My Helmut Merklein
12-01-04
During the period immediately preceding the recent conflict in Iraq, the
Saddam Hussein regime accused the Unites States of going after their petroleum
resources. This accusation resonated throughout the world, especially (and
surprisingly) in Europe. The US Government took the public position that the
Iraqi oil belonged to the Iraqi people and that the government of the US meant
for it to remain in Iraqi possession.
Now that major combat operations are over, the question arises how to restore
existing production facilities and to develop new ones, while maximizing
Iraq’s take and clearly leaving Iraqis in control of their petroleum
resources.
There has been talk of privatising the Iraqi oil industry in order to attract
foreign capital and speed up recovery. That policy makes sense for all energy
sectors, except the oil exploration and production sector. Oil production
service industries (drilling, logging, seismic, well stimulation, etc) and other
oil-related industries (refineries, pipelines, marketing facilities,
distribution networks, etc) could and probably should be privatised in whole or
in part. Iraq needs a vibrant oil industry characterized by a competitive
environment that has the capacity for rapid technological development, and that
responds quickly to changing circumstances.
However, privatisation does not make sense for the oil exploration and
production sector. In fact, there is good reason to argue that the concept that
Iraqi oil production should remain under exclusive Iraqi control should be
anchored in the Iraqi constitution.
The one thing that sets oil production apart from other industrial
activities, including downstream oil activities, is that it is in oil production
that the rents accrue -- huge rents. These rents, like all rents, belong in
principle to the resource owner, the people of Iraq, if a mechanism can be
devised to capture them.
The obvious way for the Iraqis to remain in control of their oil wealth and to
capture all of the oil-related rents is to leave the Iraq National Oil Company (INOC)
intact. If so, can they on their own attract the funds that will be needed to
restore production to or beyond pre-war levels?
The answer is yes, because not much new development is needed and the funds
that will be required are dwarfed by the wealth represented by already proven
but undeveloped reserves. As to what is needed, future production is likely to
be a function of future OPEC concessions on Iraqi quotas.
Assuming for the moment that Iraq will adhere to OPEC quotas and that, under an
optimistic scenario, it will be able to negotiate an increase in its quota to
3.5 mm bpd, up from its pre-embargo quota of 3.14 mm bpd, Iraq has sufficient
reserves currently under production to achieve this level of output, provided
the resources are made available to rehabilitate and develop currently proven
fields.
Various media sources have maintained that Iraq would be unable to produce
more than 3.0 mm bpd. Just how ridiculous that claim is can be seen from a
comparison of the US and Iraqi reserve bases and the production these bases are
able to maintain. The US has at present 22.4 bn barrels of proved crude oil
reserves; Iraq has 112 bn. The US produces 5.3 mm bpd from that base.
At five times our proven reserve base, Iraq can produce five times the US daily
production rate, or some 23 mm bpd. Without any additional exploration. These
are proved reserves. The Iraqis have some 73 oil fields, 58 of them idle. All
they have to do is drill them up. They have been there. They have done it in the
past. In December of 1979, Iraqi oil production peaked at 3.7 mm bpd. For that
year, it averaged 3.48 mm bpd.
Our Prudhoe Bay Field, for example, with its original reserve of 10 bn barrels,
produced 2.7 mm bpd at peak, 1.5 mm bpd or more for 12 years, and more than 1.0
mm bpd for two decades. Their East Baghdad Field, equivalent to our Prudhoe Bay
Field in size, at 11 bn barrels, produces only 50,000 bpd.
There is no reason to believe that Iraqi technicians cannot match our
performance. Thus, by our standards, the East Baghdad Field by itself is capable
of producing 2 mm bpd. That is just one field or 11 bn barrels of reserves,
compared to Iraq’s total reserve of 112 bn barrels. For the country as a
whole, Iraq could achieve production rates of 3.5 or even 4.0 mm bpd in months
rather than years, provided their downstream infrastructure is repaired and
sabotage is under control.
And they can achieve this rate on their own, hands down. The Iraqis have been
producing oil for the last 31 years, i.e., since they assumed control of their
petroleum industry in 1972. They are quite capable of boosting production
without the help from international oil companies. They have the experience,
they have a lot of practical know-how, and they are known to be inventive and
flexible.
Whatever they don’t have by way of technological advances, they can acquire
through outsourcing in the open market, much like the multinationals do when
they turn to seismic firms for exploration, drilling firms for drilling, logging
firms for reserve definition, and reservoir engineering firms for production
optimisation. The only thing that the Iraqis do not have at present, and the
multinationals do, apart from their insulated past and the short-term handicap
of being subjected to acts of sabotage, is the cash flow to underwrite big-time
reserve development projects.
The fact is, for the restoration or enhancement of their productive capacity the
Iraqis don’t need anywhere near the capital mentioned in the press. They
certainly don’t need $ 10 bn, as projected by the Council of Foreign
Relations, or $ 38 bn for "green field development" (Deutsche Bank),
which really makes little sense, given the enormous undeveloped reserves that
are already connected to Iraq’s petroleum infrastructure.
