Natural Gas: A ‘Game Changer’ with Myriad Challenges for Israel

The buzz-word “game-changer” suffers from misuse, overuse and abuse. It is applied so liberally to situations in business, politics and even sports that any minor gaffe by a candidate, the launching of an enhanced version of an existing product, an upset in a routine league fixture — anything that can generate a news item — tends to be hailed as a potential “game-changer.”

But major discoveries of natural gas by Israel, a country that imports virtually all of its energy requirements, are viewed by many in the country as a genuine economic game-changer. Given the nation’s strategic location, observers say, the discoveries could spur economic and political powers to consider large-scale infrastructure investments in Israel to facilitate the development of the resources — meaning the game being changed is not just economic but also geo-political.

Indeed, in Israel, the interaction between macroeconomics and geo-politics is almost inevitable. But the scale of the impact of a series of significant-to-major natural gas discoveries made off Israel’s Mediterranean coast in recent years — and the prospect of more to come, probably including oil as well — is likely to prove sufficient to change some of Israel’s most fundamental and seemingly intractable features.

In terms of corporate activity, Israel has become used to hosting R&D facilities of most of the Western world’s leading technology companies — and, in many cases, of production facilities as well. On the other hand, all major — and virtually all mid-sized — energy companies have tended to give the Jewish state a wide berth because doing business there would surely cause them to lose business, existing or potential, among energy-rich Arab and predominantly Muslim countries, from Algeria to Iran and even Indonesia.

From an economic point of view, the Israeli economy’s most consistent feature since the country’s creation in 1948 has been its trade deficit. With no important natural resources to speak of, other than the mineral deposits extracted from the Dead Sea region, Israel has always had to import most or all of its raw materials, foodstuffs and, of course, energy. Thanks to the high-tech revolution of the last generation, the gap between imports and exports of goods has shrunk, while in the services sector the country runs a growing surplus.

The surge in energy prices in recent years has sent the import bill through the roof — and pushed the trade deficit to record levels in the last year. If those oil imports could be replaced by usage of domestically produced natural gas or, alternately, if the bill for imported oil could be offset by revenues from exporting natural gas, the trade deficit would shrink or vanish entirely and the country’s overall balance of payments would move to a massive surplus position, experts note.

In the political sphere, the potential impact could be as great — indeed, it is already visible. Russian President Vladimir Putin made Israel his first port of call after being re-elected to the presidency in June, with the subject of future Israeli natural gas exports to Europe a key item in his discussions with Israeli leaders — and the possibility of Russian energy giant Gazprom playing a major role in their development. Meanwhile, China has offered to build a rail link from Ashdod, on the Mediterranean, to Eilat, Israel’s port on the Red Sea, to allow trade on the China-Europe route — including natural gas from the Mediterranean — to bypass the Suez Canal. Both these developments stem directly from the gas finds and, observers believe, neither was remotely imaginable before them.

Domestically, natural gas offers equally enticing prospects, notably including an energy source that will be not only much cheaper, but also much cleaner and hence conducive to a healthier environment in the country’s crowded center. A slew of energy-based industries could broaden the scope of the economy, as well as spurring growth in existing sectors.

Given such an outlook, it is hardly surprising that many Israelis, especially in government and industry, became euphoric about the country’s commercial and diplomatic prospects after the discovery of the Tamar and Leviathan fields in early 2009 and late 2010 respectively. Tamar has proven reserves of 9 trillion cubic feet (TCF) and the aptly-named Leviathan, with 17 TCF, is one of the largest finds in recent years anywhere in the world. However, in the understandable excitement generated by the finds, the road between identifying the existence of the gas and actually selling it and booking a profit on it — and the host of problems lurking along the way — tended to get overlooked or downplayed, observers say.

Serious Challenges

The euphoria soon dissipated in the face of problems as numerous and as multi-faceted as the potential impact of the bonanza. First, and perhaps foremost, there are huge physical and practical difficulties to be overcome. The very discovery of deep-water deposits — Tamar, for instance, lies under 6,000 feet of water — is itself only possible thanks to very recent technological advances, and the extraction of the gas requires complex and challenging, and hence very expensive, investments.

No less challenging is the need to bring the gas to market, whether domestically or overseas. This could be done by constructing a pipeline, or by turning it into liquefied natural gas (LNG) and shipping it in specially fitted tankers, but either of these options involves huge investments in infrastructure.

