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Национальный исследовательский университет -

Высшая школа экономики

Международный Институт Экономики и Финансов

ВЫПУСКНАЯ КВАЛИФИКАЦИОННАЯ РАБОТА

на тему: Valuation of the bypass projects: Case of the Baltic Pipeline System-2

Студент 4 курса

Дорошева Ирина

Научный руководитель

Дементьев Андрей Викторович

МОСКВА, 2014 год.

Abstract

In 2012 the construction of BPS-II was finished and Vladimir Putin celebrated the firs oil ton launched via the BPS-II. This project was aimed to bypass the parts of oil pipeline “Druzhba”, passing through the territory of Ukraine and Belarus. Since the later were considered to be unreliable transit partners after the observation of the opportunistic behavior.

Thus in the framework of the research we can definitely state that bypass construction is not motivated by direct market incentives (i.e. expansion of capacities for the increase in consumption from demand side), but the assurance of the political risks, risks of opportunistic behavior and prevention of the sabotage from the transit side. Certainly, independence of the supply side solves the problem of the possible hold-up, arranged by transit side. But would such independence at such cost increase the welfare of the exporting side? Answer to this question is the objective of this research paper.

In order to answer the following question one should value the investment project of BPS-II and then apply the cost benefit analyses. But if we apply standard future cash flows framework we would definitely end up with negative Net Present Value, since the extension of the transport capacities was not determined by the demand increase, and extension of the capacities would not result in the additional profits. Still that does not necessarily mean that the decision of BPS-II construction was irrational. This paper introduces the real option analyses of the binomial form: several options arise from the imperfect information about the possibility of the credible threat construction from the supply side and from the possibility of the sabotage from the transit side.

The model proposed would be maximally adapted to the case described. Thus it would also account for the quantity of oil supplied to the CIS transit partner at a subsidized price. The later would also be the variable of decision of the export side.

Introduction

oil export transport europe

Russia is at the first place of oil reserves. The main supplier of oil and gas in the Western Europe. Approximately 20% of exported oil goes to Germany and Poland, which resulted in the billion dollars of export oil revenue for Russian producers. In order to supply energy resources to the final consumers, Russian side has to communicate with the transit side such as Belarus and Ukraine.

During the past decade there arouse several serious disputes between the producing side and the transit side of oil business the last dispute in 2006 resulted in the complete stop of supply of oil in Western direction because of the case of the sabotage from the side of Belarus. As a result, Belarus was considered an unreliable transit partner, who broke the commitment and is likely to be involved in sabotage one more time, unless the Russian side formed a credible threat to make its partner to keep the commitment in the future. Such a threat is a bypass pipeline construction, i.e. expansion of the existing capacities in a way that the oil supply side would be completely independent of the external transit agents. The expansion had to be realized through construction of Baltic Pipeline System-II.

The Baltic Pipeline system-II project presupposed the construction of the sea port Ust-Luga, the pipeline from the station Unecha in the Bryansk region to Ust-Luga - the seaport on the coast of the Baltic Sea. The decision of constructing a bypass oil pipeline was taken by Vladimir Putin in 2006 after the issue of the sabotage of the Belarusian transit partners.

BRS-II is a controversial project because

· Firstly, it is a very ambitious and thus costly project, while it does not lead to the market expansion and the profit increase

· Secondly, there are concerns about the incentives of such an ambitious and expensive project.

Concerns arise from the fact that BPS-II is a bypass project, it creates the excess capacities in the Western direction. Combined with the fact that the transport of oil in Russia is a natural monopoly - the overinvestment is not the case of entry deterrence, but case of assurance of risks of the sabotage of the transit partners. This fact also implies that the irreversible investments are not market driven, the project of expending capacities is not fully rational in future cash flows terms. There arises the issue that the overinvestment is not justified, and the decision is taken because such a project gives rise to the bribery opportunities.

