Finding Energy to Beat a Recession

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As a global economic recession looms, the medium-term development prospects for the world's energy sector will change substantially. Fifteen years of rapid growth, and the assumption that it would continue, led us to expect a corresponding increase in the demand for energy. This, in turn, led to the appearance of numerous extremely ambitious energy-related projects. Now, however, is the time for careful spending.

The stock market's record fall in September suggests that the impending global financial crisis is not just some kind of bad dream, but the new reality. With globalization, it is clear that the next few years will be painful for both the world economy as a whole, and for the energy industry -- one of its most important sectors -- in particular.

On the one hand, a global recession will inevitably lead to if not a decrease in the size of the world energy market, then at least a slower rate of growth in energy consumption. With a number of economically developed countries slipping into recession against a backdrop of high energy prices, the demand for oil and gas is already decreasing. Declines in production and incomes combined with increased unemployment and the other ills that accompany a recession reduce people's spending power and demand for energy. Consumers have no choice but to tighten their belts.

The rate of growth in electricity consumption, which is highly dependent on economic growth rates, could suffer the most. This process will be aggravated as a number of the largest energy-consuming countries make the transition to post-industrial economies, with significantly higher portions of their gross national product generated by the service sector. Energy consumption in these countries is already declining, and the severe financial conditions will further constrain their economies.

Serious changes in supply are inescapable as well. The global liquidity crunch is making borrowing more costly. This limits energy companies' access to the loan capital that serves as the basis for practically all of their large-scale projects. It will be especially painful for energy suppliers in developing countries. These countries control most of the planet's hydrocarbon resources, yet their economies are less immune to fluctuations on the world's financial markets. Russia is no exception: The international credit market is already practically closed to Russia's largest borrowers, and the cost of loans on the domestic market has doubled.

The natural reaction for energy companies in such conditions is to cut back on investment. A host of Russian companies have already announced cutbacks, and we can expect most of the world's energy-producing companies to follow suit by the end of the year. Who needs mega-projects in a period of decreasing demand? Who will be willing to finance these projects? The crisis has forced banks to re-examine their exposure to risk and to employ greater scrutiny in lending. Companies will have to be more responsible in selecting priority projects, favoring modernization to increase efficiency and, ideally, scope, but not the development of entirely new mega-projects.

As a result, energy companies will have to control expenses in order to survive. There has been an explosive growth in costs over the last two years, with expenses doubling in upstream operations, and as much as tripling in the electric power sector. The sharp increase in capital costs for projects -- metals, equipment, land, services and workers' salaries, which are especially high in post-industrial societies -- has radically changed the economics of energy-sector projects. Given these rising costs, only fantastically high growth in energy supply and prices allowed them to stay afloat. Nonetheless, a number of major oil and gas companies were already reporting in mid-summer that runaway expenses were eating into their margins, despite record incomes. If expenses can't be reined in, companies will not be able to survive. Companies must therefore devote all of their managerial energy and know-how to cutting expenses.

The amazing variety of ambitious projects that sprang up around the world on the wave of general economic euphoria are now doomed to undergo drastic cuts. At the start of 2008, it seemed possible to connect any two points on the globe with oil pipelines, and plans for high-priced nuclear power plants were sprouting like mushrooms after the rain. For the last two years, the catchphrase had been: "With prices this high, any project is cost effective."

But every drinking binge is followed by a hangover. It is difficult to imagine who would risk financing the enormous Nabucco project or run a pipeline from Alaska to Russia during a financial crisis. Completion dates for most projects will have to be pushed back. The postponement of major investments and project delays will lead to a reduction in global energy supply. Overall, this is not tragic -- a new balance will be found, only at lower levels of production and consumption. This is actually beneficial because it will generate a sort of natural selection to find the most cost-effective projects. Companies seemed simply to forget about cost criteria in recent years, apparently caught up in the boom market hysteria. But this kind of financial restructuring is almost inevitable after the long and even unprecedented economic growth that began in the early 1990s.

A growing number of the world's economies can already be described as post-industrial. Russia and Brazil are already moving in that direction. The high expense of hiring qualified personnel has forced companies to relocate their energy hungry and material-intensive production facilities to developing countries. And the inevitable depletion of energy resources -- despite technological and administrative progress -- leads naturally to higher prices. Wealthier countries with high standards of living can afford to buy high-priced energy, including "green" alternative energy sources, since their demand tends to stabilize over time. There is no longer a need to force the development of large-scale projects or to build colossal production capacity. The time has come to learn how to make the optimal use of and to perfect what we already have. The world will hit an energy consumption plateau in the next five to seven years. Following that leveling out will come another period of growth, but before that happens, we will have to deal with the baggage of the past.

Tatyana Mitrova is the director of the Energy Research Institute of the Russian Academy of Sciences