Middle East Economic Survey

VOL. XLIX

No 25

18-June-2007

A Sound Legal Regime For The Iraqi Petroleum Sector

By Justin Dargin

Justin Dargin is a third-year law student at Michigan State University College of Law, specializing in International Law and Natural Resource law. He has also interned in the legal department of OPEC, and studied International Petroleum Law at the American University in Cairo. Currently, Mr Dargin is researching Middle Eastern gas issues at the Oxford Institute for Energy Studies.

How Is Iraq’s Oil Revenue To Be Distributed?

Revenue sharing, and the more technical issue of who has day-to-day control of the fields, is critical to Iraq’s future. Common practice in most of the world holds that, at a minimum, a portion of the oil revenue will stay in the region from which it was produced, to compensate for infrastructure investments and ecological externalities from oil extraction. Ongoing violence and recent nonviolent protests by unionists suggest a negotiated distribution of Iraq’s oil wealth among the competing stake-holders is vital to that nation’s ability to survive as an embryonic democracy.

However, many of Iraq’s particular fields are in disrepair after decades of under-use or destruction. The future share of Iraq’s oil production will likely shift from fields now being produced, to those which were previously undiscovered or underutilized. With the vast percentage of Iraq’s oil concentrated in the North and the South, the central and western portion of the country could become impoverished. Iraq has 80 known oil fields, but only 20 have been developed, and of those 20 at only a fraction of their potential. Therefore there is much to be done developmentally.

Those who argue for regional autonomy feel that an extremely centralized system would leave certain regions underutilized at the whim of central authorities. The opposing side believes that too much autonomy would lead to secessionist calls as regions blessed with an overabundance of resources feel that they are supporting the other regions excessively.

Potential Legal Ramifications For IOCs

The oil majors have not set foot in Iraq for a number of reasons, political instability and sectarian violence being the principal ones. However, the most important reason appears to be the lack of a clear petroleum law, and the resulting ambiguity as to the legal rights of investors. 

The Kurdistan Regional Government (KRG) has been rushing to form deals with any oil company that will come to the region. Norway’s DNO¹, Canada’s Heritage Oil and Western Oil Sands, and Britain’s Sterling Energy² are the current signatories to the main exploration and development contracts.

The IOCs and the KRG negotiated these deals without the approval or knowledge of the central authorities in Baghdad, which insists that it be a party to all negotiations and finalizations. The KRG has offered very attractive terms for oil companies willing to work in an uncertain legal environment.³ Adding more potential obstacles for the investor are the two redundant administrations effectively controlling Iraqi Kurdistan, the Kurdistan Democratic Party (KDP) ministry with its base in Irbil⁴ and the Patriotic Union of Kurdistan (PUK) ministry in Suleymania.⁵ A unification agreement was signed in early 2006, with the creation of the KRG. But a full merger between the two will not be easy.

Iraq’s current Prime Minister, Nuri al-Maliki, has unstintingly declared that he intends to suppress regional claims on oil resources, in deference to the control of the central authority in Baghdad. However, that will prove difficult as he will have to alienate key Shi΄a and Kurdish members of his ruling coalition. The oil majors are waiting to see the result of the regional licenses, and it is far from certain that the central authorities will recognize the latter.

Iraq Needs To Encourage FDI

No one can project with reasonable certainty the status of the regional contracts, and most of the regional licenses are for relatively unexplored fields. The legal validity of these regional licenses must be determined to encourage the majors to invest. Iraq desperately needs investment. The oil sector has deteriorated greatly after two decades of war. Before the Iran-Iraq war, Iraq’s production capacity was 3.5mn b/d, but it reached a low of 1.2mn b/d during the height of sanctions, and current production is approximately 2mn b/d.⁶

Iraq needs to woo substantial foreign investment, but as long as there is ambiguity, the oil majors are likely to take a more wary attitude until they can determine who the policymakers are. The majors are especially unlikely to invest due to the high risk of losing their investments if the regional licenses are found to be invalid.

Even before the insurgency is quelled, many of the majors would likely follow the independents to Iraq if a viable legal framework were developed, even if investments were limited to the relative safety of the Kurdish Autonomous Zone. Investments there could serve as a base to expand for future operations, when the violence in the rest of the country subsides.

