Friday, June 28, 2013

Chevron and Total Continue Investing in the K.R.G. A Brief Analysis of Baghdad's T.S.C.s vs. Erbil's P.S.C.s.

Friday, June 28, 2013

BEIRUT, Lebanon Production sharing contracts (P.S.C.s) between international oil companies (I.O.C.s) and the Kurdistan Regional Government (K.R.G.) continue to be signed notwithstanding the opposition of Iraq's central government, which instead signs only technical service contracts (T.S.C.s). Baghdad affirms that it alone has the right to negotiate and sign energy deals for the whole Iraqi territory, the K.R.G. included. Since U.S. ExxonMobil entered the K.R.G.'s energy sector in October 2011 at that time the company acquired six exploration blocks other major I.O.C.s have been investing in the semi-autonomous Kurdish region. Presently, there are in Iraqi Kurdistan around fifty international energy companies (among them four big names: U.S. ExxonMobil and Chevron, France's Total and Russia's Gazprom), which together have invested more or less $20 billion.

Approximately ten days ago Chevron and Total respectively announced that they had increased their activities in the K.R.G. In specific, on Monday, June 17, through a statement issued from Erbil, Chevron announced that it had signed an exploration deal  the third with Kurdish authorities in relation to the Qara Dagh field. This block is located in the southern part of the K.R.G. and totals about 860 square kilometers (or 332 square miles). "Chevron will acquire an interest in and operatorship of the Qara Dagh block production sharing contract from the Kurdistan regional government," the company said in the statement. The U.S. company was awarded the exploration deal last January, while, in July  2012, it had already acquired from India's Reliance Industries Ltd. an 80 percent stake in two blocks two (called Rovi and Sarta, with the related operational control) located north of the city of Erbil.

Almost in the same days, Total expanded its presence in the K.R.G. In fact, having purchased an 80 percent stake in the Baranan block (with the K.R.G. owning the remaining 20 percent), south of the city of Suleimaniya, Total now has four assets in the country. This block (a.k.a. K9) had been previously held by the Canadian oil and gas company Talisman Energy until it decided to hand over the acreage last year. In 2012, the French company purchased a 35 percent stake in the Harir and Safen exploration blocks in the Erbil-controlled territory, while at the same time it owns a minority interest in the Taza exploration block in the Kurdish province of Suleimaniya.

In dealing with Baghdad, the position of Chevron and that of Total in are different. In fact, if on the one side, the American company does not have any energy stake in central and southern Iraq, on the other side, the French company owns a stake in the Halfaya oil field in southern Iraq. In this regard, since last year Baghdad has warned Total requesting that it cancel or freeze its contracts with Erbil unless it wants to be forced to relinquish the Iraqi asset. Up to now, the company has continued to operate in the K.R.G. and in Iraq. The only measure implemented by Baghdad has been banning the two companies from future contracts in Iraq. Then, two events have changed the picture. First, last March Total was preselected with six other companies with reference to a call for bids in an oilfield in Nassiriya, in southern Iraq and second, still in March, ExxonMobil  announced its intention of increasing its investment in its West-Qurna-1 oilfield (a $50 billion investment) located in southern Iraq. From this two events, it's possible to understand that Baghdad does not have the upper hand. Indeed, it goes by itself that replacing big companies of the likes of  Total or ExxonMobil it's not an easy task. 

In order to understand what is happening in Iraq and the K.R.G. at the level of energy deals, the real question to be answered is: Why are I.O.C.s all flocking to the K.R.G.? 
There are three main reasons for the I.O.C.s interest in Iraqi Kurdistan:

A) The presence of abundant energy reserves  Current Kurdish data speak about 45 billion barrels of oil, i.e., one-third of Iraq's proven reserves (proven reserves are those with a 90 percent certainty of being produced at current prices with current commercial terms and government consent, known in the industry also as 1P) which are estimated at 150 billion barrels. In other words, quantitatively (not qualitatively because Erbil has heavier oil) the K.R.G. could be another Libya. In addition to oil, the K.R.G. has from 3 to 6 trillion cubic meters (TCF) of potential gas reserves, as recently underlined in London by the minister of natural resources of the K.R.G., Ashti Hawrami, at the Iraq Petroleum Conference 2013 organized by C.W.C., a company specialized in the dissemination of the energy and infrastructure knowledge.  

