February 22nd, 2012

BR 4: The New Incentives



Companies prequalified to bid for one of 12 blocks in Iraq’s upcoming fourth licensing round have since last week been poring over the adjusted terms introduced by Iraq’s oil ministry to the second version of the draft “exploration, development and production service contract” or EDPSC. The new terms offer incentives to companies based on comments and observations they provided to the petroleum contracting and licensing department. It took longer than expected to review 600 pages of comments received on the first version, to integrate new concepts in the draft and come up with formulas that create a win-win situation on a service type contract. And if more time was at hand, the latest draft could have undergone further improvements, the contract’s authors tell me. That will have to wait for the final draft to be issued in April, once further IOCs comments are received.

A service contract is what Iraqis could gather consensus on when they decided to open up the sector to foreign oil companies a few years ago when even uttering the word production-sharing would create an uproar and accusations of selling out to those who led a war for oil. As one Kuwait-based representative of an oil major told me years ago when Kuwait was struggling to open up its sector to Big Oil but could only work around service contracts to make them acceptable to a hostile parliament “we would accept service contracts, provided the terms are right”. The challenge faced by Iraq is how to make the terms right, and even more so, on an oil and gas exploration contract, offer enough incentives for companies to take it up while maximizing the benefit to its people.

Here’s a quick look at some of the new incentives introduced in the February draft of the EDPSC:

Contrary to the development and production service contract model of the previous rounds, where a state partner held a 25% carried interest, the new exploration model does not include a state partner. So the Iraqi side will not share any responsibilities for delays or other unsatisfactory results and will not share the benefits either.

Prices used in the calculation of revenue have been raised. The new draft calculates the price of dry gas price at 50% of the export oil price and the price of NGLs (natural gas liquids) as equal to the oil price, instead of 25% and 60% respectively in the previous draft. The objective is to improve the return on the investment since although an investor will be paid a fixed remuneration fee in dollar per barrel of oil equivalent, the deemed revenues enter in the calculation of the R-factor. Adjustments were also introduced to the R-factor itself, which is an adjustment mechanism that determines the cash flows based on expenditures in addition to revenues.

A major incentive is the possibility to export gas. Now a foreign company with a major gas discovery can enter into a separate agreement with the Iraqi government to market and sell dry gas in markets outside of Iraq once the local market has been satisfied. As a result, companies will be able to increase their take from the commercialisation of the gas, not just from the fixed fee per barrel of oil equivalent.

The draft contract still maintains the possibility of a holding period of up to seven years on oil discoveries in order to pace the new production capacities to come on stream with those already contracted under previous bid rounds. However, in addition to exploration costs bearing an interest at LIBOR plus 5% during the holding period, Iraq will also pay an additional interest of LIBOR plus 3% on costs related to work undertaken on behalf of the government such as infrastructure.

With an eye on the future when Iraq will be producing more than it can export, Iraq opted to make payments in crude oil instead of cash. Drawing on the experience of the previous contracts and the complications created by the current complex payment method, this is expected to be a welcomed by the companies.

The ball is now in the companies’ court. According to the latest timetable released by the Iraqi oil ministry, companies have now until March 16 to send their comments on the latest version of the draft contract, before the definitive contract and the final tender protocol are released on April 20. The bidding date remain for now as May 30th and 31st.

(Edit Feb.25: corrected the price of dry gas equals 50% of export oil price, not 60%)

The View from Baghdad