Mediterranean PaPer SerieS 2010

Can algeria be a stable and sustainable sourCe of energy for europe?
trevor Witton Independent MENA Energy Consultant London

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Can Algeria be a Stable and Sustainable Source of Energy for Europe?
Mediterranean Paper Series January 2010

Trevor Witton Independent MENA Energy Consultant London

What is Energy Security? Energy security means different things to different people. From a European perspective—as a significant energy consumer and net importer of oil and gas—energy security means access to reliable sources of energy, at competitive prices, produced in environmentally responsible and safe manner. From an Algerian perspective, as a significant energy producer and net exporter of both oil and gas to Europe, the concern is not so much about security of supply, but security of demand. Five hundred million European consumers benefit from what have been, to date, reliable deliveries of Algerian oil and gas into a stable and growing energy market. The European Union (EU) relies on Algeria for up to 20 percent of its gas demand alone, but despite Algeria’s prolific gas reserves and its obvious geographical proximity to the European market, its energy exports have had to compete for market share in an increasingly global market place. Winston Churchill said that “safety and certainty in oil lies in variety and variety alone.” The same principle applies to energy security today. Diversity of supply—types of energy, its supply chain geography and production technologies, all help reduce reliance on any one source. Energy diversity is, therefore, a founding principle of energy security. It enables global markets to operate by helping balance supply and demand. Advantages of Open Energy Markets The world has become steadily more dependent on traded energy, volumes of which have roughly doubled over the last 20 years. Europe is no exception. Growth in energy trades is seen by free markets as a good thing; it is an indication that commoditized markets are deep, resilient, and robust. Free trade between energy producers and consumers creates mutual dependence and mutual advantage between supplier and customer. Proof that open, transparent, energy markets work can be

seen from the fact that despite recent geopolitical disruptions, including two major wars in the Middle East, 9/11, and several natural disasters, there has been no major physical shortage of energy supplies in the last 25 years. Energy is always available, albeit at a price. Anxieties about energy security arise when existing market arrangements fail, or look likely to fail. Specific supply disruptions can arise from production shortfalls anywhere along the supply chain—a major field, facility, or transport system suddenly goes off-line due to unforeseen events; or because of a contractual dispute between supplier and buyer. Global shortages of energy caused by imbalances between supply and demand are usually signalled well in advance by the advent or advance of high or higher energy prices. In deeply commoditized markets like oil, the impact of sudden outages is never usually serious, as shortfalls can easily be made up in the market. In gas markets, however, where supply is usually tied to specific end-user contracts, making up unexpected losses can prove more problematic. Although the global energy market is deepening all the time, to remain efficient and to signal the need for investment, at the right place and at the right time, the market has to be transparent and operate without constraint. Protective measures, or restrictions of scale or capacity of production, will always send the wrong market signals, discouraging investment with consequences for energy security. Instead, the commercial conditions that promote open and transparent markets need to be encouraged and incentivized to ensure sustainable and durable relationships between supplier and consumer are maintained as an important plank of energy security. In open and transparent markets the economic response to energy shortages is to invest in additional sources of supply. Unfortunately, the

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global energy market is not a perfect economic system. The oil market is distorted, first by the presence of the OPEC cartel and secondly by either a reluctance or inability of non-OPEC producers to make the necessary investments when signalled by the market. Taken together, both dent economic theory, leading to market-price dislocations. The rise of energy prices between 2006 and 2008 was an example of strong global demand chasing tight supplies against a background of either underinvestment in production and delivery capacity or reluctance to place available supplies in the market. Whether this was due to a breakdown in supply-demand theory or market manipulation has been much debated, but either way, price was the significant market response—there was always just enough supply to keep the market fully liquid. The recent global economic depression and associated collapse in energy demand quickly quenched the high energy prices of 2008. For the first time in recent memory, global demand for oil and gas has fallen, not least in Europe, leading to significant energy surpluses chasing weak market demand and lower prices. Ironically, these current energy surpluses are most likely to be the catalyst to future supply shortfalls as investment in new sources of supply is withdrawn or slowed in the face of financial distress, exacerbated by lower prices, particularly for gas. The long-anticipated wave of new Liquefied Natural Gas (LNG) supply is beginning to arrive in the market, boosting overall supplies by 15 percent in 4Q09 and by as much as 25 percent by 2010. With subdued Asian LNG demand, most of the new LNG will continue to price itself into Europe, causing intense gas-on-gas competition for all players—not least Algeria. Significantly, in the context of European energy security, Algeria is both a member of the OPEC oil cartel and a founder member of the relatively new Gas Exporting Countries Forum—which some believe is an attempt to form a sellers cartel with a

