How Natural Gas Works in Egypt

Egypt’s former minister of petroleum from 1999-2011, Sameh Fahmy, has just been sentenced to 15 years in prison for his part in the export of Egypt’s natural gas to Israel. So has the alleged “holder of the keys of corruption,” ex-spy businessman Hussein Salem who invested in the project and cashed out before the gas started flowing for a 500% profit; several other state petroleum officials received 10 years. The legal reasoning behind the conviction seems obscure, however, as the full text of the judgement has not yet been released. News summaries say the conviction is for selling gas below the international price, without following proper procedures, and thus “squandering national resources.” Taken alone, each of those steps doesn’t mean much, but together with the fourth factor that the buying party was Israel, they add up to political dynamite. I don’t know much about the detail of the legal procedures, but I doubt that this could be much more of a technicality, given that the old regime could tailor petroleum legislation to its needs with impunity. As Bradley Hope of The National points out, Egypt built a similar pipeline across the Gulf of Aqaba in 2006 to export its gas to Jordan at similar prices, but nobody will be convicted for that crime.

The issue of Egypt-Israeli relations aside, I did some reporting about the industry here from 2005-2006 and I have a few points to make about the nature of natural gas production that none of yesterday’s news stories made. The petroleum industry likes to keep its contract dealings opaque because, like the finance industry, the complex structures of these deals are the source of their huge profits. The free market is a myth, in particular for a commodity like natural gas with spacial restrictions on its use. We are conditioned to think of fossil fuel energy as a fungible commodity with a perfectly competitive global marketplace (although futures speculation and OPEC, to name a few, manipulate the price of oil). However, the concept of an “international price” for natural gas is somewhat misleading. Unlike liquid oil, it is not cost effective to export gas long distances, particularly overseas, because gas is not dense enough. Countries with surplus gas mostly export to directly adjacent countries through pipelines: for example, the United States, which imports the vast majority of its natural gas from Canada. This means internationally traded gas is more expensive in regions where demand outpaces supply, and cheaper where there is an abundance of gas — like the Middle East.

It was only Japan’s voracious appetite for gas in the 1970s, which it could not pipe in, that prompted oil companies to develop cryogenic tanker ships that carry liquid methane at -162 Celsius. This makes it 600 times as dense as gas at room temperature and thus profitable. This technology also helped small island nations like Trinidad and Tobago, with a large surplus, export it to mainland consumers. (Trinidad is America’s #2 import source). However, the process requires massive capital investment: each plant costs $1 billion, and the ships are $200-300 million each. As a result, most liquified natural gas (“LNG”) transactions are in multiple-year contracts between producers and consumers, mediated by the international oil companies. Very little LNG enters the open market like crude oil. So with the volatility in energy markets in the past five to seven years , the “international price of gas” has been much higher than the average amount paid almost anywhere in the world under fixed supply contracts.

Egypt has a lot of natural gas. But producing this gas requires economic operations of hugely inconvenient and political dimensions. By a twist of fate, international oil companies discovered much of it about 15 years ago under the continental shelf of up to 200 km off the northern shore of the Nile delta in water fifty to several hundred meters deep. Getting at these reserves requires technology and engineering techniques that the Egyptian government doesn’t have, so it has contracted the work out to BG (formerly British Gas), BP (formerly British Petroleum, a different company), Shell, EMI and Union Fenosa. When BG (to take the largest natural gas contractor in the country) makes a discovery, the Egyptian Petroleum Ministry’s state-owned marketing company, the Egyptian General Petroleum Corporation, forms a joint venture company with BG that produces and the sells the gas — either back to EGPC for the domestic market, or for export.

Therefore, there are three crucial points of negotiation in forming this production deal:

1) How much “profit gas” (after all expenses are paid) does each partner take? Onshore, this is usually in the range of 75% Egypt to 25% oil company, but in offshore production the oil companies have leverage and get 30% or more.

2) How much must the joint venture give to the Egyptian grid, and how much can it export? Before the late 1990s discoveries, this was a non-issue: there were no pipelines and no ships. But the magnitude of these discoveries, which was at the time much greater than domestic demand, allowed the oil companies to convince Egypt to build several of its own LNG terminals. In fact, they made it a condition of doing riskier, higher-investment offshore work. The enticement was there, because Egyptian industry couldn’t use the gas (for electricity, plastic, fertilizer, etc.) at the rate the companies could produce it, but they would get a 65% share of a high net-back price (after transportation fees) from France or America, bolstering Egypt’s foreign exchange reserves. When Egypt entered the contracts in the early 2000s, they committed somewhere around 2/3 of the new gas (in multiple contracts) for LNG export and 1/3 for the domestic market. This is a ratio which by 2006 they were already regretting because of increased domestic demand. Even though Egypt has a gas surplus it is a net energy importer, in the form of oil. At the same time it planned to export this gas, other sectors of the economy (electricity generation and compressed natural gas taxis, to name two) were switching over to use natural gas because it was much much cheaper for the country than subsidizing imported diesel or fuel oil. This price difference was both because international oil prices are high — but local natural gas prices are under state control (below).

