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

Researched and written by Greg Muttitt of PLATFORM www.carbonweb.org, with assistance from Guy Hughes and Katy Cronin of Crisis Action www.crisisaction.org.uk.

Advice on economic modelling provided by Dr Ian Rutledge of Sheffield Energy & Resources Information Services (SERIS) www.seris.co.uk

Published by PLATFORM with Global Policy Forum, Institute for Policy Studies (New Internationalism Project), New Economics Foundation, Oil Change International and War on Want - November 2005.

Design by Guy Hughes www.power-shift.org.uk. Cover design by Ishka Michocka www.lumpylemon.co.uk.

Printed by Seacourt Press on recycled paper (75% post-consumer waste) using a waterless process in compliance with ISO 14001 and EMAS.

While the Iraqi people struggle to define their future amid political chaos and violence, the fate of their most valuable economic asset, oil, is being decided behind closed doors.

This report reveals how an oil policy with origins in the US State Department is on course to be adopted in Iraq, soon after the December elections, with no public debate and at enormous potential cost. The policy allocates the majority (1) of Iraq’s oilfields – accounting for at least 64% of the country’s oil reserves – for development by multinational oil companies.

Iraqi public opinion is strongly opposed to handing control over oil development to foreign companies. But with the active involvement of the US and British governments a group of powerful Iraqi politicians and technocrats is pushing for a system of long term contracts with foreign oil companies which will be beyond the reach of Iraqi courts, public scrutiny or democratic control.

Economic projections published here for the first time show that the model of oil development that is being proposed will cost Iraq hundreds of billions of dollars in lost revenue, while providing foreign companies with enormous profits.

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:

The development cost is low when compared to the return;

As a consequence, the payback period is very quick;

Since there are considerable proven but currently undeveloped oil reserves, risk to capital is very low (as no exploration is required for immediate field development). In the longer term, Iraq will explore but even this is relatively cheap and low-risk.

Iraq's investment requirement is expected to peak at around $3 billion per year.(75) This is well within the range of current budgetary allocations: the 2005 Iraqi oil investment budget is $3 billion76 (out of a total Iraqi budget of around $30 billion).

Furthermore, within at most three years from the start of development, revenues from new production would well exceed the ongoing investment requirements, and could therefore provide this finance. In other words, at worst Iraq would have to invest $2.5 – 3.0 bn of its existing budget for three years.

One argument commonly advanced in favour of foreign investment in Iraq’s oil is that it would save government budgetary expenditures for other priority areas. For example, the British Foreign Office argued in 2004, in a Code of Practice issued to the Iraqi Oil Ministry:

“In the absence of a very high oil price, Iraq would only be able to finance this investment [in oil development] itself if it could secure a very generous debt reduction deal and was prepared to make substantial cuts in government expenditure in other areas. Given Iraq's needs, it is not realistic to cut government spending in other areas, and Iraq would need to engage with the International Oil Companies (IOCs) to provide appropriate levels of Foreign Direct Investment (FDI) to do this.”(76)

In other words, if Iraq pursued the option of direct financing, the amount of money invested from the government budget would no longer be available for schools, hospitals, roads etc. Economists say that this capital has an opportunity cost.

However, the use of discounting techniques (see Appendix 2) is precisely designed to allow for the opportunity cost of capital. In the previous section, we saw that, having considered this opportunity cost by discounting, the Iraqi government is still better off investing its own money. The (2006) net present value lost by the Iraqi state as a result of adopting the PSA policy would be between $16 and $43 billion, at 12% discount rate.

This shows that, in purely economic terms, the policy is bad for Iraq. However, the choice of what development path to follow – whether to develop more quickly now, or to build steadily for the long term – is ultimately a political one. As such, this decision should be made by the Iraqi people; but it should be made with a full understanding of the economic implications.

In the previous section, we found that companies could expect rates of return on their investment of between 42% and 162%, depending on the field characteristics and the PSA terms. These rates of return can also be seen as the cost of the capital to the state if Iraq decides to use the PSA financing route.

When looking at it in this way, it is helpful to put all 12 fields together and consider them as a single investment. In this case, we get ‘company’ internal rates of return of:

Libya PSA terms: 75%

Oman PSA terms: 91%

Russia PSA terms: 119%.

The financial structure of PSAs versus bank loans are different, so these are not directly equivalent to bank interest rates. However, by comparison with bank rates, we can see that the cost of PSA capital would be huge and could not justify the political considerations outlined above.

THE NEED FOR TRANSPARENCY

Ensuring that Iraq's oil wealth benefits the majority of Iraqis is not only a question of the contracts themselves. Appropriate development also depends on good governance.

There are very few oil-producing countries that have managed to prevent corruption in their oil sectors, and Iraq is no exception. Indeed, during the three decades of national control over the industry, Iraq’s oil wealth was used to sustain a brutal dictatorship and its internal security apparatus, to personally enrich Saddam Hussein and his family, and to finance devastating wars with Iraq’s neighbours. Meanwhile, corruption became endemic at all levels of Iraqi officialdom.

Corruption is already a problem in post-Saddam Iraq. Investigations by US and international agencies into the financial operations of the Coalition Provisional Authority and Iraq's interim governments have concluded that billions of dollars have been lost due to corruption, theft and inadequate accountability. The vast majority of that money, estimated to be at least $4 billion, was derived from Iraq's oil income, which was meant to be invested in the reconstruction of the country.(85)

Whether Iraq’s oil is held in the public or the private sector, good governance and effective democratic institutions will be essential. In order to prevent the emergence of another Saddam, it is particularly important to curb the discretionary power of the executive over oil income and expenditure. It is also necessary to ensure that adequate oversight powers are given to appropriate government bodies and that transparency is enshrined in law.(i) Furthermore, all oil income and expenditure must be included in a transparent and accountable budgetary process. Auditors should report to parliament and parliamentarians should be able to call ministers and senior officials to account. No national reserve fund should be allowed to be used as a “slush fund”.(86)

These challenges are enormous in Iraq. However, the insistence by the United States, the oil industry and their allies on constitutional and contract terms favourable to foreign investors with minimal state regulation, is likely to hinder, not help, transparency and accountability.

Although civil society around the world is now pressing for disclosure of contracts, with some initial successes (ii), confidentiality remains the norm. Minimum requirements for any form of contract must be the prohibition on non-disclosure clauses and the publication of the contracts themselves.(87) Even then, PSAs present serious difficulties: as this report has already shown, their complexity makes them notoriously difficult to monitor.

