In Europe, large-scale shale gas production can first be expected in Russia, France and Great Britain. The oil and gas industry in Poland and in other states in the region still operates according to the rules known from the epoch of real-socialism.
When it comes to onshore oil and gas exploration and production “Europe remains a little bit of a basket case.” This is how the current situation was summed up by one of the most senior executives of an oil and gas supermajor. And indeed, this conclusion reflects the current state of affairs as regards the exploration of unconventional gas in Europe, and, at the same time, also the frustration over it. However, geological, technological and technical problems—jointly referred to as “below-ground risks”—are not what’s at stake here, though there is no denying that they are substantial. The European Union has become a “basket case”because on the one hand, at a time of a serious economic crisis, similarly to the United States, it would like to safeguard cheap supplies of energy; obviously, ideally from its own sources. This would enhance its balance of trade. On the other hand, nothing is done in Europe to do away with the barriers, nor is anything undertaken to create regulatory and financial incentives to facilitate the process. Hence, Europe reminds us of a patient who does not realize that he is suffering from schizophrenia. Another undeniable fact is that private companies within the oil and gas sector are aware of the situation but only slowly beginning to understand its root causes.
Europe Without Foundations
With the benefit of hindsight, there are many reasons to claim that it is no coincidence that shale gas production was first developed in the United States. In the early 80’s, the US government implemented tax regulations which encouraged the development of technology for the purpose of hydrocarbon production from unconventional deposits. Shale gas was by no means a privileged option and neither was it the most attractive one back then; tight gas and coalbed methane (CBM) were actually considered more promising options. And there were no guarantees of success either. This uncertainty, along with soaring prices of natural gas in the U.S. at the beginning of the 2000’s, led to competition between suppliers of various technologies. The American government did not favor any of them. It actually acted favorably against all initiatives aimed at providing a secure gas supply; and it was the free market that was to have the last say as to which option would achieve commercial success. And even though several years ago it was not obvious at all, shale gas has won. This does not mean however that tight gas and CBM do not stand a chance; the only difference is that initiatives to import liquefied natural gas (LNG) to the U.S. are in peril.
This proved that competition is favorable for development, whereas tax incentives are necessary to reduce investment risks for trailblazing projects so as to make them able to compete with established operations. Moreover, mineral rights in the U.S. are in private hands, as a result of which the division of the extracted resources’ value is a private affair of their owners and investors. Consequently, the market for acquiring rights to explore and extract hydrocarbons in the U.S. is substantially flexible and competitive. Each agreement is negotiated separately and the terms and conditions are subject to changes, depending on the current risk assessment and the general situation on the market.
Yet, this multi-market mechanism is hardly achievable in a transparent way if the mineral rights belong to the state. It is feasible through production sharing contracts but it requires a complex system of tender arrangements. If those in power as well as the society lack an in-depth knowledge of how the industry of exploration and production of hydrocarbons operates, and if the broader society does not sufficiently trust the government, the former will inevitably be accused of stealing the state’s property. And worst of all, on the political level such accusations are not verifiable.
Frequently, we will hear voices referring to the Norwegian or British model. This implies that the extracted hydrocarbons are taxed under general rules. However, this model was being developed for decades, in times of high social confidence and it was created as a result of decisions made in unique circumstances. Apparently, management boards of private enterprises exploring hydrocarbons on the ground in Europe do not realize that those in power in European states (apart from the United Kingdom, Norway, the Netherlands and, perhaps, Denmark) and in European institutions do not grasp how investment decisions are met. At the same time, understanding is crucial for the development of this industry in Europe; unlike in the U.S., both governments and society have a direct commercial interest in those investments.
The exploration and production of shale gas is subject to different business rules than the exploration and production of conventional hydrocarbons. The initial production wells are in fact mere prototypes of future wells—and we need hundreds of those, or even thousands. Against the background of financial incentives and a flexible licensing and service market in the U.S., companies seemed not to have realized that they were entering into an absolutely new business model. Back in Europe, the lack of understanding by those in power—both on the national as well as the EU level—of this shift of business model has resulted in a situation in which a meaningful dialogue between all the interested parties is simply unfeasible. Therefore, if private enterprises want to expand exploration and production of shale gas in Europe on the ground, they must ensure general understanding of the commercial regulations underlying the operation of the industry.
