Lebanon could be on the way to join the club of other Middle Eastern oil and gas producers, albeit on a smaller scale. Whether this ambition can be realized will largely depend on its ability to build successful and sustainable relationships between the government and the international oil industry.

On February 15 the Lebanese government announced the pre-qualification process for companies that are interested in obtaining licenses for oil and gas exploration and production off the Lebanese coast. This process will last until the end of March and eligible companies will be notified by mid-April. Bidding is then expected to start in May and to continue for six months before the first exploration and production agreement can be signed in February 2014. While this encouraging development is the official start of Lebanon’s first-ever offshore licensing round, it thus marks the beginning of a new and potentially difficult experience.

Interested oil companies will submit applications to convince the Lebanese government that they have the technical and financial capability necessary to carry out exploration and development programs in Lebanon’s offshore waters. At the same time, they need to convince their senior management and shareholders that locking capital and human resources here is a worthwhile undertaking.

Investors have limited resources and, especially since the shale gas “revolution”, have increasingly had more opportunities than the financial and human resources required to develop them. Inevitably, priorities will need to be established. Rational investors will allocate resources to those opportunities that offer the most attractive long-term returns and allow for the highest capital efficiency. They will therefore seek to achieve reasonable returns at an acceptable level of risk.

While the timing is good for Lebanon due to an era of consistently high energy prices, problems arise from shale oil and tight oil opportunities being developed in many countries, which open alternative propositions for many companies. And whether the high-price environment can be sustained, given these new opportunities, remains an open question for now.

Weighing investor risk

Investors typically consider a variety of factors next to the geological potential, such as commercial prospects, political risk, security risk and, of course, the fiscal terms. A government cannot influence geology, or even commercial prospects, which depend on technology and prices. Among the factors it can influence, the fiscal terms are perhaps the most important.

Lebanon will largely depend on international expertise and capital to explore and develop its potential for hydrocarbons. Most oil and gas producing countries follow this approach. Very few countries, such as Saudi Arabia or Mexico, adopt the ‘go-it alone’ strategy for their oil sector. The exploration and exploitation of oil and gas requires significant financial and technological resources that would exceed the capability of most oil producing countries. And the high risk of failure involved renders a purely national approach to the exploitation of petroleum difficult to implement and manage.

The geological risk is currently high in Lebanon. Its offshore waters are still virgin territory for exploration. Although seismic data shows promising potential, concrete proof can only come through drilling. Once a commercially viable discovery is made, investors’ perception of this particular type of risk will decrease significantly. At this stage, the Lebanese government should focus on encouraging exploration and competition in order to mitigate risk in the province.
Exploration and development activities are most responsive to fiscal terms. In Lebanon, comments have been made that the fiscal regime will be fair and competitive. That, however, is easier said than delivered, especially if a more dynamic, long-term perspective is considered.

Lebanon opted for a contractual fiscal arrangement called a production sharing agreement, which is a popular regime among developing countries and which emerged during the oil industry nationalization wave in the 1960s and 70s.
Under this system, the oil company acts as a contractor, which operates at its own risk and expense, providing all the financing and technology required for the operations. In case of a commercial discovery, it is rewarded a share of production, to which it takes title to; the rest goes to the government. Some would argue that contractual arrangements are tougher than concessionary arrangements. This, however, largely depends on the fiscal package in place. In Lebanon, the details of the fiscal terms haven’t yet been published.

Petroleum taxation has been, and continues to be, a controversial issue. The most common objective cited by host governments is to generate for the nation a fair share of the proceeds while providing an acceptable and sufficient level of profitability for international oil companies. Quite obviously, the key question then becomes: how is “fair” defined, and  by whom?

High rewards beckon

Oil price volatility, for example, ensures that views of what constitutes a ‘fair share’ constantly change. While governments may find a share of 50 percent acceptable with oil prices at $60 per barrel, they are unlikely to retain their view once prices climb above, say, $100. Similarly, a large unexpected discovery may be good news for investors and governments alike, but often will lead to unfortunate fiscal consequences for investors. Governments keep the question of a ‘fair share’ under almost constant review, adding fiscal risk to the many other risks that make up the oil and gas extraction business.

The 2010 Lebanese Offshore Petroleum Law refers to the possibility of state participation, but officials confirmed that this will not apply in the first licensing round. The law also refers to the possibility of creating a national oil company. Such provisions, if implemented, threaten tighter government control. State participation can also increase the total government share of potential returns.  One addition to the long list of risks that investors normally face is the political risk, which is notable in Lebanon. The war in Syria is still ongoing and spillovers to Lebanon are looming. One could argue that oil and gas operations will take place offshore, but even far in the Mediterranean, maritime border disputes between Cyprus, Israel, Lebanon, Turkey and potentially Syria give reason for concern to those planning offshore operations and export options.
For societies, oil and gas resources too often are a curse rather than a blessing. Will cooperation and the rule of law, so plainly missing in today’s Eastern Mediterranean, prevail to turn them into a blessing for Lebanon?

The oil and gas sector has many distinctive features, which can be summarised as high risks and high rewards. One has to look through current troubles in making long-term decisions. Only the coming years will tell whether the risks investors need to take in Lebanon will be worth their while.

Carole Nakhle is an energy economist specializing in international petroleum contractual arrangements and fiscal regimes, world oil and gas market development, and energy policy