Taking Stock / Drilling for Answers

The people have questions about the gas finds. Your faithful author tries to answer them.

I read in your newspaper that tremendous amounts of gas have apparently been found in Israeli territorial waters, beneath the Mediterranean Sea, as much as $100 billion to $300 billion worth. I also read that the State of Israel takes royalties of only 12.5% from the gas and oil companies. Does this mean that tens to hundreds of billions will be going into the bank accounts of a few oligarchs, while the rest of us settle for chump change?

Arad oil drill
Daniel Bar-On

First, the royalties that Israel takes are from revenues, while the producers' profits are after their exploration and extraction costs. Second, the general public owns shares in the petroleum exploration companies. Third, these firms pay corporate taxes, as do all the companies involved in this great energy enterprise.

So our hackles can settle? There will be a fair, reasonable and equitable distribution of this natural resource?

I didn't say that. The chance of any distribution being "fair, reasonable and equitable" is remote. It's ludicrous to expect the free market to divide national resources fairly and reasonably. Under the law governing drilling in Israel, there is a good chance that most of the profits and revenues from the gas, billions upon billions of dollars, will stay with a handful of entrepreneurs, local and foreign.

Billions of dollars for a handful of businessmen? That's outrageous. It simply can't be the case that in a modern, open, just economy, so few would get so much.

Perhaps. But by stating that it will limit the profits of the exploration entrepreneurs, Israel is essentially stating that it is eliminating the free market mechanism, which is based on the principle that talented entrepreneurs can achieve extraordinary profits. Companies and entrepreneurs won't take risks or aspire to greater efficiency if the outcome is confiscation of the sweet fruit of their labors. The risk in drilling for oil and gas is great, so it makes sense for the reward in the event of success to be correspondingly great.

I see. So it's natural and right that the tycoons could potentially earn tens of billions of dollars because of the big risks they took. But does that mean we can't discuss raising royalty fees?

We can, and there are many neglected issues related to the subject that must also be examined. Perhaps they were overlooked because this is the first discovery of this size in Israeli territory. But now we need to know all the details about the financial risks involved in the exploration. Who really undertook the risks; how are the drilling operations financed? Are the risks real, meaning would the entrepreneurs really have shouldered all the losses had the exploratory drills failed? Are they taking in additional money on the side, such as in management fees or by providing services to the companies that will produce the gas?

Are those the only questions?

No. Here's a big one. What royalty rate would balance two key interests? On the one hand we need to create an environment that's attractive to oil and gas explorers. On the other hand we need to make sure that the public gets the lion's share of national resources.

Why actually is the public entitled to the lion's share?

A good question, the answer to which is all but forgotten. The businessmen, company owners, managers, however successful, often owe their success (and wealth ) to society and the state. They have a duty not only to themselves and their shareholders but also to the general public, whether as consumers or as taxpayers. Most successful companies would have failed if not for the services they receive from the state and its citizens.

Okay, but some countries do let the companies keep most of the profits. Why should we be any different?

Yes, in Russia, Thailand and Turkey, for instance, the norm is for nearly all the profits from infrastructure, communications or natural resource projects to go to just a few families. In Russia, in the past 20 years hundreds of billions of dollars from natural resources went to about 100 men. These countries maintain oligarchies, and the spoils are shared between the people in power and their cronies. Theodor Herzl, David Ben-Gurion and most of the Jews who came here in the last century had other ideas about the kind of society they wanted to see here.

But I read an article in TheMarker, by a lawyer for a number of tycoons, claiming that any change to Israel's royalties policy would be destabilizing and create opacity, the greatest enemy of an advanced economy.

TheMarker will continue to publish opinions and responses by all the relevant players, of all types, including lawyers representing tycoons. That's the lawyer's job, to represent the interests of the client, and that lawyer in particular is in high demand, in part because he is willing to uncompromisingly identify with his clients' interests in issues of significant public interest.