The attitude of multinational oil companies can also be unhelpful. Corruption problems often arise from the ‘ultra-presidential’ status of the executive and Iraq Revenue Watch warns:

“Foreign influence also has had a hand in promoting ultra-presidential systems. During the 20th century, companies mainly preferred to deal with one “negotiator,” either the president or his representatives, and the executive branch in many resource rich countries grew all-powerful as oil rents flowed through it. As foreign oil companies engage in more business with Iraq’s nationalized oil industry, Iraqis must be vigilant to the potential role of those companies in encouraging an ultra-presidential government.”(88)

The emerging lesson from the growing body of evidence of the ‘resource curse’ – where countries with natural resources such as oil suffer high levels of corruption, and even (paradoxically) economic decline, is that before massive influxes of capital or oil revenue, it is necessary to have in place the institutions to manage them and an economic base that is broader than sole reliance on the oil economy.(89) In this context, it is precisely the speed of Iraq’s opening to the oil multinationals, with rapid change and a lack of clear governance structures, which is likely to create the conditions for corruption and economic failure.

i For more on this, see www .pblishwhatyoupay.org - website of the Publish What You Pay coalition of over 280 civil society organisations.
ii Such as in Azerbaijan – legal agreements were unavailable until civil society pressed for them to be published. After which BP posted its agreements on its website www.caspiandevelopmentandexport.com

OPTION 2: GOVERNMENT / STATE OIL COMPANY BORROWING

An alternative option would be for state oil companies (or the government) to borrow the money, either as

1. loans from banks, using future oil production as collateral;

2. concessionary loans from multilateral agencies, such as the World Bank; or

3. the issue of government bonds.

As with the direct funding option above, the low cost of development and quick payback make this quite an attractive option.

Helmut Merklein, a former senior official of the US Department of Energy, comments that the foreign investment/PSA approach, “would be like securing a $300 loan by pledging a fully paid-for $300,000 residence as collateral. In contrast he notes:

“With that kind of collateral, there will be no shortage of commercial or governmental (bilateral or multilateral) credit institutions eager to supply the required capital needed to rehabilitate oil production in Iraq.”(78)

Muhammad Ali Zainy, an expert on Iraqi oil at the Centre for Global Energy Studies, looks specifically at the Majnoon field as an example, noting that:

“If INOC [Iraq National Oil Company] borrows the $3 billion amount to be repaid over 20 years at 10% interest compounded annually, the debt service (principal and interest) would be around $352 million/year, or around $1.6 per barrel per day. … [Combining this capital cost with production and transportation costs] the total FOBb cost to INOC would be $3.5 per barrel. If this oil is sold at $35 per barrel, the rent to INOC would be $31.5 per barrel. With these prices and costs, it should not be very difficult for INOC to borrow from the banks, with incremental oil as the collateral.”(79)

What is unclear at this stage is how such an approach would interact with Iraq’s existing national debt – the largest (relative to GDP) of any country in the world.

The International Monetary Fund is expected to issue a Standby Agreement, setting out conditions with which Iraq will have to comply in order to receive some debt relief, by the end of 2005. It is unknown whether this will place restrictions on Iraq’s future borrowing. The IMF recognises the need for investment in Iraq’s oil sector but the IMF is also infamously keen on pressuring countries to privatise their industries.

There is similarly a question of whether commercial lenders would be deterred by Iraq’s high level of debt. Their decision will depend in particular on what agreements are made on repaying the existing debt. In any case, the points made by Merklein and Zainy, above, are convincing: given the huge scale of the available rentsc, and the corresponding potential collateral (from future oil production), it would seem to be more a question of negotiating the right terms than of finding a lender willing to participate.

Furthermore, in light of the priority given by the international community to rebuilding Iraq, lower-cost loans from the World Bank or other multilateral agencies should also be an option.

There is a very strong case, being made by the Jubilee Iraq network (80) and others, that the bulk of Iraq’s debt should be treated as odious debt. That means that the debt was incurred by Saddam Hussein without the consent of, and not for the benefit of, the Iraqi people. Rather, he used it to fight wars and to finance internal repression. Thus, it is argued that the people of Iraq bear no legal or moral responsibility to repay that debt.(81)

Were this argument to be accepted by the Iraqi authorities, international borrowing could be quite straightforward. As the Wall Street Journal pointed out:

“We wouldn't blame (Iraq’s) leaders if they decided that some of those financial obligations are indeed odious. And given that this is such an extreme case, international lenders probably wouldn't hold it against them for long.”(82)

In any case, it is noteworthy that even the strongest advocates of PSAs – including corporate lobby group ITIC, the British government, and Iyad Allawi – seem to accept that borrowing is an option.(83)

OPTION 3: MORE EQUITABLE AND FLEXIBLE CONTRACTS?

Iraq’s neighbours Iran, Kuwait and Saudi Arabia have recently allowed some limited foreign investment in their oil and gas industries, although in a very different way from PSAs.

They have used alternative contractual options such as risk service contracts, buyback contracts or development and production contracts.

Each of these contractual forms allows a foreign company to provide investment in an oil development, but gives it no direct interest in the oil produced. The oil remains with the state and the company is paid as the state’s contractor. As such, these contracts can be seen as modifications of the technical service contract to allow investment.

All three give operatorship of the field to a foreign company, but with much more limited rights, and in the case of buybacks and DPCs, for a much more limited period of time than PSAs. Importantly, in all three contract types, the foreign company does not have the opportunity to make excessive profits, as it is paid either a fixed fee or a fixed rate of return.

Obviously any form of external financing has a cost. Indeed, even with the borrowing option above, Iraq will have to carefully consider the terms of any loan, and its future implications(l) . Iraq should be careful not to tie its hands, either through contracts, or through collateral arrangements. The challenge will be to weigh the advantages of freeing up government funds against the cost of the finance.

We have seen that if Iraq’s oilfields are developed by foreign companies under PSAs, the cost to Iraq’s economy will be enormous. We have also seen that PSAs would give considerable control away to the multinationals for many decades.

It is in these respects that buyback, risk service or development and production contracts may be preferable for Iraq. For the same reasons, the oil companies argue that such forms of contract are not sufficiently appealing to them (not profitable or wide-ranging enough) to justify their investment.(84) In large part, this is a negotiating position – inevitably, companies will downplay their interest in order to get a better deal.

Even if it is true to some extent, Iraqi negotiators should not be pushed into accepting terms that are not in Iraq’s interests. In the previous section of this report, we have shown how damaging PSA deals would be; in this section, we have tried to show that other options are available. If the oil companies will not sign fair contracts, then Iraq can develop its oil industry without them.

ALTERNATIVE CONTRACT TYPES

Algeria has made significant use of a mechanism known as the Risk Service Contract. In this model, a foreign company invests capital, and when production begins is reimbursed their costs (from oil sales), plus generally a fixed fee per barrel of oil produced. (iii) The company can thus increase its profits by increasing the rate of production; on the other hand, the company carries the risk that the venture will fail (especially where exploration is involved). This model may also be used in Kuwait’s opening to investment of four of its northern oilfields (Project Kuwait), which is still under parliamentary debate.