similar mission to that of OPEC. Membership of such associations is notoriously prone to political overtones outside of market forces and must therefore be factored in to any assessment of energy security by European consumers—though quite how to characterise such risk often remains enigmatic. Algeria’s Conventional Energy Potential Despite these wider energy market concerns, few doubt Algeria’s long term oil and gas potential. Geology has blessed Algeria with several prolific hydrocarbon basins that have been exploited by the state energy monopoly, Sonatrach, since its nationalization. At current rates of production the state has about 20 years of remaining proved oil reserves and around 40 years for natural gas. However, Algeria has stated publicly its commitment to grow both oil and gas production through an aggressive program of new investment, reported to be around $63 billion for the period 2009-2013. Sonatrach’s plan is to increase sustainable crude oil production capacity from about 1.8 million barrels a day (mbd) today to 2.0 mbd by 2010, and to further increase this figure to 2.5 mbd by 2015. However, in reality these targets appear unrealistic, both in terms of volume and timing. Even if Sonatrach had established proven reserves to back their policy aspirations, oil production remains constrained by OPEC quota restrictions (which show no signs of easing in the short term) and exports are limited by existing export facility capacity. In terms of gas potential, as the world’s fifth largest producer of gas, Sonatrach is a significant global player and justly proud of its leadership position. Algeria has stated that it plans to increase gas exports from the present rate of around 61 billion cubic metres a year (bcma) to 85 bcma by 2012 and to perhaps as much as 120 bcma by 2015. Again, these production targets appear to be hugely optimistic and are unlikely to be met.

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Despite all the talk, gas exports from Algeria have been almost flat since 1999. Despite many small discoveries, significant new reserves have not been established over the last decade to support Algeria’s gas export growth aspirations. A program of multiple, multi-billion dollar investments in upstream exploration will be required to establish the reserves to back these targets if they are to be realistic. Assuming such a campaign is successful, further tens of billions of dollars will then be required to build the field facilities and related pipeline and export infrastructure if any new reserves are to be monetised. The relatively poor uptake of new acreage by foreign investors in the last two licensing rounds, however, suggests that securing new reserves and investment may further delay these goals. If energy security is about investment to define additional reserves and to build energy infrastructure to bring them to markets, it is also about energy substitution. Algeria’s appetite for domestic energy is making serious in-roads into its production of both oil and gas. Generous price subsidies encourage profligate use and inefficiencies which limit the surplus available for export. The more that can be done to improve the efficiency of the domestic energy market via investment incentives and fiscal measures, the more efficient the use of domestic energy will become, liberating valuable supplies for export and improving security of supply. Conventionally, energy efficiency has been about the application of new technology, particularly in the power generation and transport sectors— both big consumers of Algeria’s domestic reserves. Algeria is pursuing a program to build new, more efficient, gas-fired power generation plants by upgrading and retiring older single-cycle units and replacing them with modern combinedcycle gas turbine technology. However, the state generator, Sonalgaz, is severely debt laden and

capital-constrained because it can only levy state prices for supplies of gas and electricity which are below the cost of production. Algeria has instead turned to commercial partners to help Sonelgaz deliver new generation capacity. Although several joint ventures have been involved in building new plants, nearly all have suffered from construction and commercial related difficulties. The lack of a properly regulated, competitive dispatch and transmission grid operating system and state controlled gas feedstock and end-user electricity prices makes it difficult for potential inward investors to see an attractive return. But with electricity consumption growing at between 4–5 percent per annum, urgent investment is required just to maintain current domestic capacity, which offers little reserve to meet periods of high seasonal demand or outages—let alone meet strong demand growth. The Future: Alternative Energy? Despite the challenges presented by conventional energy, Algeria has considerable potential for the development of alternative and renewable energy sources—principally solar and wind-energy. According to publicly available sources, Sonatrach and its subsidiaries have ambitious plans to become a major generator and exporter of solar power to Europe, provided that the vast investment costs can be secured and a viable commercial model can be developed. If such investment were to occur, it would diversify the energy mix and help free both oil and gas for export, contributing to energy security through diversity of supply, while also addressing the increasingly pressing climate change agenda. Headline projects to promote the development of renewable energy schemes in Algeria based on large-scale solar power generation with submarine transmission links to Europe may look good on paper, but in practice they face significant

