The decision by Egypt’s state energy firms to stop selling gas to the operator of a pipeline to Israel has brought the curtain down on a deal that has been dogged by controversy and disaster since it was first mooted in the early 2000s.

Politicians on both sides have sought to play down suggestions that the dispute could lead to a diplomatic crisis, threatening the Camp David peace accords. However, the incident is symbolic of the degradation of Egyptian-Israeli relations since the 2011 revolution. As the legal ramifications unfold, it could herald further trouble.

The impact on the two countries’ energy sectors will be minimal, as the El-Arish-Ashkelon pipeline has been in effect closed for a year due to repeated sabotage attacks, while Israel will begin production from its own offshore gas fields from 2013. Losing a politically contentious export customer will not hurt the Egyptian gas industry – its main challenge is to get upstream investment moving after a long hiatus, which has resulted in the erosion of Egypt’s capacity to export gas at all.

Damaging Egypt’s reputation as a safe haven for investment

There are concerns that the gas spat could further deteriorate Egypt’s reputation as a safe haven for investment, but existing stakeholders in the country’s energy sector are likely to view the Israel gas affair as a special case.

The Egyptian General Petroleum Corporation (EGPC) and the Egyptian Natural Gas Holding Company (EGAS) announced on 22 April that they were terminating the agreement whereby they guaranteed supplies of natural gas to East Mediterranean Gas (EMG), the owner and operator of the pipeline to Israel.

EGAS chairman Mohammed Shoeib said the decision was taken because EMG had not fulfilled its commercial obligations. An official at Ampal American Israel Corporation, one of the principal shareholders in EMG, said the company interpreted the move as being related to the arbitration proceedings initiated by EMG against EGPC, EGAS and the Egyptian government. These include a request to the International Chamber of Commerce (ICC) to rule that any termination of the gas sales and purchase agreement between EMG and EGAS would be illegal.

The idea of exporting Egyptian gas to Israel was first mooted in 2000, after the appointment of Sameh Fahmy as Egypt’s petroleum minister. Fahmy was a strong advocate of exporting a portion of Egypt’s rapidly increasing gas production, and he had already worked with some of the principals of EMG in his capacity as chairman of Midor, an Egyptian-Israeli oil refinery venture, prior to his appointment as minister.

Midor was conceived by ousted president Hosni Mubarak and the late Israeli prime minister, Yitzhak Rabin, as a means to cement the peace treaty, and they entrusted the project to businessmen with strong security connections: Hussein Salem from Egypt; and Yosef Meiman and Nimrod Novik from Israel.

As part of a strategy to increase the use of natural gas in its energy mix, Israel wanted to supplement production from its own recently discovered fields. One option was to tap into the gas field discovered in Gaza’s waters by the UK’s BG Group. This made commercial sense, but was politically problematic and the Egyptian option prevailed.

The Midor shareholders regrouped as EMG and the major commercial agreements were signed in 2005. These included the gas sales and purchase deal with EGAS, which was also a minority shareholder in EMG. It also included a memorandum of understanding between the two governments, whereby Egypt guaranteed the “continuous and uninterrupted” supply of gas to EMG and Israeli offtakers for 15 years, at a rate of up to 7 billion cubic metres a year.

The precise terms of the contracts between the parties remained under wraps. It was widely assumed that EMG would purchase gas from the Egyptian grid on similar terms to those afforded to Spain’s Union Fenosa for the first liquefied natural gas (LNG) project in Egypt (the second, between BG and Italy’s Edison involved a tolling mechanism, as the gas came from BG-operated fields).

Deal controversy

Part of the controversy surrounding both EMG and Union Fenosa has stemmed from the lack of transparency about the gas price. It was implicitly acknowledged that EMG had obtained preferential terms when in 2009 the government negotiated a higher gas price, but details were still not revealed. Meiman has said that the price is the highest for any Egyptian export project and is above the purchase price for exporters in Qatar and Russia. But the statement still suggests that EMG has been getting favourable terms.

As the construction of the pipeline got under way, EMG’s shareholding structure changed. In 2007, Ampal American, a US-incorporated company headed by Meiman, bought part of Merhav’s stake and put in additional equity. Ampal American now holds 12.5 per cent of EMG, according to its most recent annual report, of which 8.2 per cent is a direct stake and 4.3 per cent reflects its holding in Merhav Ampal. Thailand’s PTT acquired a 25 per cent stake the same year, buying almost half the shareholding held by Mediterranean Gas Pipeline Company (MGPC), which was owned by Hussein Salem.

PTT said in a statement on 14 April that Salem subsequently sold MGPC, but it is not clear when this happened or who the buyer was. Salem is in Spain awaiting the conclusion of proceedings to extradite him to Egypt to face a range of corruption charges. Most of the remaining shares in EMG are held by Israeli pension funds.

The pipeline started up in 2009, supplying 1.7 billion cubic metres of gas to Israel, out of total Egyptian gas exports of 18.3 billion cubic metres, according to the BP Statistical Review of World Energy. The following year, Egypt’s gas exports dipped to 15.2 billion cubic metres, reflecting production shortfalls and surging domestic demand. But gas sales to Israel rose to 2.1 billion cubic metres. EMG signed further supply contracts with Israeli buyers, bringing its total commitments to 6.3 billion cubic metres, including 1.5 billion cubic metres in options.

Revolution aftermath

The Egyptian government faced legal opposition to the EMG deal during 2009 and 2010 in the form of suits claiming that the gas sales were unconstitutional, but this did not impede operations. In the wake of the revolution, the deal was widely condemned as one of the most egregious symbols of Mubarak-era corruption. Islamist and leftist parties have pledged to secure huge windfalls through changing the price structure of all of Egypt’s export deals.

Within weeks of the revolution, the pipeline’s operations were stopped because of a bomb attack on the Sinai network of Egyptian Natural Gas Company (Gasco). This was the first of more than a dozen such incidents over the past year. With the exception of one unsuccessful assault on an EMG compound, all of these attacks were on Gasco facilities. EMG’s own pipeline is more difficult to attack because it runs mainly offshore.

EMG initiated its arbitration suits against EGAS and EGPC in September 2011. It sought damages for the failure of the Egyptian parties to meet their obligation to supply gas and it called on the ICC to afford protection to EMG from any claims from the company’s Israeli customers.

The ICC has yet to decide on the request from EMG that EGAS/EGPC should be prevented from terminating the gas sales and purchase agreement, and that matter now appears to have been superseded by the actual termination. Separately, Ampal American has indicated that it has launched proceedings against the Egyptian government under the provisions of the US-Egyptian treaty for the protection of investments. It is expected to seek damages in the order of $8bn.

The Egyptian government is likely to brazen the crisis out, although this risks creating further tensions with the US. The contract termination with EMG has raised the legal stakes, but it could placate domestic opponents of the Israel gas deal and lead to a halt in attacks on the Gasco network. This would allow exports to Jordan, which have been renegotiated at a higher price, to continue uninterrupted.

Despite the legal and political risks, the Israel deal is only a small part of Egypt’s gas sector. Much more important for the country’s energy sector are the issues of reforming domestic prices and accelerating the development of Mediterranean gas fields that have been discovered over the past decade, but have so far been left idle because of a failure to agree feasible investment terms.