"...Engaging China and India in the Energy Security System..."

The Times
April 01, 2006
The world is waking up to new era of power politics
By Daniel Yergin
The institutions and policies set up after the 1973 Arab oil embargo can no longer meet the needs of energy consumers or producers, says our correspondent

Old questions, new answers

ON THE eve of the First World War, Winston Churchill, the First Lord of the Admiralty, made an historic decision: to shift the power source of the Navy’s ships from coal to oil. He intended to make the fleet faster than its German counterpart. But the switch also meant that the Royal Navy would rely not on coal from Wales but on insecure oil supplies from what was then Persia. Energy security thus became a question of national strategy.

Churchill’s answer? “Safety and certainty in oil,” he said, “lie in variety and variety alone.” Since Churchill’s decision, energy security has repeatedly emerged as an issue of great importance, and it is so once again. But the subject needs to be rethought, for what has been the paradigm of energy security for the past three decades is too limited and must be expanded to include many new factors. Moreover, it must be recognised that energy security does not stand by itself, but is lodged in the larger relations among nations.

Energy Security will be the No 1 topic when the G8 highly industrialised countries meet in St Petersburg in July. The renewed focus on energy security is driven by an exceedingly tight oil market and by high oil prices. It is also fuelled by the threat of terrorism, instability in some exporting nations, a nationalist backlash, fears of a scramble for supplies, geopolitical rivalries and fundamental need for energy to power economic growth. In the background is renewed anxiety over whether there will be sufficient resources to meet energy requirements in decades ahead.

Concerns over energy security are not limited to oil. Power blackouts in the United States, Europe and Russia, as well as chronic shortages of electric power in China, India and other developing countries, have raised worries about the reliability of electricity supply systems. When it comes to natural gas, rising demand and constrained supplies mean that North America can no longer be self-reliant, and so the US is joining the new global market in natural gas that will link countries, continents and prices in an unprecedented way.

At the same time, a new range of vulnerabilities has become evident. Al-Qaeda has threatened to attack what Osama bin Laden calls the “hinges” of the world economy, that is, its critical infrastructure — of which energy is among the most crucial elements. The world will increasingly depend on new sources of supply from places where security systems are still being developed, such as oil and natural gasfields off West Africa and in the Caspian Sea. And the vulnerabilities are not limited to threats of terrorism, political turmoil, armed conflict and piracy. Last year hurricanes Katrina and Rita delivered the world’s first integrated energy shock, simultaneously disrupting flows of oil, natural gas and electric power.

Events this year underline the significance of the issue. The Russian-Ukrainian natural gas dispute temporarily cut supplies to Europe. Tensions over Tehran’s nuclear programme brought threats from Iran, the second-largest Opec producer, to “unleash an oil crisis”. Attacks on oil facilities reduced exports from Nigeria, a major supplier to the US.
Since Churchill’s day, the key to energy security has been diversification. This remains true, but a wider approach is now required that takes into account the rapid evolution of the global energy trade, supply-chain vulnerabilities, terrorism and integration of new economies into the world market.

Although in the developed world the usual definition of energy security is simply the availability of sufficient supplies at affordable prices, countries interpret what the concept means for them differently.
Energy-exporting nations focus on maintaining “security of demand” for their exports, which generate the overwhelming share of their government revenues. For Russia the aim is to reassert state control over “strategic resources” and gain primacy over main pipelines and market channels through which it ships its hydrocarbons to international markets.

The concern for developing countries is how changes in energy prices affect their balance of payments. For China and India, energy security lies in their ability to adjust rapidly to their new dependence on global markets. For Japan, it means offsetting its scarcity of domestic resources through diversification, trade and investment. In Europe, the major debate centres on how to manage dependence on imported natural gas — and in most countries, apart from France and Finland, whether to build new nuclear power plants and perhaps to return to (clean) coal. And the US must face the uncomfortable fact that its goal of “energy independence” — a phrase that has become a mantra since first articulated by Richard Nixon after the 1973 embargo — is increasingly at odds with reality.

