INTERNATIONAL GAS MARKETS: ECONOMICS, GEOGRAPHY AND POLITICS
Yury Egorov, University of Vienna, BWZ, +43-1-4277-38108, [email protected]
Franz Wirl, University of Vienna, BWZ, +43-1-4277-38101, [email protected]
Draft: 14 August 2009
Online Proceedings of the 10th IAEE European Conference, Vienna, Austria, 7-10 September 2009
1. Introduction
Gas is an interesting example in which the market structure cannot be derived from pure economic aspects. Due to huge
required investments, substantial transport costs and large heterogeneity in gas deposits and major consumption areas
geography is very important. Politics also plays an important role possibly constraining the economically optimal
development. As a consequence, land locked countries (like Central Asian) have very few choices of transport routes, and
geopolitics more than economics governs the choice of pipelines including projects. The Baker Institute World Gas Trade
Model [1] makes an attempt to forecast future development of gas markets till 2040 and reveals the crucial role of both
geography and political constraints on future development. Therefore, any analysis of the gas market must include economic
theory, geography and geopolitics.
The works in regional science have shown that spatial factors can produce effects different from those of non-spatial
economics. Thus, it represents an alternative self-organizing force. When we deal with gas markets, spatial distribution of
consumers also plays a role similar to Hotelling (1929) model. Geography plays the crucial role in the selection of paths of
pipelines or LNG ports. In abstract setting, one should solve an optimization problem of selecting optimal trajectories of
pipelines in 2-dimensional space.
The rising importance of gas as a primary energy source brings concerns about gas pricing and security of gas supply.
Analysts have given particular attention to the risks of insecure supply from pipeline projects that cross transit countries. In
fact, emergence of transit countries is a purely geographical and political effect that is ignored in classical microeconomics and
industrial organization. Transit countries must contend with the fact that transit fees they earn are linked to a service that is
fundamentally contestable. The issue of transit countries generates the games between gas producers and transit countries. In
the case of few options of producer to diversify (like Turkmenistan) transit country can charge too high transit rent. However,
this rent can also be substantially higher than transit cost even if producer has many routes (the example of Russia and
Ukraine).
Methodology represents a combination of tools from different branches of economics and social sciences. This paper uses
recent analyses of the natural gas markets to survey this crucial market and to emphasize the much neglected aspects of
geography and politics. The consequences of geography and politics shaping the global natural gas networks are stressed, with
emphasis on particular cases (Russia and Turkmenistan). The goal of this paper is to suggest theoretical approach for
modelling gas markets based on empirical evidence and combination of tools both from economics and regional science.
The paper formulates assumptions to be used in modelling gas markets. Traditional economic theory considers consumers with
preferences, and producers with technologies. The reality of gas markets shows that this is not sufficient, because they have to
be connected to the market. This connection (via pipelines or LNG) requires substantial investment that is comparable with the
production cost. Moreover, after connection to the market all market participants find themselves in asymmetric conditions.
This changes the whole market structure. Interestingly, most of externalities have geographical or political origin. And this is
not only asymmetric distance to the market that puts some more distant producers or consumers in less favourable position as
they have to pay a higher transport cost. It is also a possibility for a third party to bring negative externality. The most typical
example is the delay of pipeline construction between Turkmenistan and Pakistan due to political uncertainty in Afghanistan.
Simple models of gas transit games and Hotelling-type market structure are presented. Gas market structure is modelled with
non-uniform density of consumers over intervals with fixed location of fims at the edges. In this set up there are no problems
for market equilibrium for realistic linear transport costs. On the other hand, this set up can be applied for gas market in
Europe, with main gas suppliers (Russia and Norway) out of EU both spatially and politically. Transit games did not emerge
in Hotelling’s set up, but they take place in real life. A brief game theoretical analysis of the recent transit conflict between
Russia and Ukraine is presented.
2. Literature Survey
One of the objectives of this paper is to prove the necessity of new theory development based on works showing the
importance of interaction between economics, politics and geography in the case of gas in general. Such an idea is not new in
social sciences. Substantial progress has been reached by Isard (1969). However, in recent publication we do not observe
similar activity. The objective of this short survey is to prove the importance of geopolitical considerations for gas markets.
We can observe different market organization for natural gas in different parts of the world. On one hand, we have spatial
(nodal) pricing of natural gas in Northern America that correctly reflects substantial infrastructure and delivery cost. On the
other hand, we have the tendency to liberalize internal gas markets in the EU that seems to neglect spatial differences in
delivery cost in favour of other arguments. Depletion of world gas resources makes delivery more costly and space more
heterogeneous, and this naturally leads to growing local monopoly power of some gas producers. At the same time,
development of LNG technology makes world markets more integrated and transforms this market from previously regional to
more global. Under these conditions, it becomes clear that purely economic arguments about market structure and natural gas
policy not always work. And it becomes increasingly important to develop interdisciplinary science that will take into account
those complexities. The book of Victor, Jaffe and Hayes [1] became an important contribution that has revealed the
importance of geopolitics for gas markets. It is based on several case studies but also draws some general conclusions.
This paper uses recent analyses of the natural gas markets to survey this crucial market and to emphasize the much neglected
aspects of geography and politics. This highly neglected issue in the economics literature is to some extent surprising given the
news headlines devoted to specific issues in the gas market – such as those involving the cuts in supply to Ukraine. Finally,
the consequences of geography and politics shaping the global natural gas networks are stressed, with emphasis on particular
cases (Russia and Turkmenistan).
