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

Introduction

Despite the post war interest displayed by foreign oil companies (“FOCs”) in entering Iraq’s oil and gas market, they have shown little interest in Iraq’s fourth and most recent licensing round for exploration and production work. This is in stark contrast to the increased interest of FOCs in the semi-autonomous Kurdistan region of northern Iraq where the Kurdistan Regional Government (KRG) has signed approximately 50 contracts with a number of FOCs.

The primary reason for this shift in interest is due to the differing contracts offered by the KRG and the federal government of Iraq (Federal Government). Restricted by constitutional interpretation, the Federal Government offers FOCs a model technical service contract (TSC) while in Kurdistan, the KRG offers a production-sharing contract.

Overview of Production Sharing Contracts and Technical Service Contracts

Under the terms of a standard form PSC, an FOC and the government (be it regional or federal depending on the territory in question) work together much like a joint venture. The ownership of the oil is shared and the FOC is permitted to use revenue from produced oil to recover expenditure. Once expenditure is recovered, profit is then split. Thus under PSCs, the FOC and the government body share revenues and operating costs, although the FOC supports all capital expenditure and financial risk.

Under the TSC, the relationship between the parties is fundamentally different. The Ministry of Oil (MoO) has created the National Oil Company (NOC) through which the government has absolute control of the operations and oil. Rather than operating as a partnership with the government, the FOC operates as a contractor: retained for its services and paid a fixed fee per barrel known as a remuneration fee per barrel (RFB). FOCs bear all capital expenditure and financial risk, as under the PSCs but, in addition, all operating costs are compensated only by the RFB, which is taxed at 35 percent. All revenues apart from the RFB return to the NOC.

Crucially, the RFB is only paid if the production exceeds a certain specified minimum level. This targeted production level has made the TSC model particularly unattractive where bidding is for licenses over areas with largely unproven reserves; an FOC which falls short of the targeted production level will lose out on remuneration. This explains why FOCs bid competitively for the first and second licensing rounds, which featured fields with largely proven reserves. While FOC bidding during the third and fourth licensing rounds – covering areas with largely unproven reserves and requirements for expenditure on exploration – was comparatively anaemic.

Licensing Rounds

The first and second licensing rounds (held in 2008 and 2009, respectively) saw bidding competition, with FOCs striving to offer the lowest RFBs possible, leaving the MoO maximum profits; in some cases bidding at RFBs below US$2 per barrel. To offer such low RFBs, an FOC must be in a position to affirm that it possesses the combination of technology, expertise and available reserves to minimize capital and operating expenses while simultaneously delivering the minimum target production levels of oil and gas.

Such confidence in production efficiency was clearly not shown by FOCs for the licenses on offer in the third and fourth licensing rounds. Licenses offered under the fourth licensing round in 2012 covered largely undeveloped fields, in contrast to the earlier licensing rounds in which many of the fields had been at least in part developed, and required primarily redevelopment. The fourth licensing round resulted in just one successful bid out of seven available gas exploration and development sites, and two successful bids out of five available oil exploration and development sites.

Poor bidding results in the fourth round were compounded by a revised formula for the calculation of RFBs, which now necessitates that FOCs are paid RFBs only on the production net of production costs – a tactic designed to encourage FOCs to reduce production costs. MoO announcements that Iraq might adhere to OPEC production quotas by 2014, thereby limiting the amount of oil which could legally be produced, would only have served to enhance FOCs disenchantment with the TSC model.

Constitutional Interpretation

Ostensibly, the reason the MoO has given for offering TSCs rather than PSCs is directly related to its interpretation of the Iraqi Constitution. Iraq’s new constitution – approved by referendum 15 October 2005 and which came into force in 2006 – states that “Oil and gas are owned by all the people of Iraq in all the regions and governorates,” (Article 111 of the Iraqi Constitution). The Iraqi government therefore interprets the PSC model, which grants FOCs an interest in the oil produced and a right to profit from the sales, as illegal. In the four bidding rounds since the invasion of Iraq, only TSC contracts have been offered.

In reality, constitutional fidelity aside, the TSC has provided the Federal Government with the means to extract favorable contractual terms from bidding FOCs in the first two rounds. However, this winning streak appears to have drawn to a close. Having failed to secure better contractual terms, FOCs have turned their attention northward to the semi-autonomous Kurdistan region, where the KRG is offering a PSC with more FOC-favourable provisions.

Kurdistan Regional Government Production Sharing Contract

Like the TSC offered by the MoO, the KRG-model PSC contains provisions relating to the duration of contract, relinquishment, national interests and minimum work obligations.

The key differences are found in the cost and profit provisions. On costs, the KRG-model PSC contract states that “from the First Production in the Contract Area, the CONTRACTOR shall at all times be entitled to recover all petroleum costs incurred under this Contract…”

The profit provision is equally appealing stating: “From first production and as and when Petroleum is being produced, the CONTRACTOR shall be entitled to take a percentage share of Profit Crude Oil and/or Profit Natural Gas…..”

The benefits to the FOC are therefore clear. While there is always a degree of risk, the PSC offered by the KRG allows the FOC to curtail risk by allowing recovery from cost oil. Further, payment based on a percentage of profit oil is more likely to yield a profit, than a fixed fee.

Conclusion

The MoO announced in March that the fifth licensing round would be held in the next few months and will come from ten oil blocks. The Petroleum Contracts and Licensing Directorate has stated that it will be amending the terms on which the bidding will take place. It remains to be seen whether or not those terms will be enticing enough for FOCs to take on the expenditure required for the proposed blocks.

Client Alert 2013-164