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Iraq could be the next oil superpower despite obstacles

To reach its potential, Iraq’s oil sector must overcome many obstacles

In a region rife with bad news, Iraq’s rising oil production is a rare flash of light. Output last month was just shy of 3.2 million barrels a day (b/d), its highest since the days when Donald Rumsfeld was shaking hands with Saddam Hussein in Baghdad, back in 1983. Oil is pouring out of new loading facilities onto tankers near Basra. These exports, now totaling more than 2.6m b/d, are helping plug gaps in Iranian supplies lost because of sanctions. Almost a decade after the second Gulf war, Iraq is once again a critical component of global oil supplies.

Its role will grow significantly in the coming years, alongside a massive surge in production, believes the International Energy Agency (IEA). Iraq’s oil output should almost double by 2020, reaching 6.1m b/d, and rise to 8.3m b/d by 2035, making it the world’s fourth-largest producer. For all the fervour around North America’s oil renaissance, the Middle East remains global oil’s core: Iraq’s rising supplies will account for almost half of the extra oil produced worldwide in the next 22 years, says the IEA. Its chief economist, Fatih Birol, reckons that unless Iraq delivers, global oil markets are headed for "troubled waters".

If the world is relying on Iraq’s oil, so are its citizens. Oil dwarfs all other sectors of the country’s economy, accounting for more than 70% of its GDP and 95% of the government’s income last year. Despite growing export income, however, Iraq remains poor. Last year, per capita GDP was just $3,500, according to the IMF; among oil exporters in the Middle East and North Africa only Yemen’s was less. Electricity provision remains sparse – few Iraqis can count on more than 16 hours of power a day. Yet the push to 8m b/d would earn $5 trillion in cumulative oil revenue by 2035, according to the IEA, enough to rebuild a war-torn country and turn its economy into a regional powerhouse. By contrast, delays in lifting production, says the agency, could lower this bonanza by $3 trillion.

But many obstacles make the longer-term progress of Iraq’s oil output, far from certain. Birol says "consensus" in the country’s politics is a prerequisite. But after years of debate, Iraq still doesn’t even have an oil law. Baghdad’s feud with the Kurdistan Regional Government (KRG), which governs the semi-autonomous region in the north, has created a two-track oil industry and simmering tensions, especially in disputed border areas, could morph into conflict, splintering Iraq’s troubled federation. Shia-Sunni sectarianism, frequently violent, still troubles parts of the country. Iraqi politics is vicious. The country’s Sunni vice-president, Tariq Al-Hashemi, is in Turkey, having fled murder charges in Baghdad. In the south, corruption and red tape cause headaches for the international oil companies (IOCs) charged with developing the mega-projects that will provide the bulk of Iraq’s output growth. Fed up, the world’s largest oil company, ExxonMobil, wants to sell its position in one of them, the first-phase development of the 43bn barrel West Qurna field, known as West Qurna-1. Despite the new loading buoys near Basra, Iraq will struggle to build sufficient infrastructure to support the forecast rise in exports. Opec’s quota system will also, perhaps soon, curb production.

Mega trouble

For now, resolving problems with the mega-projects in the south, the bedrock of Iraq’s growing oil economy, is the priority. Among IOCs, the lure of Iraq’s vast, cheap-to-extract oil reserves, which at 143bn barrels are the world’s fifth largest, has faded since many of them signed contracts for these projects in 2009.

ExxonMobil’s decision last year to invest in six blocks in Kurdistan, where proved oil reserves are around 11bn barrels, made the sentiment plain. Baghdad considers the production-sharing contracts (PSCs) offered by the KRG to be illegal. The supermajor knew that investment in Kurdistan could risk its 60% operating stake in West Qurna-1 (Shell holds the rest), but went ahead anyway.

Now, ExxonMobil is selling its position in the south, with Russia’s Lukoil, already running West Qurna-2, and China National Petroleum Corporation (CNPC), a partner with BP at the Rumaila field, believed to be the leading candidates to buy it. Hussein Al-Shahristani, Iraq’s deputy prime minister with oversight of oil policy, says he wants the deal done by the end of the year. The central government "appreciated" that ExxonMobil did not challenge its decision to strip the company of its contract, Shahristani said last month. "We told them: ‘don’t be misled by your lawyers’," he added, referring to reports that the supermajor could have challenged the legality of Baghdad’s ultimatum. ExxonMobil would not comment.

