Get well soon

The Iraqi oil industry has faced many challenges in recent years, but Greg Hammond says the prospects are fast improving.

Iraq is possibly unique among the major oil-producing nations. Its oil production profile over the past 30 years shows a succession of truly spectacular collapses in production. Depicted on a graph it would resemble the jagged blade of a giant saw.

Since its all-time production peak in 1979 Iraq has, of course, been subjected to three devastating wars, which brought the country to its knees and destroyed key elements of its hydrocarbon infrastructure.

As if this was not enough, the source of the world’s fourth-largest oil reserves has experienced a number of other setbacks. Religious and cultural divisions, for example, between Shia and Sunni Muslims, as well as between the Kurds in the north and the Marsh Arabs in the south, continue to create barriers.

These divisions are also sometimes reflected in the political landscape. Following the elections in 2010 it took more than nine months for a coalition government to be formed, which delayed and further hindered Iraq’s rebuilding effort.

In addition, Kurdistan continues to ­govern itself semi-autonomously through the Kurdistan regional government (KRG), with the result that there are differing oil and gas licensing regimes in Kurdistan from the rest of Iraq. These differences resulted in the oil embargo imposed by Baghdad, which has recently frozen exports out of Kurdistan.

Another source of friction between Baghdad and Erbil has arisen from the KRG’s preference for a traditional production-sharing contract (PSC)-style licensing arrangement in contrast to the south, where a form of technical services contract (the development and production-sharing contract (DPSC)) is more typically used. It rewards participants with a cash fee per barrel of oil recovered rather than with a pre-agreed percentage share of physical oil.

One of the starkest logistical problems facing Iraq relates tothe lack of transportation facilities and storage capacity for hydrocarbons. While a network of ageing pipelines does exist up and down the country, Iraq is still a long way short of the infrastructure that will be required if its production targets are to be achieved.

Boom time

Of course, security also remains an issue, both with regard to the safety of employees and the security of assets and infrastructure. Hijackings and bombings continue and there is concern in some quarters over the ability of the Iraqis to maintain reasonable standards of law and order once foreign forces have left.

On a more practical level, unexploded munitions from the Iran-Iraq war and two Gulf wars often need to be removed before fields can be accessed and developed. Indeed, the form of the Iraqi DPSC makes specific reference to the preparation of a “de-mining work programme”, which must then be performed as a recoverable cost of the contractor parties.

Wars – and even previous production methods – have on occasion damaged the oil deposits themselves, leading to bypassed reservoirs and unpredictable operational difficulties. As one might expect, three wars in quick succession have also resulted in the loss or destruction of years of accumulated appraisal data. Oil reserves information is therefore often based on limited data, giving scope for interpretation or error.

In addition, the once-plentiful pool of world-class technical experts emanating from Iraq has been reduced severely by war and emigration. Add to that the global financial crisis, the resulting drop in the oil price and the collapse of Dubai as the hub for Middle Eastern finance, and the list of problems, handicaps and restricting factors goes on and on.

There are even claims in some circles that certain fields in the south of Iraq may be subject to the stringent environmental laws that govern the area of the marshlands around Basrah, protecting its water supplies, flora and sensitive fishing stocks.

So why in 2009 did BP and China National Petroleum Corporation (CNPC) buck the trend and enter into a DPSC under the first licensing round, when all other bidders declined? More intriguingly, why in 2010 did the market capitalisation of one AIM-listed oil producer soar to £1.5bn when its oil production in Kurdistan is both limited and currently transported solely by road?

In short, why does the tide now appear to be turning in favour of investment in Iraqi oil and what are the prospects in the medium to long term for investors there?

The oil industry is essentially an exercise in understanding and assessing risk, which can take many forms and is often present along the full length of the oil exploration, production and offtake chain.

Fields of dreams

The big difference in Iraq is that one of the key customary risks – exploration risk –

can often be almost eliminated due to the unusual degree of confidence that hydrocarbons are present. In the south of Iraq this is frequently because most of the oilfields that have been the subject of the latest three licensing rounds are known to have existed and have been in full-scale production at some point over the past 30 years.

The existence of these huge fields has, of course, been the justification for the technical services arrangement embodied in the Iraqi DPSC, on the basis that there was never any exploration risk for a bidder. All that was required was a large balance sheet and the technical expertise and resources a major international oil company could provide to bring a particular field back on stream.

