How Iraq Is Punishing Big Oil

12/18/2009 9:44 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

In recent auctions, US oil companies and other international majors were all but shut out. This continues a shocking shift in global oil power—and investors should pay attention.

All that blood and no oil?

Even if you don't believe the Iraq war was all about oil, the country's recent auctions for the right to explore and develop its huge oil reserves was shocking: US companies were just about shut out.

Exxon Mobil (NYSE: XOM), which in November won the right to develop Iraq's West Qurna 1 field, is the only US company to lead a winning bid. And Occidental Petroleum (NYSE: OXY) is the only US oil company that wound up as a junior partner in a winning bid.

Yes, Iraq's oil fields, which could produce more oil—11 million barrels a day—by the end of the next decade than Saudi Arabia produces now, will be developed with almost no participation by US oil companies.

As shocking as which companies didn't win bids is which companies did:

  • Royal Dutch Shell (NYSE: RDS.A) will operate the Majnoon field (production target: 1.8 million barrels of oil a day) and hold a 45% share. Its major partner, with a 30% share, will be Malaysia's Petronas.

  • Petronas, Hong Kong's CNPC (OTC: CNPXF) and France's Total (NYSE: TOT) will develop the Halfaya field (production target: 535,000 barrels a day).

  • Russia's largest private oil company, Lukoil (OTC: LUKOY), and Norway's national oil company, Statoil (NYSE: STO), will develop the West Qurna 2 field (production target: 750,000 barrels a day).

  • Angola's national oil company, Sonangol, will develop the Qayara oil field (production target: 120,000 barrels a day) and the Najma field (production target: 110,000 barrels a day).

  • CNPC and BP (NYSE: BP) will develop the Rumaila field (reserves of 17.8 million barrels).

  • Petronas and Japan's Japex will develop the Gharraf field (reserves of 860 million barrels).

  • Russia's Gazprom (OTC: OGZPY), Turkey's TPAO, South Korea's Kogas and Petronas will develop the Badra field (production target: 170,000 barrels a day).

See a pattern here?

The list of winners is dominated by national oil companies. The international majors that once dominated the global oil industry are, by and large, absent.

That's quite a different story than in the 1920s, when Iraq was ruled by the United Kingdom under a League of Nations mandate. Then, after the discovery of huge reserves in 1927, oil production was monopolized by Iraq Petroleum, which was owned jointly by the predecessors to BP, Total, Royal Dutch Shell, Exxon Mobil and a consortium of other US oil companies. The Iraqi government, which had been promised a 20% share of the company in the San Remo Conference after World War I, was frozen out.

Given that history, it shouldn't be surprising that in the early 1960s, Public Law 80 appropriated more than 90% of the assets of Iraq Petroleum for the country. The nationalization of Iraq's oil industry was completed in 1966 with the formation of Iraq National Oil.

Bigger than Big Oil

There are two reasons, one obvious and one not so obvious, that national oil companies dominate the list and international majors are absent.

First, the Iraqi auction continues the shift of power in the global oil industry to national oil companies.

In 2007, according to Petroleum Intelligence Weekly, 70% of world oil production was controlled by national oil companies. Exxon Mobil, the biggest of the international majors, produced 3% of the world's oil. Three national oil companies exceeded Exxon Mobil's production: Saudi Aramco (12% of global production), National Iranian Oil (5%) and Pemex, the Mexican national oil company (4%).

Access to the world's oil reserves is even more concentrated in the hands of national oil companies. International oil companies had full access to just 6% of the world's oil reserves in 2008, according to PF Energy. An additional 10% was controlled by national oil companies that provided limited equity ownership to the international majors. Russian oil companies, which sometimes had international partners, controlled 6%. The remaining 78% of reserves was controlled by national oil companies that did not allow or severely limited equity stakes by the international majors.

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Second, the terms of the Iraqi auctions made them, by and large, unattractive to international majors, but not to national oil companies. The auction results show how different the motives are that are driving these two parts of the global oil industry.

If you are an international, investor-owned oil company, the terms of the Iraqi auction were close to punitive.

The Iraqis set production targets that the winning companies had to meet or exceed. (Now, remember, we're talking about a nation whose oil industry faced horrendous difficulties in reaching relatively low pre-war production levels because of violence against oil workers and attacks on oil industry infrastructure.)

If a company promised to exceed the government's target for production, that gave its bid an edge. A big edge if it promised to exceed the target by a lot. So, for example, Royal Dutch Shell's winning bid for the giant Majnoon field promised to deliver not only the government's production target of 700,000 barrels a day but a massive 1.8 million barrels a day. That's 1.1 million above the government's target.