These would be daunting problems anywhere in the world — but in the eastern Mediterranean they come overlaid with additional layers of risk. Israel’s fields are adjacent to those of Cyprus, and the two countries are co-operating in developing their assets. But Cyprus is in the throes of a financial crisis, which is itself part of the wider European financial turmoil. Furthermore, Cyprus is divided into rival Turkish-Cypriot and Greek-Cypriot regions, with Turkey unhappy about anything that could make Cyprus as a whole more independent. Meanwhile, Turkish-Israeli relations have been under severe strain in recent years, for reasons unconnected with the energy sector.

These, however, are just the political and diplomatic issues. Lebanon, where the government is dominated by the Shi’ite Hezbollah party, which is closely aligned with Iran and hostile toward Israel, has its own claims to some of the offshore fields, despite Israel and Cyprus having defined their maritime borders to their mutual satisfaction. Hezbollah in Lebanon, as well as the Hamas-ruled Gaza Strip in the south, pose serious security problems for Israel with respect to offshore oil platforms and any potential refining or liquefying installations it may decide to build. An attack on a weapons depot in Sudan October 24 that has been attributed to Israel may have been aimed at preventing weapons with the capability of hitting Israeli energy installations from reaching Hamas, observers note.

Even in the two or three years since the big discoveries, the geo-political situation has become more complicated. In Egypt, the Arab Spring revolution led to the overthrow of the Mubarak government in early 2011 and, soon after, to a series of disruptions in the supply of Egyptian natural gas to Israel and Jordan via a pipeline in the Sinai Desert. The attacks on the pipeline came at a particularly inopportune time for Israel.

The initial small offshore finds, made in 1999, triggered a strategic decision by Israel in 2004 to switch much of its electricity generation to natural gas, with its advantages of being cleaner and cheaper — and potentially plentiful, thanks to supplies from both domestic fields and from Egypt. By 2010, Egypt was providing some 40% of Israeli natural gas requirements, while Israel’s existing fields were being exploited to the full, in expectation that when the Tamar field came on stream — then scheduled for 2012 — they would become redundant.

But the pipeline attacks effectively blocked Egyptian supplies, forcing Israel to buy expensive and polluting heavy oils for its refineries, at great expense and dislocation to the natural gas conversion program. The supply problem became acute in April 2011, experts note, when the Egyptian government formally cancelled the 2007 agreement between Israeli and Egyptian energy companies, albeit on commercial rather than political grounds — leaving Israel with a shortfall that came close to causing system-wide power cuts in the hot summer of 2012.

Was the Egyptian move politically inspired? Most independent analysts do not believe so, pointing instead to growing domestic Egyptian needs versus dwindling supplies from the country’s gas fields, and to a widespread feeling that the Egyptian government and corporate officials involved in the deal with Israel were part of the corrupt apparatus of the Mubarak regime.

Sarah Ma’udi, the Israeli Foreign Ministry’s expert on maritime and humanitarian law, shares this assessment. In an interview with Israel Knowledge@Wharton during a recent visit to campus, she was asked whether the Israeli government regards the discontinuation of natural gas supplies from Egypt as a diplomatic issue and a test of the new Egyptian government’s attitude toward the Egypt-Israel peace treaty and Egypt’s commitment to it. Her reply was: “I think that’s going a bit far…. This is a commercial issue and it’s being handled between commercial actors there. I think to tie it in with the peace treaty is a little bit like mixing apples and oranges.”

Making Progress

Whatever the motives behind the move, it has generated problems for Israel, at least until the gas starts flowing from Tamar — now expected to happen in the second quarter of 2013. But the last couple of years have not been lost from Israel’s point of view, observers say. On the contrary, two critical issues that are entirely in its control have been addressed and largely resolved.

The first is the structure of the taxation and royalties levied on companies engaged in exploring for and extracting oil and gas. The old regime, dating back from a time when there was no energy profits tax, was finally updated after a contentious process in early 2011. Profits of oil and gas companies were increased from 33%, one of the lowest in the world, to a top rate of 50% while royalties on hydrocarbon discoveries remained at their previous level of 12.5%. The tax on energy profits begin only after the developers have reached a payback on their investment of 150%, at which point the tax rate is 20%. It rises to 50% after companies have achieved a return of 230% on their capital spending. All told, the state’s take in tax and royalties is as much as 62.5%.

The second issue that the Israeli government needed to resolve was the domestic argument over whether the country’s new-found natural resource should be exported — and if so, how much and how quickly. The two extremes in this debate were “all” and “nothing”. On the one hand, there were those — led by, by not limited to, the energy companies involved in exploration — who urged that there be no caps on exporting natural gas, since this would maximize revenues and profits not just for the companies involved, but also for the state. Furthermore, it would act as a powerful incentive to other energy companies to join the exploration activities in the eastern Mediterranean. The “nothing” camp, on the other hand, argued that the gas should be seen as a strategic national asset that should be leveraged to end Israel’s dependence on imported oil, as soon as possible and for as long as possible into the future.

