Battling for Sunken Treasure

Did the Sheshinski Committee, charged with determining the taxes that energy companies will pay on revenues from large natural gas findings, go too far – or not far enough?

By ZIV HELLMAN
Eytan Sheshinski (photo credit: Marc Israel Sellem)
Eytan Sheshinski
(photo credit: Marc Israel Sellem)
EYTAN SHESHINSKI IS finally beginning to feel some relief. Nine grueling months after he was tapped to head a government-appointed committee studying Israel’s fiscal policy with respect to royalties and taxes from oil and gas fields, Sheshinski, professor emeritus of public finance at the Hebrew University, has good cause to feel vindicated.
His committee’s recommendations, whose bottom line calls for increasing the overall government take from oil and gas fields from 25 percent to a sliding scale ranging from 50 percent to 62 percent, has been strongly supported by top-level financial officials in the country, including Finance Minister Yuval Steinitz, Bank of Israel Governor Stanley Fischer, and Prime Minister Benjamin Netanyahu himself.
Netanyahu’s government has voted in favor of adopting the Sheshinski Committee’s recommendations as the basis for new legislation, which is currently being debated in a Knesset committee prior to a vote in the full plenum.
But Sheshinski has paid a high personal price. Both he and his committee were the targets of an ugly public smear campaign, one of the worst Israel has ever seen. Full-page newspaper advertisements – many with no outwardly identifiable source – regularly pilloried the committee.
Demonstrators camped outside Sheshinski’s home in Jerusalem’s Yemin Moshe neighborhood, loudly accusing him of being an “Arab lover” (apparently an insinuation that by increasing taxes on natural gas production, Sheshinski intended to make domestic gas production unprofitable, thus forcing the country to buy gas from Egypt instead). He and his family were harassed by frivolous law suits and rattled by death threats.
Lobbyists for the energy companies that discovered large natural gas findings off the coast of Israel put intense pressure on public figures, government ministers and Knesset Members to reject the committee’s recommendations.
“What we saw happening here goes beyond distressing. It is appalling,” says Daniel Doron, director of the Israel Center for Social and Economic Progress (ICSEP), a pro-market public-policy think tank. “The power wielded by tycoons in our society is simply perverting public discourse, and clearly harming the economy.”
“The fabric of democracy has been shown to be fragile,” laments Daniel Gutwein, professor of history at Haifa University. “This was no less than a tear in that fabric, and the threat here is clear and alarming.”
“IN A LAW-ABIDING DEMOCRAcy, it is certainly legitimate for everyone to have free expression, even if that expression is of anger or rage,” Sheshinski tells The Report. “But there has to be a measure of proportionality. From my position as head of the committee, I saw an asymmetry between wealthy interests and the authorities. This asymmetry may pose a danger to the balance of power. And that raises some very serious questions.”
Behind his calm demeanor, the professor has piercing hazel-colored eyes that fix a firm and determined gaze forward when he defends the committee’s months of work. “It is not only the right of the state to increase the government take from oil and gas production, it is its duty to do so,” he says emphatically. “If anything, we were too lenient with the energy companies in our final recommendations.”
Sheshinski, 73, has enjoyed a long career as one of the world’s leading experts on public financing, privatization and taxation.
He completed a PhD in economics at the Massachusetts Institute of Technology in 1966, and, in addition to his permanent position at the Hebrew University of Jerusalem, he has been a visiting professor at a long list of prestigious institutions, including Princeton, Harvard, MIT, Columbia and Stanford. As an emeritus professor, he is a member of the Hebrew University’s Center for the Study of Rationality.
In the private sphere, Sheshinski has served as chairman of the Board of Directors of Koor Industries and is a member of the board at the Discount Bank and the Psagot-Ofek Investment House. In public service, he has, among other positions, been an economic consultant to the Knesset, consultant on welfare policy to the Prime Minister’s Office, and chairman of a committee of experts on tax reform.
But even this extensive résumé did not fully prepare him for the ordeal. “When we first began our deliberations, I told the members of the committee that if we find that the government take in Israel from natural resource drilling places is ‘somewhere in the middle of the pack’ relative to the rates taken by countries around the world, we should leave things as they are,” Sheshinski tells The Report. “What we did insist on was proportionality. And it turned out that things here were very far from being proportional.”
