Crude Designs: The Rip-Off of Iraq’s Oil Wealth

Photo: Greg Muttitt
Under PSAs, Iraq would hand sovereignty over oil resources, to foreign companies and international investment courts

This loss of democratic control is illustrated by the case of BP’s Baku-Tbilisi-Ceyhan (BTC) oil pipeline, which is being built from the Caspian Sea to the Mediterranean. This project is governed by a Host Government Agreement, some of whose legal provisions are comparable to those in PSAs.

In November 2002, the Georgian Environment Minister said she could not approve the pipeline routing through an important National Park, as to do so would violate Georgia’s environmental laws. Both BP and the US government put pressure on the Minister, through then President Shevardnadze. The Minister was forced first to concede the routing with environmental conditions, and then to water down her conditions. Part of the reason for her weak bargaining position was that two years earlier Georgia had signed the Host Government Agreement for the project, which set a deadline for environmental approval within 30 days of the application and stipulated that the contract had a higher status than other Georgian laws. The environment laws the Minister referred to were irrelevant. Ultimately, on the day of the deadline, the President called the Minister into his office, and kept her there until she signed, in the early hours of the morning.(6)

Shortly after Shevardnadze was overthrown in a ‘rose revolution’ in November 2003, new President Mikhail Sakashvili commented, “We got a horrible contract from BP, horrible”(67) – but he could not change it.

MULTINATIONAL COMPANIES FAVOUR COMPLEXITY

Another feature of production sharing agreements is that they are the most contractually complex form of oil contract. PSAs generally consist of several hundred pages of technical legal and financial language (often treated as commercially confidential). It is their complexity, not their simplicity, which is advantageous to oil companies.

The simplest form of oil fiscal system is the royalty (defined as a percentage of the total value of the oil), which can be seen as a company paying the state for its oil – effectively ‘buying’ it. This is used in most concession agreements, and sometimes in PSAs. In comparison with production sharing formulae, it is very clear what the state should receive from royalties – a fixed percentage of the value of oil. As long as the number of barrels extracted is known, and the oil price, it is easy to work out what royalty is due from the oil companies.

However oil companies dislike royalties and prefer systems based on an assessment of profits, such as PSAs. The reason is that they want what they call ‘upside’ (i.e. opportunities for greater profits) – ways they can reduce their payments, rather than being subject to a fixed level of payment for oil extracted.

Under profit-based systems, revenue is based on the profit remaining when the oil companies’ production costs have been deducted from the total revenue. As such, they depend on complex rules for which costs can be deducted, how capital costs are to be treated, and so on. The more complicated the system, the more opportunities there are for a company to maximise their share of the revenue by sophisticated use of accountancy techniques. Not only do multinational companies have access to the world’s largest and most experienced accountancy companies, they also know their business in more detail than the state they are working with. Consequently a more complicated system tends to give multinationals the upper hand.

For example, in the Sakhalin II project in Russia, the complex terms of the PSA resulted in all cost over-runs being effectively deducted from state revenue instead of from the Shell-led consortium’s profits. During the planning and early construction of the project, costs inflated dramatically. In February 2005, the Audit Chamber of the Russian Federation published a review of the economics of the project, finding that cost over-runs, due to the terms of the PSA, had already cost the Russian state $2.5 billion.

Although three PSAs were signed in the mid 1990s in Russia, they have been the subject of extreme controversy ever since. The changing view of PSAs in Russia in general also illustrates the loss of democratic control inherent in PSAs – if the government or political climate changes, the terms of a PSA cannot change to reflect new priorities. PSAs generally last for between 25 and 40 years. In Russia’s case, the rush to privatise in the early 1990s is now being questioned – but with the PSAs already in force it is impossible to rectify mistakes.

