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July 4, 2006 3:00 am

Eyeing energy supplies from opposite ends of a telescope

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With only days to go before the Group of Eight summit in St Petersburg, high-level officials are still struggling to agree a common text on energy security, the top item on their leaders' agenda.

No doubt they will succeed in finding a form of words to paper over their differences. But the problem in agreeing more than platitudes is that they are looking at energy security from opposite ends of the telescope.

On the one hand there is Russia, a huge oil and gas exporter, that wants to ensure "security of demand", above all for Gazprom, the gas monopoly.

On the other are the big consumers of the original G7, such as the European Union, where dependency on energy imports is likely to increase from 50 per cent today to 70 per cent in 20 years' time. They want "security of supply", meaning diversification of their sources: just what Gazprom does not want.

The two sides should have a common interest in reliable production and delivery of oil and gas, but ever since Russian President Vladimir Putin switched off the gas to Ukraine on January 1 - if only briefly - they have been divided by political suspicion and misunderstanding. The same is true of the whole energy security debate.

For a start, is there a problem, and if so, what is it? "Energy security has been debated since at least 1973, generating much policy heat, but little light," says Jonathan Stern, director of gas research at the Oxford Institute for Energy Studies. He suggests at least four different definitions of the problem: *Inadequate investment in energy supply and infrastructure to meet future demand; *Developed countries becoming increasingly dependent on imported energy from unstable countries or regions (such as Middle East oil or Russian gas); *China and India needing such a huge volume of energy for future industrialisation that it puts an intolerable strain on resources; *Rising oil and gas prices threatening to deprive the poorest countries of affordable energy.

To those might well be added the fear of terrorist attacks on energy installations, or natural disasters such as Hurricane Katrina, in a market with very little margin of spare capacity.

The debate over global warming also adds an extra dimension, with fears that those countries seeking to reduce their greenhouse gas emissions will make themselves uncompetitive, or be forced to turn back to nuclear energy, in spite of its uncertain financing and costs of waste disposal.

The immediate cause of the present debate is clear. Oil and gas prices have doubled in the past three years. A combination of factors has been responsible. Global insecurity since the terrorist attacks of September 11 2001 has coincided with a period of rapidly rising demand from China and other emerging economies, after a prolonged period of low investment in production, transmission and refining capacity. But is it a short-term or long-term problem?

"Current high oil prices are the cost we are paying for around two decades of low oil prices," says Paolo Scaroni, chief executive of Eni, the Italian oil company. "As a result of excess capacity, global under-investment, low prices and intense demand growth, the world's spare oil capacity dropped from about 15 per cent to 2-3 per cent of global demand."

That lack of production capacity has been compounded by a "tight and inadequate" refining system, unable to produce enough of the main products in demand, such as diesel and aviation fuels.

Yet all is not quite as it seems. The high prices overstate the problem of inadequate supply and excess demand. The oil market is greatly influenced by commodity traders and hedge funds speculating on fears of future disruption, including such concerns as the effect of US-led action against Iran, nationalisation of energy assets in Latin America, and attacks on oil production facilities in the Niger Delta.

How severe are the supply constraints? Colin Campbell heads the Association for the Study of Peak Oil. He argues that global oil production is in an irreversible decline.

"Globally, discoveries peaked in 1964," he says. "We are not replacing what we use, and that has been the case since the early 1980s."

Most industry analysts are more sanguine. For a start, they say, high prices give a clear signal to producers to step up their investments. "Higher oil prices will do what higher prices usually do: fuel growth in new supplies by significantly increasing investment and by turning marginal opportunities into commercial prospects," says Daniel Yergin, chairman of Cambridge Energy Research Associates.

Mr Scaroni predicts that the present shortage in the oil market will be overcome by 2010 because of a surge in investment. But oil and gas are very different commodities. Demand for natural gas is rising rapidly. The Eni chief executive is uncertain if investment in gas supply - Russia and Iran control 50 per cent of global reserves - can, or will, keep up.

Huge investments are needed in production, pipeline capacity and in LNG re-gasification terminals. Yet Russia's Gazprom, for one, is not even keeping pace with current demand, preferring to invest in non-core activities such as property and electricity generation, rather than more gas production.

The gas market is regional and depends largely on long-term contracts between supplier and consumer. The oil market, in contrast, is fungible: it does not matter who produces oil and where, as long as it gets to market. Yet that basic difference seems to elude many policy-makers, including President George W. Bush, when he talked in his State of the Union address of reducing US "dependence" on Middle East oil.

Another misunderstanding concerns the importance of China. China and India are certainly behaving as if they believe that oil and gas supplies are dwindling. But China's energy consumption accounts for only 8 per cent of world demand, although it does provide some 30 per cent of the growth in that demand. Indian consumption, meanwhile, is less than 40 per cent of China's. Their national oil companies have been aggressively seeking to buy new sources of supply.

The real engine of demand on the energy market, however, remains the US economy, where the latest surge in oil prices is only very gradually having an effect on the political debate over the need for fuel economy. It is estimated that an increase of 10 miles per gallon in US fuel economy standards for cars would reduce oil imports by about 2.5m barrels a day - nearly one quarter.

The Chinese and Indian actions are not logical so long as there are adequate global energy supplies. Whoever controls the oil and gas will still need to sell it. Suppliers may enjoy high prices, but not so high that they drive customers to alternative energy sources too fast. As for the consumers, they want long-term supplies at stable prices.

That should be the conclusion of the St Petersburg summit: both sides need a huge investment programme to tap new energy resources more efficiently.

They need to liberalise their markets to attract it. The question is whether they can agree on that gracefully, or allow political mistrust to muddy the water, and be forced to agree ungracefully, and belatedly.Additional reporting by John Murray Brown in Dublin

Tomorrow: the Middle East and the fear factor in oil markets

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