Production-Sharing Agreements For Iraq – Exploding The Myths
By Majid Jafar
Majid Jafar is Executive Director of the Crescent Petroleum Group of companies and a Board Member of the Iraq Energy Institute.
Iraq is now widely seen as the last major untapped source of oil production, something the whole world takes a keen interest in because of rising global energy prices and a lack of certain new oil supplies. With over 50 major discovered oil and gas fields requiring development, and more than 400 well-defined but unexplored structures, Iraq’s potential oil reserves easily rival those of Saudi Arabia, and its future production potential is a source of hope for the international community and above all for the Iraqi people. If managed correctly, Iraq’s oil and gas resources should provide the much-needed and overdue boost to Iraq’s economic and social development, propelling Iraqis towards a higher standard of living after decades of destruction and lost opportunities.
On all this there is little disagreement amongst Iraqis. Iraq’s pitiful production of barely 2.5mn b/d is a mere fraction of what it should be today. The debates rage, however, over how best to increase production and over the mechanisms for management of the oil sector. One area in particular that has fueled a lot of discourse and comment is the type of oil contracts Iraq should be adopting, with particular venom shown by numerous politicians and self-appointed Iraqi “oil experts” towards Production-Sharing Agreements (PSAs), with all sorts of accusations and crude propaganda made against such contracts or anyone who may espouse them, including even questioning their patriotism! The increasing false propaganda promulgated in the media now threatens to become the accepted wisdom amongst commentators, Iraqi politicians and the Iraqi people in general, and therefore it is time to set the record straight.
We must start with the assumption that the national objective is to maximize the economic return from Iraq’s oil wealth for the people of Iraq, while of course maintaining national sovereignty and ensuring adherence to good oilfield practices and principles. Again, few Iraqis would disagree with this. It follows that this will be achieved by maximizing Iraq’s production, in a responsible and sustainable manner of course, while ensuring the highest possible returns to the state from this production. This is a question of sound economic management, and we must not allow political or emotional issues to confuse the matter. (There are other important political questions of course – such as whether the regional or federal government should be allowed to sign contracts, and also how the revenues earned by the state should be shared and invested, but these are totally separate issues and largely governed by Iraq’s constitution in any case).
There is also little argument against the view that private oil companies are needed to urgently invest and work in Iraq’s oil sector to achieve this important goal – not even the most socialist of oil-producing countries rejects this principle, and it is both required by Iraq’s constitution and a necessity when one considers the urgent need for results and the dilapidated state of Iraq’s state oil sector, including insufficient qualified human capital. The debate therefore begins over how to involve the private companies, and specifically what type of contracts Iraq should sign to engage their investment and work. In actual fact, it really doesn’t matter what type of contract is signed – providing the interests of the government and the oil company are properly aligned, and maximum economic returns for the state are achieved.
This rational outlook has been clouded by dogmatic political stances, which argue against PSAs in favor of Service Contracts, with numerous scaremongering falsehoods put about supporting this stance. These myths about PSAs’ alleged risk are, unfortunately, misguiding Iraqi policy-makers and harming Iraq’s long-term interests, and therefore require a careful and systematic scrutiny to uncover the truth.
1. PSAs Are ‘A Tool Of Western Imperialism’
Like many historic oil-producing nations, Iraq has a difficult history marked with abuse by western powers and their representative oil companies. (Indeed my own grandfather, Dr Dhia Jafar, battled the western oil majors as Development Minister in the early 1950s to secure better terms for the state, as until then the companies were paying a fixed royalty of only 4 shillings [£0.20] per tonne!) This anti-imperialist sentiment therefore has deep roots in Iraq. Indeed, Baghdad hosted the founding of OPEC in 1960, and the nationalization of the oil sector in 1972-75 was extremely political and ingrained into the consciousness of all Iraqis as a national victory against western imperialism. However, we must not allow this to cloud our judgment for the right policy going forward. PSAs are not a tool of western imperialism, but were in fact invented by the Government of Indonesia, a socialist and Islamic government, to protect the national interest while developing their petroleum sector. They have since been widely and successfully adopted by many developing countries worldwide, including most oil-producing countries in the Arab and Islamic Worlds.
2. PSAs Are ‘A Threat To Iraq’s Sovereignty’
A frequently repeated argument against PSAs is that somehow they result in Iraq “sharing” sovereignty or control over its oil resources. This is of course not the case. In fact, Iraq’s constitution states that: “Oil and gas is the property of all the Iraqi people in all the regions and provinces.” And most national constitutions contain similar clauses relating to sovereignty over natural resources, which in no way prevents them from engaging private companies to invest in and develop these resources for the national benefit. The fact that the people of Iraq own all of Iraq’s oil and gas in the ground should not prevent Iraq from using a small portion of Iraq’s produced oil or its value to pay oil companies for developing its oil. Iraq’s oil has no value to Iraqis if left in the ground, and the Iraqi constitution also specifically requires the government to draw up “strategic policies to develop oil and gas resources to bring the greatest benefit for the Iraqi people, relying on the most modern techniques of market principles and encouraging investment.” The key thing here is that paying (through PSAs) the dues of private companies developing Iraq’s energy sector does not in any shape or form amount to relinquishing the sovereignty of Iraq to these companies, as some politically-motivated “experts” would like us to believe. It is up to the Iraq government to tighten terms of the contracts to ensure full sovereignty over its resources, irrespective of the name of the contract.
