The Fuse

Destiny Delayed: Oil in Kurdistan

August 21, 2015

Guest Post by Matthew M. Reed | @matthewmreed

Matthew M. Reed is Vice President of Foreign Reports, Inc., a Washington, DC-based consulting firm focused on oil and politics in the Middle East.

This time last year the Kurds of Iraq looked like they were ready for a divorce. To many, including Kurdistan Regional Government (KRG) President Massoud Barzani, it seemed like the natural next step after the Kurds began exporting oil without Baghdad’s consent. A year later, that calculus has changed dramatically, even though the Kurds are exporting more oil now than ever before.

The war with ISIS and the ensuing flood of refugees cost the KRG dearly; defending territory gained after the ISIS blitz cost the Kurds even more. To make matters worse, world oil prices are now less than half what they were last summer. While the Kurds sold some oil on their own last year, the effort stuttered when challenged by Baghdad in courts around the world, including the U.S. Finding consistent buyers was not easy.

global supply growth

Crude export volumes from Iraq and Kurdistan are a significant issue for global oil markets. With volumes climbing over 4 mbd, Iraq is contributing to today’s oil market glut and OPEC’s record production levels. In the near term, even if Iraq’s production were to suffer from the spat between Baghdad and the KRG, or the war with ISIS, the global oil market would not be affected significantly, given supply-demand balances. But the volumes in question have huge implications for Kurdistan’s independence and Iraq’s bottom line.

Iraq faced a similar predicament. Oil output rose last year and production is up again this year but Baghdad’s financial situation is still dire.

Desperate and broke, the KRG and Iraqi government put off divorce. Instead, Baghdad and Erbil—nudged by the U.S.—reached a deal in December to combine oil exports to and through Turkey, using Kurdish infrastructure. The deal called for Iraq’s State Oil Marketing Company (SOMO) to arrange sales of some 550,000 b/d: 300,000 from fields operated by Iraq’s North Oil Co. and 250,000 from the KRG, thus legitimizing the bulk of KRG oil exports. In return for moving the oil to market, the KRG would get its share of the national budget (17 percent before deductions), which Baghdad slashed after the Kurds started making moves in early 2014.

Desperate and broke, the KRG and Iraqi government put off divorce.

The December deal was only possible because the KRG, with the help of international oil companies, built up its oil sector from scratch after the U.S. invasion of Iraq in 2003. Baghdad has resisted this project every step of the way. However, it failed to stop independent oil companies from entering the KRG early on; Kurdistan adopted its own oil and gas law in 2007, attracted its first foreign major in 2011, and ramped up oil production more recently.

A good deal at the time

The Baghdad-Irbil deal made good sense when it was reached. From Baghdad’s perspective, Kirkuk oil was stranded with no outlet. Under normal circumstances, that oil would be delivered to Ceyhan via the Kirkuk-Ceyhan pipeline, but the Iraqi leg was sabotaged in March 2014 and the ISIS takeover made repairs impossible. The previous winter, the Kurds took matters into their own hands again and completed their own pipeline connecting their fields to the Turkish border. It was this pipeline, which bypassed ISIS territory and tied into the Kirkuk-Ceyhan line inside Turkey, that the KRG ultimately connected to Kirkuk fields, thus facilitating northern exports from Kurdistan and northern Iraq.

On paper, this outcome was a win-win. Combined exports from northern Iraq and Kurdish fields were expected to represent at least 17 percent of Iraq’s total exports when the deal was agreed to. Anything beyond that would of course mean that Baghdad would come out ahead, because the revenues would be greater than the federal government’s budgetary obligations to the KRG. The Kurds, whose independent sales were limited and controversial in 2014, saw SOMO’s involvement as the easiest way to increase exports and revenues—so long as Baghdad paid up.

erbil

Source: Iraqi Embassy to the United States

Feeling Cheated

At least that was the plan. Joint exports were limited in the first quarter of 2015. As a result, Baghdad paid the KRG less than what Erbil expected. In April, however, joint exports climbed to 534,000 b/d and stayed relatively high in May (at 450,000 b/d). These volumes were below what was agreed to, but they were still substantially higher than what was exported in January through March. In spite of this, Baghdad’s payments didn’t reflect the rise in SOMO sales. The Kurds complained that there was no obvious connection between what they were paid and the volumes exported.

Fed up and feeling short-changed, the Kurds cut out the middle-man. They flipped the deal on its head in June and began exporting most of the oil for themselves.

Fed up and feeling short-changed, the Kurds cut out the middle-man. They flipped the deal on its head in June and began exporting most of the oil for themselves. Ships waiting at Ceyhan never received SOMO oil. More and more ships turned up to load KRG oil and, with Turkey’s blessing, those vessels were given priority. Kurdistan’s direct sales from Ceyhan hit nearly 400,000 b/d in June and jumped to about 500,000 b/d in July. The Kurds delivered just 150,000 b/d to SOMO in June and about half that in July, blaming “technical issues” inside Turkey.

One would expect a war of words now but the two sides remain remarkably restrained. Prime Minister Haider al-Abadi has taken a much more constructive tone than his predecessor, Nouri al-Maliki. Oil minister Adel Abdul-Mahdi and Finance Minister Hoshyar Zebari continue to call for reconciliation. The Kurds insist they are committed to the deal and regret resorting to independent sales. At Ceyhan, the Kurds haven’t completely cut off Baghdad and they’ll probably avoid doing so, hoping that some SOMO exports are good enough to keep the deal on life-support. The volumes may be small but in its current situation, Iraq needs every dollar it can get.

A long road for Kurdistan

The Kurds are exporting the most oil they ever have, but their position is precarious. By directly selling oil, the KRG is surely earning more revenue than Baghdad was prepared to hand over, but at today’s prices/volumes, it’s still facing a huge budget shortfall. The Kurds can’t simply ramp up production either. To do that, they’d need to convince foreign companies that additional capacity is a worthy investment. No doubt the KRG will have to pay down debts to those companies before any of them dare to invest more in Kurdistan. And even if fields in Kurdistan are relatively safe, it remains to be seen whether or not Baghdad will continue to play nice.

Kurdistan’s fortunes also depend on the integrity of the pipeline that links its fields to international markets via Turkey, which has been shut repeatedly by smugglers in southeast Turkey.

Kurdistan’s fortunes also depend on the integrity of the pipeline that links its fields to international markets via Turkey. That pipeline—the KRG’s jugular vein—has been shut repeatedly by smugglers in southeast Turkey who tap the line. More recently, in late July, the Kirkuk-Ceyhan pipeline was sabotaged by Kurdish militants inside Turkey who are now at war with the government in Ankara. Some of these repairs take hours; others take days or up to a week. During those times the Kurds can only sell oil from storage in Ceyhan.

An August 18 statement by the KRG’s Ministry of Natural Resources estimated that smugglers and saboteurs cost Irbil $500 million between July 1 and August 17. Last month the pipeline was closed for 111 hours—or 15 percent of the time. The militants now promise they won’t strike the pipeline again but there’s no guarantee that all fighters will abide by that pledge.

The Kurds of Iraq can’t be faulted for dreaming of independence. But given the circumstances, they also can’t be faulted for waiting a while longer to declare it.