Sisi's Gas Pains

Why energy, not terrorists, could be the Egyptian strongman's undoing

Egypt faces plenty of threats, from a growing insurgency in the Sinai to a shaky and still unstable presidential regime. But the dramatic reversal in the country's energy fortunes in recent years, and the stark challenges that poses for the economy could end up proving the biggest headache for strongman Abdel Fattah al-Sisi.

Before the Arab Spring, Egypt turned its abundant reserves of natural gas, the third largest in Africa, into lucrative exports shipped to Europe and Asia. It sent gas by pipeline to neighboring countries, including Jordan and Israel. It had ambitious plans to further develop offshore natural gas resources, and was expanding its creaky electricity system on the back of natural-gas fired power plants.

Today, Egypt is scrambling to import natural gas just to meet skyrocketing domestic demand. Exports have plummeted: One of the two terminals that liquefied natural gas and shipped it to southern Europe has been shuttered since 2012; the other is wheezing, starved of gas for export by voracious demand at home.

In a sign of just how quickly Egypt's once-advantageous position has changed, there are reportedly talks underway to import gas from Israel -- less than two years after Cairo shut off exports headed there.

The abrupt reversal is a result of unsustainable economic policies, such as generously subsidized fuel prices at home that spur unbridled growth in gas consumption. And it's one big cause for concern about Sisi's ability to tackle the country's economic challenges.

The energy crunch threatens the electric power sector and big portions of Egyptian industry. The IMF forecasts Egyptian growth of just 2.8 percent this year, among the lowest in the region, making it even tougher to cut into double-digit unemployment. Coupled with blackouts and energy shortages, that could conjure up a repeat of the tumult of 2011 and 2013, which led to the toppling of Hosni Mubarak and Mohamed Morsi.

"The inevitable result is energy shortages and the concomitant social pressures that come with blackouts, lack of cooking gas, and fuel," Steven Cook, an Egypt expert at the Council on Foreign Relations, told Foreign Policy. "Sisi is going to have to confront these serious economic problems or he too will be confronted with people in the streets demanding change, and it won't just be the Muslim Brotherhood."

In 2009, Egypt exported 647 billion cubic feet of gas, mostly liquefied gas to satisfy demand in Europe, but also gas shipped by pipeline to Israel and Jordan. By 2012, gas exports had fallen to less than half, or 256 billion cubic feet; pipeline exports plummeted to one-tenth of their peak level. In 2013 exports continued to plunge. The latest government figures showed nearly a 50 percent decline in year-on-year exports in November.

The impacts aren't limited to Egypt or its reeling fiscal situation. Spanish utility Gas Natural Fenosa, which started importing gas from an LNG terminal in Egypt a decade ago, has watched the terminal sit idle since 2012. British gas giant BG Group in January declared "force majeure" and took a $1.2-billion-dollar write-down on its Egyptian LNG operations because natural gas is being diverted from exports for domestic use. The company warned investors that it doesn't know how much, if any, Egyptian gas it will be able to export this year. Consuming countries, including Japan and India, that once imported Egyptian gas have had to find alternative supplies on the spot market.

What's to blame for the sudden turnabout? Gas production has declined in recent years, but that's only partly responsible for the crunch. More important has been the jump in domestic consumption of natural gas, which rose 25 percent between 2009 and 2012 and which has essentially doubled over the last decade. More consumption at home leaves less gas for export, even though gas sold to Europe and especially to Asia is worth billions of dollars a year, while gas fed into the domestic market is kept artificially cheap.

Demand is growing so fast because Egypt, like other countries in the Middle East, heavily subsidizes the cost of energy, including fuel for transportation and natural gas for power generation. Energy subsidies alone represent about 10 percent of Egypt's GDP, according to the most recent budget. Natural-gas prices in particular have been kept low for industrial users, the power sector, and especially for households.

The Egyptian government is trying to tackle the cost of energy subsidies, especially as it struggles to rein in a budget deficit approaching 14 percent of GDP. In recent years, Egypt has tweaked the prices that big energy consumers, such as cement manufacturing plants, pay for gas, but the reforms didn't affect the cost of gas used in power generation, the biggest source of domestic demand. This year, backed by a grant from the World Bank, the country started work on a comprehensive reform of energy pricing, but experts say the country will be hard-pressed to roll back subsidies and ease fiscal pressure any time soon.

Raising domestic energy prices would threaten social unrest; but spending billions subsidizing energy aggravates the deficit and removes a source of substantial export earnings.

"In its attempt to correct energy market structure and distortions, the Egyptian government is caught between a rock and a hard place," concluded one report prepared by the Arab Petroleum Investments Corporation.

Ultimately, Egypt hopes to pull itself out of the energy crisis by boosting production from the promising reserves found offshore; BP announced a major new gas discovery last fall, for example. But raising production requires getting those international energy firms to invest, something that's proven devilishly difficult thanks to the domestic unrest, unfavorable contract terms for exploration, and the fact that Egypt owes foreign energy firms about $6 billion. Dwindling export revenues and increasing subsidies only add to that financial distress.

In the meantime, to meet demand and bridge the supply shortfall in coming years, the Egyptian government is trying to import natural gas, a stark turnabout for a country that was a big supplier.

But there are two big problems with that strategy: The government can't quite manage to build a terminal that can receive LNG for the local market, and imported gas is a lot pricier than Egyptian gas.

Plans to contract with a Norwegian firm to build a floating LNG import terminal appear to be on hold, and the Egyptian government's hopes of securing LNG imports in time for the summertime jump in demand appear to be dashed. Even if Egypt can get an import terminal, it will have to pay market prices for imported natural gas, which are much higher than domestic prices.

