy.” International Pricing Mechanisms for Oil and Gas, 2007). Market instability and the phenomena pertaining to it have also been a topic of discussion (Alexander Arbatov, Maria Belova, Vladimir Feygin. “ Russian Hydrocarbons and World Markets.” Russia in Global Affairs, No. 1, January/March 2006; Vladimir Feygin. “ The Price Swingboard.” Global Energy, October 2008 – Russ. Ed.).
As the oil market began to develop along the liberal model and saw a sharp inflow of financial players, price establishment turned into a separate business for the relevant “ professionals.” This business only requires a monetary resource. The commodity is separate from the business and the people involved can guess the correlations between supply and demand only through tentative signs – rumors, expectations, statements – and sometimes by individual parameters, such as changes in the reserves of oil and petroleum products in the U.S. The participants are inclined to overstate the significance of some factors, partially due to scarce information and partially because they have a material interest in rocking the market. For the very same reason, they are interested in coordinating their behavior to a large enough degree and are not interested in unlimited competition. If the market is rocked by only one or a few participants, it requires sizable financial costs and is risky.
The direct involvement of commercial players in this process is insignificant (at any rate they are almost never present on the market under their own names). Their efforts were much more noticeable earlier when the market was smaller. It is well known, for instance, that British Petroleum was fined for attempts to manipulate the market.
In the current crisis, the involvement of financial investors on the oil market is diminishing, but those who have stayed behave in the same way, or delicately coordinate their efforts. The forms of coordination may differ, but the essence remains unchanged, since financial players make profits on it.
Oil is a special commodity. Many other commodities are also susceptible to price leaps and falls, but oil prices draw much greater attention and this issue is far more politicized. When prices were high quite recently, producers of oil and other vital energy resources would say that their commodities would continue to become ever more expensive and that it would even be possible to buy up the economies of developed countries with dollars gained from oil, gas, steel, etc. They would even claim that world markets should work according to the rules established by producer countries.
There are a number of opinions out there today claiming that an oil price of $30 to $40 per barrel is acceptable during the crisis period and producer countries should not act selfishly, keep their appetites in check and make sacrifices so that the world economy get out of this crisis. Yet such prices mean a mortal blow to the economies of many oil-dependent countries, like Nigeria or Venezuela. So would it be justifiable to get out of the crisis at their expense? One of the compromise solutions suggests that countries should renounce defending extreme positions: claiming that justice is being established on the international market, and, adversely, interpreting the essence and results of the existing balance too broadly. As we have said earlier, modern markets do not resolve long-term issues. Attempts to create long-term instruments for oil and gas markets were made in the past when long futures were considered in this capacity. But neither their reliability – in essence they prolonged the tendencies that took shape in the sphere of short-term futures – nor the volumes traded could turn them into instruments of investment. Another example was the efforts made in Britain to use futures for the market entry price at terminals in order to justify investment decisions: in the final run, the Transco company acknowledged this practice as faulty.
So how is it possible to make up for the shortcomings of the market that stem from player shortsightedness and interest in coordinated moves, including those that go beyond the limits of reasonable price corridors? Using the language offered above, what are the stabilizers of the market? The answer for today is clear: as regards the crude oil market, it is OPEC (or possibly OPEC in cooperation with other producers) that is making efforts – albeit tough ones – towards harmonizing supply and demand.
Further prospects for normalization involve modification of the mechanisms of crude oil trading. It is important to return to the fundamental principle of price formation as a balance of supply and demand, rather than a balance of market derivatives. This is possible if more trading floors are opened and producers bring the amounts of crude subject to sale (for instance, 10 to 15 percent of their sales over a coordinated period of time). Trading will be done as a price auction for the real amounts of supplies.
The impossibility of selling the stated quantity of products at the prices that would satisfy the suppliers will mean the excessiveness of the amounts offered or of the prices quoted. As in other places, the sellers and consumers of commodity batches will have an opportunity to change their offers, tap mutually acceptable terms of transactions or reject them. Technical issues – and they are many – can be resolved as well. This practice may lead to a sharp growth in market transparency and information awareness by the participants. Naturally it will influence the behavior of petroleum exchanges that will adjust their role to the new conditions on their own.
