It may not play well on the Arab street, but Egypt’s new energy pricing policy holds the potential to further stimulate industry development ahead of three new bid rounds and some very expensive E&P investment, needed to maintain the oil and gas export boom, writes Nadine Marroushi in Cairo.

Officials including Petroleum Minister Sameh Fahmy are signalling that, this time, Cairo really is grasping the nettle, and that Egypt’s recent decision to phase out gas and electricity subsidies for energy-intensive industries has real significance for the economy’s future health, as well as for developing gas-fuelled industries.

The reform, announced this summer, was widely seen as the first step towards satisfying international oil companies’ demands for better prices for gas sold into the domestic market, and frees up producers in their choice of domestic customers.

Fahmy told African Energy he saw the move as a further incentive for IOCs to invest – and he will be promoting three licencing rounds in the next quarter alone on the back of an improved investment climate (see article below).
Financial markets have been most receptive to the reforms pushed by Prime Minister Ahmed Nazif’s government, while IOCs have been more ambiguous; they praise Egypt’s pragmatism in allowing them to develop a significant gas export industry in record time, but have been highly critical, in private at least, of the authorities’ inability to tackle key subsidy and pricing issues; as well as burdening the exchequer with unwieldy deficits, the Nasserite subsidy regime has acted as a strong disincentive to invest in domestic projects.

Simon Kitchen, senior economist at Cairo-based investment bank EFG Hermes, told African Energy that under the new system, “IOCs are expected to sell directly at the cost of production, once industrial users start paying $2.65/m British thermal units (Btu) after three years, when the final pricing agreement comes into play.”

The cost of natural gas will rise to $2.65/m Btu from $1.25, equivalent to cost price, over three years.

Electricity prices will be increased over the same period.

Following the first phase, prices will be variable, based on a formula linking cost and international prices. Eventually it will rise to $4.69/m Btu, according to Edinburgh-based consultant Wood Mackenzie’s Craig McMahon.
Meanwhile, energy subsidies for other industries will be gradually phased out over the next six years. Initially, 40 companies will be affected in the cement, iron and steel, aluminium, fertiliser and petrochemical industries.

The government also plans to allow IOCs to sell directly to industrial users in the hope of encouraging further development of local gas fields.

The industry is talking up the move. According to McMahon, “where necessary, the Egyptians have shown pragmatism to renegotiate domestic gas prices to promote development.”

Cautious flows the Nile

With energy subsidies costing over $6bn/yr, urgent reforms are needed, but as ever the authorities will move cautiously. Last year’s energy price readjustment contributed significantly to inflation surging to 12%.

Finance Minister Yousef Boutros Ghali has been trying to keep consumer price rises down to 6%-8%. Hovering near 8% in September, inflation numbers are being closely watched following the latest adjustment.

According to Kitchen, companies included in the pricing reform receive 14% of annual energy subsidies, which in fiscal year 2007/08 are expected to cost the government E£36.5bn ($6.5bn).

Savings to the fiscal account next year are expected to be E£1.8bn (0.2% GDP), which should help the government meet its target of reducing the budget deficit by 1%/yr, providing no unexpected contigencies occur. This year an extra E£5bn had to be spent on food subsidies, because of the July 2006 energy price adjustment, which affected transport costs.

Total savings are estimated by Trade and Industry Minister Rashid Mohammed Rashid at E£30bn over the next five years. He told Euromoney’s annual Egyptian investment conference in Cairo that the new pricing policy would stimulate the development of labour-intensive small and medium sized enterprises: “We issued the new policy to ensure that all production units are competing on a level playing field.”

The burden of subsidies

Subsidies weigh hugely on the budget, along with the other big items: interest on debt and salaries. Each cost between E£50bn-60bn. EFG estimates that in 2007/08 total subsidies will cost E£55bn, two-thirds of them from energy.
The International Monetary Fund has been warning of high energy subsidies’ negative effects, with the IMF arguing that “continued efforts are needed to reduce the under-pricing of energy, which remains an important distortion that risks attracting investment into sectors where Egypt may not have a long-run comparative advantage, encourages levels of energy consumption that impose high environmental costs, and uses up vast public funds that could be more productively spent, for example on education or infrastructure.’
A recent IMF report said that “fuel subsidies recorded in the budget amount to 5-6% of GDP; however, valuation of domestic oil and gas production at world market prices would put the implicit subsides substantially higher still.”