The basic tools of industrial organization in particular the theory of general equilibrium provides some important insights, or
at least a yardstick. The gas market model developed by the Baker Institute in Hartley and Medlock [4] uses the core economic
methodology of general equilibrium theory, industrial organization and investment under uncertainty. Their model (in the
absence of political constraints) suggests quite uneven development of gas industry, leading to asymmetric R/P ratios
throughout the world. Indeed, classical investment theory gives the net present values for particular projects and given some
structures of existing pipelines, LNG ports and ownership, industrial organization theory allows to predict the market
outcomes (volume and prices). However, such a model will not be complete, because geographical and political forces change
the industrial structure, equilibrium prices and trade flows. In particular the following reasons are given for the peculiarities
found in the natural gas market:
•
Huge sunk costs and relatively small (almost negligible) variable costs and the risk of hold up and risk allocation
explain the contractual nature (long term, take or pay).
•
Gas is distributed on Earth quite unevenly, and its transportation is costly (above 8 times more than oil) in terms of
location specific infrastructure investments. Long term contracts were used to minimize the risks of investment.
•
Often bilateral relations, i.e., monopolistic-monopsonistic relationships (e.g., between Norway and the Ruhrgas
consortium).
•
Transit countries may and do try to capture rents from the gas trade that can create an externality making a costineffective investment preferable.
•
Many players are ‘nations’, companies on the supply side, transit countries, formerly and sometimes still also on the
consumer side, to which regulation is severely restricted compared with anti-trust regulation of private companies.
The works in regional science (see, for example, [13,14]) have shown that spatial (or geographical) factor can produce effects
different from those of non-spatial economics. Thus, it represents an alternative self-organizing force. When we deal with gas
markets, spatial distribution of consumers also plays a role similar to (Hotelling, 1929) model. However, we have also other
effects. First of all, geography plays the crucial role in the selection of paths of pipelines or LNG ports. In abstract setting, one
should solve an optimization problem of selecting optimal trajectories of pipelines in 2-dimensional space. Even apart from
the issues of optimal capacity, associated risks and political constraints, we have a problem with spatial density of discovered
gas deposits and density of consumption across the world, and a continuum of possible paths. Fortunately, many of the
conceivable paths can be aggregated under one label, e.g., NABUCCO refers to many potential realizations with the common
feature of connecting the Caspian region with Europe. Therefore, we can deal with a rather small set of generalized strategic
pipelines, meaning by each pipeline not an exact project with fixed route and capacity, but a class of ideas.
There exists several case studies that show how geography and politics perturbs otherwise optimal economic decisions. The
case study of Turkmensitan (Olcott, 2006) is a good example since it presents the case when geopolitics becomes more
important than economics. While Turkmenistan has substantial gas reserves, it is a land locked country, for long time having
the only pipeline via Russia, thus giving Russia monopoly power over its gas transmission. The pipeline to Turkey via Iran
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was proposed by US State Secretary A.Haig in 1993. It was never implemented, and US sanctions over Iran at present in the
main problem here. In 1996, USA banned $ 40 mln. of investment in Iranian energy sector as part of Iran and Libya sanctions
Act (ILSA). Instead, a small link to Northern Iran was constructed (Korpedzhe-Kurt-Kui). It does not enter Iranian gas
network; it was cheaper to create this link than link from other Iranian gas deposits. Pipeline of 200 km long and 100 cm in
diameter costed $ 190 mln. It has 8 bcm peak capacity with possibility of expansion to 13 bcm (see Olcott [8], p.213). The
development of pipelines from Turkmenistan is a zero-sum game, in which one route will win and other pipelines will be
abandoned later. Trans-Afghan pipeline is one of the alternatives. 1400 km pipeline with capacity of 20 bcm could cost
between 1.9 and 2.5 bln. USD. In 1997, Unocal and Pakistan concluded price agreement, but Taliban did not agree with
planned transit fee of only 15 cent per mmbtu [8, p.219]. This pipeline could be extended to India. India has growing gas
demand (projections: 19 bcm in 1995, 23 bcm in 2000, 57 bcm in 2005, 75 bcm in 2010). However, Kashmir problem caused
growing tensions between India and Pakistan. Finally, Unocal withdrew from Trans-Afghan pipeline, and this worked to
Russia’s advantage (it kept monopoly power for transporting Turkmenian gas). Those gas reserves were crucial for Russian
domination in European gas market. Gas goes via Russia in the Central-Asia-Centre (CAC) pipeline system, built between
1960 and 1974. It is 2000 km long and has the capacity of 90 bcm. Itera became marketing agent for Turkmen gas. In 1996, it
paid only $ 42 per tcm, but later price went up. In late 2005 Russia and Ukraine entered 3-side bidding war over gas from
Turkmenistan. In the end, Russia agreed to buy Turkmenian gas for $ 65 per tcm and to sell it to Ukraine at $105 per tcm [8,
p.225]. However, recent developments show some chances of improvement in geopolitical situation (and bargaining power)
for Turkmenistan. The whole Central Asia is land locked area, with pipelines as the only access. There are 3 main reserve
holders (Kazakhstan, Uzbekistan and Turkmenistan) but only Turkmenistan can create substantial export capacity. Its role is
important not only for filling NABUCCO, but also as strategic counterweight to Russian position in Europe (Bilgin, 2009).
