Iraq Tries for Oil's Major Leagues

The June 30 auction Iraq held in Baghdad for development rights to oil and gas fields has been portrayed as a dud. The Iraqis, after all, managed to award only one of the eight fields up for bid.

But that lone field, Rumaila, is a monster, already producing 960,000 barrels a day. It's the fourth-largest in the world, according to BP (BP) Chief Executive Officer Tony Hayward, boasting 65 billion untapped barrels. And BP, partnered with China's CNPC for the winning bid, hopes to triple Rumaila's production in six years.

While that's no sure thing, such a boost to output would vault the country out of oil's minor leagues and begin to tap its vast potential. Iraq's long-term target is 6 million barrels per day, which would put it second only to Saudi Arabia in OPEC.

Iraq is widely believed to be the one country that could rival its Saudi neighbor. Alex Munton, an analyst at consultancy Wood Mackenzie, in Edinburgh, thinks that as much as 300 billion barrels of oil could be found in Iraq. "Given the lack of exploration ... I think that is a plausible figure in terms of the upper limits that Iraq might ultimately have," he says. Iraq's proven reserves now stand at 115 billion barrels, compared with 264 billion for the Saudis.

A more prolific Iraq, although years off, may rewrite the global oil equation. It could open the door to the Gulf region for Big Oil, now mostly shut out of Saudi Arabia, Iran, and Kuwait. If Iraq does more deals—and does them well—it could soften attitudes to foreign investment across OPEC. And the oil-supply shortage, predicted by many analysts to arrive in the next 20 years, would shrink.

Of course, massive obstacles stand in the way of Iraq realizing its oil potential. Its record since Saddam Hussein's ouster in 2003 is understandably less than stellar. Current production of 2.4 million barrels per day is a slight decline over this period, and the government has been unable to consummate the agreements with international interests it needs to turn its oil industry around.

The recent auction did little to silence skeptics. Wary of being seen as overeager or corrupt, Oil Minister Hussein Al-Shahristani was determined to be hard-nosed and transparent. He succeeded, but left unanswered the question of how Iraq is going to obtain investment and technology. "We set tough contractual terms with foreign oil firms, but all that is to make it clear to all Iraqis we are keen to safeguard Iraqi oil revenues," Al-Shahristani told reporters after the bidding.

Those tough terms explain why seven fields failed to find takers at auction. The Iraqis set fee-per-barrel maximums that were so low oil companies didn't think they could make acceptable returns. Al-Shahristani was unwilling to compromise, and the companies, except for the BP consortium, passed.

At the Baghdad auction, Rumaila came up for bid first, and BP quickly found itself on the spot. The Iraqis made clear they wouldn't pay more than $2 per barrel for any increase in production that BP achieved. BP had bid $3.99. Such haggling "normally would have taken place in a closed room," BP CEO Hayward said at a press conference on July 28. Then BP executives realized they were the only ones who had struck a deal (which has yet to be finalized).

After a weekend spent checking its arithmetic, BP appeared satisfied. It gives the company "a presence in the Middle East working on the biggest Iraqi field," Andy Inglis, BP's exploration and production chief, said in an interview. And executives hope Rumaila will give it a first-mover advantage that will lead to a larger role in Iraq.

The company's experts also think they know Rumaila well. BP developed the field in the 1950s and has worked on it with the Iraqis for the past five years. Its partnership with CNPC will provide Chinese-made drilling rigs and equipment at rock-bottom prices. An Iraqi state company will have a 25% stake, while BP and CNPC will share the rest, 75% and 25%, respectively.

MODEST REWARDSBut there are huge risks that come with working in Iraq, including security and political hazards. Many Iraqis, among them oil workers and some officials, don't want foreign oil companies working in their fields. BP and CNPC will have to smooth ruffled feathers to succeed. With a general election coming in January, Iraq's oil program could face more delays and uncertainty.

In light of these risks, the financial rewards for BP and CNPC will not be that great. BP's deal is a service contract, and the $2 it gets for every extra barrel it can extract above current levels can't be called generous. A consortium of ExxonMobil (XOM) and Malaysia's Petronas offered the Iraqis a higher target—3.1 million barrels per day vs. BP's 2.85 billion barrels—but walked away from Iraq's tight terms.

In an indication of how stiff the terms are, Wood Mackenzie estimates that the BP consortium's fees will amount to just 1% of the estimated $1.2 trillion in total revenues from the project. Wood Mackenzie figures the value of the deal to the consortium will be $3 billion: "This is quite modest for a field which should produce 16 billion barrels at least." But BP points out that what it agreed to in the Rumaila deal is not so different from what's on offer elsewhere in the Middle East. For instance, in Abu Dhabi, BP is paid $1 per barrel.

Another auction in Baghdad, set for December, will place fields with reserves estimated at 35 billion barrels on the block. Iraqis have serious thinking to do if they want to move their oil and gas program forward. But Al-Shahristani has one huge factor in his favor: International oil companies, which salivate over fields a fraction of the size Iraq is offering, will remain keenly interested.

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