Egypt needs to reform to ensure post-revolution investment
Egyptian policy-makers face significant challenges - not least stabilising the country's energy sector and encouraging much-needed inward investment
Since the ousting of Hosni Mubarak at beginning of 2011, Egypt has endured significant turmoil. The revolution of 2011 caused the Egyptian economy to essentially collapse and the resulting political instability made it difficult for Egypt to retain and attract foreign investment. Egypt's national revenue has fallen, and debt to foreign oil companies has increased significantly.
The underlying strength of the economy and energy sector has been brought into question, and as a consequence, investors have been frightened away from the Egyptian market. The Egyptian government has recognised this, and over the past year has taken several steps to revitalise both the broader economy and, more specifically, the energy sector. However, in the short- to mid-term, no matter the steps taken by the government to meet its energy demand, natural gas and power demand is poised to rapidly outpace domestic production, with Egypt obligated to divert gas from existing liquefied natural gas (LNG) projects and turn to the international energy market to meet this shortfall.
Since the political transition that occurred with the downfall of Mohammed Morsi’s administration, Cairo took a number of positive steps to redevelop its energy sector, including issuing new exploration licences to attract foreign investment and announcing its intention to reduce the debt owed to foreign energy companies.
Egypt has since received substantial assistance from several Gulf countries. However, it is unlikely that this assistance will continue for long, as it is essentially a short-term palliative measure that will not solve the structural ills plaguing the Egyptian natural gas sector.
Moreover, Egypt increasingly faces budgetary pressures to reform its energy subsidy programme, which it delayed due to the fears it could spark a strong political and social backlash. Yet, it is a problem that can’t be avoided and it is likely that Egypt will begin to undertake crucial, yet incremental, energy sector reform, focusing on the natural gas sector, over the next five years.
However, the Egyptian government is facing a strategic dilemma. “It must decide whether it should satisfy rising national primary energy demand - the majority of which, approximately 94%, is supplied by natural gas and oil - by which hydrocarbons are granted to consumers at regulated prices, or whether it should preserve its foreign revenue through natural gas export. Maintaining hard currency revenues from oil and gas exports at international market prices is essential for the Egyptian economy, even with the risk that it accelerates depletion rates of proven reserves.
Nonetheless, despite the current problems, the Egyptian natural gas sector has been expanding considerably, both from a consumption and production vantage point. Natural gas accounts for the majority – 56.2% – of primary energy supply. Indeed natural gas has an increasingly important role in the Egyptian economy. For instance, in 1982, natural gas represented 12% of hydrocarbon consumption. However, Egyptian domestic consumption has been rising due to an expanding population, low-cost natural gas and power tariffs and an effort to stimulate industrialisation by increasing natural gas consumption in the industrial production process. While the country’s oil output has declined since the 1990s; natural gas production has risen (at present to about 15% of Africa’s total), albeit, more slowly than demand growth, particularly when taking into consideration Egypt’s gas export commitments.
The importance of the natural gas sector relative to the Egyptian economy has been growing over the past decade as well. Since 1993, when crude oil production in Egypt peaked, the strategic focus of the Egyptian government has been to increase exploration and production of natural gas.
The strategic shift away from oil as the mainstay of the Egyptian economy to natural gas was due to a number factors. The most pressing reasons were the rapid rise in natural gas demand and policies designed to produce more natural gas for domestic consumption, leaving oil output for export abroad. Egypt, since the inception of a natural gas focus, had a series of successful natural gas discoveries and heavy foreign investment in the sector.
While Egypt does not have a dominant position in the global gas sector, it played a large role in regional gas supply. All of the natural gas consumed in Lebanon, nearly all of Jordan’s supplies, and more than half of the natural gas consumed in Israel originated in Egypt.
Despite its key role in the region and success it had in attracting investment, Egypt will need to reform its natural gas sector in order to foster investment by international energy firms and create foreign partnerships. This will create an environment which will allow increased natural gas production to keep up with increasing consumption.
Energy sector outlook
Figure 1: Population growth
Egypt is the largest non-Opec oil producer and second-largest natural gas producer in Africa. Egypt’s production strategy has always been to produce at high volumes which can then be sold on the international markets at a profit.
However, domestic demand for natural gas has increased commensurate with Egypt’s growing population. To meet the rising domestic demand, Egypt has had to import energy and then sell it at a lower rate on the domestic market than it could on the international markets, leading to reduced profits. This creates an unsustainable model for business, and has resulted in rising debt and illegal smuggling of energy, especially liquefied petroleum gas, to sell at a profit.