Status Of Kirkuk

Kirkuk is located in Northern Iraq, about 250km north of Baghdad, near the foot of the Zagros Mountains. With approximately 10bn barrels of proven reserves, and exports totaling about half of Iraq’s oil exports, Kirkuk is a flashpoint in the country’s oil politics. Whoever controls Kirkuk effectively controls Iraq’s oil and wealth.⁷ The KRG proposes that Kirkuk join the Kurdistan region through a referendum in 2007.⁸ The issue is particularly inflammatory due to the uncertain status of the Kurds displaced under Saddam’s Arabization resettlement policy.

Kirkuk stands at the battleground, as the Kurdish residents are being resettled in the city at a rate which will soon outnumber the other ethnic groups, namely Turkomen and Arabs. Each group has its patrons, such as the Sunni Arabs, who are supported by Baghdad, which favors the Arab citizens; Turkey, favors its ethnic brethren, the Turkomen, and intends to bar the Kurds from power. The Kurdish Administered North favors the local Kurds and wishes to bring the Kirkuk governorate, with its 10bn barrels of proven remaining reserves, into the KRG fold.⁹

The referendum will be held in 2007, and the residents of Kirkuk will vote on whether the region should be incorporated into the Kurdish region. This will be highly complicated, since there are reports of ethnic Arabs being driven out of the Kirkuk, and of reprisals and counter-reprisals. The Kurds see their arrival in the city as an important response to redress the wrongs committed under Saddam Husain’s arabization program.

Further, the Kurds feel that the oil revenue gained from the city will help solidify their hold as an autonomous region. At present, KRG’s annual budget is derived from its share of overall Iraqi oil exports, and amounts to 17% of the total.¹⁰ The Kurds fear that they will be economically starved if the Shi΄a dominate. This embattled feeling drives the KRG to solidify its hold on regional contract negotiations.

Throughout most of the 1990s, Iraq lacked access to the latest, state-of-the-art oil industry technology, such as 3D seismic, directional or deep drilling, and gas injection, and to sufficient quantities of spare parts, or capital investments. Instead, it sustained production with sub-standard engineering techniques that included deliberate over-pumping, water injection techniques or “flooding”), and obsolete technology. Oil wells were generally in various states of decay and well casings frequently corroded. Reversal of all these practices and utilization of the most modern techniques, combined with development of both discovered fields as well as new ones, could result in Iraq's oil output increasing by several million barrels per day. There should be no rush to judgment, however, since former Iraqi Oil Minister Issam al-Chalabi declared in February 2004 that recent efforts to boost Iraqi production might be harming the country's oil reserves¹¹.

Although Iraq has made long strides from its previous incarnation as a despotic regime, it finds itself in a very precarious position. The national constitution made great headway as a starting point for national reconciliation and as a first step path towards a viable nation-state. Although vague expediencies may have been necessary during the negotiation stage to forge agreements that created a nation-state, some of these intentional ambiguities have also induced regional, ethnic or sectarian divisiveness.

Although the present Iraqi government can implement transparency and accountability in any national oil management regime, the sustainability of the Kurdish region depends on its interdependency with the rest of the country. No discussion of the development of the Kurdish Administered area can take place without the formation of institutions within a larger Iraqi national framework.

Some proposed recommendations that can serve to overhaul and reform Saddam’s legacy of exploitation and corruption are:

Legislative Recommendations:

• Establishment of a Transparent and Accountable Budgetary Process.
  Any section of the constitution that details the responsibility for the national budget should specifically include all oil-related revenue and expenditures as a portion of the public budgetary process. The legislature must have oversight of the Executive branch and of cabinet ministers to monitor spending decisions and actions. An audit board should not only give annual reports to the parliament, but should be armed with the authority to investigate alleged misappropriations.
   

  It is essential that, even if committed to the decentralized vision of the new Iraq, all proposed budgets should flow through a central authority that will be legally authorized to monitor the budgetary process.
   

• National Petroleum Law
  A National Petroleum Law, based on the constitution, would reassure oil companies before they commit large sums of FDI to the petroleum sector. The new petroleum law not need be exhaustive, but should cover all aspects and phases of operations, with a focus on the main principles and leave details to future regulations, individual agreements, and legislative amendments.
   

• Formulation of  Model Petroleum Agreement
  The petroleum law and subsequent regulations will serve as the overarching feature of petroleum policy, and create a legal basis for the relationship between the host country and all licensees. However, the specific details of the relationship should be documented in individual commercial agreements and contracts. It is necessary to implement a model Production-Sharing Agreement, which will leave ownership of the fields in Iraqi hands, but encourage FDI in the industry.

