Upstream Iraq

T?he U.S. military surge in Iraq that began in January 2007 brought with it deployment of an additional five brigades to Baghdad and a new counterinsurgency strategy built around nurturing a Sunni “awakening” in al-Anbar province. Its purpose, as stated at the time by President Bush, ­­was to provide “breathing space…to make progress in other critical areas” such as legislation, reconstruction and infrastructure—especially in the oil sector.

From a security perspective, the surge was instrumental in brokering a tactical retreat by Sadrist militias in urban centers and in empowering tribal forces in more remote parts of the country. Attacks on security forces, civilians and infrastructure declined precipitously after June 2007, when all brigades were deployed and the revised counterinsurgency doctrine was in place. ­­­Of course, the increased military presence was only one factor improving the security environment. The increasing proficiency of the Iraq Security Force, recently deployed to occupy Basra, coupled with the grim completion of ethnic cleansing campaigns in Baghdad and grassroots reactions against militant excesses, were also pivotal in securing a sharp drop in violence.

In particular, the completion of Pipeline Exclusion Zone (PEZ) projects securing oil shipments from Kirkuk north into Turkey is credited with curbing the number of pipeline interdictions and permitting a sustained uptick in both production and exports.

By spring of this year, it appeared as if the “breathing space” necessary to jump start the legislative process, ramp up reconstruction and expand oil-sector development had been achieved. Prime Minister Nouri al-Maliki informed the European Union parliament that passage of the oil and gas law was imminent. Iraqi oil minister Hussain al-Shahristani boasted that nearly 150 firms had applied to prequalify for Iraq’s inaugural oil development licensing round.

Shahristani, however, also fatefully indicated that several stopgap technical service contracts (TSCs) being negotiated separately with major international oil companies (IOCs), which were intended to raise Iraq’s overall oil production by 500,000 barrels per day within two years, would be partially compensated by lifting extra crude oil. According to Shahristani, paying in crude was necessary to compensate the substantial cost of equipment required to improve the fields in question.

Shortly thereafter, American advisors to the Ministry of Oil were accused of favoring U.S. and European firms and promoting a contract model—production sharing—that would give foreign companies legal ownership of Iraqi oil. Concurrently, documents emerged showing that State Department officials tacitly supported U.S. companies entering into contracts with the Kurdish Regional Government (KRG)—contracts that Iraq’s federal government has declared “illegal” in the absence of an oil law.

These developments immediately triggered alarms within Iraq and abroad that the long-suspected true objective of the U.S.-led invasion—seizing control of Iraq’s oil—was about to be realized. In southern Iraq, labor unions and Shia militants opposed to any whiff of privatization or production sharing geared up to contest federal authority and inhibit Western “exploitation” of Iraq’s natural resource. U.S. politicians decried the reported meddling in Iraq’s oil industry and forced the State Department to launch an internal audit into its advisory apparatus. The recent withdrawal of a consortium led by Anadarko Petroleum Corp. from the TSC process seems to be a sign that the buoyant optimism surrounding the June 30, 2008, launch of the licensing round is colliding with the complex political and operational hurdles confronting foreign participation in the country’s oil sector. At press time, Iraq cancelled six no-bid contracts with ExxonMobil, Chevron, shell and others.

Unfinished business
The controversy over awarding the TSCs neatly frames some of the challenges confronting foreign energy companies in Iraq. First and foremost, it reveals that the Ministry of Oil has been unable to consolidate authority over the industry—an issue inextricably bound to the fate of hydrocarbon legislation. In the face of popular uproar, Shahristani was forced first to revise the understanding he had negotiated with the IOCs regarding equity crude and eventually to demand new bids altogether, compressing the contracts from two years to one.

Operations in oil-rich Basra province, meanwhile, remain primarily under the authority of a patchwork of interests comprised of the powerful Southern Oil Co. (SOC), the provincial governor, the oil-installation protection force, and various criminal syndicates that have been smuggling crude abroad since the first round of international sanctions following the Gulf War.

