Oil and gas policy, laws and contracts are not written in a vacuum. They reflect cultural and political pressures, a country’s economic needs and geological complexity. The terms and conditions of an oil and gas contract are normally governed by a national Petroleum Law whose details reflect the country’s cultural, political, economic and fiscal policy. Where there is a Petroleum Law, a contract complements the terms and conditions of the law; an absence of law requires very detailed contracts.
It is thus important for oil and gas exploration and production (E&P) policies to determine a country’s target plateau output, reserves to production ratio and regional development priorities. Factors to be considered include: Viewing any one field’s reserves within the context of the country’s reserves as a whole; economic feasibility of development; national economic and social needs; and supply and demand economics (both local and global).
Oil field development ought to be carried out under a composite master plan setting out uniform development specifications and examining relative capacities of discovered and producing fields from a technical and economic perspective. The plan should take into consideration the country’s economic development needs and future plans. This necessitates centralization of policy and planning.
However, in today’s Iraq the integration of these various aspects is lacking. There are conflicting policies between Baghdad and the Kurdistan Regional Governorate (KRG). Meanwhile, the central Ministry of Oil (MoO) has adopted an oil and gas policy based on the old plan for the years 1988-89 and 1990 and a draft petroleum law. The plan of 1988-89 entailed three production capacity targets: 4.2, 6 and 8mn b/d, revised downwards in 1990 to 4.2, 5 and 6mn b/d, respectively. The plan involved further development of current producing fields in bidding Round-1, and of discovered semi-developed fields in Round-2. Further rounds then followed.
The first two major bid rounds awarded fields containing some 82bn barrels of proven reserves, 71% of the country’s total: three further rounds followed. The first two rounds, in June and December 2009, saw eleven long-term oil development service contracts awarded mostly to the world’s largest international oil companies (IOCs), including ExxonMobil, Royal Dutch Shell, BP and CNPC. The objective was to increase Iraq’s oil production capacity from around 2mn b/d to around 13mn b/d in seven years. The third bidding round, held in October 2010, awarded three gas field development contracts. The fourth awarded twelve oil and gas (mostly gas) exploration and development service contracts. A fifth round is currently in hand.
IRAQ’S PETROLEUM LAW
The overall objectives of the MoO’s first draft of Iraq’s Petroleum Law were to optimize oil and gas exploitation, maximize returns and unite the country. It aims to unify policy and plans across Iraq. Central decision making involves the participation of the provincial regions and governorates.
Supervision of oil and gas operations is shared between the provinces and the central MoO with a web of checks and balances to enhance transparency and minimize corruption. The draft broadly defines the authorities and responsibilities of the central government in consultation with the provinces. All model contracts are required to honor the following five main principles:
• National control of resources;
• National ownership of resources;
• Optimize national economic rent;
• Appropriate return on investment;
• Provide reasonable incentives to IOCs in order to achieve solutions for Iraq which are optimal in the long-term: including the use of improved and enhanced recovery, technology transfer, training and development of Iraqi personnel and optimal utilization of the infrastructure.
In general, contract models can take the form of a concession, or offer payment for defined services. In a concession contract, the state grants rights and privileges to a contractor to carry out exploration and production for oil and gas. The state collects tax and royalties leaving a fair return on investment for the contractor with, invariably, an incentive to optimize operations and oil and gas recovery. The extent of these rights and privileges can vary widely.
In a service contract, as the name implies, the state or its national oil company (NOC) hires the services of a contractor in accordance with terms and conditions to carry out outlined oil and gas exploration and/or production services, while remaining the ultimate decision-making authority. In traditional concession contracts the state collects tax on profits and royalties at a predetermined level on the produced oil. Other types of concession contracts include Joint Ventures and Production Sharing Agreements (PSA) over relatively long contract durations.
Service contracts take many forms, from engineering, management and other technical service contracts, to oil and gas exploration and production service contracts for a fee over a relatively short duration. The buyback contract model defines capital investment and operating costs for oil and gas exploration and/or production services and pays a predetermined return on the investment. The hybrid contract model combines features from concession and service contracts. Baghdad’s service contracts have been of a hybrid nature, with PSA features for defined services and paying a predefined fee in kind or cash.
PSA MODEL CONTRACTS
PSAs are widely accepted by most IOCs and some host countries, but have had a bad press within Iraq. The PSA is generally very detailed, covering almost every technical and fiscal aspect, the role of the oil company and the government’s regulatory and supervisory functions. It leaves little room for the state’s petroleum law to apply. Its life stretches to 20, 30 or 40 years without review.
