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Iraq is one of the OPEC nations with vast oil reserves, but the political turmoil since the end of the Iraq War has prevented it from investing in oil producing activity, which resulted in reduced oil production. Although political stability has yet to return completely, global oil producing companies are optimistic about the oil producing capabilities of this region. However, due to the existing political landscape, oil companies like Exxon Mobil (XOM) aren't motivated to operate there. On the other hand, the semi-autonomous government in Kurdistan offers attractive deals for oil companies. This is attracting major oil players to this region of Iraq. With presence in a number of locations in Iraq, Exxon Mobil is weighing the opportunities and risk of investing in those projects.

Is the decision correct?

Exxon Mobil announced the sale of more than half of its stake in the West Qurna I project in Iraq to Petro China and Pertamina in August this year. Exxon Mobil held a 60% stake in this $50 billion project. Out of this stake, it will sell 25% to Petro China and 10% to Pertamina. The sale was motivated by two reasons -- one was the lowering returns from the venture and the other is on-going issues with the Baghdad government and the semi-autonomous Kurdistan region government, or KRG.

Inflexibility in the contract

West Qurna I is one of the largest oil fields in the world. Exxon entered into a technical service agreement in 2010 with the Iraq government for increasing the production of the oil fields from around 250,000 barrels of oil per day to around 2,825,000 barrels of oil per day within seven years. At that point in time, Exxon, along with Shell (RDS.A) (RDS.B), held around 75% of the project. According to the agreement, Exxon and Shell will be paid $1.90 for each additional barrel of oil produced over the 250,000 production levels from these fields.

The agreement between Exxon Mobil and the Iraq government is a technical service contract. In a technical service contract, a company is paid a fixed amount for the service it is employed for. In Exxon's case, the company is employed to increase the oil productivity. The company gets paid for the extra oil it produces and is not allowed to report the number of barrels it produces from the West Qurna I fields. Reporting the number of barrels produced is an important metric for performance measurement in the investor community. Also, the service contract doesn't allow the company to gain on the higher fuel prices as compared to the production sharing contracts. This makes the contract less lucrative because of poor margins.

Besides the contractual drawbacks, there are also uncertainties related to operations in the region. The country has yet to develop proper infrastructure facilities and there is considerable amount of government red tape. Moreover, the companies in this region face problems like visa permits for the employees and security issues. Although the resource availability in the region is very high, there are many barriers arising due to the overall operational environment.

The production from this field is expected to reach around 600,000 barrels per day this year. This production is 350,000 barrels of oil above the benchmark level of 250,000 barrels of oil. After the sale of stake and assuming that Exxon receives $1.90 per additional barrel, the lost revenue opportunity from this oil field would be around $84.95 million per year.

The Kurdistan issue

Kurdistan is a region located to the north of Iraq. This region also has a significant amount of oil resources as shown in the chart below. Companies are attracted to this region as the semi-autonomous government, known as the KRG, offers favorable contractual terms to oil companies. Exxon signed contracts with the KRG in 2011 for the exploration of the oil blocks. The contracts were signed on a production sharing basis. In a production sharing contract, a company can report the number of barrels of oil it produces and can take the advantage of upward movement of oil. Also, the better security in the Kurdistan region of Iraq offers a better operating environment.

However, despite these advantages, there are inherent risks associated with the KRG deals. The Iraqi Central Government doesn't recognize the validity of such regional contracts. This could result in Exxon losing out on future contracts from the Central Government.

Other players in the region

The other players in the region that are making significant entry into the Iraq oil exploration are Marathon Oil (MRO) and Total (TOT). The oil reserves in Iraq are estimated to be around 143 billion barrels of crude oil and 126.7 trillion cubic feet of natural gas, which is the fourth highest reserve after Venezuela, Saudi Arabia, and Iran. The Kurdistan region accounts for 43.7 billion barrels of proven oil reserves, 25.5 billion barrels of unproven oil reserves, and between 3 and 6 trillion cubic meters of gas.

Total has bought an 80% stake in the Baranan block in the Kurdistan region of Northern Iraq. It has already drilled a well in the Kurdistan region and plans to drill a total of four wells in this region by the end of this year. Marathon Oil has significant portion of 45% in the oilfields of Harir and Safen, and Total has 35% in each. Marathon Oil also holds a 15% stake in the Atrush block. Marathon oil is exploiting the commercial potential in the Atrush region, which may have more than 627 million barrels of oil equivalent in the block.

Iraq is rising as a major oil producing country because the sliding growth rate of oil production and the sanctions imposed on Iran. According to the International Energy Agency, oil production in Iraq is assisted by "high oil reserves, easy geology, and low production costs." All these factors combined are why oil companies are vying for a share in Iraq's oil producing market. The chart below shows the projection of oil production in Iraq:


(Click to enlarge)

As per the chart above, Southern Iraq has more reserves when compared to Northern Iraq, and companies are looking for a share in the oil producing activity. However, the more liberal agreements offered by the KRG are attracting oil companies to invest more in the Northern Iraq region. The disagreement between the Central Government in Baghdad and the KRG remains an area of risk for the oil companies operating in the Iraq region.

Company

P/E

EV/EBITDA

Forward P/E

Marathon Oil

15.9

3.27

11.44

Total

10.44

3.71

8.21

Exxon Mobil

11.16

6.19

11.11

The above chart shows a comparison among the P/E ratios of the companies. We find that both Marathon Oil and Exxon's P/E ratio are higher compared to that of Total. The table also shows that Exxon Mobil's EV/EBITDA ratio is highest compared to the other two oil companies. As we have discussed, Marathon Oil and Total have a greater presence in the Kurdistan region where the political tensions are low, giving them a better position in the Iraqi oil producing market compared to Exxon Mobil.

On the other hand, by reducing its stake in the Western Qurna I project, Exxon Mobil has significantly reduced its exposure to the political risk. However, it has also reduced its presence in Iraq. This could reduce the company's future revenue opportunities from the Iraqi oilfields.

Source: Exxon Bulls: Let's Talk About Iraq