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commercial hurdles. Although undoubtedly attractive to EU policymakers, the export of solar generated power to Europe via submarine cables is an enormously capital-intensive supply option. The commercial assumption that solar power generated in Algeria can be delivered to demand centers in Northern Europe via Spain and Italy, and at competitive prices relative to more conventional alternatives, requires imaginative thinking. Demand for electricity in the southern sectors of Spain and Italy is only modest and grid connectivity and line capacity northwards to key demand centers is limited. Significant investment will be needed to build new transmission capacity required to reach more northerly energy demand centers—always assuming that transit countries adhere to European Energy directives that call for unconstrained third party access to existing and new infrastructure—by no means a given based on current behaviors. These economic assumptions—the price of solar generated power, the cost and efficiency of subsea transmission of electricity, and the restrictions in transmission-grid connectivity—present Algeria with a daunting commercial challenge and risk. Algeria appears to be banking on one or other of two EU energy policy development assumptions. The first is that consumers in EU member states are actually willing to pay the necessary premium for ‘green’ solar power relative to alternatives. Supporters argue that they must if member states are to meet their agreed, and some believe somewhat aggressive, EU 2020 emissions targets. The second assumption, possibly linked to the first, is that EU member states will somehow enter into a protocol with Algeria to subsidise such ‘green’ generation capacity so that it can compete on price with European alternatives, thereby underwriting its commercial viability. These assumptions are far from being tested in the market and until and unless they firm up, external project finance for such

schemes is unlikely to be forthcoming, at least from external private investors. But if these ambitious projects do proceed, they pose serious questions for Europe’s future energy security. Europe’s energy dependency on Algeria would increase—not just as a source of oil and gas, but under this scenario, for supplies of electricity as well. The Challenges Ahead If Sonatrach is to achieve its growth aspirations for increased production and export of energy, it must overcome at least five major obstacles that will challenge its ability to remain a long term and stable energy supplier to Europe. The first is geology, or at least difficult geology. Second, is access to sufficient capital to underwrite urgently required investment. Third, Sonatrach must somehow embrace properly incentivized commercial terms that are grounded in non-ambiguous and sustainable legislation to ensure it can attract partners and investment and in a sustainable manner. Fourth, the production from new projects has to compete for markets, especially incremental gas production. Finally, to make it all happen, Sonatrach needs to secure, retain and mobilise people with the necessary skills to drive the projects to successful and profitable completion, on time, and at the right time. Securing New Reserves The first of these essentials is to establish new or incremental reserves. Algeria will have to look increasingly to its mature fields to meet its contractual obligations, let alone its growth aspirations—at least over the short to medium term. Although Sonatrach is keen to advertise its many exploration successes, most new discoveries have been located in difficult and remote locations where the geology is technologically challenging and the commercially recoverable reserves appear only modest. The new basins to the southwest and southeast of the established fields are difficult to

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image and produce, and very expensive to develop. Most new discoveries are characterised by very ‘tight’ reservoir formations that often require pattern-type in-fill drilling and the application of expensive and cutting edge completion technology. The new discoveries are also located in areas of extreme desert terrain, presenting daunting engineering challenges for the transportation of new reserves to the northerly gathering centers, which are about 800 km distant. Establishing new reserves in commercial quantities and transporting them to the gathering centers is not, however, the end of the story. Significant new investment will be required to upgrade existing gathering and processing facilities to ensure any new reserves from the southern basins can be delivered to coastal ports for export located some 1000 km to the north. As volumes climb, new pipeline and export infrastructure will also be required to supplement even upgraded capacity—especially where existing infrastructure is old and corroded. Serious questions also need to be asked about the potential for its existing sources of supply to meet future demand growth. Reservoir depletion in Algeria’s aging giant fields is increasingly visible, particularly affecting gas production. Faster than expected production decline rates in the major fields is creating rising uncertainty for the long term supply of both oil and gas to Europe. Reservoir depletion management is an expensive and exacting science at the cutting edge of technology, computing power, and human ingenuity. If properly applied, timely investment in pressure support, in-fill drilling, or downhole completion technology may extend field life for decades, especially in giant accumulations. However, fields with enormous reserves and long production profiles are equally vulnerable to abuse. They are often used as ‘swing producers’ to make up shortfalls from smaller fields, or to take advantage of favorable market conditions.

