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Offshore gold rush

Since 2008 successive explorations off the coast of Israel uncovered deposits of natural gas. But the recent discovery of a mammoth site reignited the national debate on handling the proceeds of this newly found national treasure.

The gold rush

Whaling is not a trade associated with Israel. But the announcement in December 2010 that its Leviathan 1 offshore gas field almost certainly contains16 trillion cubic feet of natural gas caused a national stir. Leviathan is the Hebrew word for whale, and the excitement caused by the announcement would rival that of any harpoon wielding mariner on first sighting of a great grey back above the waves. But gutting a big fish can be a smelly business and doing it wrong could be disastrous.

Israel is experiencing something of an offshore resource gold-rush. The already active Tamar field is expected to start commercial production of its 8.4 trillion cubic feet of natural gas in 2013. Since mid 2008 the Oil & Gas Exploration Index of the Tel-Aviv Stock Exchange (TASE) rose by more than 500% (see chart).

Gas Exploration Sector Index TASE
Source: TSAE

And there are signs of more to come. Nobel Energy, a 39.66% working interest share holder in Leviathan 1, says as much as 25 trillion cubic feet may be found in the area. With one estimate of the value Leviathan 1 at €95 billion this could mean significant export potential.

Long term prospects of global demand are also looking positive. BP’s latest Energy Outlook predicts that, “Natural gas is projected to be the fastest growing fossil fuel globally to 2030”.

Big money brings big problems

Since the dawn of this ‘gold-rush’ a debate has been raging on how to split these newly found riches between the prospectors and the state. In a timely move an independent committee set up to evaluate that very issues published its findings four days after the latest Leviathan 1 announcement. The Sheshinski Committee proposed the state receive between 52%-60% of oil and gas revenues. The figure is lower than its initial proposal and the debate rages on. Regardless of what the the revenue split will be, Israel must consider the effect of a seismic discovery on its tiny economy.

Revenues spurts and sputters

Oil and gas incomes are notoriously unstable. Global demand, supply side shocks, and geopolitical conditions make gas prices as volatile as the gas itself. Over the last ten years the Henry Hub Natural Gas Front Month Futures price has fluctuated between $2.15 to $14.75 per million MMBTU (see chart).

Henry Hub Natural Gas Front Month Futures, Source: FT.com
Source: FT

Large random injections of revenues into the economy is like having unregulated water supply to your house. You open the tap to make a cup of tea, one minute there is a trickle and the next thing the kitchen is flooding. Likewise a government can’t plan ahead when revenues are so erratic. The waves created by the leviathan at sea could damage the land that owns it.

Controlling the flow SWF-tly

Norway, a country not unfamiliar with throwing a harpoon or two, was confronted with a similar problem when it first discovered the North Sea oil off its shores in the 1970s. Following two decades of volatility and a financial crisis it came up with a solution that seems to work. In 1990 it created a national oil fund with the aim of stabilising those revenues at the tap.

The fund acts as a buffer between unstable oil revenues and government spending. Each year, all the oil revenues are channeled into the fund. If there is a budget deficit for the year without the oil revenues (a non-oil deficit), then the money from the fund is used to balance the budget. Surplus revenues remaining in the fund, only after the budget is balanced, are then invested in overseas securities. As there is no gain in saving if the government needs to borrow, the first priority is to balance the budget.

It took Norway five years to start saving in this way, but over time a surplus was accumulated and the Government Pension Fund Global (GPFG), as it was renamed in 2006, is one of the world’s largest Sovereign Wealth Funds (SWF) with $512 billion assets under management. The chart below shows revenues from the fund since 1998.

Government Pension Fund Global
Source: NBIM

As Norway’s economy generally runs a budget surplus a fiscal rule was introduced in 2001 to determine how much the GPFG’s profits should contribute to the national budget. The ‘4% rule’ stipulates that these transfers should not exceed 4%, the fund’s projected annual return (see Annualised cumulative returns in the chart above). In so doing Norway has provided a stable revenue source regardless of market and output fluctuations.

The great transparent hope

It is unlikely Israel’s offshore oil and gas will match the scale of Norway. There are also other examples, notably in Qatar and the USA, where profits from large natural gas discoveries failed to materialise.

But as the nation waits on its great Israeli transparent hope it is worth remembering that other factors can affect distribution of profits. One of the successes of the GPFG is the way it is managed. The fund regularly scores a perfect 10 on the Linaburg-Maduell Transparency Index, a measure of sovereign wealth fund accountability.

In stark contrast, the FT reported on 21 January that Nigeria has all but depleted the $20 billion held in its Excess Crude Account, which is designed to perform a similar function to the GPFG. According to the article, “No one in government has been either willing or able to put a finger on exactly how much has gone in and out of the account”. This despite there being a clear legal framework. A reminder that big gutting fish can indeed be a stinky business.

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