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Legal Challenge to Iraqi Oil Contracts

Legal Challenge to Iraqi Oil Contracts

By Ahmed Salih Al-Janabi – Amereller Legal Consultants (in association with MENA Associates).

This article was originally published in Who’s Who Legal, and is reproduced in full with their permission.

For additional analysis on the status of this challenge, please click here.

The Supreme Court of Iraq is currently considering the legality of the Rumaila oilfield contract awarded by the Iraqi Ministry of Oil to BP and China National Oil Petroleum Co (SINOPEC) in the first bidding round for oil and gas field development contracts in 2009.

The lawsuit has been filed by a former Iraqi MP, who argues that the BP contract violates the Iraqi constitution. The outcome of this case is likely to have significant implications concerning the legality of the contracts that were awarded to international oil companies (IOCs) by the Ministry of Oil in 2008-09.

Iraq Oil and Gas Licensing Rounds

The Iraqi government, in an attempt to redevelop its domestic oil and gas industry following years of war and sanctions, opened two licensing rounds in 2008 for the further development of six existing and operational oilfields and two gas fields. The first licensing round was launched in June 2008, with results announced in June 2009. The second licensing round was launched in December 2008, with results announced in December 2009. The Rumaila oilfield, Iraq’s second-largest, was the only deal offered in the June licensing round. Seven oil fields were awarded in the second licensing round.

The contracts awarded in the bidding rounds are 20-year technical service contracts (TSCs), which are based on IOCs accepting a fixed fee per barrel of oil instead of an equity stake. Under a TSC, the IOC becomes a “Contractor” for the relevant Iraqi regional oil company (ROC), such as the South Oil Company or the North Oil Company, for the development of the relevant oil fields.

The Regulatory Framework of Iraq’s Oil and Gas Sector

The Iraqi Constitution of 2005 (the Constitution) contains several provisions that address, often in a fairly vague language, the control and distribution of natural resources. The Constitution states that all oil and gas is owned by “all the people of Iraq in all regions and governorates.” The language, on the face of it, does not admit to the ownership of any particular resource by any particular group or geographical or political region. Notably, the Constitution does not vest oil and gas resources in the “state”, nor does it allocate the resources to particular regions or governorates as defined by the Constitution. It only states that the federal government, with the “producing” governorates and regional governments, shall manage oil and gas “extracted from present fields” subject to a revenue distribution formula, and provides for equitable distribution of revenues in proportion to the population, and that distribution “should be regulated by a law”. However, the term “present fields” has not been defined. Thus, it is not clear if it includes fields that are only currently producing or if it also extends to other fields. It is also unclear whether the currently producing fields include the partially developed fields.

Another point of contention concerns the proper roles and authorities of federal and regional authorities for equitably sharing oil and gas and making strategic decisions on the utilisation and management of resources. This ambiguity has contributed significantly to the deadlock between the Iraqi government and the Kurdistan Regional Governorate (KRG) over the draft of a new legislation on oil and gas. The federal government maintains that the Constitution does not allow the KRG to adopt unilateral and permanent measures over the management of the oilfields and, as such, any contract signed after the draft oil and gas law was agreed in February 2007 is “illegal” until reviewed and approved by the Iraqi Ministry of Oil.

Ironically, the Constitution does not expressly authorise the Ministry of Oil to award contracts to IOCs either. However, the Ministry of Oil maintains the legality of the contracts awarded to the IOCs on the grounds that (1) the constitutional requirement for the approval of the Councils of Representatives only applies to international treaties and agreements between the State of Iraq and other States, and so commercial contracts between an ROC and IOCs do not need such approval; and (2) the TSCs were awarded under the proposed Hydrocarbons Law, although this has not yet been approved by the Council of Representatives.

The Draft Hydrocarbons Law

The draft federal Hydrocarbons Law was agreed, in principle, in February 2007 and received the approval of the Council of Ministers. It was to be submitted to the Council of Representatives for approval. The draft law contains a package of interconnected measures and several other companion laws and legal texts (eg, revenue sharing and taxation) designed to restructure and rehabilitate Iraq’s oil and gas sector.

The draft law calls for a nationalised oil system while also paving the way for privatisation of the Iraqi oil and gas sector. This approach drew immediate criticism from certain commentators and interest groups in Iraq, who said that by contemplating foreign and private-sector participation in exploration and production, the draft did not sufficiently preserve the Iraqi national interest and Iraqi sovereignty over its resources. A revised draft was circulated in April 2007 which still did not include a clear mechanism for revenue sharing between the federal government and regional authorities and contained many provisions deemed unfavourable to Kurdish interests. For these reasons, and as the Kurdish regional government allegedly had not been consulted on the revised draft, discussions concerning finalisation of the law broke down. Consequently, the KRG drafted its own “Kurdistan Region Oil and Gas Law”, approved by the Kurdistan National Assembly on 6 August 2007 and signed by President Barzani on 9 August 2007, along with a model Production-Sharing Contract (PSC). A number of companies subsequently entered into PSCs with the Kurdish authorities regarding blocks in the Kurdish region. The federal authorities in Baghdad have protested against this development on the basis that, inter alia, it is unconstitutional, declaring the PSCs as invalid.

