Big Oil Gets the Boot From Iraq

By virtue of signing contracts with the Kurdistan Regional Government, ExxonMobil (NYS: XOM) and Chevron (NYS: CVX) simultaneously established a business deal in Iraq and were banned from doing business in Iraq. Confused? Don't be. It's just another day of doing business in the Middle East.

The beef
Essentially, the Iraqi central government has a problem with the autonomy of the Kurdistan Regional Government, or KRG, when it comes to the oil business. At the heart of the matter is, naturally, money. Crude oil exports make up two-thirds of the country's GDP. As domestic demand increases, the importance of maintaining complete control of its reserves and production increases as well.

Part of maintaining that control means avoiding production-sharing contracts with foreign oil companies, which is exactly what Iraq has done. The central government signs service contracts instead.

But, production-sharing agreements are much more lucrative than the typical service contracts offered by many foreign governments with national oil companies. It is the reason, for example, that Exxon won't do business in Mexico; that country's constitution outlaws PSAs.

Naturally, when Kurdistan offered up production sharing contracts, the majors jumped at the chance.

The sauce
Exxon signed its deal with Kurdistan last October, and the anger of the Iraqi government continues unabated. Prime Minister Nuri al-Maliki has gone as far as asking President Obama to intervene and prevent Exxon from exploring and producing in Kurdistan.

But American private companies can do as they please, and Chevron followed Exxon's lead, acquiring Reliance's oil interests in Kurdistan last week. Iraq promptly labeled the deal illegal and banned the company from doing business with the central government.

Now that Exxon and Chevron have paved the way, other foreign majors are beginning to show interest in Kurdistan, which will assuredly increase tensions with the Iraqi central government. Add to this the fact that Iraqi oil exports have decreased steadily since reaching a post-war high in April, and you've got a situation that's growing increasingly precarious.

Declining oil production
Bad weather accounts for a decline in production in the South, but difficulty with the central government is what's to blame in the North. Kurdistan announced it was halting exports because the Iraqi government wasn't paying companies operating in the region.

In April, exports reached 2.5 million barrels per day. Halfway through July, Southern exports were at 2.07 million bpd, and Northern exports were around 325,000 bpd. It is a significant difference, especially for importers looking to replace Iranian oil exports now blocked by sanctions.

This constriction on supply may increase the price of oil, but more importantly, it will ratchet up tension in a region that is already extremely volatile.

Something's got to give
There are numerous ways this situation could play out, with different impacts on investors. We could see either the KRG or the Iraqi central government acquiesce peacefully to the other, or perhaps come to some sort of mutual profit-sharing agreement. If the majors are allowed to remain in Kurdistan with production sharing contracts, that is great news for investors. If they are forced into service contracts, it is not so great news. However, if this situation were to erupt into violence, which is always a risk, then nobody wins.

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