OVER A DECADE AGO, A UNITED States Geological Survey report concluded that there were significant signs of structures – meaning deep wells – containing natural gas and petroleum in the eastern Mediterranean. Energy companies began to take the idea of intensive exploration off the coast of Israel seriously.
This had long been advocated by geologist Joseph Langotsky, whose theories had once been met with ridicule.
A consortium led by Houston-based Noble Energy struck its first jackpot in 2009 in a natural gas field called Tamar, named after Langotsky’s daughter, located at a depth of 16,000 feet (4,800 meters) some 80 kilometers (50 miles) off the coast of Haifa.
Tamar’s reserves of natural gas, which Noble Energy estimates at 238 billion cubic meters, were considered a major, gamechanging find at the time.
But even this was soon overshadowed by yet another field drilled by the Noble consortium, aptly named Leviathan. Leviathan, about 80 miles offshore and 29 miles southwest of Tamar, holds a gross mean of 450 billion cubic meters of gas, according to Noble Energy.
Noble holds a 39.66 percent interest in the consortium, with Isramco Negev 2 holding 28.75 percent, Delek Drilling 22.67 percent, Avner Oil Exploration 22.67 percent, and Ratio Oil Exploration rounding out the holdings with 15 percent. Ratio Oil began a handful of years ago as a start-up, employed five people, and was worth less than $500,000; its market value today exceeds $1 billion.
Taken together, the two natural gas field finds, the largest in the world in the past decade, contain a staggering amount of energy reserves. The quantity of gas is so great that the fields will not only supply Israel’s domestic needs for decades – they will catapult Israel onto the list of energy exporting nations, a development with far-reaching implications. Leviathan alone has been estimated as containing $80 billion to $90 billion worth of resources. The United States Geological Survey’s latest estimates of oil and gas reservoirs in the eastern Mediterranean, from March of last year, indicate that there may be as much as $300 billion worth of natural resources within Israel’s territorial waters.
With those kinds of numbers, it should come as no surprise that the government quickly became interested in the potential state revenues. But to the dismay of the tax authorities, the existing law governing natural resource taxes and royalties in Israel, the Petroleum Law, was an antiquated piece of legislation dating to 1952. Over the years, attempts to update the law, most recently in 2002, never managed to obtain Knesset approval.
The Sheshinski Committee, formally named “the Committee to Examine the Fiscal Policy on Oil and Gas Resources in Israel,” was appointed in April 2010. It was charged with conducting an in-depth examination of the oil and gas exploration market in Israel and around the world – particularly the natural gas market – and providing the government with recommendations. The committee submitted its interim report on November 15, 2010 and its final report on January 3, 2011.
ALL NATURAL RESOURCES ARE always the sole property of the state, but to encourage the private sector to explore for resources, the state issues drilling licenses that, according to law, can grant those who strike oil or natural gas tremendous profits. An initial permit is issued for 18 months. If the holder of the permit is satisfied that sufficiently positive indications have been found, the permit may be upgraded to a three-year license. If a discovery is subsequently proven, 30-year exclusive mining rights are issued to the license holder; these may be renewed even further if the natural gas or petroleum field continues to yield usable resources.
The permits, however, are not issued by competitive tender. All a company needs to do is present a reasonably professional work plan for drilling a particular location to the regulating authority. The fee for obtaining an initial permit is only a few thousand shekels.
Contrast this with the drilling permits issued by the US government, which are granted by the Department of the Interior to the highest bidders. Obtaining a permanent drilling license in the US, once initial indications of the presence of oil or natural gas are found, further requires paying a stiff upfront bonus.
“The Israeli system, issuing drilling permits ‘almost for free,’ led to rent-seeking behavior,” complains Sheshinski, using a term economists draw on to refer to profits made by someone solely because he or she has obtained a state-sanctioned monopoly instead of honest hard work. “Individuals issued a drilling permit in Jerusalem in the morning would strike it rich by the time they returned to Tel Aviv in the afternoon [by expensively selling exclusive rights they had bought cheaply].”
Indeed, for years, oil exploration companies have been making exaggerated claims about the imminent signs of striking it rich – which almost always proved false but nevertheless artificially inflated the companies’ share prices on the Tel Aviv Stock Exchange.
Despite this, Sheshinski does not advise switching to a tender system for drilling permits.