In the 1990s, Iran developed the Buyback Contract, which it has applied on a number of oilfield investments. This is very similar to the risk service agreement, but is generally for a shorter period – commonly 5 to 7 years of production (following 2-3 years of development) – after which the state oil company becomes the operator of the project and keeps all revenue. The fee is paid in oil rather than
cash and is calculated as a percentage of the capital invested. Thus the company obtains an agreed rate of return on its investment, provided a sufficient rate of production is achieved (although, again, the company carries the risk that little or nothing will be produced). Returns are generally 15-24%.

In the late 1990s, Iraq under Saddam Hussein developed a new form of contract along similar lines, known as the Development and Production Contract. In this, a company would develop and operate an oilfield for a fixed period – commonly 12 years. After that, operatorship would be passed to the state oil company, but with the foreign company providing services under a Technical Service Agreement (often for a further 15 years), during which the company also has a right to buy oil – either at market price or at an agreed discounted rate.

All of these contract types limit the profits that can be extracted by foreign companies, so guarantee more effectively the state's income, and do not cede the same degree of sovereignty as PSAs.

iii The term “risk service contract” is slightly ambiguous – it is alternatively revenues are shared (in cash), rather than production itself.

7. Conclusion

We have seen in the preceding chapters that, under the influence of the US and the UK, powerful politicians and technocrats in the Iraqi Oil Ministry are pushing to hand all of Iraq’s undeveloped fields to multinational oil companies, to be developed under production sharing agreements. They aim to do this in the early part of 2006.

The results for Iraq would be devastating:

Iraq would lose an enormous amount of revenue (making it conversely highly profitable for the foreign companies);

The terms of the contracts would be agreed while the Iraqi state is very weak and still under occupation, but be fixed for 25-40 years;

PSAs would deny Iraq the ability to regulate or plan its oil industry, leaving foreign companies’ operations immune from future legislation;

PSAs would shift decisions on any disputes out of Iraq into international arbitration courts, where the Iraqi constitution, body of law and national interest are simply not relevant.

Yet, Iraq has other options for obtaining investment in its oil sector, including:

Direct financing from government budgets;

Government/state oil company borrowing; or

Less damaging contracts with multinational oil companies, such as buybacks or risk service agreements.

These decisions should be made with the full participation of the Iraqi people, not in secret by unaccountable elites. Care should be taken not to take major irreversible steps that would later be regretted.

Getting these decisions right is vital for the future of Iraq.

Appendix 1: How a production sharing agreement works

In a Production Sharing Agreement (PSA), a foreign company provides capital investment. In Iraq’s case, in the medium term this will include drilling and the construction of infrastructure, but not exploration – as Iraq has around 65 known but undeveloped fields.

The first proportion of oil extracted is then allocated to the company, which uses oil sales to recoup its operating costs and capital investment – the oil used for this purpose is termed ‘cost oil’. There is often a limit to what proportion of oil production in any year can count as cost oil.

Once costs have been recovered, the remaining ‘profit oil’ is divided between state and company in agreed proportions.

The company is often also taxed on its profit oil and, to add further complexity, there may also be a royalty payable on all oil produced. Often a bonus is paid to the government on signing, and sometimes on start of production. However, such bonuses are generally small compared to the revenues themselves.

AN EXAMPLE OF HOW PSAS WORK

To illustrate how a PSA works, let us consider a hypothetical case which includes all of the above elements, with the following terms. This example illustrates the mechanisms involved, and is not based on terms that would be appropriate to Iraq.

Profit oil split: 60 state : 40 company
Royalty: 15%
Profits tax: 40%

DIAGRAM A1.1: SPLIT OF REVENUES IN A HYPOTHETICAL PSA

In the diagram above, we show how these elements are divided. Royalties are charged as a percentage of the total value of the oil. Cost oil is then deducted. In this case, we assume that development and production costs amount to 40% of the total revenue (this is determined by the physical and economic characteristics of the oilfield, rather than by the PSA terms). The remaining 45%, after deducting royalties and cost oil, is divided between state and company 60:40. The company’s share of profit oil is then taxed.

Putting all of these together, the company receives 50.2% of total revenues including the recovery of its costs. As the profits of the field are 60% of the revenues (after deducting the 40% costs) – thus the state take is 82% of the profits; the company’s take (share of profits) is 18%.

Sometimes the state also participates as a commercial partner in the contract, operating in joint venture with foreign oil companies as part of the consortium (as in Libya, for example). In this case, the state is considered as a shareholder in the ‘company’ – so the ‘company’ share of profit oil is split between the state and private investors. If the state has a 50% participation share, it provides 50% of the capital investment, and receives a further 50% of the company share of profit oil (after the state-company split).

A newer form of PSA divides ‘profit oil’ not in fixed proportions, but on a sliding scale, intended to reflect the profitability of the venture.a The theory is that the more profitable a venture, the quicker costs are recovered, and so the more is available for the state. The sliding scale can be based on rates of production (90), ‘R’-factors (defined as the ratio of cumulative receipts to cumulative expenditures) or the company’s internal rate of return.(91)

The argument for rate-of-return style PSAs is based on allowing the state to capture a reasonable share of profits, but in practice this advantage can be outweighed by other consequences:

1. the investor’s profits are effectively guaranteed, by denying the state a fair share of revenue until the specified profit has been achieved;

2. while the specified level of profits is assured, this does not preclude the investor from obtaining much higher profits (at the more normal, lower share of profit oil);

3. it is in the investor’s interests to inflate costs (a process known as ‘gold-plating’), especially if they can sub-contract operations to another company in the same group (for example, from one Shell subsidiary to another Shell subsidiary) – as the subcontractor profits from their work, the project operator still profits according to the PSA, and the state gets little or nothing.

Appendix 2: Discounting in oilfield economics – key concepts

THE TIME VALUE OF MONEY

Investments in the oil industry generally last over a period of decades. A large amount of capital is invested up-front, and then income is received over the life of the project.

When modelling such investments, it is important to consider the time value of money. A specified amount of money is worth more now than it is at some later date – even neglecting the effect of inflation.a This is because money received now can be invested, and so will earn extra profits.

For example, if I have �100 now, and invest it in a bank account with 10% interest (0.1 in decimals), I will get �10 interest in the first year. After one year, I will have:

100 + (0.1 x 100) = 100 x 1.1 = 110.

In the second year, I will get �11 interest (10% of �110) – this includes interest on the original �100, and also on the first year’s interest – known as compound interest. After the second year I will therefore have:

100 x 1.1 x 1.1 = �121.

Extending this logic, in five years’ time, I will have:

100 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 = �161.

This is written 100 x 1.15 (100 times 1.1 to the power of 5). Thus, if this level of interest is available, �100 now is worth 61% more to me than �100 in five years’ time.