The KRG’s PSCs are far more attractive than the mega-projects’ technical services contracts (TSCs), which pay the companies a per-barrel fee to produce oil. When the IOCs agreed to these terms, Iraq was one of the few major oil plays that offered significant production potential. But business has not gone smoothly in the past three years. "Our adrenaline rush now is not what it was when we entered Iraq," Eni’s chief executive, Paolo Scaroni, said at a conference recently. "Iraq is more complex than we first thought."

Delays and mishaps have dogged the projects. Importing parts and materials through Basra takes far longer than the companies expected (some companies now bring their kit in through Kurdistan, where customs officials get things done more quickly). Many non-Iraqi workers hired for the projects end up in Dubai, waiting weeks for their visas to be processed. Equipment goes missing en route to the fields, presumably ending up on the black market. Corruption is a problem: Transparency International, an advocacy group, last year ranked Iraq the 175th most transparent country in the world. Violence sometimes afflicts the oil projects. Much of this, says Shahristani with some justification, was inherited from the previous regime, or a legacy of war. But even when security is not a risk, says Gala Riani, an analyst at Control Risks, a security firm, local issues have begun to vex the IOCs, which struggle to meet "bottom-up demands" from people living in poverty near their installations.

Investors could stomach all that if the projects were wildly profitable. But West Qurna-1, say analysts, has turned into a loss-maker for ExxonMobil. It is paid a miserly $1.90/b for the oil it produces from the field, so the company’s priority was to ramp up production quickly and cheaply. This has not happened. Iraq has been slow in paying the companies for the oil they produce and despite the new export capacity near Basra, delays building other key bits of infrastructure to handle production growth have been a drag on the companies’ upstream progress. Even ExxonMobil, a company renowned for its cost discipline, could not make the numbers work. "It was never a sustainable partnership," says Valerie, a fellow at think tank Chatham House, of the IOCs’ contracts for the mega-projects.

With ExxonMobil’s imminent departure from Iraq’s south, the central government has belatedly begun talking of changing its contracts. The failure of the fourth bidding round, held earlier this year, to attract little interest, has also had an impact. Shahristani’s original production targets, which called for output to reach more than 12m b/d by 2017, have been officially scrapped – long after the industry judged them unrealistic. Now the government talks of 9m b/d by 2020. The government will renegotiate some of the terms with IOCs and publish the details next year, Shahristani said last month. The plateau production target will be "slightly adjusted", meaning reduced, and the period in which the projects produce at this plateau will likely be extended, giving investors longer to recoup their cash and turn a profit.

Baghdad-to-Beijing

Those terms probably won’t be enough to reinvigorate Western IOC interest in the south – leaving the arena for investors from Asia. Whether such companies have the technological and capital capacity to deliver the projects according to Iraq’s schedule and terms is debatable. In a briefing to journalists in London in November, Shahristani rejected that, insisting that ExxonMobil’s replacement by Asian or Russian companies would make little difference because the new unnamed investor would be "very capable and have the financial capabilities" to execute the project.

The arrival of another national oil company (NOC) to take ExxonMobil’s place in West Qurna-1 will also confirm a trend in which Asian companies target Iraq’s south and Western capital increasingly focuses on Kurdistan. NOCs, especially those from Asia, may see the TSCs more favourably than Western majors, points out Marcel. The per-barrel fee arrangement is less lucrative, but the returns are more predictable than PSCs, which hand ownership of the oil – and its marketing risk – to the investor. Marcel points to Iran’s earlier experience as an example. There, Western firms baulked at the country’s infamous net-back contracts; but Asian NOCs such as Petronas happily signed on. And Iraq’s upside potential remains unquestioned. Much of the country is unexplored, suggesting its reserves could grow substantially. Drilling success rates are around 70%, among the highest in the world.

