Iraq Oil and Gas Regime - Part 1

by Reed Smith
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This article is part one of a two-part series on the Iraqi oil and gas licensing regime. This article serves as an overview of the political and legal issues affecting the current Iraqi oil and gas licensing regime. Part two will explore the model contracts currently employed by the Iraqi Ministry of Oil in greater detail and will highlight areas of concern – to foreign oil companies – that are deterring inbound investment.

Introduction

Iraq is currently the world’s eighth largest producer of petroleum and holds the world’s fifth largest proven petroleum reserves (currently estimated at 141 billion barrels). As only a small percentage of Iraq’s proven reserves lie in fields which are in current development, the Iraqi federal government (the Federal Government) through the Ministry of Oil (MoO) is keen to fast track the development of the country’s oil and gas reserves.

In the past few years, however, this planned development has slowed considerably because of various issues plaguing the Iraqi oil and gas licensing regime, to the considerable consternation of foreign oil companies (FOCs) keen on post-war participation. It is interesting that the greatest deterrent to FOC activity, in a region destabilised by post-war sectarian infighting, is not the resulting security issues, or inadequate, damaged, infrastructure, but uncertainty regarding the legal validity of certain, regional oil and gas exploration and production (E&P) contracts, and unfavorable provisions that the standard form contracts – approved by the MoO – seek to impose on the FOCs. Such have been the effects of these contractual issues that the FOCs seem to have all but lost interest in tendering for Iraqi licenses, as evidenced by the poor turnout in the most recent (fourth) Iraqi licensing round.

For a nation whose freedom from Saddam’s despotic rule has been marred by assertions that foreign military intervention was largely a power play for the country’s oil reserves, it is ironic that the major FOCs have as good as turned their attention away from central and southern Iraq, and northwards to Kurdistan, where the licensing regime is perceived as considerably more FOC favourable.

Federal Tensions

Iraq’s hydrocarbon resources are unevenly split along sectarian divides. The majority of Iraq’s hydrocarbon resources, approximately 60% of proven oil reserves, are located in the southern regions populated predominantly by Shiite Muslims. Approximately 17 percent of proven oil reserves are based in the northern, predominantly Kurdish regions. Central Iraq, which is predominantly Sunni, has comparatively few proven hydrocarbon resources. Three fields: Kirkuk in the Kurdistan region, and the North Rumaila, and South Rumaila in southern Iraq currently produce the majority of Iraqi crude oil, estimated at three million barrels per day.

The Iraqi Constitution (“Constitution”) , which was approved by referendum 15 October 2005 and came into force in 2006, provides measures for the equitable redistribution of the profits derived from hydrocarbon extraction across the country and, specifically, to assist regions which have been particularly damaged by the war. Article 111 of the Constitution states that “Oil and gas are owned by all the people of Iraq in all the regions and governorates,” whilst Article 112 states that:

“The Federal Government, with the producing governorates and regional governments, shall undertake the management of oil and gas extracted from present fields, provided that it distributes its revenues in a fair manner in proportion to the population distribution in all parts of the country, specifying an allotment for a specified period for the damaged regions which were unjustly deprived of them by the former regime, and the regions that were damaged afterwards in a way that ensures balanced development in different areas of the country, and this shall be regulated by a law. The Federal Government, with the producing regional and governorate governments, shall together formulate the necessary strategic policies to develop the oil and gas wealth in a way that achieves the highest benefit to the Iraqi people using the most advanced techniques of the market principles and encouraging investment.”

Constitutional Uncertainty

Issues arise regarding which aspects of hydrocarbon governance may be exclusively managed by the regional governments and which require Federal Government approval. The Constitution is silent on these finer points, which are to be dealt with in the proposed Hydrocarbons Law which, to date, has not been passed.

The passage of the planned Hydrocarbons Law would provide a much-needed legal matrix for the governance of Iraq’s oil and gas regime, and would purportedly clarify the roles of the regional and Federal governments in managing the country’s hydrocarbon resources. However, in the absence of the Hydrocarbons Law, the MoO continues to rely on its interpretation of the Iraqi Constitution asserting that: (i) contracts with production-sharing provisions, granting FOCs interest in the extracted hydrocarbon resources, are contrary to its interpretation of Article 111 of the Constitution – being that Iraq’s oil and gas resources may only validly be owned by the government as representative of the Iraqi people; and (ii) contracts must be approved by the Federal Government, which interprets Article 112 as requiring Federal Government agreement on the manner in which regional governments manage their oil and gas resources.