If their objective were to restore production to their pre-Gulf-War quota of
3.14 mm bpd, they would need a capital infusion of less than $ 1.0 bn. And they
categorically do not need the multinationals to get access to that kind of
investment. $ 1.0 bn is less than 0.1 % of the value of Iraq’s currently
proved reserve base.
That would be like securing a $ 300 loan by pledging a fully paid-for $ 300,000
residence as collateral. With that kind of collateral, there will be no shortage
of commercial or governmental (bilateral or multilateral) credit institutions
eager to supply the required capital needed to rehabilitate oil production in
Iraq.
The assertion that Iraq can restore its productive capacity to pre-Gulf-War
levels for less than $ 1.0 bn will not go unchallenged. Hence a little
explanation may be required here. With current production at 2.2 mm bpd, it
would take a one-million barrel boost to reach pre-Gulf-War OPEC quotas. With
average per-well production conservatively assumed at 1,428 bpd, it would take
700 new wells to achieve a 1 mm bpd increase.
The cost to drill 700 on-shore wells to 8,000 feet would be in the neighbourhood
of $ 350 mm in the US (EIA data), probably less in Iraq. The cost of lease
equipment for 700 wells is $ 112 mm (EIA data), for a total cost of $ 462 mm, or
less than $ 1.0 bn. And that assumes that the increase in production requires
the drilling of 700 new wells when, in fact, much of the increase will be coming
from rehabilitating and recompleting existing wells.
This is not exactly news. It is just not accepted wisdom in the West. The
Iraqis certainly know they can go it alone if they have to. Shamkhi Faraj,
Director of the State Oil Marketing Organization (SOMO), has recently been
quoted as saying that he expects Iraq’s production to be 2.8 mm bpd by March
of 2004 and that it would not require "large investments" to boost
Iraqi output to 3.0 mm bpd.
In a similar vein, the Oil Ministry expects Iraq’s output rate to be 3-4 mm
bpd by the end of 2005, and 6 mm by 2010. From a technical and financial point
of view, that is a very reasonable, i.e., achievable target. Whether it is
feasible in terms of OPEC relations is another issue.
The one, and probably the only one, compelling reason for Iraq to go it alone
is that this is just about the only way to capture 100 % of the rent associated
with oil production. Going it alone in this context means having a National Oil
Company and setting it up as the sole producer of Iraqi oil.
The case for going it alone if the country can afford it (most can’t, Iraq
can) is compelling for exploration and production since that is where the rent
is, which constitutes Iraq’s true wealth. With the exception of pipelines that
are natural monopolies, none of the other petroleum activities (refining, sales,
etc) produce rents.
These activities may or may not be wholly or partially nationalized. If
properly managed, through competitive bidding and with transparent accounting,
they produce about the same income to the host country, whether nationalized or
not. In fact, the presence of foreign companies in the downstream sector and the
upstream petroleum service sector, adds an element of competition andefficiency
that would benefit the host country.
There have been suggestions of combining downstream rehabilitation or new
construction with upstream ventures. For example, building a new refinery
coupled with some production-sharing arrangement in a proven oil field. The
problem with that is that the production activity will produce rents for the
foreign partner and the refinery operation will not. Thus by combining the two,
partial rents will be captured by the foreign partner, rents that Iraq has no
reason to give away, since under competitive procurement, the refinery will be
built as a free-standing project, without the need to give away rents.
The standard petroleum contract these days is the production-sharing
agreement (PSA), where revenues from oil sales, after capital recovery and
production costs (profit oil) are split in accordance with an agreed-upon
formula. Other exploration/production agreements are concession agreements,
joint venture agreements, and service agreements, to name some. None of them are
appropriate for Iraq.
For all the sophistication and the bells and whistles these contracts have, such
as capital up-lift, signature, discovery, and production bonuses, excess profits
taxes, R-factors and others, they all have two basic flaws, which make them less
than perfect in terms of capturing rent. They are subject to distortions through
petroleum price fluctuations in world markets, and they generally fail to
provide the host country with its proper rent if the field turns out to be
greater than expected. Various triggers in those agreements reduce the host
country’s exposure, but they never really eliminate it.
In the final analysis, the oil exploration and production business is a risky
undertaking, and the generally high rates of return reflect that risk. Standard
world-wide exploration and production contracts, likely to be proposed by oil
companies, have little meaning here, since Iraq is sitting on top of a huge
proven resource base that will obviate the need for massive exploratory
investments for the foreseeable future.
That eliminates the riskiest activity of a generally risky business and
substantially reduces the high risk premium generally embedded in conventional
petroleum contracts and the very substantial corresponding make-or-break rate of
return to reflect that risk. The internal rate of return that would be required
in an essentially exploration-free environment and resulting from a truly
competitive procurement procedure (the latter being standard under US Federal or
State proceedings) would be substantially lower in Iraq than your standard
production-cum-exploration internal rate of return anywhere else in the world.
