Estimating the economic price of gas

The calculation of the real cost of resources often referred to as the "economic price" or "shadow price" is not an easy or unambiguous task. The task becomes even more difficult if the resource is exhaustible. The natural gas of Bangladesh is one such exhaustible resource. Besides its exhaustible nature, its proven reserve enough to carry us no more than 15 to 20 years makes the policy makers and academics wonder alike about the real worth of this resource. Recently, there has been an attempt by Professor Wahiduddin Mahmud to estimate the shadow price or economic price of natural gas in Bangladesh in the context of its sale price to a foreign company -- Tata -- proposing to make a huge investment in Bangladesh.

Professor Mahmud estimates the current price of natural gas to be around 5 to 6 US dollar per mcf. He assumes this price to be a medium to long run price of natural gas. He then assumes that the present proven reserve of natural gas will be exhausted in ten years' time. Then applying an assumed social discount rate of 8%, he calculates the current economic price of natural gas to be 2.78 U.S. dollar per mcf. Mahmud mentions that by assuming an extended exhaustion period of 5 and 10 years will reduce its economic price to $1.86 and $1.28 respectively.

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But the difficulty with Mahmud's estimate of economic price of natural gas is that it does not take into account the exhaustible nature of the natural gas (other than the assumption that its reserve will be over in ten years' time). So this estimate of economic price is not a suitable measure to evaluate, particularly, the long-term project like that of Tata involving long run supply of natural gas at a fixed price. The standard definition of the economic price of a resource is its opportunity cost.

Now, the "opportunity cost" may be either the replacement cost of the resource itself or the productivity foregone. According to Mahmud, our country will need to spend currently $6 to replace one mcf of natural gas (Mahmud's own calculations show that a price of $6 per mcf of natural gas is equal to the cost of importing equivalent amount of crude oil at a price of $35-40 per barrel). By implication it means that we can also sell our natural gas for similar price (Mahmud himself cites the example of China and India planning to import natural gas from our neighbouring Myanmar at a price of $5 per mcf). If it is so, how can we conceive an economic price of natural gas to be less than $6 per mcf? If it is, however, argued that the natural gas is not a freely and easily traded commodity and so we can not sell it presently at a price equal to its import price, then its economic price should be the one at which we can export it. If the export price of natural gas is taken as its economic price, then we will be able to avoid the possible error arising out of the two vital assumptions made by Mahmud. The assumptions of the constancy of crude oil price in the long run and the "exhaustion period" of the national reserve of natural gas in Bangladesh are both debatable and, hence, controversial.

Now, how do we get the export price of natural gas of Bangladesh. Although, currently we are not exporting natural gas to any foreign country, we are nevertheless engaged in international transaction of our natural gas. The IOCs engaged in gas exploration in Bangladesh sell their share of production to us at an international price. According to the terms and conditions of the PSCs, if we are not ready to buy the natural gas at a price set by the IOCs, we should let them export it abroad. We can reasonably assume that these IOCs will not sell their share of natural gas to other countries at a price below what they charge their Bangladeshi client. So we can take this price of natural gas we pay to the IOCs as the export price of our natural gas. This is because we can arguably assume that Bangladesh can easily sell her own share of natural gas at a similar price less a small premium for the pipe-line transmission and marketing costs.

Currently, our export price of natural gas can, therefore, be assumed to be $2.34 per mcf (the price we pay to the IOCs to buy their share of natural gas in Bangladesh). So we can take this as the economic price of our natural gas and use it as a measure to determine the current use of natural gas. But even this price does not reflect the real cost of our resource when we enter into long-term supply contract.

We know that the natural gas is a depletable resource -- the more we use it for current consumption the less will be available for future use. Consequently the price of such resource will increase as the existing stock of the resource dwindles over time.

But what should be the rate of price increase for natural gas? The answer, which was discovered by the American economist Harold Hotelling, tells as that under perfect competition, the price of a depletable resource with unchanged extraction cost must rise at the market rate of interest.

Therefore, the economic price of natural gas should provide for incorporation of such price increase resulting from the depletable nature of the resource. Besides, foreign companies -- like Tata -- making direct investments normally seek long-term contract for the supply of natural gas at a fixed price. Suppose, a 20-year contract for the supply of natural gas is sought. One way to incorporate the annual price increase in the economic price of natural gas is to have the current "export price" appreciated at an annual compound rate of interest for the entire contract period.

Thus, using a current export price of $2.34 and an annual interest rate of 8% (using Mahmud's social discount rate) and assuming a 20-year contract period, the economic price of natural gas works out to be the average of the current year and end-year prices which is $6.62 per mcf. This is also interestingly close to the long-term replacement equivalent costs ($6 per mcf) for natural gas estimated by Mahmud. We can see that this estimate of economic price of natural gas is based on far more solid assumptions about the real opportunity cost of the resource. It does not involve any 'certain' assumption about the uncertain long-term supply price of imported fuel oil nor does it require any controversial prediction about the exhaustion-period of the national gas reserve. Mahmud himself admits that his estimate of economic price of natural gas is very sensitive to these assumptions.

Hence, we should use two economic prices for our natural gas. The current "export price" of natural gas should be used for making decisions about its current use while the "inflated" export price should be used for long term supply contract at a fixed price. It may, however, be mentioned here that the "economic price" is not the actual transaction cost or market price of a resource. It is the "imputed price" of a resource and it is used as a tool to determine the real cost-benefit of any actual transaction involving the concerned resource. Any actual transaction of a resource at a price below its economic price indicates the magnitude of excess cost of the project transaction. Whether the policy-makers decide in favour or against such project transaction should depend on the carefully evaluated benefits vis-à-vis the costs.

The author is a Professor and ex-Chairman of Department of Economics at the University of Chittagong.