Thesis Proposal

Introduction Since the integration of fossil fuels as the predominant energy source the global economy, many states have nationalized their energy sectors in the name of energy security. To that end, state-run energy companies are posed with the challenge of meeting its countrys energy demand while providing affordable and stable prices to its consumers. This mission, however, is contradictory in nature because it possesses tradeoffs between stability and efficiency. For instance, when ensuring energy security, companies often choose to control the entirety of the production process through vertical integration. Although this purchasing strategy guarantees supply and stable prices, vertical integration may tie companies to infrastructure that wont allow them to take advantage of changing market conditions in the future. This inherent risk, in turn, often leaves countries with higher energy prices, which subsequently offsets any gains in energy security. In this regard, these tradeoffs highlight the central question: Should a state-run energy company choose to vertically integrate when attempting to secure energy at the cheapest price? To answer this question, this research will conduct a case-study on South Koreas state-run liquefied natural gas (LNG) importer, KOGAS, and examine how its purchasing strategy of vertical integration is creating an inefficient LNG shipping market, which is subsequently increasing the cost of LNG worldwide. Furthermore, this research can assist other state-run energy companies, like KOGAS, to better address this tradeoff between price efficiency and supply security. State-run energy companies in developing countries with large consumer bases and a heavy reliance on the

Rogers 2 international market can learn from KOGAS case study by understanding the true ramifications of integration on price efficiency. These national energy companies include CNPC and Sinopec (China), ONGC Videsh (India), Gazprom (Russia), and Petrobras (Brazil). These firms can then develop more balanced purchasing strategies avoid price inefficiencies associated with integration while maintaining political and economic stability within their own countries, etc. Literature Review A connection between KOGAS strategy of vertical integration and global shipping inefficiencies can be brought about through an understanding of the motivations behind South Koreas energy policy. Since 1986, when South Korea made the strategic decision to import LNG, it looked to diversify its primary energy mix away from oil to hedge against price volatility in the global marketplace. Now, 25 years later, LNG has become an integral part of South Koreas energy consumption, and has reintroduced concerns born out of the 1980s. Worries about energy dependence have resurfaced because South Koreas consumption of LNGcurrently 47 bcms annually1accounts for approximately 16% of its total energy consumption.2 These concerns are magnified further when considering that South Korea imports 98% of all of its LNG, a huge vulnerability in todays global gas market.3 According to Jonathan Stern, in his book, Natural Gas in Asia, KOGAS has tried to cope with this vulnerability by diversifying its imports to a variety of LNG-producing countries including Qatar, Russia, and Indonesia , yet has had to rely on the spot-market to mitigate the seasonal nature its demand. Because of its unique geographic location, South Korea suffers from

1 2

BP Statistical Review of World Energy 2012 Korean Gas Union, http://www.kgu.or.kr/eng/gasindustry/statistics.html 3 Natural Gas In Asia, p. 176

Rogers 3 severely cold winters, which require KOGAS to provide additional gas for home heating and electrical generation during the winter months. While spot transactions allow KOGAS to address seasonality, the availability and price of these short-term contracts are subject to supply and demand conditions within the market. Since Korea does not possess any geological natural gas storage facilities, sustaining large amounts of LNG storage during periods of off-peak usage is expensive. Avoiding these costs by purchasing LNG on a short-term basis leaves KOGAS vulnerable to higher, seasonal prices in the spot market as KOGAS must meet demand regardless of the market price. KOGAS fell victim to price volatility in the spot-market as worldwide demand increased by 13 percent while supply began to stagnate between 2000 and 2008.4 As China and Indias demand doubled, exporting nations could not meet their long-term contractual obligations and investment in new upstream projects did not come online in time to meet growing demand. During this period, Indonesian exports dropped 30 percent,5 forcing Indonesias state-run gas company, Pertamina, to renegotiate its long-term contractual obligations with Japan, Taiwan and South Korea at lower levels of output. Additionally, the increasing cost of investment and the shortage of skilled labor stalled the development of new LNG production capacity. According its 2007 Natural Gas Market Review, the IEA reported that LNG mega-projects under construction in 2006 had accumulated an average delay of 11 months and a 30 to 35 percent increase in capital costs, totaling on average 2.26 billion per project6. These two developments drew premiums for spot-cargoes, making KOGAS purchasing strategy more costly. When KOGAS underestimated winter consumption in 2006, it had no

4 5

BP Statistical Review of World Energy 2012 LNG Trade Flows in the Atlantic Basin: Trends and Discontinuities, p. 32 6 Natural Gas Market Review 2006: Security in a Globalizing Market, p. 45

