Israel Needs To Capitalize On Leviathan

There are several issues the Israeli government must address to ensure the Leviathan discovery pays off.
William A. Mogel, Energy Consulting and Legal Services, and Benjamin Schlesinger, Benjamin Schlesinger and Associates LLC

Leviathan, the biggest deepwater natural gas find in a decade, raises questions regarding the legal and regulatory issues that will arise from producing, transporting, and distributing the field’s 16 Tcf of natural gas. According to The Wall Street Journal, Leviathan’s potential reserves in the Mediterranean Sea, if exploited, could meet Israel’s natural gas requirements for 100 years.

Prior to the energy crisis triggered by the earthquake and tsunami in Japan and the rebellions in the Middle East and North Africa, an Israeli energy expert said, “It’s not a great time for Israel to enter a lot of the markets. European consumption is going down and new supplies are coming on.”

In contrast, another Israeli expert said, “A country that supplies itself with a large part of its energy is more economically stable and less sensitive to swings in energy prices.”

In 2008, oil and coal accounted for nearly 80% of generating fuels used by IEC, a percentage that has decreased significantly in the past two years. (Source: US Energy Information Administration)

The Israeli government also has fueled a controversy in connection with its royalty and taxing regimes. The country’s Finance Minister, Yuval Steinitz, said he was considering retroactive changes. Also under consideration is a recommendation to abolish tax breaks for energy companies and to impose increases of 20% to 60% on windfall profits.

Israel’s Energy

Israel is a net importer of petroleum, coal, and natural gas. It has been reported that the country has deposits 30 miles (48 km) southwest of Jerusalem that could yield 250 Bbbl of shale oil. Because of the lack of significant deposits of fossil fuels within Israeli territory prior to Leviathan and discoveries in other nearby fields such as Noa and Mari 10 years ago and Dalit and Tamar in 2009, Israel has developed significant programs aimed at converting power generating plants from imported oil to less costly coal. Israel also is investing in developing and deploying solar energy, an area in which the country has been acknowledged as a leader.

The country has made several offshore natural gas discoveries between 1999 and 2000, and gas imported via the Arish-Ashkelon pipeline – a subsea Egyptian natural gas pipeline that entered service in 2008 and branches from the Arab Gas Pipeline in the Sinai Peninsula to Ashkelon, Israel – supplied 35% of Israel’s demand in 2009, nearly all of which was sold to the Israeli Electric Corp. (IEC). As a result of these developments, the country’s annual gas consumption grew from 42 Bcf in 2004 to approximately 155 Bcf in five years. Currently, about 40% of Israel’s electricity is generated from natural gas. Legal, Regulatory Issues

The legal and regulatory regime applicable to Israeli natural gas markets is the 2002 Natural Gas Sector Law 5762-2002, the goal of which is to incent development of the natural gas market, encourage competition, and regulate activities and operations. The Natural Gas Authority was established to regulate the market, ensure compliance with license terms, approve tariffs, establish criteria for service, and oversee safety issues.

The Natural Gas Law is divided into four major parts: supply, transmission, distribution, and marketing. Regarding supplying natural gas, neither the sale of the resource, nor agreements between suppliers and consumers require a license. However, the installation and operation of pipelines require a license. E&P activities are not regulated by the Natural Gas Law but are subject to Israel’s Petroleum Law, which licenses the exploration, development, and production of natural gas.

In terms of transmission, Israel Natural Gas Lines Ltd. (INGL), a government -owned company, has been authorized to build and operate the high-pressure system, the INGL Grid, which has open access and is used to transport gas to large consumers and distributors. The fee for transporting third-party gas must be approved by the Gas Council. Israel’s Gas Law has a provision similar to eminent domain, which allows compulsory expropriation, with compensation, of land used for facilities and pipelines.

Distribution licenses have been granted for low-pressure systems in two regions and a tender has been issued for a third system. These systems will operate as open-access carriers and will interconnect from the INGL Grid to end-user customers and marketing companies. Restrictions can be imposed on licenses. For example, a transportation license holder also cannot hold a distribution license.

At present, no license is required for marketing companies since no market exists for natural gas or bundled products trading.

Prior to the demand estimated to be triggered by the Japanese crisis, as well as the current uncertainty in the Middle East and North Africa, the global LNG glut was expected to persist through the mid-2000s as more supplies come onstream from Australia, the Middle East, and West Africa. (Source: International Energy Agency “World Energy Outlook 2010”)

Although Israel currently does not export natural gas, Leviathan’s reserves could create the opportunity for natural gas to be exported via pipeline and as LNG. No law prohibits exporting natural gas, but authorizations could be required for facilities construction.

According to the “Gas Regulation 2010” report by Global Legal Group Ltd., “Pursuant to the Gas Law, the Minister of Natural Infrastructures may prescribe provisions…regarding the provision of transmission service for…exporting natural gas from Israel, or for transferring natural gas between two places in Israel through Israeli territory.”

In 2009, the Israeli Gas Authority initiated a prequalification process for an offshore LNG receiving terminal with an annual processing capacity of approximately 140 Bcf of natural gas. In connection with foreign investment, licenses granted pursuant to the Gas Law can only be issued to an Israeli company, however there are no restrictions on foreign individuals or companies owning shares.

Marketing Gas Reserves

Markets exist for the Leviathan field’s gas reserves, both in-country and abroad, via pipeline and LNG. The domestic market is the first of several opportunities for Leviathan. Israel is almost entirely dependent on imported fuels, including coal, crude oil, refined petroleum products, and natural gas. In 2008, oil and coal accounted for nearly 80% of generating fuels used by IEC, a percentage that has decreased significantly in the past two years.