The Sakhalin II PSA is an example of a special type of PSA, which is growing in prominence. In such PSAs, the sharing of ‘profit oil’ is based not on a fixed proportion, but on a sliding scale, based on the foreign company’s profitability. The state receives only a low proportion of profit oil (or in the Sakhalin case, none) until the company has achieved a specified level of profit. Thus, states are deprived of revenue, while corporate profits are guaranteed. (See Appendix 1).

IRAQ WOULD FARE NO BETTER

In theory, Iraq may be able to negotiate PSAs with much more stringent terms than those used elsewhere in the world. As noted above, we do not know what exact terms Iraq might adopt if it uses PSAs. Iraq could also, in theory, avoid some of the more draconian legal clauses outlined above.

However, we have also seen that there are a number of structural features of PSAs which are likely to act against Iraq’s interests, whatever the terms. Helmut Merklein, a former senior official of the US Department of Energy, explains this based on the concept of economic rents – the excess profits of oil production (after deducting production costs and a reasonable return on capital):

“For all the sophistication and the bells and whistles these contracts have, … 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.”(68)

The generation of rents is a feature of oil production. Because of oil’s sheer value, its extraction generates profits beyond what is normally expected on an investment. These rents should belong to the country that possesses the oil resource. However, Merklein’s point is that PSAs cannot – in unpredictable economic circumstances – deliver the country its fair share of the rents, and inevitably tend to give foreign oil companies excessive profits at the country’s expense.

To the flaws identified by Merklein, we would add the long-term and restrictive nature of PSAs, that their terms are fixed as negotiated in a situation which – one hopes – will not persist in Iraq; and that they also place legal constraints beyond the issue of revenue-sharing, as we have seen.

In some countries, circumstances in the oil sector may favour investment through a mechanism such as PSAs, in spite of these disadvantages – such as where fields are offshore, risk capital for exploration is required, or the country lacks technical competence. In Iraq, however, these conditions do not apply, and given the country’s huge oil wealth, it does not need to accept the negative consequences of PSAs.

On top of these structural flaws in PSAs, there are grounds to doubt whether the specific terms Iraq might achieve would be any better than in other countries, despite Iraq’s enormous oil reserves. The key issue here is bargaining power: the Iraqi state is new and weak, and damaged by the ongoing violence and by corruption, and the country is still under military occupation.

In fact, rather than negotiating a more stringent PSA deal than elsewhere, the oil companies will inevitably wish to focus on the current security situation to push for a deal comparable to – or better than – that in other countries in the world, while downplaying the huge reserves and low production costs which make Iraq an irresistible investment.

Indeed, precisely this point is being pushed by the oil companies and their governments. The corporate lobby group ITIC attempts to invert conventional economic logic, by implying that there is greater competition among oil-producing countries than among private companies:

“Although Iraq’s potential petroleum wealth is enormous, the government still faces competition from other countries offering petroleum rights to investors. … Investors, too, are competing for access to attractive petroleum deposits but competition among them may be limited if the project in question requires scarce expertise or depth of financial resources.”(69)

Thus one of ITIC’s key recommendations is that Iraq “offer to companies profit potential consistent with the risk they bear”.(70)

Their argument that countries, not companies, must compete is especially perverse given the high oil price, and the wide recognition of supply constraint: that there is a shortage of access to reserves, not of access to capital.

Similarly, the US government’s development agency USAID has advised the Iraqi authorities that

“Countries with less attractive geology and governance, such as Azerbaijan, have been able to partially overcome their risk profile and attract billions of dollars of investment by offering a contractual balance of commercial interests within the risk contract, one that is enforceable under UK and Azeri law with the option of international arbitration.”(71)

If Iraq follows that advice, it could not only concede a contractual form which is not in its interests, but specific terms which radically understate the country’s attractiveness to the international oil industry. Along with much of its future income, Iraq could be surrendering its democracy as soon as it achieves it.

