Contractual Incentives and Penalites to Motivate Oil Companies Increase Iraq Oil Production to 12 million barrels per day

Stuart Staniford chart on Iraq Oil

Jay Park describes why he thinks Iraq can achieve its 12 million barrels per day in 6-7 years This was a comment on an article (crossposted to the Oil Drum) by Stuart Staniford of Early Warning blog.

Jay Park is a Partner, and Chair of the Global Resources Practice Group with Macleod Dixon, where he has practiced oil and gas law since 1980. Based in Calgary, Jay leads a team of international energy lawyers.

He is the instructor of the “International Petroleum Transactions” course at the Faculty of Law of the University of Calgary. He co-instructs the five day training course, “World Legal Systems and Contracts for Oil & Gas”, which is held semi-annually in London. He also co-instructs the five day courses, “Global Gas Transportation and Marketing” and “International Petroleum Joint Ventures”, which are presented annually in London and other locations.

Stuart Staniford has a lot of excellent information on iraqi reserves by province.

Stuart’s Iraq Oil analysis on his site

Stuart article on how long it takes to ramp up mega-mega oil projects

Jay Park’s Analysis of the Likely Development of Iraq Oil

I [Jay Park] have been involved for a number of years with the Iraqi oil industry, and I am familiar with the Technical Service Contracts (TSCs) which were awarded in the First and Second Petroleum Licensing Rounds by the Petroleum Contracts and Licensing Division (PCLD) of the Iraq Ministry of Oil (MoO). I have met Dr. Al-Shahristani and many of the other MoO executives. Consequently, some of what I know can shed light on the opinions and comments above.

It seems to me that the possibility that Iraq may actually succeed in doing this should be taken seriously.

Let me explain why I agree with this sentiment. In 2004 and the years that followed, MoO entered into a number of “Memoranda of Understanding” with various major international oil companies (IOCs) to study the discovered Iraqi fields, both producing and non-producing, and share this information with MoO. Extensive analysis work was done by the IOCs, in the hopes that the work would lead to an award of a contract for the fields, or at least, the knowledge gained would give an upper hand in a bid process. Neither proved to be the case; all contracts have been awarded by bidding, and all information was shared with prospective bidders. The consequence is that all IOCs went into the bid process with good knowledge of the fields.

The Technical Service Contracts impose an obligation on the IOC (who becomes a a “Contractor” for the relevant Iraqi regional oil company, such as the South Oil Company, or the North Oil Company) to increase production to the Plateau Production Target. This must be done within 6 years (for First Round fields) or 7 years (for Second Round fields). The PPT must be maintained for 7 years.

The Plateau Production Target was one of two factors which the IOCs bid during the rounds. The second bid factor was the Remuneration Fee, expressed in dollars per barrel. The winning bid was determined using a formula involving (in the First Round) the product of the production target and the remuneration fee, or (in the Second Round) a point system that put 80% of the weight on the Remuneration Fee.

In either case, there was a tremendous incentive on the bidding IOCs to propose a VERY high Plateau Production Target. It has been said that MoO was amazed at the PPTs that were bid. MoO had hoped to get commitments for 6 million bbl/day of production; instead, they got 12 million bbl/day, even though less than all of the fields were awarded.

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Can these production rates actually be achieved in Iraq? On the ‘yes’ side of this case are the following arguments:

1. The IOCs had good information about these fields
2. The Contractor’s remuneration fee is based on a per-barrel fee which creates an economic incentive to achieve the PPT
3. The Contractors have a contractual obligation under the TSCs to reach the PPT. If they fail to do so, there are non-performance penalties under the TSC that grind down the already-modest remuneration fees, and other possible consequences

I don’t make it my business to bet against some of the world’s most capable companies achieving objectives that they are contractually bound to perform, and with economic incentives that encourage such performance, when they voluntarily set those objectives with all the relevant information they needed.

The following are reasons why these production levels may not be achieved:

1. Iraq may choose to comply with an OPEC quota at less than 12 million bbl/day. The TSCs expressly permit MoO to take less than the PPT. This triggers certain other consequences under the TSC to protect the Contractor’s interest (such as relief from the penalties associated with failing to acheive the PPT, and the right to extend the contract term so that the expected total remuneration fees can ultimately be earned at lower production rates). There is now an active debate in Iraq regarding what might happen with its OPEC quota. Some Iraqis think that OPEC will give Iraq a generous quota in recognition that it has underproduced for more than a decade. Personally, I think that is an unrealistic expectation– I don’t see Hugo Chavez cutting back Venezuelan production rates to compensate Iraq for problems of its own making. Other Iraqis think that they will quit OPEC if they don’t get all the quota they need; but others point to the fact that Iraq was one of OPEC’s founders, so quitting will not be a decision to be taken lightly.

2. While IOCs are very good at achieving their committed goals, the TSCs (particularly for the First Round fields) give them quite limited control over ensuring that operations are successful. It is up to MoO to develop the transportation and export infrastructure to take away all the produced oil, and MoO’s performance record since 2003 in increasing Iraqi production is less than stellar.

3. Security issues in the fields or attacks on pipelines may prevent the Contractors from being able to fulfill the PPT.

In a presentation I heard from Mr. Thamir Ghadhban, a former Iraqi oil minister, and now an oil advisor to the Iraqi Prime Minister Maliki, he doubted that 12 million barrels/day could be achieved. He believes that the IOCs bid too high, just to get the contracts. However, others have suggested to me that a really good oil field can be very forgiving– and have no doubts, these are some of the world’s best oilfields. Kirkuk has been producing since the 1930s, and shows no signs of stopping.

Indeed, production capability could conceivably go over 12 million bbl/day, once the Kirkuk field contract is negotiated (probably with Shell), and if Kurdistan region production is added. The Kurdistan Regional Government’s Minister of Natural Resources, Dr. Ashti Hawrami, predicts that there could be 1 million bbl/day from Kurdistan within the decade. In my view, it is only a matter of time before there is resolution of the political wrangling that prevents Kurdistan production from being exported (I can explain my reasoning for this in another post if anyone cares).

Also, the First and Second Bid Rounds were dealing only with discovered fields. There are 430 geological anomalies in Iraq; only 130 have been drilled, with a 70% success ratio. There is bound to be some oil in the 300 or so that haven’t yet felt a drill bit.

The remuneration fee is the ‘profit’ to the Contractor. And it is less than many people understand. The table in Stuart’s post that lists the fields and the remuneration fee shows the gross fee. There is an Iraqi state partner in the Contractor consortium who gets 25% of that remuneration fee, and then there is income tax of 35% on the remainder. So the $2.00 per barrel fee that BP and CNPC agreed to receive for Rumailah becomes only $0.97 after those deductions. At $80 oil, that is 98.7% government take– a new world high.

Please remember that Iraq’s situation is unique. In 2003, they had six discovered fields with reserves of over 5 billion barrels of proven reserves– and only three of them were producing. They had 21 discovered fields with between 500 million barrels and 5 billion barrels of proven reserves, and only nine of them were producing. And they have 35 fields with less than 500 million barrels of proven reserves, and none of them were producing. It is this significant discovered but non-producing capacity that is the source of the potentially large increase in production. This is not comparable to the development profile of other basins, because no other country has ever kept so many fields offline for so long.