Shock to supply and demand
After the Gulf War, concern over energy security seemed to recede. Saddam Hussein’s bid to dominate the Gulf had been foiled and it appeared that the world oil market would remain a market (rather than becoming Saddam’s instrument of political manipulation) and that supplies would be abundant at prices that would not impede the global economy.
But 15 years later prices are high and fears of shortages dominate energy markets. What happened? The answer is to be found in both markets and politics.
The past decade has witnessed a substantial increase in world demand for oil, primarily because of dramatic economic growth in developing countries, in particular China and India. As late as 1993 China was self-sufficient in oil. Since then its GDP has almost tripled and its demand for oil has more than doubled. Today China imports three million barrels a day, almost half its consumption. Its share of the world oil market is 8 per cent, but its share of total growth in demand since 2000 has been 30 per cent.

World oil demand has grown by seven million barrels a day since 2000; of this growth, two million barrels a day have gone to China. India’s oil consumption is less than 40 per cent of China’s, but its demand will accelerate. The impact of growth in China, India and elsewhere on global demand for energy has been far reaching. In the 1970s North America consumed twice as much oil as Asia. Last year, for the first time, Asia’s consumption exceeded North America’s. The trend will continue: half the total growth in oil consumption in the next 15 years will come from Asia, according to Cambridge Energy Research Associates (Cera). However, Asia’s growing impact became widely apparent only in 2004, when the best global economic performance in a generation translated into a “demand shock” — that is, unexpected worldwide growth in petroleum consumption that represented a growth rate more than double the annual average growth rates of the preceding decade. China’s demand in 2004 rose 16 per cent from 2003, driven partly by electricity bottlenecks that led to a surge in oil use for improvised electric generation. US consumption grew strongly in 2004, as did that of other countries, resulting in the tightest oil market in three decades (except for the months after Saddam’s invasion of Kuwait in 1990). Hardly any wells were available to produce additional oil.

