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Shale and Beyond: The Next Phase of Latin American Energy Integration

Tuesday, March 5, 2013

The past two decades have brought dramatic swings in the pace and extent of Latin American natural gas and electricity integration. Enthusiasm among the region’s investors and governments has waxed and waned as the economic and political drivers of cross-border investment and cooperation have evolved. Recent technological developments that have unlocked shale gas resources in the United States will be extended to Latin America. At the same time, renewed political momentum for regional economic cooperation and trade also extends to the energy sector. As a result, a new phase of regional energy integration is gathering pace, but it will be very distinct from what was seen two decades ago.

1990s Euphoria

The 1990s saw a surge of energy integration in Latin America as the region’s economies stabilized after the tumultuous 1980s. Greater economic openness and liberalization across the continent facilitated a wave of investment in power transmission lines and natural gas pipelines that steadily linked the region’s substantial energy resources with its growing demand.

Prior to the mid-1990s, the Yabog pipeline, built in the early 1970s between Bolivia and Argentina, was the only international natural gas pipeline in South America. Between 1997 and 1999, seven additional natural gas pipelines were built across the Andes to connect Argentina’s natural gas reserves with resource-poor Chile. Their combined 1.16 billion cubic feet (Bcf) per day capacity supplied methanol facilities in the far south and brought natural gas to more than 35 percent of Chile’s power generation by 2003. During the same period, the InterAndes power plant was built in northern Argentina to supply electricity to northern Chile -- a competitive alternative to exporting natural gas by first converting it to electricity.

The massive Bolivia-to-Brazil natural gas pipeline Gasbol was also completed in 1999, stretching nearly 2,000 miles from Bolivia’s newly proven natural gas reserves to Sao Paulo, Rio de Janeiro and ultimately southern Brazil. The pipeline’s 1 Bcf per day capacity was more than double Brazil’s total natural gas demand at the time it was completed, and roughly 10 times Bolivia’s market size. Smaller pipelines were also completed during the period, such as the Parana-Uruguaiana pipeline, completed in 2000, which provided Argentine gas to a power plant in southern Brazil, and the Cruz del Sur pipeline, completed in 2002, which connected Argentina with Uruguay.

Further proposals were put forth, including extending the Cruz del Sur pipeline to Brazil and reversing flows through the Yabog pipeline to allow Argentine gas to reach Brazil via the Gasbol pipeline. All told, the various projects aimed to link Peru, Bolivia, Brazil, Chile, Argentina, Paraguay and Uruguay, thereby creating a “Southern Cone gas ring” to connect the region’s growing natural gas markets.

The integration of electricity transmission grids also expanded during this period. A 1-gigawatt (GW) direct-current intertie was built between southern Brazil and Argentina in 1999 and then doubled to 2-GW capacity in 2002. The interconnection allowed Brazil access to Argentina’s thermal power capacity during dry months or periods of drought, and allowed Argentina access to Brazil’s cheap hydropower production during the summer wet season, when Buenos Aires’ demand is highest. Argentina-Uruguay and Brazil-Uruguay transmission links were also built, albeit on a much smaller scale, to protect Uruguay’s hydropower-dominated system against the risk of drought.

To the north, natural gas pipeline capacity between the United States and Mexico nearly tripled in the late-1990s, reaching 2.4 bcf per day in 2002. The strengthening natural gas trade contrasted with limited power-sector integration, however, as the two countries’ power grids shared only a few small interties. The main exception was Baja California, which was isolated from the Mexican system and instead fully synchronized with the western U.S. power market.

Central America also embarked on ambitious plans to consolidate the region’s six national power systems. Creating a single market roughly equal to Chile in volume of demand and physical dimensions would better position the region to develop its hydropower potential and support the construction of a natural gas pipeline from Mexico or Colombia. The SIEPAC treaty, signed in 1999, established the regulatory and operational guidelines for managing the new regional system, and international investors lined up to build the new transmission infrastructure that would form the backbone of the system.

