Special report. Energy security. Nervous energy / The energy empire

Consumers are highly vulnerable to a sudden break in energy supplies. But so are producers

IF YOU leave a loaded weapon lying around, it is bound to go off sooner or later. Snow-covered northern Europe heard the gunshot loud and clear when Russia cut supplies to Ukraine this week as part of a row about money and power, the two eternal battlegrounds of global energy. From central Europe right across to France on the Atlantic seaboard, gas supplies fell by more than one-third. For years Europeans had been telling themselves that a cold-war enemy which had supplied them without fail could still be depended on now it was an ally (of sorts). Suddenly, nobody was quite so sure.

Fearing the threat to its reputation as a supplier, Russia rapidly restored the gas and settled its differences with Ukraine. But it was an uncomfortable glimpse of the dangers for a continent that imports roughly half its gas and that Gerard Mestrallet, boss of Suez, a French water and power company, expects to be importing 80% of its gas by 2030--much of it from Russia. It was scarcely more welcome for America, which condemned Russia's tactics. And no wonder: it consumes one-quarter of the world's oil, but produces only 3% of the stuff. Over the coming years, the world's dependence on oil looks likely to concentrate on the Middle East, particularly Saudi Arabia. Russian oil had seemed a useful alternative.

Fear of the energy weapon has a long history. When producers had the upper hand in the oil embargo of 1973-74, Arab members of the Organisation of the Petroleum Exporting Countries (OPEC) cut supply, sowing turmoil and a global recession. When consumers had the upper hand in the early 1990s, the embargo cut the other way. After Saddam Hussein invaded Kuwait in 1990, the world shut in 5m barrels a day (b/d) of production from the two countries in an attempt to force him out.

With oil costing $60 a barrel, five times more than the nominal price in 1999, and spot prices for natural gas in some European and American markets at or near record levels (see chart 1), power has swung back to the producers for the first time since the early 1980s. Nobody knows how long today's tight markets will last. "It took us a long time to get there and it will take us a long time to get back," says Robin West, chairman of PFC Energy in Washington. A clutch of alarmist books with titles such as "The Death of Oil" predict that so little oil is left in the ground that producers will always have pricing power. The question is how worried consumers should be. What are the threats to energy security and what should the world do about them? The answers suggest a need for planning and a certain amount of grim realism, but not for outright panic.

A classic tale

The unhappy history of Ukraine, Russia and gas is the story of energy security in miniature. When it comes to hydrocarbons, geopolitics and geology are inextricable. That is a problem for most countries in eastern Europe, which would love to get their energy from allies, and feel understandably twitchy about having their former master as a big supplier.

Russia sees it differently. It wants to use its energy riches to the maximum effect in the world market. It sees former communist satellite countries as nuisances, which scrounge subsidised gas, pay late if at all, and jeopardise sales to western Europe by brinkmanship about transit fees.

It is easy to understand why Ukraine and other Russian neighbours are exasperating Gazprom, Russia's huge gas monopoly. Its gas has long been siphoned off in vast quantities and Ukraine, like Georgia, has a dreadful record of falling behind with its payments. The main power station that supplies Moldova doesn't pay its bills at all. In 2005 Ukraine paid only $50 per 1,000 cubic metres of Russian gas, compared with the $240 paid by the EU. Now Gazprom says it wants to sell to these countries on a purely commercial basis.

That seems fair enough, but there is another dimension. Formally, at least, the $50 price is part of a framework that is supposed to last until 2009. Moreover, Gazprom is not asking for the same increase from each of Russia's neighbours. The independent Baltic states have two years to adjust. Georgia, which like Ukraine has an independent streak, faces a doubling of prices. Belarus, still friendly and dependable, is keeping its price and giving away part of the control of the pipeline to Russia instead. Gazprom and its chairman, Dmitry Medvedev, who moonlights as the head of Vladimir Putin's presidential administration, decided which deal is presented to which country. And Russia's way of pressing its case was an example of energy politics of the most brutal sort.

On January 1st, when Russia kept gas out of the "Brotherhood" pipeline crossing Ukraine, it also stopped gas from Turkmenistan and Kazakhstan, big suppliers to the country, from flowing through its pipes. Although enough was left for the rest of Europe, Ukraine simply tapped off some gas for itself as usual. "Theft", Gazprom called it; though the Ukrainians asserted they were taking only the Turkmen and Kazakh gas that was due to them. For European consumers, the argument was academic. All that mattered was their shortages of gas: Italy experienced a fall of one-quarter; France, one-third; it was worse in countries such as Hungary, Austria and the Czech Republic, which get more of their supplies from Russia.

The tussle with Ukraine is only one of the fraught dealings Russia is having with its former satellites (see box). It even cut off the gas to Belarus two years ago. All such confrontations contain combustible mixes of the money, power and mishap that seem to bubble out of the ground whenever a huge supply of oil or gas is for sale. The risk of the whole business going terribly wrong is especially high when global markets have undergone a dramatic shift from glut to shortage, as they have in the past five years. Shifts disrupt the prices, power relations and patterns of consumption that everyone has learnt to live with. Suddenly everything is out of kilter.

Ever since the mid-1980s, when OPEC's attempts to keep the oil price high collapsed in the face of rising supply, only war has been potent enough to lift the price back to the levels of the 1970s. The difference today from the last era of high prices, says Tom Collina, of 20/20 Vision, an environmentalist group, is that "oil producers are pumping as fast as they can, but cannot keep pace with demand."

The robust economic growth of America, coupled with industrial revolutions in China and India, has helped to ensure a very different market for energy. The world got used to relying on spare capacity of a few million b/d in Saudi Arabia that could always cap price spikes in an emergency (it did just that in the first Gulf war and again during an oil-workers' strike in Venezuela in 2003). But demand has steadily eaten away reserves and investment has failed to keep up (see chart 2 on next page). In the tight markets for energy since 2004, some identified a "fear premium" of $10-15 a barrel reflecting the threat of lost supply. Even slower demand growth in 2005 did little to lower prices.

