Cyprus Oil and Gas: Strategic Development Options

23 March 2013 | Philip Ammerman

23 March 2013 (re-posted from 11 May 2012)

In May 2012, Navigator published a short brief on the status and potential of hydrocarbon exploration in Cyprus. With the Cyprus financial crisis currently in full swing, it's worth taking a renewed look at oil and gas potential, and our forecasts from this time.

On February 11th 2012, the Republic of Cyprus announced the launch of an international tender for hydrocarbon exploration and exploitation licenses in 12 offshore blocks in Cyprus’ Exclusive Economic Zone (EEZ). Previous exploration undertaken by Noble Energy in Block 12 revealed natural gas resources of between 5-8 trillion cubic feet (tcf).

The clock is now ticking for the strategic development of Cyprus’ offshore oil and gas. Bids are due 90 days from the date of publication (i.e. by May 11, 2012), and an award decision is promised within 6 months of this date. By 2014, Cyprus will have a more complete picture of its full offshore gas resources in the Mediterranean Sea.

There are several strategic issues involved in hydrocarbon exploration and exploitation in Cyprus. The political issue vis-à-vis Turkey is an obvious one, and extensive attention has been focussed on this. Yet a more important one is the commercialisation strategy Cyprus will follow to valorise its natural gas resources. The investment costs of this strategy will be a key factor in determining the economic reserve estimate of hydrocarbons, together with the success with which Cyprus can attract foreign investors to develop these resources. This paper examines the potential scale of resources versus reserves as well as the strategic options and challenges of successful development.

Figure 1: Cyprus Exclusive Economic Zone and Exploration Blocks

Resources, Reserves and Economic Value

The optimism on Cypriot oil and gas reserves is the result of exploration work undertaken by Noble Energy International. In 2007, Noble won the rights to explore in Block 12, which is adjaceant to the Israeli EEZ where hydrocarbons have been discovered in the Leviathan and Tamara offshore fields. 2D and 3D seismic surveys were carried out in 2009 and 2011; gravity and magnetic surveys were implemented in 2011. In September 2011, the drilling programme started.

Natural gas was discovered on December 28, 2011. According to data released by the Energy Service, this amounts to 7 trillion cubic feet (tcf) of estimated mean resources. The gas is hosted in Miocene sand over a 40 square mile area, and occurs within a total depth of 5,860 meters, with a water depth of 1,688 meters. Noble Energy puts the resources at between 5 and 8 trillion cubic feet.

This discovery put Cyprus on the energy map once and for all. Given that this discovery was within only one Block, and that 12 more are available for drilling, it’s clear that significant economic potential exists. Data from some other fields are illustrative. The US Geological Survey, for instance, estimates that the Levant Basin, which is found between Cyprus and Israel, may hold up to 122 tcf of natural gas. Noble Energy estimates that the Tamar field holds 9 tcf while the Leviathan field may hold up to 20 tcf.

Estimating the exact value of Cyprus’ hydrocarbon reserves is difficult. On the one hand, the exploration has not been fully completed. On the other hand, the classification of gas from the resource category to the reserve category [1] is dependent on a wide range of factors, starting from international gas prices to the estimated costs of extraction. It is important to be extremely careful in estimating reserves, i.e. economically-recoverable resources, given the tremendous volatility in prices, as well as the fact that Cyprus still needs to decide its development strategy.

However, we can provide a few estimates here. If we assume that 100% of the Block 12 are recoverable reserves, then we need to multiply the estimate of 7 trillion cubic feet by an average gas price per cubic foot.

I’ve taken monthly US wellhead prices for natural gas as reported by the US Energy Information Administration (EIA) between 1990 and 2011 and implemented a simple price average over the period. Figure 2 below illustrates the volatility in natural gas prices. In July 2008, for instance, natural gas reached its highest recorded wellhead price of $ 10.79/thousand cubic feet (mcf). Immediately thereafter, the price slumped, a clear indication of the economic recession in the US, as well as the fact that speculation was almost certainly a factor in high gas prices.[2]

This 22-year average provides an average monthly price of $ 3.64/mcf. This figure in itself is deceptive, since the large economy of scale in US gas rigs means that exploitation costs will probably be lower in the US than in Cyprus. Nevertheless, this number represents a good starting point.

Figure 2: US Wellhead Gas Prices, $/mcf

Different scenarios for the valuation of potential recoverable reserves are presented in Table 1, below. Column one provides an estimate for recoverable reserves, starting from 7 trillion cubic feet, and rising to 100 tcf. The reserve value is calculated using the $ 3.64/thousand cubic feet (mcf) wellhead price, coverting into Euros at a rate of USD 1.3 : EUR 1. The annual value provides an estimate for annual value produced at the wellhead, assuming a 20-year exploitation lifespan. The final column provides an estimate for government income, assuming that a 25% government profit level (which may be on the high side of estimates).

