While the declaration of force majeure by UK-based energy company BG Group for its Egypt operations came as a shock to the market, it was much less surprising to anyone tracking the country’s persistent energy problems.
In its January 27 statement, BG Group issued a profit warning and declared force majeure for its Egypt operations, “reflecting the ongoing diversions of gas volumes to the domestic market.”
BG, which has been operating in Egypt for more than 25 years, said it would be unable to meet its obligations to customers due to a force beyond its control: The Egyptian government, it says, is failing to honor agreements regarding the allocation of gas supplies.
“The operating climate in Egypt has worsened,” said BG chief executive Chris Finlayson in a call with analysts on the same day. As a result, he added, BG Group has been unable to meet its contractual obligations to export Egyptian liquefied natural gas (LNG) supplies to its customers.
The announcement, which came a week before BG released its 2013 earnings, made waves on the stock market. Within eight days, the company’s stock lost 18 percent of its value.
The news was a hit for BG, which depends on Egypt for about one-fifth of its total production. But it also doesn’t bode well for Egypt’s current government, namely with the military-backed interim Cabinet striving to present its cadre of technocrats as amply qualified to set the floundering economy back on course.
The wave of popular discontent that preceded the fall of former President Mohamed Morsi in July was driven in no small part by anger with recurrent power cuts and lengthy gas queues that plagued the country throughout the spring of 2013, especially in the week leading up to the June 30 protests.
When the interim Cabinet was appointed by the military, the energy problems seemed to swiftly disappear. However, BG’s announcement last week, coupled with a recent unprecedented wave of winter power cuts, suggests that little progress has been made to truly resolve Egypt’s power crisis.
Kinks in the supply chain
Egypt depends on companies like BG to extract the gas the country needs to keep its factories and power plants running. Like all multinational energy companies in the country, BG operates under a production sharing agreement with the Egyptian government. In exchange for providing the capital and expertise needed to drill for gas and oil, and for taking on the financial risk of prospecting, BG is entitled to a share of the gas it is able to extract from beneath Egyptian soil.
After a portion is held back to recoup expenses, the remaining gas is split between the company and the Ministry of Petroleum, with roughly half of production going to meet local demand.
The ministry and its holding companies pipe their share into the national grid, where it is sold at below-market prices to power plants, industry and households, powering everything from cement factories to streetlights to cooking stoves. In the past, Egypt has even exported gas to Jordan and, more controversially, Israel.
The balance of the gas goes to the multinational, which liquefies and exports it to customers abroad, generally under a long-term contract.
As long as there’s enough gas to go around, Egypt gets the fuel it needs to keep its economy running, and the multinational makes a hefty profit selling LNG on the global market.
The system breaks down when there isn’t enough gas to go around, which is the position Egypt currently finds itself in.
According to a recent Reuters report, the Ministry of Petroleum forecast that in the upcoming financial year, consumption would reach 5.57 billion cubic feet per day, outpacing predicted production of 5.4 billion cubic feet per day. Because much of that production is already tied up in export contracts, the local shortfall is already significant.
Egypt’s electricity is produced primarily by burning natural gas, so when demand for gas exceeds supply, parts of the electrical grid have to be shut down.
Poor maintenance and equipment failures are responsible for some of Egypt’s blackouts, but the wider issue is a shortage of natural gas, explains Robin Mills, head of consulting at Dubai-based Manaar Energy.
With Egypt’s population and economy continually expanding, the demand for electricity rises by around 10 percent annually. Egypt sits on a wealth of untapped gas reserves, but extracting it requires energy companies to stump up hundreds of millions of dollars up front, a risky prospect in a time of political and economic turmoil. The government is also unable to overcome investor reluctance by offering high prices for gas supplies — if companies could sell to Egypt at the same profit margin as the global market, they would likely be more inclined to invest.
“The shortage of gas is just going to get worse and worse,” predicts Mills.
Importing gas isn’t currently an option for Egypt. The gas available on the global market is liquefied for transport, and converting it to a useable state requires specialized, and costly, re-gasification terminals, which Egypt lacks. In 2012 the government announced it was seeking bids for a floating re-gasification terminal, but the project fell apart before a contractor was selected. Other ideas that have been floated, such as adapting existing pipelines to import gas from Israel or from Iraq through Jordan, while technically feasible, would require time and funds as well as political will.