The Minister of Natural Resources of the K.R.G., Ashti Hawrami
I.O.C.s invest where there are energy resources and especially considering the supermajors  they are accustomed to investing in so-called difficult countries and harsh environments. For instance, Lebanon  a troubled country whose recent history has always been entangled with Syria's (in the latter country there is an ongoing civil war, if not something more because of the external actors, which are involved in the warring operations within and outside the country. Up to know, there have been only sporadic spillovers of Syria's civil war into Lebanon) has recently been able to attract for the prequalification phase of its offshore gas exploration contracts forty-six I.O.C.s.   
B) Security and a safe business environment  The K.R.G. with no doubt offers now more security and a safer business environment (for instance: a modern and open investment law and a progressive hydrocarbons (oil and gas) law for the Kurdistan Region) than those present in Iraq. Moreover, during the last years Erbil has been able to implement progressive economic policies and to increase its government transparency. "The K.R.G. also remains committed to the criteria and goals of the Extractive Industries Transparency Initiative (E.I.T.I.) and last year submitted a full report on production and revenues", said Dr. Hawrami still at the Iraq Petroleum Conference 2013.

On the other hand, Iraq is a volatile and unstable country, where the Shia-led government had struggled to restore order until an increase of U.S. troops in late 2007 was able to push insurgents and militia out of the cities and provinces that they were trying to conquer. The row with the K.R.G. about the disputed territory, and in specific about the destiny of the ethnically mixed city of Kirkuk (around 1,000,000 inhabitants, although the figures are disputed, the population should consist of one-third Turkmen, one-third Kurds and one-third Arabs) with its hydrocarbon riches (the city sits on the second largest oil field in Iraq), has continually threatened to derail the peace progress. As a result, insurgents in Iraq continue using violence in order to undermine the government. And according to the United Nations (U.N.), May 2013, when more than 1,000 people were violently killed, has been the deadliest month since the sectarian slaughter of 2006-07.   
C) The K.R.G.'s P.S.C.s are more attractive for I.O.C.s than Iraq's T.S.C.s  Let's now examine the two different typologies of energy contracts used respectively in Iraq and the K.R.G. 

C1) Baghdad's T.S.C.s  Since 2008, Iraq's Ministry of Oil has tried to redevelop its energy reserves by bringing in the country top-notch foreign technology. And it has done so through a series of technical service contracts (T.S.C.s) in four bidding rounds (these service contracts have taken also other names like Development and Production Service Contracts or Exploration and Production Service Contracts, but the basic assumptions are quite similar). In practice, with T.S.C.s, I.O.C.s get only a small contribution per barrel while Iraq has full control and ownership of the resources. The companies have no right to lift, market or book reserves, plus they bear all the capital expenditures and financial risks.

Contracts linked to the first three bidding rounds, held in 2009, 2009 and 2010, had for the I.O.C.s an economic return that was not as high as expected and later some of  the companies tried to renegotiate or to cancel the contracts. In fact, the fees per barrel were as low as $1.15 to as high as $7.50. Plus, the fees were additionally reduced by a 25 percent fully carried state participation and by a 35 percent income tax. In the end, the government take in some cases was as high as 99 percent. Moreover, the barrel per fee was reduced by up to 70 percent as the R factor increased from 0.0 to 2.0 (the R factor is a sliding scale that employs a ratio of two numbers to determine a rate. In the oil and gas business the most common R factor is obtained dividing cumulative revenues by cumulative costs). For instance, ExxonMobil from the assigned supergiant West Qurna-1 (which is now producing about 500,000 barrels per day) earns $1.9 per barrel. The profit for the company is substantially fair, but the problem is the produced quantity. In fact, to recoup 30 to 35 percent of its initial investment it should produce 2 million barrels per day, which is not doable now. Plus, as an additional hurdle, the companies that signed these contracts have become entangled with bureaucratic hurdles. 

