Lessons for Managing Unconventional Resources

Recently, a report produced by the US Energy Information Agency noted that Egypt has significant proven and prospective volumes of natural gas and sizeable deposits of crude oil. There are around 2 trillion cu meters of proven conventional natural gas reserves and nearly further 3 trillion cu meters in unconventional reservoirs. Egypt also has 4.4 billion barrels of proven crude oil reserves and around the same volume in unconventional deposits. Whilst these are not the highest figures in the world, if optimally managed, such resources could play a significant role in Egypt’s economic development. Considering that Egypt is in the midst of sociopolitical change, it may be productive and forward-thinking to examine economic factors and options for development that can potentially serve as the foundation of a stable and prosperous economic future.  Egypt has a long history in oil and gas and therefore has the institutional and infrastructural capacity to support unconventional oil and gas exploration and production. The pursuance of unconventional gas may be a productive medium-term option for future economic growth.

Over the last 20 years the US and Canada have demonstrated that unconventional hydrocarbon resources are technically feasible, but can also provide the foundation for considerable industrial rejuvenation. Countries such as the US, Norway, Canada and Australia have provided examples as to how unconventional resources can be developed for a long term as a source of economic prosperity, industrial growth and high-quality jobs, especially for younger generations.

In developing upstream unconventional resources, governments and investors must bear in mind that 75% to 80% of risks stem from above ground. The development of unconventional gas in Europe, particularly Poland, has demonstrated that the presence of unconventional resources does not guarantee rapid and sustainable development, as there are always fiscal and technological challenges with the development of unconventional resources.

Egypt stands to gain much by branching out into the unconventional sphere. In consideration of the fact that, historically, oil and gas companies have demonstrated they are adept at pushing technical and technological boundaries, unconventional resources may be a viable option for the development of the Egyptian oil and gas sector. As resources are only part of the equation, Egypt must develop effective measures to mitigate “above-ground” risks if it seeks to fully tap its unconventional reservoirs.

Hard planning
Historically, the most efficient way to develop natural resources is through private companies in a competitive environment. “Resource nationalism” and/or state monopolistic approach guarantees state control, but has proved economically inefficient. State control of upstream activities frequently leads to resource mismanagement, waste and delayed development. Given the high cost of exploration and development, private companies should be paid a fair percentage as they bear all of the risk. From the state side, ideally, natural resource revenue should be invested in infrastructure, education, and health systems, to ensure a prosperous future.

The problem arises in balancing public and private risk and reward and determining “fair” percentages. Only a few countries such as the UK, Canada, Australia and Norway have developed systems that maximize national wealth and, simultaneously, attract foreign investment in oil and gas. Norway serves as a successful example of balancing private and public interests in the realm of oil and gas exploitation.

The Norwegian government’s firm commitment to transparency (often defying bureaucratic convention) contributed to the successful development of Norway’s oil and gas sector simultaneous to increased levels of foreign investment. Despite high taxes, companies know that the government will always adjust rules to the prevailing conditions, as the Norwegian economy is highly dependent on the oil and gas industry.  If times are good, the pressure on taxes would be high, if times are not that good, the government will adjust the fiscal rules so the companies will be able to get through. While there is a preference for the local “champion”, Statoil, the company is made to compete with private companies.

So whilst it may not be exactly a level playing field, it is still quite fair to foreign companies. The Norwegian success is based on the fact that the government manages these elements very well. Ultimately, the government understands one thing: if it wants to keep private companies, it must let them be successful. Otherwise they would pull out and the ultimate loser would be Norway.

Amidst Norwegian successes, Poland has attempted to develop its unconventional gas resources. Initially Poland gave away, freely, nearly all its exploration licenses for shale gas thereby eliminating almost any competition amongst investing companies. In light of reserves estimated at 5 trillion cu meters of natural gas, numerous companies expressed interest including ExxonMobil, Chevron, ConocoPhillips, Marathon, Nexen, Talisman Energy, ENI, and Total. Despite such positive indicators, less than 50 wells were drilled over the past five years and very few – less than 10 – were fracked.

