Rebuilding Iraq on Shifting Legal Sands

Contract Negotiations | Development Challenges | Oil Legislation | A Way Forward

With no end in sight to the political impasse over its oil law, Iraq's central government is proceeding with negotiations to develop the country's largest fields, in partnership with several international oil giants and a handful of Iraqi companies.

Though the Iraqi government has set aside its earlier offer of no-bid development contracts in favor of a more transparent and open bidding process, the country's lack of a clear legal framework continues to hinder international engagement in the country's oil sector, and to prevent Iraq from maximizing its oil output to the global energy market.

Contract Negotiations

Over the past year, the Ministry of Oil has been engaged in negotiations with a number of hand-picked oil majors-including Exxon, Chevron, BP, Shell and Total-over the terms of technical-service contracts meant to boost output from Iraq's main producing fields. These no-bid contracts were envisioned as a stop-gap measure pending substantial long-term development agreements, and proposed two-year consultancies aiming to boost the output of Iraq's main producing fields from 2.5 to 3 million bbl/day, at a reported cost of $500 million USD per field.

However, instead of signing these proposed short-term contracts at the end of June 2008 as was anticipated, Iraqi Oil Minister Hussein Al-Shahristani announced the launch of a bidding round for longer-term development contracts aimed at boosting the capacity of the same fields up to 4 million bbl/day, and also adding the development of two new natural gas fields. This tender, which will take a full year to complete, will be open to thirty-five companies short-listed earlier this year, and an additional group of six national oil companies.

The companies involved in the short-term negotiations were selected without competition. Though these are service contracts, not investment contracts, and the companies would not acquire an equity stake in Iraq's oil sector, such contracts are required by law to be awarded through a competitive process.

It was originally assumed that the companies negotiating the stop-gap agreements would have an advantage in the tenders for long-term contracts, through an opportunity to match the winning bid or a requirement that the winning bidders enlist them as partners. This would have reduced the legitimacy of the tenders. The Oil Ministry now denies such intentions, saying that all competitors will have the same rights.

The negotiating parties were also exploring the option of payment in crude oil. This would have been more lucrative for the companies, who would have had access to a guaranteed supply of oil in a tight market, and to the Iraqis, who would have avoided the need for cash payments. It would also have enabled Iraq to direct its resources to other urgent investment priorities, particularly public services. However, this approach contradicts prevailing UN Security Council Resolutions which set strict mechanisms for the disposal of Iraqi oil. Such payments could also contradict the Stand By Arrangement with the International Monetary Fund, a standard that is required for the Paris Club cancellation of Saddam era debts. In the end this notion was apparently abandoned.

Minister Al-Shahristani has indicated that the contracts awarded in the current process will follow a service model similar to the one currently in use in Saudi Arabia and Kuwait, and thus will not grant any foreign company an equity stake in Iraqi oil assets. As the Minister put it: "This is Iraqi oil and we do not intend to share it with anyone." He added that the companies' desire for a share in oil output was one of the main impediments to the signing of the short term no-bid contracts.

The minister also criticized foreign companies for their reluctance to station their own personnel in Iraq. The oil companies involved in negotiations for the proposed short-term contracts had sought to provide long-distance technical assistance, but Iraq is now stipulating that bidders for long-term contracts open offices in Baghdad, operate inside Iraq, and enlist Iraqi partners for at least 25% of the contracts.

These statements mark a clear departure from earlier indications that Iraq might now be friendly to foreign oil ownership, and the change could indicate a hardened central government position on the issue.

Development Challenges

Though Iraq's position may be growing more inflexible, the national and international oil sector cannot afford to remain on the sidelines of production. Iraq has the world's largest remaining deposit of so-called "traditional" (i.e., easily accessible) oil. Yet many companies apparently remain concerned about the safety of their staff in Iraq, and discouraged by the challenges of the contract negotiation process . Foreign countries face slow and confusing negotiations for short-term, no-bid contracts and for competitive long-term agreements. The on-again, off-again nature of the negotiations, their overall lack of transparency, and most of all, the absence of a comprehensive and predictable legal framework governing Iraqi oil remain major obstacles to development.

The continued instability that has threatened more than once to consume the country has also eroded Iraq's ability to use its own resources in the oil sector and its capacity to negotiate or manage complex investments. Like other state institutions, the Iraqi Oil Ministry has suffered during nearly two decades of sanctions and war. Many skilled officials were purged, or have fled or retired. Iraq's negotiating team has only one member with the experience of negotiating oil deals like those currently on the table.