There is geostrategic logic, too. The IEA’s Birol talks of a "Baghdad-to-Beijing" axis emerging. Asia accounted for 32% of Iraq’s exports in 2008. By the end of last year, that had risen to 52%. By 2035, Asian importers will buy around 90% of Iraq’s exported oil. This leaves Iraq dangerously exposed to Asia’s market, especially China, believe some analysts. But with demand falling steadily in the OECD – also the centre of new non-Opec production growth – the process looks inevitable, as does the growing role of Chinese firms in Iraq’s upstream.

There is less oil in Kurdistan, but IOCs like the profits available on it. Western investment there follows the typical pattern for a frontier area. Generous terms, in the form of the KRG’s PSCs, lured smaller, less risk-averse companies to the region’s upstream. As the play was shown to be viable, the majors began sniffing. Since ExxonMobil’s decision to pounce, the onslaught from IOCs has become full blown. Gazprom Neft, Total and Chevron all signed upstream contracts with the KRG in the summer, joining a list of companies blacklisted by Baghdad from future contracts in the south. According to a Reuters report in September, Shell was also negotiating with the KRG. The company, which operates the Majnoon field in the south and has a large gas contract in place with the central government, denied the report. The UK’s BG Group, say sources, was in Kurdistan in October – a scouting mission supported by the British government that involved talks with Ashti Hawrami, the KRG’s oil minister.

The attraction of Kurdistan is not just generous contract terms. The region is 11 years ahead of the rest of Iraq in terms of commercial development, says Luay Al Khatteeb, head of the Iraq Energy Institute, a think tank. Power supplies and other infrastructure are far superior. Security, he says, is on a par with western Europe. Visas, imports of equipment and property laws are not fraught with the same problems that bedevil business in the south.

The KRG is bubbling with foreign investment as the larger oil companies begin spending money. According to Iraq Oil Report (IOR), an Erbil-based newsletter covering the sector, ExxonMobil has spent or allocated about $250m in Kurdistan already. Locals say it has been buying up land to house employees, with more oil-related work to begin in earnest in December, according to IOR.

For now, Kurdistan’s oil production is modest, less than 200,000 b/d. Bolder plans to lift output to 1m b/d within three years and 2m b/d by 2019 are where the problems begin. Either the extra oil would go through pipelines owned and controlled by the central government – an option not palatable to Kurdistan’s oil investors – or the KRG will follow through with plans to build its own pipeline to Turkey. A dispute earlier this year between the central government and the authorities in Erbil crystallised why the KRG wishes to go it alone. Suspicious of the accounts submitted to the Iraqi oil ministry by companies producing in Kurdistan, Baghdad delayed paying them for the oil being exported through the central government-controlled pipelines. In return, the companies shut in their production. Only months later, in September, did the KRG and Baghdad reach a deal allowing oil companies to resume production.

That spat between the KRG and Baghdad is hardly their most serious. But it rumbles on. In November, Shahristani said Kurdistan had breached the terms of the September agreement and would receive no further payments from the ministry this year. One payment, of 650bn dinars ($557m), had been made, although Kurdistan had not kept its pledge to pump 200,000 b/d from 1 October. The government would watch more carefully next year, Shahristani suggested, when if the KRG’s companies are to be paid at all, they must increase output to 250,000 b/d.

Resolving the feud between the KRG and Baghdad could be accomplished by the passage of an oil law for Iraq, believe some optimistic analysts. Ideally, legislation would resolve fraught questions over oil-revenue sharing and control of exports. Shahristani says the draft law could be passed by parliament next year. But scepticism abounds. An advisor to the committee that was working on a draft says too many men now thrive on the confusion wrought by the absence of such legislation, from smugglers in the north, who trade barrels by truck across Kurdistan’s Turkish, Iranian and Syrian borders, to politicians in Baghdad whose political importance lasts as long as they carry weight in the oil-law debate. Development of both the mega-projects and Kurdistan’s oil sector is carrying on without a law anyway, point out some in the industry. Don’t be surprised if enactment of any draft proves elusive, there is little give and take by either side. Baghdad remains stubbornly opposed to the KRG’s two-track view of Iraq’s oil sector. Thamir Ghadhban, a former Iraqi oil minister and now an advisor to the prime minister, Nuri Al-Maliki, reiterated in a speech in October that "no federal government in Baghdad will ever accept the exporting of two oils from a unified federal Iraq" and that exports have "always been and shall remain the responsibility of the federal government". Wider disputes between the KRG and Baghdad – including personal rivalry between Massoud Barzani, the KRG’s president, and Maliki, against whom Barzani tried to engineer a vote of no confidence this year – remain an obstacle. "No one in Kurdistan believes an oil law will ever be passed," says one analyst of the region, "and as long as there isn’t one, they can argue that they’re not breaking any laws."

