Iraq’s technical service agreements— a stopgap measure?

CGES | APRIL 2008 | SOURCE: Global Oil Insight

The invasion’s aftermath Iraq’s oil production capacity was around 2.8 mbpd when the US-led coalition invaded Iraq on the 20th March 2003. Due to damage resulting from combat operations, looting and sabotage, Iraq lost around 1.9 mbpd of its output capacity.

The bulk of the loss (86%) occurred in the producing fields belonging to the South Oil Company (SOC); in comparison, the North Oil Company's (NOC) capacity loss was very much smaller, as Table 1 clearly shows.

The kind of damage inflicted on Iraq’s oil industry in the invasion’s aftermath was wide ranging, from the smallest item to the very heaviest equipment.

Direct war-related damage, looting, sabotage, or a combination of these, were inflicted on degassing stations, oil pumping stations, gas compressor stations, production facilities, industrial water supplies and water injection facilities, storage tanks, vehicles, cranes, drilling rigs, field laboratories, office equipment, electric generators, stores, workshops, chemicals, tools, spare parts, control and safety equipment, civil, mechanical and electrical works, gasoline and LPG filling stations, field offices and camps. Even a field hospital was looted.

As a result, Iraqi oil production declined precipitously when production ceased in the south of the country on the 20th March 2003 (except for the Misan fields producing around 40,000 bpd for power generation) and ceased from both the north and south on the 9th April 2003, when Baghdad fell (see Figure 1).

Failure to deliver

A restoration plan was drawn up to regain Iraq's pre-war production capacity, the key contractor being the American firm Kellog Brown & Root (KBR), but for a whole host of reasons — including among them a serious lack of security, inept management and corruption and fraud — the target capacity of 2.8 mbpd was never attained.

The highest average annual production level that was reached by the Iraqi oil industry since the invasion was 2.12 mbpd last year, as Table 2 shows.

The physical destruction of the oil industry’s infrastructure was the main reason behind the capacity loss, but mismanagement at the producing oil fields, especially the giant ones, played a big role too.

Proper reservoir management requires continuous and efficient reservoir monitoring and reliable oilfield surface and subsurface measurements. Such measurements stopped completely during the UN embargo on Iraq, which started with the invasion of Kuwait in 1990 and continued until the collapse of Saddam’s regime.

In order to maximise its oil revenues during the embargo, the Ba’athist regime ordered oil production to be increased to the maximum extent possible regardless of the damage inflicted on Iraq's oil reservoirs and that situation became more precarious when the UN lifted in 1999 its embargo on Iraqi oil exports.

Sadly, this state of affairs continued even after the Saddam regime collapsed. The loss of specialised equipment to monitor the reservoirs and the absence, or inactivity, of service companies in the country because of the chaotic conditions and the lack of security, coupled with the new regime’s desire to maximise production irrespective of the state of Iraq's reservoirs, caused further damage to Iraq’s producing fields.

Many oil wells in the north and south have watered out and others have fallen prey to salt water corrosion. All these events, over the period from the imposition of UN sanctions in 1990 to the present, have lead to a decline in Iraqi oil production capacity and a loss of ultimately recoverable oil reserves.

Stalled oil and gas law

In an endeavour to increase Iraq’s oil production capacity to a level commensurate with its reserves, which would almost certainly require the technological expertise and financial muscle of the international oil companies (IOCs), a draft petroleum law was written with the express purpose of, inter alia, encouraging the exploration for and the development, production and marketing of Iraq's oil and gas riches, and regulating the relationship between the Iraqi authorities and the IOCs.

This draft law, which was prepared by three Iraqi experts, but supervised by a legal firm appointed by the US administration, caused an uproar when it was first made public in Iraq. It is generally thought to contain serious flaws, which many deem detrimental to the long-term interests of the Iraqi people (see “Ratifying Iraq’s new oil and gas law”, CGES Global Oil Report, July-August 2007, pp.13-16).

The key bone of contention is the proposed law's advocacy of production sharing agreements (PSAs) as the basis of the contractual relationship between the IOCs and Iraq. PSAs are viewed, both in Iraq and elsewhere, as useful contractual devices to encourage oil exploration in frontier areas and areas characterised by high risk and a low probability of finding commercial reserves, whereas the 70-plus billion barrels of low-cost oil reserves that have already been discovered in Iraq do not involve much risk and are merely waiting to be exploited.

While the Bush administration and the US Congress have spared no opportunity to press for the ratification of the draft law — the latest of which was US Vice President Dick Cheney’s visit to Baghdad last month — it remains hostage to the Iraqi parliament’s perennial gridlock, as do many other draft laws, including a vital constitutional amendment, which if ratified will push the door wide open for formal acceptance of the proposed oil law.