Of course, if producers (with the involvement of consumers and the minimum possible brokering) assume this approach as a guideline, problems of a different kind may appear. It is good when a traded commodity has wide accessibility and is homogeneous, and market participants abound on both sides. As for oil, its homogeneity is quite relative (it has several basic brands). But what about its abundance?
It is obvious that natural factors and the principle of state sovereignty over natural resources also play a significant role. When oil prices “ went off scale” and OPEC claimed that there was an abundance of oil on the market, developed countries apportioned all blame to “ resource nationalism.” Their claims suggested that state-run companies in producer countries are inefficient, reluctant (or unable) to run a sufficient number of projects, and thus they create a shortage in oil supply. The producers, on the contrary, made assurances that they were doing their best to develop production capacity, including reserves, yet they could not catch up with growing demand. Remarkably, OPEC again said quite recently that it is implementing new projects in this crisis amid rapidly falling oil prices, and that it had set for itself a task of restoring the required level of reserve capacities.
A few simple questions arise. Do multinational corporations, which are not run by the state, create sufficient reserve production capacities? Which factors (except market ones, like the influence of consumer countries) can stimulate them to expand these capacities? Why has all the talk about a malicious OPEC died down now that demand has begun to shrink?
There is another question: Do producers have a duty to fill up the market with their resources amid such conditions? It appears that, generally, the answer is no.
And how will the liquidity of the markets be guaranteed? The answer is in a natural way – that is, by providing sufficient amounts of the commodity and a sufficient number of trading participants, along with due observance of the principles of openness (for commercial participants interested in transactions of the type that will be effectuated on these floors).
If this is the case, a chance will appear that the volatility of prices will diminish sharply and stabilize within a fundamental corridor (the upper limit of which marks the possibility of a changeover to other energy resources). This will require that market players understand that they should moderate their behavior to a certain extent. It will also require their mutual responsibility for the market’ s long-term stability (particularly in creating reserves and modest expectations of state support for alternative energy projects – see below for a discussion of this new sector).
Synchronized steps may be needed to interact in investment processes, as the shortcomings of the oil market have the largest noticeable impact on investment decisions – they are likewise a basis for durable stability in the oil and gas industry.
Governments acting in a reasonable union with private businesses and using market instruments have a significant role in the process. This does not imply “ socialization,” which has become a scarecrow thanks to some analysts. Yet if the purely financial market has failed to create reliable instruments for long-term projects like nuclear and hydropower plants, it is impossible to shun the role of the state. That this should not be confined to government investment only is another story. For instance, it would be reasonable to issue long-term maturity bonds for private investors in such projects that would have reliable guarantees, including the profitability of these projects exceeding that of secure deposits.
THE NATURAL GAS MARKET
Let us now look at the specificity of the gas market – first of all in Europe – from the point of view of the problems discussed above.
The gas industry needs long-term stability to an even greater extent than the oil industry. Gas projects, including the construction of appropriate infrastructures, require more capital investment and have longer payoff periods. It is well known that these factors contributed to the rise of a system of long-term agreements on the European market with a sizable (70 to 80 percent) share of take-or-pay obligations.
Why do the parties to them – suppliers and customers alike – hold on to them? These agreements provide for the sharing of risks, although they do not get rid of risks. Each party assumes the risks it finds easier to assume considering the market situation, experience, etc. The general principle is that the customer bears the risks for supply volumes and the seller, for prices.
The customer under a wholesale contract is not the end consumer of gas – he is an intermediary trader in fact, simultaneously offering various services. He bears the risks for selling the amount of gas stated in the contract and at prices specified in it.