The sudden dissolution of the Soviet bloc had important consequences for Russian gas exports. First, disintegration of
COMECON bloc created transit countries. Second, the USSR has disintegrated itself in 1991. Both factors brought new
uncertainties for gas supply. In particular, transit games took place with Ukraine and Belarus. At the same time, the collapse of
the USSR and further economic transition caused the shrink of economy and domestic gas consumption. Russia consumed 420
bcm in gas in 1990 and only 350 bcm in 1997. Russian gas export to CIS also declined: from 10 bcm in 1990 to 76 bcm in
1998 (see Victor & Victor[5], p.135). Most of Russian export gas goes through Ukraine. The Transgas system has the capacity
of 79 bcm per year, and it can be increased by boosting pressure. Since 1990s, there was a problem with Ukraine that did not
pay Gazprom its debts in time. The first incident was in October 1992, when cold weather caused 45% shortfall in gas
delivered to the West [5, p.145-146]. Yamal-West project assumed the construction of gas pipelines to Europe via Belarus, but
it was path dependency (development of Urengoj and Yamburg fields first) that caused the delay of this project. [5, p.147] As
for Nord Stream project (over the bottom of Baltic sea), it was on table since 1990s, but that time Gazprom had little
experience in similar projects. This project was delayed. If economics alone were to determine gas exports, more than half of
total European demand for gas after 2020 would come from Russian suppliers [1, p.470]. This means that geopolitical factors
(in a broad sense) reduce the potential of Russian gas supply to EU to the detriment of both.
There also exists policy driven literature (that also shows partial superiority of politics over economics for gas markets) that
sets some political objective and uses economics for its implementation. Here we can refer to dissertation of V. Putin
(mentioned also in (Ericson, 2009)) that shows the role of state that can make Russia an energy superpower with rising control
over other countries, the argument that is successfully implemented into practice.
Therefore, economic theory must be complemented. We can conclude that for natural gas it is necessary to incorporate
geopolitics and technology into formal economic model. The next section suggests some approaches.
3. Necessity for New Modelling Approach
The reality of gas markets shows that not only preferences and technologies are important, but also connection to the market.
This connection (via pipelines or LNG) requires substantial investment that is comparable with the production cost. Moreover,
after connection to the market (which initially connected only some pairs producer-consumer and only later became global) all
market participants find themselves in asymmetric conditions.
Another difference is temporal structure of the corresponding model of the market. While most of microeconomics is static,
there are also theories of durable goods and even intertemporal externalities. In the case of gas market we have a clear
intertemporal problem, not because gas is a durable good but because associated investment in infrastructure (that is a part of
production function) is durable and have to be optimized under many additional conditions. The problem is the conflict
between low flexibility of long term contracts and the desirability to secure the investment in infrastructure.
How the markets for gas can be modelled in a theoretical way?
a) We have a set of consumers i=1,2,..N with their preferences for gas (as usual, but also with spatial coordinates)
b) We have a set of producers j=1,2,...M with technologies of gas production (as in classical microeconomics, but now
also with spatial coordinates of location)
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c)
d)
e)
f)
g)
We have a set of links A (pairs of type ij, that connect some producers with some consumers with pipelines)
We have a set of links B (network of producers and consumers that have access to LNG)
We have set of contracts (with different duration and other conditions) between producers and consumers
We have free market where the residual of gas can be sold at spot price
We have external forces (non-producers and possibly non-consumers that has an influence on market as externality;
the origin can be political or geopolitical)
h) We have set of investors who invest in links between producers and consumers (note that contrary to classical
microeconomics, producers and consumers do not automatically belong to the market from the beginning
i) We have a list of potential investment projects, among which investors choose those with higher NPV under current
geopolitical conditions
j) Links between producers and consumers are evolving over time
The market is characterized by:
a) Preferences of consumers (that can also evolve over time, as the response of product availability for particular
consumer)
b) Production functions (also evolving, taking into account depletion of resources and new discoveries)
c) Optimization of extraction paths given market structure and rational expectation about its evolution (a typical model
in resource economics)
d) Optimization of sequence of investments in different infrastructure (subject to perturbations due to externalities and
new discoveries)
e) Price pattern (the function of both space and time)
This is indeed a very complex problem, and may lead to difficulties in analytical description. That is why it makes sense to
focus on reductions and policy implications. Some reductions include the following simplified (but actual) problems:
a) Gas transit games
b) Spatial structure of the market
c) Geopolitical externalities
d) Study of optimal extraction paths given market structure
e) Study of optimal infrastructure investment path given preferences, production functions and externalities
The listed problems constitute interesting research topics for investigation. Since there are already at least two markets
(electricity is another one) where standard economic modelling is not sufficient to describe important effects, there exists a
necessity to elaborate more advanced economic theory that would be able to tackle such problems.
4. Modelling Gas Games
In this paper we will make the first step in the development of such theory. The first problem is related to gas transit games.
Being an important practical problem (that brings a lot of discussion, especially after gas conflict between Russia and Ukraine
in January 2009 with substantial negative externalities for Europe (see (Yegorov, Wirl, 2009) for detailed analysis), it also
brings an interesting piece of theoretical modelling under detailed study.
4.1. What Games Can Emerge in Transit Case
Gas transit gives rise to different types of games, and both geography and politics determine their structure. Geography often
prevents competition, especially in the case of unique pipeline via third country. If this pipeline transit generates revenue
above cost level, we have emergence of pie, with pie-splitting game (first considered by Rubinstein). But even when we have
international regulation of transit prices, we still have a particular topology of locations of producers and consumers that give
rise to typical oligopolistic games known from industrial organization literature. Finally, there may be political externalities in
addition to these IO games. Some countries have a possibility to punish another country using monopoly over transit. In these
case not only direct economic revenue but also (geo)-political payoffs have to be taken into account.