Though there has been some progress due to improved security and redoubled efforts by Iraqi technocrats to repair the machinery of the state, it is unlikely that Iraq will be able to spend the $100 billion USD it is expected to earn from oil exports this year.

Nonetheless, the new contracts are vitally important for Iraq. The fields in question-Iraq's main breadwinners-are mostly mature giants which have suffered from neglect and abuse in the past. They are in need of urgent maintenance to prevent irreparable damage and precipitous decline in output. The Iraqis do not have the technology to perform such maintenance which could present even greater challenges than the development of new fields. The work will require the participation of experienced international companies.

If successful in boosting output, the contracts would also reduce the pressure on the stalled negotiations over a new hydrocarbon law. The legislation touches at the very foundations of the new Iraqi state, its economy and the way it is to be governed. The violence and the inadequacies of the political process have hampered open and inclusive debate among Iraqis on these issues. Space and time are needed if the process is to produce a genuine, legitimate compromise that all Iraqis can accept.

Oil Legislation

Iraq's numerous attempts to craft oil legislation to govern revenue and power sharing remain deadlocked. Any durable consensus on a new oil law clearly requires more time and trust. Yet the fields in question require immediate and expert maintenance. Iraq and the global energy market urgently need the added output, which could be up to 1.5 million bbl/day.

Whatever the outcome of the stalled negotiations, the fields in question are expected to remain in the hands of the central government, under the control of the Ministry of Oil or the state-owned National Oil Company.

It is the newer fields that are mired in internal controversy. The Kurdish Regional Government is seeking more decision-making power for the regions and greater private sector involvement than contemplated by the central government. But Kurdish officials and the federal government are in stark disagreement over state ownership and control of oil resources and revenues.

Despite the absence of a national strategy, the Kurdistan Regional Government has signed nearly 30 production-sharing contracts for fields in and around the Kurdish region since early 2007. These contracts were signed individually with several small and medium size international oil companies, as well as private and state-owned partners from inside Kurdistan.

Most significantly, the Kurdish contracts allow for foreign equity participation and ownership of Iraqi oil. The federal government has refused to recognize the validity of these contracts and has proceeded to black-list the companies who signed them on the premise that they have broken Iraqi law. While the Kurdish contracts may be in conflict with the federal government's policies, they follow Kurdistan's own legislation passed last year, on the basis of the region's interpretation of the constitution. Clearly, the coexistence of two radically different models for the development of industry between the center and Kurdistan is not sustainable.

Hope for reconciliation may lie with the national legislation currently pending, which is meant to govern investment in the oil sector, manage revenue sharing among Iraqis, and standardize power-sharing arrangements between federal and regional governments.

This legislation is Iraq's first significant attempt to engage with big oil since the nationalization of the oil industry in the early 1970s. As such, it is receiving intense scrutiny at home and abroad, especially because if Iraq is successful in reaching consensus on hydrocarbon legislation, these laws will have a great influence on Iraq's future oil industry and on the shape of the Iraqi oil sector.

Until legislation is finalized, Iraq and its local partners need support to ensure an efficient, transparent and equitable process. By setting high standards of transparency and fairness, officials can help guide future engagements and avoid backlash from a skeptical Iraqi public.

A Way Forward

Iraqi oil revenues are ballooning. They are expected to exceed $100 billion USD this year. This historic moment offers what may be the last opportunity to influence Iraq's oil policy. It is imperative that disclosure and integrity mechanisms be enshrined in the management of Iraq's oil sector and revenues.

Effective improvements of this kind, would best be achieved through the involvement of the World Bank's commercial lending arm, the International Finance Corporation. By supporting the contract negotiations, the IFC could assume its traditional role, offering guidance to private investors in emerging markets, as well as co-financing and superior insights into local conditions. The IFC could also help develop a transparent and accountable financing mechanism that complies with international practice and standards. Most importantly, it would enhance the legitimacy necessary for the long-term success of the process.

At this formative moment for Iraq's oil sector, the country's leaders must work to enshrine disclosure and integrity mechanisms in the management of Iraq's resource revenues. Iraq's endorsement of the Extractive Industries Transparency Initiative (EITI) in early 2008 is a positive step that demands attention and support from G8 governments. Iraq is the largest oil producer so far to join the EITI, an international standard for ensuring transparency in the management of oil, gas and mining revenues.