These risks are limited when the market is developing and consumption is growing. Gas then offers its natural advantages (obvious for the consumer) and barriers obstruct access to the market of the given customer (wholesale purchaser) for competitors. The existing risks take the form of irrational taxation, inadequate price formation in contracts or the rise of alternative technologies and energy resources, as a result of which competitiveness of supplies under an agreement (sometimes signed for a period of more than twenty years) may change.
The risks get much higher, however, in the course of market liberalization. These are regulation risks linked with the easing up of unlimited competition on the purchaser’ s traditional market after it is opened. European gas market reform ideologists suffer from a double consciousness. Initially, they hoped to get rid of long-term contracts altogether (because that is how they understood the goal of market reform – as a liberal competitive market), but then they had to put up with these contracts and even recognize their importance.
A need emerged at a new stage of reform (declared in early 2007 but still awaiting final endorsement) to decide on what mechanisms would provide for the development of infrastructure in a situation where the transportation and supplies of gas become separated from each other. This problem still remains.
The proposals being drafted in Europe have been given the nickname “ a gas Gosplan,” an allusion to Soviet-era central planning. These proposals have actually moved the decision-making on investments (and this is the most painful problem for the gas sector due to its high input-intensive nature) to the level of a bureaucratic structure while leaving the obligations on investment (and the relevant responsibility) to commercial companies (operators of the gas distribution system). Meanwhile, long-term agreements per se can serve as a basis for appropriate decisions (for more details, see: Vladimir Feygin. “ Towards a Global Gosplan.” Mirovaya Energetika, No. 8 (44), 2007 – Russ. Ed).
Thus we again face the dilemma of choosing between ideal notions about the market (which in practice result in monsters like the “ gas Gosplan”) or pragmatic decisions in the form of long-term agreements allowing a successful sharing of risks by the parties and laying the market groundwork for long-term development.
Do the long-term contracts have shortcomings? Yes, they do. For instance, they do not take account of the seasonal nature of production activity in the gas sector and the way prices are formed. This shortcoming manifests itself especially vividly during sharp oil price fluctuations, like what happened in the second half of 2008 when gas became less competitive due to the delayed factoring of the changes in oil product prices into the price calculation formula. However, these and other weaknesses are easy to analyze and correct, and contracts can be more flexible and diversified as well.
Does the presence of long-term contracts mean that other forms of contract relations on the natural gas market are not necessary? It does not, of course. But can Europe do without long-term contracts in a situation where gas is pumped over thousands of kilometers and the risks of implementing projects are very high? While previously theoreticians would try and convince everyone that this was possible, the new situation on the financial markets makes a negative answer all too obvious. So would it be more reasonable to recognize reality instead of harboring a dislike for long-term contracts and disassembling the structure of this market by introducing mechanisms that restrict the participation of suppliers, or promulgating the idea of a “ New Energy Policy” (which we will discuss below)?
NEW RISKS
Events related to the complex of problems concerning environmental protection, energy savings and alternative sources of energy have posed a serious challenge to the stability and predictability of the energy sector.
Proponents of radical measures drafted demands to developed countries to reduce greenhouse gas emissions by the middle of this century. After that, the “ horizon” of planning was brought forward to more practical deadlines. Completion of the tasks was pegged to 2030 and, according to new scenarios, including those drafted by the International Energy Agency (IEA), the volumes of emissions must return to the current levels after a certain period of further growth – resulting, in the first place, from the growth of economies in developing countries.
These scenarios suggest a giant leap in the field of energy efficiency; a steep growth in the use of renewable sources of energy; an increased share of atomic energy; and the broad use of CCS (pre-combustion carbon capture and storage) technologies, which the industrial sector still uses on a narrow scale. This means that by 2030, global consumption of basic hydrocarbon resources – crude oil, natural gas, and coal – must return to current levels.
When oil prices were high, developed countries were constantly worried about insufficient investment in the energy sector. It is appropriate to ask IEA experts now what reaction they expect to hear from the producers of energy resources or investors if the forecasts show that the solution to global climate problems can make the results of investment totally unnecessary already in the short-term.