Pipeline to independence

Any re-assertion of Baghdad’s control over Kurdistan’s oil sector would scarcely satisfy the region’s Western investors, which are plugging away with little apparent concern for the politics. Tony Hayward, the former BP chief who now heads Turkish company Genel Energy, a producer in Kurdistan, says the oil prize is so great that a political resolution will come sooner than later. Yet his company is already exporting Kurdish oil to Turkey by truck and wants to build a 400,000 b/d pipeline to link into the country’s export network. At that volume of export, $100/b oil would earn Kurdistan $14.6bn a year in revenue. This would "bring the region an important step closer to political independence by achieving budgetary self-sufficiency", said a report published earlier this year by the International Crisis Group, a non-profit organisation. Bigger ambitions mooted by the KRG, such as a 1m b/d pipeline from the region, would seal the deal. A Turkish company, Calik Energy, has already sought approval from Ankara for just such a plan. Hawrami believes the infrastructure could be in place by 2015.

Until 2011, the idea of an independent Kurdistan — while much in the mind of its politicians — was considered a nationalist pipedream. Turkey, which has been fighting a long war against Kurdish separatists, would have been opposed. So, too, are the US and UK, the two most significant Western powers in Iraq, which both insist that Iraq must remain a federal state, with the Kurds inside.

But alongside the growing presence of Western oil interests in Kurdistan, the region’s politics have shifted, too. Recep Tayyip Erdogan, Turkey’s prime minister, has become a strong opponent of Syria’s Bashar Al-Assad regime, which previously contained its own Kurdish separatists. Turkey’s relations with Iran have deteriorated, too, in part because of Tehran’s support for Assad. Animosity has built between Ankara and Baghdad for similar reasons (Iraq has been allowing the transfer of weapons from Iran to Syria, according to reports). In November 2012, Iraq expelled TPAO, Turkey’s state-run energy company, from Block 9, an oil and gas project near Basra. Shahristani was explicit recently, saying the decision came amid the breakdown in relations between Iraq and Turkey.

As Turkey’s allies in the region have evaporated, its ties with Kurdistan – particularly between Erdogan and Barzani, whose Kurdistan Democratic Party (KDP) is now ascendant in Kurdish politics – have strengthened, pitting two former regional rivals into a tactical alliance. The shift is part of what one analyst describes as Turkey’s "schizo approach to Kurdistan". Four reasons have led to this fledgling union, say analysts. Ankara believes Barzani and his KDP, have sufficient influence over other Kurdish separatists in Syria and Turkey itself, or can help keep them in check. Second, if an independent Kurdistan is inevitable, Ankara wishes to secure it as a commercial partner during its birth. Third, Turkey stands to gain significant transit fees if Kurdish oil and gas is shipped through its country. Last, Kurdish energy will break Turkey’s reliance on Russian and Iranian supplies. "There are three countries vital to Turkish energy needs over the next five years," the IEA’s Birol told a conference in Istanbul recently. "Iraq, Iraq, and Iraq." At the moment, however, Turkey sees Iraq’s energy through a Kurdish prism.

How long Turkey keeps its benign view of an emerging Kurdish state on its border is, however, debatable. Diplomats talk of "bandwidth" in Turkey’s strategy: it will only allow the independence push to go so far. Whether Ankara would risk a fundamental rupture in its relations with Iraq by endorsing a pipeline from Kurdistan is even more questionable. A wiser course may be for Ankara to insist that any new export pipeline out of Kurdistan be conditional on Baghdad’s say-so. But Erdogan’s foreign policy has been characterised by short-term decisions with little regard for the longer-term consequences, says Fadi Hakura, a Turkey specialist at Chatham House. Its relations with Baghdad could shift overnight if things change elsewhere in the region. The fall of Assad, if it happens, may also transform Turkey’s position. For now, the KRG is Turkey’s sole regional ally. "This has strengthened Barzani’s hand," says Hakura.

