Iraq Oil Problems and Possibilities

2012-07-14  By Richard Weitz

Iraq’s oil industry is indispensable to the country’s economic growth.

The oil sector provides more than 90 percent of the government’s revenue and 80 percent of Iraq’s foreign exchange earnings. Iraqi officials have tendered bids and recently awarded ten contracts to international oil companies. These investments could bring as much as $100 billion to Iraq in the coming decade.

If Iraq can avert renewed civil war and foreign invasion, and limit the invidious impact of corruption and regional tensions, then the country’s oil wealth might provide the foundation for Iraq’s recovery and renewal.

Nonetheless, wars, political conflicts, and neglect have hampered Iraq’s oil output for decades.

After peaking at roughly 3.5 million barrels per day in 1979, production nose-dived to around 900,000 barrels per day in the early 1980s due to the Iran-Iraq war. Output recovered by the end of the decade to nearly 3 million barrels per day, only to fall to less than 300,000 barrels per day (bpd)in 1991 amid the Gulf War. Oil production was on an upswing to more than 2.5 million barrels a day until the U.S.-led invasion in 2003 caused it to fall back again. The guerrilla attacks against Iraq’s oil infrastructure that began shortly after the occupation began then delayed reconstruction efforts.

Even in 2010, Iraq’s oil production was still at pre-war levels. By the following year, Iraq’s oil production had returned to 2.5 million bpd. It was only in April 2012 that Iraq’s exports exceeded the levels that existed prior to Saddam’s invasion of Kuwait in 1990.

Iraq’s oil-producing potential is enormous.

According to the U.S. Energy Information Administration (EIA), Iraq held 115 billion barrels of proven reserves in 2009, the fourth largest in the world. More recent figures cited in the press and financial media point to 143 billion barrels, making it the world’s second or third largest. Other sources say there is much more to be found, perhaps as much as 45 to 214 billion barrels in additional and unconfirmed reserves or in unexplored areas.

The Iraqi government has set aggressive oil production goals for the future: 6 million bpd by 2014 and 12 million by 2017. But that 2017 goal would be more than four times the early 2011 level of 2.6 million bpd and, if achieved, would place Iraq second only to Saudi Arabia in terms of total production capacity.

Iraqis have pursued foreign oil companies to attain these goals, but many industry observers believe Iraq’s goals are unrealistic given the country’s outdated energy production and transportation infrastructure and continuing security and instability concerns. For example, Iraq’s only pipeline to its southern oil terminal has been operating for roughly double its designed lifetime. The EIA warned that, “Both Iraqi refining and export infrastructure are currently bottlenecks, and need to be upgraded to process much more crude oil.”

The EIA assessment highlights the need for significant capital investment into the Iraqi energy sector, and Iraq’s ability to export large amounts of oil will be severely limited until this can be accomplished. Prime Minister Nouri al-Maliki has authorized a $50 billion spending program to develop Iraq’s energy infrastructure. The spending will encompass multiple areas including Iraq’s emerging natural gas industry and the construction of thousands of miles of energy pipelines. But much more private sector infrastructure investment is also needed.

French, Russian, and especially Chinese companies seem prepared to tolerate high risks in order to gain access to some of Iraq’s most lucrative oil contracts. Chinese firms have won stakes in 3 out of the 11 oil contracts offered by the Iraqi government in recent years. These deals have collectively made China the biggest investor in Iraq’s oil and gas industry, Credit Image: Bigstock

The Iraqi government faces other challenges as it seeks to further exploit its oil reserves.

The location of the oil by itself generates political and regional tensions. Iraq’s known oil reserves are concentrated in the Kurdish-dominated north and the Shiite-dominated south, leaving the Sunnis vulnerable to exclusion and the Baghdad government with a revenue-allocation challenge. The political parties represented in Iraq’s squabbling national parliament have repeatedly failed to agree on a hydrocarbon law that establishes a scheme for distributing oil revenue among the provinces.

The agreement Exxon Mobil recently signed with the KRG to invest in oil extraction in northern Iraq confronts the central government with a predicament. Baghdad wants to exercise resource sovereignty over all of Iraq but not dissuade Exxon from making lucrative investments in the country.

Iraq’s post-Saddam constitution reflects the recognition that the various levels of Iraq’s federal government must cooperate to ensure the fair distribution of revenues.

The constitution contains several key articles that deal with revenue sharing. Article 112, for example, protects the oil rights of the Kurds and Shiites: ”The federal government in cooperation with the producing regions and governorates shall administer the extracted (produced) oil and gas from existing oil and gas fields provided that the proceeds (revenues) are evenly distributed in accordance with the demographic distribution around the whole country, and a specific share of the proceeds for a specific period of time shall be allotted to the regions which were unjustly deprived by the previous regime, and were affected by it, to secure a balanced development of the different areas of the country and this shall be regulated by law.”

But the constitution leaves a number of questions concerning the country’s energy sector unanswered.

