21 May 2013 Pre-selling Cyprus gas: a 95% haircut on our children?

This week the Ministry of Finance announced that it was considering pre-selling gas. It must of course be tempting when we are faced with what could be a EUR 20 bln debt by 2016.
But there are a number of reasons to believe that it would not be a good idea to sell all of it, at least not until the other blocks are drilled and additional reserves are proven.
You might have heard stories about the 7 trillion cubic feet (tcf) of gas in Block 12 being worth USD 80 bln (EUR 62 bln).
That is only true if the following is the case:
1) It costs absolutely nothing to get it out of the ground (exploration and extraction costs).
2) You do not deduct the amount used for domestic consumption, which reduces the amount for export by around 15% or to 6 tcf.
3) You do not deduct the significant amount sucked every day by an energy-intensive LNG plant, which reduces the amount available by another 1 tcf to 5 tcf.
4) You do not deduct the USD 12.5 bln cost of exploration, building a pipeline to Vassilikos and the liquefied natural gas (LNG) plant, which alone will cost USD 10 bln.
5) You do not deduct the profit margin to the companies (a number known only to the government).
6) Last, but not least, you assume that shale gas will have no impact on gas prices in 15 years’ time. (For reasons I will not go into here, it will take 15 years to find the buyer, the financing and to build the LNG plant).
After deducting all of these, a pessimistic projection for gas prices puts its value to the government budget, if it is exported as LNG over its full 20-year supply lifetime, at EUR 20 bln.
A more optimistic one puts the value at EUR 30 bln.
That translates into an additional EUR 1 – 1.5 bln per year going into the government budget. When total revenue is only EUR 7 bln (and falling) per year, that is a significant boost to long-term finances.
And it might just be enough to pay off all of our public debt.
(Revenue from a pipeline to Turkey would leave us with plenty of change too, but we all know the barriers to that happening).

That is all very good news. And only God knows why the troika did not take it into account when they declared that lending us the whole EUR 17 bln would make Cyprus’ debt unsustainable.
But what would the gas be worth if we sold it before it came out of the ground; before export facilities had been built; before it had been turned into LNG?
Selling something before it is ready (think about buying a house before it is built) comes with a big discount. But how much of a discount?
Luckily we have a recent example to go on.
Israel’s Leviathan block is an estimated 19 tcf, roughly three times the size of Block 12.
In December 2012, 30% of Leviathan (the equivalent of 5.7 tcf) was sold to Australia’s Woodside for a conditional USD 2.5 bln (around EUR 2 bln).
This is despite the fact that its “in the ground with no costs” value, comparable with the USD 80 bln Block 12 discussed above, should be around USD 65 bln.
In other words, it was sold at a massive discount of around 95%.
If you apply the same discount to the 7 tcf in Block 12, the government could expect to raise USD 3 bln or EUR 2.4 bln by selling all of the gas in Block 12. This is about enough for two years’ budget deficits.
This is a far cry from the EUR 20 – 30 bln that could be raised by waiting until it is sold as a completed product, namely LNG.
In other words, we would be flogging 20 years’ worth of handsome budget revenue just to pay civil servant salaries for a couple more years.

That does not mean that the idea will not go away.
If my forecasts are correct, by 2016 we are going to be in deep trouble.
Our debt will be peaking towards 160% of GDP, people will have woken up to the fact that an LNG plant is well over a decade away, and the government will be thinking about the next election.
But by 2016, the other licensed blocks are unlikely to have been proven. If Noble finishes drilling by the second half of this year, it will have taken 5 years from being issued a licence to declaring proven reserves.
Maybe Total, Eni and Kogas have deeper pockets and can do it a little faster. But there is also a shortage of rigs, so it is still likely to take them until 2017 to prove the reserves.
So, we face a risk of selling our only egg before it has hatched: selling the gas in Block 12 before we know if we have any in the other blocks.
But just as we do not actually have to sell the gold to raise much-needed finance, we do not actually have to sell the gas.
There are plenty of financial instruments out there that will allow us to use the gas (or the gold) as collateral against a loan.
Let’s hope that the government and (or the central bank, in the case of gold), looks into these options, rather than making panicked decisions.
Otherwise, it could end up imposing a 95% haircut on Cyprus’ children.  Read on