royalty relief

For more than half a century, hydrocarbon deposits have enriched many middle-eastern countries beyond measure.  But geology didn't favor all spots equally, and Israel pretty much came up dry.  The closest they came to oil gushers was the dark mud of the Dead Sea.  So development shifted elsewhere:  to tourism, high tech, and sustained investments into alternative energy. 

Moving beyond mud

This all changed with the discovery of large reserves of natural gas off the coast of Israel in 2009.  The Tamar field began production in March 2013.  Drilling in the even larger Leviathan field is expected to begin in 2015.  It will never be on the scale of Saudi Arabia or Kuwait, but the finds are a game changer nonetheless -- and not only in postive ways.  More secure domestic energy supplies and higher government revenues will be beneficial.  But rising currency valuations risk threatening existing core industries (the "Dutch Disease"); supply chains can become even more brittle; and historical efforts to diversify energy supply (many of which were also low-carbon) can be derailed. 

Better managing the windfall

The State is not ambling blindly in addressing these risks.  Government officials have established a number of commissions to review how best to move forward on gas development.  And they have commited to forming a Sovereign Wealth Fund to capture a portion of the windfall gains from the developments in order to invest them for the benefit of current and future generations.  Earth Track has reviewed this information, identified a number of remaining risks, and made a series of recommendations (below) to address them.  A more detailed discussion can be found here.

1)  Market pricing of all gas.  Use market-based pricing of natural gas sold in domestic or international markets in order to avoid politically-distorted decisions on export versus domestic consumption levels and to optimize revenues to the government.  This pricing neutrality should extend to associated royalties, excess profit fees, and recovery of field-related security charges.

2)  No subsidized conversion. Allow natural gas prices to determine the pace and location of infrastructure conversion to gas.  Don't subsidize either conversion-related capital or natural gas flows to particular industrial or commercial enterprises.

3)  Energy vulnerability tax on choke-points.  Institute an energy vulnerability tax or surcharge on energy flows through key chokepoints within Israel in order to protect and expand energy diversification efforts.  This would apply to all chokepoints, not just the new ones created by the Tamar and Leviathan fields.  Shifting some existing taxes on fuel end-users to a differentiated vulnerability tax on flows going through chokepoints can greatly improve price signals to invest in supply diversification and resiliency without adding additional energy taxes on a gross collections basis.    

4)  Full royalty capture. Review allowable exclusions and deductions from royalties to identify and correct areas of potential gaming and likely friction as fuel and revenue flows grow in future years.

5)  Fund principal invested in global, non-NIS securities.  Retain investment restrictions now in the Fund for Israel proposal that targets investment into global, non-NIS assets.

6)  Payout rules that allow fund appreciation over time.  Review and likely reduce payout rates from Fund to allow some investment earnings to compound within the Fund to grow principal over time. 

7)  Annual distributions direct to long-term capital projects.  Look to more closely align spending of income distributed from the Fund to Treasury with long-term investments into human and physical capital. 

8)  Tighter rules on borrowing from Fund principal.  Tighten rules on what counts as an emergency under Fund rules to ensure that resultant borrowing of Fund principal (and potential subsequent debt forgiveness) occurs only in the most extreme of circumstances.

9)  Review appointment procedures of key Fund oversight functions.  This would ensure that the direct and indirect influence of political figures over the structure and management of the Fund is appropriately checked in order to protect its independence.

Taxpayers for Common Sense (TCS), a Washington, DC-based organization focused on improved transparency in government budgeting and spending, has just completed a nice summary of the state-of-play in federal oil and gas royalty subsidies. 

Royalties are the payments that private firms make to the government to compensate the states owning the resources for natural resource wealth the firms have extracted from public lands.  They are normally a percentage of the market value of the resources extracted, so inherently adjust to changing market conditions.

While many countries have far worse transparency than the US in terms of who gets access to resources and what they pay, the US system continues to have its fair share of problems. These have spanned decades, and include problems with calculating the proper amounts, auditing the payment systems, and even some basic soap opera sleeping around messing with royalty collections.

Poor wording (assumedly unintentional, though at one point there was talk of a criminal inquiry though I'm not sure where it ended up) in lease agreements for production in the Gulf of Mexico has led to royalty-free extraction of billions of dollars of oil and gas even in periods of very high energy prices.  A lower court ruling in favor of oil companies was let stand by the US Supreme Court in October, and will result in an estimated $53 billion in lost royalties over the next 25 years.

Basic rules of risk sharing are routinely ignored in these contracts, with absolute royalty reductions granted rather than contingent reductions available only in adverse market conditions.  Won't happen again?  The Gulf incident was not the first time the feds have been tripped up on proper risk sharing for complex contracts.  The core issue is that legislators focused on changing rules for current market conditions have a hard time viewing technologies and markets as dynamic, or trying to plan for the wide array of potential outcomes as basic facts and conditions change. 

Foolishly worded contract agreements to provide a federally-run, break-even, repository for civilian nuclear wastes with little risk sharing by the private firms is another example of this generic problem.  As with the royalty scandal in the Gulf of Mexico, poor risk sharing on the nuclear waste repository is already starting to cost taxpayers dearly.

These two examples should be cautionary tales of how expensive simple mistakes in statutory wording can be.  Energy legislation running thousands of pages is becoming ever more frequent while the language and concepts contained in these bills are growing increasingly complex.  It should be expected that gaffes or intentional loopholes such as the Gulf royalty-free zone and the lack of risk sharing on nuclear waste contracts will sneak into the murky depths of this new legislation as well.  Yet, even as the public financial commitments keep growing, few people have read and understood the details of what is being proposed.

At least in the area of royalty relief, fixes seem straightforward.  New types of fuels in harder to reach locations are regularly trotted out as deserving of royalty relief.  Yet every industry has emerging technologies and applications with higher costs than existing products.  It is not surprising that the oil and gas sector, too, has a rising cost supply curve where some types of deposits are not economic with existing technologies or at current market conditions.  This is not a defect; it is a routine part of market functioning.  Oil and gas producers should be treated more like a routine industry, forced to innovate on their own dime towards making these emerging resources competitive, rather than continually seeking subsidy.  It hardly makes sense spending large amounts of public money to clamp down on carbon emissions on the one hand while subsidizing carbon extraction with the other.