6. A better deal: Options for investment in Iraq’s oil development Back to top

A central question for Iraqi planners and politicians is how to invest in the country's oilfields – revenues from which will provide the central plank of the Iraqi economy for the foreseeable future. In the last section we saw, by looking at common practice elsewhere in the world, that investment through production sharing agreements (PSAs), would be likely to come at considerable cost to Iraq.

A RADICAL DEPARTURE

Much as their proponents like to claim that PSAs are standard practice throughout the world’s oil industries, in fact International Energy Agency figures show that just 12% of world oil reserves are subject to PSAs, compared to 67% developed solely or primarily by national oil companies.(72) Thus it is far from inevitable or necessary that PSAs must be used in order to obtain investment in Iraq’s oil development.

PSAs are often used in countries with small reserves; however the nationalised model is almost exclusively used in all countries with very large oil reserves.

The use of PSAs in Iraq would represent a major departure from common practice among the large oil producers of the region. Iraq and three of its neighbours (Saudi Arabia, Iran and Kuwait) are the world’s top four countries in terms of oil reserves, with 51% of the world total between them.(73) None of them use any form of foreign company equity involvement in oilfields.

Looking further afield, these four Gulf states together with the United Arab Emirates, Venezuela and Russia, hold 72% of the world’s oil reserves. These latter three all have some foreign involvement in their oil industry, although both Venezuela and Russia are currently drawing back from it, following unsuccessful expansions in foreign investment in the 1990s. Of these seven countries with major oil reserves, only Russia has any production sharing agreements.

In the Russian case, three PSAs were signed in the mid 1990s; they have been the subject of extreme controversy ever since due to the poor deal the state has obtained from them, and it now looks unlikely that any more will be signed.

OPTIONS FOR INVESTMENT

One argument that is deployed by proponents of PSAs is that Iraq has no other option to generate the capital investment needed to rebuild and expand its oil industry.

This is simply not true. In fact Iraq has at least three options for generating investment in its oil industry, without giving away its revenue and control over the industry:

1. Direct investment from government budget.

2. Government / state oil company borrowing from banks, multilateral agencies and other lenders.

3. Investment by international oil companies using more flexible and equitable forms of contract.

It is not the role of this report to advocate any particular structure for the Iraqi oil industry, nor to advocate for or against the use of foreign investment. That decision rests with the Iraqi people. However, in this section we briefly explore each of these options, all three of which are superior to PSAs in terms of consequences for the Iraqi economy and people.

Photo: Greg Muttitt
After 50 years of rip-off by foreign companies and over 20 years of war, Iraq needs the right policies to develop its oil industry.

First, it should be stressed that there is considerable technical competence among Iraqis themselves and foreign companies are not required to manage the industry. Indeed, the most successful period in the history of Iraq’s oil industry was between nationalisation in 1972 and the start of the first of Saddam’s wars with Iran in 1980. Freed up from the foreign interference that had unhappily characterised Iraq’s previous petroleum history, the Iraq National Oil Company moved forward confidently and effectively: between 1970 and 1979, INOC increased production from 1.5 million to 3.7 million barrels per day and discovered the four super-giant fields West Qurna, East Baghdad, Majnoon and Nahr Umar, and at least eight giant fields.

In some areas, the state of Iraqi knowledge may not be the most up-to-date, because of the sanctions era. However, this is easily solved within any of the above models by employing specialist companies under short-term technical service contracts to provide drilling and production expertise when required. Thus what is at issue is how capital is obtained, not skills.

OPTION 1: FINANCING FROM GOVERNMENT BUDGETS

The simplest model would be for the required investment to be provided each year out of government budgets. This is quite possible and appropriate in Iraq’s case, because in contrast to many other countries:


	Photo: Greg Muttitt The key US-UK "energy security" priority is secure control over an increasing supply of Gulf oil, preferably delivered by investment from their own companies


	Current Iraqi oil policy - first designed in Washington, DC - would give at least 4% of Iraq's reserves to foreign companies

By Greg Muttitt

Crude Designs:
The Rip-Off of Iraq’s Oil Wealth