The differences between the U.S. and Europe mentioned above, regarding the local business and regulatory determinants, bring more risk to the already risky business of exploring and extracting hydrocarbons. These determinants— unlike the already quoted below-ground risks— are referred to as the above-ground risks. They account for about 70% to 80% of the whole investment risk. Consequently, the risk related with exploration and production of hydrocarbons on areas of European land is as a whole significantly higher than in the U.S. This fact has not been sufficiently appreciated by the industry. Even experts from respected institutions such as the World Economic Forum considerably underestimate the share of the above-ground risks. This is confirmed by the media coverage which is predominantly focused on the scale of shale gas deposits and the economic and geopolitical impact of potential large-scale production of shale gas in Europe and in the world.
This picture of huge differences between the exploration of hydrocarbons in Europe and in the U.S.—which works against Europe—is compounded by the tightness and sickliness of the service sector accounting for accessibility to equipment and exploration services offered on competitive terms.
Poland, or Where Time Has Come to a Standstill
Poland is the first European state at the forefront of shale gas exploration. For over 70 years the country has had no experience in exploring oil or natural gas on a large commercial scale. Since 1989 not much has changed in this respect. Not only is Poland still massively dependent on supplies of hydrocarbons from Russia or, formerly, from the USSR, but actually this dependence has been increasing for the past 20 years. As a result, Poland is not a full-fledged participant in the international oil and gas market. Moreover, the internal gas market is monopolistic and remains under direct state control not only in terms of distribution and trade, but also with respect to oil and gas service industry.
The existing state monopoly covers the whole value chain of exploration and production of hydrocarbons; the law and regulations only petrify this state of affairs. For instance, the tax levied on production of well-explored and easily accessible conventional hydrocarbons remains at the level of corporate tax (CIT) which amounts to 19% plus 1%–2% in the form of other charges. Furthermore, in 2004, when oil and gas prices were soaring dramatically, CIT was reduced by 8%, without exempting the production of hydrocarbons. In conjunction with the previously mentioned dependence on the gas supplies from Russia, this led to a situation in which Poland pays considerably more for gas from Russia than other European states; ironically, the imported gas supplies are transmitted through Poland. As for cheap gas production in Poland, it is used to subsidize the gas price on the internal market, through tariffs determined by regulatory bodies. Due to this mechanism, and against the background of current gas prices, Poland pays Russia through the nose, overpaying by as much as 3 billion USD a year.
In the face of estimated giant deposits of shale gas in Poland, numerous private enterprises acquired exploration licenses between 2007 and 2011. Another encouraging factor was the fact that this was a cheap and simple process, even though already back then it should have provoked some second thoughts. Corruption and related phenomena were by no means rare. Low taxation of the extracted hydrocarbons was presented as a good thing; this gave the impression that representatives of private companies entering Poland were not aware that such low taxation was only possible against the backdrop of the state monopoly and the few small companies operating on the market. In the event of large-scale shale gas production, amounting to, say, 20–30 billion cubic meters a year, this situation would have been socially and politically unacceptable. Surely, it would have been perceived by the public as a robbery of the state. Hence, the very low taxation, instead of encouraging exploration works, considerably increased the above-ground risks, a fact which many private companies did not realize.
Upon deciding to begin exploration of shale gas in Poland, many companies believed that Poland’s dependence on gas supplies from Russia was a positive thing for business as it meant that Poland would want to become independent. But this assessment was only seemingly rational, supported by appropriate declarations by the politicians of governing parties and main opposition parties. However, it escaped their attention that the level of declarations—or rather pure rhetoric based on slogans preaching detrimental consequences of dependence and the need to become independent—is one thing, whereas real actions aiming at achieving this are something else. In reality—and in contradiction to those slogans—everything Poland did in the field of gas exploration and production during the last 20 years actually reinforced the dependence on gas supplies from Russia. Another and an undeniably complex question is if this was an unintentional result of bad decisions, or a consequence of deliberate actions.
As a result of the dependence of PGNiG (Polish Oil & Gas Company) on gas supplies from Russia, marked by inflated prices and subject to long-term agreements, any potential large-scale gas production by private entities would threaten not only the position but also the very existence of the state monopoly. This picture of generally high above-ground risks is complemented by the lack of experience and know-how of Polish authorities in the field of managing large-scale projects dealing with the exploration and production of natural resources by private entities in a competitive market. As an ambassador of a large European state that is a large-scale gas producer noted, the Polish authorities have increased the above-ground risks to hydrocarbon exploration and production sector investment opportunities to such a degree that the combined risk in this field in Poland actually exceeds that of Arctic exploration and production investment.
