19 September 2012
Since 2008, Iraq has been conducting a series of high profile oil and gas licensing rounds, with the Iraqi govern¬ment’s strategy being to increase its energy reserves and raise oil production from current levels of 2.5 million barrels per day (BPD) to 6.5 million BPD by 2014.
With the country having among the highest oil and gas deposits in the world (with proven reserves of 143.1 billion barrels of oil and 111.9 trillion cubic feet of gas), the previous three licensing rounds have been hugely popular, with the major international oil companies (IOCs), including BP, Shell, Total and Eni, competing hard and, in the process, accepting tough contract terms to secure a foothold in the region.
The fourth licensing round involved the auction of seven gas and five oil sites, with the focus for the first time being on the gas sites.
The results were announced on 30 May 2012 and, for the reasons consid¬ered below, display a far more muted response from the IOCs, with success¬ful bids being received for just one of the gas exploration sites and two of the oil exploration sites.
Lack of Proven Reserves
Each of the previous three licensing rounds offered rights to immediately commence or raise output at large and medium-sized sites with proven reserves. The fourth licensing round on the other hand, only involved areas with undetermined levels of hydro¬carbons on offer.
There was, therefore, little or no guaranteed return for the bidding IOCs; Abdul Al-Ameedi, the director general of Iraq’s Ministry of Oil (the “Ministry”), the government body responsible for the licensing rounds, admitted as much in an interview leading up to the fourth round when he said that “there is a higher risk [in the fourth licensing round sites] since the contractor could spend millions of dollars and find dry holes and lose everything he spent.”
Use of Service Contracts
Production sharing models, which typically give foreign companies the right to a portion of oil produced or profit made from sales, are used in Kurdistan and are the most com¬monly used model for exploration work of this type. The Iraqi govern¬ment’s belief is that such a model would be in contravention of Iraq’s constitution (which states that the oil and gas in Iraq is the property of the Iraqi people and therefore should not be shared).
The Ministry therefore, as with the previous rounds, insisted on using a “service contract.” Under the service contract model, IOCs are paid a fixed fee per barrel of oil or gas equivalent, subject to a tax at 35 percent. Furthermore, this fee is only payable once prescribed production targets have been reached.
While service contract terms have been acceptable to the IOCs in the previous licensing rounds, those have all concerned already producing, or production-ready, fields where the spoils on offer have been greater and more certain. It is almost unseen in the industry to ask companies to accept service contract terms for oil and gas exploration work. In particular, agreeing to a fee per barrel, which may be redundant or inappropriate when it comes to the point of production, carries with it considerable risks.
Tougher Contract Terms
Throughout the licensing rounds, one of the few redeeming features of the service contracts from the perspective of IOCs has been the fact that a service contract model does not impose a ceiling on costs and, under the terms of the contracts already signed, all costs are entirely repaid by the Ministry.
This benefit, however, has been countered in the revised service contract for the fourth licensing round, which introduced a new formula for the calculation of the fee per barrel (FPB), meaning that the IOC will only be paid the FPB on the remaining production after deduction of costs. This is aimed at increasing the cost-efficiencies of the IOCs with the cost of the subcontractors being deducted from total production (on which the contractors fee is determined). The example pro¬vided by the Ministry is that if total production is 1 million barrels and the contractor has spent the value of 300,000 barrels on a subcontractor, the contractor will receive payment only for the remaining production, or 700,000 barrels.
While one can see the reasoning behind this amend¬ment from the point of the Ministry, it has seemingly done little to incentivize the IOCs, which were already being asked to stretch themselves into accepting service contracts terms for exploration licenses, into bidding again, particularly as the terms of the revised service contracts on offer were otherwise broadly the same as those that have been signed in the previous licensing rounds, which involved production sites.