Table 1: Upstream Reserve Value Scenarios by Average Wellhead Price

The results, however, are highly encouraging. Assuming reserves of 50 tcf, Cyprus stands to gain an annual income of EUR 7 billion per year (nearly ½ of current GDP), with government income of EUR 1.75 bln. This would be enough to close Cyprus’ budget deficit and pay down its existing debt within 5 years.

It should also be confirmed that the valuation scenarios above are based on wellhead prices. The actual sales values will be depend on the end-use of the natural gas. LNG prices, for instance, are significantly higher; as are “citigate” prices. The further “downstream” one moves in the value chain, the higher government income will be (for instance, via value-added tax income on natural gas sales to industrial users).

On the other hand, we have to be aware that forecasting energy prices over a 20-year time period is typically fraught with error. Although global populations are rising and energy consumption expands with rising middle class populations, there has also been a commensurate expansion in natural gas supply, particularly through onshore shale development in North America. Gas prices in North America fell to $ 2.27 mcf in early March, and many forecasts point to the price reaching a floor of $ 2.00 mcf in the near future.

For these reasons, the reserve value scenarios described above should not be seen as guaranteed income, but as moving targets which depend to a great extent on the commercialisation strategy followed by the Republic of Cyprus. These options are discussed in the next section.

Three Strategic Options for Development

The main strategic question Cyprus must answer is how to effectively commercialise the hydrocarbon resources discovered in the EEZ. Broadly speaking, there are three main options, none of which is mutually-exclusive:

Domestic consumption, replacing imported oil and gas
Export to markets by pipeline
Export to markets in liquefied form.

In addition, there are certain minimum investments which must be made for large-scale exploitation. The investments required for each of these options are significant, though not prohibitive. Each option is considered in turn.

Minimum Infrastructure

Unless an alternative arrangement is to be considered (for instance, a floating LNG plant), the natural gas will have to be transported by pipeline from the production fields to Cyprus. The government has determined that a gas storage and LNG plant will be built at Vassiliko: this is the obvious terminus for one or more pipelines which will be required.

Additional infrastructure will be needed depending on industrial demand for natural gas in Cyprus. It is likely that most natural gas will be used for electricity production by the Cyprus Electricity Authority (AHK). Nevertheless, given the liberalisation of the European Union’s energy sector, it is not impossible that private electricity generation companies emerge, or that industrial consumers (such as cement plants or even some hotels) find it cheaper to generate their own energy from natural gas, rather than purchasing it from AHK (which has the highest electricity retail prices in the European Union). In principle, even municipalities could found their own district heating generators, powered by piped natural gas.

In 2010, the Electricity Authority has tendered for engineering services relating to a gas pipeline network. This tender was made on behalf of the Natural Gas Public Company, DEFA. It is likely that this will have to be revised to take into account the ongoing strategic planning relating to the offshore gas production.

Domestic Consumption

In 2010, before the Mari explosion, the EAC generated 5,205 GWh of electricity, consuming some 1.211 million tonnes of fuel to do so. This fuel was imported and cost EUR 439.5 million, or 2.5% of gross domestic product (GDP). A key benefit of using own gas supplies would therefore be to switch from fuel imports, improving the current account balance.

The 1.211 million tonnes of fuel had an average calorific value of 42,906 kJ/kg in 2010: Cyprus produced some 52 trillion kJ that year. This is equivalent to about 48 million mcf natural gas, not taking into account the thermal efficiency of a modern gas-fired plant versus the CHP or oil-fired plants used by AHK. AHK reports average generating efficiency of 36.08% in 2010, which reflects the age and mix of different generation technologies used. Upgrading the entire national power plant infrastructure to a modern CHP technology could result in significant increases of efficiency – perhaps up to 50% of total generation. This is the main reason why AHK has been wanting to change over to natural gas, and why political delays have cost AHK so dearly, leading to a high energy price in Cyprus.

Leaving this efficiency ratio stable, and calculating the thousand cubic feet produced per year under the original reserve scenarios at 20 years lifespan shows that even under the lowest reserve estimate (7 tcf for all 13 blocks), Cyprus can easily cover its domestic consumption requirements.

Table 2: Cyprus Annual Natural Gas Production, mcf

In other words, Cyprus has two options before it:

It can choose to invest in energy-intensive industries, such as aluminium production, in order to absorb its surplus energy. This option is almost certainly not an option given resource and space limitations and environmental constraints.
It can export the energy surplus. Given plans for an LNG plant, with an alternative plan for export pipelines, it’s clear that this appears to be the most rational option available.

Before examining the export scenario, however, it’s worth a quick parenthesis on the impacts of natural gas on renewable energy targets.