All of that is bad news for Egyptian firms that rely on natural gas for power. The cement industry, for example, has been hammered over the past year because of natural-gas supply shortages. The Lafarge Group, a big cement maker, said production tumbled in Egypt last year because of gas supply shortages. And things are getting worse: In January, the state-owned natural gas holding company slashed gas allocations for cement plants by 50 percent, driving down production by a similar amount.

While that's bad news for the economy, especially at a time when tourism revenues are in free fall thanks to domestic turmoil and terrorism, a more immediate danger to the Egyptian government could come from the electric power sector.

Blackouts used to be a summertime phenomenon, because higher temperatures increased the need for electricity. But they've now become commonplace even in the winter, thanks to supply shortages.

"The long gas lines and constant electricity cuts that occurred under Morsi could return under Sisi, enraging the public and broadening support for protests," Eric Trager and Gilad Wenig recently noted in Foreign Affairs.

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The Loan That Launched A Crisis

The Ukrainian conflict isn't just about politics.

As the carnage continues in Ukraine - with scenes of wounded protesters, raging fires, and armed police in full riot gear -- it's easy to forget the whole crisis was set off by a disagreement over a loan.

Late last year, with Ukraine's state coffers running low because of overspending on political priorities like subsidizing natural gas and increasing the wages of government workers, President Viktor Yanukovych faced a choice. The European Union offered a trade deal that promised to boost Ukraine's sluggish economy in exchange for harsh and politically unpopular austerity measures. Russia offered $15 billion and didn't ask Yanukovych to change much of anything. Unsurprisingly, he rejected the EU deal and opted for Moscow's bailout instead. Thousands of angry Ukrainians took to the streets in protest, and they haven't left.

Those early demonstrations were peaceful, but Ukraine has seen a spasm of bloodshed in recent days. Yanukovych called for a truce Wednesday and said he was ready for negotiations with opposition leaders. The deal collapsed almost immediately, and security personnel and protesters engaged in running battles throughout the day Thursday.

Snipers shot into crowds, and firebombs came flying back. At least 70 people were killed, bringing the weekly death toll to at least 101, according to the Associated Press.

In response, European officials moved to sanction Ukrainian leaders. After an emergency meeting in Brussels, EU foreign ministers said that they would freeze the assets and revoke the visas of officials they consider responsible for the violence.The United States issued a similar visa ban on Wednesday.

The Russian government also pressured Yanukovych to restore stability, suggesting that it could withhold the next $2 billion installment of financial assistance. Prime Minister Dmitry Medvedev said Russia would "try to fulfill all our promises" to Ukraine, but that it could only deal with "legitimate and effective authorities - a leadership which people aren't wiping their feet on like a doormat," according to Reuters. Russia had agreed in December to give the Ukrainian government $15 billion to replenish state coffers. The Russian deal also included a 33 percent discount on natural gas imports, which Ukraine depends on.

European officials turned toward sanctions after months of trying to cobble together a competing financial deal for Ukraine. U.S. Treasury Secretary Jack Lew reminded Ukrainian leaders Wednesday that they could still get a deal from the West in exchange for "steps to fix their economy."

While Kiev is still burning, it seems unlikely that Ukrainian officials would sit down with a bunch of bureaucrats at the IMF to talk about economic reforms. But if Yanukovych steps down or agrees to share power with opposition leaders, a new interim government could reopen those negotiations. That, in turn, could clear the way for Kiev to receive desperately needed funds.

"Ukraine is eminently salvageable," said Douglas A. Rediker, a visiting fellow at the Peterson Institute and a former IMF executive board member. "The economic issues that were confronting Ukraine were important, but not existential."

The Ukrainian government was facing a slew of economic issues that stemmed from the fundamental problem of spending more money than it was taking in. While the domestic economy sputtered, the government continued to increase wages, raise pensions and subsidize the country's energy costs.

Yanukovych didn't want to make any changes to that system for fear of weakening his grip on the country. Wealthy businessmen and people close to Yanukovych have grown wealthy, even as the rest of the economy slipped into recession.

"There's a reason that Yanukovych's son, a dentist by training, is now one of the most successful businessmen in Ukraine," said Steven Pifer, a former ambassador to Ukraine and a senior fellow at the Brookings Institution.

The Ukrainian government also sunk a lot of money into hosting the European soccer championships in 2012. Ukraine spent $14 billion to get ready to host the games with Poland, according to a Bloomberg report at the time.

But perhaps Ukraine's biggest problem was paying a high price for imported natural gas and then selling it to consumers and businesses at a lower price.

The IMF criticized these energy subsidies in a December report that outlined a whole raft of changes that it wanted Ukraine to make. The government had agreed to many of them on paper when it accepted a $15 billion loan in 2010. In December, the IMF reiterated the need for those changes, including reducing the government deficit, reforming energy markets, and better regulating the banking sector.

The IMF said Ukraine's high gas subsidies, which were 7.5 percent of GDP in 2012, led to "one of the highest energy consumption levels in Europe." The subsidy scheme led to a government deficit and losses at state-owned energy company Naftogaz, which was late on payments for gas imported from Russia.

Natural gas imports have often figured in disputes between Russia and Ukraine for years, with Russia periodically shutting off the spigot. Still, that didn't stop Yanukovych from turning to Moscow when faced with what he considered onerous loan terms from the West.

Former IMF Chief Economist Simon Johnson said Ukrainian leaders were faced with a decision about whether to change the direction of the economy.

"Do you have a relatively few people get a lot of power and economic opportunities or do you have rule of law and a broader economy?" said Johnson, who is now a professor at the MIT Sloan School of Business.

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