3) The crucial point at hand — What price does the EGPC pay for the gas being produced? It took me weeks of research and talking to industry officials before I understood the signs and lingo that allowed me to approach this sensitive question. In 2000, after the gas had been discovered, the ministry decided to set a cap on all its contracts at $2.65 per million metric British thermal units (mmbtus), which was within international norms at the time which was appropriate for the increased costs but kept local subsidies under control. The oil companies were happy to comply, because they were getting to export a large portion of the gas as LNG to France where they were getting maybe $3.50 after transportation costs.

This is around the time that Egypt and East Mediterranean Gas (Hussein Salem’s Israel pipeline concession) entered negotiations. Remember, none of these shady deals would have been possible had there not been an abundance of gas available to the domestic market. According to The National, the original price Egypt was going to sell to East Mediterranean Gas, was an implausibly low $0.75-$1.50 per mmbtu. I’m not sure when this price dates to, but I imagine it is based on the the cost of onshore gas before the $2.65 offshore contracts came online. By 2006, when the BG gas was finally flowing, the energy markets had gone haywire: the price of a liquid natural gas unit on the US open market peaked at $14 that winter. It is not clear to me why Egypt did not just end the deal with Israel at this point and try to export more as LNG, or save it for the domestic market, but the answer is probably a series of bribes between the officials concerned (allegedly — again, I saw no direct evidence of this in the judgement yesterday). Deals like this have inertia. Millions had already been spent on the infrastructure, so Egypt and Israel renegotiated the Egyptian price to $3 per mmbtu (for a 35 cent profit per mmbtu) and proceeded. In defense of this reasoning, a pipeline is much less of a commitment than an LNG plant, both in capital and its requirement for a constant flow. The Israel price was not as much as Egypt was getting from the US (where it became the #3 source of natural gas (!) from 2006-2010) for its free-market LNG, but it also required nowhere near the infrastructure to make that transaction. One can’t wish an LNG plant into existence overnight; it takes five years to build.

The defense for Sameh Fahmy argued that gas giant Qatar was also receiving $3 per mmbtu for the gas it was selling as LNG. The fact stands that Egypt was selling maybe 3% of its total production to Israel, but 10% or more to Jordan at similar prices to fuel 80% of its electricity generation. (These sales are now suspended, because of repeated Bedouin attacks on the segment between Port Said that feeds both pipelines, and Jordan is forced to use much more expensive fuel oil). Does getting $3 when LNG is at $6 mean that the Egyptian taxpayer is subsidizing this gas? As you can tell, that is a subjective call.

There is little doubt that Fahmy and the men in power manipulated the system for personal gain, but determining what they did was illegal is essentially a political act. I believe that the media should be more transparent about the fact that state monopoly control over certain resources means that all choices — prices, production levels, trade partners, etc. — produce rents that these economic actors will fight over. The $2.65 capped production price for new gas is probably long-gone. I don’t know the new contract prices, as they are well-kept secrets. If international gas prices remain as high as they have been in the past several years (excepting the recession slump), it will be difficult for Egypt to convince the oil companies to prospect in deep water unless they pay more or let them export most of it — two unpalatable options.

“Munubul” — Mubarak’s Egypt

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About ericschewe

PhD, History. This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 Unported License.
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3 Responses to How Natural Gas Works in Egypt

