From Stratfor

For the energy industry today, few other places present such a complicated chessboard. The eastern Mediterranean has elicited more and more interest from major international oil companies, particularly in the wake of a series of discoveries crowned by the giant Zohr natural gas field off Egypt in 2015. Thanks to the sea’s myriad riches, BP, Eni, ExxonMobil and Total have all descended upon the area, yet it has been less than plain sailing. In the past month, Italian oil and gas company Eni has found itself embroiled in two major political disputes — one between Israel and Lebanon and another between Cyprus and Turkey — over its activities in the region. With every country intent on using their resources for their own ends, the political challenges facing energy companies are part of the region’s underlying complexity and challenges, all of which will likely stymie the development of much of the eastern Mediterranean’s hydrocarbon potential.

The Leviathan Wakes

The riches of the eastern Mediterranean attracted renewed attention from the wider world in 2009, when a consortium headed by U.S.-based Noble Energy discovered the Tamar field off Israel’s coast. It was the biggest natural gas field ever found in the area at the time. Containing roughly 320 billion cubic meters (bcm) of proven and probable reserves, the Tamar natural gas field was set to bring self-sufficiency to the Israeli gas market. But if Tamar was a godsend for Israel, the next discovery was a game-changer. Just a year after Noble’s first discovery, it made an even bigger find. Appropriately dubbed Leviathan, the new reservoir boasted roughly 600 bcm of proven and probable reserves. The new reserves gave Israel enough resources to not only satiate its own demand but to also make it a significant exporter.

Noble’s good run continued the following year — this time in Cypriot waters. Just 30 kilometers (19 miles) northwest of the Leviathan discovery, the U.S. company discovered another reserve, the 130 bcm Aphrodite gas field. Energy officials estimated that the three fields could collectively produce 40 bcm per year and held roughly 1 trillion cubic meters in total reserves.

However, disagreements quickly emerged between Israeli Prime Minister Benjamin Netanyahu and the consortium. Noble Energy hoped to link the three fields to a liquefied natural gas (LNG) export terminal — whether floating or land-based — to export to global markets. The consortium struck a preliminary deal with Australian-based LNG experts Woodside Petroleum to pursue the project, but neither the company nor Israel agreed to the structure of the deal. When Woodside Petroleum abandoned the project, the hopes for an LNG export facility disintegrated.

Before the discovery of Tamar and Leviathan, Israel had been dependent on natural gas from neighboring Egypt. This reliance, however, presented major problems for Israel. Because the country has long strived to cultivate self-sufficiency in a number of areas — water, food, energy or military procurement — any dependency on foreign natural gas represented a strategic liability. Perhaps even worse for Netanyahu’s government, the situation provided a regional power with an opportunity to exert considerable leverage over Israel. Moreover, the domestic unrest — which included attacks on pipelines — that pervaded Egypt after the Arab Spring threatened the stable supply of energy to Israel.

After the Tamar and Leviathan finds, Israel’s government passed a law in 2013 requiring that a majority — 60 percent — of the country’s natural gas reserves be allocated for domestic consumption. Officials said that the arrangement would ensure Israel’s self-sufficiency in natural gas until the 2040s, while the large amount of gas in the fields presented Israel with an opportunity. By redoubling efforts to export the other 40 percent of its reserves, the country hoped to draw neighbors Europe, Jordan, Turkey and Egypt into closer relations through sharing deals.

None of Israel’s export plans, however, came to fruition, because disputes among the Noble-led consortium, Netanyahu and the rest of the Israeli government pushed Leviathan into six years of development purgatory. Netanyahu faced stiff domestic opposition from Israel’s anti-monopoly watchdogs, who argued that the consortium’s control over so much natural gas could harm Israeli natural gas and electricity markets. The objections prompted Netanyahu to invoke the national security clause in Israel’s Restrictive Trade Practices Law to circumvent the watchdog’s opposition. Israel’s Supreme Court subsequently blocked Netanyahu’s move, which no prime minister had ever previously attempted, but all parties to the plan finally came to an agreement in early 2017, allowing the consortium to make a final investment decision regarding the first phase of Leviathan. The field will supply natural gas domestically to Israel and the Palestinian Authority (which counts as internal for the 60 percent domestic consumption law) and for export to Jordan. But the half-decade dispute and uncertain regulatory environment significantly delayed Leviathan’s development and deterred the Noble-led consortium from completing regional agreements to export natural gas from a planned second phase of development.

Egypt Finds a Bonanza

As Israel considered its natural gas strategy after the discovery of Tamar and Leviathan, Egypt canceled its export contract with its neighbor in 2012, claiming that the latter was in arrears on payments. In truth, however, the reason behind Cairo’s termination of the agreement was more mundane: Its natural gas was running out. Nearly a decade of underinvestment due to harsh terms had limited exploration and production in Egypt, ultimately forcing Cairo to import natural gas. The popularly elected President Mohammed Morsi seemed unwilling or unable to make the necessary economic reforms to revive incentives for the exploration for new reserves. At the time, Israel’s new discoveries might have provided a strategic opportunity to export to Egypt, but Israeli domestic constraints and Cairo’s preference for LNG precluded any deal.