Rogers 4 choice but to purchase an additional 2.1 Mt/y of LNG from Qatar at $10/MMBtu well over the average Japanese Crude Cocktail price of $7.9/MMBtu of that year.7 This exposure to price volatility has caused the South Korean government to put pressure on KOGAS to purchase equity in upstream development. Equity purchases in upstream projects allow KOGAS to essentially become independent of the spot-market through vertical integration. According to the Reuters, KOGAS expects to invest $2.5 billion, or 50 percent more than a year ago, to development overseas oil and gas projects in 2012 (Reuters, 2012). To date, KOGAS possesses upstream assets in eight countries on four different continents and hopes to source 25 percent of its imports from equity shares by 2017.8 Some officials within the South Korean government have even called for a merger between South Koreas state-run oil company, KNOOC, and KOGAS in order to better compete in the bidding process for upstream assets.9 Moreover, the governments push to fully integrate KOGAS purchasing strategy exists in a larger political context. Since the 1960s, the success of the South Korean economy has depended upon protectionist policies enacted by the government. Under its export-driven growth model, the South Korean government aimed to keep prices of inputs low in order to ensure the export industry was price competitive abroad.10 The government accomplished this mainly by nationalizing industries that supplied inputs, thereby allowing the government to set input prices domestically. Consequently, these protectionist policies directly influenced to the success of the "chaebol" or large manufacturing giants in South Korea (Hyundai, Daewoo, etc.) and created over 300 nationalized companies including KOGAS.11

7 8

Natural Gas In Asia, p. 191 Reuters, p. 1 9 Natural Gas in Asia, p. 199 10 Industrial Policy in Export Propelled Economy: Lessons From South Korea, p. 6 11 Korean Politics, p. 69

Rogers 5 Therefore, as LNG prices become more volatile and future supply remains uncertain, the South Korean government will continue to have a vested interest in maintaining stable LNG prices, and will thus argue for more integration. Providing stable gas prices is crucial to South Koreas economic and political stability. This sentiment has been echoed by labor unions and consumers as unions fear the loss of their jobs within the gas industry, while consumers fear higher prices on electricity, etc.12 To that end, this anxiety is directly responsible for the ever evolving mission of KOGAS. Yet vertical integration, however, hasnt allowed KOGAS to adapt to changing market conditions within the global LNG industry, which has actually increased the cost of its current purchasing strategy. The advent of the 2008 global recession and the expansion of the shale gas boom has made spot-marketing more cost-effective for buyers. While the economic impact of the recession decreased global gas consumption, the increasing production of shale gas within the U.S. forced international suppliers, mainly Qatar, to divert supplies originally planned for anticipated increases in U.S. demand to more willing buyers abroad. This two-fold effect has made more gas available for spot-marketing, thereby lowering spot prices to competitive levels relative to those within long-term contracts. Starting in 2009, price disparities between these contracts entered the European market. In their 2010 World LNG Report, the International Gas Union reported the average oil-linked contract price exceeded the spot price by ~$2.16/MMBtu at the National Balancing Point in 2010.13 Producers and upstream stakeholders are beginning to capitalize on this evolving market by reserving volumes for the spot-marketing and diverting those cargos to the most willing

12 13

Reuters, p. 1 World LNG Report 2010, p. 21

Rogers 6 buyers.14 Evidence of this strategy can be seen through the growing number of spot market transactions and number of diversions over the past few years. According to the International Group of LNG Importers, spot-market trading accounted for 25 percent of total trade up 50 percent from 2010 while over 200 cargos were diverted from the Atlantic to Pacific basin in 2011 alone.15 Although this trend may be attributed to Japans growing LNG demand in response to the Fukushima nuclear disaster, the ability to divert spot-cargos across markets highlights the flexibility suppliers have in responding to changes in demand. Yet in light of more upstream capacity, KOGAS current strategy may be producing an increasingly inefficient market as shipping routes have grown an average of 1,000 kilometers since 2000.16 Overlap in shipping routes between KOGAS, spot-suppliers, as well as other vertically integrated companies could contribute to these increases. Steve Engelen and Wout Woullaert have argued that operators of liquefaction and regasification terminals often owned by vertically integrated firms determine schedules deliveries of shipments without taking into account the shipping capacity necessary for contracts.17 This lack of communication creates fluctuations in carrier demand, which prevents shipping companies from using their fleets optimally. To that end, KOGAS global equity shares may be preventing providers from pursuing contracts with the most optimal shipping schedules, forcing them to contract with less geographically efficient suppliers or shipping companies.18 These contracts create shipping overlap, which in turn increases shipping distances and raises costs.