Second, the furor around the TSCs may have strengthened the hand of resource nationalists ahead of crucial provincial elections this winter. Despite numerous attempts to fracture the independent power base embodied by the Southern Oil Co.—by purging union leaders and Fadilah partisans, hiving off new national oil companies and sending the Iraqi army into Basra—the central government still does not control the “facts on the ground”, and its dictates are routinely and easily ignored.

Indeed, Shahristani has taken production-sharing arrangements off the table for the time being in deference to pressure from resource nationalists. Given that around two-thirds of gross domestic product (GDP) and nearly all of foreign exchange and government revenue derive from oil receipts, it is clear that control over Iraq’s oil industry is tantamount to control over the state itself.

Finally, even as recent security gains remain “fragile and reversible,” according to the U.S. military, uncertainty over the trajectory of oil and gas policy—embodied by the indefinitely stalled hydrocarbon legislative package—injects a significant degree of political risk into license bidding and investment strategies. While licensing is going to proceed under legacy rules requiring contractual review by the cabinet and the parliamentary oil and gas committee, and mandatory joint ventures with appointed Iraq companies, it will be vulnerable to revision as either political fortunes change or policy is implemented. Unlocking the hydrocarbon package and setting clear terms for long-term deals—essential for any private multinational oil company—will not be easy. The crux of the dispute is the division of authority and revenues between the central government and the KRG, which claims expansive powers over its oil industry under Article 112 of the constitution.

In addition to trading barbs over the legality of wildcat exploration, at stake is the eventual status of Kirkuk, one of Iraq’s largest producing fields, containing nearly 10% of the entire country’s reserves. Recent jostling between central government and Kurdish military forces in the Kirkuk Field area ominously suggests that any confrontation could quickly escalate into regional destabilization. Sunni Arabs, meanwhile, have supported the draft oil law but remain wary of fully endorsing an oil framework that will effectively be controlled by Shia political parties through their dominance of the Iraqi electorate and cabinet.

Incremental progress
Even hobbled by political disputes, Iraq’s oil industry is set to deliver a staggering $70 billion to federal government coffers in 2008 alone, according to the U.S. Government Accountability Office. The windfall should make a substantial dent in oil-sector capital needs, estimated at up to $30 billion over the next seven years to meet government production targets, and $100 billion to rebuild the industry overall, according to the office of the U.S. Special Inspector General for Iraq Reconstruction.
The Ministry of Oil’s capital budget for 2008 is only $2 billion, however, which remains almost entirely unspent due to procurement red tape and the aforementioned political infighting. While budget execution rates are improving each year, in 2007 the Ministry of Oil only spent around 60% of its budget.

Early this year, in an attempt to unlock their capital budgets, key ministries such as oil, electricity and public works were authorized to circumvent the procurement process for contracts of up to $50 million. In the absence of clarity on Iraq’s political and economic trajectory, the Ministry of Oil has used this authority to begin the lengthy process of reconstructing and developing the oil sector piecemeal. It is focusing primarily on strategic efforts such as restarting refineries (which currently meet only half of domestic product demand), repairing pipelines, restoring and purchasing drill rigs, rehabilitating wells and drilling exploration wells.

The goal appears to be maintaining inertia in oil-sector development with small-bore projects while the larger political issues of the oil law and the licensing round—let alone of obtaining a monopoly over the use of force by government-sanctioned security forces—are resolved. While IOCs in pursuit of long-term development licenses will likely wait for stable contract terms and a political resolution of the oil law before committing their resources in Iraq, ongoing development suggests some scope for international service and equipment providers willing to work with Iraq’s state-owned oil companies to develop and pursue opportunities in the near term.