3. PSAs Are ‘Only Suitable For High-Risk Areas Such As The North Sea, Not The Middle East’
The principle of PSAs is quite simple: the investing oil company is allowed to recover its investment from the oil revenues, plus a profit as a percentage of the oil produced. This “profit oil” percentage figure needs to be as low as possible from the state’s perspective, but just high enough, depending on risk, to give the right incentive to the investing oil company to make its investment and responsibly manage the field over the long term. In high-risk areas such as the North Sea, or where exploration is involved, the number may be higher, though in all cases the state will of course collect the majority of revenues. In Iraq’s case, where many large and low-risk discovered fields are awaiting development, the profit oil allowed to the oil company will be in the lower single digits, certainly below 5% in today’s high oil price environment, and nowhere near the figures appearing in the press or used by some “politicized experts” in their campaign to discredit the whole concept.
There are also additional mechanisms (such as the R-factor and other price cap mechanisms) to ensure that the percentage of the profit oil given to the company is further reduced when oil prices rise more than expected, and the windfall profit benefits go primarily to the government. Therefore, the type of contract clearly has nothing to do with where in the world it applies to, and the commercial terms in the contract will clearly be much more beneficial to the State in Iraq than in the British North Sea. Indeed, PSAs are successfully utilized worldwide, across the Middle East and in most of the Arab oil and gas producing countries including Egypt, Libya, Algeria, Tunisia, Sudan, Syria, Jordan, Qatar, the UAE, Oman, Yemen and elsewhere, without any risk to national sovereignty and while ensuring highest returns to the state. (The previous Iraqi regime, as obsessed as it was with sovereignty matters, had negotiated and actually signed PSAs during the last 10 years of its rule.)
4. Iraq Has ‘No Need For PSAs As Service Contracts Can Deliver A Better Return’
It is true to say that Iraq has no need for PSAs or any particular type of contract. (Indeed it has been suggested that far better might be a simple tax rate, well over 90%, that would be easily understood by all without any misleading terminology.) What matters however is that the investing oil company should have the incentive to behave in the manner that best serves the interests of the host government, by investing for the long run, minimizing costs and maximizing production. This is achieved by the win-win investment-type contracts such as PSAs, where the investor’s profit is tied to the government’s returns, something which has been extremely difficult to achieve successfully with service-type agreements, where the investor earns a fixed fee for the work done (sometimes as a percentage of the amount invested or a fixed number of dollars per barrel), irrespective of the efficiency of his operations, and the overall investment costs that are finally borne by the state. Overall, such service contracts have failed to attract proper investment, and encourage a short-term approach and tend to inflate costs. In fact, often with such contracts the company gets higher rewards with increasing investment costs. Thus, such contracts are inherently not committed to the long term performance of the oil and gas fields, and will only fulfill the requirements of a seemingly satisfactory short term production policy within the term of the contract.
Indeed, out of over 80 petroleum fiscal regimes worldwide, the only real example of a major oil producer using service contracts is Iran, whose constitution, written after the Islamic Revolution of 1979, prohibits investment contracts such as PSAs (unlike Iraq’s constitution, which arguably requires them). Iran has instead been forced to develop and implement ‘buy-back’ service contracts, which have failed to attract the required level of investment. The results speak for themselves, with Iran’s production having fallen from 6mn b/d in 1979 to below 4mn b/d today, and Iran still a net importer of natural gas despite holding the second largest gas reserves in the world. (The Iranian government is currently actively engaged in modifying these service contracts to make them more like PSAs, and recent reports even suggest they are trying to find a way to adopt PSAs within the restrictions of their constitution.) It would clearly be wrong for Iraq to emulate such a failing policy and contract type, particularly as it has no legal restrictions of this kind.
By contrast, Egypt has successfully implemented PSAs and now has some 64 private companies of different sizes and nationalities working in its oil and gas sector – boosting its oil production and doubling its gas reserves in the last five years alone.
5. State Sector Can Do The Work, ‘Only Technology And Advice Are Needed From Private Companies’
There are those who argue that the Iraqi state sector can do all the work with no need for private sector investments – just technology and advice or services, limited in duration. In fact it is not technology or capital that is the issue, but efficient management and project implementation. The objective of the state should be regulation, oversight to ensure the responsible operations and good oilfield practices, and maximizing revenue collection – not trying to carry out commercial operations and run the economy itself. All the countries of the region and the world have realized the importance of encouraging the private sector, including in the petroleum sector, and in Iraq’s case in particular the decades of isolation, brain-drain and depletion of qualified and experienced petroleum sector personnel make this especially so.
