“If we choose to bury our greatest dreams because of a wave of shallow populism, or take a wrong turn – we could loose an economic and geopolitical chance forever. Countries that choose to act against their own growth drivers because of regulatory failures, or because of waves of populism, remained behind.
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“During this challenging time, economically and politically, Israel must not miss this rare opportunity. We hear voices calling today for a boycott of Israel. It’s a huge challenge for us as a country, and one thing we must not do is to create an environment that would encourage international companies that are already in Israel to rethink. We must create a stable and consistent regulatory order to attract new investors.
“What we need to get back on track is leadership, governance and faith in our way. We shall continue to act with determination and leadership to fight the destructive regulation, with axes.”
Here’s a riddle for you: Who is proposing to take axes to stubborn regulators?
One might hasten to think it was Prime Minister Benjamin Netanyahu saying these things, after deciding two weeks before to override his own antitrust commissioner and strike a “package deal” with the gas monopoly (Israel’s Delek Group with the U.S. company Noble Energy) roughly according to the lines those companies wanted.
Actually the speaker wasn’t Bibi, it was Gideon Tadmor, chief executive of the Avner exploration company and chairman of Delek Drilling. The Delek Group and Noble own the biggest gas discoveries in Israeli waters, Tamar and Leviathan. But Netanyahu had said the same things a few days before.
Hot air and the bottom of the sea
The day after Tadmor’s broadside, delivered at a conference, Netanyahu returned to the subject, repeated the thesis and added, “The alternative is for everybody to lose and the gas to stay at the bottom of the sea. It’s happened in several countries. They argued over the perfect model and ultimately nothing happened. I won’t let that happen in the State of Israel.”
Long-term economic reforms are controversial and take time, the prime minister said. “But when the natural gas reaches Israel, lowering power prices and creating jobs, it will be clear who was right and who was just making baseless noise,” he added.
It’s no coincidence that Netanyahu’s and Tadmor’s texts are all but identical. The Israeli government has decided to embrace the rhetoric of the gas monopoly.
The whole story is like a textbook case of blurring boundaries between politicians and monopolists after a major natural resource is discovered. There’s good reason why democracy suffers in these cases – the resource producers will always want to extract and export it as fast as possible, before the people wake up and realize they’re being robbed.
With his unique talent, Netanyahu is misleading when he argues that reforms always lead to arguments. He indeed led several important reforms over the past decade, but the debates around them were the opposite of the current debate: Then, the tycoons and interest groups fought him because he tried to boost competition, or shift value from them to the public at large. In this case, the allegations against the prime minister come from a handful of social movements and opposition politicians, after Netanyahu wholly adopted the position of the gas monopoly headed by Noble Energy, which – other than funding television ads – did not ever bother to hold a dialogue with the Israeli public about the extortion going on behind the scenes.
Most Israelis don’t delve into economic complexities. They rely on experts and journalists. But the events of the past decade have taught vigilant citizens that complementary systems – politicians, regulators and even some of the media – tend to cease serving voluntary interest groups.
This case just shows how extreme the weakness of the government is. From this point it is engaged in excuses and wriggling so the citizens won’t realize the capitulation to the gas monopoly.
There’s a simple acid test the people can use to grasp the weakness of the prime minister’s arguments regarding the “package deal”: his decision to wrap the economic explanations in glittery political-cum-security explanations. That mix should sound warning bells to wakeful people on both left and right: The prime minister, who in the last year has adopted a more hawkish diplomatic-security line than ever before in his dealings with both the West and Arab nations, the man who says time and again that there’s nobody out there to talk with, that we’re surrounded by a cruel Islam that wants to destroy us, is suddenly arguing that we need to export gas for “geopolitical” reasons, or because of the “boycott.”
Rhetoric and rude awakenings: some figures
What characterizes Netanyahu, the gas companies and unfortunately, now the Finance Ministry as well, is that they aren’t citing figures and data, but are confining themselves to political language.
