The global economy is entering a period in which demand for oil will exceed supply for the first time. Several economic and political trends are simultaneously converging that indicate the international oil and natural gas markets are about to experience a major restructuring process. This occurs at the same time that international political developments are establishing new objectives for U.S. energy policy and introducing new geopolitical dimensions to America's foreign oil and gas supplies. It is therefore imperative to examine some of the salient features of these changing conditions.

Not only does the United States remain dependent upon foreign oil, but North American natural gas production is declining at a time when demand for natural gas is rising. The U.S. is set to become a net importer of natural gas on a significant and sustained basis for the first time. This is cause for concern, especially considering that the Middle East, the largest regional supplier of oil to the international markets, is in turmoil-even by Middle Eastern standards. Iraq supplies much less oil to the international markets than before the war, while widespread adversarial attitudes to the United States are developing in other Islamic states. Continuing instability in the Middle East and Southeast Asia threaten secure access to these regions' large oil and gas supplies. Latin America, a major supplier of oil to the United States, is in political and economic trouble. The most promise appears to be Russia, the world's largest natural gas producer and the second largest oil producer, which is planning to increase its production and enter new markets.

Compounding the problem of threatened oil supplies is rising demand, which creates incentives to develop sizeable new international supplies of oil and gas in non-Middle Eastern locations. This process requires large investments and explicit contracts between investors and suppliers that establish delivery volumes and prices. Achieving these contracts will require America's concerted diplomatic effort but will have the effect of solidifying long-term relationships with new international parties-most importantly, Russia. Such contracts (and the new relationships that sustain them) could very well help the United States achieve some of its emerging geopolitical objectives.

Why Hydrocarbon Prices are Rising

The mechanisms that keep oil and natural gas prices low are breaking down. In the case of oil, the marginal pricing system of the New York Mercantile Exchange (nymex), in which the price of small amounts of a commodity determines the price of the entire commodity, kept oil prices at low levels and gave world economies the benefit of cheap energy for a period of economic expansion during the 1980s and 1990s, a period of surplus oil-production capacity.1 Such a price system is efficient for keeping prices low during periods of surplus, but it does not offer a return on sunk costs. It does not, therefore, attract investment.

New sources of oil supplies typically require large up-front capital investments, which were not forthcoming during this two-decade period. The domestic oil industry and overall worldwide activity contracted by about 75 percent in the late-1980s, and new supplies were not developed. While the large surpluses that were previously available are now gone, investors have been driven from the business, and exploration and producing companies have not generated capital for re-investment in new fields and sources of supply.

Marginal pricing is also efficient at increasing prices during periods of shortage, as we are now beginning to experience in the oil markets. Buyers bid prices up to the limit they can pay for the oil or gas and still stay in business. Worldwide demand is growing slowly and will increase as economic growth resumes. Supply shortages are thus expected to become more frequent and severe over the next few years, creating a general trend of higher prices if new supplies are not developed. Although prices will trend upward, investors in large projects will be discouraged by knowledge that new large supplies will cause price drops and increased volatility. Without investment, the upward price trend will accelerate and present an ever-increasing constraint on economic growth.

Natural gas prices are also rising, but for different reasons. Because of the difficulty and high cost of transporting natural gas, it was traditionally used only in areas where it was produced or could be transported cheaply by pipeline. The U.S. national pipeline network, interconnected with Canada's, allowed for gradual expansion of natural gas use in North America. Because gas is a clean-burning fuel, compliance with clean-air regulations dictates that nearly all new U.S. electricity-generating plants be gas-fired. In addition, most new residential and commercial structures now use gas for heating. But, because environmental considerations severely restrict gas-well drilling, declining production and increased demand have thus combined to cause domestic gas shortages and rapidly increasing prices.

"Demand destruction" is becoming the mechanism for balancing gas supply and demand. Residential and commercial users are not often in a position to switch to other fuel sources (e. g. coal-fired furnaces or generators) and so have no option except to pay higher prices for gas and electricity. Shutting down industrial activity, with resultant unemployment, is not a desirable situation for an economy attempting to recover from a slump. Gas prices are determined by trading on the commodity market a­nd exhibit the same volatility and sensitivity to small changes of supply and demand as oil prices.