Production is shared between the state and the IOC as partner or contractor. First ‘profit oil’ is calculated by subtracting from the total production the costs of investment and operations, in terms of barrels of oil (using on-going current prices), ‘cost oil’. The percentage ceiling for ‘cost oil’ is typically between 20-40% and seldom exceeds 50%. The profit spilt naturally depends on prevailing crude prices. Economics feasibility calculations are usually used to help determine the state-IOC profit split. This in turn determines the IOC’s return on investment. This, in a cash discounted form, is typically in the range of 10-20% internal rate of return (IRR), reflecting the commercial and political risks. Management decisions are made through joint committees.
Typical contract duration used to be 30-50 years but changing awareness of producing countries and higher crude oil prices have let it fall to a typical 20-30 years. PSA contract lengths depend on the oil prospect under exploration and the likely production life cycle of the prospective fields, in addition to the duration of the payout, which is dependent on the anticipated investment and IRR.
A PSA is classified as a concession contract because the state concedes its right to decision-making in the management of the natural resource, which then is shared with the contractor. This lack of autonomy is the major obstacle for its adoption along with the fact that the IOC assumes ‘ownership’ of a share of the resultant production. As such, critics say PSAs encroach on state sovereignty.
THE SERVICE CONTRACT MODEL
In service contracts, as the name implies, the contractor is employed to carry out a specific task, be it exploration and/or development, invariably for a predetermined fee and specific duration, usually only a few years. Iraq’s MoO has since the 1990s used a wealth of PSA/service contract hybrids to cater for different exploration and production rights. They include: Development Production Contracts (DPC); Exploration Production Contracts (EPC); Exploration Development Contracts (EDC), and Field Development Contracts (FDC).
The FDC was modified to make the Iraq Production Field Technical Service Contract model (PFTSC) used in the key bidding Rounds 1 and 2 of 2010. Iraq’s first draft oil law included a PSA modified into a hybrid service contract proposed by the Iraq National Oil company (INOC). However this option was ruled out to avoid confusion with the standard PSA.
The EPC model was used in a number of pre-1999 contracts with IOCs, but none were signed. After the exploration period, the contract follows DPC model terms from commercial discovery onward.
The EDC becomes an exploration service contract post-commercial discovery. The fiscal terms are negotiated and agreed as an FDC to attain a fair return for the contractor. Two such contracts were signed and ratified in 2000 and 2002 with ONGC and Pertamina on Block 8 and Block 3 respectively.
A DPC model governed Russian and Chinese contracts of 1997, in which the profit split was constant. Through use of a price cap mechanism and R-factor windfall profits to the contractor, arising from price increases above a certain base price, are avoided. The ‘R-factor’, cumulative revenue divided by cumulative cost, exerts downward pressure on profits, preventing windfall profits to the contractor. The R-factor and a profit cap offer protection for both parties. Their use safeguards the right of the state to benefit from higher prices and increased production and protects the contractor’s depressed return from unforeseen higher costs.
The FDC model is the equivalent of an oil Field Technical Service Contract (FTSC), originally derived from the Iranian buyback model but modified to offer an option to the contractor to purchase up to 20% of output at market prices for 15 years from the date of contract handover. Contract duration was theoretically set at 10-12 years, based on then prevailing low crude oil prices; this was cut by around half when prices subsequently rose sharply. A handover date to INOC, by the end of the duration term, took place on the first payout (when the contractor had fully recovered investment costs). The FDC model governed 2002 contracts with Petro-Vietnam.
There are many other forms of service contracts. The Engineering Procurement Contract (EPC) was widely adopted in Iraq during the 1990s but lost its luster post-2003.
Buyback is a form of service contract, widely used in Iran, whereby the return on investment is pre-determined as compensation for services to be rendered in the exploration and/or production of oil and gas.
In the PSA, the contractor is given a defined limit for the ‘cost oil’ and ‘profit oil’ share for a fair return on investment. This is normally defined as the internal rate of return (IRR) when discounted based on project cash flow using anticipated production, investment schedules and revenue over the term of the contract. The price cap mechanism and R-factor serve to protect against unforeseen changes to fiscal parameters, such as price, production rate and cost.
The MoO’s FTSC adopted an R-factor. It fixed remuneration per barrel of built capacity, subject to the R-factor, but did not tie it to a ‘profit oil’ cap. As a result, increased costs lead to higher remuneration, which in turn provides an incentive for the contractor to spend, sometimes ‘gold plating’ goods and labor.
