Global Policy Forum

Will Iraq Repeat Russia’s Oil Mistakes?


By Greg Muttitt

Carbon Web
October 2006

Iraqi oil Minister Hussein Shahristani announced last week that he aimed to sign oil production contracts with foreign companies by the end of next year. Notably, the announcement was made in Australia - like most of the significant statements of Iraqi oil policy, it was made to non-Iraqi ears.

The same was true of the confirmation last month of the form of such contracts. Speaking to the conference of the International Compact for Iraq, a meeting of international donors in Abu Dhabi, Deputy Prime Minister Barham Salih, who heads the committee drafting a new oil law, announced that production sharing agreements (PSA) would be used - the type of contract favoured by the companies themselves.

Putting Mr Salih's comments into context, the US government representative to those talks threatened that any future economic assistance to Iraq would be conditional on economic reforms - the priority among which was the passing of an acceptable oil law.

But this announcement was made with unfortunate timing. Just a week later exactly that same structure came under renewed fire in Russia for the unfair deal it gave the state. A dispute flared up when the Russian government announced that it was suspending an environmental permit for the Sakhalin-2 oil and gas project, which is currently under construction.

The project, on Sakhalin Island in Russia's Far East, is being developed by a consortium led by European oil giant Shell, together with two Japanese companies. While the Sakhalin-2 project does indeed suffer from serious environmental problems, most analysts believed that Russia's real motivation was to change the unfavourable economic terms.

As Jarmo Kotilaine, a Russia expert for the Control Risks consultancy commented, "In Russia, environmental audits are often politically motivated. What the Russian government wants is a renegotiation of the PSA." This was echoed by Adam Landes, an oil and gas analyst at Moscow-based Renaissance Capital, who said, "It seems to be a brutal way of renegotiating previous deals that were quite humiliating for Russia."

The Sakhalin-2 contract was signed in 1994, while Russia was undergoing rapid economic liberalisation, following the collapse of the Soviet Union. Ever since then, the contract has been criticised for its economic terms. In January 2005, the Russian audit chamber warned that, "We have drawn a conclusion that PSA terms for Sakhalin-2 are decidedly not beneficial for Russia." Indeed, so unfair were the terms that leading energy economist Ian Rutledge called it a "production non-sharing agreement".

But it was in July 2005, when the costs of the project nearly doubled from $12 billion to $22 billion, that the dispute really intensified. The Sakhalin-2 PSA is structured in such a way that the Russian state receives nothing (apart from a small royalty) until both the costs and a specified profit for Shell have been deducted. The result is that Shell's profits are guaranteed, while the state effectively carries all of the risk of cost over-runs.

Ironically, two of the main arguments commonly given for oil to be developed by foreign companies are that it reduces the state's risk and that only multinational companies have the capacity to manage major projects - something Shell proved by both the cost over-runs and the environmental damage that it was not up to.

However, despite all these problems with the contract Russia does not have the right to revoke, amend or renegotiate it. Even worse, the contract effectively lasts for an indefinite period of time, with an initial period of 25 years, followed by a right for the company to renew it (without consent required by the Russian state) for further periods of five years in perpetuity.

It is for these reasons that Russia was forced to revoke the environmental permit in order to halt the project. Russia has only signed three production sharing agreements, all in the early to mid-1990s. All three were controversial and no more have been signed since. In fact, the other two have also both come under pressure following the Sakhalin-2 dispute.

The parallels with Iraq are striking. All three of Russia's PSA contracts were signed while the country was in a weak position and going through rapid change. It was only later that it became clear what the country had given up.

But Russia is not the only country that is reconsidering the terms of foreign investment. Bolivia famously nationalised its gas production earlier this year. Algeria and Indonesia have both revised the terms of future oil contracts, and Venezuela has done so for its existing contracts. Thus Iraq - despite being a founder of OPEC, and a leader in taking national control of its oil industry through Law 80 of 1961 - seems to now be bucking the international trend.

So why would Iraq pursue such a policy?

A clue lies in the fact that both the deputy prime minister's announcement that PSAs would be used and the oil minister's statement that they could be signed by the end of next year were made to foreign audiences, not within Iraq. It seems it is outside interests that are driving Iraqi oil policy.

During the drafting of the oil law over the last five months, three consultations have taken place - none of them with Iraqis. The US government and the multinational oil companies were presented the draft law for their comments in July. Last month, the International Monetary Fund joined this list, examining the draft oil law in its quarterly review of the Iraqi government's compliance with its economic conditions.

But the Iraqi people have not been consulted, nor even has the Iraqi parliament. Indeed, Iraqi civil society groups and parliamentarians who have asked to see the draft have been told that it does not exist. Instead it will be presented to the parliament in December, to be pushed through (the government intends) as a fait accompli.

Russia realised the mistakes it made by signing PSA contracts only when it was too late. It remains to be seen whether Iraq follows the same course.

More Information on Iraq
More Information on Oil in Iraq
More Information on the History of Oil in Iraq


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