KRG Ministry of Natural Resources

22 June 2009 

Open Letter from Dr Ashti Hawrami, Minister of Natural Resources, Kurdistan Regional Government, to: 
The Federal Council of Ministers, 
The Federal Council of Representatives, 
The Oil and Gas Committee of the Federal Parliament. 

Proposed Federal Ministry of Oil service contracts not in the best interests of Iraq 

Yesterday the Kurdistan Regional Government (KRG) received, from sources in Baghdad, a baseline economic analysis for each of the oil fields in respect of which the Federal Ministry of Oil (MoO) promises to announce its awards of contracts on 29 June. The baseline economic analysis was apparently prepared for the MoO and is based on contract models published by the MoO in November, 2008. We believe the federal government should not proceed with the service contract awards, for the following reasons: 

The model demonstrates that the contracts are likely to be too expensive, that they will not maximise value for Iraq, and that they will provide incentives for the contractors to “gold plate” or maximise costs, instead of being efficient in maximising production. The contracts must be reconsidered. The federal government will be paying more that it should for incremental production, whether measured against international standards or even against the “exploration” contracts of the KRG. 

On an equivalent basis, international oil companies (IOCs) under the proposed MoO contracts will receive, on average, twice the amount than the IOCs under the KRG contracts. This comparison is all the more striking when bearing in mind that the KRG blocks are both much smaller and were in respect of undiscovered reserves. 

In his January 2009 report to the Oil and Gas Committee of the Council of Representatives, independent petroleum economist Pedro van Meurs concluded that the service contracts were “corruption inducing”, because the terms of the contracts are not fixed. The KRG agrees with the van Meurs analysis. Any contract entered into by the federal government should, like the KRG contracts, have clear, fixed terms that continue for the life of the contract. Any federal government contracts should also, like the KRG contracts, allow for no parallel negotiations on the same contract area. 

These problems with the service contracts are in addition to the fact that there is no constitutional or other legal basis for the contracts. The federal government should not proceed with the service contract awards. The contracts are being rushed, perhaps to meet short-term political objectives and to obscure past mistakes and failures. 

A full explanation of our view of the service contracts is given below. 

Revealing projections 
The analysis provides a number of revealing projections for each of the fields. 

The first is that the expected capital expenditure of international oil companies (IOCs) for each field related to incremental production is in the billions of dollars – on average $5 billion dollars per field over the first five years. However, according to the analysis the IOCs’ net cash-flows become positive for each field after only the first three years of the contract. In other words, the proposed contract provides for very rapid capital recovery, and less initial cash-flow to the government of Iraq – Iraq is therefore funding it own projects.. 

The second is that the net present value (NPV) at a 10% discount rate that the IOCs will receive under the service contracts at the first glance appears very low in relation to the NPV retained by Iraq – only around 4% of the total NPV of each field will inure to the IOCs. However, this low figure of 4% is deceptive and the real figure must be explained and understood. It is deceptive because the NPV10 calculations are made by combining the base line current production of each field with the incremental production that the IOCs are supposed to achieve for that field. However the IOCs in fact will need to spend very little money to maintain the base line current production, apart from the general operating costs. If the NPV calculations are more accurately made by using only the incremental production revenues and the related capital costs and operating costs, then the NPV that the IOCs actually receive will be over 10% of the total NPV of each field. 

The third, and most revealing projection, is that the amount paid to the IOCs for each barrel of incremental oil will, on average, be $5.70, based on cumulative cash flows going to the IOCs, in addition to the operating costs relating to the baseline production. This works out to be approximately $2.20 per barrel on a NPV basis when the cash flows are discounted in accordance with the model’s discount rate of 10%. This payment to the IOCs is based on the capital and operating costs that relate to the incremental production, and is based on the model’s assumption that the incremental production fee is bid at $6.00 per barrel, and assumes an oil price of $60 per barrel. 

