Middle East Economic Survey
VOL. LII
No 10
9
Iraq Contract Options
By Helmut A Merklein
Dr Merklein is a consultant in oil and gas policies. He was Assistant Secretary of International Affairs and Energy Security at the US Department of Energy and Administrator of the Energy Information Administration (EIA) from 1984 to 1990. As head of the EIA, Dr Merklein was in effect the government’s chief energy analyst. Prior to joining the Reagan Administration, he was Professor of Petroleum Engineering at Texas A&M University. He can be contacted at helmut.merklein@verizon.net. This article is a companion-piece to Dr Merklein’s recent analysis of Iraq’s reserve base and production potential (MEES, 16 February).
Short Term Options
Taking it for granted that the production sharing option was not on the table in earlier Iraqi oil negotiations and that the term of the technical support agreements was limited to 18 months, three alternative options appeared to be available. They are risk service contracts, no-risk contracts, and pursuing the oil field development through the Iraq National Oil Company.
Risk Service Contracts
Generally, in a risk service contract, the contractor bears the risk for the investment. The specific conditions of the Iraqi 18-month technical support agreements under negotiation are unknown. Typically, the contractor would be expected to undertake the required exploration, drilling and, if successful, field development at his expense and risk, with costs recovered from the sale of the oil produced. The remaining oil belongs to the host government, except for an agreed-upon fee that the contractor is entitled to under the contract.
The central issue regarding risk service contracts revolves around the method of payment. If the oil to be used to reimburse the contractor is specified in volumes, this is a production-sharing contract, albeit one with a cap, regardless of the label it is given, since it retains its vulnerability to price-induced windfall losses. In a true risk service contract, the oil to be used as payment for agreed-upon fixed dollar-denominated fees would be valued at market prices as of the transaction date.
Risk service contracts can be quite lucrative. Their advantage is that they engage both the technical expertise and financial resources of the contractor. They are particularly well suited in cases where the investment risk is low and the host government lacks the resources to finance its own development. Proven but undeveloped fields in developing countries would be likely targets for such contracts, now that the price of crude oil has improved the economic viability of such fields, as would be the Iraqi producing fields here under discussion.
If negotiations on the five fields now under consideration fail, the proposed Iraqi technical support agreements in their current or in altered forms could be offered to the full set of 41 eligible oil companies. The advantage of this alternative is that the companies now on the list have been pre-cleared, which permits almost immediate implementation. If time permits another round of reviews, large oil field service companies capable of securing funding for a $500mn oil production development project in known giant oil fields could be included. Names like Halliburton, Baker-Hughes, Schlumberger, and Weatherford International come to mind. Funding would likely use significant equity participation by the contractors, with outside commercial or institutional debt infusion, which the service companies may or may not be in the position to provide, as per their internal corporate policies.
No-Risk Service Contracts
These are contracts in which the resource owner, the Government of Iraq, bears the risk of the project. This would require that the Government of Iraq pledge all of its existing reserves against the loans that the contractors would need to implement their projects. Such an arrangement would permit the inclusion of well-established independents who have the required expertise but lack the needed funding capability.
The five fields under consideration are all producing onshore fields where independents have excelled for decades. They are familiar with conventional and horizontal drilling techniques, well completions and recompletions, artificial lift technologies, secondary oil recovery, and similar methods used to stimulate production from ageing, declining or underperforming fields.
The Ministry of Oil has taken great care in selecting established oil companies with Iraqi experience as their first choice for partners in their technical support program. The Ministry’s aversion to risk-taking under the circumstances is understandable. Yet if an agreement cannot be forged because the international oil companies cannot bring themselves to accept what to them must appear to be a revolutionary turn to untested or undesirable financial arrangements, it may be well to remember that the production-sharing contract that they adhere to now was opposed by them with considerable tenacity nearly five decades ago, when a tiny independent producer no one had ever heard of, the Independent Indonesian American Oil Company, developed and signed the first production-sharing contract, the form that dominates the industry today.
