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A practitioner's perspective on modeling prices and trade in a globalizing natural gas market.

Article Excerpt
1. INTRODUCTION

In its September 2007 Report 23, Prices and Trade in a Globalizing Natural Gas Market, the Stanford Energy Modeling Forum (EMF) has once again pursued a challenging agenda seeking to combine leading edge thinking on economic theory with practical application in order to provide insights that actually improve both energy policy and corporate strategic decisions. As the executive representing Suez Energy North America,1 Inc. in the study group, the emphasis on getting from theory to practical insight was paramount. GDF Suez, after all, is a company with large positions within the LNG value chain for whom such insights are critical to strategic success. At the same time, industry practitioners must recognize that sound theory is an essential pre-requisite for practical success.

The purpose of this paper is to advance some principles for practical application of energy models that were used during EMF 23. These principles, which are arguably more philosophical than technical in their nature, include an unbending decision-focused perspective, recognizing and embracing uncertainty, fact-based rather than subjective, able to navigate the complexity of systems, and unequivocally recognizing the important distinction between insight and unattainable precision. Models grounded in these principles have in fact been applied in the energy industry and the best of them have been systematically successful in helping companies make better decisions. The principles offered here are designed to foster the assistance of better decision making by models and modelers.

It is said that economics is the science of negative feedback. (2) Prices always adjust to equate supply and demand. Quantities and capacity additions adjust in the face of prices. Proper market modeling and interpretation must always represent the negative feedback in markets. Although there may be positive feedback and amplification for some period of time, and protracted positive feedback often catalyzes overconfidence in models and results, over the medium and long-term there is significant negative feedback in economic systems. Markets tend to undermine the apparent stability of extrapolated trends. How many analysts in the month of July 2008 said that oil and gas prices were never going to drop from $140/BBL and $13/MMBtu because the forwards were up in the stratosphere and avowed energy experts were singing dirges about the limits of resource availability? Many--and while a few may have dissented from the conventional wisdom, the majority did not. Less than three months later in October 2008 oil and gas prices have declined dramatically to levels predicted by models with negative feedback.

The most recent experience on Wall Street, characterized by the severe impairment in the value of securitized debt portfolios far exceeding anything that the models for these securities anticipated, has sparked further commentary on the failure of models. (3) However, the more thoughtful commentary on the subject seems to have recognized that the present difficulties have not so much been a failure of models but rather a failure of thought. Models provide useful insights but do not provide a substitute for thought and must always be applied with careful attention to their limitations. The illusion of precision that from a practical, fact-based perspective was not realistic was arguably a significant cause of model failure. The amplification of model risk through errors that are compounding rather than diversifying--always an issue in navigating the complexity of systems--was another significant cause.

There are perhaps useful lessons that energy modelers can learn from having observed the Wall Street experience even though the models that "failed" were not energy models per se. Brief summaries of each of the five aforementioned modeling principles and how they apply to prices and trade in a globalizing natural gas market follow. (4)

2. DECISION FOCUS

Several market trends relevant to future company and government infrastructure investment decisions were highlighted by the study, which consequently turned it into much more than just an "academic" exercise. Of most interest from a practitioner's perspective were those trends on which the several models included in the study came to a consensus. One important example of this is the conclusion that by 2020, given the geographical configuration of the world natural gas resource base, LNG imports will capture a greater percentage market share in North America than in Europe. (5) Along with this comes the related conclusion that North American delivered gas prices will be...

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