This paper is intended to evaluate the infrastructure investment in the strategic terms: namely, the change in distribution of the rent that arises from construction of the credible threat, also the change in distribution of the negotiation power between the transit side, the supplier side - the upstream and the downstream firms.

The analysis would be constructed as a 2 stage sequential game with perfect information.

· The suppliers' side possesses a first mover advantage in decision of irreversible sunk specific investment in construction of the bypass pipeline and outcomes of adopting the following strategies is analyzed. Suppliers' side implements one of two options and after the decision on this option is made the transit side determines its strategy

- Transit side also has two options: to arrange the sabotage, namely expropriate all the rent from the German market or not, still the transit side knows that in the result of the sabotage would damage their welfare if and only if the bypass is constructed.

In this paper I would start with the case description of the Baltic Pipeline System -II construction. From this case I would extract the players, identify which variable is determined by each of the player and then proceed to the analytical model which will result in the upper bound of the investment.

Case description

The place of Russia in the oil export market

Following United States and Saud Arabia, Russian Federation took the third place in liquid fuels production in 2012 with the average of 10.4 million bbl/d during the year. As reported by the Oil and Gas Journal, oil reserves as at 1 January 2013 uncounted 80 billion barrels of crude oil.

In 2012, Russia produced an estimated 9.9 million bbl/d of crude oil, consuming roughly 3.2 million bbl/d. Russia exported over 7 million bbl/d of total liquids in 2012, including roughly 5 million bbl/d of crude oil and the remainder in products. The major demand (79%) for Russia's crude oil exports came from European countries (including Eastern Europe), particularly Germany, Netherlands, and Poland (See Figure 1.). Still there is a Pacific direction of the crude oil export from Russia: around 18% of Russia's crude oil exports were destined for Asia (China, Japan), while the remainder went mostly to the Americas. Still the later might be considered as secondary markets in terms of the volumes supplied.

Figure 1. Source: www.eia.gov

From Figure 1 it is obvious that the Germany, Netherlands, Poland and Belarus are the biggest oil markets for the Russian companies. The following research would be concentrated on examination of the downstream market - oil pipeline transport concentrating on the oil transport infrastructure in the western direction.

Infrastructure of the pipeline oil transport

Although in Russian Federation there are several options of oil transport (seaborne, railway etc.), the most common is transport through pipeline system. Each year more than 80% of the all the volumes of crude oil produced in Russia is transported via pipeline system of Transneft plc. The later is the state-owned public company holding a natural monopoly right to transport oil and oil products on the territory of Russia. Moreover, being the natural monopoly on the oil transport market sequentially it occurs to have monopolistic rights not only on exploiting the existing pipeline system, but also on the construction of the new pipelines.

Referring to the market of the research interest, namely oil markets of Germany, Poland and Belarus, more than 80% I transported by pipelines, namely the transit system «Druzba pipeline», Baltic Pipeline System-I and Baltic Pipeline System-II. The latter two provide the pipeline transport only to the Baltic ports.



Figure 2. Source: customsonline.ru

The demand of Europe for crude oil

Germany and Poland are dependent on the import of crude oil (the graph of oil consumption and oil net export) with very few energy reserves, Highly dependent on the external energy supplies Poland and Germany are interested in the secure channels of distribution and can bargain for the decision od the bypass construction lie the case of the Nord Stream (joint venture of Russia, Germany and France).

Although the market power of the Russian oil companies in the oil European market is much less than in the gas market. Thus the construction of the bypass was solely motivated by the fear of loosing of the German and Poland market. (the percentage of the oil export to Germany and Poland graph 2006 - 2012)



Figure 3. Source: iea.gov

Pipelines

In the territory of Russia, numerous pipelines integrated in the network serve for supplies of crude oil and oil products to domestic and export markets. The vast majority of pipelines are owned by the state-controlled open joint stock company Transneft. It implements the transportation of about 88% of all crude oil and about 27% of oil products produced in Russia.