Proposed Constitutional Amendments

Generally, fundamental principles of a country are enshrined in the constitution. Subsequent legislation details the exercise of these principles. Constitutional amendments to the Iraqi constitution should safeguard oil revenues.

• Ownership Restriction Clause
  Any amendment to the Constitution should include ownership restrictions to prevent the corruption that has so often occurred with the management of natural resources. An amendment should limit the ownership of any single person, family, clan or entity. Ownership provisions will also have the benefit of forcing rival groups into economic interdependence. However, the regulators must monitor usage of dummy corporations or front people, designed to thwart the restrictions.
   

• Clearing Up Ambiguities
  There should clarification of the ambiguities, omissions, and contradictions contained in the articles of the constitution relative to petroleum. A good starting point would be the use of the phrase ‘existing fields’ in Article 109/1. ‘Existing fields’ is not a standard petroleum industry term and is open to multiple interpretations. A proposed amendment to Article 109/1 would replace the hazy term “existing fields,” with language that enables central authorities to supervise all oil/gas exploration and production. The amendment will also delineate the proposed share of revenue that will go to the producing regions and provinces.
   

• Establishment Of A Natural Resource Fund
  A Natural Resource Fund (NRF) should be established through a constitutional amendment; this will prevent the Petroleum Sector from being a victim of political wrangling, ensure its (semi) immutability, and enforce interdependence among the various stakeholders. There are two methods of structuring a NRF:

-  A Stabilization Fund should channel excess revenue to the NRF, when oil prices are high and draw from the fund when oil revenues are low. This mechanism should, thereby, stabilize budgetary revenue and expenditure.

-  A Saving Fund will channel a constant share of oil revenue that will be saved for future generations. If the fund is successful it will lead to higher governmental savings in the aggregate.

If a constitutional framework is developed alongside an environment of interdependence, the legislative and constitutional changes suggested should have a lasting impact in Iraq and build a hopeful future.

Notes:

1.    In 2006, the first new oil well since the invasion was drilled in Kurdistan by DNO. Initial indications are that the field contains at least 100mn barrels of oil and will be pumping 5,000 b/d by early 2007.

2.    “Kurdish Oil Deal Shocks Iraq’s Political Leaders” Kurdish Media

       <http://www.kurdmedia.com/articles.asp?id=10745>

3.    Calibre Energy Inc announced on 15 September 2006 that it entered into an agreement with Hawler Energy, Ltd to participate in an Exploration and Production-Sharing Agreement (EPSA) with the KRG covering its Bana-Bavu structure. See Iraq Update < http://www.iraqupdates.com/p_articles.php/article/10544>

       The three previous Production-Sharing Agreements, signed since the US led invasion of 2003, were with the Turkish companies Petoil in April 2003, Genel Enerji in January 2004, and recently the Canadian company Western Oil Sands. Id.

4.    The Western KDP region, headed by Mas΄ud Barzani, has a population of roughly 1.8mn, while the Eastern region is headed by Jalal Talabani, (around 1.2mn citizens with the capital being Suleimaniyah). The KDP and PUK have established independent administrative, legislative, and executive entities. See Flashpoint Guide to World Conflicts <http://www.flashpoints.info/FlashPoints_home.html>

5.    Kurdistan Development Corporation < http://www.kurdistancorporation.com/FDImagazine.html>

6.    Dar al Hayat: “$18 billion: Iraq’s annual oil losses”.  <http://english.daralhayat.com/business/04-2006/Article-20060411-89398c8b-c0a8-10ed-0105-0034c1c49534/story.html>

7.    “Kirkuk oil and the dance of death”. < http://www.docstrangelove.com/2006/04/27/kirkuk-oil-and-the-dance-of-death/ >

8.    Radio Free Europe: Kurds Maintain Stance on Kirkuk Elections. 17 January 2005, Vol 8, No 2.

9.    US Energy Information Administration, Iraq Country Page,

       < http: //www.hrw.org/reports/2003/iraq0303.htm>

10.   Christian Science Monitor: Kurds quietly angle for independence.

       <http://www.csmonitor.com/2006/0426/p07s02-woiq.html>

11.   Mr Chalabi was Iraq’s Oil Minister from 1980 to October 1990. He contends that extensive damage occurred during the last decade of Husain’s rule, and that significant subsurface work should be conducted to determine the extent of the damage (MEES, 7 February 2005). See also Sam Fletcher. “Former Iraqi Oil Minister calls for Iraq Production Cap, Reservoir Repairs”, Oil and Gas Journal: Energy Bulletin, (15 February 2004).