That remains the case today, and there is a further catch. What additional oil might be produced cannot be easily sold because it would not be of sufficient quality to be used in the world’s available oil refineries.
Refining capacity is a major constraint on supply, because there is a mismatch between the product requirements of the world’s consumers and refineries’ capabilities. Although often presented solely as a US problem, inadequate refining capacity is a global phenomenon. The biggest growth in demand worldwide has been for “middle distillates”: diesel, jet fuel and heating oil. Diesel is a favourite fuel of European motorists, half of whom now buy diesel cars, and is increasingly used to power economic growth in Asia. But the global refining system does not have enough deep conversion capacity to turn heavier crudes into middle distillates. This shortfall has created additional demand for the lighter grades of crude, further boosting prices.
Other factors, including problems in several major energy-exporting countries, have also contributed to high prices. Indeed, the current era of high oil prices really began in late 2002 and early 2003, just before the start of the Iraq war, when President Hugo Chávez’s drive to consolidate his control over Venezuela’s political system, state-owned oil company and oil revenues sparked strikes. The loss of oil to the world market from the strikes was significant, greater than the impact of the war in Iraq on supplies. Venezuela’s output has never fully recovered, and is currently 500,000 barrels per day below the pre-strike level.
Saddam’s failing regime in Iraq did not torch oil facilities in the 2003 war, as many had feared, but a postwar surge in Iraqi output has not occurred. The tens of billions of dollars required to bring output back up to its 1978 peak of 3.5 million barrels per day have not been invested. As a result, Iraqi oil exports are 30 to 40 per cent below pre-war levels.
Over the past five years, Russia’s oilfields have been central to growth of worldwide supply, providing almost 40 per cent of the world’s total production increase since 2000. But growth of Russia’s output slowed substantially last year because of political risks, insufficient investment, uncertainties over government policy and geological challenges. Meanwhile, other sources that get less attention, such as Brazil’s and Angola’s offshore fields, were increasing output — until Katrina and Rita shut 27 per cent of US production (as well as 21 per cent of US refining capacity). As late as January, US facilities that before the hurricanes had produced 400,000 barrels of oil a day were still out of operation.
All of these problems have provoked new fears that the world is running out of oil. But global output has actually risen 60 per cent since the 1970s, the last time the world was supposedly running out of oil.
Although talk of an imminent peak in oil output followed by a rapid decline has become common in some circles, Cera analysis indicates that net productive capacity could increase as much as 25 per cent over the next decade. Despite current pessimism, higher oil prices will do what higher prices usually do: fuel growth in supplies by increasing investment and by turning marginal opportunities into commercial prospects (as well as moderating demand and stimulating development of alternatives).
A good part of this capacity growth is already in the works. A substantial part will come from the exploitation of non-traditional supplies, ranging from Canadian oil sands to deposits in ultra-deep water to a very high-quality diesel-like fuel derived from natural gas.
Conventional supplies will grow as well: Saudi Arabia is on track to increase its capacity by about 15 per cent, to over 12 million barrels per day, by 2009.
Although energy companies will be prospecting in more difficult environments, the major obstacle to development of new supplies is not geology but what happens above ground: international affairs, politics and energy investment and technological development. However, current projections do show that after 2010 the major growth in supplies will come from fewer countries than today, which may accentuate security concerns.
New framework
The current energy security system was created in response to the 1973 Arab oil embargo to ensure co-ordination among the industrialised countries in the event of a disruption in supply, encourage collaboration on energy policies, avoid bruising scrambles for supplies and deter any future use of an “oil weapon” by exporters.
Key elements are the International Energy Agency (IEA), whose members are the industrialised countries; strategic stocks of oil; monitoring of energy markets and policies; and energy conservation and sharing of supplies in the event of disruption. The emergency system was set up to offset major disruptions that threatened the global economy and stability, not to manage prices and the commodity cycle.
Since the system’s inception, co-ordinated emergency drawdown of strategic stockpiles has occurred only twice: on the eve of the Gulf War in 1991 and in autumn 2005 after Katrina.
Experience has shown that to maintain energy security, countries must abide by several principles. The first is diversification of supply. But diversification is not enough.
A second principle is resilience, a “security margin” in energy supply that provides a buffer against shocks and facilitates recovery after disruptions. Resilience can come from many factors, including spare production capacity, strategic reserves, as well as plans for responding to disruptions. Hence the third principle: recognising the reality of integration. There is only one oil market, a complex and worldwide system that moves and consumes 86 million barrels of oil every day. For all consumers, security resides in the stability of this market. Secession is not an option.
A fourth principle is the importance of information. High-quality information underpins well-functioning markets. On an international level, the IEA has led in improving the flow of information about world markets and energy prospects.
That work is complemented by the new International Energy Forum, which will seek to integrate information from producers and consumers. Information is no less crucial in a crisis, when consumer panics can be instigated by disruptions, rumours and fear. In such situations, governments and the private sector should collaborate to counter panics with high-quality information.

Important as these principles are, the past several years have highlighted the need to expand the concept of energy security in two critical dimensions: the recognition of the globalisation of the energy security system, which can be achieved especially by engaging China and India, and acknowledgment that the entire energy supply chain needs to be protected.

There is no shortage of suspicion: some in the US see a Chinese strategy to pre-empt America and the West when it comes to new oil and gas supplies, and some strategists in Beijing fear that the US may some day try to interdict China’s foreign energy supplies. The actual situation is less dramatic. Despite the attention paid to China’s efforts to secure international petroleum reserves, for example, the entire amount that China currently produces per day outside its own borders is equivalent to just 10 per cent of the daily production of one of the supermajor oil companies.

