Zaab Sethna quoted on Iraq's economy

September 30, 2015

Petroleum Economist

September 2015

Iraq struggles to plug the financing gap

HIGHLIGHT: Baghdad is facing a cash crisis, while losing control of its northern oil assets

Iraq's oil minister, Adil Abdulmahdi, has overseen a sustained rise in oil output and exports this year that has propelled the country up the roster of Opec's big guns. It has recovered territory it lost under Saddam Hussein. But a toxic mixture of low oil prices, Kurdish secessionism, and bitter conflict has left Baghdad bereft of cash and struggling to maintain control of its oil and gas resources.

Even as it plots an ambitious growth in export capacity Iraq's government finds itself under renewed pressure. Despite posting highest-ever crude production in the summer, exceeding 4.25mn b/d in July, low oil prices mean that Iraq's increased capture of Asian market share has delivered comparatively scant fiscal reward.

The impact of the decline in oil prices is very significant for Iraq, says Zaab Sethna, managing partner at Northern Gulf Partners, an Iraq-focused investment fund. "There is a financial crisis in the country and very large budget deficits," he notes. According to the IMF, the decline in oil prices has accelerated the decline of Iraq's international reserves, which dropped from $84bn at end-2013 to $67bn at end-2014. The erosion of its fiscal buffers is continuing. The budget deficit is expected to reach 18.4% of GDP this year, forecasts the fund, compared to 5.3% last year. And the picture is worsening. In August, Iraqi crude was selling for an average $40.6/b, forcing revenues down by more than $1bn over the previous month, to $3.87bn. This was the first time monthly revenues had slipped below under $4bn since February.

All this has a material impact on Iraq's oil sector investment plans. The energy ministry has requested the international oil companies (IOCs) to scale back field development projects in light of the difficulty in remunerating them at the target plateau rates. Low prices have prompted the renegotiation of existing service contracts in order to include a link between IOC profits and the actual oil price level. The net effect is that IOCs are not geared to growing production at the previously determined rates. The likelihood is that oil production will only rise to 4.7mn b/d in 2017, down from 5.7mn b/d.

The fiscal pinch may force the ministry to find new ways to generate revenue. One idea under consideration is to mimic the Kurdistan Regional Government's (KRG's) policy of undertaking forward sales of oil. This would involve officials taking a dedicated volume of production, potentially around 200,000 b/d, and approaching buyers with an offer of a 10-year contract with upfront payment. This would involve the negotiation of a formula that would balance an increase in prices so that buyers would pay more should oil prices increase.This idea is being floated in Baghdad, and discussions are understood to be underway with potential buyers in the Far East. Given that the likes of Russia and China are currently busy filling their strategic petroleum reserves with cheap oil, the Iraqi forward sales offer may prove enticing for some. For Iraq, though, it is the only way it can maximise its hydrocarbons incomes to meet pressing immediate needs.

The picture in the north is no better as far as Baghdad is concerned. The central government has this year effectively been forced to concede Erbil full control of its northern production, given the KRG's ability to sell oil directly through Turkey's Mediterranean port of Ceyhan. After the melting away of Iraqi state forces from the Kirkuk region after Islamic State's mid-2014 advance Baghdad has lost direct responsibility for fields operated by North Oil Company (NOC). At least one-quarter of the KRG's pipeline crude exports are made up of NOC crude, formally outside the Kurdistan region territorial borders. This represents a body-blow to the Iraq government's pretensions to being the master of its own destiny. The December 2014 agreement between Baghdad and KRG, which succeeded in reopening northern exports via Ceyhan in return for a resumption of budget transfer to the Kurds, has been steadily undermined to the point of collapse. That deal rested on exports of 250,000 b/d from the KRG and 300,00 b/d from the Kirkuk fields, controlled by the KRG. But Baghdad's inability to extend the 17% of the budget payments owed to the Kurds under the constitution, blamed in part on the government's fiscal woes, left no incentive for the KRG to do Baghdad's bidding.

Fewer supplies are being delivered into the federally-controlled network. In August, the Kurds were transferring an average of just 50,000 b/d to Iraq's State Oil Marketing Organisation, down almost one-third on the previous month. The KRG took matters into its own hands in May of this year, delivering rising volumes of crude to oil traders at Ceyhan through a pipeline that bypasses IS-controlled areas. By July, export volumes through the pipeline reached 516,000 b/d, and though they slipped by 8.5% to 473,000 b/d in August, this is finally replenishing some of Erbil's depleted coffers.