The oil and gas sector in Poland still functions in accordance with the rules of real-socialism. With the government not implementing any thorough reforms, there are no rational premises to believe that the country could, in a relatively short time, become an important producer of shale gas. Even if the deposits really prove to be giant and easy to extract technically, the internal determinants will keep hindering its development. Despite this, in mid-2011 we could still hear many voices claiming that exploration and production of hydrocarbons was very promising. For instance, The Economist announced: “Other Europeans fear fracking. Poland is steaming ahead”] (“Fracking heaven,” http:// www.economist.com/node/18867861?story_ id=18867861&fsrc=rss). Not only was this a poor assessment; the article also expressed an opinion which led the authorities to complacency.
Companies which obtained licenses for shale gas exploration in Poland must have believed that they would be able to convince the government to introduce legal and regulatory changes that could enable large-scale exploration. Some of them— notably, the bigger ones—were actually certain that they would enforce the changes through efficient lobbying. So as to credibly estimate the potential of the deposits, over 200 wells were required, and in fact 10 wells per each one of the over 100 licenses. So far however, after a half- decade long period of exploration, only 40 wells have been performed, whereas cases of fracking horizontal wells can be counted on one hand.
Against the rhetoric of building a second Norway and instead of reforming the oil and gas sector so as to enable private companies to operate on a large scale, Poland’s authorities created a sort of “resource nationalism.” In practice, this eliminated opportunities for private companies to operate under competitive rules. As early as in mid-2010 one could see that Poland did not take any steps in the direction of “the second Norway;” rather, it chose the direction of a “second Turkmenistan.” The reason is that despite the fact that the previously mentioned above-ground risks do not constitute any business barrier for private companies—because in fact it is the controlling owner—i.e. the state, which is accountable for those risks and their effects; for private companies higher aboveground risks act as a blockade for investments as it is the management boards who are responsible for risk assessment.
It is precisely the scale of above-ground risks which has brought about the current passivity of private companies in the field of exploration activities. For the time being, some of those companies are attempting to do away with this deadlock through dialogue with the authorities. But the authorities do not understand how to manage the risks related with hydrocarbons exploration or… maybe the current standstill is simply beneficial for them. Regardless, the declarations and the reality do not tally up. Surely, this situation is good for the state-held monopoly PGNiG as it eliminates any possible competition, at the same time maintaining the system which is a relic of the previous epoch of real-socialism. The dialogue between the government and private enterprises is consequently fruitless and only results in mutual frustration. Hence, shale gas exploration in Poland—in reality not even commenced yet—is already entering a state of decline.
All facts considered, it seems that the very structure of the gas sector, from exploration and production to distribution, trade and the service industry, remain unchanged: It is still marked by the dominant position of the state monopoly PGNiG and by dependence on gas supplies from Russia with considerably inflated prices. And there will be no change in this respect if in a couple of years one of Poland’s state companies begins to produce shale gas, with the use of 10 or 20 wells. This will surely be deemed a success, but in fact it will be a tiny rate of production, we could say, nominal, with no real strategic and commercial meaning for the country as a whole.
The Quieter You Go, the Further You Reach
In other European states, business and regulatory conditions for hydrocarbon exploration are quite similar to those in Poland, with the exception of Norway, Great Britain, the Netherlands and maybe Denmark. Moreover, the gas market in those states is still far from flexible—and in Central-Eastern Europe almost closed down and based on local monopolies or national champions. The latter are companies with dominant positions that are not inclined to facilitate access to their “own” markets. At the earliest, shale gas production can be expected in Europe in those countries which are able to minimize aboveground risks.
Russia is the first contender. Firstly, current circumstances force it to fight to keep its share in European markets; the present state of conventional gas production indicates that we are bound to face production deficiencies in comparison to export obligations. Secondly, shale gas deposits in Russia are estimated to make up half of all deposits globally. Thirdly, the transmission infrastructure constructed with a view to exploit conventional gas deposits has been in place for a long time and can also be used to transmit shale gas. This considerably lowers marginal costs. Fourthly, the formal and legal limitations, including those relating to environmental regulations, are subject to arbitrary decisions by authorities. Fifthly, there is little likelihood that private companies owning shale gas production technology would like to wage a price war of attrition on the European market, competing with gas producers from Russia; the potential results of a conflict like this can be observed on the American market. Therefore, both parties will be inclined to cooperate. The first signs of this cooperation are the agreements concluded by Rosneft with ExxonMobil, ENI and Statoil. If we add up shale oil reserves in the area of Western Siberia, amounting to around 300 billion barrels, which is comparable with the deposits in Saudi Arabia or in Venezuela, Russia seems to be quite an attractive partner for private companies. As its current market position is under peril, a fact indicated by the events unfolding over the previous year, most probably it will be inclined to begin cooperation with private enterprises that have shale hydrocarbon production technology. However, Russia cannot speak too loudly about those plans, even though this is no mystery to the industry, because this would introduce a note of discord to the anti-shale propaganda spread in Europe.
