Why aren’t all oil contracts service contracts? Evidence from Iraq

 When I first started to study oil contracts in a serious way, something puzzled me. Why weren’t all oil contracts service contracts? That is, why didn’t countries simply hire oil companies to extract their oil at a fixed fee per barrel? After all, that’s what many oil contracts turned into after the fact. Consider Venezuela: Chávez’s “nationalizations” basically had the effect of keeping the oil companies’ revenues per barrel around a flat $11. Or consider Chad, where the World Bank and major oil producers acquiesced in the Chadian government’s demands for more revenue as oil prices spiked above all expectations. (They didn’t have to: the government’s oil revenues were deposited with the World Bank, E.U. troops protected the facilities, and President Déby relied upon French military support to stay in power. But why not? It avoided all sorts of trouble.) Ecuador temporarily raised its windfall profits tax to 99% of all revenues when oil rose above the price at which the contracts had been signed, but implementation has been spotty. (Hm. Bernard may have been right about Mr. Correa, although the jury is still out.)

	Oil revenue		Payments to Chad
	Actual	Original	Actual	Original
2003	$234	$0	$45	$0
2004	$2,063	$600	$166	$31
2005	$3,138	$1,186	$300	$80
2006	$3,444	$1,197	$774	$88
2007	$3,600	$1,210	$1,220	$96
2008	$5,040	$1,216	$1,564	$1,000
Cumulative	$17,519	$5,409	$4,069	$1,295

Source: Ben Esty, World Bank.

The answer to the puzzle is simple: exploration risk. Lots of fields turn out to be much harder to work than anticipated. Similarly, exploring for oil is a very costly undertaking these days — in general, if the oil were easy to find, somebody would already be extracting it.

And that is exactly what Oil Minister Al-Shahristani realized made Iraq unique: the exploration risk was minimal. The fields had all been explored back in the 1970s. If it hadn’t been for the Iran-Iraq and First Gulf War, they would have been developed and on-line a long time ago. So why not auction off service contracts to the fields? Competing consortia were allowed to bid on how much they would increase production from the fields. They were also allowed to bid on the per barrel fee they would receive above a minimum level fixed by the Iraqi government. The winners would have to post a bond which they would lose if they didn’t invest a specific amount within a certain amount of time.

So how did it go? Not too well in the first round. There were few bidders—most fields were uncontested, in fact—and all the consortiums posted per-barrel fees that the Iraqi oil ministry considered too high. Lifting costs in Abu Dhabi are about $1.50 a barrel, and Baghdad considered $2.00 a reasonable maximum for most fields. The only bid to be accepted came from a consortium of British Petroleum (which isn’t called that anymore, but hey) and the China National Petroleum Company. The two bid $3.99 per barrel on the Rumaila field, but accepted the government’s insistence on $2. They also put up a bond (called, perplexingly, a “recoverable signature bonus”) of $500 million, and pledged to take production up from the current 1.02 million barrels per day to 2.85 million … although they would only earn a fee for production over 1.75 million bpd. The lowest bids on the other fields were rejected.

If that doesn’t sound like a good deal, that’s probably because it wasn’t. There were real questions as to whether BP-CNPC would exercise the option that it had (in effect) purchased for $500 million. Would it? Should it? What was BP thinking? Had Shahristani gotten a deal that really was too good to be true?

Many questions. Thoughts? More questions? Anyone? What about you, LT?

Comments

[Jonathan]

Seems kinda complicated and perhaps orthogonal: Iraq wants production to increase, so they should charge a flat annual fee for exploitation, with maybe a minimal per-barrel commission after 20% over current output. What is your professional-grade suggestion for aligning the interests of oil ministry and oil drillers?