Dividing up the prize - Iraqi oil

What oil policy should Iraq have once it has a new government? While US media and politicians discuss Iraq’s elections, freedoms, weapons of mass destruction and intelligence failures, there’s one subject that they’re not talking about — the black stuff under the sand.

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By  Nicholas Wilson Published  January 8, 2006

|~||~||~|While US media and politicians discuss Iraq’s elections, freedoms, weapons of mass destruction and intelligence failures, there’s one subject that they’re not talking about — the black stuff under the sand.

Elsewhere, most people understand that the war was about oil, and that Uncle Sam’s tanks wouldn’t guard pipelines that snake across the desert if they carried water or cooking oil. As one Wall Street energy analyst put it: Iraq is “the most sought-after piece of real estate on Earth.”

While former president Saddam Hussein may take his final bow on the world stage from a scaffold, the most urgent problem for Baghdad’s new government is what it should do with the prize — the world’s third-largest oil reserves, some 115 billion barrels of it, with 90% of the country being still unexplored.

Iraq needs to get as much oil revenue as fast as it can to rebuild the country. It also needs to distribute it fairly to cool the largely Sunni-led insurgency. If Sunnis see new schools and sewers in their regions, they will be less hostile to what will probably be a Shia-dominated government.

And it needs to move fast. Last month the sound of Norwegian drills on Iraq’s border with Turkey resonated all the way to Baghdad, after exploration firm Det Norske Oljeselskap cut a deal with the Kurds’ regional government and struck oil.

The former federal interim administration’s Deputy Prime Minister Ahmad Chalabi and Oil Minister Ibrahim Bahr Al Uloum both want UK and US oil firms to be given first bite of the oily pie to thank their governments for liberating Iraq.
Iraq should do no such thing.

First, the original reason the chameleon-like allies gave for invading Iraq was to take out weapons of mass destruction. Tony Blair claimed that Saddam could have WMDs ready in 45 minutes after giving an order to prepare them.
Self-defence doesn’t need rewards.

Secondly, it may unfortunately look as if the victors are dividing up the spoils of war, and remind people of the colonial-like days when Henry Kissinger, assistant secretary of state said: “Oil is too important a commodity to be left in the hands of the Arabs.”
Such a move might explode under the new government and pour fuel on the insurgents’ fires.

However, massive amounts of foreign cash are needed because much of the impoverished country lies in ruins with empty coffers.

Inviting Arab and Indian oil firms to compete for the contracts would take the sting out of foreign firms operating on Iraqi soil.

With regards to contracts, the trick is finding the balance that pumps the least amount of oil money into overseas producers’ bank accounts, instead of into clinics and schools, while getting crude out of the ground as quickly and efficiently as possible. And it has to make it worth investors’ while to sink money into a high-risk zone. In short, a win-win deal is needed.

Should the energy sector be state owned and what is the role of foreign capital with its attached strings?

A government firm’s profits would be spent on public services instead of shareholders, and would be more responsive to state economic planning.

Private firms, however, face competition and are usually faster on their toes and more innovative than lumbering state-owned companies. Furthermore, markets punish any corruption, nepotism, over-staffing, idleness, bureaucracy or cronyism that make firms less efficient. Enron is with us no more, whereas some zombie-like state-owned firms litter the planet, leaking cash, being kept alive in their cosy cocoons by government protection for decades.

And when a government is almost entirely dependent on a monopoly for its revenue, it may have little interest in opening its operations to independent auditors or ecological watchdogs.

If Iraq, whose interim government complained bitterly about theft and corruption in its oil industry, does choose state-ownership, it still needs foreign investment.

It could go to the bond markets, which will demand very high interest rates due to the risks. Not everyone’s keen on lending money to a nation that may plunge into civil war if its government gets it wrong.

If Iraq turns to foreign oil firms, it would get cash, know-how and technology, but again at a price.

Baghdad could offer them service contracts (SC) where a specific job is done for a set fee, such as drilling a well to a certain depth, but these often attract little interest from big oil, as the rewards aren’t great enough. Mexico serves as a warning: It only offers SCs, resulting in a rusting industry that is due to become a net importer of oil by 2010 if radical changes aren’t made.