Furthermore, the fuel subsidy has been handled inefficiently, with only 20% of the subsidy reaching those who actually need it. The remaining 80% is being utilised by sectors such as the cement industry, where for some companies, energy can account for up to 50% of their total costs, and therefore, pushes for reform are likely to be met with hostility.
The longer the Egyptian government allows energy subsidies to continue, the less attractive the Egyptian energy sector becomes to foreign investors, and the greater the damage to the sector and economy.
In November 2013, prime minister Hazem al-Beblawi announced that before leaving office in 2014, the government would make changes to the fuel subsidy programme. However, it appears that this would be dependent on presidential elections, due later this year. Therefore, the military administration seems unwilling to make an immediate change, but it is likely to be addressed after the elections.
Egypt’s energy challenges are significant; however, they are not insurmountable if creative and proactive strategies are undertaken. The natural gas trends for Egypt indicate that increased domestic demand, tied to maturing natural gas reservoirs, will lead to a decline in Egyptian export capacity over the coming decade. This is already occurring as Egypt diverts natural gas from its LNG plans to the domestic market to meet the critical peak demand expected during the summer.
Egypt also faces a challenge to retain a large portion of the value of natural gas in the domestic economy. There are very weak forward and backward linkages throughout the economy. The low levels of integration between energy-intensive industries and the national economy have led to low job creation and low rates of technology transfer for domestic industry. The value-added sector faces similar challenges; the refining and petrochemical sector suffer from lack of investment capital due to the lack of state liquidity on one hand and the centralisation of the sector.
Similarly, the country has lately experienced power blackouts that have affected a large swath of the population. Fast-paced economic growth in the 2000s, as well as major expansion of the industrial and manufacturing sector has led to electricity demand increasing by approximately 8% per annum, which put enormous strains on the country’s power supply of 23 million megawatts (MW). In response, the government pledged to expand power generation capacity by 58m MW over the next 20 years. In the face of declining natural gas production, without natural gas sector reorganisation, it is difficult to foresee how demand will be met.
Over the past decade, Egypt had been a model for the MENA region in terms of its proactive policies to create attractive investment terms for international oil companies (IOCs) in the country’s upstream. Egypt awarded the largest number of energy concessions in the region in the decade to 2010, but it is now facing looming gas supply shortages. The 1990s saw a number of significant deep-water natural gas finds in the country’s offshore, but recent exploration has not been as successful, meaning that Egypt’s natural gas production has not matched the steadily growing rate of consumption.
Since the 1990s, Egyptian natural gas production has more than tripled, reaching more than 62.7bn cubic metres (cm) last year. However, the global financial crisis of 2008 and the political transition of early 2011 disrupted market confidence and led to repatriation of investments. This, in turn, saw gas output stagnate. Yet Egypt does have the potential for increased gas production based on its potential reserves However, most of the country’s incremental supply will come from deep-water fields in the Mediterranean, estimated to hold about 75% of Egypt’s total gas reserves.
These new reservoirs are geologically complex, high-pressure, high-temperature reservoirs. To stimulate production, these fields require significant investment, operators with specialised skill-sets and advanced technology. Even though Egyptian prospects for an increase in natural gas production are immense, if steps are not taken, then the country risks – in the worst case scenario – seeing runaway gas demand growth forcing it to become a net importer of natural gas by the end of this decade. Egypt is already on the way to being what is known as an “Export Land” country.
An Export Land country is one that is caught in the scissors of declining oil production and rising domestic demand, which therefore reduces its ability to export. In that scenario, the decline in exports is proportionately larger than the decline in production.
Considering that Egypt depends upon oil for hard currency, it is expected that with the decline in oil output, natural gas will make up a proportionately larger share of revenues. Yet, it appears that the natural gas sector is following the same pattern with demand rising as output plateaus. The trend was exemplified by the official announcement in 2008 that no new export contracts will be negotiated and there would be a moratorium on further gas exports. The natural gas deficit has already begun to appear at that point. In 2008, Egypt imported primary fuel – not, however, natural gas – to offset declining gas production.
Under a much more moderate forecast, it is likely that Egypt will face a sharp curtailment of its natural gas exports in order to satisfy domestic demand for the medium-term. Although Egypt has continued to discover new gas reserves, production has slightly slowed down and its reserves to production ratios have begun to decline. These factors alone make discovery of new gas fields all the more important. In any case, it is apparent that in the near term, Egypt will have to import LNG on a temporary basis to meet peak demand requirements.