Millennial Hangover

The energy integration euphoria of the late-1990s and early 2000s faded in the decade that followed as economic liberalization gave way to more protective and less investment-friendly policies in many countries. Argentina’s 2001 peso crisis halted new investment in energy supply and infrastructure, even as subsidized prices supported a boom in energy demand. The resulting imbalances ultimately led Argentina to cut off natural gas exports to Chile in 2004, forcing its neighbor into an energy crisis of its own.

Political turmoil in Bolivia, culminating in Evo Morales’ 2006 election as president, resulted in the progressive nationalization of the natural gas and electricity industries in that country. The subsequent fall in upstream investment halted the country’s growth in natural gas reserves. This put an end to Gasbol’s planned expansion as well as to proposed natural-gas fired power plants on the Bolivia-Brazil border that would have served western Brazil.

Plans for a Southern Cone gas ring also faded as the investment climate soured and both Bolivia and Argentina’s ability to honor supply agreements was called into question. Instead, the region turned increasingly to global markets. In the latter half of the first decade of the 2000s, Brazil, Argentina and Chile all built liquefied natural gas (LNG) regasification terminals to meet their growing natural gas needs. Peru’s LNG liquefaction project, the first in South America, was completed in 2010, allowing Peruvian gas to reach Mexico and the United States rather than its immediate neighbors.

To the north, Mexico built three new LNG receiving terminals as pipeline imports from the United States became increasingly expensive and uncertain. Indeed, the United States began its own LNG program, with more than 50 receiving terminals proposed or under construction. Mexico’s proposed pipeline to Central America was meanwhile scrapped, as the country had difficulty keeping pace with its own natural gas demand growth. At the same time, although the planned Central American power transmission line was eventually built more than a decade after the SIEPAC treaty was signed, the expected regulatory and operational integration remains elusive. Cross-border power trade in 2011 represented less than 1 percent of total Central American demand.

Trinidad’s LNG export capacity expanded significantly to serve growing U.S. demand, but Venezuela’s proposed projects remained moribund. Instead, in 2005, Venezuelan President Hugo Chavez proposed a Great Pipeline of the South that would stretch up to 9,000 miles from Venezuela’s coast to Sao Paulo and Buenos Aires. The project never moved beyond discussions, although a small pipeline linking Colombia and Venezuela was completed, allowing Colombian natural gas to supply western Venezuela’s oil production facilities. The pipeline was expected to reverse flows once Venezuela’s oil and associated gas production increased to reach state targets, but has yet to do so as Venezuela’s oil production continues to face challenges.

Signs of a New Transition

The environment for regional energy integration is now shifting once again. The United States’ shale gas boom has turned expectations for regional LNG flows on its head. The U.S. now has the potential to be a major natural gas exporter, rather than the major gas importer it was expected to be in the mid-2000s. Sizeable shale gas potential in Mexico, Argentina and Brazil, as well as expected growth in natural gas production from Brazil’s offshore pre-salt discoveries, has the potential to work similar transformations. A renewed interest in economic and energy sector liberalization, most notably in Mexico, is also raising investor interest.

Thus it would appear that the prospects for further regional energy integration in Latin America are now at an intriguing crossroads. Recent technological and economic trends suggest there is now less of an impetus for substantial integration. New production from shale gas reserves in Argentina, Brazil and Mexico, and new discoveries of traditional reserves in Brazil, Uruguay and, potentially, Paraguay, can increasingly make these countries self-sufficient in natural gas. This “democratization of natural gas supply,” combined with growing environmental concerns about the development of large-scale hydro projects, removes much of the economic incentive for power integration, as the widespread availability of natural gas across the region removes a major source of long-term electricity price differences across countries. Local gas plants can also backstop hydro units in case of drought, removing the need for hydro-dominated systems to link with neighbors with greater thermal capacity, since countries can now just build their own. Not building major hydro projects also means fewer projects that require cross-border linkages to justify their construction.

