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The Economics and Politics of Israel’s Offshore Energy Discoveries

Published on Oct 11 2011 // Features, Natural Gas, The Daily Pick

By Josh Kaplan for IsraelStrategist.com*– October 2011

 

 

 

 

 

In a way, discovering natural resources is to a national economy what winning the lottery  may be to an individual household—it will result in meaningful lifestyle changes.  But for a  country to capitalize on a discovery of natural resources, it must work to ensure that its new  wealth will not be squandered or encroached upon by others.  Israel’s recent natural gas  discovery, which is one of the largest recent natural gas discoveries in the world, has the  potential to be the country’s most exciting economic discovery in recent years. (See    information about the discovery provided by Noble Energy).  At the same time, it is a  provocative political issue.  The Leviathan Basin, where most of Israel’s natural gas is  located, is in the northern most part of Israel’s territorial waters in the Eastern  Mediterranean.  Other countries are claiming rights to some of these waters—there    is a  dispute over the maritime borders between Israel, Cyprus, Lebanon and most recently    Turkey. This dispute is a significant potential roadblock for Israel in its effort to reap the        gains from its newfound resources.  An in-depth discussion of the potential economic  impact and the geopolitical issues at stake will reveal why this natural gas discovery has  created several “high-class” problems for the State of Israel.

Potential Economic Impact

There are those who doubt that Israel’s natural gas reserves will have the overwhelming positive impact that many have predicted it will. There are two reasons for this doubt: (1) that the fundamental worldwide supply and demand balance of natural gas provides unfavorable conditions for marketing natural gas; and (2) that the Bank of Israel and the Israeli government will most likely try to contain spillover effects of the current account surplus into the overall economy.

1.      Background on Israel’s Energy Infrastructure

Recently, Israel’s energy demand has risen in line with its GDP growth and a moderate growth rate is predicted to prevail.  Natural gas has been taking a larger and larger share of this growing pie over the years.  In 2003, approximately 33% of electricity was generated by burning natural gas and approximately 64% by coal.  A UBS report estimates that, as soon as 2013, 46% of electricity production will be coal-based and 48% will be natural gas-based; and that by 2020, 80% of Israel’s electricity production will come from natural gas. (Two UBS reports are relied upon throughout this article. See the bottom of the page for PDFs of the reports).

Since natural gas has been used in electricity production in Israel, nearly all demand has been met by imports—until just a few years ago, when imports of natural gas seemed to reach a plateau while demand growth was being met by domestic production.  And, throughout Israel’s history, nearly all of its coal and petroleum needs have been met by importation (though Israel has been a net exporter of refined petro products).  Last year, 95% of Israel’s energy needs were met by way of imports, one-third of which was natural gas.  But given the amount of the natural gas resources newly discovered in Israel, there could be a tremendous shift in Israel’s energy structure and trade balances.

 2.      The Big Picture: Estimates of Impact on GDP 

To understand the magnitude of Israel’s natural gas discovery, consider this: In 2010, Israeli GDP was roughly 218 billion U.S. Dollars; according to Noble Energy, there is potentially 16 trillion cubic square feet of natural gas reserves in the Leviathan Basin, equal to approximately 16 billion MBTU’s which, at today’s prices, would be worth around 66.5 billion U.S. Dollars.  This amount is equal to approximately 30% of Israel’s 2010 GDP.  Of course, this is a simplified estimation of the gross value of the natural gas deposits.  A Barclays Capital research report estimates that net revenues from gas production will average 1.5 billion U.S. Dollars per year from 2016 to 2020, and 2.3 billion U.S. Dollars per year from 2022-2049.

Estimates of the net effect (accounting for necessary investment spending, extraction costs, and taxes) of Israel’s whole natural gas program (including other drilling sites like Tamar and Dalit) have been projected by analysts.  A UBS report estimates Israeli GDP growth attributable solely to natural gas production-related activities to be between 0.1%-0.2% in 2011 and 2012, and 0.2%-0.4% between 2013 and 2016.  Production at the Leviathan site is expected to come on line in 2017, when the impact on GDP growth will be 0.6%-0.7%.  GDP growth is expected to stay at this level through 2020 before tapering off to 0.1%-0.2% in 2021 and beyond.  Analysts disagree on some of the details. Barclays Capital analysts, for example, believe that operations won’t become profitable at all until 2020.

