Energy's New 'Great Game'

Energy security has leaped to the top of many investors' minds because of ongoing geopolitical and economic trends. It's a bit like a modern-day version of the 19th century Great Game, when Czarist Russia and the British Empire fought for control and influence in Persia and Central Asia. In the New Great Game, the European Union, Russia, Central Asia, and the Middle East are locked in a high-stakes dance over energy supplies, with the U.S. and China—the two biggest actors of all—jumping in when it suits their needs.

The first and most obvious result of this titanic struggle is a growing wave of energy mergers and acquisitions, both in the U.S. and around the world. The industry has already seen significant consolidation via domestic mergers and cross-border strategic investments. Now, nations are widening their reach. Royal Dutch Shell (RDSA) and PetroChina (SNP) recently announced they would acquire Australian oil and gas exploration company Arrow Energy in a $3.2 billion cash deal. China's Sinopec (SHI) paid $4.65 billion for a 9 percent stake in Syncrude Canada. And MacArthur Coal (MACDF) of Australia reengaged a bid by American coal mining company Peabody Energy (BTU).

China, as the world's second-largest oil consumer, recently overtook the U.S. as the largest buyer of Saudi oil, and its state-backed ventures are aggressively courting targets in Africa, the Middle East, Australasia, and the Americas. American demand for crude oil and petroleum products will average 18.84 million barrels a day this year, while Chinese demand for refined products is projected to jump to 9.12 millions barrels a day, according to figures from the U.S. Energy Dept. and the International Energy Agency. In response to Chinese activity, the Indian government recently set up a state-backed energy consortium with an eye to making strategic acquisitions of overseas energy assets.

What are the geopolitical—and implicitly economic—factors driving these trends?

Turning the Screw

A resurgent Russia is one factor. In a vivid demonstration of the importance of energy security, Russia has in recent years effectively used the threat of switching on and off the natural gas spigot to extract economic concessions from other countries. The targets of Russia's ploy were not just Ukraine and Belarus, both of which sit within its traditional sphere of influence, but also Western Europe.

The recent installation of a more pro-Moscow government in Kyrgyzstan is yet another example of Russian strategic resurgence. Though Kyrgyzstan shares no direct border with Russia proper, it is geographically critical if Russia seeks to exert control in the Fergana Valley, the economic and demographic heart of Central Asia that spans Kyrgyzstan, Uzbekistan, and Tajikistan.

Events surrounding Iran are another factor. Sitting atop the world's second-largest oil and natural gas reserves, Iran exercises significant leverage on the international energy scene. Iran also has an extensive intelligence apparatus—further accentuating its power—with a presence in Iraq (another major energy producer) and in such Gulf states as Oman and Bahrain. Yemen, located at the intersection of the Red Sea and the Gulf of Aden, accuses Iran of arming and supporting the Houthi Shia rebels who battled the government in north Yemen.

The Keystone of Turkey

Iran also exercises sway over events in Afghanistan—which remains a geographically important country in the Eurasian energy arc—and is assiduously trying to make inroads into Azerbaijan. In the past, Iran has used the delivery of natural gas to its Western neighbor Turkey as a pressure point. The destabilization of Iran through a reckless unilateral or international approach could jeopardize energy routes and create economic turmoil, raising the possibility of a "double dip" recession. The price of oil has already topped $80 a barrel and could easily spike back up to the highs of a few years ago. The result would be serious blow to business and consumer confidence.

As a direct consequence of these developments, Western European countries are trying to cultivate alternate energy conduits to reduce their exposure to Iran and get around potential Russian choke holds. The construction of the Ceyhan pipeline across Turkey—and the commensurate growth of Turkey's role as an energy hub and regional power—has provided a template for Western Europe as it seeks to ensure access to energy supplies from landlocked Central Asia. The Ceyhan pipeline now brings crude oil from the Caspian Sea across Azerbaijan and Georgia into Turkey and is set up to become a natural gas route from Northern Iraq as well. The rise of Turkey will help soften Iranian influence and designs in the Gulf, the Caucasus, and Central Asia, while also providing Western Europe relief from reliance on Russian sources.

The Nabucco natural gas pipeline project is another major step toward diversifying Europe's energy supplies and rivals the South Stream project pushed by Russia's Gazprom (OGZPY). Nabucco aims to link Eurasian natural gas to Europe through a pipeline running from Turkey to Austria. Expected to be operational by 2015, Nabucco will carry more than 30 billion cubic meters of natural gas per year, enough to meet a sizable chunk of Europe's energy needs. The U.S. and the European Union both consider the Nabucco project crucial to maintaining a peaceful regional balance in the Eurasian sphere.

Renewable Alternatives

Another step many countries have taken is to invest considerably in renewable energy sources as a viable future alternative to oil and natural gas. Germany and Denmark have both built an impressive regulatory and legal framework for wind energy. Unlike oil or natural gas, however, many renewable forms of energy require a great deal of up-front investment, as the issue is not simply the production of the energy but also building a distribution network to allow the use of diffuse power away from the source site.

Turkey, looking to diversify its current dependence on Iranian natural gas, is considering up to $20 billion worth of investment in the renewable energy field over the next few years, according to Turkish Energy Minister Taner Yildiz. In addition to investing in wind energy, the use of more efficient hydroelectric turbines can generate more energy from existing Turkish dams. In Northern Europe, Finland just granted permits for the construction of two new nuclear reactors, as the Nordic country attempts to wean itself off energy imports from historic rival Russia.

President Obama's Nuclear Energy Security summit a few weeks ago in Washington was really driven by concerns about energy security and the changing sands of the geopolitical landscape. Obama surprised many by announcing plans to start drilling for oil and natural gas in the Atlantic Ocean and Gulf of Mexico, though the recent BP (BP) oil spill in the Gulf may throw those plans into jeopardy. Federal approval was also recently granted for America's first offshore wind farm near Cape Cod. The President had been expected to defer bold energy initiatives in order to concentrate on health-care and financial reform; the fact that he shifted focus underscores the urgency and importance of energy at this time.

Saudi Diversification

Even oil and natural-gas rich Saudi Arabia recently announced the establishment of the King Abdullah Nuclear and Renewable Energy City in Riyadh. Sensing the shifting balance of pipeline diplomacy, the Saudis have wisely invested a tremendous amount of money in education and infrastructure in a bid to diversify away from their traditional reliance on oil and natural gas exports. Highlighting the Kingdom's economic liberalization moves—and a clear sign of Saudi Arabia's coming of age as an investment target—private equity company the Carlyle Group recently bought 30 percent of Saudi Arabia's largest lighting fixture manufacturer, the General Lighting Company.

All players are exploring the technological edge that LNG (liquefied natural gas) brings to the table, allowing easier and more cost-effective shipment from areas where pipelines don't currently reach, such as Qatar, which sits atop the third-largest natural gas reserves in the world after Russia and Iran, or Abu Dhabi, which has sizable natural gas reserves.

Given all these factors, it's safe to assume that the recent takeover and consolidation wave in the energy business will only continue. The New Great Game is well under way.