The major exception to this trend is Central America and the Caribbean, where natural gas is still not widely available. Expanding natural gas supply and the growing disconnect between natural gas and oil product prices will steadily increase the pressure to build the infrastructure to bring natural gas to the region.

At the same time as these trends work against further energy integration, economic integration is gaining political support. The recent ratification of free trade agreements between the United States and Colombia and Panama, the creation of the Trans-Pacific Partnership proposal and the pending expansion of the Panama Canal are all reviving interest in regional economic linkages. Brazil is reorienting toward the region with significant investment in its neighbors, including new transportation corridors from Brazil to the Pacific. This in turn is leading to growing coordination among the “reverse J-curve” countries of Colombia, Peru, Chile, Argentina and Uruguay to balance Brazil’s economic and political influence. Ecuador and Bolivia are likely to continue their current domestic energy policies, but there is a growing sense that Venezuela and Argentina are ripe for change as their current policies increasingly fall short of their voters’ expectations.

This renewed interest in regional trade also spills over into energy integration. Regional energy analysts are increasingly focused on hemispheric energy issues, particularly the potential for North American energy independence. The evolution of this balance between shifting physical and economic needs for integration and the political support or perceived benefit that it may bring will ultimately determine Latin America’s future energy path.

As Latin America enters this latest phase of energy integration, the lessons learned from the experience of the past two decades can offer insights on the likely path ahead.

Lessons Learned

Energy integration is often driven by complementary structural differences in the physical characteristics of adjacent energy markets. Differences in supply availability and cost, peak demand timing or seasonality, and energy prices can help justify the cost and operational complexity of integrating across international borders. Politics also plays an important role, however, from the local issues surrounding the location of new power projects to national and international geopolitical considerations. Latin America’s experience over the past two decades provides four main insights into how each of these factors may influence future integration.

First, clear physical and economic rationales can overcome political opposition. Across the continent, major cross-border infrastructure projects have enabled stranded natural gas reserves and hydropower potential to be exploited and have expanded electrification and natural gas supply to isolated communities regardless of international borders. A clear economic imperative can help overcome the political difficulties that inevitably arise, in part by generating benefits that can be shared among various constituencies. In contrast, projects that do not have a clear economic benefit to all parties involved are more likely to face delays or fail to reach completion. For example, delays in building Central America’s SIEPAC transmission line caused each country to build new generation capacity to meet its own needs. This in turn removed the immediate pressure to complete the project. In addition, many of the new power plants would likely be uneconomical in the event of further integration, and so they now represent a group of constituents against integration.

Second, regulatory arbitrage can also drive projects. For example, Mexico’s Baja California became a major destination for power investment and was the location for an LNG regasification terminal and natural gas pipeline precisely because it was close to California without being subject to California’s environmental regulations. Project developers favored Baja California for its simpler permitting process and relatively limited local opposition to energy infrastructure projects.

Third, supply and demand imbalances that drive integration are rarely permanent. In many examples, the supply and demand imbalances that originally prompted regional integration evolved in unexpected ways after a project was completed. Argentina’s rapid shift from natural gas exporter to importer illustrates how falling upstream investment can erase expected supply. New discoveries or enabling technologies such as the shale gas revolution can also make energy supplies available from entirely new geographies, making long-distance integration of infrastructure redundant. This is the case in the United States, for example, as LNG receiving terminals that were built over the past decade to cope with a growing gas shortage are now unnecessary. Instead, project developers are now seeking to replace them with LNG liquefaction capacity to facilitate the export of a growing natural gas surplus.

Finally, the flexibility to choose among multiple options is valuable, indeed critical, to long-term success, given the potential for dramatic changes in the physical, economic and political underpinnings of any energy infrastructure project. Energy integration brings together energy providers and energy consumers. The more options and potential partners there are on each side of the transaction, the more robust the connection will be. Direct physical linkages, such as natural gas pipelines and power transmission lines, can be vulnerable to disruption, as they are fixed between specific partners, while LNG infrastructure, for both liquefaction and gasification, can connect any number of parties. Even so, pipelines and transmission lines can reverse flows should the market balance shift among the partners; LNG infrastructure is not as flexible, being dedicated to either import or export, and so is more vulnerable to major shifts in the host country’s supply and demand balance.