Additionally, there is speculation that oil may exist in or near the Leviathan site in deeper layers under the water; this raises the stakes for the countries involved, not least because oil is easier to commercialize than natural gas. According to the UBS report mentioned above, Noble Energy has assigned a 17% chance of finding an additional 3 billion barrels of oil and an 8% chance of finding another 1.2 billion barrels of oil.  In nominal terms given the probability scenario that Noble Energy has provided, the expected recoverable amount of oil would be equal to $57.6 billion, or 23% of Israel’s 2011 GDP.

     a.  Fixed Investment

Foreign and domestic infrastructure spending is necessary to capture and distribute the natural gas.  UBS estimates that, from 2013-2016, when the Leviathan site is being developed, GDP growth will be attributed to: (1) increased production capacity at the Tamar site; (2) fixed investment spending in developing the Leviathan site (on oil drilling rigs, pipelines, and related services, for example); and (3) preparing the country’s domestic infrastructure for a larger shift from coal and oil to natural gas use.  Fixed investment spending for the project is estimated to total about $1 billion per year for 4 years. Much of the spending, though, will be on imports; already, drilling at the Leviathan site has been delayed due to mechanical problems which could not be fixed with domestically produced goods.  Imported investment goods bear a negative weight on GDP.  In addition, approximately $10 billion will be needed to develop liquefied natural gas plants in Cyprus and/or Greece—the countries from which Israel’s product may be distributed.

An increase in investment spending will help boost GDP. It will help drive the Israeli economy further into expansion mode because of the spillover effects of such spending, including increased employment and demand for domestically-manufactured equipment.

     b.  A Positive Balance of Payments Impact

More importantly for the average Israeli and the State of Israel are the effects on Israel’s overall balance of payments picture.  Balance of Payments transactions are important because there is little ambiguity in the effect they have on the general economy—they occur before government taxation occurs.  Balance of Payments is the accounting system used to keep record of transactions made by the individuals, firms, and the government of one country with the rest of the world.  Balance of Payments transactions are considered with respect to the interest-rate and foreign exchange environment.  A change in the strength of a country’s currency has important implications for its overall wealth.  A large export-oriented natural gas program would positively affect Israel’s Balance of Payments (and in this case it would also factor positively into GDP).

     c.  Current Account 

Israel is very much a value-adding economy; it imports resources and exports final products and services.  This is a cornerstone of Israel’s recent economic strength.  Because of this feature of its economy, Israel currently enjoys a current account surplus despite its
importation of energy-related goods.  The chart to the right shows the value of Israel’s current account with and without energy-related imports, with respect to overall GDP.  It shows that importation of energy is currently a 5% drag on Israel’s current account.

But because Israel’s energy demand is growing along with its economy, domestic energy production will have to expand faster than the economy does in order to significantly reduce the ratio of imported energy resources to domestically-produced energy resources.  Israel’s potential natural gas industry could help the country meet its domestic demand without having to increase energy-related imports.  Furthermore, Israel may be able to export natural gas by around 2017—bringing in approximately $3 billion per year to start (0.7%-0.8% of GDP), and $6 billion per year from 2020 to 2030 (1.3%-0.7% of GDP).  Overall, as the graph shows, there could be a significant swing in the current account picture as a result of the development of an export-oriented natural gas program.

Another potential impact from the exportation of natural gas on Israel’s current account is the investment income that could be derived from a sovereign wealth fund (SWF).  A Sovereign Wealth Fund is a government-owned investment account which would be used to house the government’s income derived from the natural gas industry.  Israel may set up an SWF in order to manage the impact that the industry might have on the economy.  UBS estimates that this fund could rise to $42.5 billion by 2030 (5% of GDP) and could earn a 5% rate of return (0.04% of GDP/year).  One thought here is that, while government taxation on natural gas may have the effect of draining income from the private sector, government revenues from the natural gas industry will increase government expenditures, thus allowing flow into the private economy in a more controlled manner.

     d.  Capital Account and Official Settlements Balance

A sovereign wealth fund may be needed because, on the whole, Israel’s natural gas program will likely result in a sizeable balance of payments (BOP) surplus.  As discussed above, Israel’s natural gas industry could push the country’s current account further into surplus.  So too with its capital account, which has been in surplus and which is expected to grow further as Israel’s financial sector develops.  An overall BOP surplus necessarily means that The Bank of Israel will have to take steps to meet liquidity needs for the rise in economic activity—which may have unintended negative consequences on the economy.  It will have to absorb significant amounts of foreign exchange reserves in return for supplying the market with the highly-in-demand Shekel.  Even if an SWF is established, the Shekel ought to appreciate due to both real industrial needs and market speculation.

The power of a shekel in high demand could have the most profound economic impact of all—by, among other things, precipitating a general shift away from consumption of normal goods to consumption of luxury goods, which could in turn increase overall consumption spending, consumer and investor confidence, and the ability of Israelis to travel abroad more cheaply.

In sum, Israel’s potential natural gas industry could bring the country significant wealth and even stronger economic fundamentals than it has now.