By now, he notes, so many offshore locations in the Mediterranean have been explored that some companies would gain an unfair advantage under a tender system. In fact, although there is supposed to be a maximum of 12 permits per company, some have obtained 20 or more permits.
SHESHINSKI’S COMMITTEE FOcuses on the state’s revenues from successful natural resource extraction.
The 1952 law established that, in exchange for the right to extract natural resources and sell them, a company holding a license must give the government 12.5 percent of revenues in royalty payments.
However, in order to compare with international standards, it is necessary to consider what is termed the total “government take,” that is, the total percentage that the state takes from an oil or gas company’s profits, including royalties, direct taxes on profits, corporate taxes, government subsidies of development costs, depletion allowances, tax credits, and so on. Sheshinski displays a chart based on figures taken from an issue of the Oil and Gas Journal, published five years ago, with figures on average government takes in various countries around the world.
The highest government takes are levied by countries that are not exactly at the top of the Freedom Index tables. Sheshinski quips, “The Good Lord did not distribute world energy reserves among countries based on the quality of their governance.” Libya and Iran, for example, have government takes of around 95 percent or more.
Ignoring those examples, Sheshinski concentrates on Western-style democracies, members of the OECD. Norway, for example, has a take between 75 to 79 percent. The comparable figures for the Netherlands are 62 to 66 percent, for Denmark 62 to 64 percent, for Canada 60 to 63 percent, and for the United States 47 to 50 percent.
But if no changes are made to the existing rates, the total government take in Israel in 2016 will be a mere 25 percent of the enormous projected revenues: from Tamar over $40 billion and as much as $80 billion to $90 billion from Leviathan.
That is why his committee’s main recommendation is to levy a tax on natural gas and oil fields. And it is that recommendation – which the energy companies suspected was on the way and tried to ward off – that led to the uproar. The Sheshinski committee has been accused of “moving the goal posts.”
By imposing new rules “retroactively,” the companies accused, the committee is unfair ly undercutting the assumptions and expectations that had led them to undertake their very risky and expensive explorations.
As long as it was unclear whether or not natural resources could be found, say opponents of the committee’s findings, the state made commitments for the sake of encouraging exploration – and then reneged on those commitments as soon as it became clear that the results would be positive. The implication is that if the energy companies had known that the total government take might be raised, they would not have conducted risky explorations in the first place.
REPRESENTATIVES OF THE energy companies refused to speak with The Jerusalem Report. The Report has learned, however, that officials in the major drilling partners at Tamar and Leviathan are still seething at the Sheshinski Committee’s recommendations, which they compare to the nationalization of oil industries in Latin American countries – acts that they point out were accompanied by compensation paid to the oil companies operating in those countries, while they will suffer financial losses they estimate may be up to 60 percent of their net present value without any compensation.
They also feel betrayed because they believed they had commitments from senior government figures that no changes in tax policy would be imposed on the Tamar field, which they counted on while pouring $1.3 billion so far into development at that site.
Sheshinski categorically rejects these arguments. “Governments always make fiscal changes,” he points out. “Tax rates rise and fall, and businesses adjust accordingly.
No government in the world can have its hands tied.”
In fact, Sheshinski points out, the energy companies were fully informed all along that the government retained the right to make these changes and they signed statements accepting that fact. “All the drilling permits and licenses issued by the State of Israel, including those issued to Noble Energy, included explicit statements that taxation rates on oil and gas fields may be subject to change,” he states.
And in response to those who keep waving the 1952 law and insisting that its terms should be honored according to their “original intent,” Sheshinski points out that if the natural gas had been discovered in 1952, the government take would have been 58 percent, because corporate tax rate in Israel was very high in the 1950s (it is now slated to drop to as low as 18 percent by the middle of this decade).
“Somehow,” he says dryly, “when the tax rates go down, no one ever complains about ‘retroactive changes.’” Actually, Sheshinski says, his committee was too lenient on energy companies. The committee’s final recommendation leaves the royalty rates at 12.5 percent, while imposing an oil and gas levy on profits that increases the government take to between 52 to 60 percent. The taxes are imposed gradually and incrementally. No taxes are due until recovery of 150 percent of the investment in the exploration and development, at which point the tax rate will be 20 percent and then increase progressively to 60 percent after 230 percent of investment is recovered. The rates kick in so gradually that some have estimated that it may take eight years of production in medium-to-large wells before the government would get a significant take.