The Iraq National Oil Company
If it were not for the urgency to develop immediate and massive funding for the reconstruction of the Iraqi economy, there would be no need for short-term technical support agreements. Of course, one could make the argument that the most recent price increase has lessened the pressure for outside funding. The average price of crude oil was $72/B in 2007, when the plans for the five oil field projects to be quick-started were drawn up. By mid-2008, these prices were running in the $130-140/B range. The associated windfalls that the five projects were to generate 18 months or two years down the road, if fully captured by the Iraqis through the assumption of operational responsibility by the Iraq National Oil Company, would begin to provide the needed reconstruction funds now. True, the price of crude oil at the moment stands at $35-40/B, but we are talking about 20-30 year leases, with prices destined to approach again the $100/B mark.
The argument that Iraq is well positioned, in terms of technical expertise and access to funding, to develop its oil reserves on its own, will be made in connection with long-term options. Suffice it to point out here that the decision to pursue a long-term policy of self reliance in oil production would obviate the need for any short-term options. Instead, the short-term and long-term options under the self-reliance case would merge into a single long-term policy.
Long Term Contracts
On the assumption that the Ministry of Oil meant it when it stipulated that the new structure of the Iraqi oil industry give the improved service contract first preference over production-sharing contracts, what are the long-term options beyond the 18-month technical support agreements?
There are, of course, hundreds of variants of production agreements. Almost all of them contain some sort of windfall options, which is what has made these contracts so lucrative to the oil companies and so unappealing to host governments. This section briefly describes two long-term options. The risk utility service contract and the option for Iraq to pursue upstream oil activities on its own.
The Risk Utility Service Contract
If a long-term cooperative route is chosen, with multinational oil companies undertaking heavy investments, there is a type of contract that truly captures all of the rent while providing desired rates of return. This is what one may call a utility service agreement, in which a freely and competitively negotiated internal rate of return is the bidding, trigger and target variable, rather than one of the many trigger variables discussed earlier that are generally used for contractual adjustments elsewhere, in favor of host governments. In the utility service contract, adjustments are made by compensatory revenue payments, up or down, to make sure the agreed-upon rate of return is maintained. Anything beyond that rate belongs to the host country.
Utility contracts are commonplace in the US and in Canada where they have been used for decades in the electric and natural gas distribution and transmission sectors as regulatory tools to control excess profits by setting prices at levels designed to achieve quasi-competitive target rates of return. But there is a difference between the US utility contracts and those discussed here in connection with Iraqi oil production. The regulation of Iraqi production operations, where prices are set extraneously in competitive world markets, would require retroactive adjustments of recent revenue payments to oil companies to achieve the contractual rates of return. This would involve reviews and approximate interim adjustments of payments to or from oil companies on a quarterly basis, followed by detailed annual adjustments. While this is technically a risk service contract, the risk to the oil companies of not reaching the target rate of return is practically nil since the required increase in oil production from the underutilized fields in Iraq is virtually guaranteed.
Increases in oil prices in preceding quarters will trigger compensatory payments from oil companies to the government and price reductions will direct compensatory payments from the government to oil companies, to keep the rates of return at contractual levels. However, in no case can an elusive contract rate of return be forced by pre-empting normal fiscal obligations such as profit taxes and legislatively established fees as they existed prior to contract letting. In the long run, prices will surely continue to rise, so that there is essentially no risk to the government, except for sporadic short-term downward movements of prices.
This is a novel concept that will probably not be particularly appreciated by international oil companies (IOCs). However, the introduction of production sharing agreements by Indonesia in the 1960s was also novel and fiercely opposed by IOCs, only to become the standard today. Standards evolve, and beneficiaries of existing standards will always be opposed to the development of new ones, especially when their winning position is at risk.
The utility service contract has its pros and cons. From an oil company point of view, the upside is that it protects against losses if prices collapse. The downside, or so the companies would have you believe, is the need for a clumsy, overly detailed, and prohibitively expensive accounting procedure. That, however, is a flawed argument, since detailed accounting is required in any event, for tax purposes and for the determination of profit oil in production sharing or other types of contracts. Moreover, accounting expenses are routinely charged against oil production, so that the host government in effect reimburses the oil company for these costs, which are definitely minimal compared to potential windfalls.
