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Israel’s Populist Energy Crisis

The opinions expressed by columnists are their own and do not necessarily represent the views of
Direct foreign investment in Israel is in free fall. According to a report published last month by the UN Conference on Trade and Development, (UNCTAD), foreign direct investment in Israel in 2014 was 46 percent below levels in 2013, dropping from $11.8 billion to $6.4bn. During the same period worldwide direct foreign investment dropped a mere 16%, meaning the drop in investment in Israel was nearly three times the global average.

Some responded to the report by blaming Operation Protective Edge or the boycott Israel movement for the sudden downturn. And there is probably something, although not much, to that view.

Israel tends to bounce back relatively quickly after wars end. Since 2006, the impact of wars on Israel’s economic growth has been marginal.

As for boycotts, it is hard to enact them. Only 5% of Israeli exports are finished consumer products capable of attracting the ire of Jew-haters. The other 95% are business to business sales with Israeli exports incorporated into products assembled in other countries, and so largely immune to boycotts.

The real cause of the plummet in investments is elsewhere. And to understand it we need to understand recent developments in the natural gas industry.

For nearly 60 years – from 1952 through 2011 – the regulatory situation in the Israeli energy sector was stable. By law, the state was to receive 12.5% of royalties on the sale of energy supplies developed by holders of development licenses, in addition to normal rate corporate taxes.

The regulatory situation was well suited to a market where costs of exploration and development are high and the chance of profits is low.

Opportunity costs also played a role in determining the investor-friendly license conditions. Due to the Arab economic boycott, companies that sign energy contracts with the Jewish state risk being denied energy contracts with the Arab states. And whereas the probability is low that an investor in Israel’s energy market will turn a profit, the probability of profits in Arab energy markets is high.

When, at the end of 2006, the US firm Noble Energy entered the exploration concession for the Leviathan basin gas deposits, which among other things includes the Tamar and Leviathan gas fields, chances of finding gas were not considered high. Noble entered the market after British Gas abandoned its rights to the fields because they were not deemed profitable.

Without Noble, or another firm with comparable capabilities and experience, Israel wouldn’t have been able to develop or operate the fields. Delek Energy and the other Israeli partners lacked the capacity to carry out the complex operations required. To develop the Tamar gas field, a well was built across 500 meters of water at a depth of 5,000 meters. The drilling was carried out at exceedingly high pressures and beneath a thick layer of salt.

The drilling operation at Tamar cost Noble and its Israeli partners $140 million. To transport the gas to Israel required an additional investment of $4b.

When Noble began its drilling operation at the end of 2008, it estimated its chances of success at 35%. Tamer wasn’t expected to be particularly large. But by early 2010, it was clear that Noble, Delek and their smaller partners had hit the jackpot. Tamar with its 9 trillion cubic feet (Tcf) (254.85 billion cubic meters) of natural gas was the largest find worldwide in 2009.

In 2011, Delek and Noble’s luck continued when the initial drilling at the Leviathan gas field exposed an estimated 21 Tcf of gas. The Leviathan find was the largest of the decade. Together, the two fields not only have sufficient gas to make Israel energy independent for decades. There is enough gas in the two fields to transform Israel into a significant player in the global energy market.

Rather than celebrate the miraculous find, and then sit back and wait for the tax revenues and royalties to start flowing in, adding unanticipated billions to the Israeli economy, and additional investors to flock to its shores begging for development licenses, whatever the cost, Israel’s populists pounced on Delek and Noble’s extraordinary find like a street gang and proceeded to mug them.

Here it is necessary to note that aside from sell licenses, the government did nothing to develop the gas fields. It incurred no economic risks. Yet from the tenor of the debate begun in 2010, you might have thought that the clerks at the Finance Ministry and the opposition MKs in the Knesset had swam to the bottom of the sea and carried out the gas by hand.

A rent-a-mob composed of socialist politicians and activists, regulators and bureaucrats, all upset that free market forces enriched investors without their permission, demanded a confiscatory cut in the profits from the energy resource Israel now enjoys only because private companies invested hundreds of millions of dollars to extract it from the bottom of the sea.

Rather than stand by the investors and stare down the populist bullies, then-finance minister Yuval Steinitz joined the mob and appointed the Sheshinski Committee. The committee was tasked with recommending ways to breach the government’s contracts with the energy companies in order confiscate a far larger share of their future profits.

