Trade and Investment

Could trade help achieve energy security?

Switzerland has the highest energy security rank in the world, as per WEF and Accenture analysis

Switzerland has the highest energy security rank in the world, as per WEF and Accenture analysis Image: REUTERS/Issei Kato

Kenneth B. Medlock III
Senior Director, Center for Energy Studies
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Oil and Gas

  • The concept of energy security gained prominence in public policy discourse following the oil price shocks of the 1970s.
  • With the fluctuating demand and supply gaps in the global oil production and consumption patterns, what the world now needs is an energy secure future.

Global energy markets are in a period of dramatic transition, largely because of rapid growth in oil and gas production from shale in the US, and augmented by new dimensions of demand growth, particularly in Asia.

This has challenged the long accepted global supply-demand paradigm and altered patterns of energy trade. In fact, the last 15 years have turned the energy world upside down and left many scrambling to figure out what could possibly come next.

Top performers for energy security and energy access
Top performers for energy security and energy access

The transformation of the energy sector

In the US, oil production growth since 2009 has been so dramatic that the prospect of exporting crude oil has entered into mainstream policy discourse. This is particularly shocking when one considers that just a decade ago, US dependence on foreign-sourced oil was of such concern in Washington that it triggered policy measures to raise domestic biofuels production in the name of energy security.

At the same time, China rapidly became one of the world’s largest importers of oil and until recently was expected by many to continue on its breakneck pace of demand-led growth.

Altogether, these changes have been revealed in price. Indeed, since the late 1990s oil price increased from around $10 per barrel to over $140 by mid-2008, then declined back to the low $30s in late 2008, only to rise and stabilize near $100 through mid-2014. Since then, the price has more than halved. That’s because on the demand front, developing Asia has slowed and the economies of Europe remain weak. On the supply side, US production remains fairly resilient (to date) and OPEC strives for market share. These manifestations of demand and supply have led to a large global inventory overhang. Not since the 1970s and 1980s have oil markets experienced such tumult.

An even bigger shift towards energy security

As the oil market has been undergoing its transition, global natural gas markets are arguably undergoing an even greater shift. Supply growth in the US is again central to this change. In fact, shale gas production has been so robust that liquefied natural gas (LNG) exports from the US will commence in early 2016. This is quite a development, since the US was largely believed to be an emerging sink for global LNG, as natural gas prices between 2003 and 2006 were higher in North America than anywhere else in the world.

The global natural gas market was previously characterized as three distinct markets – Asia-Pacific, Europe and North America – but the last decade has born witness to significant growth in liquidity, triggered by an expansion of trading and the emergence of market hubs. The emergence of the US as an LNG exporter will only exacerbate this energy security dilemma.

Already, the continental European natural gas market has seen movement away from trade being almost solely characterized by oil-indexed contract-dominated gas sales to one where commodity transportation services are increasingly being offered on the basis of price, similar to what happened in the US decades ago.

The Asian market, largely dominated by LNG trade, is witnessing the emergence of new supplies, particularly out of Australia and soon the US, which has been targeting new demands that so far have been slow to materialize. The result is a market flush with supply and participants seeking arbitrage opportunities to maximize value in a buyer’s market. This, in turn, is triggering interest in the development of market hubs where price formation will be central. As this occurs, Asia, Europe and North America will become linked through trade. In effect, global natural gas market liberalization with greater price transparency is being driven by market forces.

Implications for energy security

What exactly does a rapid and largely unexpected market transition mean for broad concepts of energy security?

First, some background: the concept of energy security gained prominence in public policy discourse following the oil price shocks of the 1970s. A negative correlation between oil price and macroeconomic performance in oil-importing countries – highlighted by the fact that all but one recession in the OECD since World War II has been preceded by a run-up in the price of oil – has prompted interest in designing policies to mitigate the deleterious impacts of rising oil prices. In this context, “energy security” generally refers to the concept of ensuring an adequate supply of energy at a stable and reasonable price, thus leaving us with three basic tenets to achieving energy security – adequacy, stability and reasonableness.

Diversification of the overall energy supply portfolio is one means of ensuring stability in supply at a reasonable price. The ability to access a variety of energy sources to avoid economic dislocation is a crucial component in most energy security arguments. The concept of diversification is not limited to the overall energy supply portfolio: it can also refer to an ability to draw upon multiple sources for a single fuel. For example, any temporary market disruption can be overcome if there is an easily accessible alternative market outlet for the same fuel. This, in turn, mitigates the risk associated with uncertainty in demand (from seasonal influences, for example) or supply (due to unexpected disruptions, for instance).

It follows, therefore, that diversification of supply options is generally viewed to be beneficial for energy security. Europe has become all too familiar with this over the past decade, as tensions revolving around natural gas payments from Ukraine to Russia have resulted in temporary pressure reductions on pipelines providing supply to Europe from Russia traversing Ukraine.

How does one enhance energy security, then?

In a word, trade. This can be spatial – through deepening international trade – or it can be intertemporal – through storage and inventory management. In either case, we will see an increase in commodity fungibility and market liquidity. This makes the goal of the role of trade in mitigating price dislocations paramount.

In sum, in a market setting where trade can occur, there are incentives for investment in new infrastructure, which further increases trade. This, in turn, enhances fungibility, and ultimately recalibrates regional prices and mitigates price volatility. When barriers to trade exist, there is no market incentive for investment in infrastructure to facilitate trade, which renders all market participants more vulnerable to unexpected market disturbances.

Fortunately, the current energy market is in a period of transition that is enhancing trade pathways. This will ultimately lead to better energy security in the future.

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Trade and InvestmentEnergy Transition
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