Furthermore, some foreign national oil companies (NOCs) are making inroads outside the license round, reviving Saddam-era service contracts and making preparations to deploy in-country. CNPC (China National Petroleum Co.), for example, recently negotiated a $3-billion fee-paying service contract to operate Ahdab Field in Wasit province, north of Basra. In tandem, Chinese engineers will build a $940-million power plant nearby, a tried-and-tested method of using infrastructure investment to sweeten oil and gas deals likely to be replicated by other NOCs. Asian, African and Russian oil and gas companies are also more likely to secure the political blessing of Iran—which wields extensive influence through both central government political parties and southern militias—in their attempts to enter Iraq’s upstream.

Estimating risks and rewards
The evolving political situation in Iraq implies a certain fluidity to even firm deadlines for oil-sector development, especially for big-ticket items. It is already apparent, for example, that plans to raise production to 3 million barrels per day by 2009 on the back of the TCSs will slip. The June 2009 deadline for awarding development licenses could also be revised backward, depending on the central government’s ability to entertain bids from its preferred partners, namely the Western majors.

In the interval, two processes are worth watching. First, passage of the election law, which was suspended due to the summer parliamentary recess, will set the eventual timeline for provincial elections, which have already been pushed from October to December and may slip further. It is unclear how much progress on the second process—passage of the hydrocarbon legislative package—can be made in advance of these elections. Indeed, concerns about a political realignment may have been behind Shahristani’s summer deadline for the TSCs, reflecting a desire to get them under way before the parliamentary recess and elections.

Components of the hydrocarbon package, consisting of laws to set up the Iraq National Oil Company (INOC), determine the revenue split between the federal government and the provinces and reorganize the Ministry of Oil, in addition to constructing the contract and development framework, are at various stages of completion. Drafts of the contract and development and revenue-sharing laws are, as discussed above, still being parsed by the various political interests nationwide. If agreements are not reached before the run-up to next year’s parliamentary elections, passage of these key components will be further delayed.

Laws to reorganize the ministry and establish INOC, meanwhile, have not yet been sent to parliament. While perhaps less fundamental to disputes over Iraq’s oil sector, these laws still embody key areas of political authority. INOC, for instance, is envisioned as a mandatory 25% minimum joint-venture partner in all exploration and production. In addition to working out differences between the authority of INOC and that of the regional oil and gas company (Southern, Northern, etc.), contracts engaged in advance of INOC’s creation will likely have to be renegotiated once the law actually passes.

A further issue regards the status of coalition forces and the expiration of the U.N. Security Council’s mandate for the use of force in Iraq at the end of this year. While the U.S. will likely maintain a base presence in-country, the Iraqi government is seeking to secure withdrawal of all combat forces by 2011. Oil and gas companies entering Iraq will therefore have to negotiate directly with Iraqi security forces, from local trivial militias to the Iraqi army.

Pros and cons upstream
Iraq possesses significant hydrocarbon reserves, major producing fields and substantial prospectivity. The surge, coupled with domestic security developments, has opened a window onto Iraq’s upstream potential and piqued the interest of the IOCs, foreign national oil companies (NOCs) and independent juniors and service providers. But the pros and cons for each class of potential investors are not equal.

IOCs are unlikely to enjoy the stable political and regulatory environment that is necessary to justify large, long-term investments in Iraq, for some time. Foreign NOCs, many of which are pressing claims obtained under the Hussein regime, may be more likely to shrug off some of the risks or bring bilateral diplomacy to bear in reducing them, but will still approach Iraq with caution. Independents and service companies likely have the best near-term prospects, given both the size of tenders emerging from the ministry and the avowed need to bring world-class skills and equipment to bear.

For all companies, a detailed and local assessment of the risks to an operation is vital. Protection measures are not simply physical barriers such as perimeters and vehicles, but also procedural measures including training for client personnel, travel security measures, including the deployment of armed protection teams, and communication plans with the local community and other stakeholders.

Iraq will remain a very complex and challenging operating environment for years to come, but with a proper assessment of the risks, it is likely to provide substantial rewards.