Future Prospects

For much of the region, the physical requirements for integration are waning, leaving political drivers as the main force for new integration. As such, massive new infrastructure projects to create regional power or natural gas grids are unlikely in the coming decade. Instead, existing energy links will be deepened through stronger institutions and greater coordination. Plans for new infrastructure will focus on specific opportunities that clearly justify the investment, such as linking isolated hydropower potential to the market or bringing natural gas to Central America and the Caribbean. For example, Brazil is exploring new hydropower projects in eastern Peru and developing wind projects in Uruguay. Chile’s main transmission projects are all domestic, including a 1,000-mile link between Santiago and large hydro projects in the far south, and connecting its own central and northern grids.

Even so, political interest is growing to promote an integrated power grid within the reverse J-curve coalition of Colombia, Peru and Chile, with the potential to expand to include Argentina and Uruguay. The proposal is designed in part to counter Brazil’s growing influence in the region, and so is tied to other regional trade and cooperation proposals. The economic rationale for a fully integrated power market along the western side of the Andes is not clear, however, given the distances, the limited demand and lack of a clear cost driver. This suggests that progress may be slow or limited to specific cross-border projects.

In natural gas markets, more flexible arrangements like LNG, where there is ocean access and sufficient scale, and compressed natural gas (CNG) for smaller-scale markets are also more likely to move forward than major cross-border pipelines. In Central America’s case, introducing natural gas could help revive the region’s stalled integration process, while small-scale CNG projects could finally bring natural gas to the small island nations of the Caribbean after decades of failed proposals.

The major exception to this trend toward flexibility is the future development of U.S.-Mexico natural gas pipelines. Up to 3 Bcf per day of new cross-border capacity has already been proposed, with many projects traversing routes that were originally planned to facilitate the re-export of LNG arriving at Mexican receiving terminals but ultimately destined for the United States. Mexico’s growing power demand, its desire to shift power generation away from residual fuel oil to cleaner natural gas and its close economic ties with the United States all support greater cross-border gas trade.

One risk to the proposed plans is Mexico’s own shale gas reserves. Estimated to be nearly 700 trillion cubic feet, their development would disrupt natural gas imports from the United States. Today, Mexico is focusing scarce state resources to meet the challenge of maintaining oil production. If Mexico liberalizes its hydrocarbon upstream sector, as President Enrique Pena Nieto has suggested, greater access to international capital and expertise could rapidly increase Mexican natural gas production. In that event, the stage would be set for yet another shift in the economic and political underpinnings of regional energy integration.

The past two decades have demonstrated how quickly the physical, economic and political drivers for energy integration can change. Today’s expectations for the path forward are no different. Concerns regarding the environmental effects of shale gas production could curtail its development in one or more countries, putting some integration projects at risk and supporting others as the regional natural gas supply equation shifts. Economic growth also remains fragile; a new crisis would slow energy demand growth and potentially derail support for trade liberalization. A final unknown includes climate change policies and whether they will treat natural gas as a beneficial, low-carbon transition fuel, or as a dangerous distraction, giving a false sense of security while making zero-carbon energy development more difficult.

In this state of uncertainty, flexibility and an adaptive approach -- whether to executing a project, developing corporate strategy or designing country policies -- can provide the best defense against future change. Continuously testing biases and assumptions to ensure they still hold true can give early warning of shifting conditions, providing time to adjust to the new landscape even as it unfolds.

Jed Bailey is managing partner of Energy Narrative, a research and consulting group focused on Latin America's energy sector based in Cambridge, Mass. His research has been widely quoted in publications ranging from the Economist and Financial Times to the Iran Daily, and he has appeared on Bloomberg Television and CNN International.

Photo: Pipeline in Mexico (photo by Flickr user grauliflower licensed under the Creative Commons Attribution-ShareAlike 2.0 Generic license).