EXTRACTIVE INDUSTRIES

With proven reserves of over 115 billion barrels of oil and estimated reserves upward of 300 billion barrels, Iraq has the potential to be one of the largest oil producers in the world, second only to Saudi Arabia. Indeed, Iraq's reserves are the planet's single largest untapped pool of traditional (easily extractable) oil.

About 75% of Iraq's proven oil reserves are concentrated in the three southern governorates, with 25% in the middle and the north. The Kurdistan Regional Government (KRG) controls about 6% of these northern reserves (or 15%, if the Kirkuk area is included).

Iraq has other mineral resources, including largely unexplored reserves of natural gas, phosphates and other minerals, but these are dwarfed by its oil wealth.

Iraq's oil and gas reserves have been historically underdeveloped, both by the international companies who sought to keep output and prices under control, and then by Iraqi authorities who missed many opportunities due to political unrest, wars and sanctions.

Iraq's oil output peaked at 3.5 million bbl/day shortly after the start of the Iraq-Iran war in 1980. At the beginning of 2008, output stood at more than 2.5 million bbl/day, with exports over 2 million bbl/day, near the levels prior to the 2003 conflict.

Most oil is produced in the giant fields in the South. Kirkuk has been producing between 300,000-600,000 bbl/day. Disruption to pipelines is the main factor limiting production in that area, where production could potentially increase to 2 million bbl/day. Most associated gas is flared.

There are two main outlets for Iraq's oil: several terminals in the Persian Gulf in the South and a pipeline through Turkey in the North. Pipelines to Syria in the West and the Kingdom of Saudi Arabia in the South have been disused. Sabotage reduced Northern pipeline exports to almost nothing over the past five years, but this showed improvement in late 2007. As of early 2008, Iraq exports about 0.3 million bbl/day through the Northern route. These numbers are dwarfed, however by Iraq's potential output of 6-8 million bbl/day, given known reserves.

Historical Background

Before the establishment of the modern Iraqi state, oil was controlled by the Turkish Petroleum Corporation (TPC) which was formed in 1918 as a result of the Red Line Agreement. The TPC was owned in equal shares by the predecessors of BP, Exxon and Total, with an additional 5% owned by Galoust Gulbenkian. TPC had a concession area covering the entire territory of the just defeated Ottoman Empire, including Iraq. After the formal establishment of the modern Iraqi state in 1921. TPC’s concession area in Iraq was separated as the Iraq Petroleum Corporation which continued to manage Iraq's oil until nationalisation in 1970.

In 1960, the same year in which the Organization of Petroleum Exporting Countries (OPEC) was established in Baghdad, the Iraqi government revoked IPC's concession for 99% of Iraqi territory. IPC's new concession area was limited those areas where it had operations at the time. In 1970 IPC was fully nationalized.

Iraq National Oil Company (INOC) was established in the early 1960’s with a high degree of operational independence. Staffed by former IPC employees, it was one of the most efficient NOC's in the region. INOC independence and efficiency gradually eroded until it was abolished in 1987. Since then the Iraqi oil industry was run directly by the Ministry of Oil.

After a brief boycott in the early 1970's, international oil companies returned to Iraq but only as service providers. In the 1990's, Saddam Hussein signed several production sharing agreements with international oil companies. including Lukoil of Russia and China National Petroleum Corporation. In order to comply with the Nationalization Laws, each agreement had to be adopted by parliament as individual law.

There are currently no major international operators in Iraq's oil sector outside the Kurdistan region, where 25 mid-cap companies have signed Production Sharing Agreements (PSA's) in recent years. Output, however, remains negligible and there are no officially reported exports.

Most major IOC's have Memoranda of Understanding (MOUs) with the Ministry of Oil to offer pro-bono desk research and capacity-building services.

The Iraqi Government is currently negotiating technical service agreements with five oil majors including Exxon, Total, BP, Sheel and Chevron. The agreements covering five major producing fields aim to raise output by 100,000 bbl/day for each field within two years.

The oil ministry is also renegotiating some of the Saddam era contracts.

In February 2008 the ministry finished short-listing companies for a bidding round for long-term exploration and development contracts, with bidding expected in mid-2008. These contracts will have some form of risk sharing but it is not clear whether they will follow the Production Sharing format. Draft model contracts are delayed along with the rest of Iraq’s hydrocarbon legislation.

Revenue Management

Despite a raging conflict, Iraq generated over US$41 billion in oil revenues in 2007. Oil accounted for over 75% of GDP and 95% of government revenues. The economy is expected to grow by 7% during 2008.

Since the invasion in 2003, all Iraqi revenues from export sales of petroleum, petroleum products and natural gas are deposited into the Development Fund for Iraq (DFI) -an account held by the Central Bank of Iraq a the Federal Reserve Bank of New York.

The DFI is governed by UNSCR 1483 of 2003 and protected from creditors by a U.S. Executive Order. The DFI is managed by the Iraqi Ministry of Finance and administered by the Central Bank of Iraq. It is monitored and audited by the International Monitoring and Advisory Board (IAMB) which includes, among others, the controllers of the IMF and the World Bank. IAMB appointed international accounting firm Ernst & Young to audit the DFI on an annual basis.

Export revenues are deposited directly into the DFI. Expenditures from DFI are carried out on Checks issued by CBI on instruction from the Iraqi Ministry of Finance on the basis of the budget.

The budget which is passed as a law by Parliament is drafted by the Ministry of Finance in consultation with other Ministries, Governorates and the Regional Government. The investment (capital) budget is drafted with the assistance of the Ministry of Planning.

