Iraq prepares to halve its oil production goals

Iraq’s argument that global demand could struggle to absorb such vast volumes seems to be confirmed by recent OPEC estimates and actions, with Saudi Arabia recently pulling back its output, which it had raised earlier this year to compensate for supply disruptions in Libya and fears of political unrest spreading across the Middle East and North Africa.

There have also been signals implying that the sharp rise in global oil prices since Iraq’s target was set during 2009 would mean that Iraq would earn about as much from producing 6.5-7 million b/d of crude in a price environment close to today’s as 12 million b/d at 2009 prices, meaning that Iraq’s financial plans—and its ability to reconstruct the country—would remain unchanged, in what at least makes for a very politically elegant line of argument for domestic consumption.

The saving of a considerable portion of Iraq’s oil reserves for “future generations” without immediate recovery and reconstruction plans being affected further enhances the appeal of this argument.

The direct implications of the massive slash are not straightforward though, as the 12-million-b/d production target—however incongruous it might have been—was set through the addition of the individual field production plateaus which IOCs, by signing Iraq’s technical service contracts (TSCs), committed to reach by the 2017 timeframe.

Slashing the individual contracted plateau production targets will therefore involve rewriting the contracted goals for the oil companies that signed up to Iraqi oil projects in its first and second licensing rounds, and in a small number of additional directly negotiated oil deals, chiefly CNPC’s al-Ahdab field contract.

While notionally straightforward, the IOCs are, however, paid a per barrel fee for every barrel produced above a certain minimum threshold, meaning that in order for the oil companies to turn Iraq’s tight margins in their favour, achieving the highest possible production volume has been key to their profitability. Apart from now having to adjust the ultimate field production plateaus, Iraq and the IOCs are therefore likely to have to come up with an improvement of the per barrels fees, in order to make the contracts sufficiently profitable.

While the slashed targets naturally will lower the IOCs’ investments needed to develop the high production capacity, actual capital expenditure (capex) investment in the oilfields is recoverable outside of the per barrel remuneration fee, which, apart from the IOCs’ profit margin, is meant to cover mainly their operation costs.

While these costs too will fall, as operations will be much smaller, it is quite likely that the Iraqi government will have to give the IOCs a bit more in one way or another, especially as its own problems in financing the infrastructure expansion (falling outside of the scope of the TSC contracts) will still be considerable.

The Iraqi government has been looking for ways to roll more of those costs into the TSC contracts, despite the fact that transportation normally just adds a further cost and no income to the companies unless the remuneration fee is adjusted in one way or another accordingly.

Anyone Surprised?
IHS Energy has not been alone in saying, since the targets were first communicated, that Iraq’s hope of reaching a 12-million-b/d production capacity by 2017 were completely unrealistic, with our initial—and since largely unchanged—estimate that even a target half of that by 2020 would be a tall order, which is also widely accepted in a wide spectrum of the energy industry.

Indeed, while work has started up on many of the IOC projects and some early results have been reached with great success, Iraq’s planned oil boom has increasingly been showing all the signs of delays, structural problems, emerging financing difficulties—for the government—and bottlenecks, that we were expecting.

Also, few if any forecaster, even outside of the energy industry, has really planned for Iraq to come anywhere near its 12-million-b/d production target, meaning that on the face of it the Iraqi target slash should have few implications on the markets. Nevertheless, the sharp cut in Iraqi targets also says a lot about the country’s long-term opportunities and some lingering hopes that Iraq by the next decade potentially could emerge as a second swing producer in OPEC, rivaling Saudi Arabia.

This would ease a lot of concerns about the long-term ability of OPEC and other oil producers to come up with the much higher crude volumes that are thought to be needed to meet global demand growth in a 15-year-plus timeframe. Such fears have also been stoked because of a widespread belief that Iraq’s new targets, if indeed set at the level reported, still remain very optimistic. Indeed, as IHS Energy repeatedly has said, a 6-million-b/d production capacity by 2020—not 2017—still remains the absolute best case scenario and best case scenarios have rarely been realised during Iraq’s modern history.

Outlook and Implications
Even with the slashed production targets, Iraq will still face a massive task of financing and project managing the repairs, upgrades and expansions of its oil infrastructure, with recent reports by MEED indicating that a USD50-billion plan to undertake pipeline, storage and export terminal enlargements and upgrades is being prepared.

How Iraq will finance that plan at a time when IOCs start recovering costs for their massive upstream investments at its oilfields is a crucial question, especially as the Iraqi population is starting to become increasingly frustrated with its politicians over the repeated failure to rebuild the supply of basic services such as water, power, healthcare and education.

Effectively lowering the investment targets at a time of high oil prices could be a way of providing relief, but the still tight contract deadlines are likely to make little change to the government’s financial situation in the years running up to 2017, as a rise in Iraq’s production capacity from today’s 2.6-2.7 million b/d to 6.5-7 million b/d by that time is still an optimistic undertaking. Iraq’s lack of sufficient numbers of skilled personnel, funding and project management resources, together with its logistical challenges will continue to mean that project cost inflation should be considerable as all the parallel upstream ventures get under way.

Recent examples of the government’s inability to cut red tape and ease project bottlenecks has also pointed to a host of other structural problems that the Iraqi coalition government will struggle to deal with efficiently.

An even more time-consuming challenge could be the need for renegotiation of contracts, which could mean that ongoing work slows down, unless the process is properly handled. IOCs are already facing tight profit margins in Iraq and further political uncertainty over long-term remuneration will not be conductive to the companies parting with massive investments—which many of them are about to start doing this year.

Given that Iraq’s contracts have been structured around a remuneration fee paid per barrel produced, lower volumes will mean lower returns for IOCs, something for which they will need to be compensated in order to move the projects forward. This is even more necessary if they are to help Iraq out with the development of its pipeline and export infrastructure, something that the Iraqi Oil Ministry will struggle to manage given its stretched resources. Hence contract renegotiations dealing with the IOC remuneration levels are highly likely—this is probably one reason why Iraq has decided to move its upcoming exploration-focused licensing round back from November to early next year—as the model contracts are about to change.

Politically, the issue of IOCs’ profits is very sensitive and although the government hopes that—without the pressure of elections and having to deal with existing contracts—the talks will appear overly technical to parliamentarians and the wider population, a backlash that paralyses the fragile coalition government further cannot be ruled out. This would further increase the uncertainty for IOCs, although the likely imminent airing of the new lower production targets will mean that the most unrealistic investment and project development pressures are lowered, allowing them to approach the projects at a more measured speed.

About the author:  Samuel Ciszuk is the IHS Senior Middle East Energy Analyst.