This is probably a good moment to put aside the slogans of the left-wing Knesset members and social organizations that “the gas is ours” and look at actual numbers. Facts. The numbers businessmen look at. Without populism.
Revenues from the gas, like from any other natural resource, are known as rent. The question is how that rent is divided between the government, the consumers and the companies.
Let’s start with a basic term from financing: IRR, or internal rate of return (also known as economic rate of return), which is a measure of a project’s profitability. (Investopedia: A discount rate used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero.) It is an accurate and sophisticated way to calculate desired or anticipated annual returns, at the compound interest of a project with fluctuating income and expenses.
When a project involves one investment at its start and income at its finish, annual returns are easy to calculate. When a project involves a lot of incomes and outlays (as does gas drilling), one needs to resort to IRR. Ultimately, though, the mathematics are the same.
Let’s demonstrate: If we invest $1 million in the first year and require annual returns of 5%, in 20 years we will want to see $1 million in income multiplied by 1.05 to the power of 20, which is $2.65 million. The wonders of compound interest: A million dollars grows by 165%. Or as Warren Buffett says, the secret to investing is the power of compound interest – you start saving young and try to live long.
IRR does not give us more than “project value,” which has to be checked through cash flow capitalization or net current value. Nor is IRR a good way to compare projects. But it is a good way to examine the merits of a single project.
With that clear, we can read together the report the Public Utilities Authority (Electricity) commissioned from an Italian consultancy headed by a man who had headed the Italian public utilities authority, regarding the Israeli gas economy and how it should be regulated.
You might think that horribly expensive
The Italian expert took the financial statements of the Israeli gas companies and some of their foreign peers, their contracts with the Israel Electric Corporation and other customers, looked at the costs of the gas drills, and calculated the expected IRR of Tamar.
His conclusion was pretty astonishing. Tamar’s IRR is about 23%, he estimated (after taxes and offloading all possible costs), compared with the norm of about 8% to 12% returns in the gas industry elsewhere in the world.
If you skipped the basic financing explanation above, you might think double the usual rate is horribly expensive. Or, in contrast to what the prime minister and his entourage and gas companies say, not only isn’t the Israeli government deterring foreign investors, it’s giving them phenomenal terms.
If you didn’t skip the basic financing explanation, you’d understand this isn’t a horribly expensive price or doubled profit; it’s an utterly insane price with profits that are bigger several-fold.
Let’s do some more math: Say we have two imaginary investors, Mrs. Cohen of Hadera and Mr. Tshuva of Netanya. She puts her pension savings into a project with a 10% annual rate of return over 20 years. He invests in the same project but the state guarantees him an annual return rate of 20%. Who will have more money to retire with?
Say both invested a million shekels and for the sake of simplicity, both invested all the money in the first year and get all the returns in the last year. After 20 years, Mrs. Cohen gets a million shekels times 1.1 to the power of 20. Mr. Tshuva gets a million shekels times 1.2 to the power of 20.
Mrs. Cohen gets 6.7 million shekels. Mr. Tshuva gets 38.3 million shekels, not double the amount as you might have thought, but 5.7 times the amount.
Stark truth about the “Israel risk”
The Italian expert published his estimates half a year ago. We thought that within days, maybe weeks, the monopoly would announce he’d got it wrong, point at hidden costs, argue the revenue estimates and conclude that the IRR was lower.
That did not happen. What did happen is that the Israeli gas authority, which usually protects the gas monopoly, published an opinion paper claiming that the return rate is high, but “that is the norm” in high-risk countries. Again, note the public authority defending the monopoly.
Is Israel a particularly risky country? Of course not. Israel is a country with roughly the biggest foreign exchange reserves in the world. It has never defaulted. It is running a surplus in its balance of payments, a surplus in its foreign currency balance, and hasn’t felt the burn of financial crisis for 30 years. Its foreign debt is roughly the same as the Western average. All this is reflected in the returns on Israeli government bonds, Israel’s sovereign credit rating and the price of capital for the gas partnerships.
