Petroleum Economics and Oil Field Management - Coursework Example

PETROLEUM ECONOMIC AND OIL FIELD MANAGEMENT by Petroleum Economics and Oilfield Management How the structure of the natural gas industry can develop into a ‘natural monopoly’. What problems arise from this? A natural monopoly can be defined as an industry that is efficient for a single firm to dominate production and selling of a particular product or service. The structure of natural gas industry can develop into a natural monopoly in various ways natural gas is a form of energy that plays an essential role in every country’s economy. Because of the promises that the natural gas industry holds, governments in Asia, Europe and America have introduced reforms to promote efficiency and attract private investment to the natural gas industries. However, these regulations are not enough to prevent the industry from developing into a natural monopoly because it is entirely a new industry (Baumol, 1977). Secondly, the natural gas industry requires a firm that has financial muscle to produce the natural gas because it is an expensive venture. Such a firm will have excessive power to dominate control, and regulation initiatives even from governments especially if it is a multinational company. The natural gas industry mainly operates through pipeline transportation and distribution aspects, which are naturally monopolistic because they are characterized by high fixed costs and long lead time making duplication uneconomical. This creates a wide barrier to entry for potential participants and competitors. They also require price and non-price regulation. Without effective regulation, the natural gas industry can develop into a natural monopoly. In fact, price regulations sometimes fail to control the prices because such prices depend on various factors such as production costs, inflation and transportation costs among others (DiLorenzo, 1996:45). In situations where governments run the natural gas industry, the industry turns to state monopoly such as in Mexico. The Mexican government introduced a program of reform in 1988. However, it was until 1995 that reform in natural gas industry began to include private companies. However, before this, state owned firms controlled the industry making it a monopoly. In fact, even after the entrance of private firms state owned firms still ruled the market making it a state monopoly (Joskow, 2007:1227). The graph below shows the natural gas as a natural monopoly Q1 represents entire size of the market. Point E1 is the equilibrium that cooresponds to quantity at Q1 and determines the price at P1. Thus, when there is one firm only producing natural gas, the marginal cost of supply is P1 and is lower than the duopoly price P2. Thus, the presence of one firm in the market will be price efficient compared to two firms. Problems If the natural gas industry becomes a monopoly, it presents several problems. First, natural gas is a utility which is a necessity of life for instance in cooking. Therefore, when firms charge monopoly prices, the public will suffer because of the application of marginal revenue equal marginal cost (MR=MC) pricing that is high than a free market pricing. If the natural gas industry becomes a monopoly, consumers will suffer through dead way loss because firms will take advantage of them because they have no alternative. In fact, the public utilities commissions, for instance those at the state-level in U.S will have no power to ensure that the firms stay in business without enjoying monopoly profits. In addition, firms in such a monopoly will be difficult to regulate because they will use the ‘rate case’ on a utility commission to ensure that the commission passes it. In such a scenario, the utility commission becomes unhelpful and the firms become over-capitalized in the market. Graph showing dead way loss In a natural monopoly, there will be no competition, which means that innovation and efficiency will be lacking in production and use of natural gas. In a natural monopoly, for instance the natural gas industry, the public utility commission could allow firms to earn a certain amount of money and any extra be returned to the public. While this is good for the public, it will prevent innovation and efficiency because it will not be beneficial for the firms (Davis & Muehlegger, 2010:791). Another problem posed by a natural monopoly in the natural gas industry is the X-inefficiency that indicates the internal wastes occurring in a natural gas producing firm. This is because, such as firm does not face any pressure from any other firm to keep its costs at the most competitive minimum. This issue presents another problem that could affect consumers because inefficiencies within can lead to loses that may lead to reduced production or even closure of the firm leaving the market without the most precious good, in this circumstance, natural gas. In addition, a firm operating as a natural monopoly in the natural gas industry could fail to effect cost reduction measures that exist in a competitive market because the firm understands that the profits made are not shortlived and thus can mismanage funds without concern. Such wastage is not good for the society. Shale Gas: Role and Influence in the Global Natural Gas Market Shale gas is a by-product of natural gas, mainly found trapped within existing shale formations. These formations are often rich in both natural gas and petroleum. Through hydraulic fracturing and horizontal drilling, Man has been able to access large volumes of the gas. Both natural gas and oil do fundamentally influence lives in varying countless ways. As earlier aforementioned, this natural resource is found in only a few state-entities. An increment in the overall growth