The duration period was 25 years; long enough to cover the whole development cycle, from initial production to plateau and decline. The duration is being renegotiated for some fields with extensions to 30 or 35 years, although the MoO has not transparently published either signed or modified contracts.
Partnership on a service contract basis between NOCs and IOCs could have provided a balanced policy option for Iraq. Theoretically, it provides technology transfer and management, eases capital investment needs and ensures orderly exploration and/or development and oil marketing. It also facilitates the option of IOCs being paid in kind, as in a PSA. However, once capital investment is provided by the IOC, it implies shared decision-making. As such, the state is no longer the sole decision-maker, opening up service contracts to the same objection as with PSAs.
The Production Service Contract, as the name implies, leaves the state’s sovereignty intact. It generally pays the contractor in cash or kind. It is applicable to the exploration and/or development phases or part thereof.
Erbil has unilaterally enacted some 50 oil and gas exploration and development PSAs. Among the many shortcomings of these agreements are:
• Noncompetitive and nontransparent negotiations, with the resultant contracts not published until years later, and even then apparently not in full.
• IOCs granted a high profit share of up to 50%, tantamount to windfall profits. In contrast, a few years ago Libya’s PSAs managed to grant as low as 7%. Today, with oil prices around $100/B, and given Iraq’s low exploration and development costs, the oil profit share for field development should be as low as 1-2%. This could go as high as 5-10% if capital investment costs double or triple, as could be the case with frontier exploration (though exploration success in Kurdistan has proved to match past exploration throughout Iraq).
• High front-loading of expenses, 50% or more in a few cases. (PSAs traditionally allow in the region of 20-30% of the production stream towards payment of contractor costs, unless in areas of very low prospectivity.)
• Agreements lack ‘local content clauses’, so there is no obligation to partner with local firms (Iran and Russia stipulate a local partner takes 51%, and Norway 70%). such partnerships ensure the transfer of management and technological know-how, build up private national enterprises and help retain a large percentage of wealth in the country.
• The KRG took a unilateral decision to manage oil and gas resources, not just within the three Kurdish governates, but also in contested areas, without reference to Iraq’s central government, the national parliament, nor the MoO, forcing the latter to pursue its own development policy.
• The climax was the takeover of the Khurmala Dome, one of the domes of Iraq’s key Kirkuk oil field. Oddly enough, the central government has remained silent: Deputy Prime Minister for Energy Affairs Husain al-Shahristani initially condemned the act but later appeared to acquiescence!
• Above all, these KRG agreements are incompatible with Iraq’s constitution and have not had central parliamentary approval.
BAGHDAD’S SERVICE CONTRACTS
The central government has adopted the following service contract model for oil and gas exploration and/or development:
• Producing Field Technical Service Contracts (PFTSC) were applied under Round-1 to oil fields already producing for decades, such as Rumaila and Zubair, with a view to further production capacity development and to improve and enhance recovery.
• In Round-2, Oilfield Service Development and Production Contracts (OSDPC) – PFTSCs with minor modifications – were awarded for discovered fields which are partially or not yet developed, such as Halfaya, Majnoun and West Qurna.
• Gas Field Service Development and Production Contracts (GSDPC) granted for four developed gas-producing fields.
• Service Exploration and Production Contracts (SEPC) for new exploration areas, mainly gas-prone, of which two contracts have been enacted.
• In conformity with the constitution and the MoO’s own draft Petroleum Law, the MoO began negotiating a Technical Support contract with IOCs for 1-2 years to support the further development of 500,000-600,000 b/d from producing oil fields, only to abandon it after many months of negotiations.
A consultancy contract was awarded to a foreign consulting firm (believed to be owned by an American service contractor with interests in Iraq) on non-competitive basis. A technical support service model contract for producing oil or gas fields was prepared by modifying the MoO’s 1990s contracts into a long-term IOC-financed service contract, one assumes by the consulting firm, to meet MoO’s forthcoming bid rounds.
Baghdad has enacted 14 PFTSCs and OSDPCs, of which 12 alone encompassed 82bn barrels of oil reserves and envisaged production capacity of 12-13.5mn b/d. These awards were via a competitive and televised tendering process (albeit with serious flaws), though contracts have not been published in full.
The Service Contract model is unique in the sense that it is a long-term contract (20-25 years) and calls on the contractor to provide the capital investment: service contracts are traditionally for a short duration (1-5 years) and financed by the government (in cash or loans).