Problems with Renewable Energy

One of the potentially unwelcome impacts of domestic electricity generation from natural gas will be to highlight the price differential between gas-fired electricity and renewable energy sources. Renewable energy plants in Cyprus benefit from a 20-year feed-in tariff (FIT) established by the Government of Cyprus to promote investment targets in this sector. Large wind turbine plants receive an FIT of EUR 0.166 /kWh for 20 years, while large solar power (photovoltaic) plants receive an FIT of EUR 0.31 /kWh.

The Electricity Authority does not currently produce electricity from natural gas: 100% of generation is from fuel. However, it is interesting to compare the generation price in Greece, where Public Power Company (DEH) reports a price of EUR 0.099 /kWh for electricity produced by natural gas in November-December 2011.

Given that natural gas will become the predominant generation feedstock, it’s clear that the renewable energy FIT will be subsidised by natural gas, at least as far as AHK is concerned. This is a potentially dangerous situation which requires a careful balance of policy priorities.

Energy Exports

There are two basic options for natural gas exports: by pipeline or liquefied natural gas (LNG). A third option is to export electricity via transmission lines. These are also not mutually exclusive, although political considerations will play a major role.

The possibility of exporting natural gas to Crete and onward to mainland Greece by pipeline has been raised. However, this solution is likely to be technical complex as well as expensive. Nevertheless, DEPA, the Greek natural gas operator, has commenced a feasibility study into connecting Cyprus with the Greek Peloponnese via Crete using an underwater pipeline. The pipeline would be run at a depth of approximately 2000 meters and would have to navigate extreme terrain.

A variant of this proposal would be to transform the gas into electricity in Cyprus, and connect either Greece or Israel to a submarine cable. This so-called “Euroasia Interconnector” concept has been proposed by a consortium led by DEH Quantum Energy, a subsidiary of the Hellenic Public Power Corporation, Quantum Energy of Cyprus and the Bank of Cyprus. In this proposal, a 287-km, 2000 MW undersea cable will link Israel and Cyprus, and later Crete, connecting Israel to the grid. Should this prove feasible (the feasibility study has just started), then a logical next step might be to expand transmission capacity between Greece and Cyprus in the same manner. The initial project is estimated to cost EUR 1.5 billion.

A third option is that of establishing an LNG plant and exporting the gas in liquid form by supertanker. This option has a number of positive elements:

The LNG liquefaction complex can be converted to a gasification complex in the future, if Cypriot gas reserves run out. This will enable the onshore power generation and pipeline facilities to be used into the future, although for practical purposes, any power generation and pipeline infrastructure will be fully depreciated.
Exports by LNG allow greater market security. Rather than being tied to a single pipeline customer and transit country (Greece), Cyprus could export to a wider range of markets, including Italy, France, Spain, Croatia, etc. This could enable it to contract some supplies based on spot market prices in parallel to long-term supply agreements, gaining greater profitability. It would also enable Cyprus to become a strategic supplier to political allies such as France and Italy.
This option would bring a number of collateral benefits, not least of which is the reinforcement of the attractiveness of the Cypriot flag for LNG supertankers and related shipping assets. Cyprus would gain immeasurable market prestige in linking LNG exports with using Cypriot-flagged vessels.

There is one further export option which has not been extensively explored. Cyprus could run a pipeline north into Turkey, joining with the Blue Stream and Nabucco pipelines which supply central Europe. Such an alliance would utilise existing assets and would probably be cheaper to construct than a new pipeline to Greece. If negotiated properly, this could also provide the groundwork for a solution to the Cyprus issue. However, the political preconditions to not appear to be in place for such a decision to be made. Moreover, a Turkish pipeline also carries the same political risks as a pipeline to Greece: it places the security of Cypriot supply to European customers in the hands of a transit country.

This brief introduction serves to raise the next issue relating to the strategic development of hydrocarbons in Cyprus: the international political climate.

International Political Considerations

Cyprus’ handling of hydrocarbon exploration and development provides a useful case study in developing hydrocarbon resources in a conflict region. Cyprus has complied with international every step of the way. Its first action was to declare an Exclusive Economic Zone fully compliant with United Nations and international law. Its maritime borders with Egypt, Lebanon and Israel were carefully delineated based on bilateral negotiations.

When exploration licenses were tendered, international interest was low. Noble Energy was the sole company to win an exploration license, and exploration took place without excessive international attention focussed on Cyprus. It was only once the initial seismic studies showed promise, and exploratory drilling started, that hostile attention from Turkey ensued. Since then, Turkey has conducted air and sea exercises around the exploration area; harassed Cypriot and Israeli forces in the area; threatened Noble and other international companies; and announced its own drilling programme, complete with an armed escort.