 

The Geopolitical and Legal Hurdles

1.     Israel’s ability to reap the economic rewards of its gas supply is dependent on its ability to protect its property rights

Property ownership over the land that contains the newly found natural gas has become a hotly contested political issue.  The Leviathan Basin is the general area of the Eastern Mediterranean which is west of the land border between Israel and Lebanon.  In the past year or so, the Israeli government licensed one American and several Israeli exploration and drilling companies to survey the area and begin developing Israel’s natural gas program.  The Leviathan drilling site (marked in the map and only a part of the greater Leviathan Basin) is generally not in dispute, though areas of Cyprus’ waters which would be part of a joint drilling project with Israel are being disputed. Block 12, which is the southwest area of Cyprus’ exclusive economic zone in the map, is the most controversial area.  In addition, the area between the two proposed Israeli-Lebanese borders may prove to have more natural gas and oil.

Several countries surround the area of water in question—Israel, Cyprus, Lebanon and Turkey—and each one wants a piece of the pie.  Without much friction, Israel and Greek Cyprus have come to an agreement over the appropriate maritime borders upon which to move forward.  However, Lebanon and Israel have yet to come to agreement and, as of late, Turkey is creating difficulties for both Israel and Cyprus on this issue.  Although the Leviathan drilling site seems to be clearly within Israel’s territory no matter what boundaries would be drawn, there are areas north of that site which may contain more gas and, more importantly, which may contain oil—and this area is in question.

The Lebanese may just be posturing. But the Lebanese government seems to be serious about following through with either legal or military action on its claims to the maritime territory.  As reported by StatesTimes, Lebanon’s President Sulayman said: “[no one should doubt] Lebanon’s determination and its readiness to defend its territory, its land and sea borders and protect its right and its [natural] wealth by all available and legitimate means.”

Israel too seems unshakable at this point.  The typical response of Israeli Minister of Foreign Affairs Avigdor Lieberman to statements by Lebanese officials goes something like this: “in terms of procedure, international law and maps, we have a very strong position, and we won’t give an inch.”

Additionally, Turkish officials have recently threatened to increase the country’s naval presence in the Eastern Mediterranean in order to ensure that its exclusive economic zone is not encroached upon by the Israeli-Cypriot partnership.

In the end, Lebanon’s border claims may actually have some degree of substance based on internationally-recognized law.

 a.  U.N. Convention on the Law of the Sea

Perhaps the most important determinant (next to military or naval conflict) of the outcome in these border conflicts is international law.  The presiding laws over this issue and precedents set by similar former disputes may shed some light on how this conflict will be resolved.

The United Nations Convention on the Law of the Sea, set into force in late 1994, is the most comprehensive and recognized set of laws concerning exclusive economic zones in the sea.  The Law of the Sea states that: “Coastal states have sovereign rights over the continental shelf (the national area of the seabed) for exploring and exploiting it; the shelf can extend to at least 200 nautical miles from the shore, and more under specified circumstances.” (Excerpts are from the United Nations website)

(1)   “Coastal states share with the international community part of the revenue derived from exploiting resources from any part of their shelf beyond 200 miles.”

(2)   “Disputes can be submitted for the International Tribunal for the Law of the Sea established under the convention…the Tribunal has exclusive jurisdiction over deep seabed mining disputes.”

(3)   The continental shelf comprises the seabed and its subsoil that extended beyond the limits of the territorial sea throughout the natural prolongation of its land territory to the outer edge of the continental margin or to a distance for 200 miles from the baselines from which the territorial sea is measured.

(4)   A baseline is the line from which you begin measuring the seaward limits of a state’s territorial sea.  Normally the line is drawn from the low water line, which is the spot where the water recedes the furthest during lowest tides of the year.

But, just because there is relevant law doesn’t mean the legal solution to the dispute is readily apparent.  The term “natural prolongation” of land territory is ambiguous.  While the procedure for determining a country’s exclusive economic zone with respect to distance from shore is well-described by the law, and not being contested by Turkey or Lebanon, the procedure for determining the breadth of territorial waters is not well-described.  The breadth, in Israel’s case, would be the northern and southern boundaries of its exclusive economic zone in the Mediterranean.

An examination of “common law” is useful here. The Beaufort Sea dispute between the United States and Canada in the Arctic Ocean near Alaska bears a close resemblance to the dispute between Lebanon and Israel (though the Beaufort dispute has yet to be resolved).  The Beaufort Sea is important because it contains an abundance of fish and potentially oil and gas.  A map of the area is shown below:

The U.S. claims that the border line should be drawn as a line equidistant from the land border.  An equidistant line would create a 90 degree angle off the coastline beginning at the endpoint of the land border.  This is also the position that Israel has taken in its own dispute.  The Canadian claim is that the maritime border ought to be an extension of the land border which, in this case, would be different than an equidistant line.  Lebanon takes the Canadian position in its dispute with Israel.

