Iraq Finally on World Gas Map

The Iraqi council of ministers has finally given its final stamp of approval today for the first gas deal of its kind in Iraq’s energy history based on the agreement initialized on July 12 between Royal Dutch Shell, Mitsubishi and South Gas Co, to capture and process flared gas in southern Iraq. This deal would put Iraq on the global gas map, something long due in view of the country’s huge oil and gas resource base. Basrah gas Co, to be established according to this final agreement, will be one of its kind.

It took more than three years since the first Heads of Agreement was signed Sept.22, 2008 between Iraq’s oil ministry and Royal Dutch Shell, after the cabinet gave its consent two weeks earlier with a Sept. 27 decree that opened the road for the first agreement of its kind. For more than three years, the project was surrounded with controversy and accusations of a sell-off of Iraq’s gas to a monopoly although, ironically, it took the oil ministry just two years to award 12 long term contracts that “mortgaged” about 70 billion bbl of Iraq’s oil and gas reserves for 25 years. A few weeks ago, the head of the oil and energy committee in Parliament Adnan al-Janabi declared that when it comes to flaring gas, a bad deal is better than no-deal. The question is how do you judge whether it’s a bad deal. The figures, though based on investment and returns estimates, tell a whole different story.

Based on a $75/bbl oil price, which is the price used by the oil ministry for this project, the financial benefits to Iraq, as oil ministry documents show, are estimated at about $58 billion calculated as follows: Corporate taxes and customs would amount to $21 billion over the life of the project. Somo would rack up to $846 million in export fees of LPG, condensate, gas or LNG. South Gas Co’s(SGC)  share of the profit would be about $18.7 billion while the sales of raw gas to Basrah Gas Co (BGC) would insure it another 17.7 billion.

That $58 billion income does not take into account the disbursement of about $27.5 billion which will be allocated by the state to subsidize the gas price to consumers. That still leaves Iraq with about $31 billion net assuming the government does not lift subsidies or increase the price of gas to the consumers over the 25 years of the project. To that, one can add the value of crude and fuel oil which will be freed and made available for export once dry gas is used as feed for power plants. At $75/bbl, this could mean up to $40 billion of additional cash to the state over the 25-year term of the contract.

This cash surplus will be achieved with an estimated investment of about $17.2 billion over the first 10 years of the project, of which $12.8 billion is allocated for the local supply project to be invested within the first 4-5 years, and $4.4 billion for the LNG export project if the partners decide to go ahead when excess gas is available once the domestic market is sufficiently supplied. As the director general of the oil ministry’s legal department Laith al-Shaher states, SGC, the partner with the 51% share will finance its part of the first chunk of investment using $1.5 billion worth of assets and $3.7 billion in government funds while the remaining investment will be covered from the returns on the project to SGC.

But the most important benefit to Iraq is definitely the currently wasted $1.8 billion/year worth of gas that is being burnt daily and flared in the air. If anything, to me, having seen the doznes of flares covering the horizon as you travel on road between the two Rumailas (north and south) all the way to West Qurna field, as well as watching those fires billowing when you fly over Zubair and the rest of the south, stopping this bleeding of gas – and money – is the biggest blessing Iraqis will remember this project for. Watching those flares over and over, sometimes blazing from behind mud houses, over the years pre- and post-2003, has been disheartening. Of the 1,100 MMcf/d produced today, more than 700 MMcf/d is flared. And it doesn’t end here. As production from the southern oil fields goes up, so will associated gas production. This means that with every 1,000 b/d of oil increase, there’s on average an additional 500,000 cf/d of gas that will be flared. Putting an end to this is, in my view, the main merit of such a project.

The road to the final agreement was far from straight. It was a very long and strenuous negotiation with lots of ups and downs, blowing hot and cold according to the political temperament, with lots of “squeezing” in between until the final agreement took shape. During all this time, the project has evolved in magnitude and economics and with every change, negotiators from both sides had to revert back to the drawing board every time, and carry out number crunching again and again until the final agreement was initialized on July 12, 2011. At the same time, negotiators had to navigate the labyrinth of Iraqi laws to make sure the legal basis for what they are creating – a first in the history of Iraq’s gas industry – is legally sound.

It was only a few months ago, for example, that the two sides agreed the final volume of raw committed to the project from the three dedicated fields, reducing it from 2,500 MMcf/d that was the basis for all the negotiations over the past period, to 2,000 MMcf/d, on the oil ministry request. The latter was trying to fine tune the project to avoid getting trapped into the deliver-or-pay clauses. As a result, all the numbers had to be revised, from capex to the domestic gas price and the economic model had to be reworked. With each revision, different mechanisms were introduced and formulas reworked, adding more safety valves that make sure that if the oil price (and fuel oil price, being the substitute fuel for power and industry that is the basis for the calculation of dry sales gas) go up, the gas price remains under check.

So while SGC will be paying $3.22 per million BTU when Brent is at $75/bbl, the actual dry gas price for the domestic user – calculated at one third of the price of the substitute fuel – would be discounted. That discount is supposed to increase every time the oil price goes up based on an introduced mechanism that raises payments SGC receives for raw gas. But dry gas will be sold to the Iraqi consumer at the current subsidized sales price of $1.04 per million BTU, regardless what the oil price on the international market is. As Mr Shaher notes, the subsidized price does not reflect the cost of collecting the gas, processing it and delivering it to the local market.

The project itself is not to blame for the difference in price and the need for the government to allocate funds for subsidies from the cash flows SGC is receiving from the project, since the choice to pay subsidies lies with the government alone. The calculations of subsidies do not enter into, nor do they affect, the project’s economics. The day the government estimates it is in a position to reduce or eventually lift those subsidies, its revenues will go up accordingly. The project itself will not be impacted.

The next chunk of detailed negotiations will come when the joint venture decides to go ahead with the export project. What the main agreement guarantees, when and if the export project receives the green light, is a maximum of 600 MMcf/d of raw gas for 20 years for a 4 million tons/year capacity LNG project. Everything related to the sales and purchase agreement will be negotiated then, though it is already agreed that the prices that would be applied then would be international market prices.

How The Numbers Add Up