If there were a serious controversy between the US and China involving oil or gas, it would likely arise not because of competition for resources themselves, but because of larger foreign policy issues. Indeed, from the viewpoint of consumers in North America and Europe, Chinese and Indian investment in development of energy supplies around the world is not a threat but something to be desired, because it means there will be more energy available for everyone as India’s and China’s demand grows.

It would be wiser to engage these two giants in the global network of trade and investment rather than see them tilt toward a mercantilist, state-to-state approach. Engaging India and China will require understanding what energy security means for them. Both countries are rapidly moving from self-sufficiency to integration in the world economy, which means they will grow increasingly dependent on global markets even as they are under pressure to deliver economic growth for their huge populations.

Thus, the primary concern for both China and India is to ensure that they have sufficient energy to support economic growth and prevent energy shortfalls that could trigger political turbulence. For India, international production is also a way to hedge against high oil prices. And so India and China, and other key nations such as Brazil, should be brought into co-ordination with the IEA energy security system to assure them that their interests will be protected in the event of turbulence and to ensure the system works more effectively.
Security and flexibility
The current model of energy security focuses on how to handle any disruption of oil supplies from producing countries. Today, the concept needs to be expanded to include protection of the entire energy supply chain and infrastructure.
In the US alone, there are more than 150 refineries, 4,000 offshore platforms, 10,400 power plants and 1.4 million miles of natural gas pipelines. None of the world’s complex, integrated supply chains were built with security, defined in this broad way, in mind.
Katrina and Rita brought a new perspective to the security question by demonstrating how fundamental the electric grid is to everything else. After the storms, Gulf Coast refineries were unable to operate — not because of damage, but because they could not get power.
Energy interdependence and the growing scale of energy trade require continuing collaboration among both producers and consumers to ensure security of the entire supply chain.

There are also many chokepoints along the routes of seaborne oil and, in many cases, liquefied natural gas (LNG) that create vulnerabilities. Ships scuttled in strategic waterways could disrupt supply lines. Securing pipelines and chokepoints will require augmented monitoring and rapid-response capabilities. The challenge of energy security will grow more urgent because global trade in energy will grow as world markets become more integrated.
Assuring security of global energy markets will require coordination on an international and a national basis among companies and governments.

The lines of responsibility — and sources of funding — for protecting infrastructure are far from clear. The private sector, government and local agencies need to co-ordinate activities. Maintaining commitment to do so in periods of low or moderate prices will require discipline. Energy security will be part of both the price of energy and of homeland security.
Markets need to be recognised as a source of security in themselves. The energy security system was created when energy prices were regulated in the US, energy trading was only just beginning, and futures markets were years away. Today large, flexible and well-functioning energy markets provide security by absorbing shocks and allowing supply and demand to respond more quickly and with greater ingenuity than a controlled system could. Such markets will guarantee security for the growing LNG market and boost the confidence of countries that import it.
After Katrina, markets were back in balance sooner and prices came down more quickly than almost anyone expected. Emergency supplies from the US Strategic Petroleum Reserve and other IEA reserves were released, sending a “Do not panic”. At the same time, two critical regulatory restrictions were eased. One was the Jones Act (which bars non-US-flagged ships from carrying cargo between US ports), which was waived to let non-US tankers ship supplies bottlenecked on the Gulf Coast. The other was the set of “boutique gasoline” regulations that require different qualities of gasoline for different cities, which were temporarily lifted. The experience highlights the need to incorporate regulatory and environmental flexibility into the energy security machinery.

The US Government and the private sector should also make renewed commitment to energy conservation. Finally, the investment climate must become a key concern in energy security. There needs to be a continual flow of investment and technology for new resources to be developed. How to facilitate energy investment will be a critical question on the G8 agenda in 2006.

Daniel Yergin is chairman of Cera and author of The Prize: The Epic Quest for Oil, Money, and Power. He is writing a new book on oil and geopolitics


[Energy Security]
[China, India,Russia, Saudi Arabia, Iraq]
[Oil, Liquid Natural Gas, IAE]