Some of the objections to service contracts are worthy of consideration here:
Objection: There is no incentive for investors to explore for large low cost fields – the main driver would be to find high cost small fields.
Response: This is generally true for service contracts, but not for the utility contract here under discussion, since the oil companies will be freely and competitively bidding on fields for which they have an abundance of data, so they will set their rates of return to reflect their expectations of the fields they are bidding on, regardless of high or low prospective costs.
Objection: There is no incentive for investors to have low cost operations – in fact there is a strong incentive to have high cost operations based on poor development plans.
Response: Again, this is generally true for service contracts and for production-sharing contracts where the low-cost high-volume prospects would be the first bidding targets of oil companies, because that is where the windfalls are greatest. But in the utility service contract, the windfalls have been eliminated. The (discounted) rate of return is assured so that there will be no particular preference one way or the other.
Objection: There is no incentive to achieve a maximum recovery of the oil and gas, and in fact a lower recovery could be more profitable to the IOCs.
Response: Again, true in general but not applicable under the utility service contract. The most efficient oil company will have the lowest rate of return, so it will carry out recovery operations farther than oil companies with higher bids. Beyond that, whatever happened to farm-outs and to contractual provisions that limit the terms of oil contracts (large fields of the type here under consideration will easily exceed the usual term limits) and what happened to provisions that prescribe the transfer of oil fields back to the host government at the time the oil company deems them no longer profitable?
Objection: The IOCs have an interest in low oil prices.
Response: As the model results in Tables 1 and 3 of the earlier article have shown (MEES, 16 February), high oil prices in production-sharing contracts favor oil companies. Their enormous wealth today would never have been accumulated in the absence of the high oil prices that OPEC quotas have generated. For service contracts of the cost-plus type, without regard to rates of return, there is the danger of empire building, ie of incurring high costs in preference to seeking the most efficient least-cost operations. However, a wealth of institutional and legal history has led to the establishment of procedures in the US and Canada to control deliberate moves towards high-cost operations that would be easy to emulate in Iraq. Space and time does not permit to discuss these procedures here in detail.
In the end, if the utility contracts are such a good deal, why are they not widely used in the international oil business? They are not in use because most host countries are not in a strong enough bargaining position to impose them. Not so in Iraq, which holds all the cards, since it could, but does not have to, engage the cooperation of multinational oil companies. In fact, working with multinationals in upstream operations, even under a utility service contract, is a second-best solution, compared to going it alone. Iraq’s natural inclination should be to develop its oil reserves on its own.
Of course, multinational oil companies will be opposed to the use of utility service contracts, because they would be less lucrative for them. They would be bidding on one variable only, no bells and no whistles. That variable would be the internal rate of return, in a competitive and transparent bidding procedure that would prevent the use of convoluted features which tend to work to the multinationals’ advantage. The more complex and obscure the agreement, the easier it is for the multinationals to drive a good bargain.
Pursuing Oil Field Developments Through The Iraq National Oil Company
There has been talk of privatizing the Iraqi oil industry in order to attract foreign capital and speed up recovery. That policy makes sense for all energy sectors, except the oil exploration and production sector. Oil production service industries (drilling, logging, seismic, well stimulation, etc) and other oil-related industries (refineries, pipelines, marketing facilities, distribution networks, etc) could and probably should be privatized in whole or in part. Iraq needs a vibrant oil industry characterized by a competitive environment that has the capacity for rapid technological development, and that responds quickly to changing circumstances.
However, privatization does not make sense for the oil exploration and production sector of a country that in a few years will be the fourth largest oil producer in the world, after Saudi Arabia, Russia and the US. The Saudi Arabian model might well serve as an example for the oil sector development in Iraq. The Saudi national oil company, Saudi Aramco, has exclusive operational control of upstream oil operations, where the government’s equity holdings are 100%. On downstream operations, Saudi Aramco freely enters into contracts with foreign companies where lucrative but rent-free capital-intensive projects are eagerly pursued by foreign partners. Shell, ExxonMobil, Sumitomo, Total, ConocoPhillips, and Dow Chemical come to mind.