DISCOUNTING AND PRESENT VALUE

Put the other way round, money is five years’ time is worth less than it is now – to consider its equivalent value today, we have to discount it.

When we compare different transactions at different times, we discount all future amounts to what they would be worth now, allowing for the time value of money. What they would be worth now is called their present value.

DISCOUNT RATE

The effect time has on the value of money depends on what return would be available were the ‘now’ money to be invested. So if we could only get 5% interest, �100 now would be worth 100 x 1.055 = �128 in five years’ time.

The annual rate at which today's money would grow – and hence the rate at which ‘later’ money must be discounted in our model – is called the discount rate.

Reversing the calculations above allows us to work out present values. �100 in five years’ time has a present value of:

100 / 1.055 = �78 at a discount rate of 5%; and
100 / 1.15 = �62 at a discount rate of 10%.

The oil industry commonly uses a discount rate of 12% in real terms, or 15% in nominal terms (allowing for inflation).

The discount rate can be considered to be the opportunity cost of capital. By investing capital in a project, the investors have lost the opportunity to invest it elsewhere. Therefore they will not invest in the project if the capital could be invested elsewhere more profitably (e.g. in another project, or in a bank account, or in bonds or stocks). The discount rate is the return they would expect to get by investing elsewhere.

NET PRESENT VALUE (NPV)

So when we consider the profitability of a capital-intensive project such as an oilfield development, we have to look at discounted values. Rather than simply counting the profit as minus , we look at the net present value (NPV) of the project, which is defined as [sum of present values of receipts] minus [sum of present values of expenditures].

Net present value is always given with a specified discount rate – if the discount rate is not stated, the NPV is meaningless.

We can illustrate this with a simple example of a five-year project, with the following cashflow:

Year

Expenditures

Receipts

1

75

0

2

20

30

3

10

40

4

10

40

5

10

40

This project has total expenditures of 125, and total receipts of 150. But to see whether it is profitable, we need to use discounting.

Year

Net cash flow (NCF)
(= Receipts less expenditures)

Present value of NCF
at 12% discount rate

1

-75

-75

2

10

= 10 / 1.12 = 8.93

3

30

= 30 / 1.122 = 23.92

4

30

= 30 / 1.123 = 21.35

5

30

= 30 / 1.124 = 19.07

This project has a net present value of � -1.73, at a discount rate of 12% (the total of the right-hand column) - so is not considered profitable.

Note that profitability depends on what discount rate we use. At a discount rate of 10%, the same project would have a net present value of � +1.91 so it becomes profitable at this discount rate.

INTERNAL RATE OF RETURN (IRR)

The other concept that is used to assess profitability of oilfield projects is internal rate of return (IRR). This is defined as the discount rate at which the project NPV would be reduced to zero.

IRR can only be worked out numerically – by trial and error. For the project above, we can see that the IRR is somewhere between 10% and 12%. However, modern spreadsheets programmes can calculate IRR automatically. Using a spreadsheet, we can find that in fact the IRR for this project is 11.03%.

The investor considers the project profitable (and will decide to invest in it) if the IRR is greater than the discount rate. The higher the IRR, the more profitable the project.

Appendix 3: Iraqi oilfield data

As noted in section 4, Iraq’s emerging oil policy is that the Iraq National Oil Company will continue to operate the oilfields which are currently in production, while all new fields will be developed by private companies through production sharing agreements.

In March 1995, the Ministry of Oil (under the Saddam regime) listed 25 new fields to be earmarked for priority development if sanctions were lifted: 11 in the south, 4 in central Iraq and 11 in the north. The list was presented by Ministry officials including Thamer al-Ghadban, who subsequently became “chief executive” of the Ministry during the first few months of the occupation in 2003, and then Oil Minister in the Interim government of Iyad Allawi.

These fields are listed below, with summary data. This data has been taken from recent reports by the US Department of Energy's Energy Information Administration, Deutsche Bank, the Iraqi Ministry of Oil and BearingPoint strategic consultants for the US Agency for International Development (USAID).

In June 2005, the Ministry of Oil announced that it was seeking discussions with multinational companies on the development of 11 oilfields in the south of Iraq.(96) Although they did not list the fields, we assume that it is the same 11 southern fields listed above.

The Khurmala and Hamrin fields in the north are now being developed through technical service agreements, signed respectively with Turkish company Avrasya in December 2004 and with the Canadian OGI in March 2005, leaving just 9 fields in the north, in two groups.

Appendix 4: Economic analysis - methodology & assumptions

The impact of the proposed Production Sharing Agreement policy on Iraq’s revenue will of course depend on the terms of any PSA, as well as on physical circumstances, especially development and production costs, and the oil price.

In this appendix we consider a number of possible terms used in other countries, and apply them to a ‘base case’ physical scenario; we then test sensitivity to variations in the physical scenario. The aim of the exercise is to examine how PSA performance compares to the current nationalised system.

Theoretically the state’s percentage of net revenues from a PSA – known as state take – can range anywhere from 0.1% to 99.9%, according to how the contractual terms are set. In practice, according to Petroconsultants’ 1995 review of petroleum fiscal regimes, on economically marginal oil fields, state take ranges from 25.1% in Ireland to 101%2(m) in Syria, while on very profitable ‘upside’ fields it ranged from 25.0% in Ireland to 87.7% in Abu Dhabi. However most PSAs provide for a state take of between 60 to 90%.

We have selected three different scenarios (Oman, Libya and Russia)(n), with varying terms, and then applied them to the physical characteristics of Iraq’s oilfields, to consider their economic implications.

Oman was selected as, like Iraq, it has relatively low-cost onshore fields, and is one of the only countries of the Gulf region that actually uses PSAs.

Libya was selected as it has produced oil for many decades, and has recently reopened to foreign investment following a period of international sanctions. Libya’s most recent (“EPSA IV”) terms are widely considered within the oil industry to be among the most stringent in the world, so might be considered a ‘best case’ PSA for Iraq.

Russia was selected as it is the only country which currently uses PSAs and has oil reserves which are remotely comparable in size to those of Iraq. Like Iraq, Russia has had an oil industry for many decades. Russia's PSAs were also signed during a period of rapid liberalisation following major regime change. Indeed, there is substantial technical collaboration between Russia and Iraq.

PSA TERMS

Russia (Sakhalin II)

PSA terms for the Sakhalin II project in Russia are as follow:(97)

$50m of bonuses; $160m reimbursement of state’s exploration costs; $100m to Sakhalin Development Fund.

6% royalty.

No cost oil limit.

“Profit oil” split only once costs and 17.5% company IRR have been achieved: 10:90 (government:company) for two years, then 50:50 until 24% IRR achieved; then 70:30.

32% tax on company profits, for which capital costs are depreciated over 3 years on a straight-line basis.