"The Kurds are now selling oil completely independently and keeping 100% of the proceeds. Basically they have achieved fiscal autonomy, though it's not sufficient to meet all their needs," says Sethna. The Iraqi government's hands are tied. "Baghdad is not doing anything to challenge the KRG now because they have other urgent priorities," says Sethna. He says the Kurds have presented Baghdad with a fait accompli.

With established export routes and a burgeoning customer base that is growing dependent on Kurdish supply, Erbil appears to have emerged as the clear winner from this battle. The situation is not black and white, however. Alhough the KRG has continued direct oil sales from Ceyhan, mitigating the non-payment of its federal dues, the Kurds continue to suffer same fiscal challenges that have plagued their counterparts in Baghdad. This challenge has manifested itself in the accumulation of sizeable debts by the main oil companies active in the KRG, after Erbil's failure to recompense them fully for their efforts. Between December 2014 and September 2015, oil companies active in the KRG went for nine long months without a dollar reaching their bank accounts. For the three companies operating the Tawke, Taq Taq and Shaikan fields that account for the majority of Kurdish oil production, DNO, Genel Energy and Gulf Keystone Petroleum respectively, the situation was becoming untenable, until a timely $75mn payment was approved by the Kurdish government September 7. Sourced from direct sales of crude, $30mn of this were transferred to Turkish-based Genel, $30mn for Norway's DNO and $15mn to UK-listed Gulf Keystone Petroleum. That still leaves the latter owed more than $200mn by the KRG. Genel, which in 2015 has boosted production by 41% to 88,000 b/d, saw the payment as confirmation of the KRG's commitment, reiterated twice in August, to pay contractors for oil exports. "We look forward to the normalisation of oil export payments in coming months. Regular payments would allow us to plan for continued investment in our KRI oil and gas assets, which have the potential to create significant further value for the Kurdistan Region of Iraq," said Murat Ozgul, CEO of Genel.

Oil companies were adamant any further investment in KRG assets was contingent clear payment schedule was forthcoming. According to the ministry of natural resources, the KRG envisages making additional revenue available to the exporting IOCs to enable them to begin to catch up on the past receivables due under their production-sharing contracts. The resumption in payments is a sign that the KRG is finally addressing a problem they had preferred to kick down the road, says Shwan Zulal, head of Carduchi Consulting, a Kurdistan-focused advisory firm. "It had got to a point where it was difficult to justify not paying the oil companies. There's been a lot of noise from them, even if they have been discreet about it. They had told the KRG firmly that they could not carry on as it was endangering their existence as operators, by haemhorraging money every month," says Zulal. With DNO owed at least $1bn, that still leaves a sizeable fiscal commitment on Erbil. Indeed, the $75m paid in September is less than 5% of the total $1.7bn the companies are owed. Analysts are nonetheless quietly confident that the payment has drawn a line in the sand. "The fact that the KRG had said they were going to make the payment in September and actually did that, and earlier in the month rather than later, is very encouraging, particularly for Gulf Keystone," says Will Forbes, head of oil and gas at Edison Investment Research. The Gulf Keystone-operated Shaikan field has the potential to produce 100,000 b/d, but is producing at less than half of that. Payments will help the company to proceed with full field development. But this still leaves open a question about whether the payments will be regularised. Until companies see at least three months of payments in a row, few would bet on being in a position to invest and help the KRG build on recent production increases. "They need to at least make it regular, whether monthly or quarterly. As long as some payment keeps coming in that will keep confidence high," says Zulal.

Both Erbil and Baghdad appear resigned to the fact that there will be no resurrection of the December 2014 agreement. "Baghdad doesn't want to concede politely to the KRG and the KRG knows that if they do a deal with Baghdad, at the end of the day they will get less than they are receiving from independent oil sales," says Zulal. This standoff mirrors the evolving political dispensation, which has shattered Iraq's semblance of unity. Central government funds are neither reaching Mosul or Erbil. With large tracts of the Sunni Arab-dominated north and west in the clutches of IS and the Kurds cementing control of their natural resources, the government is even more focused on satisfying its Shia powerbase. If Baghdad can ever plug the large holes that have emerged in its public finances, it may find that there is only a vestige of a centralised state left to defend.