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Iraq's crazy goings on

Shell's dissatisfaction with its Iraq operations exposes flaws in the country's contract model for IOCs

Iraq has the second-largest proven oil reserves in the Middle East and the fastest growing production. When a major operator, Shell, is considering exiting one of the world's top 10 super-giant fields in that country, something is drastically wrong.

The field in question is Majnoon, the Arabic word for crazy. Situated in oil-rich Basra province, southern Iraq, and operated by Shell with a 45% stake, partnered by Petronas (30%) and the Iraqi government (25%), the field has long been one of the most prized in the Middle East and North Africa (MENA) region. Shell won the field in Iraq's second bid round and signed a contract in 2010 to develop the 25bn-barrel reserves for a fee of $1.39 per barrel remuneration plus cost, to ramp up production from 50,000 barrel a day to 1.8m b/d in 2017.

On the basis of first-mover advantage, qualified international oil companies (IOCs) in 2009 signed up for Iraq's Technical Service Contract (TSC), at a time when oil prices were rising. IOCs' business decisions were made with the intention of improving TSC terms later on. Almost all IOCs began these negotiations in 2012 and managed to agree new commercial terms from the Ministry of Oil (MoO) in September 2014. However, Shell's efforts to secure commercial revisions failed.

After seven years of Majnoon development, but still short of the 2017 production plateau target at only 235,000 b/d, the government applied the performance penalty and remuneration factor on the Shell-operated venture. This heavily impacted Majnoon's commerciality, with the Shell JV now only making 4.6 cents/b, leaving no option but to seek an amicable exit, as no sensible investor would consider such a low net back.

However, surrendering Majnoon for the government to develop could lead to more strain on the national budget because national oil companies still suffer a deficit in capacity, finances and skilled manpower.

Source: Petroleum Economist

The failure of Iraq's TSC model has coincided with Iran's modernisation of its petroleum model contracts which have attracted Shell to the Azadegan field, adjacent to Majnoon, with bids being prepared for 2018.

At the same time, Shell is planning to divest $30bn between 2016 and 2018 as part of its global asset disposal programme. This has further pushed Shell to consider selling its 20% share in West Qurna-1, an oilfield operated by ExxonMobil in Basra province, and Shell has already been approached by a potential buyer offering $0.55bn. As part of reducing its footprint in commercially challenging territories, Shell has reduced cost globally and continues to downsize its value chain; this will impact further investment in higher-risk areas.

Nonetheless, the way the MoO is proceeding with the new fields—inviting IOCs to table their own proposals—is hopeless as long as failed TSCs remain the contract of choice. Renegotiation has resulted in a further loss of time while operators have missed the initial plateaus, even after reducing production targets to nearly 40% and the carry interest down to 5%, in return for temporary commercial benefits, just to stay in business.

The current TSC model used in the development and production of Iraq's super-giant oilfields is based on the contractor receiving the recovery of all petroleum costs, plus a remuneration fee for its services. Net revenues after deducting the petroleum costs and remuneration fee go to the government. Therefore, the TSC has serious deficiencies in its design. The government and contractors are not aligned.

In most international contracts, the contractor makes lower profits when costs are higher. The TSC provides higher profits to contractors when costs are higher and therefore creates a strong incentive to incur high costs.

In contrast to most fiscal systems in the world, the TSC doesn't encourage efficiency. At the same time, the fee to the contractor isn't based on price. Therefore, with low oil prices the TSC is relatively favourable for investors compared to other projects in the world—precisely when Iraqi government revenues are low. Therefore, with high oil prices, investments are strongly discouraged. Thus far, the TSC model has cost Iraq nearly $70bn just to arrest decline and add 1.3m b/d to the 2009 production plateau of 2.4m b/d. Most spending was wasted on cost-inefficient oil with very little profit for IOCs.

Iraq needs a contract that doesn't require it to refund company expenditure when the government is financially strapped. A new model contract is needed, highlighting the benefits of a lower-cost administration, plus faster decision making and capacity building.

If the MoO insists on keeping the current TSC model and penalising operators for what it might deem as sub-par performance, other IOCs could follow Shell's path. If Shell were to leave Majnoon, the vote of confidence in Iraq's oil industry would be revoked, especially if IOCs are simultaneously transitioning to projects in Iran.

LUAY J. Al-KHATEEN is Executive Director, Iraq Energy Institute, and Fellow, Center on Global Energy Policy, Columbia University-SIPA

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