Another option is buy-back contracts (BBC), which offer firms a percentage return on the money they invest over a fixed period of time.

Iran serves as another warning: The majors don’t like its BBCs’ short terms (usually 8 – 12 years) and are unhappy with such deals in a high-risk environment. The result is massive, chronic under-investment and fields lying idle. Furthermore, under a BBC the government loses out if crude prices drop.

In production-sharing agreements (PSAs), which are typically long term (25 - 40 years), the private firm keeps a percentage of what it finds and has operational and strategic control. On occasions, big oil has managed to extract a rate of return on investment as high as 160%, whereas most businesses are happy with 10 – 15%.
Iraqi taxpayers may not be ecstatically happy with PSAs.
Another disadvantage of PSAs or unrestricted privatisation is the state’s loss of control of the commodity, which underpins the entire economy and provides 95% of its revenues.
Opec may require Iraq to raise or cut-out production. And the country’s six million barrels per day potential would give it global muscle, letting it single-handedly move oil prices at times of tight supply.

What government would want to hand over that power to private firms?

At the centre of the debate is risk.

The oil majors talk about the above-ground risk. At best their pipelines get blown up, and at worst the nation plunges into civil war.

And then there’s the other camel in the room that US media and politicians aren’t talking about — Washington’s powerful Israeli lobby. The combination of a possible Israel-Iran showdown, and the election of a Shia-dominated and perhaps pro-Iranian parliament in Baghdad, complicates calculating the Iraq investment risk. Iran’s president wants to “wipe Israel off the map” and go nuclear. Israeli intelligence says Iran may start its nuclear weapons programme this March, which Jerusalem calls “the point of no return,” and Tehran has warned Israel not to attack its reactors. (In 1981, Israeli warplanes bombed Iraq’s Osirak plant.) Israeli jets may have to fly through Iraq’s US-controlled skies to do this, and in any subsequent air and missile war, which would place Iraq firmly in the middle.

None of which brought Yuletide cheer to the hearths of investors who are eyeing the prize.

The Iraqis, however, point to the below-ground risks: There aren’t any.

“Wherever you dig in Iraq, you find oil,” said one Dubai-based analyst. And it flows easily and isn’t far from the coast, so doesn’t need much pipeline investment. There are almost-untouched, proven, giant oil fields such as West Qurna, Nahr Bin Omar and Majnoon. These are the prize’s crown jewels that may end up at an auction.

Next door, Kuwait’s parliament is considering an interesting proposal about its own fields, which may be an attractive model for Iraq — incentivised buy-back contacts (IBBCs). These would give foreign firms a fee per barrel found, de facto a percentage of the oil they find, which is linked to petroleum prices and the amount of money they invest. But they are not allowed to “book” reserves, and the Kuwaiti government keeps control over production levels, strategic management of the ventures and full ownership of petroleum and gas.

Another way to fill government coffers is good old-fashioned tax and royalties. Many countries have special — and high — tax regimes for oil firms. The UK charges hydrocarbon hunters a 50% corporation tax. These firms get off lightly when operating in the UK-controlled North Sea. Should they cross to the Norwegian side, the tax rates hit 78%. In Libya, they face 80% tariffs. Furthermore, taxes are more flexible than oil investment contracts and can be lowered or raised in accordance with crude prices and risk. Should the insurgency abate, then tax rates can rise.

The second question is how to keep the Sunnis happy and the insurgents away from oil installations.

The constitution says hydrocarbons belong to the whole country, and regional governments as well as Baghdad are responsible for managing oil and gas from existing wells. Oil income is to be shared out by quota to provinces based on their populations, with extra cash going to areas neglected by Hussein’s regime. It does not mention new exploration in current fields, which has made the Sunnis jumpy. They think the Kurds cut deals with foreigners to cut Sunnis out of the oil cash.

The politicians have to move quickly and decisively because outside parliament’s fortified gates, big oil salivates over the prize, rebels drop grenades down oil wells, and the sound of those Norwegian drills drifts down from the Kurdish mountains and reverberates across the Middle East.
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