Suppose that a piece of pipeline between producer and consumer is owned by a third party, transit country. The issue whether
this is normal or legal, will be considered in the next section; now this fact is taken as given. If all the contracts between
producer and consumer can be signed and monitored, and international law would be clear about rights and obligations of
transit country, and this law would be enforced, still there is a room for games in this case. In particular, there is lack of
competition in transit, and transit country has some monopoly power on charging transit price. Clearly, transit revenue cannot
exceed the whole profit (otherwise, producer will stop export) but transit country can have high bargaining power and take
large share of this profit. So, the first game emerges in the case if there is a unique transit route and is related to the split of
surplus between producer and transit country. This is a standard bargaining game, and the split depends on distribution of
bargaining powers.
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Consider the case of Ukraine as net gas importer and transit country. Here both the case of no regulation of transit fee (as at
present) and regulation of transit fee have to be considered. Von Hirschhausen, Menihart and Pavel (2005) present a
theoretical model and simulations of a gas pipeline game between Russia and Ukraine. They derive the gas price for Ukraine
and the transit tariff for Russia as the results of bargaining between two countries. Although this model is interesting, it does
not answer the question: why does game emerge at all? In traditional economic literature games are typically set as given, and
the mechanism of their emergence is not discussed. If there would be international norms for transit price and enforcement on
violation of transit conditions, there will be no scope for the game. In this case we can apply normal economic theory, with
symmetric access of all producers and consumers to the market, promotion of competition and Pareto efficiency. The paper
(Yegorov, Wirl, 2009) tries to answer the question about the origin of gas transit confrontation and finds either too little
rationality or asymmetric information about the game structure. It is clear that the origin of the conflict comes from the
existence of some surplus that has to be split as well as no clear mechanism about its split. Several issues considered below
(subsection 4.3) influence the emergence of pie splitting game.
In principle, there are many possibilities of structures of transit games, and some of them will be considered below. Here we
do not focus on modelling Ukrainian transit, but can refer to other studies related to its modelling: Victor & Victor (2006). We
focus on the transit game with transit country as net exporter. Such situation is more complicated than the case of transit
country as gas importer from the modelling perspective. The game emerging from the transit of gas from Turkmenistan via
Russia is theoretically richer because here a transit country is also net gas exporter with substantial market power.
Turkmenistan not only uses pipeline capacity of Russia, but its transit flow also influences the price at the final destination
(Europe) that is a part of Russian gas export strategy as a local monopolist. Thus, here we have a combination of monopolistic
optimization problem with bargaining between Russia and Turkmenistan over gas price on their border.
4.2. Modelling Russian transit for Turkmenistan: Notations
Contrary to the previous case, here Russia is net gas exporter. Again, two cases (no regulation of transit price and regulated
transit) are considered. Consider the following model. There is one way of net gas exporter (Turkmenistan) to European
market – via Russia. But Russia is also net gas exporter. For simplicity, we neglect Russian and Turkmenian production of
natural gas for own consumption, and consider only the gas for European consumers. The following notations are introduced:
•
QT – volume of gas produced by Turkmenistan,
•
QR – volume of gas produced by Russia,
•
Q – volume of gas imported by Europe from other producers (fixed here),
•
PT – price of gas from Turkmenistan at the border with Russia,
•
PE – price of gas in Europe,
•
C(QR ) – unit cost to produce and deliver gas from Russia to Europe,
•
CT – unit cost to produce gas in Turkmenistan (assumed to be constant),
•
τ – unit cost to transport gas via Russia,
•
T – transit price via Russia (for unit of gas assuming international regulation),
•
a – bargaining power of Turkmenistan (1-a – power of Russia).
This problem is naturally decomposed into two sub-problems:
a)
bargaining between Russia and Turkmenistan over gas price PT;
b)
optimization problem of Russia taking into account demand function and bargaining outcome.
In principle, there exist many possibilities of formal modelling. We can take into account market power of Russia (large
producer) in influencing European gas price (as we do below) or neglect it (considering European price fixed). The model can
consider or neglect the growing marginal cost of Russian gas. Here we consider the mix of monopolistic optimization and
bargaining, the set up that reflects well the nature of the process but has not been studied in economic literature. The main
focus is on contrast between internationally regulated and non-regulated transit.
4.3. Regulated transit
First consider the case of regulated transit price. Now Russia knows that it can get only mark up QT(T- τ) for transiting gas
from Turkmenistan, which it sells directly to Europe. The profit of Turkmenistan is now
ΠT = QT (PE - CT - T),
(4.1)
and it is Turkmenistan who decides about production volume. Russia has to decide now only about its own production,
considering its strategic influence on European price. Formally, it solves the problem (taking Q and QT as given):
Max Π1,
Π1 = QR PE(QR+ QT+Q) + QT(T- τ) - CQR,
(4.2)
QR
In order to get analytical solutions let us specify the demand function as linear:
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PE=A-Q.
In the case of internationally regulated transit no pie-splitting game emerges. Russia can decide on its own output, while
Turkmenistan on its own. However, there exist several constraints: a) on production capacities, b) on transit capacity. There
may also be asymmetric information about transit cost in Russia, and like in many regulation model it is allowed to get some
(moderate) profits from transit. What about the volumes of flow? Since European price depends negatively both on gas export
volumes of Russia and Turkmenistan, any increase of QT undermines price in Europe and profits of Russia. Since Russia has
strategic location (between producer and consumer), it may exploit asymmetric information about its transit capacity and own
production for strategic reasons, limiting the transit flows of Turkmenistan. But will it always have incentive to do that?