Algeria’s giant Hassi R’Mel field is an excellent example; it provides the majority of Algeria’s gas production (~80 bcma, with about a third reinjected to support liquids production, leaving around 50 bcma for export). Over the years, Hassi R’Mel has been exploited by Sonatrach to balance demand for Algerian gas, but there is now strong circumstantial evidence that reservoir pressures are declining faster than anticipated with implications of ultimately recoverable reserves. The risk is that if the field is produced beyond its physical limits, reserves may be irrevocably lost and production profiles will collapse even faster. Without proper (and expensive) reservoir management, short term gains may jeopardise ultimately recoverable reserves in the longer term. Attracting Sustainable Investment The second prerequisite to underwriting increased energy exports from Algeria is investment. Securing the capital required to build new, integrated, energy supply chains represents a major challenge for Sonatrach. Tens of billions of U.S. dollars are needed to ensure existing and new reserves are brought to market; Algeria’s hydrocarbons are after all worth nothing in the ground. Coordinated, long term, planning is essential to building integrated supply chains capable of linking new discoveries to markets. Although Sonatrach’s overall production record has been good, urgent investment is needed in new technology to enhance the potential from existing fields, to improve recovery rates and to harness often remote, difficult and relatively expensive new reserves. For example, if Sonatrach’s recovery factor for conventional oil reservoirs could be raised by just 5 percent, it would add significant reserves and production capacity to Algeria’s slate. However, in Algeria, calls for urgent investment in existing facilities must compete with more headline grabbing projects that may be politically favored, including overseas investment that confers upon Sonatrach international prestige or helps the state

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reinforce its bilateral relations. As a consequence, reservoir management may be relegated in order of investment priority despite the fact that in terms of long term value it should be top of the list. Despite Algeria’s huge foreign exchange reserves— officially estimated to be in excess of $140 billion— reduced income from hydrocarbon exports has put pressure on the capital available to Sonatrach to meet its investment aspirations. Weaker energy prices have severely impacted Sonatrach’s foreign exchange earnings, which make up 97 percent of the state’s revenues and 40 percent of GDP. Sonatrach must also cope with prevailing high contractor costs. Without sovereign guarantees, Algeria’s access to capital from commercial lenders will remain limited. It must instead continue to rely on domestic sources drawn from reserves— reserves upon which there are many competing demands. For example, the many tens of billions of dollars required to underwrite Algeria’s planned programme of upstream investment must compete for capital to fund downstream projects that are urgently needed to grow and sustain Sonatrach’s domestic downstream position. Over a decade of under-investment in the refinery sector has left Algeria with serious shortfalls in some products in its domestic market. Over the last few years Algeria has had to import unleaded motor fuel and diesel at times of peak demand because its domestic refinery base is aging, its volume is limited, and it lacks the necessary technological upgrades required to produce advanced products. Taken together, the competing demands for investment capital are placing additional strain on the Algerian Treasury. With limited access to foreign capital markets, Sonatrach will either have to continue to finance new projects on its own balance sheet, or look to foreign joint venture partners as a source of funding. In all cases the capital demands are enormous, representing a major challenge for Algeria as it wrestles with

