Finding the right balance: Iraq seeks new equilibrium in relationship with International Oil Companies

In April 2017, the Oil Minister of Iraq, Mr Jabbar al-Luiebi, announced that Iraq would push forward with its proposal to modify the terms of its existing Technical Service Contracts ("TSCs") through negotiations with International Oil Companies ("IOCs"). Below we examine some of the perceived flaws in the TSC model and where negotiations between the Oil Ministry and IOCs are likely to focus.

The review of the existing TSCs was first mooted in 2015 following the collapse in oil prices in late 2014 and its impact on the revenues of the Iraq government. Since then, Iraq's financial position has deteriorated. Exacerbated by the rise of the IS militant group and the resulting disruption to production, the Iraq government has faced cash flow difficulties which have in turn delayed payments to IOCs, undermining the fundamental rationale of the TSCs (which, as explained below, is based on a quick cost recovery process).

In February 2015, following a series of letters to IOCs such as BP, Royal Dutch Shell, ExxonMobil, Eni and Lukoil (in which the Oil Ministry identified "the rapid drastic decrease in crude oil prices" as the catalyst for change), the Oil Ministry entered into an informal, extended consultation with IOCs operating within the jurisdiction to discuss amending the risk-reward terms of their TSCs. Although that consultation process did not result in anything concrete, it is expected that the latest announcement does mean that proposed modifications to TSCs will shortly be put forward to IOCs. In the meantime, Iraq has been forced to increase its crude loading schedule for payments to IOCs to ensure it continues to produce enough oil to pay its bills.

Below we set out a brief explanation of some of the perceived issues with the structure of the existing TSCs, the negotiations between IOCs and the Oil Ministry and the types of amendments that are being proposed to the TSCs.
Please note that where we refer to TSCs in this report, we refer to the service contracts awarded during all of the licensing rounds conducted by the Iraq government, which are largely based on the same risk service contract model.

ISSUES WITH THE STRUCTURE OF THE TSCs

In 2009, the Oil Ministry introduced TSCs structured on the basis that IOCs would be reimbursed for their costs quickly but be paid only a relatively small per-barrel remuneration fee for production above a certain level. IOCs were prepared to accept these terms because, although the profit margins were relatively small and the upfront capital expenditure large, the anticipated rapid cost recovery alleviated much of the risk and quick reimbursement significantly reduced project financing costs.

However, the structure of the TSCs makes them particularly susceptible to collapses in oil prices. From the Iraq government's perspective, payments to IOCs under the TSCs are based on production levels, rather than project revenue (as the remuneration paid to IOCs is a fixed amount per barrel of oil produced). In the current economic climate, the result of linking payments to production is that, although oil prices and therefore the proceeds received by the Iraq government have fallen markedly, its liabilities to IOCs have in fact risen as production has slightly increased. In addition, because IOCs are typically paid in-kind (although there are usually options for payments to be made in cash), as oil prices decrease, the volume of oil required to pay IOCs has increased accordingly, leading to issues delivering and lifting the quantities needed.

From the IOCs' perspective, although the level of their remuneration from the government should remain the same during falls in oil prices, the speed at which they can recover their costs and earn their remuneration is dependent on the ability of the government to meet the required quarterly payments (through in-kind deliveries). In addition, the TSCs typically provide for a cap on the amount of cost recovery and remuneration that can be paid in a quarter (eg a cap of 50% of the 'Deemed Revenue', which is the 'Net Production' for a quarter multiplied by the 'Provisional Export Oil Price' for that quarter), Therefore, as this cap is typically linked to the 'Provisional Export Oil Price', the amounts that can be received by IOCs each quarter has reduced.

In short, whilst the Iraq government's proceeds have decreased, its costs have been static or have increased. Ultimately those costs have to be borne by the government but, in the short term, IOCs are taking on the burden of capital expenditure, delayed cost recovery and consequently increased financing costs. Therefore, the TSC structure is not benefiting either the Iraq government or IOCs, and it appears to be in both sides' interest for there to be a renegotiation and a rebalancing of the existing terms.

Another problem often identified in the structure of the TSCs is the approach to cost recovery - specifically, the eligibility of certain expenses and the seemingly guaranteed nature of the recovery. Certain commentators have argued that the terms of the TSCs, which provide that the Iraq government reimburse IOCs' capital expenditure on a quarterly basis, do little to incentivise IOCs to control costs budgets. IOCs on the other hand have remarked that the Oil Ministry does little to incentivise investment (and to encourage the use of advanced technology and know-how) and is overly uncompromising in its auditing practices and the objections it makes to attempts by IOCs to recover legitimate costs under the TSCs. In any event, how the Iraq government could incentivise cost efficiency is unclear. One of the ways mooted by IOCs is that the Iraq government could redress issues by introducing more efficiency in the procurement practices (and by having clearer contractual provisions regarding such practices), in particular, abandoning the 'lowest price principle', which only leads to further costs as the process is delayed and subcontractors are encouraged to underbid at unachievable levels (which simply stores up problems for the future).