Let QT1 denotes capacity constraint on production, while QT2 denotes capacity constraint of transit. Given the profit function
(4.1), Turkmenistan is interested to export gas on the maximal level, i.e., QT= min{QT1, QT2}= QTM.
Assume first that capacity constraint is binding. Then, the optimization problem for Russia involves only the decision about
own production:
Max Π1, Π1 = QR PE(QR+ QTM+Q) + QTM(T- τ) - CQR.
QR=(A-Q-QTM-C)/2,
P=(A-Q-QTM+C)/2.
(4.3)
Suppose that T- τ > PE – C for all range of prices given feasible set of Russian strategies. That means that marginal profit from
transit exceeds one from exporting Russian gas. This can happen if either transit price set by regulators in high enough
comparing to Russian cost, or when getting extra unit of Russian gas becomes too expensive. In the opposite case, T- τ < PE –
C, marginal gains from transit are low and Russia is interested to substitute it by own gas. Then it can use any asymmetric
information to limit the flow of gas from Turkmenistan (as it did in April 2009, when European prices dropped).
It is well known that new gas deposits in Russia are located in regions with costly extraction (Yamal, shelf). Thus, it is natural
to assume that cost depends on quantity. Assume that the marginal cost to extract unit of gas in Russia is C for Q< QR1, and
sharply increases to bC (where b>1) for Q> QR1. Then this may set a natural threshold for Russian export at Q=QR1. Since
European gas price depends on the sum, QR+QT, the marginal cost of extra unit of gas in transit is QR1, while the marginal
benefit is T-τ. If T-τ-QR1 >0, Russia will allow all possible transit gas from Turkmenistan.
4.4. Non-regulated transit. Monopolistic Optimization and Bargaining
Now consider the case of bargaining first. We start from the benchmark model of monopolistic profit maximization by Russia.
Formally, Russia solves the following profit-maximizing problem:
Max Π,
{QR;QT}
Π = [QR+ QT] PE(QR+ QT+Q) – C(QR) - PTQT.
(4.4)
It takes into account belief (may be rational or not) about price of Turkmen gas and decides how much to produce its own gas
and how much gas to import from Turkmenistan. Assume for simplicity that cost is linear-quadratic, C(QR)=c QR+d QR2,
while demand is linear, PE=A-Q-QR-QT, where Q is the volume of gas coming to Europe from different destinations . Two
first order conditions lead to equations that reflect equalization of marginal costs for Russia to produce extra unit of its own
gas or to import it from Turkmenistan, on one hand, and monopolistic decision about the optimal sum of flows, QR+QT, on
the other. Finally,
QR= (PT-c)/2d, QT= (A-Q-PT)/2 – (PT-c)/2d.
(4.5)
This result shows that Russian decision about exploitation its new more costly resources depends on the price at which it can
import gas from Turkmenistan. A very important question: Who sets the game and defines pie size? This is a non-standard
approach in game theory (where game is set by God, i.e. given a priori). In fact, here we see that game structure and even its
existence depends very much on geography and legal structure. If Russia believes that it can set its transit conditions for
Turkmenistan (that is, bargaining, over surplus will not take place), then we have microeconomic efficiency about exploitation
of resources controlled by Russia. Here Russia restricts quota for Turkmenistan given some (previously agreed) price PH.
Indeed, the recent (April 2009) cut of gas supply from Turkmenistan was the outcome of falling demand in Europe and too
high price set before.
However, if future bargaining will take place and Russia is not rational about it, the pie splitting game will lead to suboptimal
allocation, since Russian plan in model (4.4) was to set maximal profit for itself, and not the size of joint pie. Let us turn to the
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case when Russia rationally expects future bargaining and thus optimizes the joint profit (pie size) which later has to be split.
Now it solves the problem where price of gas from Turkmenistan is substituted by its cost:
Max Πj,
{QR;QT}
Πj = [QR+ QT] PE(QR+ QT+Q) – C(QR) – CT QT.
(4.6)
In this case we have slightly different solution, with optimal output depending not on price, but on cost of gas from
Turkmenistan:
QR*= (CT-c)/2d, QT*= (A-Q-CT)/2 – (CT-c)/2d.
(4.7)
Turkmenistan gets the payoff
B = QT(PT-CT),
(4.8)
where gas price PT is the outcome of bargaining game. Given its power is a, Turkmenistan gets share a of the pie size S. How
the pie size can be calculated? It is the difference of the values of its profit obtained when it sets optimally both quantities
(given by formula (4.7)) and its profit when no gas comes from Turkmenistan:
S= Πj(QR*, QT*) – Π0(QR**, 0),
(4.9)
where Π(QR**, 0) is the solution of the baseline problem considered below. The baseline is no transit of gas from
Turkmenistan (with zero payoff as an external option of Turkmenistan). Then Russia solves the problem
Max Π0,
QR
Π0 = QR PE(QR+Q) – C(QR),
(4.10)
and gets the baseline profit Π0 at optimal level of output QR**. Given that Turkmenistan has bargaining power a, it gets the
share a of the pie, that is, it gets B=aS, and we can find the bargaining outcome for the price on its border:
PT = CT +aS/QT**,
(4.11)
where S is defined by (4.9) and outputs are given by (4.7) and the solution to (4.10).