"Opacity" isn't the greatest enemy of an advanced economy. In fact, some of the most effective investment arenas in the world are far more opaque than Israel, such as China and South America. Israel's true enemies are the decline of its education system, the weakness of its academia, the loss of our economy's competitive edge and, of course, the absence of governance and the high concentration of power in the economy in the hands of the few, who have castrated the government and crippled its ability to manage the state with a long-term, professional perspective.

If the government is to act reasonably, based on thorough economic analysis, and the explorers with enough profit to reasonably reward them for their real risks, that would avoid "opacity." It would prove that Israel is an advanced nation, not an oligarchy of governors and their friends. Investment in oil exploration would actually be spurred.

One possibility is for the state to announce that royalties would stay at their present level, up to a certain point of returns for the investors - and if the returns exceed that point, the public's share would increase.

I read warnings in the papers that if the state changes its policy on gas royalties, foreign investors would flee.

A lot of warnings have been issued every time the state tries to institute one structural reform or another over the last 30 years. All have been without merit. Foreign investors in the telecommunications market, for instance, have made terrific returns in the last couple of years and are happy as clams for all the warnings.

Also, all the chatter about the need to encourage foreign investment isn't entirely relevant. Israel's been running a surplus in its balance of payments for the last five years. Our foreign currency reserves are gigantic and our external debt is negative. It needs to rethink its position on foreign investment. Israel needs foreign investment only in areas where the foreigners bring some other added value, or where their contribution would be to dilute the concentration of power.

Maybe all the profitable companies should be nationalized. Or all the companies providing an essential service to the public.

That's another bit of balderdash bruited about lately. Deniers of the free market and its advantages, some ignorant and some vigorously avoiding the facts, have been recycling that nonsense, trying to make a case in the debate about failures of the free market.

The free market is still the best driver behind innovation and prosperity. The state's job is to exploit the free market system to advance the economy. The state should use it wisely, keeping a constant watch on developments and results.

Sometimes the free market births distortions that can be as bad as those under government management. For instance, privatization in Israel has often failed to achieve any of its goals in the last decade, because while selling its companies, the government neglected to ensure the conditions for competition.

But it seems that the free market you defend has no checks against the accrual of wealth and power by businessmen.

There are checks. First and foremost is competition. When a business is highly profitable over time, competitors arise and profits drop. Only the best, most innovative firms can maintain leading positions.

The second check is regulation. Free markets are full of failures, mostly to do with the absence of competition, or conflicts of interest among "agents" - the people managing other people's money. A free market without regulation, without supervision, without disclosure, without brakes, without balances and without an aware public can lead to oligarchy. From there the nation's road to loss of freedom and independence is short.

Drat, this is so complicated. Why can't you come up with clearer slogans?

Yes, it's complicated and only getting more so, which is exactly why thorough economic study is required. There are two dominant voices in Israel's economic debate: the oligarchs and the newspapers they control, which are advancing their agendas, and the "social consciences," some of whom secretly represent a certain economic interest, such as the big unions that belong to the powerful companies. A third voice needs to be heard - economists who do not feed from the trough of narrow private interests.

Are these new opinions you and TheMarker editors have formed following the financial crisis of 2008?

Far from it. John Maynard Keynes was often slammed by critics for changing his opinion, to which he said: "When the facts change, I change my mind. What do you do, sir?"

The truth is that our opinions on these matters haven't changed much in the last 10 years. But it is possible that in the late winter days of 2009, when a host of Israeli tycoons helped by a friendly press and regulators imposed terrific pressure on the government to give them tens of billions of shekels, we understood that the market isn't really free. It's free when it's convenient for them and it's regulated when that's convenient for them. The rescue of the banks in the West during 2008 begged similar thoughts.

The great challenge faced by the Israeli government and the people who care about the public good is to create a truly free market in Israel, a market of opportunities for all, not only for the 20 families, the cronies, and the powerful unions. The challenge is a hard one and can bring its proponents to weep from time to time. But it is the right thing to do.