A result of exasperation

Owing to a number of factors, among them a lack of technological expertise and the continuous drain abroad of qualified personnel, Iraq's oil ministry found itself unable to complete repairs to the country's battered infrastructure and rehabilitate Iraq's currently producing oilfields. A clear measure of this inability is the ministry’s failure to invest more than a modest fraction (no more than 15%) of the annual budget allocation of $3-4 billion in the oil industry.

Furthermore, the ministry of oil cannot combat on its own the ongoing natural decline of Iraq's mature oilfields and simultaneously increase Iraq's oil production capacity at a time when the proposed oil law — which was viewed initially as Iraq's saviour and a sure conduit for the latest oil industry technology — has fallen victim to the Iraqi parliament’s ongoing paralysis.

In the circumstances, the decision by the Iraqi oil ministry to work with certain IOCs on selected oilfields, on the basis of technical support agreements (TSAs) with the aim of increasing the productive capacity of each field by 100,000 bpd, was quite logical. The oilfields involved, together with the contracting companies, are shown in Table 3

These TSAs should be finalised around the end of this quarter and no interference from the Iraqi parliament is envisaged. The role of the IOCs will be confined to technical direction and advice, and equipment and material procurement; it is clear that the IOCs' personnel are not expected to be involved on the ground.

The ministry of oil’s SOC will carry out the necessary work on the Basrah and Misan fields while the NOC will carry out work on Kirkuk. As a result of this programme of TSAs a total capacity increment of 500,000 bpd is expected to materialise within two years from the start of work at a total cost that could reach $2.5 billion.Payment for the provision of technical services is believed to be in oil instead of cash, as preferred by the IOCs.

A cost estimate of $2.5 billion for the provision of technical services and the purchase of equipment and material in order to raise the production capacity of some Iraqi producing fields by 0.5 mbpd implies an investment cost of $5,000 per peak daily barrel.

This seems too high, given the generally accepted cost estimate of $5,000 per daily barrel to add grass-roots oil production capacity in a country such as Iraq (which could perhaps be stretched to $7,000 per peak daily barrel, if the general cost escalation the oil industry has experienced of late is taken into consideration).

One should not jump to conclusions, however, since the details of these TSAs and what they entail have not yet been made public. For the record, the Iraqi oil minister claimed recently that the cost of equipment would amount to around $2 billion, leaving around $0.5 billion for the technical services.

PSAs — a remote possibility

There is a strong desire on the part of the IOCs to transform these short-term service contracts eventually into long-term relationships involving these oilfields and also other Iraqi fields that have already been discovered. By adding 500,000 bpd to Iraq’s current production capacity, the country's pre-war capacity of around 2.8 mbpd will be attained.

This, however, can be but only a temporary aim. The real objective of the oil ministry is to raise Iraq’s oil production capacity to a level commensurate with its oil reserves, which would require adding another 4-5 mbpd of productive capacity.

Who could bring about such an increase? The IOCs have the expertise and the financial capability, but these companies would like to secure long-term relationships based preferably on PSAs.

Will this be possible? Long-term relationships might well be feasible, but not necessarily on a PSA basis. The present Iraqi government, supported behind the scenes by the incumbent Bush administration, is facing an uphill battle to persuade the Iraqi parliament to ratify a hydrocarbon law that accepts PSAs.

Resistance to PSAs has become entrenched in Iraq, be it driven by oil nationalism (as viewed from abroad), or patriotic sentiments (as viewed from within), or merely because Iraq’s huge, already-discovered, low-cost oil reserves do not warrant PSAs.

Service contracts that secure a reasonable rate of return for the international oil companies will always be on the table and variations of buyback agreements will also be available in certain cases, as the CGES has been led to believe.

For their part, the IOCs prefer PSAs to other kinds of contractual agreements because they can book their share of production, be it cost or profit oil, as part of their declared hydrocarbon reserves, according to the reporting guidelines of the US Securities and Exchange Commission (SEC).The booking of reserves, in turn, has a bearing on the companies’ financial position and enhances the value of their shares, which is why the companies favour PSAs.

Under IOC pressure, the SEC is now reviewing its archaic and outdated reserve valuation rules and those that determine what should and should not be considered part of a company's stock of oil and gas reserves.

One such existing rule is the reliance solely on December the 31st pricing for the quantification and valuation of oil and gas reserves in an era when oil and gas price volatility has increased and prices vary considerably within the year. Another such rule treats unconventional oil reserves in Canada’s oil sands as 'bookable' if the oil is produced by means of in-situ, steam-assisted gravity-drainage (SAGD) methods, but not so if the oil is produced by surface mining.

Times have changed and, as a consequence, economic and political realities at present are very different from those prevailing 35 years ago. One such reality is that the international oil companies do not have direct access to the Middle East’s low-cost oil anymore.

Perhaps if the SEC were to start allowing the IOCs to register as reserves the oil they are due as payment in their service or buyback contracts, then the companies might be more willing to come to Iraq and participate in developing the country's upstream oil industry on the basis of contracts other than PSAs.

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