Oman

PSA terms for Oman are as follows:(98)

Signature bonus of $0.25m; discovery bonus of $3m; production bonuses of $1m each when production levels of 25, 50, 75, 100, 125 and 150 kbpd are reached.

Cost oil limit of 40% of revenues.

Profit oil split 80:20.

No royalty.

No tax.

Libya (EPSA IV round)

Libya uses a modified joint venture-type PSA. Terms for Libya's EPSA IV round are as follows:(99)

No tax (tax is paid only by the National Oil Company, from its share of profit oil).

No royalty.

Signature bonuses and state participation share were open for companies to bid in an auction, with the contract going to whichever company offered the highest share of production to the state (or whichever offered the higher signature bonus if two companies bid the same share). State participation shares of profit oil ranged from 61.1% to 89.2% (average 81.5%), and signature bonuses from $1m to $25.6m (average $8.8m). In applying Libyan-type terms to Iraqi oilfields, we take these average bonuses and participation shares.

On top of the signature bonuses, further production bonuses apply for each block. In our model, we take the bonuses of Libya’s Block 54, which constitute: $5m when 100m barrels have been produced, then a further $3m when each of 130, 160, 190, 220, 250,280, 310, 340 and 370 million barrels have been produced.

State provides no contribution to exploration costs, 50% of development capital, and share of operating costs equal to its participation share.

Profit oil is split according to production rate and ‘R’ factor (ratio of contractor’s accumulated receipts to accumulated costs). This varies from block to block in Libya. For our analysis, we take the terms from Libya’s Block 54, which does not consider production rate, but divides profit oil according to ‘R’ factor as follows:

‘R’ factor Contractor share

0.0 - 1.5 90

1.5 - 3.0 70

> 3.0 50

OIL FIELDS CONSIDERED

We now consider the economic impact on Iraq, using these three sets of PSA terms.

For this assessment, we consider only the fields likely to be opened soonest via PSAs: Halfaya, Bin Umar, Majnoon, West Qurna, Gharaf, Nasiriya, Rafidain, Amara, Tuba, Ratawi, East Baghdad and Ahdab. These are the priority fields identified for development in 1995 (as listed in Appendix 2), excluding Hamrin and Khurmala which are now already being developed, and also excluding 11 smaller fields on which full data was not available.

PSAs could potentially be signed on all of these in 2006.

ECONOMIC MODELLING

To consider the economic impact of the proposed PSA policy, we have constructed economic models of each of the twelve priority oil fields listed in Appendix 3. The results are shown in section 5.

We consider only oil, not gas, in this analysis.

All figures are in real terms (2006 prices) – i.e. with no inflation.

We assume that economic factors (including production rates, costs etc.) are the same whether oil is extracted by the Iraq National Oil Company or by foreign companies through PSAs. This assumption is based on the technical expertise existing within Iraq’s own oil industry, and its access to new technological resources through technical service agreements.

We use a discount rate of 12%.

The analysis assumes PSAs are signed in 2006, followed by feasibility and appraisal expenditures of $10 million in the three subsequent years. Project sanction (and hence first development investments) occur in 2009. First oil is achieved in 2011, at 30% of the peak level, then rising steadily to peak in 2014.

Production profiles are based on the figures for reserves and peak production cited in Appendix 2, with constant exponential declines in production ranging from 3% for the largest fields (Majnoon, W Qurna, East Baghdad) to 15% for the smallest (Ahdab). Similarly, production plateaus range from zero (single peak) for the small fields to over 20 years for the largest.

Development expenditures are based on those used by PetroConsultants, adjusted according to the field size and production rate, generally continuing until two years after the end of peak/plateau production.

Iraqi oil experts estimate operating costs between $0.5(100) and $1.5(101) per barrel. We assume this to relate only to variable operating costs; for our analysis, we take $1.0 per barrel. We add fixed operating costs of 5% of development costs.

For simplicity, we do not include transport costs – thus the oil price used is effectively the wellhead price. If transport costs $0.5 per barrel, then the FOB oil price is $0.5 higher than the wellhead price.

References

(1) Letter to Arthur Balfour, Foreign Secretary, 1918, cited in Daniel Yergin, The Prize (Simon & Schuster, London, 1991), p.188

(2) Introductory paper on the Middle East by the UK, undated [1947], FRUS, 1947, Vol. V, p. 569, cited in Mark Curtis, The Ambiguities of Power (Zed Books, London, 1995), p. 21

(3) Memorandum by the Chief of the Division of Near Eastern Affairs, undated [1945], FRUS, 1945, Vol. VIII, p.45, cited in Mark Curtis, The Ambiguities of Power (Zed Books, London, 1995), p. 21

(4) BP, Putting energy in the spotlight, Statistical Review of World Energy, June 2005

(5) Dick Cheney, speech at the Institute of Petroleum Autumn lunch, London, 15 November 1999

(6) National Energy Policy Development Group, National Energy Policy report, May 2001, p.8-5

(7) Jack Straw, Secretary of State for Foreign & Commonwealth Affairs, speech on 'Strategic priorities for British foreign policy', 6 January 2003

(8) Ministry of Defence, White Paper: Modern Forces for the Modern World (Strategic Defence Review), July 1998, chapter 2, paragraph 40

(9) Foreign and Commonwealth Office, UK International Priorities: A Strategy for the FCO, December 2003

(10) US Department of Commerce, Memorandum for the President, Transmittal of the Report on the US-UK Energy Dialogue, 30 July 2003

(11) Ibid, Section 1

(12) Ibid, Section 1

(13) Foreign and Commonwealth Office (FCO), Code of Practice for the Iraq Oil Industry, undated (summer 2004), pp.4-5

(14) UK Secretary of State for Foreign and Commonwealth Affairs, Government Response to Seventh report of the House of Commons Foreign Affairs Committee, on 'Foreign Policy Aspects of the War Against Terrorism', September 2004

(15) Dr Kim Howells MP, answer to Parliamentary Question by Harry Cohen MP, 12 July 2005, Hansard column 878W

(16) James McLaughlin (Iraq Policy Unit, Foreign & Commonwealth Office), letter to Lorne Stockman (PLATFORM), response to request under the Code of Practice on Access to Government Information, 9 December 2004

(17) For more on ongoing US influence in Iraq, see Herbert Docena, 'Shock and Awe' Therapy, Focus on the Global South, April 2005

(18) Jim Krane, "US will retain sovereign power in Iraq," Associated Press, 21March, 2004

(19) Bearing Point, report to USAID, Options for Developing a Long Term Sustainable Iraqi Oil Industry, 19 December 2003

(20) Eric Watkins, 'Iraq seeks E&D investment, nixes reserves privatization', Oil & Gas Journal, 16 February 2005

(21) Then the Turkish Petroleum Company - renamed in 1928

(22) Daniel Johnston, International petroleum fiscal systems and production sharing contracts (Pennwell, 1994), p.39