competing demands for precious capital, skills and people. Although Sonatrach professes to have access to all the capital required to finance its ambitious plans from domestic sources, there is plenty of evidence of project deferments and cancellations. Political uncertainties at the top have slowed important decision making as budgets come under pressure due to lower than expected energy receipts. Perceived political and commercial risk associated with foreign direct investment in Algeria, exacerbated by recent changes in Algeria’s foreign investment laws, is further limiting inward flows of capital. Failure to secure the investment required to bring the next generation of Algerian projects to the market, and at the right time, is therefore a significant threat to Europe’s future energy security. Partnerships of Mutual Advantage The third hurdle that Sonatrach must clear if it is to meet its ambitious targets is the ability to work in long term and harmonious partnerships with foreign investors. If Sonatrach is to achieve its production goals, working along the entire supply chain with strategic partners is likely to be essential if new resources are to be unlocked and exported to the European market in an efficient and competitive way. Strong, durable partnerships between Sonatrach and international energy partners will ensure that technology, capital, market access, and project management skills are aligned along the value chain and applied on time. To attract such partners, Algeria must promote stable and incentivized commercial and contractual terms to encourage foreign investment. However, despite the urgent need for investment, and the obvious advantages of joint venture activity, recent developments in Algeria’s energy policy show a marked trend towards greater energy nationalism. Foreign investment in the energy sector is becoming more, not less, complex.

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Commercial contract structures have moved from ‘tough but fair’ to ones burdened with commercial risk and fiscal disincentives. Recently revised commercial terms leave little on the table for partners relative to upstream investment opportunities available elsewhere (as evidenced by the limited interest shown by foreign investors in the last two licensing rounds). The existing hydrocarbon law, the legislation related to taxes applied to hydrocarbons and the commercial terms on offer, make it difficult, if not impossible, for energy partners to invest along the value chain in a commercially attractive way. In addition, punitive and retrospective windfall profit taxes have been levied on foreign energy investors without recourse. Such measures are seen as counter-productive and a deterrent to foreign investment with serious implications for Algeria’s long term energy relationships with Europe. Enhancing Europe’s energy security is therefore not just about the scale of Algeria’s remaining energy reserves and avoiding supply disruptions, important though these are; it is also about bringing new reserves to market efficiently and properly priced to make them competitive. To create the conditions for mutual cooperation and investment, the energy market needs trust, confidence, and optimism—qualities that are difficult to secure in Algeria’s current political and economic climate. For investment projects to be sustainable they must offer commercially realistic terms that provide foreign stakeholders with enough ‘rent’ to ensure that the business is on a sound and long term footing. Capturing Future Market Demand Securing new markets for incremental supplies, particularly in gas markets, is the fourth essential to meeting Algeria’s energy plan. During the recent period of high energy prices, Sonatrach moved towards a preference for shorter term

gas-supply contracts priced against prevailing market conditions as opposed to more traditional long terms agreements secured directly between supplier and consumer. Shorter term gas supply contracts are particularly vulnerable to periods of over-supply and price competition as buyers are not committed to long term off-take provisions. By moving to a regime where Algerian gas is sold on more speculative basis, Sonatrach has been exposed to immediate market risk. Sonatrach has had difficulty competing on price against suppliers with significantly cheaper cost of production. Such gas-on-gas competition has enabled those from farther afield to absorb higher transport costs. For example, LNG from Qatar and Australia’s North West Shelf have landed in Europe, displacing more proximal traditional suppliers such as Sonatrach, which has seen a 10 percent decline in gas sales in 2009 alone. Timing is also crucial. Even in the best managed environments it can take upwards of five years to bring a new discovery to market. Consequently, decision-making must be not only swift and joined-up, but also forward thinking, anticipating market demand. If new Algerian gas supplies are to compete in a European energy market currently spoilt for choice and over-supplied, Sonatrach will have to be ready to serve new demand as it arises and at competitive prices. This is particularly true for gas developments where lead times tend to be longer and where markets must normally be secured via direct term contracts with specific endusers before final investment decisions are taken.1 The principle of investment ‘reciprocity’ between Sonatrach and its foreign partners in projects outside of Algeria is likely to gain ground as pressure builds to bring new resources to market.
1 However, neither Gassi Touil nor the Skikda LNG plant redevelopments have secured markets; both projects were self financed by Sonatrach who decided to take market risk.