The European Commission issued in mid-November 2008 a voluminous package of documents on the so-called New Energy Policy (NEP). It aims to promote practical steps under the previously stated 20–20–20 targets – that is, a 20-percent reduction in greenhouse emissions, a 20-percent increase in energy efficiency and an equal simultaneous increase in the share of renewable sources of energy by 2020. From the very start these elegant objectives were not propped up by well-calculated measures, which means they remained political statements of intentions.
The new package of documents on the NEP incorporates – along with various proposed measures – the results of research on various scenarios for energy consumption in EU countries, conducted at the European Commission’ s request. Apart from the basic scenario (which does not bring in the 20–20–20 goals), it also includes an alternative scenario (that of the NEP) that reaches two out of the three goals (but predicts an increase in energy efficiency by 13 to 14 percent against the proposed 20 percent). Along with this, total consumption of energy in the EU is expected to decrease by 2020, while gas imports will either grow slightly or go down a little (the calculation is made against 2005).
Europeans aired assurances during the first discussion of the document held at the EU’ s initiative in Moscow last November that this is not a forecast-type document. This apparently should sound like a call to stay away from taking its provisions too seriously. No wonder. Even a superficial analysis of the scenario shows that the quantities of imported gas featured in it are smaller than the total amounts of gas put in the agreements with major supplier countries. This either means that the contracts signed earlier will not be implemented under certain scenarios or the authors of the forecast simply did not bother with such “ trifles.” The second option looks more likely.
One way or other, this is the first time ever that a package of official EU documents has planted a bomb under the basis of cooperation with energy resource suppliers – first of all with Russia. Such “ scenarios” – to say nothing of possible practical policies on them – push risks in the energy sector to a markedly new level.
U.S. President Barack Obama has also said that the development of alternative energy and new energy technologies are among the priorities for his administration. One can expect more active steps by the U.S. in designing collective actions for the post-Kyoto period. The U.S. Congress is already discussing bills on tougher measures against greenhouse emissions. But as U.S. energy sector experts analyze realistic ways to resolve these tasks, they themselves draw the conclusions that natural gas is destined to play the main role as an ecologically safe and efficient energy resource.
It appears that an analysis will eventually be needed of why the conclusions drawn by U.S. and EU experts differ so vastly.
Another dimension of the problem relates to the possibility of amassed governmental investment in developed countries in alternative sources of energy, as well as in the energy and energy-saving technologies in general. The progress of these technologies, equipment and methods is interesting and important for all countries. Otherwise, the human race will inevitably run into a shortage of energy resources or the cost will become unaffordable. But if the efforts made in order to rapidly break away from dependence on hydrocarbons entail massive state subsidizing, producers will have the right to ask questions about whether this approach frustrates the balance of interests of the sides and the principles of energy security. An analogy with fair trade principles, which are coordinated between countries in the format of the World Trade Organization, naturally comes to mind here.
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Financial markets will no longer operate as they did before and it is obvious that a change in the regulatory model is needed. This will influence the mode of functioning of commodity markets as well.
If one imagines that the objective reasons behind the current crisis have been eliminated, the critical mass of risks standing in the way of a reversion to the trajectory of rapid development remains the same. There is a need for mechanisms to increase predictability and reduce the risks that take the form of an irresponsible inflating of volatility and overblown short-term interests. They naturally include interstate instruments, the build-up of public awareness and non-confrontational interaction among the parties to the process. Stabilization mechanisms can vary, but the mutual understanding of their acceptability is highly advisable.
It is important that state interference be restricted, especially during the period that follows an acute crisis phase, and not only in producer countries.
A rejection of coordinated steps is fraught with confrontational and catastrophic scenarios, such as mass refusals by producers to supply sufficient volumes of resources to the market when prices are very low or attempts to prevent such or similar development scenarios by unconventional methods (such as the use of force) – unless the elimination of problems and unilateral approaches become a universal goal.
Author: Vladimir Feygin