(23) Thomas W W�lde, 'The current status of international petroleum investment: regulating, licensing, taxing and contracting', in CEPMLP Journal, Vol 1, no.5, July 1995 (pub. University of Dundee)

(24) Carola Hoyos, 'Big players anticipate Iraq's return to fold', Financial Times, 20 February, 2003

(25) Shell in the Middle East magazine, April 2005, available online at www.shell-me.com/english/apr05/news-me2.htm

(26) Glenn Irvine International, recruitment advertisement, August 2004, http://www.irvine-int.com/irqext.html#irqext. Luay Jawad was appointed to the post

(27) Walter van der Vijver, speech to ECSSR conference, 'A new era for international oil companies in the Gulf: opportunities and challenges', Abu Dhabi, 19 October 2003

(28) International Tax & Investment Centre (ITIC), Strategic Questions For Our Future, undated [2004] www.iticnet.org/publications/StrategicQuestions.pdf

(29) International Tax & Investment Centre (ITIC), Petroleum and Iraq's Future: Fiscal Options and Challenges, Fall 2004, p. 3

(30) Ibid, p. 3

(31) Ibid, p.10

(32) BP, op cit, p.4

(33) Marc Grossman, Under Secretary for Political Affairs, Testimony before the Senate Foreign Relations Committee, 11 February 2003; Eli J. Lake, 'US plans for post-Saddam Iraqi government', The Washington Times, 5 June 2002.

(34) Nicolas Pelham, 'Oil to be privatised but not just yet, says Iraqi minister', Financial Times, 5 September 2003

(35) Carola Hoyos, 'Exiles Call for Iraq to Let in Oil Companies', Financial Times, 7 April 2003

(36) Ibid

(37) US State Department, Future of Iraq Project, Oil and Energy Working Group (Oil Policy Subgroup), April 2003, published in Middle East Economic Survey, 'Iraqi oil policy recommendations after regime change', 5 May 2003, pp.D1-D11

(38) Ibid

(39) Carola Hoyos, op cit

(40) Philip J Carroll, 'Personal commentary', in Oxford Energy Forum (pub Oxford Institute for Energy Studies) November 2004

(41) Dr Kim Howells MP, answer to Parliamentary Question by Harry Cohen MP, 13 July 2005, Hansard column 1123W

(42) Nicolas Pelham, op cit

(43) Ibid

(44) Thamer al-Ghadban, interviewed by Bobby Schuck in Shell in the Middle East magazine, October 2004

(45) Energy Compass, 'Iraq: Puzzling over the future', 1 October 2004

(46) "For new development of undeveloped oil and gas fields, and for exploration, all of which must start as soon as possible and in tandem with INOC's efforts, these should be accomplished through private sector investment via competent international … oil companies… However, these new ventures should specifically not be allowed to partner with any state-owned enterprises, including INOC, in order to ensure state impartiality and avoid the pitfall of state interference in corporate enterprise management". [Cited in Middle East Economic Survey, 'Allawi outlines new Iraqi petroleum policy: INOC for currently producing fields/IOCs for new areas', 13 September 2004, pp. A1-A4]

(47) "Eventually, in years to come, INOC may be partially privatised through wide distribution of ownership among Iraqis through public subscription" [ibid]

(48) "Should we spend months and years trying to exact the last penny in negotiating the commercial terms? I would suggest that there is no need to waste time. Time is of the essence". [ibid]

(49) Dan Morgan and David B. Ottaway, 'In Iraqi War Scenario, Oil Is Key Issue', Washington Post, 15 September 2002, Page A01

(50) Text of the draft Iraq Constitution, translated by Associated Press, 28 August 2005, article 110

(51) Ibid, article 111

(52) Ibid, article 108

(53) Embassy of the United States, Baghdad, Ambassador Khalilzad statement on the referendum results, October 26, 2005

(54) Christian Schmollinger, 'Iraqi officials hopeful foreign oil firms will return in 2006', International Oil Daily, 15 June 2005

(55) Glen Carey & Faleh al-Khayat, 'Iraq looks to woo majors for field revivals', Platts Oilgram News, 22 June 2005

(56) Heritage Oil Corporation press release, 'Heritage Oil signs agreement for Kurdistan, Iraq field study', 28 September 2005

(57) US Department of Energy (US DOE), Energy Information Administration, Iraq - Country Analysis Brief, June 2005, www.eia.doe.gov/emeu/cabs/iraq.html

(58) Ibid

(59) Adil Abd Al-Mahdi, Finance Minister, remarks at the National Press Club, Washington DC, December 21, 2004

(60) Population and economic data taken from US Central Intelligence Agency, The World Factbook 2005

(61) ITIC, Petroleum and Iraq's Future, op cit, p.17; FCO, Code of Practice for the Iraq Oil Industry, op cit p.5

(62) ITIC, Petroleum and Iraq's Future, op cit, Annex 3, pp. 64-70

(63) Like many of the other details of the contracts, the extent to which this is a problem will depend on the outcome of negotiations. However, experience elsewhere suggests it will be difficult. For example, OPEC members Algeria and Nigeria have consistently struggled, and largely failed, to rein in foreign companies' production rates. Of the 11 members of OPEC, these two (along with Indonesia, which has recently under-produced its quota anyway, due to declining capacity) are the ones with the greatest level of foreign oil company involvement. Similarly, when Iraq under Saddam Hussein attempted to attract foreign investment in 1995, the Oil Minister admitted in an interview with Middle East Economic Survey that guarantees would have to be given to oil companies that they would be able to produce at their desired level. [Dr Safa Hadi Jawad al_Habubi, interview with MEES, 38:25, 20 March 1995, p.A5]

(64) E.g. in Azerbaijan's ACG PSA [Article XXIII, clause 23.2]: "In the event that the Government or other Azerbaijan authority invokes any present or future law, treaty, intergovernmental agreement, decree or administrative order which contravenes the provisions of this Contract or adversely or positively affects the rights or interests of Contractor hereunder, including, but not limited to, any changes in tax legislation, regulations, administrative practice, or jurisdictional changes pertaining to the Contract Area the terms of this Contract shall be adjusted to re-establish the economic equilibrium of the Parties, and if the rights or interests of Contractor have been adversely affected, then SOCAR shall indemnify the Contractor (and its assignees) for any disbenefit, deterioration in economic circumstances, loss or damages that ensue therefrom."

In the PSA for Shell's Sakhalin II oil developments in Russia, Appendix E exempts the project from, amongst other laws, the Russia Water Code which forbids discharge of flows and drainage waters in spawning and wintering areas for valuable and protected fish species and in habitat for Red Book protected wildlife and plant species. Destruction of salmon spawning sites as a result of oil spillage is a major concern in the project. Article 24 (f) also provides blanket compensation for damage caused to Shell's profits: The Russian Party shall compensate the Company for any damage caused to the consortium's "commercial position" by "adverse changes in Russian laws, subordinate laws and other acts taken by Government bodies after December 31, 1993 (including changes in their interpretation or their application procedure by government bodies and by the courts in the Russian Federation)."