In contrast to southern Iraq, the virtual elimination of exploration risk in Kurdistan arises in other ways. This was well-illustrated to me many years ago by the look on the face of one leading hydrocarbons geologist who, during the early scramble for Kurdish exploration acreage, memorably emerged open-mouthed and ashen-faced from a London data room whispering that he had seen “mountains full of oil”.

This turned out to be pretty accurate, given that the success rate for exploration wells in Kurdistan currently stands at around 80 per cent.

The man with the plan

So if one can be fairly confident in Iraq about exploration risk, how will one ever be able to get comfortable with the various political, security, transportation, educational, environmental and other risks catalogued above?

The answer may recently have arrived in the form of Abdul Karim Al-Luaibi – the newly appointed Iraqi oil minister. He is a petroleum engineer who has spent his whole career with the Iraqi oil ministry, where he started out as an engineer’s assistant. A shrewd and capable politician, he is ­reported to be close to Hussain Al-Shahristani (the ­former oil minister and now deputy prime minister) and Nouri al-Maliki (the recently appointed prime minister, who also happens to be from the same tribe).

The closeness of these relationships underscores the critical importance of Iraq’s oil industry to its leaders and also explains the unified position that appears to be emerging in energy-related matters, notwithstanding the unstable and unpredictable political scene elsewhere in Iraq.

Within two weeks of his appointment Al-Luaibi (who, as deputy minister of oil for upstream, managed the process for all three previous licensing rounds in southern Iraq) announced a fourth round of licensing. Importantly this will be for exploration blocks rather than the development of existing fields. As a result it is possible that southern Iraq will move away from the current form of technical services agreement and towards a ­traditional form of contract.

Oil be there

In the same two weeks Al-Luaibi announced a record increase in output from Iraqi oil fields, including a 10 per cent rise in BP’s production over its budgeted targets at its Rumaila field. More recently Iraq has agreed to build an oil pipeline to neighbouring Jordan and is considering plans for a ­similar project into Syria.

And if one reads between the lines, the good news does not stop there.

Recognising the importance of upgrading Iraq’s oil infrastructure, Al-Luaibi has confirmed that another immediate focus will be export routes to the south. There are therefore plans for new pipelines in conjunction with storage expansion at Faw, Nasiriyah and Zubair in the south, in a clear move to increase the flow of oil to the global market.

As regards the thorny issue of relations with the KRG, there is now evidence that North Oil Company, the vehicle used by the KRG for oil investments in Kurdistan, is being offered participations in some key oil projects in southern Iraq – thereby further breaking down the barriers between Kurdistan and the south and almost introducing an element of ‘cross-shareholding’. Al-Luaibi also announced recently that “talks with the brothers in the KRG will continue in order to reach solutions which meet the public interests”.

This was the best indication yet of a thaw in relations between Erbil and Baghdad.

Finally, in mid-January, officials from both sides confirmed that pipeline exports would recommence from two Kurdish fields with effect from 1 February – although other details about such a possible relaxation of the oil embargo are hazy at this stage.

Although not connected with Al-Luaibi’s appointment, statistics also suggest that the security situation has greatly improved since the peak of the bombings and terrorist attacks between March and June 2007.

All is well

Inevitably there will be a number of external factors that will incentivise the Iraqis and the broader oil industry to tackle and overcome the obstacles to Iraqi investment listed above. In the same way that a steadily increasing oil price, rising global demand, the desire for security of supply and the recognition of the risks inherent in other areas of the industry have driven the development of new products, such as shale gas, market forces can be expected to encourage national and international oil companies and other oil industry participants to come to the table in Iraq.

Combined with these external factors, it could be that the Iraqis have found a magical mix of political will, industry expertise, personalities and global circumstances that can help to reduce or overcome some of the risk factors that have affected them in the past and herald a new golden age of investment in Iraq. If that proves to be true, one can expect the original wave of first movers into Iraq to sit back and enjoy the parallel benefits of a rising oil price and falling Iraqi risk.

Likewise, those prime movers wishing to make further investments into Iraq, who by now will have experienced its oil industry at first hand over an adequate period of time, will be best placed to assess the new reduced risk levels and price them into their future investments.

Greg Hammond is a partner in the London office of Akin Gump Strauss Hauer & Feld