Ultimately, the decision about a Kurdish state will be taken in Washington, DC, where US foreign policy still favours a unified Iraq. "Turkey won’t build the pipeline without the US’ approval," Hakura says. Kurds hope, however, that the arrival of ExxonMobil – with Chevron and other Western firms in tow – may give an independence drive some political cover. One diplomat told Petroleum Economist that while ExxonMobil’s original decision to invest in Kurdistan was taken independently of the State Department, its more recent decision to sell the West Qurna-1 stake was coordinated with it.

Quota, unquota

Within Kurdistan, few politicians have played down the supermajor’s move. President Barzani compared the company’s investment in the region to arrival of "the equivalent of 10 American military divisions", saying that ExxonMobil, and by implication the US government, would "defend the area if their interests are there". Many analysts see subtle shifts by Western powers to concentrate more diplomatic and trade energy in Kurdistan, to the detriment of Iraq. The US has had mixed diplomatic success in Iraq in the past two years. It failed to secure Maliki’s agreement for an extension to its troops’ stay in Iraq (they left at the end of last year) and, say many analysts, has ceded much influence to Iran. The UK has also been reducing its presence in Iraq. In October it shut its consulate in Basra, one of the Gulf’s emerging commercial hubs. At the same time, diplomats say, its mission to Erbil is growing in stature within the UK’s foreign office.

For Hawrami, the influx of big firms has been an affirmation of the outward-looking energy policy he crafted. The "giant and magnificent" companies had now joined the "small and beautiful" firms in Kurdistan’s upstream, he said shortly after ExxonMobil’s gamble went public last year. He predicts that the coming years will see consolidation of fields and assets across the sector, led by the deep-pocketed majors.

If an oil law is not passed, the issue of oil-revenue sharing between the KRG and Baghdad (and other regions, such as Basra) will grow more pressing as Iraq’s production rises. This is because at some point Iraq will rejoin Opec’s production quota system. When it does, the oil ministry will have to choose which fields will sacrifice production when the cartel’s limits impinge. Given that the state’s take from each barrel produced under the TSCs is higher than its profit on oil produced under the Kurdish PSCs, it is likely Kurdistan’s oil would be sacrificed first.

In any case, Opec’s quotas are another threat to Iraq’s long-term output targets. The IEA’s Birol said last month he believed Opec would be generous with Iraq, recognising that decades of war and sanctions had depleted its economy and constrained its energy sector. For now, that may be true. Saudi Arabia, Opec’s lynchpin, wants the group to produce more oil, not less, in an effort to soften oil prices. But Opec is hardly suffused with benevolence at the moment. Iran’s oil is under embargo, for example, and far from rushing to defend the country, other Gulf producers, such as Saudi Arabia, have grabbed its market share. The group is split into factions: the Saudi Arabia-led Gulf states and the price hawks, led by Iran.

And Iraq has not played its Opec politics very carefully, say group insiders. In the past two Vienna meetings, it has coordinated its position with Iran’s, leading to bad-tempered stand offs with Saudi Arabia and other Gulf countries. (Maliki, say diplomats, while no stooge of Iran, is always careful to understand Tehran’s position; Shahristani is much closer to Tehran.) This has annoyed Saudi Arabia, which, according to sources close to the oil ministry, has tired of Iraq’s meddling in Opec. When Saudi oil-pricing strategy shifts, Iraq can expect the quota discipline to be enforced quickly. Iraqi production of 4m to 4.5m b/d would probably also be a trigger point for the quota discussion, say Opec sources.

In need of more pipes

Figure 1: Fiscal vulnerability rising (US dollars per barrel)
Figure 1: Fiscal vulnerability rising (US dollars per barrel)

In any case to reach a production level worthy of a quota, Iraq also needs to expand its export capacity, which, by law, is in the hands of the state. (Natural gas, unaffected by Opec quotas, may be treated differently, allowing for liquefied natural gas exports from the south or even Kurdish exports to Europe.) The expansion of the terminal near Basra is a good start: in the past year, two single-point mooring facilities came on stream, each with capacity of 900,000 b/d. Two more are scheduled to come on line next year, taking total export capacity out of the south to 4.5m b/d. 