The Sheshinski Committee, and the 2011 law regarding windfall energy profits promulgated on the basis of its recommendations, taxed energy profits at a rate of between 52% and 62% rather than the 27% corporate rate. The increased taxes were applied retroactively to Noble, Delek and the rest of the license holders.

Noble CEO Charles Davidson reacted angrily to the changed regulatory environment, telling The Wall Street Journal, “A retroactive change would be egregious and would quickly move Israel to the lowest tier of countries for investment by the energy sector.”

Israel was about to see just how right he was.

Ever since the European Union began threatening economic boycotts against Israel, the government has rightly urged exporters to diversify their markets in order to lower Israel’s exposure to Europe. In the gas industry, diversifying markets means exporting gas to Asian markets. To open Israeli gas to Asian markets, Noble and Delek began negotiating the sale of 25% stake in the Leviathan gas field to Australia’s Woodside Petroleum. Woodside has the technical and marketing capacity to sell Israeli gas in Asia.

In May 2014, Woodside was poised to sign the deal with Noble and Delek and enter Leviathan with a $2.7b. investment. But at the last minute, Woodside walked away from the deal. It said it would be willing to reconsider its decision if Israel enacts “material changes” in the investment environment.

Despite the draconian retroactive taxes, Delek and Noble soldiered on. They signed a new contract with the government, in accordance with the new law, despite the high taxes and the fact that the law required them to sell their rights to the smaller Tanin and Karish fields.

But that wasn’t enough for the populists. Last December David Gilo, the head of the Anti-trust Authority in the Finance Ministry, proclaimed that the deal was illegal because Delek and Noble are a “terrible monopoly” with near complete control over Israel’s gas industry. Gilo determined that they have to end their partnership, and sell of their shares in either Tamar or Leviathan.

In response, Noble announced it was suspending its development of the Leviathan field. Whereas in 2014, Leviathan was expected to come online by 2017, now it won’t be under production until 2020 at the earliest.

When the new government entered office, Prime Minister Benjamin Netanyahu – who supported the 2011 windfall profits law – decided to sidestep Gilo and approve the deal the previous government signed with Delek and Noble. Everything seemed to fall into place last week when the security cabinet approved the deal. But then Economy Minister Arye Deri decided to spike the football and refused to sign the requisite order to implement the cabinet’s decision.

This week we were subjected to yet another populist assault on Noble and Delek. Now the rent-a-mob demands that the government abide by Gilo’s ruling, using his buzzword “terrible monopoly” at every opportunity.

But as with most populist economic protests, there is no basis for their claim. The notion that Delek and Noble’s partnership in gas development is a monopoly is utter nonsense. They are licensees. They purchased their licenses lawfully, and abided by their terms. They even agreed to pay more when the state scandalously passed a law and applied its draconian regulations retroactively.

Moreover, Delek and Noble cannot dictate prices for their gas. Israel isn’t required to buy gas from them. The only reason Delek and Noble became Israel’s only suppliers is that Israel decided to buy all of its gas from them after Egypt’s Muslim Brotherhood government canceled the gas deal Israel signed with its predecessor.

If the government thinks that Delek and Noble are charging too much for their gas, Israel is free to look elsewhere.

From the perspective of the future growth of Israeli energy markets, perhaps the worst aspect of the state’s decision to abuse the investors is the timing. The government went after the investors before they had the chance to bring the Leviathan field on line. In the current regulatory chaos, the gas may well stay in the sea forever.

What serious energy company would agree to invest here now? The entire world energy sector now knows that you can’t trust the Israelis. Any exploration project in Israel is a double gamble. First you roll the dice when you begin developing a field that will in all likelihood be dry. Then, if you happen to get lucky, you have every reason to expect that the state will invent a way to seize your future profits.

This brings us back to the UNCTAD report from last week. Israel’s populist – and corrupt – treatment of Delek and Noble is a massive warning sign to investors. Not only shouldn’t you rush to Israel, you should stay away from Israel.

If we are to correct the damage – to our energy market specifically and to the Israeli economy overall – there is only one path to take. The Knesset must abrogate the 2011 windfall profits law and end all attempts to define the Delek-Noble partnership as a monopoly while seeking new, creative ways to seize their profits.

Then, the Knesset must pass a law that will protect investors from attempts to retroactively change the terms of operating licenses they receive from the State of Israel.

Israel has enough problems with the anti-Semitic boycott movement that is growing by leaps and bounds. We need to curb our populist tendencies and stop making those who want to invest in Israel feel that they are fools to do so.

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