Go East, Young Oilman

Michael Levi. Foreign Affairs. Volume 94, Issue 4. Jul/Aug 2015.

Most observers agree that the United States, propelled by its boom in oil and gas production, is becoming increasingly central to global energy. As oil prices have plummeted, American oil producers have taken credit. As U.S. imports have fallen, foreign policy thinkers have suggested that Washington could rely far less on the Middle East. As U.S. firms have prepared to export liquefied natural gas (LNG), market watchers have braced for a transformation of global natural gas markets and, as a result, geopolitics. And as U.S. energy companies have begun to capitalize on shale gas and renewable energy to tame their reliance on coal, scientists have hoped that Washington might finally take the lead in combating climate change. But when future historians reflect on the ongoing transformation of the global energy landscape, they won’t focus narrowly on the United States: Asia will feature at least as prominently, and interactions between the two sides of the Pacific will prove most important of all.

In the first decade of this century, Asia’s centrality-and China’s in particular-was obvious. China’s growing appetite for oil helped drive crude prices above $100 a barrel, for the first time ever, in February 2008. Surging coal consumption in China fueled record rises in greenhouse gas emissions. And Chinese investments in overseas energy infrastructure sparked fears that mercantilism would undermine markets and trigger resource wars. Meanwhile, the economies of India, South Korea, and Southeast Asia continued to churn through fossil fuels. Asia, it seemed, would determine the future of energy.

Then, stunning gains in U.S. oil and gas diverted the world’s attention. The new emphasis was in one sense justified; today, the United States is indeed a far more important force in energy than it was five years ago. But it was also misleading. The balance between Asian consumption and U.S. production-not one or the other-will be critical to setting energy prices for decades to come. Whether rising U.S. exports transform natural gas markets will depend on decisions that Asian leaders make. So, too, will progress on climate change, which requires large curbs on Asia’s greenhouse gas emissions. Washington must come to grips with this reality if it wants to develop an effective energy strategy; if it fails to, the full promise of the U.S. energy revolution will be left unfulfilled, and many of the world’s biggest energy challenges will remain unmet.

The Bigger Picture

Consider the conventional wisdom about why oil prices plunged in 2014, from over $110 a barrel in June to less than $50 by January of this year. Most analysts blamed an unexpected surge in U.S. oil production, which had risen from an average of five million barrels a day in 2008 to more than nine million six years later, for flooding the global market and creating a surplus of supply. They also noted that Middle Eastern countries, led by Saudi Arabia, could have cut their own production to balance the market. When it became clear that they wouldn’t, prices collapsed.

That explanation is accurate but incomplete. Asia’s slowing demand for oil was indispensable to the price crash. In 2010, 2011, and 2012, Asian oil consumption rose by a million barrels a day or more. But in 2013, it grew by less than half a million barrels a day for the first time in 25 years during a period of relative financial and economic stability. Then, in 2014, consumption rose by only half a million barrels a day again. Had Asian demand kept to its historic trend, there would have been no massive glut and probably no earthshaking price collapse.

Recent surprises in Asian oil consumption may be only a taste of things to come. To be sure, it takes a much smaller drop in demand to send oil prices tumbling for a few months, or even a year, than it does to push them permanently lower. But the basic reality is that higher Asian consumption could neutralize the effect of rising U.S. production, and lower Asian oil use could seriously compound the effect.

The trend line could move in either direction with dramatic results. The U.S. Energy Information Administration forecasts that if Asia’s developing economies grow by about six percent each year and their oil use rises half as fast, the net result will be an increase in demand of more than seven million barrels a day by 2025, a total larger than almost any projected increase in U.S. oil supplies. This figure may well be too low: it is easy to imagine that Asian economies will experience faster or more oil-intensive growth and so add over ten million barrels a day to Asian oil use over the next decade.

Yet if efforts to reduce subsidies and improve fuel efficiency cut the oil intensity of Asian growth in half from the Energy Information Administration’s prediction, developing countries in the region would add less than four million barrels a day of oil consumption over the next decade. At the same time, economic growth could fall sharply, combining with rising efficiency to limit new Asian oil demand to as little as two million barrels a day over the next ten years in an extreme case.