However, the overland options are troubled. The Iraq-Turkey pipeline system linking Kirkuk with Ceyhan, on Turkey’s Mediterranean coast, once had capacity of 1.6m b/d (through two pipes). But Iraq’s wars have left the infrastructure in bad shape: capacity has fallen by about half, with throughput often much lower. The pipes also depend on the 9bn-barrel Kirkuk oilfield, one of Iraq’s oldest producers. But it was damaged during the Saddam era by diesel and water injection. Until a major investor – possibly BP – begins work on the reservoir, doubts about its reliability persist. To make full strategic use of the export line to Ceyhan, Iraq would also need to upgrade its reversible north-south pipeline to relieve bottlenecks around Basra. But it, too, has been damaged by war and offers just a fraction of its original 1.4m b/d capacity.

Politics has put paid to two other pipelines. The first is a proposal to ship up to 2.75m b/d through two parallel lines to Banias, on the Syrian coast. But Syria’s disintegration – and sanctions against the Assad regime – has shelved the Banias option. Even if the two governments came to an agreement to build it, the system would probably not be available until 2020, reckons HSBC, a bank. The other existing option is a pipeline originally designed to carry 1.65m b/d of crude to Yanbu, a Saudi port on the Red Sea. But Saudi Arabia has cannibalised that pipeline, now using it to ship gas. It is unlikely to re-engineer it to carry Iraqi oil.

External forces

Map 3: PSC areas in Kurdistan
Map 3: PSC areas in Kurdistan

These many obstacles – from an Opec quota to the feud with the KRG and the infrastructural bottlenecks – make output of 8m-9m b/d look a remote prospect. The IEA says in a "delayed-case scenario", in which investment increases only slowly from 2011 levels, production would hit just 4m b/d by 2020 and only 5.3m b/d by 2035.

So for all the excitement generated by the IEA’s forecast for Iraqi production, there is much to prove. The shape of the country and its sector remain up for grabs. A fifth bidding round – date unknown – will test the government’s willingness to soften investment terms. Shahristani likes to boast that Iraq’s contracts are among the toughest in the world. But resource nationalism has become a risky policy. IOCs see many other opportunities to invest elsewhere, not least within Iraq’s increasingly frail federation.

More serious tests for the central government may also be in store, stemming from within the country and outside it. In November 2012, central government forces and Kurdish Peshmerga faced off in Tuz Khormato, a disputed area south of Kirkuk. The KRG’s leader Barzani said the skirmish, which killed one soldier, was "sabotage" designed to "drag Iraq to chaos" and undermine ties between "Kurds and Arabs in general". True or not, it was a reminder for investors in Kurdistan – including ExxonMobil, whose deal with the KRG included acreage in just such disputed territory – that Iraq’s politics remain on edge.

Then there is Iran, say analysts, which also has the capacity to destabilise Iraq. Its wild threats to shut the Strait of Hormuz in response to US and EU sanctions have been discounted as unrealistic by most oil-market and defence experts. But stirring up trouble in Iraq through militias in the south, which rely on Tehran’s backing, is a risk to Iraqi supplies out of Basra. Any attack on its nuclear facilities would give Tehran reason to retaliate. "Iran is far more likely to respond to Western aggression through its proxy groups in the region," says one Middle East analyst. Another flare-up of sectarian violence in Iraq beyond the regular terrorist attacks that still claim hundreds of lives each month would be devastating to the country’s politics. It would also hinder the $500bn Shahristani says must be spent in Iraq to lift its oil production in line with the targets.

Iran is not the only external force to worry about. The pace of GDP expansion, which the Central Bank expects to be 10% a year for the next three, is remarkable. But so is the oil price needed by the central government to keep its budget afloat. It breaks even at about $110/b, according to the IMF (see Figure 1), leaving Iraq exposed to the vagaries of an international crude market now characterised by tepid demand and ample supply. A long-suffering populace doesn’t need the kind of blow a global oil-price slump would bring – and neither does Iraq’s fragile politics. A country that will prove critical to international oil markets remains, for now, at their mercy.

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