Figure 2: Egyptian gas
Another major area of concern for foreign investors has been the issue surrounding the outstanding debt that Egypt owes to foreign energy companies. At the end of 2012, Egypt owed an estimated $5.2bn to companies such as BP, BG Group, Edison and TransGlobe Energy. Today, that debt has risen to around $6.4bn. Furthermore, as a result of the 2011 uprising, foreign direct investment in the oil and gas sector stagnated, and currently stands at $3bn for 2012-13, down from $11.1bn and $13.2bn, in 2007 and 2008, respectively. Furthermore, with a fall in tourism related revenue, the Egyptian economy has declined sharply, making debt repayment a struggle. Egypt’s debt problems are compounded by the current subsidy system, and the longer that the government refrains from action, the less attractive the energy sector becomes to foreign investment.
As of December 2013, Egypt has successfully renegotiated its debt repayment schedule and made a partial payment – $1.5bn – to IOCs to revive confidence in its energy sector and convince IOCs to continue to produce. The $1.5bn will be paid in three tranches, the first $1 billion by the Central Bank, the second tranche of $300m by the finance ministry (made in Egyptian pounds so as not to drain foreign reserves), and the final $200m by the Egyptian General Petroleum Corporation (EGPC).
Egypt is currently negotiating a timetable to pay off another $1.8bn. Policymakers believe that this agreement would also lead to a $15bn increase in investments from foreign companies to stimulate increased natural gas production within the next two years and bring greater stability to the overall economy. In addition, Egypt is set to receive $12bn in financial aid from Saudi Arabia, Kuwait and the United Arab Emirates. This further injection of funds should give foreign investors a degree of confidence that the economy is stabilising, leading to increased investment in the country.
Egypt is making an attempt to not only stabilise the natural gas sector but also stimulate further production growth. In early December 2013, it signed exploration agreements with GDF Suez, Shell and Apache Corporation, in an attempt to reignite gas production. Furthermore, EGPC and the Egyptian Natural Gas Holding Company (EGAS), announced on 30 December last year that there would be an auction for 22 concessions in May 2014.
However, deeper reform is needed to ensure Egypt remains attractive to foreign investors. The current administration is considering modifying the legal framework to bring greater protection to investors. One proposal is for the government to bolster the legal standing of existing contracts entered into with the state. This could mean, for example, that the state expropriation of assets could be reviewed by the courts. This proposal would help ensure that foreign investors see the country as a secure place to invest.
Natural gas pricing is also in need of reform. Indeed, this is crucial to any strategy to revitalise Egyptian production. Undoubtedly, when the government finally implements it plans to remove state subsidies from gas provision to energy-intensive factories, there will be a period when industry will have to manage the higher costs that will be incurred. But, as has happened elsewhere, higher energy prices do not necessarily translate into reduced economic performance. Egyptian industrial competitiveness as gas prices are liberalised can be met by companies using more efficient equipment, processes and practices to conserve energy consumption. In many cases, energy efficient technology can bring with it lower labour or environmental costs and enhanced product quality.
Selective liberalisation in the natural gas market to increase natural gas prices for industrial users to market level will have a strong impact on energy consumption. Increasing energy prices would also encourage companies to seek alternative energy sources through fuel switching, co-generation and least-cost supply procurement. These results tend to be greater for firms and industries that are more energy-intensive.
Nonetheless, one of the key challenges for the Egyptian government is to design an energy sector reformation policy which would ensure that a transition to a liberalised pricing scheme for the industrial sector has limited “leakage”, where firms relocate to jurisdictions that have lower energy prices. This would be of particular concern if energy prices are significantly lower in other jurisdictions and Egyptian companies are unable to pass on those costs to end-users without losing market share.
Nonetheless, incorporation of a dual strategy of energy efficiency initiatives and governmental grants should be able to combat most competitiveness and leakage concerns. One pillar of the dual strategy should focus on industrial efficiency that mandates large energy-intensive industrial consumers to conform to the voluntary international standard, ISO 50001, or a similar energy efficiency management protocol.
The other should be incorporation of a governmental funding apparatus, composed of the funds saved from reduced subsidies, which could provide financial incentives or loans for energy-intensive factories to invest in energy efficient equipment and blunt the impact of higher energy prices. Energy efficiency in the industrial sector is crucial if Egypt is to remain competitive. A spatial clustering of energy-intensive industries could be an additional energy efficiency stimulus that fosters the advantages of energy allocation rationalization, as well as the promotion of economies of scale, with spillovers in the surrounding economy.
While Egypt is still going through a difficult process of political and economic stabilisation, if steps are taken in the near term, it will be able to develop a sustainable natural gas policy for the long term.