Here is an embellished map of the area in question, taken from Noble Energy’s website:

Should the line be drawn as an equidistant line from the demarcation point or as an extension of the land border?  An equidistant line has been used to demarcate maritime borders in several other instances around the globe—and it has even been used to determine the borders between the hostile nations of North and South Korea.  If an equidistant line is drawn from the Israeli-Lebanese border, the portion of the Leviathan Basin, block 12 in particular, will belong solely to Israel and Cyprus. Otherwise, it will belong partially to Israel, but mostly to Cyprus and Lebanon.

Even a clear demarcation of borders won’t necessarily solve the issue, because gas may be extracted from outside its exclusive economic zone by way of horizontal drilling.  This is something about which both Israel and Lebanon should be concerned.

     b.  The Current State of Affairs

So far, the only deal that has been reached is between Israel and Cyprus.  On December 17, 2010, Israel and Cyprus signed an agreement which laid out the borders of each country’s exclusive economic zone. According to this agreement, the northern and western lines of the Leviathan territory are where Israel’s territory ends and Cyprus’ begins.  Israel and Cyprus are also cooperating on developing the territory. Their partnership is mutually beneficial for several reasons, one of which is that Israel has the economic and financial ability to develop a shared natural gas program, while Cyprus has international connections and friends to help in the marketing of the gas.  This partnership aligns Israel’s property rights issues with Cyprus’.

A compromise agreement to draw a median line between Israel’s and Lebanon’s claimed maritime borders would seem like a viable solution if the two countries were at peace. But Israel and Lebanon are still technically at war, and thus such a compromise is unlikely to be struck.  Hezbollah has rockets that are capable of reaching and targeting the Leviathan site. Israel has begun deploying drones for 24-hour surveillance of the area to help prevent, or at least mitigate, the potential damages from an attack by Lebanon.

Also, Turkish officials are now contesting the border drawn between Turkey and Cyprus.  If Cyprus were forced to cede part of its economic zone to Turkey, there may be negative consequences for Israel, as Turkey seems much less willing than Cyprus to cooperate with Israel in developing and marketing the natural gas.

The situation is also complicated by the fact that other countries outside the region, including Russia and the U.S., have economic and geopolitical stakes in the outcome of the border dispute.  Noble Energy is an American company and its security would probably be enforced by the American navy.  Russia too has a stake in the outcome because it is one of the leading natural gas suppliers to Europe (a market which will be pursued by both Cyprus and Israel).  In the past couple of weeks, Russia has sent nuclear-powered submarines to help patrol Cyprus’ claimed territory.  Israel has recently sent two fighter jets to survey the area.  In response, Turkey deployed two fighter jets of its own to the area, though there are conflicting news reports about the events that surpassed.

2.  Significance of Israel’s Natural Gas Program to Its Security

Even if Israel’s natural gas has minimal export potential due to the global abundance of gas, the fact that Israel will be virtually energy independent is important for security reasons.  As discussed, Israel has been dependent on energy-related imports for decades.  A longstanding peace treaty between Israel and Egypt made it possible for Israel to import much of its gas from Egypt via pipelines.  But today, as the relationship between Israel and Egypt is turning cold, there have been numerous attacks on those pipelines.  If the supply of natural gas from Egypt were shut off completely, and if Israel was without domestic resources, the country’s economy could become paralyzed, making it more vulnerable to its enemies.  In addition Israel’s adversaries would lose a potential bargaining chip in future peace negotiations if Israel were no longer dependent on them for energy-resources.

Israel’s “High-Class Problems”

As a result of the natural gas discoveries, Israel is left with several high-class problems.  The country’s advancement to the category of “economically developed nation” by MSCI was a fitting preface to the situation in which Israel now finds itself.  The rich may view estate maintenance, asset allocation, or the hiring of chauffeurs or body guards as problems, but ones that the poor cannot sympathize with.  The developed nations view dealing with infrastructure development, distribution of wealth, and national defense as problems—problems that poorer nations may not face with the highest level of urgency.  In Israel’s case, the growth and fundamental stability of the economy brought about an upgrade in its economic categorization.  An extra jolt to the economy, by way of natural resources, has brought with it several high class problems: (1) the need for heavy investment to develop the proper infrastructure required for extracting and distributing natural gas, and the need to manage foreign investment; (2) the need to prepare for the windfall impact on the economy (government budgeting, developing a sovereign wealth fund, managing foreign exchange levels and the overall balance of payments picture); and (3) the need to manage new geopolitical, strategic, and defense concerns.

In the Middle East, and in Israel in particular, missing one day’s worth of action may take a lifetime to catch up on.  It is an exciting yet precarious time in Israel’s history—and how the country handles the development its natural gas program (and potentially its oil industry too) will be a key determinant of its future economic success and geopolitical position.

*With editorial thanks to Suzanne Gershowitz and Steven Schoenfeld

UBS Report 1

UBS Report 2

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