The difference between these two possible extremes could make swings in U.S. oil supplies look small by comparison. If U.S. oil production grows faster than Asian demand, Middle Eastern countries might prove unable or unwilling to curb their own production to balance the market, as they were in 2014, a situation that would lead to lower prices, a healthier global economy, and weaker petrostates. On the other hand, Asian oil demand could easily outpace U.S. production gains, even if those gains are large. The big oil exporters could sit back, perhaps even increasing their own output, as oil prices rose and their pockets were fattened.

Shifting Straits

The prospect of falling oil prices is far from the only important geopolitical opportunity afforded by the U.S. shale boom. As U.S. output rises and consumption falls, American oil imports from the Middle East will drop. Many argue that this shift in the geography of oil could rewire global security.

On the security front too, though, Asia will shape the future. For more than half a century, global worries about the free flow of oil have focused on the Middle East. And with massive volumes of oil continuing to come from that region, concerns about the security of critical shipping routes remain. Middle Eastern producers aren’t going away anytime soon, and so the United States will still have a big economic stake in Middle Eastern stability. But increased oil exports to Asia, combined with a regional naval buildup, will lend another area new strategic importance: the East Asian seas.

These crowded waters include the Strait of Malacca, sandwiched between Indonesia, Malaysia, and Singapore; the South China Sea, bordering Brunei, China, Malaysia, the Philippines, Taiwan, and Vietnam; and the East China Sea, touching China, Japan, and South Korea. They have already acted as the conduit for massive quantities of oil and gas. (For decades, Middle Eastern oil producers have shipped more oil to Japan than to the United States.) But now the stakes are higher, with regional powers, principally China, more capable than ever of disrupting oil shipments to their adversaries. For now, at least, the United States will continue to provide security for oil shipments to its allies by maintaining its naval presence in the region. But eventually, China will probably challenge this U.S.-dominated arrangement. Given Beijing’s new assertiveness in its foreign policy, its recent provocations-including its deployment of an oil rig to a disputed zone in the South China Sea last year, which led to a tense standoff with Vietnam-are only a harbinger of things to come. How the United States and China, along with other regional powers, resolve such conflicts in the future will be as important to shaping global energy markets as U.S. security commitments in the Middle East are today.

Going Natural

In addition to driving a domestic oil boom, U.S. energy companies are producing massive quantities of natural gas-so much, in fact, that the United States will soon become a significant LNG exporter. That will be a major development that could revolutionize global energy markets, but here again, the ultimate impact will depend in large part on Asia’s response.

The global natural gas market has always been rigid. Trade routes are usually fixed by existing gas pipelines, with seaborne LNG playing a secondary role. The world’s largest producers typically strike longterm contracts with their customers, setting prices through carefully negotiated formulas that track the price of oil. Buyers have limited access to information about the wider market, and they aren’t allowed to resell LNG cargoes to anyone else. If, for example, South Korea agrees to buy LNG from Indonesia, South Korea can’t resell that gas elsewhere, even if another country desperately needs it and is willing to pay a premium. The same limitations that make gas markets opaque also make them political. Since negotiations over prices almost invariably include at least one state-owned company and since there is usually no obvious price for the parties to settle on, politics intrude. And because it is difficult for buyers to switch suppliers during a political crisis, maintaining good relations with the biggest gas-producing countries, including the likes of Qatar and Russia, is paramount.

But U.S. LNG exports have the potential to change the rules of the game, particularly in Asia, where the lion’s share of U.S. exports would likely flow. The U.S. natural gas market, not secret negotiations between states, will determine the price of natural gas exported from the United States. And U.S. exports won’t have so-called destination clauses: buyers of U.S. gas will be able to resell and deliver it to anyone. Since Asia is currently the most attractive destination for exports, U.S. gas could become a major part of the Asian energy mix. The hope is that the Asian gas market will then follow the U.S. example by incorporating transparent pricing and flexible trade. But that would take a lot more than a flood of American LNG. The United States has created an opportunity; exploiting it will fall to Asian governments.

Asia faces two primary challenges when it comes to natural gas. The first is a lack of flexibility when it comes to trade. Today, many Asian countries have relatively few ways of getting spare LNG when they run into shortages, since most of the world’s available gas is already contracted to a fixed destination. With U.S. LNG available to plug sudden supply gaps, that problem won’t be as severe. Gas markets will become more like oil ones: although a large fraction of oil shipments are tied up in long-term contracts, the market has enough free supply to make those deals far less important than they would be if a deep spot market did not exist.