Major changes, however, occurred the following year. Military leader Abdel Fattah al-Sisi overthrew Morsi amid a wave of popular discontent over the latter’s policies. Al-Sisi, who later became president, pushed through painful but crucial economic reforms. The new administration’s reforms in the energy sector in 2014 were extremely successful at spurring new interest in Egypt’s energy reserves and ending the country’s natural gas crisis. Al-Sisi halted many of the subsidies related to the natural gas and oil sectors, allowing Cairo’s state-owned energy companies to offer more attractive deals to international oil companies for any hydrocarbons they produced. In time, Egypt began offering as much as double the price to the oil companies for their natural gas production. In 2015, BP launched the West Nile Delta development project off Egypt’s Mediterranean coast, noting that the field could eventually produce as much as 15 bcm per year, or 30 percent of Egypt’s natural gas demand.

More extraordinary, however, was another discovery in 2015 that even exceeded the mammoth Leviathan. Found by an Eni-led consortium, the Zohr gas field contains an estimated 850 bcm. Officials rapidly accelerated the project, bringing it online in late 2017; by the end of 2019, the field is expected to produce a colossal 30 bcm per year. Unsurprisingly, Zohr and the other discoveries will eliminate Egypt’s need for LNG imports, perhaps as early as late 2018.

The Zohr discovery completely altered the playing field in the eastern Mediterranean. Countries such as Israel and Cyprus were immediately forced to reassess their strategies, because Egypt no longer required their natural gas. Additionally, Zohr kick-started renewed interest among the world’s largest oil and gas companies, who jostled to discover the next massive gas field in the eastern Mediterranean. Not only has exploration continued to flow into Egypt, but Cyprus also witnessed substantial interest in its 2016 licensing round, paving the way for more exploration activity this year. To the east, Lebanon also finally succeeded in implementing its own legal framework to facilitate exploration in its waters.

The Battle Over Blocks

Despite the discovery of the Aphrodite field in 2010, Cyprus had yet to benefit from any financial windfall. The field was much smaller than the nearby Tamar and Leviathan reserves, and Noble Energy and its partners showed little interest in developing it as a stand-alone site in the absence of any tie-in to another regional project. But with the Zohr discovery persuading oil companies to renew their search in the eastern Mediterranean, Eni announced last year that it would drill two exploratory wells, one in Block 6 in late 2017 and one in Block 3 in early 2018. Joining the fray, ExxonMobil and Qatar Petroleum also declared their intention to drill two exploratory wells in Block 10 in the second half of 2018. On Feb. 8 Eni reported that its Calypso new field wildcat in Block 6 had struck a major gas formation that could contain a minimum of 200 bcm — making it significantly larger than Aphrodite. Eni hopes to replicate its success in Block 3 over the next few months.

While Aphrodite never became a bone of contention in the long-running Cyprus question, Eni’s activities have raised the ire of Ankara. Though located off the southern, Greek coast of Cyprus, the northern portion of Block 6 lies on the continental shelf claimed by Turkey. Ankara also contends that Block 3, which is southeast of the island, should be administered by Turkish Cyprus rather than the Republic of Cyprus. In fact Turkish Cyprus awarded the rights to a similar block overlapping Block 3 to Turkey’s national oil company, Turkish Petroleum (TPAO), in 2011.

Turkey argues that Eni’s activities in both blocks are unjustified and has moved to obstruct, harass and disrupt the Italian company. On Feb. 6, the Turkish Armed Forces published a note declaring that it was reserving all the waters south of Cyprus, including Block 3, for military drills until Feb. 22. On Feb. 9, the Turkish military prevented an Eni drill ship from sailing between blocks 6 and 9. Turkey has extended that notice through March 10. Ankara also reiterated its rejection of all Cypriot maritime agreements, including those with Israel and Egypt, prompting the latter to voice its support for Nicosia. However, after the breakdown in Cypriot reunification talks in July 2017, Ankara is unlikely to adopt a softer line on exploration around the island in the near future. Turkey could also deploy its first modern drill ship, the Deepsea Metro II, to buttress its political claims in the region — much like China does in the South China Sea. TPAO plans to use the drill ship, possibly with a Turkish naval escort, to explore in the eastern Mediterranean in contentious areas that could include Block 6.

In 2012, Ankara threatened to review the Turkey-based investments of any company that was exploring for oil or natural gas in Cyprus. Eni has an extensive portfolio in Turkey, including investments in Blue Stream, a critical link between Russia and Turkey. And if Cyprus makes more meaningful progress toward the commercialization of its discoveries, Ankara is likely to continue its harassment and expand its pressure on the international oil companies operating in Turkey.

Lebanon and Israel’s War of Words

Although it came late to the frenzy, the other littoral state in the region, Lebanon, has also sought to pursue its own exploration activities, but the country’s confessional political system, which requires a careful balance of interests between different ethnic and sectarian groups, has hampered the development of a local energy sector. Beirut’s first planned offshore bidding round failed to proceed in 2013 due to a political crisis that left the country without a president until October 2016. Once Michel Aoun finally assumed the post, however, Lebanese authorities immediately exerted efforts to restart the bidding process.