One pipelines constituting the network were designed and suitable for domestic supplies, another - to transport crude oil and oil products to export terminals (e.g. Novorossiysk on the Black Sea, Primorsk on the Baltic Sea), third - to supply them to Western Europe. The latter group consists of, inter alia, Druzhba, Baltic Pipeline System, North-West Pipeline System, Tengiz-Novorossiysk, and Baku-Novorossiysk. Transneft is an owner of all of them except the Tengiz-Novorossiysk.

Two of the pipeline networks - Druzhba and Baltic Pipeline System II - may meet Western Europe's demands for oil. The first one carries crude oil and oil products from Russia to Germany, Poland, Belarus and some other states through the territory of Belarus that makes the latter external transit agent operating the Belarusian part of this pipeline through OJSC Gomeltransneft Druzhba. Current capacity of the Druzhba pipeline is 66,5 million tons of oil per year.

The second pipeline - Baltic Pipeline System II - is a result of the 2007 dispute between Russia and Belarus regarding oil transit through the territory of the latter. A construction of it was authorized by a Government Decree dated December 1, 2008 № 1754-r on designing and construction of second stage of Baltic Pipeline System (BPS-II). The main feature of BPS-II is that it is located only in the territory of Russia running from the Unecha junction of the Druzhba pipeline to the Ust-Luga terminal on the Gulf on England, i.e. it serves for supplies of oil to Western Europe bypassing Belarus directly to the final consumers in Europe. Initial capacity of BPS-II is 10 million tons of oil per year with subsequent upgrade up to 50 million tons during the second stage.

Pipeline	Route	Length (miles)	Capacity (million bbl/d)
Current pipelines
Druzhba	Northern Route: Belarus, Poland Germany; Southern Route: Belarus, Ukraine, Slovakia, Czech Republic, Hungary	2400	2
Baltic Pipeline System 1	Timan Pechora to Primorsk Terminal	730	1.5
Baltic Pipeline System 2	Unecha to Ust-Luga Terminal	620	1
Caspian Pipeline Consortium (CPC)	Tengiz (Kazakhstan) to Russian Black Sea port of Novorossiysk	940	0.7
Baku-Novorossiysk Pipeline	Sangachal Terminal (Azerbaijan) to Russian Black Sea port of Novorossiysk	830	0.1
Eastern Siberia-Pacific Ocean (ESPO) Pipeline	Taishet-Skovorodino-Kozmino Bay (with a 60-mile spur running from Skovorodino to Daqing in China)	270	0.6
Purpe-Samotlor Pipeline	Oil fields in the Yamal-Nenets and Ob Basin (including Vankor field) to the ESPO Pipeline	266	0.5
Proposed pipeline
Zapolyarye-Purpe Pipeline	Oil fields in the Zapolyarye region and new fields in Yamal-Nenets region to the ESPO and Purpe-Samotlor Pipelines	310	0.9
Source: Source: Transneft, IHS, PFC Energy, Petroleum Economist
Figure 4

Figure 5

The oil transit system through the territory of Belarus

· The transit tariff

· The export tax for the energy resources

· The subsidy on the oil consumed by the Belarus

Origin of a 2007 dispute

Belarus's conduct in the relations regarding the oil transit through its territory may be characterized as opportunistic.

Since 1992 when the Free Trade Agreement between Russia and Belarus was signed the main feature of oil transit through Belarus was the absence of export duties for crude oil supplying for domestic needs of Belarus (as it is provided by Art.1(1) of the mentioned agreement). This privilege made Belarus able to resell Russian crude oil to Europe depriving Russian budget of substantial part of assets. Yet, this preferential regime provided by Russia presupposed at the same time that Belarussian party would share the revenues gained by such a reselling.

As it was stated by a deputy of the minister of economic development and trade Belarus virtually stopped to share the revenues in 1998 and subsequently unilaterally cancelled a contract mandating Belarus to share the revenues from reselling of oil imported from Russia http://www.rg.ru/2007/01/10/neft-konflikt.html.