Asia’s second challenge is tougher: transitioning away from a politically charged system of pricing. The solution might seem obvious. U.S. producers will sell their gas to Asia at the same market-based price they do at home. If every country that sold gas to Asia had to match U.S. offers, geopolitics would be removed. But that won’t happen. Any Asian buyer that insisted on paying lower U.S. prices would be out of luck: sellers would simply market their gas to other countries willing to pay more. Buyers would have a chance of succeeding only if all the big Asian consumers banded together and insisted on a new pricing scheme. But the prospect of China, India, Japan, and South Korea joining forces on anything is remote.

Asia’s best chance at leveling the playing field is to emulate another key feature of U.S. and European markets: trading hubs for natural gas. A hub-a physical trading center for a commodity-brings together large numbers of buyers and sellers to bargain over transactions in a single space; their deals set prices that can then be used in transactions elsewhere. In the United States, for example, the Henry Hub in Louisiana plays a prominent role in setting domestic prices for natural gas well beyond that state; in continental Europe, several hubs do the same.

For a major hub to emerge in Asia and set prices more broadly, several things would have to happen: a single national government would need to support its physical development; ensure that the hub was run in a transparent and reliable way; and allow the emergence of a properly regulated financial system that let buyers, sellers, and others hedge their exposure to fluctuating natural gas prices. On top of all of this, that government would need to attract a critical mass of trading to its hub. The emergence of U.S. LNG, without the destination restrictions or oil-linked prices that encumber other gas supplies, could provide part of that critical mass. But at least one Asian government-the most likely candidates being China, Japan, and Singapore, each of which faces large obstacles-would need to seize the opportunity.

Curbing Coal

In the immediate aftermath of the UN Climate Change Conference in Copenhagen in 2009, U.S. and international efforts to tackle global warming were in disarray. Yet in the years since, the United States has surprised its critics and turned things around, reducing its total greenhouse gas emissions to 12 percent below their 2005 level as of 2012. A weak economy, improved fuel efficiency, and an increased reliance on renewable energy all contributed to the change. Critical, however, was a surge in the production of gas from shale formations. Shale gas, which yields roughly half of coal’s carbon dioxide emissions when used to produce electricity, edged out coal on lower prices alone. It also created an opening for regulators at the U.S. Environmental Protection Agency. Now that there was a relatively inexpensive substitute for coal, they could press forward with aggressive new regulations curbing coal-fired electricity, which would have been unimaginable just a few years earlier.

But for all its success so far, the United States cannot come anywhere close to successfully fighting climate change without Asia. The continent accounts for nearly half of all global carbon dioxide emissions, a share that has risen steadily in recent years. China and India are the world’s first- and third-largest carbon dioxide emitters, respectively. (The United States is second.) And the International Energy Agency projects that without new policies, Asia’s developing countries alone will account for 46 percent of carbon dioxide emissions from energy production by 2030, an amount more than three times as large as the projected contribution of the United States.

At the heart of the challenge is coal, the most emissions-intensive fossil fuel. Asia is responsible for more than two-thirds of global coal consumption. And although demand for coal outside the region declined from 2008 to 2013, gains in Asia more than made up for the difference. During the same period, the growth in Chinese coal consumption alone offset U.S. reductions five times over. The trend is regionwide. India consumes almost three-quarters as much coal as the United States. Japan consumes more coal than Russia; South Korea uses as much as Germany.

All the major Asian economies have made efforts to curb their emissions, but their circumstances are fundamentally different from those of the United States, and so the solutions to their emissions problems will need to be just as distinct. U.S. policymakers have long hoped that low-carbon technologies invented in the United States would prove so economically compelling that they would get adopted overseas on their own merits, without the need for ambitious climate regulations. At least for shale, however, China and other Asian countries are unlikely to adopt U.S. technology on a massive scale anytime soon. The problem is not one of raw materials: the consulting firm Advanced Resources International estimates that China has larger technically recoverable shale gas resources-an estimated 1,115 trillion cubic feet-than any other country, including the United States. It is that the barriers to exploiting this bounty are high. China’s problems start with its rocks. Not all shale rock is alike, and drillers have found that much of China has poor geology for the exploitation of shale gas. As a report in Nature pointed out, because much of China’s shale is deeper and “less apt to fracture,” it is poorly suited to the drilling technologies that U.S. oil companies have perfected and thus more expensive to develop. Then there are the institutional challenges: price controls have capped the potential profits and limited the market (although the price controls are slowly being reformed); modest government investment in mapping shale potential has made drillers less capable of taking calculated risks; and the dominance of older companies, a handful of which control most of the country’s gas systems, has deterred new firms from entering the fray.