Prospects for the Future

Only by opening new sources of oil and gas supply can shortages be alleviated. This, however, will require large investments in foreign countries, some of which are neither very stable nor friendly to the United States. The need to attract this investment will lead to restructuring of the price and market systems worldwide for oil and domestically for natural gas. Large new oil supplies can be offered to customers with long-term contracts at prices that will offer attractive returns to investors but less than those currently availab­le with marginal pricing in the traded markets. The current marginal pricing system is incompatible with the investment requirements of the industry. Investor requirements will dictate that new oil supplies will be subject to long-term contracted prices similar to current European gas purchase contracts.

The same is true for Liquefied Natural Gas (lng), which can be easily transported anywhere in the world and therefore imported and sold profitably at prices lower than current U.S. natural gas prices.2 Foreign natural gas can be imported to the United States as lng at prices ranging from about $3.00 to $4.00 per million British Thermal Units, which is roughly equivalent to the heating value of one thousand standard cubic feet of natural gas. With recent U.S. gas prices ranging from $4.50 to $6.00, lng has become economical to import.

There is still work to be done, however, to make this a reality. Large up-front capital expenditures are required for field development, liquefaction plants, loading facilities, special tankers to transport the liquefied gas at -260 degrees Fahrenheit, unloading facilities, plants to gasify the lng at the point of import and distribution systems to local markets. Nonetheless, several companies are rehabilitating lng re-gasification plants in the United States and have announced preliminary plans to expand existing facilities or build new ones. In addition, several European countries have recently expanded lng imports. The entry of the United States, the largest user of natural gas with a rapidly increasing demand for imports, into the world lng market will have a profound impact on the lng supply system.

As new supplies are developed, long-term contracts will quickly displace traded oil and gas in the markets because of their price advantage. As these contracted volumes become a larger part of the overall supply they will become a flywheel on the overall market, damping volatility and driving out high-cost production. Thus, marginal prices will be used only for marginal volumes to adjust supplies for short-term market fluctuations. Long-term prices (and supplies) of oil and natural gas, however, will stabilize.

Russia : The Joker in the Deck

Development of additional sources of oil and gas, however, cannot be expected to proceed smoothly. There are abundant deposits in places throughout Russia, Latin America, West Africa and the Middle East. Yet, these locations are characterized by unattractive fiscal and contract terms, unsafe and unattractive working conditions, political turmoil and anti-American sentiments. Bolivia just cancelled a project to supply lng to the west coast of the United States, and its President resigned in response to anti-American demonstrations. Other projects in the region are on hold. Promising reserves in Indonesia are imperiled by political instability in a country that has had four governments in five years and where terrorists are becoming more active. Environmental objections and other permitting difficulties will delay, possibly defeat and certainly increase the cost of developing receiving facilities in the United States for oil and lng imports.

Russia, the world's largest gas producer and second largest oil producer, is the wild card in any global re-alignment of political and economic power and in the oil and gas markets. Its resources rival those of Middle Eastern countries, and oil and gas production drive Russian economic growth and political stability. It has close economic ties to Europe and is seeking to expand them. (Germany is the largest foreign investor in Russia, and France is its largest source of foreign income.) Many Europeans believe that a combination of European industry, technology and capital with Russian resources (including military) can create a bloc with the economic and political strength to rival the United States. As could be expected, the apparent Bush Administration disdain for Europe is only serving to strengthen such designs.

Russian interests, however, extend to areas other than Europe-the Far East and the Islamic world, for example-and Russian President Vladimir Putin shows a preference for maintaining his freedom of action on the international stage. This helps explain Russia's growing interest and desire for participation in the Asia-Pacific region. Writing in the Wall Street Journal, Putin outlined his plans for a new energy structure in the Asia-Pacific region, and above all in East Asia, through the creation of a system of oil and natural gas pipelines and tanker deliveries of liquefied natural gas from the eastern areas of Russia which have considerable hydrocarbon resources.

