CYPRUS: Wealth fund options a dream as long as revenues are unknown

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While East Med offshore gas exploration is heating up, with Turkey upping the ante with its two offshore drilling ventures, Cyprus is to establish a so-called sovereign wealth fund, in which part of the expected gas revenues should be deposited for future generations.


The small island, of which parts are still occupied by Turkish forces, is already counting on large additional revenue streams, based on the success stories of its neighbours Egypt and Israel, where major offshore gas reserves have been discovered and are currently being produced.

As a Dutchman, it feels admirable to see the optimism in Cypriot government offices and media when the future of the island is being discussed taking into account already a multi-billion treasure trove expected to be sitting below the surface of the Mediterranean.

The options of investing these revenue streams are vast, as Cyprus, still trying to recover from the former financial crisis, has to set up major programs to revamp its infrastructure, support welfare and employment.

With a still reeling financial sector, and existing scepticism about the strength of its financial institutions and banks, setting up a sovereign wealth fund (SWF) to govern the billions expected from offshore gas is to be supported.

Not to fall into the trap of the so-called Dutch Disease, named after the discovery of the largest European onshore gas field Groningen in the Netherlands in the 1950s, which resulted in high inflation, subsidies and government budget increases, but to learn from the Norwegian Petroleum Fund and set up a functional SWF which mitigates risks while putting away money for future generations. Nicosia has still a long way to go.

This week, the Cypriot parliament will be discussing the setup and operation of a national investment fund, mainly to be set up to manage future revenues from hydrocarbons.

Discussions at present are focusing on the fund’s management and structure, accountability and supervision. At the same time, plans are being discussed in which hydrocarbon revenues will be used to pay off the high level of national debt, which is currently hovering above 80 percent of GDP.

Politicians have already stated that half of the gas revenues are to be used to pay off debt. EU-based Maastricht criteria, however, state that as soon as the debt/GDP ratio is below 60 percent, more freedom of action is available. The proposal now is that below 60 percent level, only 25 percent of gas revenues will be used to further lower debt ratios.

The approach is feasible, and if governed in the right way, could be an instrument to leverage not only income, revenues and debt ratios, but also attract additional international investments in the future.

This is based on experiences in Norway, Kuwait, Nigeria or Qatar, where a large portion of hydrocarbon revenues flows into an SWF. Future generations can reap the rewards of these potential savings, and investments when hydrocarbon income is diminishing or has stopped.

Still, not all is as rosy as it seems right now. First of all, no real indications are available yet about the possible economically producible reserves. Without having these reserves in place, current discussions or strategies are mainly meant for the public.

Secondly, assessments should be made of the results of gas reserves, its quality and production levels, before any financial discussions should be made, not to wreak havoc with public opinion if results are disappointing.

Thirdly, no revenues can be estimated before discussions with potential clients have been concluded. To count on potential windfalls before you know the levels of investments to be made to set up an infrastructure, or how much production is needed to supply Cypriots themselves for 20-25 years, assessments are to be considered worthless.

Two major dangers still exist, which are kept out of the discussion at present in Cypriot circles. The first one is without a long-term strategy of the Cypriot government what to do with its natural gas volumes, exports should not even be discussed.

Monetizing natural resources inside of the local economy holds large benefits, which should not be squandered for short-term cash.

The latter is the main other concern. Looking at the current global gas market, a vast new volume of gas will enter the market in the coming years. If local or European demand for gas does not strongly pick up, price levels for natural gas will be low.

If these market fundamentals will not change, any infrastructure investment needs to be assessed before being put into action. The investments needed for an EastMed offshore gas pipeline to Europe could mean several years of no real hydrocarbon income benefits for Cyprus if not managed well. Possible LNG options could, however, speed up hydrocarbon revenues as there is ample existing LNG liquefaction available in the region (Egypt). 

As an old saying states “don’t sell the fur of a bear, before you have shot him”. This an issue to be taken into account, also when setting up an SWF. There needs to be spare cash available to be invested for future generations, without depressing any economic growth potential at present.

When looking at the current Cypriot political and economic environment, the time is not yet right to put in place an SWF organization. Possible political interference or mismanagement of funds is still an issue not taken care of.

Optimism is rife, but clouds assessments it seems. Without the right prerequisites, which is governance in place, reserves and potential windfalls known, and enough revenue income available to diversify and strengthen a sustainable economy, no room will be there to handle an SWF approach.

Looking at other SWFs, the main statement should be that most have been successful due to their former glory. Mainstream SWFs in Norway, Nigeria, Qatar, Abu Dhabi or Saudi Arabia, have been able to reap the rewards of high and sometimes exploding oil and gas prices.

This situation is however over, prices will not be spiking very soon. At the same time, most SWFs were built on oil revenues, only the Qatari SWF QIA has been able to reap the gas rewards. The latter’s gas reserves, however, dwindle Cyprus’ most optimistic scenarios for sure.

To use the SWF as a backup to pay back debts is also not the right approach. As shown in Algeria, debt payments should not be the main reason for an SWF. The latter should be able to invest in mid- to long-term national and international equity or bonds to mitigate economic risks at home. The latter also should be a non-political instrument, as this normally will lead to the wrong investments.

The main message, as shown in Norway, or by several European pension funds (Dutch SWF approach), is not to invest in the local economy as a primary instrument. Spreading risks is more functional than paying off debts.

For Cyprus, looking at its current financial and economic situation, the first years a structural investment strategy should be set up to support economic growth and diversification.

If there is enough cash left, this should be put in an SWF vehicle, without political or governmental links or influence. Still, spending or investing future revenue streams without knowing the total is a dream, not reality.