China’s official goals reflect these limitations. In 2011, Beijing aimed to expand the country’s shale gas production to between 60 billion and 100 billion cubic meters a year by 2020-an amount roughly equivalent to three percent of total Chinese energy use in 2013. In August 2014, China slashed the target to 30 billion cubic meters, less than one-tenth of what the United States produces today. Many informed analysts are skeptical that even this will be achieved.

Elsewhere in Asia, shale’s prospects are no brighter. No Asian country other than China ranks among the top ten holders of technically recoverable shale gas resources. Estimates of India’s resources range from 100 trillion cubic feet to a mere six trillion, which would be equivalent to less than six months’ worth of Indian coal consumption today. Indonesia has an estimated 50 trillion cubic feet of shale gas. Pakistan is the only other large shale gas resource holder in the region, but political instability there makes development a distant prospect. The other big Asian consumers, most notably Japan and South Korea, have no shale gas. If Asia is to strongly curb its greenhouse gas emissions, complementing the United States’ recent transformation, it can’t count on shale gas to be its savior in the near future.

Pivot To Asia

It is tantalizing to imagine that the United States is now driving the future of global energy. But overstating the country’s influence will blind U.S. policymakers to the real work that needs to be done. In order to build an effective strategy that improves national security and combats climate change while fueling economic growth-and, in particular, to realize the full potential of the U.S. oil and gas boom- Washington needs energy and other policies that take full account of Asia’s critical importance.

One top priority should be working with Asian countries to curb oil demand. This could involve embedding national fuel-economy regulations in multinational agreements or extending existing technical agreements, such as the 2009 U.S.-Chinese arrangement to jointly set battery-charging standards for electric vehicles. Such initiatives will prove most effective if the United States takes strong steps to curb its own oil use, which would also help keep global oil prices down.

When it comes to securing the free flow of energy supplies, Washington has several roles to play. In the Middle East, it should remain committed to providing some baseline of stability; China is not ready to take the place of the United States in the region, and even if it were, that would represent a significant threat to U.S. interests there. In Asia, the United States should remain committed to providing sea-lane security for as long as possible, since a power vacuum would likely lead to regional conflict and global fears about the reliability of energy supplies. Over the long run, the United States will need to reach a larger understanding with China in which both countries agree to contribute to regional naval security.

Washington can also help facilitate a less political Asian natural gas market by ensuring that its own LNG exports remain as flexible as possible. To that end, Congress should resist passing laws that would segment the natural gas market-by favoring nato allies, for instance, or carving out special treatment for Japan-and instead allow U.S. LNG to flow freely. Washington could also lend its relatively neutral diplomatic hand to helping establish a regional gas-trading hub if regional players desire one, although in this area, U.S. leverage would be limited.

Climate change presents perhaps the greatest challenge. The United States has sought to promote the spread of shale gas to Asia, an effort that it ought to continue. But it should keep its hopes modest. The odds that coal will dominate Asia in the coming decades are still strong. As gas and renewable energy replace coal in the United States, there has been waning interest in carbon capture and sequestration technology, which would prevent most carbon dioxide produced by coal-fired power plants from entering the atmosphere. Although such technology, already expensive in its early stages, may become unnecessary in the near term in the United States as coal use declines, this is far from the case in Asia. If anything, recent developments have underlined this technology’s importance. For the United States, this means that a premium must be placed on continued investment in driving down the technology’s cost and on partnerships that can demonstrate its capabilities in Asia.

The boom in U.S. oil and gas production has many voices wisely calling for a U.S. energy strategy that exploits the United States’ new position of strength. But a narrow-minded approach that overstates the importance of U.S. energy and underappreciates the centrality of Asia is bound to fail. As U.S. policymakers chart a course for an energy strategy in a changed world, their ability to get Asia right will determine whether they succeed.