In the future, within the next 10-20 years, as a result of the development of shale gas production in Russia, Middle-Eastern European states like Poland may also become shale gas producers. This is a business logic observable in other parts of the world, for instance in Western Africa; this applies to Nigeria and countries with fewer reserves. Accordingly, production is initially developed in the most attractive state in the region, to be later commenced also in the neighboring, less attractive states. Therefore, one day Poland may become a shale gas producer as a result of its proximity to Russia. These are the dynamics of the current situation in the field of shale gas exploration in Poland, as well as the development of private companies in Russia.
As far as the production of shale gas in Europe is concerned, France is the second contender. It would hardly be a surprise if their currently binding ban on fracking was to be abolished. This would demand some action on the part of the French government, aimed at reaching an agreement between the nuclear and gas industries; those include preparing a development program for gas production which would not threaten the position of the nuclear industry. Shale gas exploration and production sector may create an immense number of jobs so one may expect that given the current economic situation, the government may be favorably inclined towards the production of shale gas. Besides, it is hard to imagine Paris just watching while Total is lagging behind the competition. If shale gas was to be extracted in France, surely this process would take the form of a national program, under close control of the government and similar to the development of the high-speed railway or, precisely, the nuclear program. Given the efficiency of the state when it comes to the implementation of national projects, one should expect success, though not without some twists and turns.
The third contender to become a shale gas producer in Europe is the United Kingdom. Its depleting reserves of conventional gas, along with the high dependence of the British population on energy from gas has created strong incentives to expand the exploration and production of shale gas; especially considering that the reserves of the latter are estimated to be considerable. Furthermore, decades of experience gained in exploring and extracting hydrocarbons, both in the field of licensing, as well as of development of the service sector, indicate that if the UK commences exploration of shale gas within the country it will be quite a dynamic undertaking, and it will be subject to competitive rules similar to those which governed the production of hydrocarbons in the North Sea. Here the sole important obstacle, as of now, is the hardly predictable level of public approval, resulting for instance from anxiety about environmental risks.
The United Kingdom, but also Norway, has one more option when it comes to the production of unconventional gas, namely offshore reserves. This may come as a surprise but in fact the first unconventional hydrocarbons in Europe could also come from the North Sea or the Norwegian Sea. Should this scenario prove true, it will not be the effect of any special developments like drilling new unconventional wells offshore—those being too costly—but rather, of further development of the current conventional deposits which can be found on the areas of unconventional reserves. In other words, this will be a step ahead for the so called “enhanced recovery,” or the tertiary recovery from new stratigraphic zones, and with the use of the existing wells for conventional reserves. Oil production will be more attractive, and yet natural gas may prove attractive as well; decisions for individual projects will be made on a case-by-case basis. The geological knowledge of deposits in the North Sea and in the Norwegian Sea is immense; the necessary infrastructure is in place, already capitalized and it is also necessary to take into consideration the vast experience and pragmatism on the part of the British and Norwegian authorities. All this considered, this utterly unrealistic vision is actually gaining probability, as most of the above-ground risks have been minimized. Yet, one should not expect much publicity over this issue.
Ukraine, like Poland, lacks experience in the field of exploration and production of natural resources by private enterprises on competitive terms. Another huge challenge is transparency. Moreover, Ukraine—even more than Poland— is held hostage by monopolistic relations on the local gas market. The resulting above-ground risks are very high, so one could speculate that private companies currently entering the Ukrainian market, are in a similar or even worse situation than when they were entering the Polish market several years ago. The chances for Ukraine to become an important shale gas producer within the next decade are slim; still, one must not exclude it. And the state of affairs in other Central-Eastern European states is almost analogical.
The conclusion we can draw from the last five years of the “shale gas rush” in Poland is the following: Instead of focusing on the scale of deposits, we should build a system which minimizes the above-ground risks through regulatory and fiscal solutions, as well as creates conditions favorable for the development of a competitive service sector. For Central-Eastern Europe it requires getting rid of the remnants of the real-socialism within the oil and gas industry. Technological and technical challenges will be dealt with by the private companies on their own. And a hundred years of recent history of the oil and gas industry is the best—and indeed spectacular— evidence for it.
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