Yet Turkey has been prevented from acting due to a number of key issues:

Cyprus is acting within its rights under international law; no other countries, nor the United Nations, have accepted Turkey’s arguments that Cypriot exploration is illegal or “sabotage”.
In Noble Energy, Cyprus has gained an important ally. Two Israeli companies own 30% of the exploration and production license in Block 12. Following the Mavi Marmara incident, there has been a intensification of the political relationship between Israel, Cyprus and Greece, driven in no small part by the realisation of common interests
The law on hydrocarbon development drafted by Cyprus is extremely transparent and favourable, and features a negotiated production agreement with zero taxation. This is extremely attractive to international companies, who find themselves dealing with extreme political risk in other parts of the world.

The second round of licensing offers Cyprus the chance to further expand the role of international oil majors and national oil companies (NOCs) to participate. Gazprom, Total, BP, Royal Dutch Shell, ENI and others are potential candidates for bidding on exploration permits in the remaining blocks. If successful, this will give major governments such as Russia, France, Britain, Italy and others a stake in the peaceful development of hydrocarbon resources, providing Cyprus with additional political support in times of future crisis.

Domestic Political and Economic Considerations

A further issue which requires careful analysis is the extent to which Cyprus is prepared to absorb the hydrocarbon wealth without adverse effects to its economy and society. Unfortunately, little debate has been heard on this area, but any objective analyst would judge it of high necessity.

Cyprus suffers from an excessively large and controlling public sector. Key areas of the economy, notably energy generation, remain dominated by the public sector despite an ostensible liberalisation. Others, such as banking, remain dominated by unions which restrict productivity. The problems of structural adjustment and economic reform in Cyprus are well-known, and have been emphasized in the recent credit downgrades of the economy by all three major ratings agencies.

What Cyprus must therefore avoid is a repeat of “Dutch disease.” This is a term which originated in the discovery of offshore gas fields in The Netherlands in the late 1970s. The sudden influx of income led to a rise in inflation, which in turn made other sectors—notably manufacturing—uncompetitive.

Cyprus finds itself very much in a Dutch situation in 2012. Incomes in the public sector are high; while private sector incomes are lower, key sectors such as tourism have become uncompetitive due to high wages as well as high peripheral costs such as food imports, electricity, the costs of air transport.

It is of vital necessity for the Cyprus government to ensure that the massive wealth which could flow into the Cypriot budget is used properly, and does not destroy national competitiveness any further. This means that the government should engage in broad social consultations to determine how the money should be spent.

One potential option would be the creation of a sovereign wealth fund similar to Norway’s Government Pension Fund, which invests Norway’s hydrocarbon income for future generations. Another potential option would be to appoint an international oil services company via international tender to manage the entire energy development process, ensuring that the state does not create yet another heavily unionised national champion / monopolist, and that real economic needs are served by the hydrocarbon wealth.

Cyprus should also begin preparing for the environmental risks of extensive hydrocarbon development, including the risk analysis and mitigation, as well as the formation of a rapid-reaction environmental response unit which is trained to handle gas field accidents and pollution. The recent Mari explosion further confirms this necessity.

Conclusions

The discovery of hydrocarbon reserves in Block 12, and the launch of exploration tenders in the remaining 12 blocks, are of strategic importance for the Republic of Cyprus. While the precise allocation of resources and reserves remains unknown in the absence of a detailed commercialisation plan, it is clear that within the next 2 years, Cyprus’ economic fortunes will being to turn around and a new, powerful source of income will complement (and hopefully not displace) Cyprus’ tourism, banking and shipping sectors.

In order for this to be implemented properly, the government needs to determine the future strategic plans regarding this sector. It is vital that energy income serves the real economy, and does not create an even more bloated public sector which engenders inflation and lower productivity. Unfortunately, in the party-dominated political system of Cyprus, there are few signs that adequate preparations are being made. We can only hope that in its quest to become the new hydrocarbon-rich statelet in the region, Cyprus can avoid the many mistakes made by other countries in the past.

The Destruction of Cyprus

23 March 2013

Economic Challenges and Priorities for Cyprus

7 March 2013

The Cyprus BailOut: Challenges, Opportunities and Lessons from Greece

13 December 2012

Cyprus Bank Exposure to the Greek Debt Crisis

30 December 2011

[1] An actual or proven mineral resource is one which has been proved to exist through geological exploration. A mineral reserve is one which can be developed profitably in the future.

[2] Suspicions of price manipulation are seen in two factors. In 2008, the gas price increased during the summer months to July, when normally the price falls in this time period (natural gas use is primarily used in energy production and district heating systems, which spike during the cold winter months).The US Government launched several investigations into price manipulation for the period April-July 2008, which resulted in several fines levied by the Federal Energy Regulatory Commission.

Anchor 1

Anchor 2