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Reciprocal arrangements play to Sonatrach’s avowed intent to internationalize its energy investment portfolio. Access by Sonatrach to more open and transparent overseas energy markets via properly incentivized commercial terms may help reinforce the benefits of cooperation based on mutual trust and respect, opening the doors to a more equitable relationship between themselves and potential investors in Algeria. In this respect, Algeria cannot afford to be complacent about its relationships with European energy partners or Europe’s half-a-billion energy consumers. Although Europe represents a large and stable energy market right on Algeria’s doorstep there is no shortage of equally viable, equally attractive, alternative suppliers—something that Sonatrach does not always appear to fully appreciate. People and Skills—an Essential Ingredient Finally, to create the conditions for better energy security requires an abundance of skills and human ingenuity—the fifth prerequisite to delivering Sonatrach’s strategy. Skilled technicians are needed to help unravel increasingly complex geology; production engineers must be capable of working at the very edge of technology if difficult reserves are to be brought to the surface, processed and transported to export facilities. As projects become larger and more complex as they integrate along the value chain to stay competitive, project management expertise becomes a core competence. Marketing skills will also be required to help build a deep knowledge of and access to new markets, particularly gas markets, including the ability to deploy an increasingly complex and sometimes bewildering arsenal of risk management and hedging tools to help protect the downside and secure the upside. These are the core capabilities needed to explore, develop, and produce Algeria’s reserves today and tomorrow. They are not easily learned. Nor

can they be bought ‘off-the-shelf ’ despite what Algerian officials may think or say in public. They are earned from experience and application, via team work and cooperation. Competition for these core skills is increasing the mobility of those that possess them; Sonatrach must be willing to pay a price determined by a global market if it is to retain its top talent. However, circumstantial evidence suggests that Sonatrach is finding itself increasing short of highly skilled people; it is struggling to train and maintain the required skills, at least in sufficient numbers, to meet its domestic and increasingly international project demands. Any deficits in Sonatrach’s ability to access and retain the required skills can be mitigated by working in partnership with international energy companies. The role of the foreign investor is to help Sonatrach provide safe, reliable, and affordable energy through cooperation; by deploying their capabilities to manage risk (geological, commercial, and market); by acting as a source of expertise (skills and human resource); and by being an informed supplier of key technologies. Cooperation with partners via joint venture agreements as a form of risk mitigation does, however, assume that mutually advantageous commercial terms can be agreed to making a joint venture an attractive incentive to the overseas investor and their shareholders. If these conditions can be met, the international energy companies are well placed to help Sonatrach fill any gaps in its skills or human resources required to tackle the frontiers of geology, geography, and technology. Sonatrach should also help itself by equipping a new generation of energy professionals with the skills required to bring increasingly difficult and expensive resources on stream. Although there is no shortage of Algerians who possess the skills and aptitude to fill these roles, some appear unwilling to endure an operating environment that some believe still favors appointments and progression

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based more on nepotism and regionalism than professional merit. On top of this, prevailing domestic hardships are encouraging skilled people to leave the country to seek a better life elsewhere. Unfortunately for Algeria, highly-skilled people are always the most mobile. Future Euro-Algerian Energy Cooperation In conclusion, five essentials are required to ensure Algeria remains a stable and sustainable energy supplier to Europe. First, material new reserves that can be produced at competitive prices must be booked with certainty. Second, access to capital is required to drive urgently needed infrastructure investment. Third, secure new markets must be won for any incremental production. Fourth, to attract foreign investment in a competitive environment Algeria must develop a more open and cooperative model of working with foreign investors based on properly incentivized commercial terms that are attractive to all parties. And finally, and most important, Sonatrach needs to secure and retain staff with the right skills to ensure projects are properly phased and completed on time—a risk to European energy security that is often ignored.

Even if all these conditions can be satisfied, the frontiers of geology, geography and technology will always tax the ingenuity of the Algerian energy industry. Meeting these challenges in a way that guarantees Europe’s long term energy security is the new frontier and the new opportunity. By adopting the right policies to help promote significant investment in facilities, skills, and people, Algeria has the potential to remain a major energy supplier to Europe. But Algeria will have to learn to compete in an increasingly global market if it is to deliver its projects to market on time and at competitive prices. Long term partnerships with foreign investors based on equitable risk sharing and fair commercial returns for all parties offer the best way of securing this future. Such cooperation confers mutual advantage and access to technology, capital, markets, and skills. In this way, Algeria will earn the demand security it needs to prioritise and manage its future economic development. Equally, European consumers will also feel assured that their long term energy needs will be met with the help of an enduring, reliable and trustworthy Algerian partner. In these circumstances, protracted negotiations towards an EU-Algerian Energy Accord designed to underwrite this increasingly important energy relationship look likely to succeed. Without such an agreement, both sides will undoubtedly be the poorer.

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