(65) Susan Leubuscher, 'The privatisation of justice: international commercial arbitration and the redefinition of the state'. MRes thesis, Birkbeck College, 2 June 2003 www.fern.org/pubs/reports/dispute%20resolution%20essay.pdf

(66) Nino Chkhobadze (Georgian Minister for the Environment), letter to BP CEO John Browne, 26 November 2002; AFP, 'Georgia approves $2.9bn oil pipeline', 2 December 2002

(67) “We won’t be bullied”, Transitions Online, 9 August 2004

(68) Helmut Merklein, 'Who needs big oil in Iraq: The case for going it alone', Middle East Economic Survey, 12 January 2004

(69) ITIC, Petroleum and Iraq's Future, op cit, p.33

(70) Ibid, p.8

(71) Bearing Point, op cit, p.5

(72) Dunia Chalabi (International Energy Agency), 'Perspective for Investment in the Middle East/North Africa Region', Presentation to the OECD, Istanbul, 11-12 February 2004, p.7

(73) BP, op cit, p.4

(74) Putting energy in the spotlight - BP Statistical Review of World Energy June 2005

(75) Oil Ministry figures give an investment requirement of $25 billion over ten years. In our economic models, the investment peaks at $3.0 bn in 2012 (the fourth year of development). However, in the models first oil is expected in 2011 - thus this will contribute to the 2012 investment. The highest annual net investment in the models is $2.3 billion, in 2011.

(76) International Oil Daily, 'Iraqi Oil Ministry Gets Big Leap in Funds', 26 October 2004

(77) FCO, Code of Practice, op cit p.4

(78) Helmut Merklein, op cit. In this comment, Dr Merklein is actually referring to the smaller cost of rehabilitating production to pre-Gulf War levels; but the same applies to the larger investment too

(79) Dr Muhammad Ali Zainy (Energy Economist and Analyst, Centre for Global Energy Studies), at the 10th Annual Energy Conference of The Emirates Center for Strategic Studies and Research (ECSSR), 26-27 September 2004, Abu Dhabi, UAE, reproduced in Middle East Economic Survey, 47:42, 'Iraq's Oil Sector: Scenarios For The Future', 18 October 2004

(80) www.jubileeiraq.org

(81) See e.g. Justin Alexander, 'Saddam's Odious Debt', Swans Commentary, 2 February 2004, www.swans.com/library/art10/iraq/alexander.html

Also The Economist, 'Those odious debts', 18 October 2003: "The Iraqi debt problem highlights a huge unresolved flaw in the international financial system. There is an overwhelming case, both in terms of economic expediency and justice, for writing off most of Iraq's debts, and doing so fast… It is clearly unfair to expect the Iraqi people to pay for the reckless waste of the regime that brutally oppressed them for so long."

(82) Wall Street Journal, editorial, 30 April 2003, quoted in Jubilee Iraq, 'Saddam's Odious Debt - Iraqis address the Paris Club', November 2004

(83) See for example, ITIC, Petroleum and Iraq's Future, op cit, p.6; FCO, Code of Practice, op cit p.5; Iyad Allawi guidelines on oil policy, reported in Middle East Economic Survey, 47:37, 13 September 2004, p.A2.

(84) For example, ITIC, Petroleum and Iraq's Future (op cit), pp.30-31: "For the most part, international oil companies do not favor risk service contracts. Such contracts have sometimes been accepted as an interim measure, or a cost of access, on the route towards eventual creation of a PSA regime. Typically risk service contracts offer relatively low returns and present difficulties for companies in booking reserves." ITIC indicates reluctant acceptance of development and production contracts, but indicates a strong preference for PSAs

(85) Ed Harriman, 'Where has all the money gone?', London Review of Books, Vol. 27 No. 13 7 July 2005; Iraq Revenue Watch, 'Audits find more irregularities and mismanagement of Iraq's revenues', December 2004

(86) Iraq Revenue Watch, Protecting the Future: Constitutional Safeguards for Iraq's Oil Reserves, Report No.8, May 2005

(87) Publish What You Pay objectives - http://pwyp.gn.apc.org/english/objectives/

(88) Iraq Revenue Watch, Protecting the Future, op cit

(89) See e.g. Striking a Better Balance: The World Bank Group and Extractive Industries, Final Report of the Extractive Industries Review Vol 1, pp.12-16 and 45-52

(90) For example, in Syria the state's share of profit oil ranges from 79% for fields producing less than 50,000 barrels per day, to 87.5% for fields producing more than 200,000 barrels per day.

(91) For example, in the Azeri-Chirag-Guneshli PSA, the Azerbaijan state only gets 30% of the profit oil until the BP-led consortium has achieved 16.75% rate of return - a comfortable level of profits. After that, the state's share goes up to 55%. Only after the consortium has achieved a 22.75% rate of return - a high level of profits - does the state's share of profit oil go up to a more normal 80%. [ACG PSA, article XI, clause 11.6]

The Sakhalin II PSA goes even further. In that case, the Russian state gets no profit oil until the Shell-led consortium has achieved 17.5% rate of return. The state then receives just 10% for a further two years, and then 50% until the consortium has obtained 24% rate of return, after which the state receives 70%. [Sakhalin II PSA, section 14. For detailed analysis, see Ian Rutledge, 'The Sakhalin II PSA - A production non-sharing agreement' (pub CEE Bankwatch Network, PLATFORM, Friends of the Earth, Sakhalin Environment Watch, Pacific Environment, WWF), November 2004]

(92) Some of these fields are producing small amounts of oil, including Majnoon, West Qurna and East Baghdad. However, their production is well below their potential, respectively 50,000, 250,000 and 20,000 barrels per day prior to the March 2003 invasion [US DOE, op cit] - essentially amounting to minor development of small parts of the fields. As such, they are commonly described as "undeveloped". [See e.g. Mohammad Al-Gailani (MD, GeoDesign Ltd), 'Assessing Iraq's oil potential', Geotimes, October 2003]

(93) Reserves figures are taken from Deutsche Bank, Baghdad Bazaar - Big Oil in Iraq?, 21 October 2002, p.12; and from US DOE, op cit

(94) Peak production figures are taken from al-Ghadban et al (Iraq Ministry of Oil), paper presented at seminar on 'The future of oil and gas markets', Baghdad, 11-12 March 1995, reproduced in Middle East Economic Survey, 38:25, 20 March 1995, pp.D1-D15; Deutsche Bank, op cit; and Bearing Point, op cit

(95) Development cost data is taken from Deutsche Bank, op cit; Bearing Point, op cit; except Gharaf field, which is taken from average of 7,000 per daily barrel, cited in al-Ghadban et al, op cit

(96) Glen Carey & Faleh al-Khayat, op cit

(97) For detailed analysis, see Ian Rutledge, op cit

(98) From PetroConsultants, Annual Review of Petroleum Fiscal Regimes, 1995

(99) For detailed analysis, see Daniel Johnston5, 'Impressive Libya licensing round contained tough terms, no surprises', in Oil and Gas Journal, 18 April 200, pp.29-37

(100) E.g. Dr Muhammad-Ali Zainy, op cit

(101) E.g. Fadhil Chalabi (former OPEC Deputy Secretary-General and Iraq Oil Ministry official, now of Centre for Global Energy Studies), quoted in Carola Hoyos, 'Big players anticipate Iraq's return to fold', Financial Times, 20 February 2003

(a)In the USA, onshore reserves belong to the landowner, which may be a public or private body or individual

(b) The last remnants of concessions were nationalised in 1975.