The one thing that sets oil production apart from other industrial activities, including downstream oil activities, is that it is in oil production that the rents accrue – huge rents. These rents, like all rents or windfalls, belong in principle to the resource owner, the people of Iraq. However, they will not accrue to the people unless a mechanism can be devised to capture them. The obvious way for the Iraqis to remain in control of their oil wealth and to capture all of the oil-related rents is to leave the Iraq National Oil Company intact and to put it in charge of all upstream operations. If so, can they on their own attract the funds that will be needed to restore production to or beyond pre-war levels? The answer is yes, because essentially no exploration and not much new development is needed, and the funds that will be required are dwarfed by the wealth represented by already proven but undeveloped reserves.
The five fast-track fields originally under consideration for the technical support agreements were already under production and were fully connected to the existing oil infrastructure, but they have never been developed to produce anywhere near full capacity. Raising production from these giant fields by 100,000 b/d each requires the drilling of extension and in-fill wells, workovers and recompletions on existing wells, the rehabilitation of existing surface lease facilities and the addition of new ones and, in some of the older fields, Kirkuk for example, well stimulations, water control projects, and secondary recovery operations. That requires considerable experience and financing.
The Iraqis have the experience, but financing, at least cash financing, is another matter. However, Iraq does not lack in resources it can pledge. The five technical support agreements offered by the Minister of Oil had a combined price tag of $2.5bn. Assuming a net revenue of $100/B, the loan required for the development of 500,000 b/d of productive capacity would be a minute fraction of one percent of the value of Iraq’s proven reserve base: 0.022% to be exact. Pledging $2.5bn against that base would be like securing a $250 loan by pledging a fully paid-for readily sellable asset of $1.2mn as collateral. With that kind of collateral, there will be no shortage of commercial or governmental (bilateral or multilateral) credit institutions eager to supply the capital needed to rehabilitate oil production in Iraq, provided of course that peace and tranquility reign in the country which, increasingly, they do. The payout on the $2.5bn investment would be a matter of months, once production is under way.
Given the fact that Iraq has the proven reserve base from which to proceed and that the investment required to get Iraq production back on par is minimal, the question is whether the country has the technical know-how and the financial wherewithal to do it on their own. As to the technical know-how, the Iraqis have been producing oil for the last 36 years, ie since they assumed control of their petroleum industry in 1972. They are quite capable of boosting production without the help from international oil companies. They have the experience, they have a lot of practical know-how, and they are known to be inventive and flexible. Moreover, it is widely acknowledged that the deterioration of the oil infrastructure is more a reflection of severe decade-long budgetary constraints imposed during the Saddam Husain regime and wanton destruction thereafter, rather than a lack of know-how. Whatever the Iraqis don’t have by way of technological advances, they can acquire through outsourcing in the open market, much like the multinationals do when they turn to seismic firms for exploration, drilling firms for drilling, logging firms for geological reservoir delineations, reservoir engineering firms for reserve definitions and production optimization, and equipment manufacturers for surface equipment rehabilitation.
Minister of Oil Husain al-Shahristani said as much this past April, when he grew impatient with the oil companies’ slow response to the technical support agreements, pointing out that “June is a bit late. If they are not ready by then we might not really require technical service contracts... we may drop them if they are not signed soon.” June came and went, and so did July and August, with no western service contract in sight, at which point Mr Shahristani proved that he meant what he had said by signing a service contract, reportedly worth $3.0bn, with China National Petroleum Corporation (CNPC) to develop the Ahdab Field.
Final Observations
Time and space do not permit dealing with some significant issues that need to be resolved, if Iraq is to gain the trust of international partners. The greatest risk by far associated with the establishment (or, in the Iraqi case, continuation) and use of a national oil company is political interference, well-meaning, misguided or fraudulent. Labor practices are among the most prominent of well-meaning but grievously costly errors. Errant workers at all levels must be subject to corporate discipline, including the ultimate corporate penalty, dismissal. If a corporation does not have that tool available, and in justifiable cases with minimal bureaucratic entanglement, a situation as observed on the bulletin board of one unnamed non-Iraqi national energy company may arise, where management asked their employees to please remember that work begins at 8:00am and not after 10:00am as commonly practiced, and that it really is unacceptable for them not to show up at all for days at a time. That is a company out of control, and its performance in terms of work efficiency and asset maintenance shows it.