This impasse in negotiations between the KRG and the Iraqi federal government has been a major setback for the draft law that was intended to optimise the Iraqi oil and gas sector through a complete structural reform. One such institutional change (to be introduced by the Hydrocarbons Law) is the creation of the Federal Oil and Gas Council (FOGC) which would be the most powerful body in Iraq’s oil sector with the power to review all contracts and to set the country’s oil and gas policy in collaboration with the Council of the Ministers. The FOGC would be comprised of: the ministers of oil, treasury, planning and cooperative development; the director of the Central Bank; a minister representing each region; a representative from each governorate not belonging to a region; executive managers from related petroleum companies, including the Iraqi National Oil Company and the Oil Marketing Company; and three or fewer experts specialising in petroleum, finance and economics appointed to five-year terms. The creation of the FOGC would introduce further reforms in the Ministry of Oil in terms of its strategic policy and planning functions.

Contracts Under the Draft Oil and Gas Law

The draft oil and gas law does not mandate the use of a production-sharing agreement as the sole model of contract and allows for other forms of service contracts (such as typical non-risk-bearing service contracts and risk-bearing buy-back contracts) as well as field development and production contracts or risk exploration contracts.

The draft Hydrocarbons Law states that the holder of an exploration and production contract is given exclusive right to conduct petroleum exploration and production within the contract area. It also sets forth the limits on contract duration, differentiating between the exploration phase and the production phase. The initial exploration term is set at four years, extendable by two additional periods of two years each. A third extension of two years (four years in the case of non-associated natural gas discovery) is possible if the extension is justified by the quality and substance of the work programme. Post-discovery development is set at 20 years, with the possibility of five-year extension on negotiated terms. Thus, contract duration can be up to 35 years. Under the proposed terms, 100 per cent of all profits can be repatriated. The only royalty required under the law is 12.5 per cent of gross production, to be paid to the government by the contract holder.

Only the Ministry of Oil has the power to sign contracts with an IOC. However, the contracts are subject to approval by the Council of Representatives. For this reason, there may be a risk that once the draft law is approved by the Council of Representatives, the TSCs awarded in the licensing rounds would need to be reviewed to ensure their constitutionality.

Key Provisions of the Iraqi Model TSC

The Iraqi Model TSC defines petroleum as “all hydrocarbons including liquid and gaseous hydrocarbons produced and saved” from the relevant oilfield. While this definition is generally in line with that found in standard TSCs used in other countries such as Turkmenistan and Namibia, it is broader than the definition contained in the draft oil and gas law, according to whch petroleum includes “all crude oil or natural gas, or other hydrocarbons produced or capable of being produced from crude oil, natural gas, oil rocks or tar sands.”

Furthermore, petroleum operations is defined to include appraisal, development, redevelopment and production operations. Production operations means “operations related to production of petroleum including workovers, stimulations, remediation, restoration, operating, staffing, supervising, repairing, decommissioning and maintaining of wells, plants, equipments, pipelines, tank-farms, terminals and all other installations and facilities.”

Once again, it seems that the definition of petroleum operations under the Iraqi Model PSA is broader than that provided by the draft oil and gas according to which “all or any of the activities related to exploration, development, production, separation and treatment, storage, transportation and sale or delivery of petroleum at the delivery point, export point or to the agreed supply point inside or outside Iraq, and includes natural gas treatment operations and the closure of all concluded activities.” It seems that the draft law would have to be amended to ensure consistency with the definitions under the model PSAs.

The Iraqi Model PSAs provide protection against any “change to the law, or by revocation, modification, or non-renewal of any approvals, consents or exemptions granted to the contractor, in order to maintain the contractor’s financial interests under this contract reasonably unchanged.” This stabilisation or pre-emptive regulatory capture clause effectively allows the IOCs to freeze the terms of the contract so that successive economic and political conditions cannot be used as a way for the state to justify modifying the terms of the contract.

Further, the contracts envisage a rate of interest at LIBOR plus 3 per cent. The remuneration fees will have to cover 35 per cent tax. The model contracts also provide for the payment of administrative overhead charges as defined by the TSC.

Public Sentiment and the Future of the TSCS

While some influential political figures in Iraq have denounced the TSCs as “illegal”, there are indications that the incoming Iraqi cabinet, regardless of its political orientation, will push for ratification (perhaps with some modification) of these contracts. In fact, the Iraqiya party, the winning electoral list in the 2010 election, led by Mr Ayad Allawi, recently warned that any efforts to cancel contracts would severely damage Iraqi credibility with IOCs and have potentially devastating economic consequences. Mr Allawi subsequently stated that he would honour deals signed with IOCs, stressing that the deals might need “some minor adjustments”.

While the argument against the legality of the TSCs does have its virtues, the legality of those contracts can be defended on the basis that they do not infringe on Iraqi sovereignty. In fact, they are consistent with the general policy of the government of Iraq to attract foreign investment in the oil and gas sector. Another argument for maintaining the legality of the TSAs is that there is no legislative prohibition on the signing and execution of those agreements. Logically, in the absence of any explicit prohibition, those agreements may be treated as valid.

The Supreme Court’s decision in the BP case could reduce the cloud of uncertainty surrounding the legal status of the TSCs. However, it seems that, in reality, the legality of those contracts is more dependent on the political situation rather than a purely legal issue.

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