One question involves the principle of federalism – how much respective authority do the central government and the regional governments have over the oil and gas development. Legislation covering hydrocarbons, revenue-sharing, restructuring the country’s oil ministry and setting up a new national oil company have been stalled for years amidst fierce disagreement between political parties. Furthermore, there is the question of which branch of Iraq’s government – parliament or the cabinet – must approve oil deals. China witnessed this firsthand when a member of Iraq’s parliament filed a lawsuit against the Iraqi Oil Ministry and Cabinet for signing the 2009 oil deal involving China National Petroleum Corporation and BP without parliamentary approval. A new national oil law would help clarify which entity has the final say on oil deals.

Underlying these questions is the Iraqi attitude toward foreign participation in the oil sector altogether.

Not all stakeholders feel the same way about allowing foreign firms a role in the development of Iraqi’s oil resources. This issue remains a highly charge political issue: Whereas some Iraqis oppose foreign participation on any terms, others support foreign participation in the form of technical service contracts, and still others favor production sharing agreements (PSAs), which would grant international companies exploration and production rights over specific areas for specific periods, subject to the terms of negotiated contracts.

Complicating matters, Iraq’s oil unions have demanded to be included in talks on drafting new hydrocarbon legislation. If the unions dislike the proposed legislation, they can strike as they did in 2007, which shut down oil operations in southern Iraq for several days. In addition, Iraq’s influential state-run Southern Oil Company has opposed the service contract plan advanced by the Ministry of Oil, underscoring another potential source for continued conflict.

This legislation issue also has a regional dimension, with Iraq’s Ministry of Oil moving forward with technical service contracts, while the KRG has relied on PSAs. Sunni Arab parties at times strongly opposed what they view as foreign “exploitation” of Iraqi oil resources. This opposition is based at least in part on the fact that Sunni Arab minority-dominated regions currently have few proven oil and gas reserves. The underlying fear is that oil revenues will not be fairly distributed.

Although Iraqis have not agreed on a hydrocarbon law, the Iraqi government has decided to proceed without this framework agreement and circumvent the process for a while in order to secure some foreign investment.

Interim revenue sharing mechanisms have been implemented and both the KRG and the Iraqi national government have signed oil and gas development contracts with some of the world’s leading foreign firms—American, European, Russian, and especially Chinese. Even so, many oil companies rejected the terms offered by the Iraqi government as to favorable to the government, especially given the high costs of investing in Iraq’s dilapidated and insecure oil sector. The terms included obligatory loans to the government, a 35 percent corporate income tax on remuneration fees, and requirements that a “state partner” have a large stake in any project.

The KRG has been moving more aggressively to develop its oil and gas resources, coming into a conflict with the central government over which government has authority to sign contracts. The agreement that Exxon Mobil signed with the KRG to invest in oil extraction in northern Iraq represents a clear challenge to the central government’s sovereignty and highlights the Kurds’ willingness to act independently of Baghdad in what amounts to a high-stakes game of chicken between the two sides. But not many foreign firms are willing to join Exxon and risk Baghdad’s retaliation by pursuing independent options in the KRG. At the same time, the deal confronts the central government with a predicament. Baghdad wants to exercise resource sovereignty over all of Iraq but not dissuade Exxon from making lucrative investments in the country.

Meanwhile, the debate continues over the creation of the new Iraqi National Oil Company (INOC), which is included in a draft law approved by the Iraqi cabinet in 2009. In the summer of 2011, Iraqi Oil Minister Abdul-Karrem Luaibi told parliament’s energy committee that the INOC was unnecessary, but Maliki’s aides still supported it.

Finally, Iraq’s energy situation is inextricably linked with the country’s regional relations.

Its export routes involve Syria, Turkey and several Persian Gulf countries. The instability in Syria and Baghdad’s confrontations with Kuwait and Turkey can leave it overly dependent on Iranian assistance for the export of its oil. This gives Tehran excessive leverage over Iraq’s economic lifelines and also leaves Iraq vulnerable to any sanctions or military action the international community employs against Iran.

A vicious circle has arisen in Iraq.

Although Iraq’s oil potential was enormous, the lack of security deterred the foreign investment needed to modernize the oil sector. And that investment was important for generating the additional government revenue Iraq required to boost its national security spending as well as create jobs and support public services to address Iraqis who are alienated by the government’s poor performance in these areas and who might therefore join the insurgency.

Breaking the circle requires a leap of faith by foreign investors.

British and U.S. energy firms seem most cowed by the malign conditions in Iraq. But French, Russian, and especially Chinese companies seem prepared to tolerate high risks in order to gain access to some of Iraq’s most lucrative oil contracts. Chinese firms have won stakes in 3 out of the 11 oil contracts offered by the Iraqi government in recent years. These deals have collectively made China the biggest investor in Iraq’s oil and gas industry, which has the world’s second largest proven oil reserves.

"If everyone is thinking alike, someone isn’t thinking."

—General George Patton Jr.

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