Among the shortcomings of Service Contract terms and conditions are:
• The model contract is a hybrid model of service and production sharing principles. It adopts a PSA decision-making process, which is the very principle that differentiates the PSA agreement from the service contract! The Service Contract model preserves state sovereignty by retaining decision-making power, while PSAs share decision-making with the contractor (in joint committees of government and the company). In Iraq’s service contracts, the contractor is in the meantime the investor, as in the case of the PSA, and hence the company becomes entitled to share in the decision-making process.
• Awards were made to the lowest offer, at or near a magical figure of $2/B of built capacity. Whilst it is difficult to make an overall statement on whether $2/B is adequate, too high or too low, for the Rumaila field, according to our in-house economic feasibility calculations, $2/B provides the company with a 30% discounted rate of return (IRR) on investment, on account of the 50% front-loading of the company’s low capital expenses (around $2/B) and a 2-year payout (the period during which the company returns its capital investment). This means that the company’s future capital investment would be paid back the same year, as if it were operating costs. The application of $2/B cannot be universally applied to all fields regardless of their size or complexity. West Qurna, for example is geologically complex with a production rate per well only a fraction of Rumaila’s, meriting higher remuneration. As such, each field merits different per-barrel remuneration commensurate with its well productivity and related geological complexity.
• The granting of rights is given to the bidder with the lowest remuneration without prior assessment of their proposed oil field development plan to ensure that the plan achieves optimum oil recovery at the least unit cost. This should be included in the tender specification.
• There are many reasons to make one wonder why Baghdad failed to adopt what it initially intended, the traditional Technical Support Contract, through which it would have retained decision-making as a sovereign state! After all the government (in accordance with the speedy 50% loading of cost) and low investment capital (some $1-1.5/B for the giant producing oil fields) paid for investment in the very year it was made. It may sound unbelievable that the traditional concession agreement pays capital investment back in 10-20 years and some PSA models pay back the investment similarly through a system of lengthy amortization of intangibles and depreciation of tangible assets.
• Baghdad encouraged in its tender conditions field development plans with high plateau production. This is not necessarily consistent with the overriding requirement of optimum recovery and lowest unit costs.
• The contract pays remuneration per barrel. This increases as cost rises, encouraging gold plating procurement instead of the right quality for the right price.
• The contracts provide a long (20-25 years) duration for a service contract. As mentioned above, this is unusual practice particularly for fields where services are confined to the further development of producing fields, which Iraq has been managing for many years. In such cases, technical support contracts over a few years would have been a better choice to provide the transfer of the latest state-of-the-art technology and management know-how, which Iraqi fields and Iraqi management need.
• These central government contracts share with the KRG agreements serious drawbacks for not having a local content clause or requiring the approval of the national parliament, which is the only and ultimate authorized representative of the nation. Strangely enough, even the Ba’ath era oil and gas laws in existence required parliamentary acts to become valid.
• The central government contracts, however, have achieved the vital role of placing Iraq and its oil on the path to meeting almost half of global incremental oil demand increases over the coming years. However, this vital role for the nation and the world requires additional conditions in order to be realized. These include stability to assure lifters of Iraq crude the long term security of supply and competent Iraqi institutions to manage, supervise and audit the oil industry and to meet the nation’s basic needs, including social justice in order to minimize if not eliminate the on-going ethno-sectarian practices, terror and assassinations and to create a society at peace with itself.
A partnership between INOC and IOCs on a Service Contract basis, under well-examined and selected technical and commercial terms and conditions ensuring an optimum return to the nation and a fair remuneration to IOCs, with incentives at critical junctions, could be viewed for Iraq as the balanced policy option. This should provide the transfer of technology and management know-how, ensure orderly exploration and/or development of oil and gas, and ease capital investment requirements through improved efficiency, while it provides the option for IOCs to be remunerated in kind or cash.
Such a service contract is characterized by a short time horizon. Once capital investment is provided by the IOC, it implies shared decision-making with the state. As such, the state is no longer the sole decision-maker and consequently the service contract shares the same objection levelled at the PSA.
However, service contracts, as the name implies, leave the state’s sovereignty intact. The model generally pays the contractor remuneration in cash or kind, and is applicable to the exploration and/or development phases or part thereof.
Ultimately, the devil lies in the details. This is where Iraq’s contracts have suffered. And, it is politicization that has been behind the devil.
*Mr Shafiq is a former Executive Director of INOC. This article summarizes key findings on present Iraq oil policy from his forthcoming book dwelling on the author’s 60-year Iraq and regional oil experience.