(c) During the final years of Saddam Hussein's regime, Iraq tried to re-open its oil industry to foreign capital. This process was highly political, and contracts were negotiated with and awarded primarily to companies from UN Security Council member countries Russia, China and France, in an attempt to win support for the dropping of UN sanctions. A PSA deal was actually signed in 1997 - with Russian company Lukoil for the West Qurna field - but never implemented, due to the sanctions. Ultimately, Saddam cancelled the contract. Disputes still continue with the new Iraqi authorities as to whether this contract has any validity. Saddam also signed a development and production contract (DPC) with China National Petroleum Corporation for the al-Ahdab field (also never implemented, and ultimately frozen), and came very close to signing a PSA deal with French company Total, on the Majnoon field. Negotiations also took place on various other fields for PSAs, buybacks or DPCs (see section 6).

(d) Bob Morgan died as a result of a rocket attack on his car in Baghdad, in May 2004

(e) In this, Allawi was being highly unrealistic. Although contracts can allow a certain degree of renegotiation, companies will not sign them if the potential for renegotiation is substantive or meaningful.

(f) Following the agreement on a Constitution, a Petroleum Law is the next step in defining how the oil industry is to be run.

(g)We also ran the models with the terms used in PSAs Qurna field in 1997 (which was never implemented, outlined here.

(h) Of these, we were unable to obtain full data on 11 fields projected production (and hence revenue).

(j) This omission compounds the inaccuracy of ITIC’s assumption barrels per day – on this point, see the section 6.

(k) We have used a 12% discount rate, as the rate most commonly used in the oil industry. However, it should be noted there is some debate among development economists as to what discount rate should be used for public sector investments. It is commonly argued that, since states can borrow capital at lower interest rates than private companies, and since states do not invest in the same way as companies (and so do not experience the same extent of opportunity costs), the discount rate should be lower than for private sector investments. For example, US public institutions use a discount rate of 7%. Some economists even argue that states should apply a zero discount rate, as the process of discounting undervalues expenditure for future generations. A lower discount rate would mean a higher NPV loss to the Iraqi state.

(l) See for example, the 'Drilling into debt' report by Oil Change International, which finds that oil-producing countries tend to experience major indebtedness.

(m)These figures are produced by applying all the countries’ terms to the same hypothetical oilfields. Clearly, the marginal field here would not be developed if found in Syria, as it would be uneconomic – the company would make a net loss.

(n) We noted in section 6 that no countries comparable to Iraq use PSAs – indeed we would argue that PSAs are not appropriate to Iraq’s situation of plentiful, low-cost, known fields. Thus there is no natural choice of country’s terms to apply in this analysis. Therefore it should be noted that the Oman and Libya PSAs are for exploration and production, and thus carry the exploration risk that no oil will be found. As a result they give potentially more lucrative terms to compensate for the risk of failure to find oil. The short- and medium-term development of Iraq’s oil will be of the roughly 65 known but undeveloped fields, whereas new exploration (especially in the Western Desert) will deliver longer-term development. However, against the lack of exploration risk in potential early PSA contracts, Iraq carries more political risk than any of these other cases. On the other hand the Sakhalin II field (which like the Iraqi fields was known before the PSA was signed) is offshore and hence higher-cost which may be reflected in more lucrative terms for the company. However, the current high political risk in Iraq could quite plausibly lead to similarly lucrative terms.

The exception would be the PSA deal signed by Saddam Hussein with Lukoil in 1997 for the West Qurna field which was never implemented and was cancelled in 2002. We have not used these terms as one of our three featured scenarios because of its unusual status. However, we did test the model against those terms. The loss of state revenue (undiscounted and NPV) is within the range of these three scenarios. The company internal rates of return, remain high by international oil industry standards (20%, 40%, 57% at $40/barrel) for the 3 fields we examined in section 5) but at lower than the three featured scenarios due to an unusually high $100 million up-front signature bonus. While the bonus is small compared to the total value of revenue, the fact that it is paid up-front impacts more significantly on the rate of return (due to the time value of money - see Appendix 2). The context of this decision was that it was signed during the sanctions era, when the regime was desperate for up-front cash, but conversely keen to win Russia's political support in the UN Security Council. In this sense it was not a 'normal' PSA so we have not used it in our main analysis. The Lukoil terms were not officially published, so in our test we used those reported by the Middle East Economic Survey [11 November 2004 - 'Lukoil Seeks West Qurna Development/Iraq Debt Deal'].

About the publishers

PLATFORM is an interdisciplinary organisation working on issues of environmental and social justice. Founded in 1984, it specialises in addressing the impacts of British oil corporations on development, environment and human rights. www.carbonweb.org

US co-publishers

Global Policy Forum monitors policy making at the United Nations, promotes accountability of global decisions, educates and mobilizes for global citizen participation, and advocates on vital issues of international peace and justice. www.globalpolicy.org

The Institute for Policy Studies strengthens social movements with independent research, visionary thinking, and links to the grassroots, scholars and elected officials. With an emphasis on the UN and the Middle East, IPS's New Internationalism Project works to strengthen the US and global peace movements. www.ips-dc.org

Oil Change International campaigns to expose the true costs of oil and facilitate the coming transition towards clean energy. We are dedicated to identifying and overcoming political barriers to that transition. www.priceofoil.org

UK co-publishers

The New Economics Foundation (NEF) works to construct a new economy centred on people and the environment. Founded in 1986, it is now one of Britain’s most creative and effective independent think tanks, combining research, policy, training and practical action. www.neweconomics.org

War on Want is a UK-based campaigning charity. Founded in 1951 it has links to the labour movement and supports progressive, people-centred development projects around the world. War on Want campaigns in the UK against the causes of world poverty. www.waronwant.org

More Information on Iraq
More Information on Oil in Iraq

By Greg Muttitt

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