Using a production-sharing agreement when the host country has the proven
reserve base, the technical experience and the financial means to go it alone is
definitely a second-best solution. Still, if a cooperative route is chosen, with
multinational oil companies undertaking heavy investments, there is a type of
contract that truly captures all of the rent, but it is not currently used in
the petroleum industry.
This is what one may call a utility-type agreement, in which the internal rate
of return is the bidding variable, rather than the trigger variable. In some
conventional PSA’s, a certain trigger level in the rate of return will act on
some other variable (boosting bonuses, royalties or profit taxes, for example)
to increase the host country’s take. In the utility contract, the rate of
return is itself the target variable: an agreed-upon rate of return is allowed,
and anything beyond that belongs to the host country.
Utility contracts are commonplace in the US and in Canada, but there is a
difference between them and those recommended here for Iraqi oil production. The
regulation of utility companies in the US and in Canada encompasses monitoring,
controlling, and setting prices to contain profits (eliminate rents).
By contrast, the regulation of Iraqi production operations (where prices are set
extraneously in competitive worldmarkets) would have to adjust agreed-upon
payment formulas for oil-production services on a recurring pattern, such as
quarterly on an approximate basis and annually in some detail, to arrive at
contractual rates of return. This is a novel concept that will probably not be
particularly appreciated by international oil companies.
But then, the introduction of PSA’s by Indonesia in the 1960s was also
novel and fiercely opposed by international oil companies, only to become the
standard today. Standards evolve, and beneficiaries of existing standards will
always be opposed to the development of new ones, especially when their winning
position is at risk.
The utility contract proposed here has its pros and cons. From an oil company
point of view, the upside is that it protects against losses if prices collapse.
The downside, or so the companies would have you believe, is the need for a very
detailed accounting procedure. That, however, is a flawed argument, since
detailed accounting is required in any event, for tax purposes and for the
determination of profit oil. Moreover, the expenses incurred in accounting costs
are charged against oil production, so that the host government in effect
reimburses the oil company for these costs.
If the utility contract is such a good deal, why is it not used widely in the
international oil business? It is not in use because, as a general rule, the
host country is not in a strong enough bargaining position to impose it. Not so
in Iraq, which holds all the cards, since it could, but does not have to, engage
the cooperation of multinational oil companies. In fact, working with
multinationals in upstream operations is decidedly a second-best solution,
compared to going it alone. Iraq’s natural inclination should be to go it
alone.
Of course, multinational oil companies would be opposed to the use of utility
type production contracts, because they would be less lucrative for them. They
would be bidding on one variable only, no bells and no whistles. That variable
would be the internal rate of return, in a competitive and transparent bidding
procedure that would prevent the use of convoluted features which tend to work
to the multinationals’ advantage. The more complex and obscure the agreement,
the easier it is for the multinationals to drive a good bargain.
On a different but related subject, there has been a lively debate regarding
Iraq’s obligations that are said to arise from past contracts with the Hussein
regime, especially petroleum contracts. In dealing with these, the general
principle of the sanctity of contracts needs to be adhered to by Iraq, but there
are legitimate questions that need to be addressed before such contracts are
declared valid.
For one thing, it is by now a well-known fact that the Hussein regime pursued
corrupt practices through a kick-back mechanism it had established with foreign
exporters of petroleum equipment (and arms and other commodities), and with
foreign importers and intermediaries purchasing Iraqi petroleum. That raises the
question of the legitimacy of all contracts signed with the Hussein regime.
In addition, the later of these contracts were signed by the Iraqi government
under considerable duress, with the result that their financial terms are almost
surely less beneficial than what they would have been in a negotiating
environment free from the threat of war. One way or the other, the issue for
Iraq is not so much whether these claims are valid, but whether and how they may
be set aside.
Even if all contractual obligations could be set aside, by voluntary waivers as
through the James Baker effort, or through litigation, there would be plenty of
opportunity left to foreign investors to participate in Iraqi petroleum
operations, including refining, marketing, pipelines and all upstream and
downstream service activities. The one exception is the obligation to compensate
Kuwait for the scorching of its oil wells in 1991.
As the multinationals are beginning to put pressure on Iraq in an attempt to
secure oil contracts, one way of pre-emptying them is to write into the
constitution that there will be an Iraqi National Oil Company and that it, and
only it, will be permitted to engage in oil and gas exploration and production
activities. This will need to be re-enforced by laws that should spell out that
there will be no such restriction on downstream and service activities.
Meanwhile, the Iraqis would be well advised to defer any decision on exploration
and production negotiations with international oil companies pending
constitutional and legal clarification.
Dr Merklein is a consultant in oil and gas policies. He was Assistant
Secretary of International Energy Affairs and Energy Security at the US
Department of Energy and Administrator of the Energy Information Administration
(EIA) from 1984 to 1990.
Prior to joining the Reagan/Bush Team in 1984, he was Professor of Petroleum
Engineering at Texas A&M University. He can be reached at helmut.merklein@verizon.net
Source: MEES