Without considering mobile (e.g., automobile) fuel demand, there is potential for approximately 265 Bcf annually of Israeli natural gas to replace oil and coal in IEC’s existing power plants (less if gas is used in high-efficiency power plants). In addition, coal and petroleum displacement potential remains in a variety of other domestic markets, including industrial, commercial, and residential customers. Even if Leviathan is produced over a 50-year period,

Gas prices in global markets vary considerably from region to region, season to season, and year to year. (Source: Benjamin Schlesinger and Associates Inc. 2011, from World Gas Intelligence, Japan Custom Clearance)

Israel’s domestic demand for electricity generation would use only about one-third of it at present consumption levels. Therefore, gas exports are inevitable.

The European market is another opportunity for Israel. Gas demand in Europe has stabilized in the range of 18 to 21 Tcf per year, slightly less than in the US. The European Union’s considerable emphasis on renewable fuels has limited gas market growth, as well as the continent’s higher gas prices compared with North America’s.

Europe’s supply picture is evolving toward open markets and less reliance on long-term contracts. In particular, there is concern regarding overreliance on gas supplies imported under long-term contracts from Russia in light of slowing investment in frontier Russian gas fields and continuing disputes involving gas transit countries. These developments – rising open access and the desire to diversify its sources of supply – along with its proximity to Israel and relatively high gas prices, make Europe an important potential market for Leviathan gas reserves. Nearby countries such as Cyprus and Greece already have begun discussing importing pipeline gas from Israel’s offshore fields. LNG exports to Europe also will follow once Israel has installed liquefaction capacity.

Gas markets in Asia also could be an opportunity for Israel’s natural gas as LNG. Global LNG trade is rising more quickly than pipeline gas movements, a trend that is likely to persist. US markets are oversupplied as a result of major shale gas finds. More than 12 Bcf/d of gas liquefaction capacity was installed in the past decade to serve the US market, and at least as much LNG-receiving capacity was installed in the country.

Prior to the demand estimated to be triggered by the Japanese crisis, as well as the current uncertainty in the Middle East and North Africa, the global LNG glut was expected to persist through the mid-2000s as more supplies come onstream from Australia, the Middle East, and West Africa. Nonetheless, some LNG importers, including China, appear eager to diversify their sources of gas and have shown considerable interest in importing LNG from emerging offshore fields in Israel.

The most important markets for Leviathan gas likely will include in-country markets – electricity generation, industrial, commercial, and domestic – as well as pipeline and LNG sales to Europe and LNG exports to Asia.

Additional Issues To Address

With the magnitude of the Leviathan gas discovery, the Israeli government will have to deal with the broad array of institutional, contractual, risk management, and other non-hardware issues, as well as the physical system and operations issues that must be addressed to bring this gas to market and to monetize it properly.

The royalties issue will need to be addressed. A workable and predictable set of percentages, a clear definition of measuring points, and resolution of netback questions all are necessary to provide developers, the government, and the public with a comfortable, predictable framework. Patterns throughout the world vary considerably on these questions, and, even if the government selected one to emulate, the question remains which one to choose. For example, US federal and state royalty rules differ from one another, and from Canadian Crown and provincial rules, in terms of applicability, first sale definitions, percentages, etc. The Israeli government will have to study international examples and develop (and maintain) a set of rules that will work best.

Taxation is another issue to consider. Ad valorem (property) taxation is levied within Israel on energy-related property involved in gas production, transmission, and distribution assets. Such taxation must be extended in a rational, predictable way to new types of facilities such as LNG liquefaction plants and LNG shipping and export facilities.

In terms of infrastructure, the economic development choices facing Israel vary widely for the Leviathan gas reserves. The principal choices in today’s gas world include domestic use (electricity, industrial, commercial, and residential markets); exporting LNG to Europe and Asia; processing the reserves into high-value fuels and products such as substitute petroleum products (gas to diesel); industrial products (plastic manufacturing); and many others. Each requires land use, causes public impact, and comes with economic and environmental issues that the government will have to address proactively, or else it will be in a reactive stance relative to individual requests for approvals.

Each of the choices for Leviathan gas must include a return to investors and the nation. The Israeli government must address the netbacks from each major market to assess the macroeconomic effects of its development choices so it can lay the groundwork for rational exploitation of the reserves in the country’s interests. The analysis of trade-offs involves marketplace valuations of gas at the point where LNG is delivered, as well as the costs of each element of the gas supply chain to such markets – pipeline tariffs/tolls and storage and compression rates versus liquefaction and shipping costs – and their attendant risks.

How project finance is structured will be key to the nation’s ability to monetize and retain economic benefits from the Leviathan gas reserves. The government should facilitate investor interest through a program of consistent polities that stimulate private capital and ensure flows of capital to the highest value forms of infrastructure. Gas prices in global markets vary considerably from region to region, season to season, and year to year. In light of these unknowns, only through encouraging risk taking and enabling competitive returns on investment, while maintaining strict safety and environmental oversight, will the government ensure a maximal gain in the country from these reserves.

Moving Forward

The excitement surrounding Leviathan is understandable. To achieve the best results and maximize the value of the reserves, the Israeli government and stakeholders must engage in and apply the best practices that have evolved in the global natural gas industry, including applying legal and regulatory principles tailored to meet the specific requirements and goals of Leviathan.