The Problems of Cross-Border Pipelines

The number of successful cross-border oil and gas pipelines, exemplified by those in North America and Western Europe, outweigh the problem pipelines, but the problem cases nonetheless have tended to have a disproportionate effect on project planning. And cross-border pipelines have a long history, especially where transit is involved, of vulnerability to disruption and conflict. The conflicts that have affected cross-border pipelines have taken many forms. There is a widespread view that conflicts over pipelines, including those due to incompatible legal and regulatory regimes, arise because of politics. Some conflicts undeniably have been political, including those that have grown out of a legacy of political divisions. For example, some of the problems of the Iraq Petroleum Company (IPC) line through Syria arose because of ideological differences between the two factions of the Arab Ba’ath Party. Attempts to build a gas pipeline from Iran to India have stalled on long-standing disputes between India and Pakistan. More recently, plans to run a gas export pipeline from Bolivia to the Chilean coast have fallen foul of a dispute from the 19-th century, when Chile annexed part of Bolivia, preventing Bolivian access to the Pacific. Instead a longer, higher risk route through Peru to the coast is being considered. These are clear examples of political conflicts, but many conflicts are based on economic issues, ranging from failure to agree on the terms of transit and on profit and rent sharing to issues regarding the obsolescing bargain. The histories of the Iraqi export lines and Tap line are littered with such disputes. Economic-based conflicts also can include squabbles between joint venture partners, reflecting the differences between public and private companies or between vertically integrated companies and standalone ventures. Should a receiving or transit country also be an oil or gas exporter there is the further danger that it may seek to reduce throughput to capture market share for itself. In general, such disputes and conflicts can be explained in the following way. All cross-border pipelines have their own characteristics, each of which may be associated with certain consequences. Together, these consequences may combine to produce one or more of three results liable to generate dispute and conflict, as follows: Different parties with different interests are involved in the pipeline project. There is no overarching legal jurisdiction to police and regulate activities and contracts. The projects attract profit and rent to be shared between the various parties. The potential for conflict that is implicit in these results can have serious implications for the producers and consumers of oil and gas at both ends of the line. The purpose of this report is to seek ways to prevent, mitigate, or contain such conflict and the disruption that it causes. The report focuses especially on how the various players can contribute to this process, examining in particular the respective roles of the public and the private sector. It also seeks, through the examination of existing pipeline projects, to define industry best practices. Pipeline economics have five main characteristics: economies of scale; the long life of specific projects; state involvement; the pipeline’s place within a longer value chain; and finally the pipeline’s susceptibility to market failure.

Economies of Scale

The capacity of a pipeline is the square of its radius. This is an exponential factor that presents potentially large technical economies of scale. The capital cost of the pipeline is a function of its surface area; its throughput is a function of the capacity. This exponential relationship means as capacity increases, average fixed costs fall rapidly. There are no obvious diseconomies of scale. In the world of pipeline economics, big is beautiful. This simple fact of physics gives rise to a number of characteristics:

- Pipelines involve large upfront investments. Costs vary depending on the terrain: mountainous rough territory normally costs far more than flat open territory.

- The structure of pipeline costs is characterized by high fixed costs and low variable costs. Other than from specific maintenance, the only significant variable cost is for the fuel to the pump, and often this is provided at concessional rates. The greater part of total costs — all of which are fixed — go to the laying of the pipeline and construction of the pumping stations. Thus, total costs are largely independent of the throughput.

- Pipelines are natural monopolies. It is clearly more economic in terms of unit transport costs to have one pipeline of 36 inches than three of 12 inches. Once the pipeline is built it is difficult to increase capacity, and the potential economies of scale are effectively used up. A monopolist supplier of pipeline services, equating marginal costs and marginal revenues, in theory would build a below-optimum-capacity line to restrict supply and to secure elements of monopoly profit. These characteristics give rise to a number of consequences that are key to understanding why pipelines may attract conflict:

- High fixed costs mean the “bygones rule” is extremely powerful. That is, if an operation is profitable it will continue: even if losses are incurred, provided that variable costs are covered and some contribution is being made to fixed costs, continued operation and (its loss minimizing consequences) is preferred to closure. Assuming economic rationality on the part of the owners, this means that they will continue to operate the pipeline for as long as there is any revenue to be gained. The result is a strong temptation for governments to take advantage of the obsolescing bargain, and in turn the creation of an imperative that the pipeline operators achieve a quick payback. Because of high fixed costs, full capacity operation is extremely important. Below-capacity operation spreads fixed costs exponentially around a lower throughput, and this can seriously damage the pipeline’s profitability. For a 20-inch (51mm) pipeline, unit costs virtually double at 50 percent capacity. In the early stages of operation, a line probably will operate at less than full capacity. This gives the pipeline owner an incentive to secure more throughput. The best way to ensure full-capacity operation typically is for the pipeline owner to produce the oil or gas at one end and to lift at the other. Ownership of the throughput is a better guarantee than contracted throughput, since contracts can be broken. As a consequence, pipelines frequently are part of a vertically integrated operation.

- Because of the natural monopoly dimension to pipelines, regulation is necessary to protect consumers. This is either to protect consumers of monopolistic pipeline services or consumers of products flowing through monopolistic pipelines. Such regulation may relate to the building of the line, in terms of determining capacity, or to the operation of the line once built. It also should address either third-party access or common carriage, to ensure that other parties have access to use of the pipeline. However, regulated access can carry important implications for financing pipelines. Where political risk is high, financing is likely to be heavily dependent on upstream producer equity and equity holders are almost certain to demand (and get) preferential access as the price for investing. Thus governments face the choice of being tough on regulated access and inhibiting investment in both the pipeline and the upstream.