Such a conduct of Belarusian party resulted in a revision of the initial decision to provide the preferences related to the oil consumed by Belarus. Therefore, on December 8, 2006 Russia extended common regulation of the oil export on Russia-Belarus relations - the oil supplying to Belarus had become a subject of collection of the export tax for energy resources. In other words, in the course of Belarus's abusive conduct Russia cancelled a privilege containing in the 1992 Free Trade Agreement.

According to new export tax adjustment each ton of oil sold to Belarus was a subject to export tax in the amount of 180$. It certainly harmed Belarussian industries and decrease government revenues.

Imposition of tariff and duty adjustment by Belarus and Russia's reciprocal measures in January 2007

Given high dependence on the subsidies on the oil exporting to Belarus for domestic consumption, the withdrawing of the latters could make uncompetitive Belarusian industries even more inefficient. In the course of prevention of that negative effect of Russia's export tax adjustment on January 1, 2007 Belarus imposed a reciprocal import duty (so called “transit tariff”) of 45$ per ton of Russian oil that crossed its territory (the decision on the imposition of this duty was announced on January 3, 2007.

According to the position of Russian officials, the latter duty was nothing more than a sanction rather than economically reasonable, justifiable and equitable duty. http://www.rg.ru/2007/01/10/neft-konflikt.html Furthermore, the WTO customs practice confirmed inadmissibility of the imposition of such a duty. Ibidem. To be fair the legal nature of the imposed duty is questionable. It is not stricto sensu an import duty since the duty imposed by Belarus is not aimed at the protection of internal producers from foreign competitors. It is not also a transit payment because the formed practice of the collections of transit tariffs had been already established by the agreement between Transneft and Belarussian party to the contract. http://www.rg.ru/2007/01/10/neft-konflikt.html; http://ria.ru/analytics/20070115/59083507.html This made a tax burden for Russian oil producers excessive and oil export through Belarus unprofitable.

Considering the Belarusian tariff adjustment unlawful, on January 8, 2007 Russia shut off crude oil supplies through the pipelines located in Belarus. It was also argued by the fact that Belarus was allegedly extracting 79 000 tons of crude oil intended for European states. This measure forced Belarusian party to initiate the negotiations.

The settlement agreement

As a result of the negotiations on the oil export, on January 12, 2007, Russia and Belarus signed an agreement on measures on settlement of commercial and economic cooperation in the sphere of oil export.

At the very beginning the parties of the agreement admits that Russia's imposition of export duty is lawful and regulated by the mentioned agreement. The agreement sets the size of the export duty collecting by Russia while supplying crude oil to Belarus. Coefficient of this duty was 0,293 in 2007, 0,335 - in 2008, 0,356 - in 2009 (basic amount of the duty - 180 $ per ton). Hence, the size of the export duty collecting by Russia in 2007 was about 53 $ per ton. Therefore, based on the present size of export duty on oil in Russia, income of the state budget from the supplies to Belarus will be 1,08 billion USD this year. Theoretically speaking, Russian might receive from Belarus 3,6-3,7 billion USD from the oil export. So the compensation comes to no more than 1/3 of this sum.

Finally, in Art.3 Belarus made a commitment that in case of supplying crude oil and oil products from the territory of Belarus to the third states it shall apply the export duties as they are established in Russian legislation. Otherwise Russia may apply full export duties on oil transporting from Russia to Belarus.

This agreement under which Russia had agreed to decrease the size of the export duty is essentially an arrangement of the sharing of revenues based on the 1992 Free Trade Agreement which had been present until 2001 when Belarus unilaterally cancelled the respective contract.