With Tamar and then Leviathan offering sufficient reserves for Israel’s projected domestic usage for many decades, an inter-departmental committee chaired by Shaul Tsemach, director-general of the Energy and Water Resources Ministry, determined that the correct strategy was a middle path between these extremes. Its final report, published in September, concluded that 53% of estimated gas reserves could be exported, equal to about 17.7 trillion cubic feet based on current estimates. The biggest, those with reserves of 7 trillion cubic feet and over, which include Tamar and Leviathan fields, are limited to exporting 50% of their output. Fields of 3.5 trillion to 7 trillion cubic feet can export 60%, and those between 880 billion and 3.5 trillion cubic feet 75%. The smallest fields can export their entire output. The committee recommended establishing a mechanism for trading export quotas between the fields, which is aimed at encouraging energy companies to develop smaller fields not now considered commercially viable.

The Tsemach estimates have come under fire from some quarters because they are not based on proven reserves and therefore pose too much risk to ensuring adequate domestic supplies. Those fears have been exacerbated by two dry wells (Sarah and Myra) in September and October in an area that had been regarded as promising.

While energy companies see exports as a means of accelerating their return on investment, the government sees them as a way of flexing diplomatic muscle. Shared energy interests have improved ties with Cyprus and could cement them with Jordan, which is desperate for new sources of energy after Egypt cut off its supply of natural gas last year. “The Israeli government wants to export the gas to neighboring countries as a means of promoting trade and leveraging that co-operation to create a political relationship,” says Nir Zonenberg, head of the research department at Meitav Investment House.

The final element is a sovereign wealth fund that will control a large part of the government’s oil and gas earnings (namely those from so-called windfall profits) and use them for specially designated projects, rather than going into the government’s regular budget. The ministerial legislative committee finalized the terms and structure of the fund in October for approval by the Knesset. The aim of the fund is to ensure that the massive export earnings from natural gas do not bring about the so-called “Dutch disease,” a rise in the value of the country’s currency that hurts the competitiveness of the country’s other export industries. The fund, which is expected to have at least $80 billion under management by 2040, will also help cover costs from unexpected events, such as a war or earthquake, which pose a threat to the economy, experts say. The committee rejected a proposal by the Defense Ministry for the fund to help cover the cost of defending energy installations. The fund’s assets and investments will be managed by a department to be set up within the Bank of Israel. The finance minister will head up the fund’s board that will determine its investment policy and monitor its implementation.

The Next Phase

With government policy mostly in place, the next stage in developing Israel’s vast gas resources is for the oil companies to secure financing for the development of the fields and to find markets. For that purpose, they will need to bring in one or more of the world’s biggest energy companies, a process that has already gotten underway. News reports have said that France’s Total and Russia’s Gazprom are both interested in becoming partners in the Leviathan project, while Australia’s Woodside has publicly announced its interest in taking a 30% stake. Meanwhile, the energy companies will have to decide what markets to direct Israeli exports to, either Europe or Asia. Europe is geographically closer to Israel, but prices in Europe have fallen amid heavy competition. Furthermore, delivering gas by undersea pipeline, as some have proposed, presents serious technological and security challenges, critics note. The second great market — and, according to some, a more promising one — is the burgeoning economies of China and India.

For the more distant Asian market, Israel would have to develop LNG facilities, but an onshore facility is unlikely to be built, says Amir Mor, chief executive officer of the consulting firm Eco Energy. “There are major security and employment benefits to having the project onshore Israel … [including] providing thousands of jobs in construction and thousands more in the operational stage. Nevertheless, the authorization for doing a project like this in Israel is challenging since intensive opposition is anticipated [due] to NIM [not in my backyard] considerations by locals and environment groups.” Therefore, two alternative solutions are being weighed — one to build an offshore facility using newly developed technology and the other to pipe the oil to an LNG plant in Cyprus, a project that the Cypriots are lobbying for. For this, Woodside would be the most promising candidate among the energy multinationals eyeing Israel, experts note.

A third alternative would be to pipe the gas to Egypt, where LNG facilities already exist, but that idea is not currently under discussion due to political obstacles. “The current situation can be used to highlight all the potential absurdities of doing business in the Middle East: Israel has excess gas supplies, but no liquefaction facilities,” says Zonenberg. “Egypt has liquefaction plants, but no gas supply to export. There exists a pipeline between the two countries which could carry Israeli gas to Egypt for liquefaction and export — but the company that owns the pipeline is in bankruptcy proceedings.”

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