Will Iraq's Oil Production Increase?

Includes: BP, PBR, RDS.A, XOM
by: Elliott Gue

Whenever I talk to investors about oil markets, questions about Iraq are sure to follow. Some want to know if a rapid increase in Iraqi production could swamp demand and send oil prices tumbling. Others ask about the best stocks to play increased Iraqi drilling activity and the auction of new contracts to produce Iraqi fields.

Iraqi oil production topped out in 1979 at roughly 3.5 million barrels per day and has been on a real rollercoaster ride ever since.

Source: BP Statistical Review of World Energy 2009

Production plummeted to roughly 900,000 barrels per day in the early 1980s amid the instability caused by the Iran-Iraq war. And after production peaked at 3 million barrels per day in the late 1980s, the first Gulf War sent output below 300,000 barrels per day in 1991. The second Gulf War disrupted the uptick in Iraqi oil production that occurred in the 1990s. Today, Iraqi oil production is just returning to the depressed levels that prevailed just before the war.

Longtime readers should be no strangers to the life-cycle of an oilfield and the bell-curve pattern of production. In the Dec. 30, 2009, issue of The Energy Letter, Down Mexico Way: Oil and Politics South of the Border, I wrote about the rapid decline in Mexico’s giant Cantarell oilfield in recent years and how it fits the pattern of a maturing field.

In contrast, Iraqi production does not fit the normal pattern. The history of Iraqi oil production has been marred by war and neglect; Iraq’s ongoing instability and political conflicts have starved its oil-production infrastructure of investment for years.

And Iraq is still a dangerous place. Although some international oil companies are beginning to invest in the country, security concerns raise their costs and make it difficult to quickly ramp up production.

These circumstances suggest that the decline in Iraqi oil production since 1979 is due, at least in part, to above-ground factors rather than the normal maturation of its biggest fields. With additional investment, better security and technology, Iraq could boost its production above its 1979 highs.

The Iraqi government aims to increase oil output to 12 million barrels per day in six years. If Iraq achieves this target, it would be second only to Saudi Arabia in terms of total oil production capacity. Although Saudi Arabia has restricted production in recent months to meet its OPEC quotas, its unfettered production capacity is around 12.5 million barrels per day.

To achieve this goal, the Iraqi government has awarded a series of contracts to international oil companies that include specific targets for production growth.

Last year, for example, Iraq awarded a contract to BP (NYSE: BP) and China National Petroleum Corp covering the Rumaila oilfield, a giant field that first entered production in 1955. The field currently produces slightly less than 1 million barrels per day; the contract with BP targets a production plateau of around 2.85 million barrels per day. BP’s original bid called for a USD3.99 per barrel remuneration fee after development costs, but the company cut that to USD2 to win the contract.

BP’s deal for Rumaila was the only contract awarded in Iraq’s first bidding round in summer 2009. ExxonMobil (NYSE: XOM) submitted a competing bid for the field that actually scored higher in the Iraqi government’s ranking system--primarily because Exxon proposed boosting output to 3.1 million barrels per day. But Exxon sought a remuneration fee that was well above the USD2 per barrel rate the government would accept.

In the second round of bidding, the Iraqi government awarded deals on seven of the 10 fields up for bids. One of the biggest contracts awarded production rights for the Majnoon oilfield to a consortium of Royal Dutch Shell (NYSE: RDS.A) and Petrobras (NYSE: PBR). Majnoon currently produces around 45,000 barrels of oil per day, and the consortium proposal targeted 1.8 million barrels per day of output in exchange for a remuneration fee of just USD1.39 per barrel after costs.

In the second round of licensing, remuneration fees range from USD1.15 for the West Qurna field to USD6 for the Najmah play. The combined production plateau targets from these seven fields amounts to roughly 4.8 million barrels of oil per day.

But actual production potential from these fields is far less encouraging. There’s little chance that Iraq will ever attain the government’s target of 12 million barrels per day, and any jump in production is likely to take considerably longer than six years.

BP’s contract on the Rumaila field was widely panned due to the low remuneration fee BP accepted to win the deal. It’s impossible for us to objectively evaluate what constitutes a reasonable fee for producing these fields because we lack all of the information that BP or ExxonMobil’s executives would pore over before making a bid. But several points about BP’s Rumaila contract appear rather unusual.

First, BP was forced to halve its bid from a remuneration fee of USD3.99 to just USD2 to win the deal. That seems like a pretty big discount for a company that presumably conducted plenty of due diligence while putting together its bid.

It’s also interesting that Exxon’s bid won the contract due to its higher plateau production rate, but the company backed out of the deal because it wasn’t willing to accept the lower remuneration fee. Rumaila is one of Iraq’s largest and most-prolific fields; wouldn’t it be logical to assume that the auction would attract more bidders willing to accept a lower remuneration fee?

And BP’s CEO Tony Hayward noted in late January that the expansion of Iraqi production would be slower than many of the majors anticipate, citing the challenges of “execution” and the need to build “capability.” He went on to suggest that there’s no way Iraq couldn’t produce 10 million barrels of oil per day in 2020 - 2 million barrels per day less than the government’s target and four years later.

Many observers believe BP accepted the Rumaila contract to get a foothold in Iraq even though a fee of USD2 wasn’t enough to guarantee a return from the field. When you consider that the BP’s CEO has painted a far less rosy picture of Iraqi oil production than the government, it would seem that the prospects for Iraqi oil production are massively overstated. BP has every reason to be optimistic, but it appears to be restraining expectations.

My take is simple. Iraqi oil production will increase as it finally invests in its long-neglected fields. But expectations that these fields will yield 10 or 12 million barrels per day in six years are outrageously optimistic; most of the companies that bid accepted rock-bottom remuneration fees to get a foothold in the country but are unlikely to meet stated targets.

The other implication is that the producers which accepted USD2 remuneration fees are not the best way to play a return of Iraqi production. At best, assuming no security issues, BP may make a return on its Iraqi investments in line with its returns on other fields.

But there is one certainty: The big oil companies will need to hire services companies to work on these contracts. Iraqi oil deals represent a USD10 to USD15 billion opportunity for services firms.

One major oil-services firm recently noted in its fourth-quarter conference call that Iraqi contracts have relatively near-term production targets which the oil companies must meet to maintain their deals. That means they will need to spend a great deal on services in the near term just to meet their contract obligations. The same services firm noted that these won’t be cheap deals; services firms are likely to charge top dollar to compensate for the security risks involved with operating in Iraq.

Bottom line: Producers will earn below average returns on Iraqi contracts but will need to spend big on services to meet their contractual goals. Forget the producers and focus on oil services to play the Iraqi oil boom.

Disclosure: "No Positions"