4.5. Capacity constraint for Turkmenistan
Let us consider a simpler problem. Suppose that Turkmenistan operates (and is allowed by Russia) on its capacity limit: QT=
QTM. Then for any price of Turkmen gas on its border (agreed via negotiations with Russia, see further), Russia decides
strategically only on its own volume. Formally, we have the problem mathematically identical to (5.3), and thus QR=(A-QQTM-C)/2, P=(A-Q-QTM+C)/2.
Next, we have to calculate the pie size and turn to pie sharing. The total pie size is
S=QTM(A-Q-QR-QTM-CT). Turkmen profit, B=aS, should constitute the share of the pie, according to assumed split of the
bargaining powers. Thus, we get:
PT-CT= a(A-Q-QR-QTM-CT);
PT= CT+ a(A-Q-QR-QTM-CT).
(4.12)
We see that pie size depends on Russian strategy, and it is transit producing country (here Russia) who defines the game. In
the considered case Russia allowed all gas from Turkmenistan to be transited, but then bargained with it about price on the
border. The different models of transit relations demonstrate that both the emergence of game and its structure depend on
geography, internationals laws and politics.
4.6. Comparing transits (Russia-Ukraine-EU) and (Turkmenistan-Russia-EU)
Let us abstract from political weights of different countries and focus on structural differences emerging from economics and
geography. The main structural difference between cases A (Ukraine as transit country) and B (Russia as transit country) is in
export property of that country. While Ukraine is net gas importer, Russia is net gas exporter. Due to regionalization of gas
markets (emerging due to high transport costs and limited number of producers), almost any exporter has substantial impact on
local gas price (market power). Thus, while export of Russian gas via Ukraine only exploits its pipeline infrastructure, export
of gas from Turkmenistan via Russia besides that has also an impact on Russian export price. The last issue gives rise to
games that are different from those associated with Ukraine.
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If we look formally at this situation, we can find a new interesting model set up, as a mixture of optimization and game theory.
In fact, Russia defines the game structure that is offered to Turkmenistan. The size of a pie (surplus) offered to Turkmenistan
for bargaining is a part of Russian optimization strategy as quasi-monopolist. The pie exists also in the case of Ukrainian
transit, but here game structure is determined neither by Russia nor by Ukraine, but more by international law (or its absence)
about transit.
We can observe that the land-locked geographical location of Turkmenistan has determined the market structure. Although,
there is some room for bargaining with Russia and there are moreover incentives for cooperation due to competing in the same
final market, Turkmenistan is highly dependent on agreement with Russia, which who the entry of gas supply from the region.
Hartley & Medlock (2009) have similar predictions about primary export of gas by Central Asian countries via Russia in the
coming decades, even if NABUCCO is constructed.
4.7. About Spatial Pricing of Gas
It is clear that the present market structure (in particular, the existence of a unique export route for gas from Turkmenistan over Russia) is an outcome of its location and geopolitical obstacles. Nowadays, there are many discussions about the
necessity of an alternative gas corridor – NABUCCO. However, future gas market analysts, Hartley and Medlock [9], predict
the preservation of dependence of Central Asian countries on Russian transit in future. The problem (as we see it) is not in the
delay of constructing NABUCCO (although it is important, and now the global financial crisis is one of the reasons), but how
little it changes the situation for Turkmenistan. Given that alternative transit cost may be as expensive for Turkmenistan as its
present transit via Russia, it will only upgrade bargaining power of Turkmenistan in its game with Russia, but not much. The
problem is the distance. In the case of Russia, due to non-transparency of internal accounting of Gazprom, we do not observe
its split of costs into gas extraction and gas transit. It is likely that the cost of transit of Russian gas over Russian territory is
comparable or even higher than the cost of its extraction. This partly justifies the difference between Russian domestic price
for gas and price for its export. But the similar argument can also be applied to Turkmenistan. We argue that even in
competitive transit environment, the price of natural gas on the border of Turkmenistan should be substantially lower than
European price, simply because of high cost of competitive transit. Non existence of unique world price for gas even by 2040
is argued in Hartley & Medlock (2005), although there is some sign of convergence of LNG prices in the long run. Therefore,
a much lower price for gas on the border of Turkmenistan is the outcome of both, its weak bargaining position with Russia and
reflects the high transport costs (including opportunity costs and competition with Russian sales).
4.8. Can These Games Be Reduced or Eliminated?
We also study the factors that can influence the game structure in both cases. In the short run, this may be updating of
international law. In the long run, it is more geopolitics that can prevent the construction of alternative pipelines either by
direct blocking or worsening of investment climate. As we have seen, transits allow for power abuse, which can put exporting
country with no direct access to consumers into a weak position. In these examples we have seen that one country (here
Russia) can be in different positions: abused by Ukraine and abusing Turkmenistan. In theory, omnipotent regulators can
prevent such games.
There exists several ways of dealing with these games. If we start from the rights of producers and consumers to contract
directly, then bargaining power of transit countries can be reduced or eliminated by corresponding amendments to
international law. However, since geopolitics also influences such legal decisions, we do not always observe economically
efficient legal implementations. Also, the rights of transit country to have rents from pipeline can be argued. In the case of
Ukraine, as an independent state it made no investment in the pipeline from which it seeks rents. The possibility of rent
seeking is a consequence of the poor legal foundation of the divorce of the FSU countries. However, the suggestion of some
Western countries to grant access to Russian internal pipelines in exchange for Russian control over gas transportation
network is not a symmetric approach, since that part was constructed by Russians and was always at their territory.