This highlights a concern raised by IOCs. While the current economic conditions make the TSCs' contractual terms less attractive, the greater issue remains the practical implementation of the TSCs and concerns relating to infrastructure, logistics and security. Notwithstanding that such measures are not provided for in the DPSC, the Iraq government has previously introduced certain procedures aimed at scrutinising costs, for example, the establishment of government committees and taking a greater role in procurement processes. Typically, the TSCs provide that Operators are responsible for approving subcontractor awards up to a certain amount (for example, USD 20 million), and the Joint Management Committee (comprising representatives from the IOCs and state companies) (the "JMC") is responsible for awards exceeding that amount up to a set level (for example USD 20 million to USD 100 million). Above the upper threshold, the relevant national oil company is responsible. However, in practice, the JMC is rarely formed and the Oil Ministry is involved at all levels. In the eyes of IOCs, not only do such measures fall outside the contractual terms of the TSCs, they tend to slow down invoicing and lifting and have introduced greater uncertainty, leading to further delays in costs recovery and disincentivising IOCs from making further investment.

NEGOTIATIONS WITH IOCs

In light of the mutual discontent, in February 2015, the Oil Ministry informally asked IOCs to freeze or otherwise reduce new development expenditure. Despite the negotiations often breaking down due to disagreement on the required spending levels, it has been reported that Lukoil cut anticipated expenditure from USD 2.1 billion to USD 1.26 billion at West Qurna 2 project and Shell reduced its budget from USD 1.5 billion to USD 855 million in respect of the Majnoon field. The Oil Ministry also canvassed IOCs for suggested amendments to the TSCs. The overarching purpose of the discussions was to find a way to better link IOCs' remuneration to oil prices. In addition, the Iraq government wished to consider the introduction of contractual incentives to limit development and production costs.

Although several IOCs claim to have submitted recommendations to the Oil Ministry in 2015, it appears that negotiations have not progressed. Notwithstanding this, the prospect of amendments to the TSCs seem to be back on the Oil Ministry's agenda for a number of reasons, not least, perhaps, the IMF's loan announced in July 2016, which was made conditional on Iraq settling all outstanding debts owed to IOCs, as well as the realisation that oil prices would not rise to the levels that would make the TSCs commercially viable (said to be USD 60-70 per barrel).

With the fiscal issues showing no signs of abating, the extent of the liabilities owed to the IOCs continues to present a serious issue for the Iraq government and IOCs.

PROPOSED AMENDMENTS TO THE TSC

It has been reported that the Oil Ministry was considering a move towards the Production Sharing Contracts ("PSCs"), favoured in Kurdistan (as well as a number of other jurisdictions), which provide for IOCs to receive a share of production (firstly to reimburse it for costs incurred, and secondly as its profit), innately linking payments made to IOCs to the price of oil, and therefore proportionately sharing the risk of a collapse in oil prices. Indeed, in October 2015, executives of IOCs remarked that proposals had been made to the government about how the country could change their contracts from service agreements to a model closer to production sharing agreements. However, in light of recent statements made by the Oil Minister (as well as the government's previously stated position that PSCs are not permitted by the Iraqi Constitution), this appears not to be the case. However, the emphasis in future negotiations nonetheless remains on ensuring that the remuneration fee is connected to oil prices, therefore making the interests of the Oil Ministry and IOCs more closely aligned.

Recent indications are that, rather than a radical overhaul of the terms of the TSCs, the intention will be to make adjustments aimed at optimising the existing contractual framework. In respect of methods for incentivising cost control, it is reported that the Oil Ministry is considering reducing the cap on the amounts of cost recovery and remuneration to a fixed dollar amount. Whether or not this incentivises cost control to such a degree that the IOCs are no longer willing to invest any amount remains to be seen. Indeed, in light of the elections due to take place in March 2018, there have been suggestions that the proposals for negotiations are politically motivated. We are aware that the Oil Ministry is hosting an event entitled the "Iraq Investment Conference" in Baghdad in July 2017, at which the relationship between IOCs and the state oil companies looks set to be discussed.

In addition, as stated above, the TSCs are structured in a manner whereby IOCs accept lower margins for expedited cost recovery and payment. If the timing of cost recovery is being increased further, the IOCs will expect higher returns per barrel to compensate for the increased risk.

Finding the balance between the parties' interests will not be straightforward. This is the challenge that awaits the interested parties as attempts to negotiate the terms of the TSCs commence. Negotiations between the Oil Ministry and IOCs are expected to start shortly. It remains to be seen whether an agreement can be reached - one that balances, on the one hand, a fair and proportionate allocation of risk with an equitable method of controlling costs and, on the other, continued attraction and appropriate incentivisation of investment by IOCs.