Who needs big oil in Iraq: The case for going it alone

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