14 15

World LNG Shipping: Dynamics in Markets, Ship and Terminal Projects, p. 121 GIIGNL: The LNG Industry in 2011, p. 4 16 Natural Gas Market Review 2009: Gas in a World of Uncertainties, p. 67 17 Transformations in Natural Gas Shipping: Market Structure and Efficiency, p. 302 18 The LNG Market: A Game Theoretical Approach to Competition in LNG Shipping, p. 229

Rogers 7 Theory/Hypothesis This research will analyze whether or not KOGAS should reassess its equity acquisition strategy. Instead of purchasing equity, it may be more efficient for KOGAS to re-contract with producers that can offer LNG shipments more efficiently relative to their previous contracts. This strategy, in theory, has the potential to match KOGAS and other consuming nations with producers that could most efficiently deliver gas supplies to their respective regions, thereby eliminating the number of diversions and decreasing shipping costs within the global market.19 KOGAS could then reap the benefits of lower prices and take advantage of current market conditions while still maintaining Korean energy demand. More broadly, breaking vertical integration could lead to an international commodities market built upon gas-to-gas competition, which could potentially to change the way state-run energy companies assess price volatility and supply security. According to James Jensen, by separating the LNG value chain among numerous third-parties, the current LNG market could be, reconstructed efficiently through independent competitive offerings of each of the relevant links which are free to operate independently of one another (Jensen 2010). This competition in turn could create an international system where firms weigh the risk of contracting with producers through an international derivatives market: Since many market decisions involve time lags between buyers' and sellers' revenue objectives with volatile price behavior in the meantime, [liberalization policies] also envisions a system of risk management through the use of various types of financial derivatives - futures contracts, options and swaps (Jenson 2010).

19

Evolution of Long-Term LNG Sales Contracts: Trends and Issues, p. 17

Rogers 8 Moreover, if state-run energy companies recognize the benefits of breaking the LNG value chain, they could effectively transform the todays regional LNG industry into an international commodities market. This would allow state-run energy countries, especially in the BRIC countries, to secure gas at more efficient prices without suffering the consequences of price volatility and supply instability. In addition, a shift in policy at this magnitude will forever change the way countries understand risk in the LNG market. Hopefully, my hypothesis will prove to these companies that vertical integration is detrimental to the market and that the benefits of liberalization policies are real. The hypothesis, however, relies upon the existence of shipping overlap and the correlation between longer shipping routes and higher prices. If a correlation does exist, this research will examine the existence of overlap and explore opportunities for KOGAS to re-contract. Research Design Testing this hypothesis will take the form of a single case-study. It will be executed by looking for overlap in KOGAS shipping routes with other shipments from GPS-tracking shipping data between 2010 to present. Overlap will be identified by first geographically mapping the shipping routes through tanker movement data and then matching those movements to spot-transactions, long-term contracts, and KOGAS integrated purchases worldwide. Shipping data and spot-market transactions will be collected from weekly LNG reports by ICIS Heren, which charts spot-transactions as well as the tanker deliveries on a weekly basis. When charting shipping routes, ICIS lists the nearest port, latest destination, approximate ETA, delivery volume and vessel operator of any given carrier delivering LNG. Information for these movements is obtained through each carriers Automatic Identification System, which is sourced from a separate database owned and operated by a different consulting firm, IHS Global

Rogers 9 Insight. Likewise, when listing spot-transactions, ICIS details the parties involved, the price of the LNG, the ship delivering the cargo, the transaction date, the origin and delivery point of the transaction. The ICIS obtains this information through a range of sources, which includes open source news, contacts at terminals, individual investor relationships, and contacts at specific firms. In addition, long-term contracts will be gathered from Poten & Partners LNG contract database. This database records all of the long-term contracts in the LNG industry from 1960 to present. Poten & Partners organizes these data by the buyer, which in this case are countries even though private firms may be conducting business on a countrys behalf. An example of this phenomenon is Gazprom, which is a semi-private company that manages all of the Russias natural gas assets. With this categorization, Poten & Partners lists the transaction date, duration, price, and volume of the contract. The price is numerated in $/MMBtu while the volume is numerated in bcm. Finally, these data are gathered from other market intelligence news sources including open source business news, country profile briefs written by government agencies, and a range of other market databases like Bloombergs New Energy Finance application and the Economist Intelligence Units online services technology. Lastly, identifying KOGAS vertically integrated purchases will be sourced from KOGAS quarterly financial statements. At the beginning of fiscal quarter, KOGAS publishes a financial report that lists the value, status, and development of their foreign assets. By matching those assets with ICISs tanker movements, I will be able to see which transactions are associated with KOGASs upstream developments. Once the shipping movements are matched with their respective transactions, these data will be mapped using POM-QM software. This software plots connections, or transactions,