BACCI - Iraq's Results of the Four O&G Bidding Rounds

Summing up, the first three licensing rounds obtained mixed results for Iraq. According to some commentators, the first one was initially a failure with only the supergiant Rumaila oil field (17 billion barrels) awarded. Only through subsequent negotiations in the following year it was possible to award three fields that initially had not been not awarded: Zubair (4 billion barrels), Maysan (2.5 billion barrels), and West Qurna-1 (8.7 billion barrels). Through these additional negotiations it was redressed a licensing round that at the beginning had raised many questions and doubts. The second and third bidding rounds almost completely awarded their blocks even if bidding was in a certain way feeble. The only really important exception was in the second round the unsuccessful assignment of the East Baghdad oil field (8 billion barrels). But it this regard  and this supports Baghdad's decisions  it should be noted that at least with reference to the first three rounds the fields on offer were all pertaining to discovered areas (some of these were supergiant fields with more than five billion barrels of oil reserves). And this meant that the risk for the companies was very low.
The fourth bidding round (oil and gas) was held in 2012 and it was a complete failure. In fact, the dissatisfaction of I.O.C.s with the terms proposed by Iraq was well shown last year when this fourth energy auction ended with very few foreign investors bidding for the blocks. The result was just 3 blocks awarded out of 12 on offer (and 8 blocks did not even receive any bid).  

Why such a negative result? If the previous three licensing rounds had offered rights to immediately start production raising output at large- or medium-sized sites with proven reserves, the fourth round instead involved areas with undetermined levels of hydrocarbons. Besides, in the fourth round there was a new formula to calculate the fee per barrel. In practice, IOCs would have been paid the fee per barrel on the remaining production after having deducted costs (for instance, if total production was 1 million barrels and the contractor had spent $300,000 on a subcontractor, it would later receive payment only for the remaining production, i.e., 700,000 barrels). In the coming months Iraq will organize the fifth licensing round for oil exploration (ten blocks). It appears now that probably Baghdad will ease its contractual terms in order to lure consistently I.O.C.s and avoid another failure. 
C2) Erbil's P.S.C.s  In Iraqi Kurdistan the oil and gas contractual terms are quite different. Today's contracts date back to the compromises included in Iraq's Constitution of 2005. In specific, Erbil asserts that the Constitution gives it full authority to sign P.S.C.s with reference to future oil and gas fields (these are fields not yet discovered when the Constitution was signed eight years ago), shared authority  for the existing fields, and the right to export hydrocarbons produced within the K.R.G. borders. On the other side, Baghdad has a completely different view: All fields (existing and future) are supervised at the central level, the government retains the right to approve or reject any future P.S.C. and Baghdad must have full control over oil and gas exports. In order to try to overcome this impasse and given the long-dated incapacity of legislating the much needed Federal Oil and Gas Law, the K.R.G. in 2007 passed the Oil and Gas Law of the Kurdistan Region. Since then the K.R.G. has entered into P.S.C.s with I.O.C.s. Baghdad has immediately considered these contracts completely illegal and has refused to pay the K.R.G. the full value of the oil produced in Iraqi Kurdistan. Baghdad has been paying as a reimbursement only part of the cost oil to the I.O.C.s working in Iraqi Kurdistan. 