  1. The 18th St. Peanut Gallery says:

    Eric,

    This was an interesting post but your core assertion–that there was clear malfeasance–is based on a misunderstanding of a series of critical issues here with these markets. Here are some of the problems:
    1. “The petroleum industry likes to keep its contract dealings opaque because, like the finance industry, the complex structures of these deals are the source of their huge profits.”
    a. Forward markets for petroleum products are deep and liquid and the vast majority of contracts are priced to a benchmark rather than a fixed price. Long-term LNG is an exception and is generally at a fixed price because you can’t finance a greenfield liquifaction / re-gas facility if the debt and equity have to take commodity risk.
    2. “So with the volatility in energy markets in the past five to seven years , the “international price of gas” has been much higher than the average amount paid almost anywhere in the world under fixed supply contracts.”
    a. This should not surprise you as the spot price for LNG should typically be higher than the spot gas price because as it corresponds to the local spot price in the supply market plus the cost to liquify, transport and gasify. There’s nothing nefarious here, you just need to pay the people along the way.
    3. “In 2000, after the gas had been discovered, the ministry decided to set a cap on all its contracts at $2.65 per million metric British thermal units (mmbtus), which was within international norms at the time.”
    a. This statement doesn’t make any sense as spot local gas is not an international commodity (you correctly note this above) unless there is an LNG train with spare export capacity. In that case you shouldn’t be comparing it to spot gas prices elsewhere in the world, but rather the LNG netback price to the producer.
    4. “By 2006, when the BG gas was finally flowing, the energy markets had gone haywire: the price of a liquid natural gas unit on the US open market peaked at $14 that winter. It is not clear to me why Egypt did not just end the deal with Israel at this point and try to export more as LNG, or save it for the domestic market, but the answer is probably a series of bribes between the officials concerned (allegedly — again, I saw no direct evidence of this in the judgement yesterday).”
    a. Again, you’re missing the different market point here. The US spot gas price is NOT the LNG export price. In 2006 the US had extremely limited regasification capacity and would not have been able to accept the gas for multiple years.
    b. There’s nothing particularly shady here. Export arrangement are typically non-cancellable contracts for the simple reason that in order to convince someone to build a multi-billion dollar facility they require the expectation of receiving a spread between the delivered and supply price. It’s perfectly fair to cancel the contract after but you need to pay the present value of the difference in revenue discounted back at the risk free rate (this will be a very big number).
    5. “The Israel price was not as much as Egypt was getting from the US (where it became the #3 source of natural gas (!) from 2006-2010) for its free-market LNG”
    a. Pretty sure these were spot prices vs. long term contracted prices.
    6. “The $2.65 capped production price for new gas is probably long-gone. I don’t know the new contract prices, as they are well-kept secrets.”
    a. The price is not really available online but it was never really a secret. Bidding for exploration blocks in Egypt was actually a fairly efficient auction process and the prices paid were well known.
    7. “If international gas prices remain as high as they have been in the past several years (excepting the recession slump), it will be difficult for Egypt to convince the oil companies to prospect in deep water unless they pay more or let them export most of it — two unpalatable options.”
    a. Prices are likely to remain high in the medium term because of the Japanese nuclear shutdown and the lack of liquefaction capacity in the US, where shale gas has led to massive supply and extremely low production costs.
    b. I don’t know why it’s particularly unpalatable to allow export capacity. At the end of the day, Egypt receives a large portion of the price at which the gas is sold, meaning that it’s mostly a profit allocation issue. If the gas is kept domestic and dumped into the local market, in the short term the spot price will crash, which will provide a massive windfall to consumers of natural gas (mostly electric utilities and large industrials). In the long term this will dry up exploration and production and lead to an increase in price to the level that supports exploration. If a portion of the gas is exported then local prices stay reasonable and the excess rents from export support exploration. If you could precisely predict supply and local demand you could allocate enough to the local market to generate any price that you wished, but you don’t so you can’t. The best you can do is take a guess and let the market deal with setting the price. Again, nothing particularly nefarious here as markets price commodities quite efficiently.

    Again, interesting developments but these are technical markets and the details matter.

    -The 18th St. Peanut Gallery

    • ericschewe says:

      Dear Park Ave. Peanut Gallery,

      Thanks for your reply. I’m sure the three readers who make it to the bottom of my post will be interested to have your technical comments.

      But I think you misinterpreted my “core assertion.” I wrote this post because none of the reporting I saw bothered to explain the court’s misleading argument that paying less than the “international price” for gas was “squandering” Egypt’s gas. There has been no discussion of the huge investment and infrastructural differences in the ways gas is exported. I hoped to show that there was NO way that the Egyptian judiciary should expect EGPC should get LNG prices from its pipeline gas. This is why (#2) “international price of gas” is in scare quotes. My core assertion is that this trial, like so many others these days, made a political and not a legal decision.

      #3) Yes, I phrased that badly. (Edited above) I did not mean to compare it to LNG, but rather what I understand was appropriate to the development cost environment at the time.

      #4 and 5) I glossed the difference between spot and contracted LNG in the interest of not making the post too long or complicated. I did not mean that all LNG was at this price but rather to show how high the “international price” could go, and thus why it was NOT comparable to locally produced gas.

      #4b) Any particular comments about Hussein Salem here you wish to make? Like the details of the free and competitive bidding process for the Israel pipeline concession?

      #7) Egypt subsidizes its natural gas for industry, power and home consumption. If EGPC/EGAS, as monopoly state owned buyer, pays a fixed price for its upstream production, and then charges a lower fixed price to its consumers, how exactly is the “market pricing this commodity”? In fact, under this state-managed system these choices — whether to use natural gas or diesel in cars, or coal in power plants — are extremely political. They seem determined more by wasta and kusa (i.e. Egyptian slang for nepotism and connections) than by “bid and ask.”

      Sure, it would be a problem for Egypt to have an oversupply on the domestic market in the short run. I’m not against exporting per se, but just that under these not-free-market conditions, it seems like a difficult decision. Shouldn’t Egypt consider promoting local natural gas consumption in the long run if it can obtain a cheaper joule of energy from this form than from imported and more heavily subsidized petroleum?

      And regarding (#1) If your company just paid you, during working hours, to argue for 1000 words about this with me — tell me exactly how I’m wrong?

      PS Why do you think Sameh Fahmy et. al. were found guilty?

  2. Venetta Hookfin says:

    You can expect gas prices to rise every spring. It seems to get earlier and earlier each year. That’s because oil futures traders know demand for gas rises in the summer. They therefore start buying oil futures contracts in the spring in anticipation of that price rise.:

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