There also may be changes in internal accounting changing the essence of games. In principle, the owner (the population) of a
gas exporting country has a right to resource rents from for exploiting non-renewable resource (royalties). Accounting for this
rent increases the cost of gas at AC border, and thus reduces the size of the pie (possibly to zero) subject to bargaining. It is
also interesting to look at a broader optimization problem of Russia, including future long run strategies related to investment
in new gas fields and infrastructure (considered in our paper in OPEC Energy Review, 2008). Given that Central Asia may not
have alternative access to pipelines bypassing Russia in the middle run (currently it is not politics, but investment climate
during global crisis and low energy prices that suppresses construction of NABUCCO, ref.:
http://gazeta.ru/business/2009/05/08/2984370.shtml), Russia can consider the trade off between elaboration of new more
expensive gas fields in its North and Arctic shelf versus more intensive exploitation of cheaper gas from Central Asia. Central
Asian republics have even higher dependence of export revenue on possibility to export gas (with transit via Russia being the
only option) than Russia itself. Given their higher discount of future, it may be beneficial for both sides to concentrate on the
extension of exploitation of Central Asian gas resources. In this case, Russia will save more of its own gas for future, like
Middle East countries.
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5. Hotelling Model for Gas
Here we will touch another aspect of gas market that is related to its spatial srtructure. If gas pipeline network is rather dense
and if we have few supplers (with particular spatial locations), then we can use the approach of Hotelling (1929). The twodimensional set up has been elaborated by Yegorov (2000). Here we present some basic results along with some real data
about European market.
5.1. Two-dimensional Hotelling model
As it was shown in Yegorov (2000), introduction of special coordinates (elliptic-hyperbolic, with location of production points
in focuses) after integration allows to write the corresponding model as 1-dimensional Hotelling model with firms at the end
of interval and some heterogeneous demand density. For a broad set of densities such a problem has Nash equilibrium in pure
strategies for linear transport costs, and thus the criticism of original Hotelling's model by d'Aspremont, Gabzgewich and
Thisse (1979) does not apply.
The main results of the paper (Yegorov, 2000) can be summarized as follows.
1. The original Hotelling model is extended to any compact area in two-dimensional space. Demand continuity is
proved for any bounded density of consumers.
2. The general case of transport cost functions strictly increasing in distance is considered. First, it is shown that in the
strictly convex case the separating border between consumers has a unique point even on the line which connects
firms. This reveals the reason for discontinuity in the original Hotelling's model and the ways to recover it. Secondly,
it is shown that in a very general case the set of indifferent consumers has two-dimensional measure zero, and this
insures the continuity of aggregate demand.
3. Finally, total demand from any firm is a continuous function of both prices in the whole range of their potential
variation for a quite general setting: any bounded consumer density on any compact set on a plane, in the
environment of a quite general class of strictly monotonous differentiable transport cost functions.
4. The Nash equilibrium, which can be also asymmetric, always exists at least in mixed strategies. Its existence in pure
strategies depends crucially on the fact whether the maximum of the profit function of one firm with respect to its
own strategy is a continuous function of its rival's strategy. Any two-dimensional problem is mathematically
equivalent to a corresponding one-dimensional problem with firms at the ends of an interval and a non-uniform
density of consumers inside. It is well known that a Nash equilibrium exists for a uniform density, when firms are
located at the end of an interval and transportation costs are linear in distance. It is shown that for rich class of nonuniform densities Nash equilibrium in pure strategies also exists.
5.2. Hotelling’s Competition between Russia and Norway
The objective is to apply this model for the case of European gas market. While in reality many producers export natural gas
to EU, for simplicity we can concentrate on two main suppliers at present: Russia and Norway. According to BP Statistics,
natural gas imports from Russia and Norway form 100 % of gas imports for 8 European countries, between 50 and 100 % - for
10 more countries, and less than 50 % for only 8 countries.
Two-dimensional Hotelling model (Yegorov, 2000) can be used for the description of spatial competition between producers
of natural gas (Russia and Norway) and European consumers. Indeed, locations of production are fixed (immobile), gas
transport network in Europe is dense (see map 1) and consumers (demand density) is heterogeneous. Remember, that in
classical Hotelling model for any pair of prices set by producers there is only one indifferent consumer. In 2-dimensional set
up with Euclidean metric, indifferent consumers are located on hyperbola. This hyperbola varies with these prices but still
remains a hyperbola for Nash equilibrium.
How this can be translated into language of trade between countries. Hyperbola divides geographical map into two regions
(say, Western and Eastern Europe, but border has nothing to do with present or historic division into two Europes), where
West buys from Western producer (here Norway), East from Eastern producer (here Russia), while some countries (those
which are crossed by this hyperbola of indifferent consumers) buy from both. We can derive two stylized facts from this
observation:
a) most of EU countries tend to have only one (main) gas supplier, and only some subset (located in the "middle") have
competition between suppliers;
b) East European countries in this set up rationally choose Eastern producer (Russia) as main supplier.
Both facts have been observed historically. Before 1990 all gas to Eastern Europe went from Russia and even now Russia is
major supplier form them despite political drive for diversification. Atlantic countries still have little supply from Russia, and
there is spatial reason behind that.
Note that the present EU policy for higher diversification of gas suppliers and higher competition does not have economic
grounding (at least in Hotelling's framework). One of the goals of this article is to attract attention to this point. Another EU
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policy - to have gas price equalization over EU border (that works now) - is also strange and counterintuitive. This means
complete non-accounting for internal differences in delivery cost. Still, EU does not reach the objective of price equalization
for consumers (because of different taxes, profit of wholesalers and monopoly power of local gas distributors over consumers.