In January 2017, Lebanon’s Cabinet passed two laws that were necessary to hold the round, while its parliament finally approved an oil and natural gas taxation law in September 2017. Thanks to these new regulations, Lebanon conducted its first bidding round in the last quarter of 2017, awarding blocks 4 and 9 to a Total-led consortium that also included Eni and Novatek.

But as the parties finalized the deals in early February, Israel issued stern warnings to the consortium and Beirut over Block 9, which includes disputed waters between Israel and Lebanon, calling any activities there “very challenging and provocative.” The militant group Hezbollah, in turn, threatened to attack Israeli offshore oil and natural gas infrastructure if Israel moved to prevent Lebanese exploration. Seeking to diffuse the tension, Total’s president for Middle East and North Africa exploration and production, Stephane Michel, said the consortium planned to drill no further than 25 kilometers from the border as the dispute centers on a roughly 7-kilometer-wide area between the countries.

If Total and its partners discover natural gas in Lebanon, the eastern Mediterranean’s “great game” will only become more complicated. Like Cyprus, Lebanon could find itself dependent on other partners’ gas resources in order to make an export project economically viable. With an Israeli partnership effectively impossible, Beirut could cooperate with Nicosia, but such collaboration could cause Israel to withdraw from any regional export deal with Cyprus due to the political ramifications of participating with Lebanon.

Moreover, Lebanon’s leaders have yet to decide how they will share any potential revenue among the country’s various groups. The government could allocate some earnings to the national budget while earmarking other portions of the windfall for a yet-to-be-created sovereign wealth fund. And depending on the location of any discovery, different Lebanese groups could demand that local contracts and local development be organized according to patronage networks.

Navigating Through Political Storms

There are three major options available for Cyprus, Israel and — possibly — Lebanon to benefit from their natural gas resources to a greater degree: They could export via Egypt’s mothballed LNG export terminals, via a link to Turkey or through a pipeline to Europe. Each alternative, however, presents numerous challenges and constraints.

In perhaps the simplest option, Egypt has sought to position itself as a potential hub. Its two LNG export terminals, Idku and Damietta, have been dormant for years and would allow Israel and Cyprus to export their gas without having to construct their own terminals. In 2016, Egypt and Cyprus signed an intergovernmental agreement that would permit producers at the Aphrodite field to use its infrastructure for exports. Israeli companies have explored a similar deal, but the prospects of a new agreement remain dim due to an arbitration dispute stemming from the cancellation of the previous Israeli-Egyptian natural gas deal in 2012. So far, only one deal has been finalized, with industrial group Dolphinus Holding agreeing on Feb. 19 to take 64 bcm from Tamar and Leviathan over 10 years. However, the parties have yet to make any announcement regarding any potential pipelines or to indicate whether Cairo participated in the talks. Moreover, the Dolphinus deal will only include natural gas from the first phase of Leviathan — not a second, larger development. Cairo, meanwhile, has said it will not sign any new deal with Israel until there is a resolution to the deal it canceled in 2012. Still, the Egyptian option could eventually entice Israel due to the former’s proximity and the prospect of sharing infrastructure.

The prospect of a Turkey route is more remote. Although Netanyahu has pushed for this option for political purposes — it is one of the reasons for Israel and Turkey’s rapprochement in recent years — the plan presents a variety of logistical headaches. A direct pipeline to Turkey must travel through either Lebanese (a non-starter for Israel) or Cypriot waters, and so long as Turkey continues to challenge the island’s exploration efforts, Nicosia will block any attempt to build a pipeline. The countries could reach a pragmatic political agreement in which Turkey withdraws and accepts Cypriot control in its maritime zone, but Ankara is highly unlikely to agree to such a deal for the sake of the pipeline.

A route to Crete and Europe might ruffle fewer political feathers, but it also presents critical economic challenges. On Dec. 5, 2017, Cyprus, Greece, Israel and Italy agreed to back the 2,000-kilometer East Med pipeline at a cost of $7.4 billion. While the countries expressed hopes of signing an intergovernmental agreement on the project later this year, no company has yet lent its support to the project on account of the hefty price tag. Even the Europe route, however, is not entirely free of potential political pitfalls. Russia is eager to prevent the entry of any new large sources of natural gas to the Continent and could reduce the price of natural gas to deter investments. Ankara, too, could present a political challenge, especially if the route traverses Turkey’s putative continental shelf area.

Thanks to its natural gas potential, the eastern Mediterranean has attracted newfound interest in recent years, with international oil companies registering major discoveries one after another. Capitalizing on the riches beneath the sea, however, is easier said than done. Newfound energy wealth has only deepened the labyrinthine power game among the area’s countries, and varying political constraints detract from each option to bring natural gas to market. But the potential is too vast to ignore. Oil companies will continue to search for the next game-changing discovery, but the region’s delicate power relations will keep countries in the region from maximizing their windfall for some time to come.

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