Significant Russian entry into the economies of the Asia-Pacific region with development of a new energy structure can be expected to have significant influence on worldwide markets. Russia obviously intends to develop a position as a major oil and gas supplier to the region as a political tool, as well as to further its own economic development. The United States should actively encourage and assist this process, for it is an opportunity to establish a strong presence in the Russian economy, the largest market in the region.

The major constraint on the growth of Russian oil and gas production nationwide is current pipeline export capacity, and several expansion programs are planned. Asian Russia currently has almost no export capacity, although proposals are under review for a system of oil and natural gas pipelines to Pacific export points. Vast potential reserves exist just northwest of Lake Baikal in the Irkutsk and Yakutia regions. These deposits are at the eastern end of the current Russian pipeline system, but the most desirable market for oil and gas in these areas lies farther east with the large and growing economies of China, Japan, South Korea and the United States, as well as other Southeast Asian countries.

In an attempt to expand into these markets, the Russian oil company yukos has proposed an oil pipeline to China, and bp plans a gas pipeline along the same route. Both could be built in about two years. But, while both companies have already committed reserves for transport to the Chinese market, neither has received Russian government approval. The government-owned pipeline companies have proposed lines to the Pacific that would be much longer and larger, provide more capacity and cost a good deal more. The private company lines to China would serve one market. The Pacific lines would put Russian exports in large quantity into the world market with flexibility as to destination. Putin's statements in the Wall Street Journal (not to mention the recent arrest of yukos ceo Mikhail Khodorkovksy) seem to indicate that the Russian government will endorse the routes to the Pacific.

The potential reserves in this inland region are characterized by low per-well production rates, necessitating hundreds of wells to supply the pipelines. Because of the high cost for field development and pipeline construction, the project is very sensitive to oil and gas prices. These reserves can be developed and the pipelines constructed only for markets that can sustain prices at sufficient levels for long enough periods to justify the investment. Long-term contracts between supplier and customer must therefore be signed at prices of $25-30 per barrel.

DROP CAP 

The oil and gas markets will undergo a major re-structuring as the world enters a period of oil supply shortage and the United States becomes dependent on the imports of non-North American gas. Introduction of long-term contracts at moderate, stable prices for large supplies of oil and gas to the U.S. market would gradually convert the pricing system for most oil and gas to such contracts.

Such a fundamental market change would serve multiple purposes. Large U.S. investment in Russia and continuing U.S. purchase of Russian oil and gas will balance growing European influence. Investment in Asian Russia will be particularly desirable because it will stabilize access to resources for China, the rest of Asia and the west coast of the United States.

By encouraging and assisting efforts to establish long-term contracts with new suppliers, the United States can accomplish several desirable geopolitical objectives. It can become a major investor in Russia and give real substance to a U.S.-Russia partnership, stimulate economic development in Latin America and diversify the West's oil and gas supplies out of the Middle East. Such accomplishments would be a crucial component to America's current war on terrorism and beneficial to its long-term national interests.

Dr. Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consults for major and independent companies in the international oil and gas industry.

1 Oil production is generally not contracted, earmarked or otherwise allocated for delivery to certain importing countries in specified amounts; rather, it is sold by the producing companies and countries into a worldwide market system from which refining companies and importing countries buy as, and when, they need oil. Particular tanker loads of oil may be bought and sold en route and re-directed from one destination to another. This system may be envisioned as a giant pot into which the producing countries sell their oil and from which the importing countries buy. The oil price is not established by the Organization of Petroleum Exporting Countries (opec), producing countries or major international oil companies; it is traded at nymex in the form of 1000-barrel contracts for future delivery of West Texas Intermediate oil (a domestic U.S. grade of oil). The price is established by traders' perceptions of the amount of oil going into the "pot" (supply) and the amount of oil customers want to buy (demand).

2. lng is not a new business or technology. lng systems were developed in the 1970s, mainly to supply Japan and South Korea with gas from Indonesia, but some lng was imported to the United States for short times in the past.