Rogers 10 through Excel and displays them in a visual map. These data will then be sent through the softwares logistical calculator, which sorts shipping routes in their most efficient manner based on the cost of LNG plus transportation. It is important to note here that efficiency is measured in the cost of the LNG value chain. To put it simply, efficiency of a companys purchasing strategy is a function of the cost associated with importing LNG. The higher the costs associated with a company purchasing strategy, the less efficient the company is and vice-versa. These two visual maps will then be transposed onto each other and provide evidence for the possibility of re-contracting. If KOGAS shipping routes have been reorganized with another providers route, then there is an opportunity for both providers to re-contract. Each case will be studied qualitatively to see why these discrepancies have not already been resolved. Any insight into these inefficiencies will most likely be explained by the incentives behind both providers purchasing strategies and will require research into the evolution of their upstream practices. In addition, the politics between both countries will also be examined to see if diplomacy could account for inefficient contracts. This analysis will then form a recommendation for KOGAS that advises them on how to best adjust their upstream strategy to the changing dynamics of the LNG market. Feasibility One problem with my research design is that I do not know how to fully manipulate the data. The ICIS Heren has been exported but must be cleaned and organized to build an econometric model. With my colleague, Bagas Dhanu, I have begun to sort these data by transaction and tanker movement, and have organized it by date. However, I have no experience creating a model using the POM-QM software. My thesis advisor has assured me he has used the software before and will be able to guide me through the process. Considering I dont have an

Rogers 11 econometric background outside of intermediate Economics classes, I will be relying on his insight to complete this thesis. If we do encounter problems with the model, we may have to adjust our hypothesis to accommodate a simplified model.

Rogers 12 References BP, 2012: Statistical Review of World Energy 2012. www.bp.com/statisticalreview. Stern, Jonathan. Natural Gas in Asia: The Challenges of Growth in China, India, Japan, and Korea, (Oxford: Oxford University Press, 2008), pp. 174-219. Rogers, Howard V. LNG Trade Flows in the Atlantic Basin: Trends and Discontinuities, Oxford Institute for Energy Studies Online (2009): pp. 23- 57. IEA, International Energy Agency, Natural Gas Market Review 2009: Gas in a World of Uncertainties, OECD/IEA (2009): pp. 76 95. IEA, International Energy Agency, Natural Gas Market Review 2006: Security in a Globalizing Market, OECD/IEA (2006): pp. 32 45. Wang, Siyuan; Nottoboom, Theo. World LNG Shipping: Dynamics in Markets, Ship and Terminal Projects (Brussels: University Press Antwerp, 2011) pp. 114 136. Engelen, Steve; Dullaert, Wout. Transformations in Natural Gas Shipping: Market Structure and Efficiency, Maritime Economics & Logistics (2010): pp. 295-325. Gkonis, Konstantinos G; Psaraftis, Harilaos N. The LNG Market: A Game Theoretical Approach to Competition in LNG Shipping, Maritime Economics & Logistics (2009): pp. 227-246. Westphal, Larry. Industrial Policy in Export Propelled Economy: Lessons From South Korea, Journal of Economic Perspectives (1990): p. 41 59. Weems, Phillip. Evolution of Long-Term LNG Sales Contracts: Trends and Issues, Maritime Economics & Logistics (2007): pp. 200-245. Kie-Chiang Oh, John. Korean Politics, (Ithaca: Cornell University Press, 1999) pp. 1-70 Jensen, James. The LNG Revolution, The Energy Journal, (2003), pp. 1-45 ICIS, Weekly LNG Market Report ICIS Heren, Inc.: London, 2010 2012. GIIGNL, The LNG Industry in 2011, The International Group of LNG Importers: Paris, 2011. Meeyoung, Cho. KOGAS to boost 2012 oil, gas investment by 50 percent, Reuters, May 29th 2012. IGU, World LNG Report 2010, Statoil: Oslo, 2010. Poten & Partners. LNG in World Markets: Pricing and Contracts, Houston, 2012.

Rogers 13 < http://www.poten.com/Publication.aspx?id=4118> KOGAS. Quarterly Financial Statements, Seoul, 2012 <http://www.kogas.or.kr/kogas_eng/html/investors/investors_15.jsp>