The tightness of capacity extends into refining and gas supply, leaving consumers vulnerable to any external shocks--such as the two hurricanes, Katrina and Rita, which hit the Gulf of Mexico in the autumn. The hurricanes put a dozen oil refineries accounting for 16% of US capacity temporarily out of action. American refining fell to its lowest level since March 1987, according to Petroleum Economist. The price of petrol rose above $3 a gallon--a level shockingly high to Americans, cheap as it might seem to Japanese or Europeans. Democrats accused the oil companies of price gouging, while Republicans argued for an easing of environmental laws restricting oil drilling and refinery building.

All this makes it a producers' world, which no one has exploited as gleefully as Hugo Chavez. Venezuela's president has always believed in oil as a tool of geopolitics, to be used against American "imperialism". In 2004 he unilaterally raised the royalties on super-heavy crude production in the Orinoco belt from 1% to 16.6%--and may yet increase it to 30%. In 2005 he increased the tax rate paid by the foreign oil companies from 34% to 50%, and then hit them with huge bills for unpaid "back taxes". The latest of his measures was to insist on the 22 foreign companies operating service contracts to switch, by December 31st 2005, to joint-ventures, in which the government would hold the lion's share. All but Exxon Mobil eventually did so.

At the same time, Mr Chavez has used cheap oil and refined products as "solidarity" to secure the loyalty of countries in the region. Those working against Mr Chavez have been threatened with a cut in supplies. Venezuela has bought almost $1.7 billion of Argentine bonds, helping Nestor Kirchner, its president, break free of the International Monetary Fund. This week Mr Chavez met the president-elect of Bolivia, Evo Morales, offering to supply the entire Bolivian diesel market in exchange for farm produce. "I don't want a cent for it," he told Mr Morales at a press conference.

Strangely, perhaps, consumers can learn a comforting lesson from all this. For all his mischief-making, even a populist like Mr Chavez has never looked like cutting supplies to what Venezuela calls its "fundamental market" in America. Venezuela says it plans to sell some 350,000 b/d to China. But the Chinese market is ten times as distant, so much more costly to supply. America would notice a cut in Venezuelan supplies, which normally account for about 12-13% of its imports. But it could always buy oil on the world market (a better source than the illusory protection of drilling for oil in the Alaskan wilderness). Venezuela would be worse hit. It would be hard-pressed to find other markets for about half of its production, especially since most of its crude is high in sulphur and unsuitable for most refineries.

The futility of embargoes as a long-term strategy for energy suppliers is well understood in the Middle East, too, where bitter experience has taught that price stability is in everyone's interest. The Saudis, for instance, found that their market share dropped in the 12 years after the brief 1973-74 embargo during which they tried to keep prices high. They are only now making it up. Not only was the price rise unsustainable, but it also prompted reckless spending, led to social strains at home and drove consumers to protect themselves with oil taxes, conservation and a big expansion of oil production outside OPEC. Even Saddam Hussein in Iraq was always desperate for the cash from selling his country's oil. So, too, in Mr Putin's Russia. "Russia would be crazy to reduce its supplies to Europe," says Paul Schapira, a specialist in European utilities at Goldman Sachs. "Europe depends on Russia as much as Russia depends on Europe."

The long-term "energy security" risk, then, is less that of an energy tyrant holding the world to ransom, than that of unforeseeable short-term disasters or upheavals (which might, of course, involve tyrants). It is less of interrupted supplies than of highly volatile oil and gas prices, buffeted by hurricanes, workers' strikes and the chaos of an unpredictable world.

The biggest bogeys are terrorism and, in the Middle East, regime collapse, though in some ways the region is more stable now than it has been for a long time. Whereas only a decade ago there were half a dozen big territorial disputes, the prickliest today (outside Israel) is over a couple of islands between Iran and the United Arab Emirates and perhaps a brewing row between a future independent Kurdistan and a rump Iraq. Regime collapse may be overblown, too, since the first thing any new leader would want is cash from oil sales.

It takes a dedicated insurrection to destroy sprawling oil infrastructure. But there are danger points, such as the Saudi oil-shipment terminal at Ras Tanura, which handles some 4.5m b/d or Abqaiq, the world's largest oil-processing complex which treats something like 7m b/d. Were these to fall victim to a dirty bomb or some other devastating weapon, the damage to the world would be incalculable.

Gases to gases

Gas is arguably most vulnerable to unforeseen interruptions of supply. Oil is reasonably easy to trade, but in most gas markets the pipeline between the gas field and the gas burner locks producers and consumers in an exclusive embrace. But a market in tradable liquefied natural gas (LNG) is rapidly emerging--flows to Europe have more than doubled over the past decade and represent about one-quarter of the world's total cross-border gas trade. Some $100 billion could be invested in LNG over the next decade. This has big implications for the gas industry, because it is possible now to import gas from distant, underdeveloped producers at reasonable prices. Over the next decade, there might even be routine price arbitrage between markets.

Consumers have stocks and special reserves as insurance to be released amid the worst threats to energy supply. Perhaps, in what Mr West calls an "age of energy insecurity", countries should ask if these provisions are enough. They can certainly also invest in energy conservation as a way of lessening the threat. But until the world weans itself off oil, there is no escaping the grim realism offered late last year to a congressional hearing by James Schlesinger, former secretary of defence: "We shall not end dependence on imported oil, nor...end dependence on the volatile Middle East, with all the political and economic consequences that flow from that reality," he said. "Instead of energy security, we shall have to acknowledge and to live with various degrees of insecurity."

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