Natural gas pricing in countries of the Middle East and North Africa.

1. INTRODUCTION

Countries of the Middle East and North Africa (MENA) own 45 percent of the world's gas resources but account for 15 percent of gas production. The latter ratio is projected to increase substantially in the next twenty years. However, the expansion of gas production capacity appears increasingly uncertain as various projects are postponed or cancelled. Although the prevailing high international oil prices should encourage the expansion of gas production capacity, there are several discouraging factors at work. First, the dynamics of oil price volatility have a complex and significant impact on investment and production decisions. As explained by Pindyck (2001), an increase in oil price volatility is accompanied by an increase in the volatility of

I wish to thank the anonymous referees of this journal for their valuable suggestions. I am also grateful to Franz Gerner, Bjorn Hamso, Ranjit Lamech, Laszlo Lovei, Kari Nyman, Sylvia Pariente-David, Jamal Saghir and Vlado Vucetic for their comments, and to Megan Good and Larisa Marquez for their assistance in the analysis of data and preparation of the manuscript. investment and an addition to the opportunity cost of current production. This has indeed created a "wait and see" attitude in upstream oil and gas investment decisions in MENA countries. Second, investment costs, which had remained stable for almost a decade, have sharply increased in the last couple of years. These sharp cost increases have wrecked the economic viability of many projects. As a result, some projects, e.g., gas-to-liquid initiatives, are deemed non-viable while some other projects are postponed with the hope that the surge in capital cost may be a temporary phenomenon. Third, mobilizing capital at the large scale, which is usually needed for many gas projects, is difficult, particularly for countries like Iran. Fourth, the low domestic price of gas creates a very serious disincentive for investment in the gas sector, particularly where such investments are expected to be made by private sector. Fifth, there is an emerging debate within each MENA country about the wisdom of allocating gas resources to export projects versus holding these resources for current and future internal consumption. This debate has also contributed to project postponement decisions.

The objective of this paper is to address the issue of domestic gas pricing. In MENA countries, the price of natural gas is set directly or indirectly by government authorities. The price charged for domestic gas is very low resulting in very inefficient use of gas, a disincentive for investment, and a bias in favor of gas exports. In this paper, we present a quantitative framework for discussing the domestic pricing of natural gas and review its implications regarding allocating gas to various uses--in particular, to export projects.

Traditionally, the economic framework for gas pricing is based on the theory of exhaustible resources [Hotelling (1931), Dasgupta and Heal (1980), Halvorsen and Smith (1991)]. The practical implication of such application is that the price of gas should be based on its "economic cost" which itself comprises two components: the long-run marginal cost (LRMC) of gas supply; and a depletion premium. In the case of "gas surplus" countries where gas reserves are expected to support the projected production for a long time (40-50 years), the depletion premium becomes negligible and the gas price is close to the lower end of the range, i.e., cost of supply. For "gas short" countries where reserves are already a constraint, the depletion premium is very large and the gas price is close to its upper limit, i.e., the equivalent price of the alternative fuel. For "surplus window" countries where gas reserves are not presently a constraint but are expected to become a constraint in the next 15-20 years, the size of the depletion premium varies depending on the production and demand profiles.

Aside from the above two concepts--LRMC and depletion premium--the gas pricing discussions (and negotiations) make note of the estimated "netback value", or market value which refers to the economic benefit of using gas for various purposes. The netback value of the internal gas use is normally calculated for the power, industrial, and household sectors. The concept of the netback value can also be used in estimating the net gain from gas export, or the net gain from using gas as a feedstock to fertilizer and petrochemical plants, and to gas-to-liquid conversion processes. The calculated netback values serve as a useful guide for allocating gas reserves to most economically attractive purposes. The netback value is also used in the discussion of domestic price of gas; it indicates the upper limit to the price of gas beyond which consumer would shift away from using gas.

The remainder of this paper is organized in seven sections:

(a) An analysis of the region's gas sector in order to provide an overview of the sector;

(b) An analysis of the economic cost of gas supply in the MENA countries;

(c) A calculation of the implied economic value of natural gas in domestic use;

(d) An estimation of net gain from LNG export;

(e) Results and policy implications, where we bring together the costs and the values to discuss gas pricing and allocation decisions;

(f) Sensitivity analysis, where we examine the impact on the results of the study of change in some major assumptions (projection of price of crude oil, the choice of discount rate, and the estimates of the capital costs); and

(g) Concluding remarks.