Restraints on Exploration and Production
The winners of the gas contracts on offer in the fourth licensing round are entitled to proceed to production immediately on discovery as the Ministry believes that gas is currently in short supply. Conversely, a clause has been inserted into the services contracts for oil sites giving the Ministry the right to impose a potential seven-year holding period on oil field discoveries, the purpose being to avoid the market being oversupplied and overwhelming Iraq’s underde¬veloped infrastructure.
The effect of impending OPEC quotas (which the Iraqi government has indicated they could agree to as early as 2014) were also of concern to the bidding IOCs. The quota figure that Iraq could be subject to is yet to be determined; however, it is thought likely to be around the 4.5 million BPD mark, which would make the Ministry’s plans to produce 6.5 million BPD by 2014 redundant.
The oil fields on offer are only exploration fields at this point; when combined with the fact that the contracts did not in any way account for the effects of OPEC quotas, it is easy to understand why the majority of the 48 IOCs that qualified for the fourth licensing round were put off by the prospect of investing in the exploration of oil fields. The possibility that any resulting production (and their potential for return given that rewards are linked solely to the FPB) may be curtailed by the need to constrict Iraqi oil production to within the confines of the OPEC quotas, as well as by Iraq’s underdeveloped infrastructure, would have clearly influenced the IOC’s decisions.
It is widely acknowledged, and has been a concern of the IOCs throughout the licensing rounds, that in order to handle the planned increases in oil and gas production, much of the existing infrastructure for both oil and gas production will have to be upgraded, and a considerable number of new structures will have to be built both inside and outside of Iraq.
Of particular relevance to the fourth licensing round—when, for the first time, the focus has been on gas—is the view strongly held by the IOCs (and shared in Iraq) that, in the long term, a more extensive gas infrastructure will be required to enable the country to access the gas pipeline routes in Turkey that supply the European markets.
The Kurdish regional government has signed 48 production sharing contracts with numerous IOCs, all of which the Iraqi government views as illegal. These agreements are far more lucrative for the IOCs than the service contracts offered by Iraq, because companies receive a share of the oil produced.
Controversially, several companies that are party to these agreements have been excluded from the licensing rounds in Iraq: Sinopec was excluded from the second licensing round, and US oil firms Exxon Mobil (which has signed six Kurdish produc¬tion sharing contracts) and Hess were excluded from the fourth licensing round, as a result of their dealings with Kurdistan.
The Iraqi government has formalized and strength¬ened its position in this respect by inserting a provision into the service contract on offer in the fourth licensing round that gives the government an automatic right of termination should a contractor subsequently engage in agreements with Kurdistan (or any other regional government).
It seems that the fourth licensing round saw the Ministry, buoyed by the successes of the previous rounds, asking IOCs to take too great a leap of faith. No attempt was made to address the IOCs’ concerns in the service contract structure for exploration work; indeed, if anything, the terms of the contract were made even harder to swallow.
The possible impact of OPEC quotas tied with the inclusion of a provision in the service contracts granting the Ministry complete autonomy over when to produce from an oil field in which reserves are discovered, makes it easy to see why the major¬ity of the prequalified IOCs chose not to participate in the bidding process. The reality is that the gamble the Ministry took by asking IOCs to bid a fixed fee (albeit slightly higher than the fees that have been on offer in the previous licensing rounds) on unknown reserves and production proved unsuccessful.
Nevertheless, the fourth licensing round was not all bad news: Block 9 near Basra, with its potential as an extension to the already producing Azadegan field on the Iranian side of the border (thus making it unlikely to be subject to a holding period once reserves are confirmed), may prove to be greatly profitable for the successful bidder, Kuwait Energy.
In the immediate aftermath of the fourth licensing round results, the Ministry announced that the state-owned Oil Exploration Company will search for oil and gas in the nine exploration blocks that were not awarded to IOCs and is planning a $160 million expansion to more than double seismic crews and equipment. The Ministry also announced that a fifth licensing round of 60 new sites would take place in the near future (with no date con¬firmed as yet).
It is hoped that the Ministry will have learned lessons from the results of the fourth licensing round and will look to revise its contract terms to make them more suitable to exploration areas and work.