But the world is more complex. Some deviations from Hotelling's model come from the following facts:
a) consumers are not buying from producers directly (there are wholesalers, distributors),
b) network is not fully dense an cost departs from linear,
c) there are other obstacles (like transit countries with rent-seeking behaviour, that changes model's geometry).
Each producer has many gas extraction points and some internal pipeline system. However, model can be reformulated in such
a way that production (source) points are now located at EU border. Then Russia should have disadvantage over Norway in
the sense that it needs to pay more for internal delivery of gas to EU border (about 3000 km pipeline) than Norway (less than
1000 km). And additional cost come from transit rent (Ukraine at present) or higher cost of sub-sea delivery (North Stream
and South Stream gas pipeline projects). If Russia and Norway are able to set equal prices at EU border, this means that Russia
should have much lower extraction cost than Norway (as it has to pay much higher transport cost to EU border).
This exercise suggests that more optimal market structure would be cooperative ownership of all pipeline network by
consumers of EU, who should carefully account for all transport cost optimization and not allow for transport price to be
above transport costs. While this setting may be Pareto optimal, it is obvious that this might have opponents, not excluding
present holders of monopoly power in gas distribution.
5.3. Estimations
Using BP data (2008), we first constructed shares of Russia (R) and Norway (N) in all gas imports for different European
countries. They are presented on Fig.1.Then we introduced the function Y=R/(R+N) as the relative weight of imports from
Russia in imports from both Russia and Norway. Further we introduced index 0<x<1 as the relative location of a country
between points x=0 (entry of Norwegian pipeline to EU) and x=1 (entry of Russian gas pipeline to EU, on border of Ukraine,
Belarus or Russia). Further we draw a plot of this function Y=Y(x). It is easy to observe (Fig.2) the linear relationship between
Y and x, with high R2=0.85. Moreover, there is clustering of several countries at Y=1, with values of x close to one
(geographical closeness to Russia).
What can be inferred from these estimations? First of all, the role of geographical factor in gas trade is confirmed. Distance
from main gas exporters plays an important role in European gas trade. Despite the strive for diversification of supply.
However, we do not observe a full polarization of trade (when the dominant fraction of countries buy from only one producer)
like Hotelling model predicts. Still, we should not expect to get such strong result due to a number of reasons. The first is EU
policy for diversification (even at the expense of optimal transport costs). Second is the lack of explicit accounting of gas
transit costs inside EU.
5. Conclusions
How the markets for natural gas can be modelled in a theoretical way? We have:
• A set of consumers with their preferences for gas and gas producers in different location, with asymmetric
access to the market.
• A set of links (spatial) and contracts (temporal) between them.
• Market where the residual of gas can be sold at spot price. external forces that influence the market.
• Investors who invest in links between producers and consumers (since producers and consumers do not
automatically interact)
• Potential investment projects, among which investors choose those with higher NPV under current geopolitical
conditions.
Then, links between producers and consumers are evolving over time. This is indeed a very complex problem, and may lead to
difficulties in analytical description. That is why it makes sense to focus on reductions and policy implications. Some
reductions include the following simplified problems like gas transit games and geopolitical externalities. Analysis of simple
models related to Hotelling-type spatial competition and gas transit games reveal that geography and politics play at least as
important role as economics in modelling of real gas markets.
There is substantial evidence related to high role of geography, politics and technology for gas markets. This perturbs
functioning of standard economic analysis for natural gas markets and calls for the development of more complex modelling.
This paper focuses on the analysis of gas transit problems. They play very important role for gas markets at present, causing
violation of symmetric and costless access of all producers and consumers to the market (standard assumption in economic
10
theory) and emergence of transit games with externalities imposed on consumers due to disagreements between producer and
transitter (the case of Russia-Ukraine gas conflict, January 2009).
The paper models are based on real examples (Ukraine and Russia as transit countries) but become highly stylized, where the
difference of transit country being net gas exporter or importer is investigated. The case of net gas exporter (Russia in the case
of gas transit from Turkmenistan to Europe) is more complex, since edge producer (Turkmenistan) has to compensate transit
country (Russia) not only for the use of its pipelines, but also for undermining trade condition through the influence on market
prices in final destination country (EU). We suggest several game structures starting from real case (when Russia sets up piesplitting game for Turkmenistan) towards the case of internationally regulated transit. We show that game structure is not
absolute but depends on geography and international law. We also suggest what measures can lead to disappearing of the
game.
When we analyse the complexity of gas trade in Europe, it is possible to study the strength of spatial effects. Despite EU
tendency to have unique gas price at its border, the pattern of imports of different European countries is quite heterogeneous
and reflects the effect of delivery costs from different producers. It is possible to apply two-dimensional Hotelling model with
linear transport costs. If we have fixed locations of selling firms (here entry points of pipelines from Russia and Norway), the
indifferent consumers are located on hyperbola that is efined by price difference and unit distance transport cost. If spatial
effect of Hotelling type competition would be absent, we would observe no effect of importer’s location on the interval, that
parametrizes set of such hyperbolas. However, we observe strong role of spatial effect in gas trade. It is also responsible for
local monopoly power of producer over closest countries, that is determined by transport cost effect and emerges as a free
choice of consuming countries.
Acknowlegdements. The work of Yuri Yegorov has been financed by Austrian National Bank through the
Jubilaumsfondproject Nr. 12826.
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Fig. 1. European gas pipelines and relative location of countries to main gas exporters: Russia and Norway.
Fig.2. Dependence of Russian share in gas imports on country’s location x
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