Unable to import, and faced with rising domestic demands, the government has naturally cast its eyes toward the one available stream of gas: the share allotted to petro-companies like BG under their production sharing agreements.
According to Mostafa Ibrahim al-Shazly, a lawyer working on international petroleum agreements for the state-owned Egyptian General Petroleum Corporation, these contracts do generally grant Egypt the right to dip into the share of gas allotted for exports, provided that the government pays market price for it.
“Everybody is happy, provided that the international company gets its money back,” adds Magdy Nasrallah, head of the petroleum engineering department at the American University in Cairo.
In BG’s case, however, the government was taking so much of this gas that BG claims it was unable to fulfil obligations to its customers. And the breaking point seems to have come well after Morsi was deposed.
As of May 2013, the final weeks of the Morsi administration, Finlayson told analysts, “so far the government has stuck to its agreements.” By the end of July, however, Finlayson was reporting that “higher diversions to the domestic market have been required by the Egyptian authorities… what we have at the moment is actually a very variable level of domestic take.”
A crisis was held off when Qatar agreed to donate five cargoes of natural gas in June, and the shipments were made in August. While Egypt couldn’t import the gas directly, supplies could be delivered to European ports to fulfil export contracts, freeing up gas for domestic use without leaving energy companies in the lurch. Of five shipments delivered over the summer, two were allocated to BG and its customers.
Initially, Egypt and Qatar were in talks about purchasing an additional 13 shipments, but negotiations broke down in August after Morsi was deposed and relations between the two countries soured.
The gas swaps stopped, but diversions to the domestic market did not.
According to Finlayson, the government had agreed to take 650 million cubic feet per day, but reneged on its promises.
“The revised pooling arrangements put in place for 2013 have not been honored and domestic diversions are currently around one billion cubic feet of gas per day, close to the system capacity,” he told analysts on January 27. Effectively, the government was taking the entire production and asking BG to put the gas on its tab.
To make matters worse, the government racked up bills faster than it could pay them off. At the end of 2012, Egypt owed BG US$1.3 billion, out of an estimated total debt to of $5.2 billion to foreign energy companies.
Flush with around $12 billion in cash from Gulf aid pledged to the interim government, Egypt has begun paying back some of the arrears. In BG’s case, the debt was paid down by the end of 2013 to the current $1.2 billion.
Despite the relative progress, it has not been enough to enable BG to fill deliveries it is contractually obligated to make, thus last week’s declaration of force majeure.
Here to stay
It’s a sticky situation for everybody involved. BG is heavily invested in Egypt, with a major new offshore well slated to come online in the third quarter of this year. With so many assets tied up in the country, BG has little to gain by antagonizing the government by airing its dirty laundry.
Indeed, in its January 27 statement, the company was careful to stress, “BG Group remains committed to the Egyptian LNG Project and will continue to negotiate with the Egyptian authorities and other stakeholders to seek a long term solution.
But with a real risk of not being able to honor contracts — and a need to justify weak earnings in advance of its annual report — BG made the decision to publicize its troubles in Egypt.
The current government urgently needs to improve deteriorating economic conditions or risk spurring renewed ire among citizens much like its predecessors.
For months, ministers have gone to great lengths to reassure investors at home and abroad. Delegations of Egyptian officials have toured the world courting foreign investment; at this point, the government can ill afford a reputation for not honoring contracts with foreign companies.
At the same time, if it is to raise gas and oil production to keep pace with increasing demand, the government needs to reassure potential investors that their interests are safe in Egypt. BG’s recent declaration will not help the government pitch gas deals to prospective investors.
“Obviously, it isn’t sending a good message to others,” says Mills. “They’d be concerned about whether the government would stick to agreements for short-term political expediency.”
The need to please foreign business partners has to be balanced against overwhelming pressure at home to keep lights on and factories running.
“The responsibility of the state and state-owned corporations is to meet domestic needs,” says Shazly of the EGPC. In the long-term, alternatives ranging from solar power to coal are being discussed, but at the moment, the quickest fix is to take the gas that’s already being pumped out of the ground, even if doing so risks discouraging future foreign investment in Egypt’s gas sector.
For the current government, says Nasrallah, it’s not even a matter of trying to carefully weigh between the short and long term interests of domestic consumers versus foreign companies.
“They don’t have a choice at this phase. They have to meet domestic needs,” he says. “Otherwise there will be another revolution.”