The January 2010 oil dispute

It should be noted that Russia-Belarus intergovernmental agreement signed in January 2007 was terminal and should expire in the end of 2009. In the end of 2009 Russia asked Belarus to pay full export duty (i.e. 180 $ per ton) for the supplies excessing the limits for Belarusian domestic consumption (which in turn were free-of-charge). The request to conclude a new agreement containing this terms was dismissed by Belarus. It argued that under the 1995 Agreement on Customs Union between Russian Federation and Republic of Belarus such an export duty would be unlawful.

On January 1, 2010 Russia unilaterally stated that full export duty was now applying while free-of-charge exports for domestic consumption granted by the 2007 Agreement retained.

The situation arisen again created a risk of failure of supplies of oil to Europe. As a result of this dispute, on January 27, 2010 Russia and Belarus signed a protocol amending the initial agreement concluded on January 12, 2007.

According to Art.2 of the redrafted 2007 Agreement crude oil transporting from the territory of Russia on Belarus's request within the limits of domestic consumption established by competent bodies of both states is free-of-charge. At the same time crude oil transporting from the territory of Russia beyond the settled limits is a subject of tax collection. Furthermore, the agreement contains a specific clause that in the case of Belarus's imposition of additional taxes or duties the limits of free-of-charge oil supplying to Belarus for domestic consumption will be decrease.

Standing alone from the confirmation that Belarus may not collect additional duties anymore, it also should be noted that the redrafted 2007 Agreement specifically regulates the issue on transit payment. As it is stated in Art.3 of this Agreement the size of this tariff should be defined not by unilateral action of either Russia or Belarus, but by bilateral agreement between Transneft and his Belarussian counterpart (or by the competent bodies of both states in the case of failure to set the size of this tariff by Transneft and Belarussian contracting party).

Belarus's command economy has been heavily dependent on subsidized natural gas and crude oil from Russia, which is now insisting that the government in Minsk pay more.

Introducing the issue of the research object: the network industries

The bypass is a phenomenon of a kind of expansion with the features of the vertical integration. The most applicable industries for the bypass are gas transport, oil transport, telecommunications and provision of the marketing activities. In these industries there is a set of the upstream firms, which produce the good, the downstream firm providing the services (i.e. transport, marketing) after that the good is received by the final consumer. Worthy of note that the downstream firm is essential for the producer unless there is a bypass. The reason for that is that the downstream producer controls the access to the final consumers. The specificity of these industries is that the downstream firm access the final consumers through the network infrastructure (pipeline, telecommunications), this infrastructure is very expensive and such sunk costs carried by the downstream firm in the past creates the foundation for monopoly power. The bypass constructed by the producer is the only means by which the market structure can be transformed towards a more competitive one- and the only means the new entrants can be admitted in the market.

Taking the example of the oil export to the Western Europe, we deal with the case of the bilateral monopoly: from the one side transit countries, such as Ukraine and Belarus exercise the monopoly power transporting oil through the territory of their countries. From the other side upstream firm is a monopsony for the transit services.

The relations occurred through interaction of the monopoly and monopsony is all about the rent seeking. Every agent tries to expropriate the greater share of the rent - the profit from export of the crude oil to the final consumer.

The problem the rent seeking results in the cases of the sabotage: the opportunistic behavior of the monopoly which contradicts the terms of the agreed contracts. The cases of sabotage cannot be prevented by the third side, since but since the rent sharing takes place at the international arena, there is no such an institute so that the cooperative solution, which excludes the opportunistic behavior of any side could be implemented from above. The only measure to prevent sabotage is the incentive system constructed by the outside options of both countries. Implementation of such a system means the transformation of the market structure. The only means of transformation of the market structure in the network industry is the bypass construction.

The monopsony has an option to make irreversible sunk investment in the bypass of the transit monopoly. This would definitely reduce the bargaining power of the bypassed side, at the same time it would redesign the outside option of the case of the opportunistic behavior.