The risk of misguided political interference covers the imposition of political criteria on corporate decision-making, at times for the noblest of causes. Using the corporation as an employer of last resort to “fix” otherwise intractable unemployment problems, allocating capital funds for local economic stimulation, developing marginal fields in deprived ethnic areas while higher prospectivity projects are available elsewhere, these and many similar practices are things that profit-driven corporations will avoid. Finally, the risks associated with fraud and corruption are likely to be more prevalent in national companies and are a realistic danger to guard against through appropriate corporate oversight, especially when salaries are deliberately kept low as they are in many countries that are trying to avoid structural salary imbalances.
Pemex, the national oil company of Mexico, is a prime example of where things can go wrong when political rather than technical and financial criteria are used in an oil company’s decision matrix. The company is the sixth largest oil producer in the world. It has been producing well over 3.0mn b/d over the last six years, averaging 3.66mn b/d since 2000. Yet, Pemex is facing serious technical and financial difficulties. Its reserve base is declining, its refineries are inadequately maintained and have not been able to keep up with domestic consumption with the result that Mexico now imports more than 25% of its domestic gasoline needs. According to Pemex managers and Mexico’s Ministry of Energy, Pemex does not have sufficient funds available for exploration and investment, due in part to high financial burdens placed upon the company by the Mexican government. Simply put, the company has been used as a cash cow of the national treasury. A flat 61% tax on revenue, recently reduced to 51%, has saddled it with so much debt (more than $75bn, including pension obligations) that the company has had a negative net worth since 2002 and has the distinction of being the world’s most indebted oil company.
However, the treasury is not the only institution apparently milking Pemex for all it can. There are allegations that corruption permeates the company and that political patronage and nepotism are rampant. The company is said to lose at least $1bn a year to corruption and it has been accused of participating in election fraud schemes through illicit campaign contributions. All of these activities are real threats to state-owned companies loaded with cash, including the Iraq National Oil Company.
Ideally, a national corporation needs to be run like a private corporation. That includes the development and enforcement of strict ethical standards, freedom to contract with corporate and financial entities, and reasonable criteria in setting their own budget, subject of course to enlightened governmental oversight through an independent board or commission that conducts general and targeted audits through independent accounting firms of international stature. This board would function much like a regulatory commission with power to establish a corporate accounting system and defining allowable expenditures. Managerial autonomy and unfettered corporate governance must be balanced with strict accounting and other controls.
Again an example comes to mind in a country where funding was slow to react to unexpected needs in a state-owned refinery where an explosion of a reformer had shut down the refinery. Funding for repairs was not approved for 14 months, due mostly to bureaucratic foot-dragging and strict adherence to budgetary procedures and cycles, with the result that a frustrated but otherwise competent technical staff had to stand by while the refinery was kept idle. This sort of thing is not likely to happen in a Shell or ExxonMobil refinery, where funding for emergency repairs is based pay-out rather than in competition with urgent national funding needs in other areas such as for water supply, electricity generation, or anti-poverty programs.
To achieve the near-autonomous corporate structure advocated here for the Iraq National Petroleum Company, the Ministry of Oil should limit itself to what ministries are meant to do: monitoring and guiding national petroleum policy and submitting legislative proposals to parliament (through the office of the head of government) and enforcing the laws that emerge from it. In Iraq’s case, that obviously also involves representation at OPEC where more than operational issues are on the table. The Ministry of Oil should not be actively involved in any of the national oil company’s day-to-day operational activities. The stakes are simply too high to ignore this fundamental axiom of separation of powers.
Iraq is currently near the bottom of the International Corruption Perceptions Index, where it ranks as the third lowest of 183 countries evaluated, ahead of Somalia and on par with Myanmar. By comparison, Denmark is listed as the least corrupt country, and the US ranks number 18, on par with Japan. Iraq’s low ranking is no doubt in part a legacy of the Saddam Husain Regime, but corruption is and continues to be rampant in Iraq. Political interference, corruption, and unions represent Iraq’s current dilemmas which the country has to address – with or without foreign involvement.