africa

Yale Center for the Study of Globalization
24.3.1 Investment uncertainty: local geology and global market conditions
One way of thinking about how this uncertainty impacts on the scale and timing of
investment in the natural gas sector is through the lens of option theory.
In the spirit of Dixit and Pindyck (1994), three features of the anticipated investment
are relevant. The first is that investment in natural gas is at least partially irreversible
and highly sector specific. Second, the profitability of the (irreversible) investment
decision is a function of uncertainty about the future evolution of prices, costs, taxation,
and even government policy. Third, when the final investment decision is under the
control of the investor—in the sense that property rights over the resource find are
secure—there may be a benefit to delaying the investment pending the resolution
of (some of) the uncertainty. These factors combine to generate an option value to
waiting. The option costs the investor a forgone return in the short run—and possibly
the loss of first-mover advantages in the sector—but it conveys benefits by offering
the flexibility to choose a time to invest as uncertainty resolves itself.
Enormous uncertainty surrounds both the cost and the revenue sides of natural
gas development in the Indian Ocean. On the cost side, deep-water offshore fields
are very costly to run. Relative to more favorable locations, three main factors are
relevant. The first stems from geology. The Indian Ocean fields currently under
exploration are in waters that are up to 150 kilometers offshore and 1,500 - 3,000
meters below sea level, in a seabed that is mountainous. They are individually
quite small and widely scattered within the exploration blocks, so that the capital
costs of linking well-heads to pipelines are high. The second factor is a reflection
of the changing global market conditions, which have seen construction costs in
LNG rising very sharply as supply conditions tighten (Songhurst, 2014). Given the
highly specialized nature of the industry, the prospects for a sharp reduction in these
costs are limited. The third element is security costs, which are unusually high in
the Indian Ocean.
There are arguably bigger concerns on the revenue or price side. The viability of
the project and the rents accruing to government will depend hugely on the state
of the world gas market in a decade’s time. In one important respect, the prospects
are very favorable. It is estimated that global demand for natural gas will increase
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