The global economy is entering a period in which demand for oil will exceed supply for the first time. Several economic and political trends are simultaneously converging that indicate the international oil and natural gas markets are about to experience a major restructuring process. This occurs at the same time that international political developments are establishing new objectives for U.S. energy policy and introducing new geopolitical dimensions to America's foreign oil and gas supplies. It is therefore imperative to examine some of the salient features of these changing conditions.

Not only does the United States remain dependent upon foreign oil, but North American natural gas production is declining at a time when demand for natural gas is rising. The U.S. is set to become a net importer of natural gas on a significant and sustained basis for the first time. This is cause for concern, especially considering that the Middle East, the largest regional supplier of oil to the international markets, is in turmoil-even by Middle Eastern standards. Iraq supplies much less oil to the international markets than before the war, while widespread adversarial attitudes to the United States are developing in other Islamic states. Continuing instability in the Middle East and Southeast Asia threaten secure access to these regions' large oil and gas supplies. Latin America, a major supplier of oil to the United States, is in political and economic trouble. The most promise appears to be Russia, the world's largest natural gas producer and the second largest oil producer, which is planning to increase its production and enter new markets.

Compounding the problem of threatened oil supplies is rising demand, which creates incentives to develop sizeable new international supplies of oil and gas in non-Middle Eastern locations. This process requires large investments and explicit contracts between investors and suppliers that establish delivery volumes and prices. Achieving these contracts will require America's concerted diplomatic effort but will have the effect of solidifying long-term relationships with new international parties-most importantly, Russia. Such contracts (and the new relationships that sustain them) could very well help the United States achieve some of its emerging geopolitical objectives.

Why Hydrocarbon Prices are Rising

The mechanisms that keep oil and natural gas prices low are breaking down. In the case of oil, the marginal pricing system of the New York Mercantile Exchange (nymex), in which the price of small amounts of a commodity determines the price of the entire commodity, kept oil prices at low levels and gave world economies the benefit of cheap energy for a period of economic expansion during the 1980s and 1990s, a period of surplus oil-production capacity.1 Such a price system is efficient for keeping prices low during periods of surplus, but it does not offer a return on sunk costs. It does not, therefore, attract investment.

New sources of oil supplies typically require large up-front capital investments, which were not forthcoming during this two-decade period. The domestic oil industry and overall worldwide activity contracted by about 75 percent in the late-1980s, and new supplies were not developed. While the large surpluses that were previously available are now gone, investors have been driven from the business, and exploration and producing companies have not generated capital for re-investment in new fields and sources of supply.

Marginal pricing is also efficient at increasing prices during periods of shortage, as we are now beginning to experience in the oil markets. Buyers bid prices up to the limit they can pay for the oil or gas and still stay in business. Worldwide demand is growing slowly and will increase as economic growth resumes. Supply shortages are thus expected to become more frequent and severe over the next few years, creating a general trend of higher prices if new supplies are not developed. Although prices will trend upward, investors in large projects will be discouraged by knowledge that new large supplies will cause price drops and increased volatility. Without investment, the upward price trend will accelerate and present an ever-increasing constraint on economic growth.

Natural gas prices are also rising, but for different reasons. Because of the difficulty and high cost of transporting natural gas, it was traditionally used only in areas where it was produced or could be transported cheaply by pipeline. The U.S. national pipeline network, interconnected with Canada's, allowed for gradual expansion of natural gas use in North America. Because gas is a clean-burning fuel, compliance with clean-air regulations dictates that nearly all new U.S. electricity-generating plants be gas-fired. In addition, most new residential and commercial structures now use gas for heating. But, because environmental considerations severely restrict gas-well drilling, declining production and increased demand have thus combined to cause domestic gas shortages and rapidly increasing prices.

"Demand destruction" is becoming the mechanism for balancing gas supply and demand. Residential and commercial users are not often in a position to switch to other fuel sources (e. g. coal-fired furnaces or generators) and so have no option except to pay higher prices for gas and electricity. Shutting down industrial activity, with resultant unemployment, is not a desirable situation for an economy attempting to recover from a slump. Gas prices are determined by trading on the commodity market a­nd exhibit the same volatility and sensitivity to small changes of supply and demand as oil prices.

Prospects for the Future

Only by opening new sources of oil and gas supply can shortages be alleviated. This, however, will require large investments in foreign countries, some of which are neither very stable nor friendly to the United States. The need to attract this investment will lead to restructuring of the price and market systems worldwide for oil and domestically for natural gas. Large new oil supplies can be offered to customers with long-term contracts at prices that will offer attractive returns to investors but less than those currently availab­le with marginal pricing in the traded markets. The current marginal pricing system is incompatible with the investment requirements of the industry. Investor requirements will dictate that new oil supplies will be subject to long-term contracted prices similar to current European gas purchase contracts.

The same is true for Liquefied Natural Gas (lng), which can be easily transported anywhere in the world and therefore imported and sold profitably at prices lower than current U.S. natural gas prices.2 Foreign natural gas can be imported to the United States as lng at prices ranging from about $3.00 to $4.00 per million British Thermal Units, which is roughly equivalent to the heating value of one thousand standard cubic feet of natural gas. With recent U.S. gas prices ranging from $4.50 to $6.00, lng has become economical to import.

There is still work to be done, however, to make this a reality. Large up-front capital expenditures are required for field development, liquefaction plants, loading facilities, special tankers to transport the liquefied gas at -260 degrees Fahrenheit, unloading facilities, plants to gasify the lng at the point of import and distribution systems to local markets. Nonetheless, several companies are rehabilitating lng re-gasification plants in the United States and have announced preliminary plans to expand existing facilities or build new ones. In addition, several European countries have recently expanded lng imports. The entry of the United States, the largest user of natural gas with a rapidly increasing demand for imports, into the world lng market will have a profound impact on the lng supply system.

As new supplies are developed, long-term contracts will quickly displace traded oil and gas in the markets because of their price advantage. As these contracted volumes become a larger part of the overall supply they will become a flywheel on the overall market, damping volatility and driving out high-cost production. Thus, marginal prices will be used only for marginal volumes to adjust supplies for short-term market fluctuations. Long-term prices (and supplies) of oil and natural gas, however, will stabilize.

Russia : The Joker in the Deck

Development of additional sources of oil and gas, however, cannot be expected to proceed smoothly. There are abundant deposits in places throughout Russia, Latin America, West Africa and the Middle East. Yet, these locations are characterized by unattractive fiscal and contract terms, unsafe and unattractive working conditions, political turmoil and anti-American sentiments. Bolivia just cancelled a project to supply lng to the west coast of the United States, and its President resigned in response to anti-American demonstrations. Other projects in the region are on hold. Promising reserves in Indonesia are imperiled by political instability in a country that has had four governments in five years and where terrorists are becoming more active. Environmental objections and other permitting difficulties will delay, possibly defeat and certainly increase the cost of developing receiving facilities in the United States for oil and lng imports.

Russia, the world's largest gas producer and second largest oil producer, is the wild card in any global re-alignment of political and economic power and in the oil and gas markets. Its resources rival those of Middle Eastern countries, and oil and gas production drive Russian economic growth and political stability. It has close economic ties to Europe and is seeking to expand them. (Germany is the largest foreign investor in Russia, and France is its largest source of foreign income.) Many Europeans believe that a combination of European industry, technology and capital with Russian resources (including military) can create a bloc with the economic and political strength to rival the United States. As could be expected, the apparent Bush Administration disdain for Europe is only serving to strengthen such designs.