And then the Iraqis set terms on these deals that weren't going to shower the winners with dollars.

Oil development and production contracts come in many flavors. Among the most common is called production sharing. In these contracts, the oil company that puts up the capital and does the work required to develop the field gets a share of the oil produced by the field.

From the company's point of view, this has the advantage of letting the oil company share in any increase in oil prices. A company's share of production when oil is $40 a barrel is more valuable when oil rises to $60 a barrel. A production-sharing deal gives the oil company a way to participate in the rising price of oil.

Of course, production-sharing deals give the oil company a share of the price appreciation of oil that many oil-owning nations think rightfully belongs to them. And production-sharing agreements are declining as a percentage of all oil development deals.

So it's not surprising that the Iraqi auction didn't include any production-sharing language. The terms call for a straight fee to go to the oil company per barrel produced. If oil prices double, all that gain goes to Iraq.

Securing Reserves, If Not Profits

What is surprising is how low those fees are. For smaller fields in more violent parts of Iraq, the winning bids called for fees per barrel of $5.50 for the Gazprom-led bid on the Badra field in central Iraq or the $6 that Angola's Sonangol will get for developing the Najma field in northern Iraq.

For bigger fields, the fee was much lower. Royal Dutch Shell's winning bid for the Majnoon field called for a fee of just $1.39 a barrel.

It's not clear to me that oil companies will make money on these deals on these terms. Look at the winning bid from Petronas and Japex for the right to develop the 860 million-barrel Gharraf field in southern Iraq: The companies agreed to a fee of just $1.49 a barrel. And to win, the partners had to agree to increase output to 230,000 barrels a day over 13 years.

The cost of that development, the two companies estimate, will be $7 billion—if cost estimates are accurate, which they never are when you're dealing with a situation as fluid as today's Iraq.

Higher-than-expected costs aren't the only potential profit killer in these deals. Many, including Royal Dutch Shell, promised production in the fields that in some cases was more than double the Iraqi government's targets. The winning bidders argue that the Iraqi government set low production targets that don't reflect changes in oil production and recovery technology over the decades since the country nationalized its oil industry. With current technology, it will be easy to exceed the government figures, they say.

Maybe. But it will be expensive, too. The newest technologies for extracting more oil from underground reserves are more expensive than the technologies used when the industry was just skimming off the easy-to-produce oil.

To me it looks like the economics of many of these deals don't work at all. They're profitable, mind you, but they don't offer a rate of return that justifies the investment.

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In other cases, the rate of return is high enough to justify the deal, but only if initial estimates of costs and production volumes turn out to be correct. In other words, nothing can go wrong.

But while that kind of calculation is likely to have dissuaded many investor-owned oil companies from bidding or from submitting the aggressive bids that won in this auction, I don't think it bothers national oil companies much. For those companies, the point is to secure control of a supply of a natural resource that's critical to the operation of a modern industrial economy.

We're used to China pursuing this kind of aggressive policy of gaining access to critical natural resources, but other countries now seem to be following China's lead. Here's how Japan Today reported the Japex-Petronas winning bid for the Gharraf field:

"Garnering the Iraq oil field deal, industry analysts say, will give Japan greater energy security as it has lagged behind China in recent years in actively pursuing a policy to secure energy resources."

If that's your goal, then a little thing like profit margin takes a back seat.

Which Win Is a Real Win?

And what about the international majors that did bid and did win?

The majors that did win are those that have been under the most pressure from investors and Wall Street to increase their reserves. Royal Dutch Shell, for example, is still struggling to fill a gap left when it had to write down improperly booked reserves in 2004. Shell has been trying to spend its way out of that hole by running the industry's biggest capital budget of $30 billion to $33 billion a year.

Winning a bid for a big reserve in Iraq might be expensive in the long run. It might even turn out to be unprofitable. But it is still a relatively cheap way for a major to acquire reserves at a time when acquiring a big hunk of reserves is very difficult and very expensive.

A major like Exxon Mobil has taken another path, with its $31 billion (plus the assumption of $10 billion in debt) acquisition of XTO Energy (NYSE: XTO). Ultimately, we won't know which was the better deal until the last barrel or cubic foot is extracted. For more on why this is a smart deal for Exxon Mobil, see this recent blog post.

But we do already know which deal has the most upside for the oil company if oil and natural gas prices rise. Royal Dutch Shell gets $1.39 a barrel no matter the price of oil. Exxon Mobil gets to keep any increase in the price of natural gas— if there is any increase.

I think investors in oil and natural gas stocks, who after all don't have to plan national energy policy, are better off going where the upside potential is greater.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

See the Jubak Picks Portfolio here

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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