The specificity of the bypass problem is that the transit side has monopolistic power on the access to the final consumer and to bypass it the producing side has to overinvest in vertical integration creating the excess capacity of transportation

Literature overview

The most

What would be new in the proposed model:

· Asymmetry of the information resulting in the possibility of different options

The existing research of the efficiency and the impact of the bypass project concern either abstract theoretical cases(i.e. (Laffont & Tirole, 1990))or the model designed for description of a certain case of pipeline construction (i.e. ) There an existing contemporary models of the gas bypass pipeline on the example of the Nord Stream. Still two projects differ significantly

- the differences in the industrial policy of the state: transport of oil has a status of the natural monopoly, monopoly tariffs are also regulated by the state

- oil and gas transport even by pipeline are different: oil is a liquid it can be transported by the sea tankers and rail way without any additional modifications. Unlike the gas industry, where sea transport and railway are possible only in case of the gas liquation. Still Nord Stream does not presuppose the transport of the liquefied gas. The main implication of this difference is that in the case of gas infrastructure Nord Stream and the bypassed pipeline are perfect substitutes- taking the gas from the producer to the final consumer. While in the case of oil infrastructure BPS-II and “Druzhba” should be considered as imperfect substitutes

Still in all the papers the authors state that there is no plenty of literature, concerning the bypass construction. Moreover, existing scope of research is very heterogeneous. Since researches have different objectives. In this section I would try to give the summary both of the recent research and the models, used as the bases of the modeling of the investment in bypass.

Plenty of papers are devoted to the gas bypass pipelines, such as Nord Stream, Yamal and Yamal. Among the 2. Though both oil and gas industries are similar in some way the modelling can be different.

Secondly there is no natural monopoly in the gas industry transport. The latter is more liberalized

First approach to analyses of the pipeline system was made by IN Europe is Stakelberg model / Such approach was suggested by Strategic InterdependenceIn Trade: A Hierarchical Stackelberg. The research is close in the research object

The frame work for the analysis of the relations between the upstream producer of gas and the downstream firm responsible for the transit and having the

Later on using this framework and the model specification Russian research was willing to find out how the expansion of the pipeline system was optimal in the framework of a Stakelberg game

The main result of that research was the quantification of the influence of bypass construction on the welfare

Still the emphasis was made on the transit fee rather on the investment and the bypass option

The gas industry relations of Russia and Western Europe did not leave the more contemporary researches indifferent.

Hubert and Ikkonnikova carried out research which examined the change in the distribution of the negotiation power with the construction of the bypass Nord Stream. In the frame work of their analyses the distribution of the rent from the capacity was proportional to the accesses to the pipeline capacities of each player (including the possible coalitions). But the point is that such a research problem is not applicable to the oil by-pass Baltic Pipeline System-II since it is not a joint venture, On the contrary it is full financed by the Russian side, it is constructed on the Russian territory and it is fully independent of the other agents. In case of the BPS-II there can not be coalition formations since the pipeline is situated on the territory of Russian Federation, it distributes oil to the Russian port Ust-Luga. It is not rational to consider the Transport system and the producer side as separate agents. BPS -II is a part of the holding Transneft, which is a regulated monopoly.

Hubert and Ikkonikova used the frame work of the cooperative games, namely Shapley vector, and analyzed the possible coalitions formation and the influence of such coalitions on the distribution of the bargaining power.Still such approach is not applicable for the analyses of the Baltic pipeline system. Since

The main objective of my research is to present the synthesis of the discussed models/ the result of that synthesis would be the model taken into account a factor not captured by the previous researches -.

One of the closest research to the considered thesis is “Contracting versus Bypassing” by Gabrielsen. They examined the scenarios occurring when there are two upstream firms: an incumbent and a potential entrant. The former has a signed contract with the distributor, while the latter might bypass that contract with the additional investment.