The limited exploration and development stems from a culmination of factors. While the licenses were huge, up to around 1000 sq km each, the obligations in terms of minimum investment were very low. Companies holding exploration licenses faced uncertainty concerning the availability and fiscal terms of production licenses, (i.e. they could have ended up taking exploration risks and another company would have reaped benefits of production). Existing regulations create additional challenges and delays. Up until June, an additional permit was required to extend wells by 1,000 feet. Approval of the permit would often take up to a year, causing serious disruptions in the drilling process. Regulations have also been criticized for being too stringent, including penalties on delays in work schedules. Concerns have also been raised over fiscal terms as the government is seeking to tax 40% of profits. Additional legislature has been proposed requiring a state-run company act as a shareholder in all production ventures, which would further increase the government’s share of profits.

In addition to this, the environmental regulations (processes rather than rules themselves) were very unfriendly. Until recently environmental impact assessments were required for the entire concession area, rather than limited to drilling sites. Poland’s unconventional sector remains further marred by the recent bribery charges against government officials and businessmen related to shale exploration licenses.

Contrary to the impression given in the worldwide media, the industry did not take off in Poland at all. In Poland, too much uncertainty increased long-term risk for the companies and practically led to a halt of shale gas exploration activities. This outcome can be attributed to two factors. First, the state authorities did not understand private companies, the way they operate and how they assess business risks. In many instances the state authorities were making decisions hoping they would be praised by the industry, but quite the contrary, they were met with disappointment. The second fact that contributed to the halt of shale activities can be attributed to a communication breakdown between private companies and the government. While the government is seeking to address some of the regulatory pitfalls in new draft legislation, it may be too little too late as companies such as ExxonMobil, Talisman Energy and Marathon decided to leave Poland. Those who remain keep their activities on very low level. Sometimes it seems that they only remain so as not to admit a failure.

The Polish and Norwegian experiences offer lessons for Egypt in terms of high resource potential and for successful development. Without optimal management, Egypt’s full potential cannot be reached. Without a stable and predictable environment private companies will not commit any significant investment.

Drawing from experience
Egypt should not be afraid of drawing upon the expertise and experience of other countries currently pursuing unconventional resources. Egypt has a long history of dealing with international oil and gas companies. As such, the institutional foundations are in place in order to develop Egypt’s unconventional resources. Egypt can draw from Poland and Norway’s experiences by establishing a clear plan for the development of unconventional resources as well as gaining further knowledge of how international companies perceive risk and reward in the realm of unconventional exploration and production, specifically in an environment of political insecurity.

Only a small percentage of risk associated with oil and gas exploration and development stems from technical and technological challenges. The majority of risk stems from “above-ground” risk factors, including fiscal terms, broader stability, regulatory conditions and complexity of operational logistics. However, proper management and mitigation of “above-ground” are instrumental to success. For example, overly lenient environmental regulations can lead to devastation and too stringent regulations can discourage private investment. Low government percentage take can lead to wasted natural resources resulting in the loss of billions of dollars. An excessive government percentage take can lead to the death of the sector as private investors have little incentive to invest with minimal reward. As so much money is at stake, a high risk of corruption is also always present.

The way forward
Only a transparent and stable system designed in a way that it benefits from other countries’ experiences can provide practical solutions to these very difficult problems. The aim is to maximize the development of Egypt’s natural resources for the benefit of the country. Egypt has enough hydrocarbons resources, conventional and unconventional, to help with building its successful future. It requires learning from their own and other countries’ experiences, a lot of careful planning and implementation. Contrary to conventional thinking the wealth of oil and gas is not only in the ground, it is mainly in the heads of those who manage the system and are responsible for it.  Without their wisdom hydrocarbon richness can easily turn into yet another curse.

By: Grzegorz Pytel – Sobieski Institute, Partner, Futurisk LLP


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