2. OVERVIEW OF THE GAS SECTOR

MENA countries hold 45 percent of the world's proven gas reserves, totaling about 81,000 bcm (or about 2,900 tcf). Despite the large gas resource endowment, these countries experienced a slow increase in gas production through the 1970s and 1980s, which accelerated in the 1990s, mostly because of the rapid growth in internal gas consumption and, to some extent, the expansion of gas exports. In the early stages of gas market development, domestic use of gas was mostly targeted to the industrial and residential sectors. However, the substantial increase in gas consumption occurred in the second half of the 1990s when most countries found natural gas a convenient fuel for power generation. Presently, close to 60 percent of MENA's electricity needs are gas-based compared to a proportion of 10 percent in the 1970s. Power sector use of gas is expected to be the main driving force for increased internal use of gas during 2005-2030 period growing by 3-7 percent per annum.

The region's gas exports have expanded primarily in the last ten years due to the possibility of exporting gas in the form of LNG. Algeria has been the largest gas exporter and is the only country that exports significant amounts of gas in the form of both LNG and piped gas. Qatar has become a significant LNG exporter and ranks second after Algeria. The IEA's forecast indicates that Qatar will become the largest gas exporter of the region by 2020. Qatar has successfully and efficiently implemented a chain of LNG plants. It is expected to expand the LNG capacity and also to export significant amounts of piped gas mostly within the MENA region.

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The above forecast indicates that gas exports will increase roughly fourfolds over a period of 25 years. In absolute terms, this would require a capacity expansion of 350 bcm/year. This is considered overoptimistic [Stern (2006)] due to its enormous investment requirements which may be hard to finance. Several countries are pursuing ambitious projects with varying degrees of success. Algeria and Qatar have now a well-established track record and are expected to expand their exports according to the announced plans. Iran, with its huge reserve potentials, is discussing various LNG and pipeline projects but its policy and its ability to finance the required investments are highly uncertain [Ghorban (2006), World Gas Intelligence (2006)]. Egypt has successfully completed implementation of its two LNG plants and is planning further expansions [Oxford Analytica (2006)].

Aside from the above ambitious plans to export gas from MENA to the rest of the world, there is also a substantial potential to export gas to other countries in the region due to the significant gas deficits in some countries. Presently, there are rather small volumes of gas movement from Algeria to Tunisia, from Egypt to Jordan, and from Oman to UAE--all through pipelines. The construction of the Dolphin project, which delivers gas from Qatar to UAE and Oman, will increase the scale substantially. The Dolphin project includes upstream investments in Qatar's North Field and construction of a 48-inch diameter, 260-mile long subsea pipeline which will carry initially 20 bcm/year gas from Qatar to the UAE and, at a later stage, to Oman. The project will bring together three Gulf Cooperation Council (GCC) nations--UAE, Qatar and Oman--into an integrated gas network for the first time. It is considered a breakthrough in the MENA region, both in terms of its size and the ability to serve the demand-supply synergy within the region.

Gas exporting countries of the MENA region have been quite assertive in seeking higher gas prices, particularly in the market environment of the last few years. The average LNG sales prices varied between $4.00 to $5.50/MMBTU in 2006, which was in line with the market value of gas in major gas importing countries. However, the price charged for domestic use of gas has remained persistently low in all MENA countries. The average price of gas in most MENA countries is below $1.00/MMBTU. The power sector, which accounts for 40 to 70 percent of domestic gas use, receives an especially favorable price. The very low price charged to the power sector was initially intended to encourage the power utilities to shift from oil-based to gas-based power generation at the time when these utilities resisted such a shift, and natural gas was viewed as a "free" resource. Presently, neither of these assumptions holds any longer; still, the governments are not willing to face the political and economic challenge of increasing gas prices and in effect subsidize the gas price very heavily. Egyptian government buys the gas from producers at the price of $2.65/MMBTU and sells it in the domestic market at an average price of $1.19/MMBTU, which results in an explicit subsidy of about $7 billion a year [World Bank (2006c)]. The Iranian government provides the gas to the national power utility at the negligible price of $0.10/MMBTU, and to other users at $0.60/MMBTU (industrial sector) and $0.45/MMBTU (residential/commercial sector). The subsidy, which remains implicit due to the government's ownership of the gas sector, is estimated at $6.5 billion [World Bank (2006b)].

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