The conclusions concerned the willingness to bypass given certain outside options and the distribution of the market shares of the upstream firms. All the contracts and investment are lump-sum, thus the first - order conditions are not applicable. Still the researches identify the range by which it is optimal to bypass the distributor. Still my model might be considered to be the case of that model with a detailed determination of the outside options using the frame work of the coalition game in case of cooperation and to the price leader game ( double marginalization) game in case of conflict point the and reduced to one agent with an option to bypass and to another agent to the

Still in cooperative games there is another suitable framework which is analogous to the Shapley vector, but can be applicable for the case of the 2 players who bargain over the rent sharing. In our model we would implement the technique used by the Nash- the Nash bargaining power,

The model. Analytical framework of analyzing the bypass investment

Benchmark case. The marginal costs of transportation by the bypass are equal to the marginal costs of transit.

There are 2 players in the set: Player R and Player B. R and B referring to Russia and Belarus from the considered case of the Baltic Pipeline System -II construction respectively. Player R is the producer- upstream firm, who has an option to make a sunk irreversible investment in bypass construction.

Player R maximizes the expected profit from its activities - export of crude oil to the final consumer, taking into account the decisions of the downstream firm- namely, Player B. The final consumer is represented by Germany and Poland, in our model they are considered the only market Player R aims at. In the framework of the game Consumers do not take any decisions, instead they only form the demand for the oil exported by Player R.

The demanded quantity by German and Poland market is

, where

Player R has the first -mover advantage while taking the decision to build a bypass or not. Building a bypass costs I, since we solve the game in terms of one period profits, I is the annualized investment payment.

It should be noted that the payoffs of the players are the shares of the maximum possible rent that could be extracted from the German and Poland market.

The maximum rent that can be extracted from crude oil export is determined by solving the following problem:

Solution:

where

The point is that Player R and Player B do not compete on the one market. They represent the bilateral monopoly in the distribution chain. Thus they share the mutual rent, not competing for the profit like in Courtnout or Stakelberg model, providing the same goods and services.

The distribution of the profit is done on the basis of the distribution of the bargaining power. Both Players have bargaining power, since the Player B can stop the transit and the Player R can close the market at all. But in case of absence of the bypass the threat of the player R is not credible, since it would be not profitable for him to close the market and Player B knows it. Thus in the next steps we examine how bypass changes the distribution of the bargaining power.

After the bypass is built, player B decides whether to be engaged into the sabotage or not. Thus the game is divided into two branches: with bypass and without bypass. Both branches differ in the distribution of the bargaining power between the players.

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Figure 6

Examining the first branch «without bypass», we state that the investment are delayed and full bargaining power belongs to the transit side. In case of opportunistic behavior of the later, all the rent is distributed to the transit side and Player R ends up with the normal profit zero economic profit with price covering his marginal costs. This way all the rent from oil market of Germany and Poland is distributed to the transit side.

Still alternative to the sabotage there is the cooperative outcome. In this case both players act as an entire vertically integrated monopoly on the German and Poland market. As a result of cooperation both firms share the rent, which is the maximum possible rent on market of crude oil export. Sharing the rent in this case occurs on the basis of Nash bargaining rule. So that both players maximize the product of the differences of their shares and the options of non-cooperative solution, represented by the maximization of the cascade of monopolies resulting in the double-marginalization problem and lower total profit.

In order to determine the payoff of the players if Player R does not construct the bypass and player B does not arrange the sabotage, at first we calculate the maximum profit, then the non-cooperative profit(when the players refuse too cooperate and act individually) and then apply the Nash - bargaining rule.

The maximum rent that can be extracted from crude oil export is determined by solving the following problem:

Solution:

where

Still if the both firms do not agree to form a coalition and act as a vertically integrated firm with the Player R in the role of the price leader, they result in the double marginalized price and a decrease in profit.