The current statistics in Iraq speak for themselves. For three years now, the Iraqi Oil Ministry has failed to spend even a small percentage of its already inadequate annual budget, and for example the state-owned Southern Oil Company by its own admission will struggle to drill even 17 of the 100 wells that were planned for 2008, due to crippling bureaucracy, poor management and slow contract awards procedures. Iraq’s oil production has now barely reached pre-invasion levels, and it currently flares enough gas to adequately power all the homes in Iraq, while at the same time still importing expensive liquid fuels worth billions of dollars per year. (In fact gas flaring has increased as a result of hasty production of oil from undeveloped fields, without the necessary infrastructure and facilities to gather and utilize the associated gas.)
Leaving Iraq’s case aside, which some may attribute to short-term or unique circumstances, its neighbor Kuwait tried in the early 1990s to acquire technology and advice from private sector companies, while at the same time keeping management in state hands, using Technical Service Contracts (TSCs) ostensibly as a stop-gap measure until longer-term investment contracts were in place. These never materialized, and TSCs are still in operation in Kuwait to date, where tens of millions of dollars have yielded little, and instead of increasing the production, they have actually caused it to fall by over 20% since TSC implementation, making Kuwait the only major producer in the GCC to see declining production. (The Iraqi Oil Ministry was also recently seeking to implement such contracts, but this has now been abandoned due to justified considerable opposition, but not before months of time and resources were wasted.)
6. PSAs Will ‘Lead To Job Losses In The National Oil Sector’
This statement is not only false but clearly counter-intuitive as well. Having more and more private companies engaged in the oil sector – both international and Iraqi – will lead to more activity and investment, increased creation of both direct and support jobs, greater opportunities for training on state of the art technology, and much higher salaries of course than can be currently supported by the state sector. Unfortunately, there has been a campaign of fear and smear spread by some outsiders among the Iraqi oil workers unions to convince them of the opposite.
7. Iraq ‘Should Take More Time To Develop And Award Contracts’
Transparency and competition are important requirements for successful contracting by the state, indeed in any sector. However, Iraq does not have the luxury of time, after decades of waste, destruction, lost opportunities and a dire socioeconomic situation. It has now been over five years since the US invasion and regime change, yet at the federal level there is no agreed policy or supporting legislation and little progress on the ground to attract the necessary investment to increase production. Every year of delay costs Iraq billions of dollars. Indeed, the Central Bank of Iraq currently pays 15-20% interest on dollar deposits, so a year of delayed oil revenues causes losses for Iraq of at least that much, leaving aside the time value of money and the opportunity cost in terms of economic multiplier effects that could be achieved by successful investing of the revenues instead of just keeping them in the bank. Therefore, wasting more years debating the type of contracts, politicizing the Iraqi petroleum sector with empty slogans in the name of nationalism, or taking years designing time-consuming bidding rounds leading to more bureaucratic delays destroys literally billions of dollars of national economic value – a crime against the people which will only compound the nightmare which has so far shattered the lives of millions of Iraqis, especially those of the younger generation who legitimately aspire to set themselves free from the grip of poverty and destitution.
Having critically examined the most common myths frequently promulgated about the need for investment oil contracts, it is useful to consider the analogy of a landlord owning a piece of land and wishing to construct a hotel. An investment contract such as a PSA is the equivalent of a hotel developer (who is able to build the hotel faster, cheaper and to a higher standard than the landlord) signing a deal with the landlord to build the hotel with his own investment and manage it for 25 years, in exchange for a tiny percentage of the net profits, say 1-5 % depending on the size and location of the land plot. The landlord maintains ownership of the hotel and the land of course, and maintains strict oversight of the developer’s operations and performance. Compare that with a service contract where the developer just builds the hotel for a fixed fee which is a percentage of the overall construction cost and then hands the hotel over, or where he is paid a fixed fee for each room that is rented out, regardless of the hotel quality or the room rates achieved. It can quickly be observed how the interests of the landlord and the hotel developer are not aligned anymore and the quality and profitability of the product will suffer at the expense of the landowner.
Of course we have been addressing here the issue of contracting for optimum development of Iraq’s oil and gas resources to achieve increased production and maximum economic returns from Iraq’s undeveloped fields or unexplored areas. There are numerous other issues relating to the oil sector that Iraqi policy makers need to resolve, such as defining regulatory authorities, the role of the national oil company in managing the already developed fields, the division of responsibilities between the regional and federal government, and perhaps most importantly, ensuring responsible management and use of the oil revenues once they are earned. These are all topics for separate consideration.
It has been truly said that if we try to solve today’s problems with yesterday’s thinking, we will never achieve tomorrow. This has never been truer than of the pitiful state of unfulfilled potential that afflicts Iraq’s oil and gas resources. There are those who may not wish to see Iraq rebound from its current state or achieve its potential, and who may be working against its interests, but all Iraqis must work together to ensure that such schemes do not succeed, and that the Iraqi people get the maximum economic benefit of the full potential from Iraq’s oil and gas reserves, a right long denied to them, and a promise whose fulfillment must no longer suffer any delay. With its enormous potential and resources, Iraq can and must be at the forefront of wealthy nations and in a sustainable manner. We owe this to the future generations of Iraq.
Copyright MEES 2008.