Moreover, at the behest of the Sheshinski Committee, which examined government royalties on natural resources, Prof. Robert Pindyck of the Sloan business administration school at MIT looked into the argument of the gas concessionaires operating in Israel and called it populist demagoguery and, mainly, professionally erroneous: The Israeli risk is not systemic and is diversifiable. Therefore companies operating in Israel do not need to demand a higher IRR than the norm. In practice, Noble Energy is already diversified, as it has various drilling operations around the world. Apropos of which, Noble’s financial statement shows clearly that its most profitable project is Tamar.
It isn’t only American and Italian economists who believe Tamar is a gushing bonanza, at low risk yet. In a presentation to investors, Noble itself remarked that Tamar is one of its most profitable wells worldwide, and provides numbers, too: It sells each British thermal unit (a unit of heat, no connection to Britain) for $5.50, while its average cost is $1.30. The marginal cost after regaining all exploration and development expenses is about 50 cents.
The gas companies don’t trouble to inform the public when they return their investments in drilling, but according to our estimate based on the financial reports of Noble and Delek, it will be within weeks. All their drilling expenses will be returned, and from this point they will earn 10 times as much on each unit of gas they sell.
Note a simple fact: Most of the money the gas companies invested is not their money, and is not invested at great risk. In fact, the amount of money invested in exploration is about 6% to 7% of the investment; the explorations cost $300 million at a 30% probability of finding gas. The rest of the investment was in the development, when the presence of gas had been proven and contracts for its sale were in place.
Even if the gas companies are entitled to a premium in return for money invested in risk, this wouldn’t apply to money invested in field development – which was the main expenditure, and would be fully regained in less than three years thanks to the phenomenal profit they could make because of the sky-high price of gas in Israel. Who of us wouldn’t want to invest in a house that returns its price in rent after three years? From which point, the rent is net profit?
At that same conference, one of the gas barons was overheard grousing that Israeli regulation was driving him nuts and all they want is certainty. That is a very standard spin – if they want certainty, it’s that the government will bow before them and assure them of minimum competition, maximum prices or both.
Netanyahu could call their bluff and say, you want certainty? Sure thing – take $3 per BTU plus linkage to international prices. The griping about “certainty” would instantly morph into yowls about “nationalization” and “Bolshevism,” as happened during the cellular reform and economic concentration reform.
Who’s using Bolshevik rhetoric
It bears stressing: The Italian expert may be wrong. The internal rate of return may not be 23% but 15%, 20% or 25%. It would be much more interesting to read analyses by the treasury people or the National Economic Council, cooked up together with Netanyahu and the gas companies. Though if any such report exists, it hasn’t been published. Instead of giving us figures and return rates, or real comparisons of risks, we’re sold stories about the gas staying in the seabed, geopolitical contributions, peace in the Middle East and fleeing foreign investors.
Who, dear reader, is the populist? Who is the demagogue? The ones who want numbers or the ones touting slogans?
The sad part is that the politician choosing to use the populist rhetoric is none other than Netanyahu himself, who has been selling slogans of free market and competition for a decade now. But at the moment of truth, the man marketing himself as the Israeli Teddy Roosevelt, breaker of monopolies, is resorting to Bolshevik rhetoric, somewhere between the Soviet Union of yore and today’s Russian kleptocracy. He doesn’t want competition, he doesn’t want linkage to international prices, but for himself and his clerks to “plan” the energy market. They will decide: 10 clerks and Yitzhak Tshuva.
For a moment one might think Netanyahu was educated by the Israeli Communist Party rather than MIT. The Israeli Communist Party, by the way, advocates nationalizing the gas outright. The truth is that if we’re to suffer a monopoly no matter what, a government monopoly would be better than the Netanyahu model, of a private monopoly controlled by regulators.
As Prof. Robert Reich of Berkley has said, “big government” isn’t the problem, big money is.