Implications: contracts are too expensive, interests misaligned 
The model demonstrates that the contracts are likely to be too expensive, that they will not maximise value for Iraq, and that they will provide incentives for the contractors to “gold plate” or maximise costs, instead of being efficient in maximising production. The contracts must be reconsidered. The federal government will be paying more that it should for incremental production, whether measured against international standards or even against the “exploration” contracts of the KRG. 

There are several reasons why these contracts are failures. The underlying planning for the contracts was poor. Some of the planners apparently still subscribe to pre-2003 regime practices. The planners also seem to lack relevant experience and their sole motivations appear to be simply to maintain their own roles. Because of the contractual structure, and the complexity of administration, the interests of the IOCs and the federal government are misaligned. The IOCs therefore have no option to increase their revenues through greater efficiency and can only achieve their returns through higher incremental production fees and increased costs, instead of through efficiencies. 

The contracts are therefore not in the best interest of Iraq – even with the important budget needs. These will be long-term contracts and need to be properly offered, reviewed, and approved in accordance with the Constitution and an oil and gas law that is in accord with the Constitution. 

KRG achieves much lower costs for exploration 
In the Kurdistan Region, by contrast, IOCs will, on average, receive a “gross undiscounted profit” figure of just $1.58 (at NPV of 10%) for each barrel of oil discovered and produced from any large field discoveries – almost 40% less than $2.20 in the case of MoO proposed contracts. 

By assuming a modest exploration risk involved in exploration and setting the chance of success of finding oil to as high as 70%, the discounted for risk profit figure under the KRG contracts reduces to only $1.10 per barrel of oil discovered and produced. The KRG figures have been independently assessed in a private equity fund report, issued for investors by Tristone Capital (an 80 page country report on Global Energy Research on Kurdistan dated June 1 2009). 

On an equivalent basis, therefore, IOCs under the proposed MoO contracts will receive, on average, twice the amount than the IOCs under the KRG contracts. This comparison is all the more striking when bearing in mind that the KRG blocks are both much smaller and were in respect of undiscovered reserves. 

“Corruption inducing” 
In his January 2009 report to the Oil and Gas Committee of the Council of Representatives, independent petroleum economist Pedro van Meurs concluded that the service contracts were “corruption inducing”, because the terms of the contracts are not fixed. At page 5 of his report, Mr. van Meurs states: 

"Very troublesome is the fact that Article 2 of the Contract permits the parties to change the service fees after the Contract has been approved by Council of Ministers. 

Also, the contract provides for the fact that the service fees only apply to the main reservoirs. These are the reservoirs that would result in the Enhanced Production Target. 

However, the Contractor can propose to develop in addition to the main reservoirs also “discovered and undeveloped reservoirs”. This would presumably result in a higher level of production. In order to achieve the development of these additional reservoirs, the parties can negotiate a revision of the service fees. Also, additionally, unexplored reservoirs below a certain depth can be explored based on a separate additional further agreement. 

It appears therefore, that significant “add-ons” are possible to the Contract after the Contract has been approved and signed. It seems that such “add-ons” would be beyond the scope of the scrutiny of the Council of Ministers; and thus cannot be subject to competition because the Contractor will have been selected and the Contract signed. 

This could open the door widely for a rigged bid process. It would enable a bidder to make a winning bid with unrealistically low service fees based on a tacit agreement with certain government or state company officials to increase the service fees later. This feature of the contract is therefore 'strongly corruption inducing'."

The KRG agrees with the van Meurs analysis. Any contract entered into by the federal government should, like the KRG contracts, have clear, fixed terms that continue for the life of the contract. Any federal government contracts should also, like the KRG contracts, allow for no parallel negotiations on the same contract area. 

New contracts needed 
These problems with the service contracts are in addition to the fact that there is no constitutional or other legal basis for the contracts. 

The federal government should not proceed with the service contract awards. These contracts are being rushed, perhaps to meet short-term political objectives and to obscure past mistakes and failures. The federal government should instead move forward with a proper constitutionally based oil and gas law and revenue sharing law and draw up new contracts based on the best international advice and practices. Those contracts should not overpay the IOCs, must instead properly align the interests of the IOC and the government, and eliminate incentives to possible corruption.