of shale gas can ultimately change both the politics and economics of the prevailing natural gas market. As influenced by spread trading, the differences present, between various benchmark prices can also influence the role of natural gas. In the event of a great increase in market prices for crude oil, natural gas may become a viable substitute. Politically, this provides an avenue through which such entities may hold advantage over other states lacking the product. This may be useful in gaining political advantages by way of foreign policy enactments, which can be essential in elevating the stature of a given nation over others (Berg & Tschirhart, 1988). Issues here can include the presence of forward market techniques, where agreed upon prices can become altered, thereby increasing the risks of gas prices changing before the delivery date. As an over-the-counter market, contracts designed with the aim of suiting the needs of all parties involved can become affected. Also affected, would be futures markets, where standardized forward contracts, are traded on various organized exchange platforms. As derivatives, these usually cover any existing financial instruments, which are valued according to other assets attached. Therefore the monthly delivery dates may become affected as a result, as increased shale gas volumes would necessitate changes in terms of delivery, pricing and volumes required. This may be influenced by the possible nationalization or government regulation of the natural gas sector. This is achievable through the political influence on the rights of exploration and drilling (concession rights), which are granted (Mouawad, 2009). The loyalties accrued by the selling nations can have both political and economic impacts as prices are mostly set on transfer prices mechanisms. This may translate to lesser natural gas being sold on an intra-firm basis, by way of transfer prices. In turn, commercial/ market-based transactions will increase, especially amongst independent players/ parties. Long-term contracts can become nullified, or in the case of valued allies, extended over longer-durations of time. Shale gas can also be priced upon the specific inequities, which are more favorable to some entities than to others present. Thus, shale gas increased output will bring about a relief to global markets (EIA, 2013). Increased shale gas production would erase the ability of existing global firms to set minimum domestic prices of the commodity, at levels favorable to their recovery of costs accrued. This would be because of a global reduction of overall pricing rates for natural gas. Economically, the high level of interdependence, between the limited producers of the gas, would provide a case scenario of increased levels of uncertainty. On the one hand, there would be global reduction in pricing, though this may be dependent on prevailing contexts in the host nations. Conversely, such nation may increase their pricing to the minimal levels as set by the existing competitor-firms. This may result in collusion between some or all producers, in an attempt to eliminate the resulting uncertainty. Through dominance, with regard to the manipulation of transfer prices, the entities affected would have to rethink their strategy. An increase of shale gas production would lead to more tax revenues to the host nations. This would provide them with both financial and regional capacity. Oil pricing would become affected, necessitating an overall reduction (Mouawad, 2009). In the economic effect would be a gradual reduction in taxes and levies gained from oil and natural gas sales, due to the fall in global market prices. The royalties and taxes paid, especially to the producing state entities would even out, after a balance is struck between the different fossil fuel output rates. This would further either reduce or enhance the powers of oil producing firms, depending on their sector of operations. Conclusion From the analysis above, if the natural gas industry grows into a natural monopoly, producers would inevitably have a weaker share, in terms of their aim of greater control on how oil resources were utilized. An increase in volume share of shale gas would make market prices of oil and natural gas fall, as competition would stiffen. What is clear is that there would be an overall reduction of prices, with regard to oil and natural gas prices, as provided for by the influence on concerned firms’ demand and price curves. Reference List Baumol, W. J. (1977). On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry. American Economic Review, 67, 809-22. Berg, S. & Tschirhart, J. (1988). Natural Monopoly Regulation: Principles and Practices. Cambridge University Press. Davis, L. W., & Muehlegger, E. (2010). Do Americans consume too little natural gas? An empirical test of marginal cost pricing. The RAND Journal of Economics, 41(4), 791-810. DiLorenzo, T. J. (1996). The myth of natural monopoly. The Review of Austrian Economics, 9(2), 43-58. EIA. (2013, April 15). Market Trends – Natural Gas [Industrial and Electric Power sectors lead U.S. Growth in Natural Gas Consumption]. U.S. Energy Information Administration – Independent Statistics & Analysis. Retrieved from: http://www.eia.gov/forecasts/aeo/MT_naturalgas.cfm Hyne, N. J. (1991). Dictionary of petroleum exploration, drilling & production. PennWell Books. Joskow, P. L. (2007). Regulation of natural monopoly. Handbook of law and economics, 2, 1227-1348. Mouawad, J. (2009, June 17). Estimate Places Natural Gas Reserves 35% Higher. The New York Times [Energy & Environment]. Retrieved from: http://www.nytimes.com/2009/06/18/business/energy-environment/18gas.html?_r=0 Appendixes Figure 1 The Oil market Evolution: As provided in 4-phase timeframes Read More