Budgets for 2005-2008 included a negotiated lump sum allocation for Kurdistan of 17%, after the deduction of sovereign and so called governing expenses, which include Ministry of Defence, Presidency. Prime Minister's Office, and Ministry of Foreign Affairs expenses, as well as Public Distribution System (food-basket) and any other in-kind transfers to the region.

Other Governorates have been receiving investment allocations, which doubled in each of the past three budgets, reaching a total of US$4 billion for all Governorates in the 2008 budget.

The KRG has not accounted for the spending of its allocation over the past 13 years (from 1995-2003 the KRG received an allocation of 13% of all oil revenues after deductions for compensation and UN expenses).

The 2008 budget requires that the Regions and Governorates account for the spending of their Grants. Although the Supreme Board of Audit has completed review of 2005-2007 budgets, they had not been approved by Parliament as of March 2008.

Emerging Legal Framework for Hydrocarbon Resources

The Iraqi constitution declares oil to be the property of the Iraqi people in all the regions and provinces. It calls for the sharing of revenues according to population, taking into account the legacy of the past. The constitution is not clear on the authority over the management and regulation of the oil sector, with the relevant articles wedged between those referring to the exclusive competencies of the Federal Government and those shared with the regions. In general the constitution envisions a high degree of decentralization.

Iraq has been developing a new legal framework for the management of its hydrocarbon resources since 2005. But negotiations between the national Ministry of Oil and the Kurdistan Regional Government (KRG) have not resolved fundamental disagreements over the distribution of power between the central government and the regions, and the role of the private sector.

While the oil ministry has sought to establish continuity with the national industry model, the Kurdistan Regional Government has argued for a highly decentralized and deregulated system , blaming centralization for inefficiency, abuse, and the repression that befell the Kurds at the hands of successive oil-financed Baghdad regimes.

A compromise was eventually reached, based on a plan to establish a separate transparent legal mechanism for revenue sharing in the from of the Financial Resource Law ,to reassure the Kurds and other regions of their fair share of revenues, while allowing a separate framework Hydrocarbon Law to provide for a more coherent management structure with the aim of maximizing revenues for all.

The compromise was built around the premise of undivided ownership of oil by all Iraqis. revenues.

It was envisaged that the legislation would proceed as a package of four laws, with an additional laws on the establishment of the Iraqi National Oil Company (INOC) and on the Reorganization of the Ministry of Oil. The framework Hydrocarbon Law was also to include annexes depicting the distribution of authority over oil fields and exploration blocks among the Ministry of Oil, INOC and the KRG. But these initial compromises collapsed in early 2007, and the Kurds then proceeded to adopt their own Oil and Gas Act and signed 20 contracts with independent international oil companies.

These contracts were awarded through a process that was neither competitive nor transparent, and without an agreed development strategy. Although the KRG asserts that the contracts comply with the region's own law and the region's interpretation of Iraq's constitution, they are clearly in violation of currently prevailing Iraqi laws, having entirely bypassed the government.

As a consequence, Iraq today has de facto two distinct and contradictory oil regimes. In the absence of new hydrocarbon legislation, the Federal Government still operates under Saddam-era laws which place the petroleum sector in the hands of the Ministry of Oil and prohibit foreign ownership of Iraqi oil. The Kurdistan Region’s Law gives final authority over the sector to the regional Government and sets Production Sharing Agreements as the main model for engagement with IOC's and the private sector in general.

The Ministry of Oil has declared the Kurdish contracts null and void and is "blacklisting" companies who signed them—these include DNO of Norway, Genel of Turkey, Addax of Canada, Crescent of the UAE, Norbest Ltd, an affiliate of TNK-BP of Russia, Korean National Oil Company, SK Energy Co Ltd, Daesung Industrial Co, Ltd, Samchully Co Ltd, Bum-Ah Resource Development Corp, UI Energy Corporation, GS Holdings Corp, Majuko Corporation, HKN Energy Ltd, a Hillwood International Energy subsidiary, Sterling Energy (International) Ltd, General Exploration Partners Inc, a wholly-owned subsidiary of Aspect Energy LLC, OMV Petroleum Exploration GMBH, a wholly-owned subsidiary of OMV AG, Kalegran Ltd , a wholly-owned subsidiary of MOL Hungarian Oil and Gas PLC, and Gulf Keystone Petroleum International Limited, a wholly-owned subsidiary of UK-listed Gulf Keystone Petroleum Limited, Kalegran Ltd Reliance Exploration and Production DMCC, a wholly-owned subsidiary of Reliance Industries Ltd, Heritage Energy Middle East Limited, a wholly-owned subsidiary of Canadian listed Heritage Oil and Gas, and Perenco Kurdistan Ltd, a wholly-owned subsidiary of Perenco S.A., Hunt Oil.

Meanwhile, the KRG continues to negotiate new deals.

Though the KRG's contracts were signed through a process that lacked transparency, it has actually has been more forthcoming with information than the Ministry of Oil, publishing draft laws, model contracts and basic information about signed agreements.

Output in Kurdistan is negligible and is mainly for domestic consumption. There are no declared exports, though there are unconfirmed reports of illegal trucking to Iran and Turkey.

Production in Kirkuk which is outside the official remit of the Kurdistan Regional Government is carried out by the North Oil Company on behalf of the National Ministry of Oil. Kirkuk is, however a disputed territory which the KRG seeks to annex. Under previous agreements the main Kirkuk fields were supposed to be managed by INOC. It is not clear what the intentions for them are now considering the collapse of the deal. Recently the KRG awarded a contract for part of the Kirkuk field to its own oil company. This field was being developed by the oil ministry until recently.