The result of the problem of double marginalization is the result of the following two stage problem with the exporter in the role of the price leader

Maximization problem of the transit side

The double marginalization problem of the Player R , taking into account the best response function of the transit side

The resulting payoff of the double marginalization problem

In case there is no bypass the transit and the exporting side get more in the case of vertical integration. Assume that in absence of opportunistic behavior both agents act as a coalition and share the profit according to the Nash multiplicative rule : Using this rule we get an efficient Parreto optimal distribution of the rent:

In this branch with an assumption of no bypass construction Player B would definitely behave in an opportunistic way and Player R would always find himself in a hold-up. The problem is that such a hold up could be arranged in every period until the export market is closed.

Still cooperation is highly desired by Player R, although he has no means to enforce such cooperation. There is no credible threat or the third party to enforce this outcome.

Analyzing the second branch of the game in the benchmark case we assume that if the bypass is constructed Player R gets the entire bargaining power, which is enough for expropriation of the entire rent. This means that irrespective of the intensions of the Player B (whether there is a sabotage or not). Anyway the payoff would be such that Player R gets monopolistic profit with extraction of the annualized investment, while Player B would end up with zero economic profit with a transit fee equal to the marginal costs. Such an outcome is possible if and only if the marginal costs of transportation via bypass are the same as marginl costs of transportation via initial pipeline. IN this case the bypass stands idle and the Player R still gets the maximum possible profit minus the annualized investment.

To solve the game for the optimal amount of investment we get the upper bound of the annualized investment. At which the cooperative outcome without bypass is less than the one with bypass. IF we compare the expected profit under bypass construction we end up with the following inequality , which should be satisfied if the investment is optimal:

?I



Figure 7/ Extension of the benchmark case. Different marginal costs of the bypass and the existing pipeline.

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Figure 8

The assumption that the marginal costs of the bypass are equal to the marginal costs of the bypassed pipeline, so that the Player R is indifferent what pipeline to choose for transport of the oil. It is very unlikely that the parameters of the pipelines would be the same: the length, capacity, surrounding infrastructure, the environmental conditions etc. This factors come in place because the existing pipeline was optimal in terms of the surrounding conditions with the minimum possible route, with already constructed infrastructure. The bypass has a narrower set of options how it could be constructed.

Moreover, it is highly unlikely in our case since the bypass Baltic Pipeline system is the pipeline from Unecha to the port on the Baltic sea, after reaching the port the oil should be transported to Germany and Poland via oil tankers, which is also costly.

How that could impact our model?

Now let us examine the same framework of the model, but we assume that the marginal costs of using the bypass are higher by than the marginal costs of the existing bypass.

This way the branch of the game without the bypass would be the same. But in case of constructing the bypass Player R can no longer make Player B set the price of the transit at the level of the marginal costs. Player B knows that the it would cost more for the Player R to implement the threat and thus there is a space for cooperation and new issue for the rent distribution.

In order the credible threat, namely all the export of crude oil goes to Germany and Poland via bypass, to be implemented the players are in point, still there is option for the welfare improvement for both sides

We are interested in the optimal bypass investment so that the final cooperative outcome would be more beneficial than the cooperation without bypass construction

We solve the Nash product maximization problem

After FOc we end up with the following distribution of the rent under constructed bypass:

Now we compare the cooperative outcome without bypass with the cooperative outcome with constructed bypass:

We get the following upper bound for investment, which is lower than in benchmark case. It is lower by the value of the rent of Player B resulting from the difference in the marginal costs of transportation

Thus we one more time apply the Nash bargaining rule to determine the proportions of the Parreto optimal rent distribution. As a non cooperative point we take (see graph), which stands for the situation when the the bypassed oil pipeline standa idle and all the oil export is transported by the bypass.

Figure 9. The new cooperative point (point D) should be compared to the cooperation point before the bypass construction(

As a result we can see that even after construction the bypass and leaving it to stand idle we end up with the decreased rent share of the transiter. Since now the transit ia able to bargain not for the monopolistic rent as before, but for the rent resulting from the difference of the marginal costs of transportation, i.e. they are able to expropriate the possible losses of the upstream firm in case the later would switch to the bypass distribution.

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