In keeping with its interpretation of the Constitution, the MoO, through its state-run oil companies, maintains a strict monopoly in upstream petroleum development. The MoO has launched four licensing rounds since 2008 offering twenty-year technical service contracts (TSC) to FOCs. Under the terms of these TSCs, FOCs are bound to accept a fixed fee per barrel of oil instead of an equity stake – in keeping with the Federal Government’s interpretation of Article 111 as prohibiting foreign ownership of hydrocarbons. Unlike the traditional production-sharing model – in which the foreign participant takes an interest in the extracted hydrocarbons – under the TSC, the FOC takes on the position of a contractor providing technical services to the relevant Iraqi regional oil company for the development of oil fields. FOCs’ displeasure with such terms and the compensation being offered has been evidenced by the ever-decreasing participation with each MoO licensing round.

The Kurdistan Regional Government

As such, FOCs have been increasingly drawn to Kurdistan which, for the past few years, has been perceived as a more FOC-friendly jurisdiction. The Kurdistan regional government (“KRG”) has been offering more traditional production sharing contracts (PSCs) with FOC-friendly provisions such as shared interests in the extracted products, rejecting Federal Government assertions thatinterests in hydrocarbons cannot be granted to FOCs and that all agreements with FOCs require Federal Government approval.

Since Kurdistan attained semi-autonomy in 2005, and in the face of continuous disapproval from the Federal Government, the KRG has passed its own hydrocarbons law, the Oil and Gas Law of the Kurdistan Region, Law No. 22 of 2007 (Oil and Gas Law). Under the Oil and Gas Law, the KRG has signed approximately 50 deals with FOCs including Exxon, Chevron and Total.

Despite the enactment of the Oil and Gas Law, the MoO continues to insist that all regional hydrocarbon contracts must be signed by the Federal Government and refuses to recognise the PSC contracts granted by the KRG, proclaiming them to be “illegal.” In reaction to the flood of FOCs heading to Kurdistan, the Federal Government has recently retaliated against certain major FOCs, requiring them to choose between pursuing operations in Kurdistan and operations in central and southern Iraq.

Circumventing Federal Government Control

Ultimately, regardless of regional interpretation and execution of hydrocarbon contracts, the Federal Government retains the ability to halt production because of: (i) control over the import and export of requisite equipment, professionals and skilled employees, etc., into and out of Iraq proper; and (ii) the means of exporting extracted oil and gas. In the past, the majority of Iraq’s oil output came from the southern fields, and the Federal Government had solid control over the majority of the country’s pipelines.

All oil exports out of the Kurdistan region were funnelled through pipelines controlled by the Federal Government, with the Federal Government collecting revenue on the distribution. However, recent tensions with the KRG over its hydrocarbon policies have seen the Federal Government repeatedly shut down the primary pipeline leading out of the northern regions into Turkey.

To circumvent the Federal Government’s stranglehold over oil exports, the KRG has resorted to sending the majority of extracted oil through its northern border with Turkey by tanker truck. With the assistance of the Turkish government, which is keen to tap into Iraqi oil and decrease its dependence on Russia and Iran, the KRG hopes to complete the construction of a direct pipeline to Turkey by the last quarter of 2013.

Conclusion

Having completed four licensing rounds, some more successful than others, Iraq now needs to look ahead and consider what needs to be done to ensure a successful fifth round.

Much would be gained from passing a hydrocarbons law in which the oil-licensing structure could be agreed and clarified. When drafting this it will be important to include all interests; regional and federal, Shiite, Sunni and Kurd to ensure that a model can be put in place that will not only clarify the system but that will work.

Iraq also needs to consider the terms that it offers to FOCs, as the requirement for expenditure increases with exploration and development obligations and poor or non-existing infrastructure for the related fields.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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