Following this move Erbil has not had the economic resources to pay the I.O.C.s  and has retaliated halting production from the K.R.G. It's important to know that based on their share of the Iraqi population, the K.R.G. is supposed to get 17 percent of national revenue. When last March 7, 2013, the federal government passed the 2013 Budget Law the agreed-upon allocation for the K.R.G. was $3 billion short of what Erbil expected. And the direct consequence of this federal law was the K.R.G. "Law of identifying and obtaining financial dues to the Kurdistan Region Iraq from federal revenue", a.k.a. the Financial Rights Law of April 2013. The aim of the law was to create a mechanism for the assessment of the amount Baghdad owed to Erbil and, especially, and for the definition, within the framework of Iraq's Constitution, of a remedy if the central government did not pay. This remedy meant direct exports of oil and gas produced in Iraqi Kurdistan. Currently, the K.R.G. Ministry of Finance affirms Baghdad's debt is as high as $20 billion of which $4 billion belongs to the I.O.C.s operating in the K.R.G.      
With P.S.C.s a contractor in general carries out all the investments and performs management implementing all the technical and operating services under the control of a state agency (many times a national oil company (N.O.C.)). Here the big difference with service agreements is that a contractor receives a share of production to recover its costs (cost oil). Subsequently, the I.O.C. will split the remaining production (profit oil) with the government to get its profits. Summing up, in a P.S.C.  the overall economic rent consists in general of five components:

1) Bonus (government share),
2) Royalty (government share),
3) Government's Profit Oil (government share),
4) Taxes (government share) and
5) Contractor's Profit Oil (contractor share)           

If it's true that the majority of the economic rent goes to the hosting government, it's also true that the contractor has the possibility of recovering all its costs (Exploration Costs, Development Costs and Operating Costs). In fact, Article 25.3 of the K.R.G. P.S.C.s format says that:

Subject to the provisions of this Contract, from the First Production in the Contract Area, the CONTRACTOR shall at all times be entitled to recover all Petroleum Costs incurred under this Contract, of up to [ ] percent ([ ]%) of Available Crude Oil ...

Plus, at the same time, in addition to recovering its costs, the contractor is entitled to obtain profit Oil. In fact, Article 26.2 of KRG's PSC says that:

From First Production and as and when Petroleum is being produced, the CONTRACTOR shall be entitled to take a percentage share of Profit Crude Oil and/or Profit Natural Gas, in consideration for its investment in the Petroleum Operations, which percentage share shall be determined in accordance with Article 26.5.

Why the K.R.G. is proposing P.S.C.s. is another good point to be raised. The reason is both based on economic and political assumptions. Erbil believes that economically speaking it has to develop its own economic agenda. Being linked to Baghdad means proceeding with a very slow pace and with unreliable economic gains postponed to future times. Iraq does remain now in dire conditions with huge security problems associated to a sectarian civil war that continues up to today and does not seem to abase. With reference to the energy sector, a national hydrocarbons law to date has not been passed and Iraq's bidding rounds, based on T.S.C.s, have been quite a failure. Moreover, Turkey is very interested into Erbil's energy riches and could be the customer permitting the K.R.G. to export its oil and gas. In other words, P.S.C.s with a more balanced revenue sharing mechanism, could be the right tool for developing in a fast manner a sector that until a few years ago (2006) had been practically nonexistent.  I.O.C.s have flocked to the K.R.G. without many doubts. If improved economic conditions will permit Erbil to create an independent state is another thing. But surely in Erbil many officials do not have positive ideas about Iraq's future. "Iraq is going to hell. If we cannot live together we must talk about something else. We Kurds are not part of the conflict between Shia and Sunnis. But if there is a fire in the house next door, it will burn you too in the end. And there is no fireman" said in an interview Fuad Hussein, an adviser to the president of the K.R.G., Massoud Barzani.         

To conclude our analysis of these two types of oil and gas contracts it should be underlined that there is no energy ontract that can really fit all the working possibilities. In fact, every contract suits different economic conditions, and it's important to strike a fair balance between I.O.C.s and the hosting state. A T.S.C. could be an acceptable contract when companies have to work in an environment where there are proved reserves and/or where the real activity is just related to a previously exploited field (for instance, a redevelopment activity). In this regard, Iraq's first three licensing rounds (and also the contracts related to fields not awarded with the first licensing round, which only later were awarded through private negotiations  see for instance West Qurna-1) have very tight conditions, but with the right amount of produced barrels (permitting a company to recoup its incurred costs) could well be profitable for the involved I.O.C.s. Things of course change if we consider areas with unproved reserves. In such a case, it's clear that contractual terms have to change if a government wants to avoid a bidding failure as Iraq's fourth oil and gas licensing round.