State and Substate Oil Trade: The Turkey‐KRG Deal

Abstract

After the U.S. withdrawal from Iraq, there has been increasing tension between the central government in Baghdad and the Erbil-based Kurdistan Regional Government (KRG) in northern part of the country. Although KRG President Masoud Barzani supported Iraqi Prime Minister Nouri al-Maliki in the federal elections of 2010, the two sides have been in open conflict over energy projects within the semiautonomous Kurdish region. The KRG is a substate actor in regional relations whose international legal status has not yet been determined. It is important to note that any future determination will undoubtedly hinge on oil and gas resources. Maliki's administration has consistently argued that the Federal Oil Ministry has primary authority over Iraq's oil sector. The KRG has claimed independent authority over energy resources in the region, including the right to sign oil-field exploration and production contracts within its territory, govern oil fields, and export oil and natural gas. The federal constitution of Iraq regulates the oil revenue-sharing mechanism and other features related to energy exploration and production. Following from this, all petroleum exported from Iraq should be marketed through the country's State Oil Marketing Organization (SOMO), with the KRG receiving 17 percent of the resulting revenues. However, the regulation of the energy sector in the KRG is unclear.1 In light of this situation, Deputy Prime Minister Hussain al-Shahristani has expressed concern regarding violations of the fundamental principle embodied in the statute, asserting that KRG authorities should follow the constitutional order and not make oil-extraction deals with third countries without Baghdad's approval.2 Until recently, Baghdad appeared to have the upper-hand in the conflict, as the export pipelines have been under control of the central government. However, the commissioning of an oil pipeline linking Erbil to Turkey is changing the status quo by physically allowing the KRG to export oil to regional and international markets. The changing status quo builds on previous overland exports by tanker truck. Instances of oil-revenue generation through domestic sales and road-based exports have been commonplace for some time though not accounted for by the Iraqi treasury. This export of oil to Turkey has been going on with little opposition from the central government in Baghdad. Nevertheless, it is the oil pipeline between the KRG and Turkey that creates new tensions between Baghdad and Erbil. The landlocked KRG has occasionally been able to strike temporary political agreements with Baghdad to feed oil into the existing Iraq-Turkey Pipeline (ITP), but such deals have lost momentum. In the absence of an agreement between the two sides, and despite the setbacks posed by the tensions, the Kurdish oil sector has begun to flourish independently over recent years. This goes hand-in-hand with the culmination of the KRG's independent energy policy, which reached its peak at the end of 2013, when the KRG started to pump oil to Turkey through the ITP. Energy geopolitics and mercantilism are the two main frameworks shaping energy-policy debates today. Energy markets and institutions responsible for their supervision challenge this statist framework.3 Oil is traded in a global market underpinned by international institutions representing the supply (producers) and demand (consumers) side of the value chain. With the establishment of the Organization of Petroleum Exporting Countries and the International Energy Agency in the aftermath of crises in the 1960s and 1970s, the oil trade has witnessed significant changes over the last three decades. The economic influence of the so-called rising powers, epitomized by the BRIC4 countries, has put pressure on the institutions of global energy governance as demand has grown at an unprecedented speed. The increasing demand on the global oil market has highlighted the key energyconsuming regions that prioritize “energy security” in their policies. While the agency of national oil companies (NOCs) is often used to ensure energy security, international oil companies (IOCs) have also determined the fundamentals of the global oil market. Through the overlap of global and regional dynamics, the process of energy globalization has produced new dimensions of energy security. The globalization of the trade in oil and natural gas is a naturally occurring phenomenon that stems from the basic logic of supply and demand. Security of supply and security of demand are mutually supportive concepts that go hand in hand, regardless of the circumstances.5 At the end of 2013, Iraq's share of world oil reserves6 stood at 150 billion barrels of oil (bbo), or 8.9 percent, making it the fifth-largest holder of global reserves (Table 1). Within the Middle East, Iraq ranks third, after Saudi Arabia (265.9 bbo, or 15.8 percent of the global share) and Iran (157 bbo, or 9.3 percent). With the increasing importance of the reserves-to-production (r/p) ratio in global oil security — a natural-resource life-span indicator — Iraq accounted for the largest addition to global crude oil in 2011–13 with an r/p of more than 100 years.7 Iraq's oil production witnessed remarkable growth over the last half of the decade; as of 2013, it stood at over 3 million barrels per day (3.7 percent of global output). Iraq sits on the world's twelfth-largest natural-gas reserves (Table 2). Proven reserves within the state have been growing, and stood at 3.6 trillion cubic meters (tcm) in 2013, equal to 1.9 percent of the global total.8 However, it has proven to be difficult to catch up to the pre-war levels of production. From 1.9 billion cubic meters (bcm) in 2008, natural-gas production shrank to 0.9 bcm in 2012, the lowest level in a decade.9 Due to security problems, Iraqi oil production is badly constrained in some parts of the country. Recent insecurity in the northeast posed by insurgents from the Islamic State of Iraq and the Levant (ISIS) is likely to challenge oil and gas investments and development within the country. The threat posed by ISIS has changed security dynamics overnight. The federal government's request to Kurdish peshmerga forces to help secure oil facilities in the north constitutes a new dynamic, transforming the KRG within the federal structure of Iraq as Erbil gains greater control of the oil resources at Kirkuk. However, as the threat from ISIS spreads across the region and starts to jeopardize assets of Western energy companies, the Kurds are gaining more support from the international community. Led by the United States, an anti-ISIS coalition began to bomb targets in September 2014. After ISIS released its hostages, Turkey finally joined the coalition, easing pressures between the state and the KRG. Tensions were high, as Turkey was hesitating to lend support to the KRG, when ISIS militants attacked the government and reached the outskirts of Erbil in the summer of 2014. As one of Iraq's oil-producing regions, the KRG's industry is still in an early stage of development. The KRG's output was approximately 180,000 bpd, of which 30,000 can be exported to Turkey by tanker trucks. The remainder was destined for refining locally prior to the signing of the Turkey-KRG oil-pipeline deal.10 Oil contractors operating in the territory under the KRG assess the proven oil reserves at more than 2 billion barrels, recoverable on P1 and P2 bases, and total resources of more than 17.7 billion barrels. KRG officials similarly claim regional oil wealth to be as high as 45 billion barrels. As for natural-gas resources, the region is said to be even more promising: more than 350 bcm of recoverable gas has been discovered on P1 or P2 bases, while the total resource base is estimated at nearly 1.2 trillion cubic meters.11 These amounts make the extent of the region's resource base comparable to those of the Shah Deniz natural-gas field in the Caspian Basin. With necessary arrangements in place, regional production could reach export levels of 1 million bpd by 2016, and 2 million bpd for oil and 20 billion cubic meters (bcm) for gas by 2020.12 Nevertheless, the incremental growth of oil production is dependent on investments by oil companies, as capital is necessary to support development. Over 50 oil companies, including industry majors such as ExxonMobil, Chevron, Sinopec, Total, Genel Energy and Gazprom Neft, have been attracted to the region, thanks to contractual production-sharing agreements (PSA) with high profit margins, offered by the KRG's Ministry of Natural Resources.13 In a world of ever more costly oil extraction, fields in the KRG offer cost savings thanks to their geology, thus making it easy to attract the attention of the oil industry. Politically ambiguous regions require oil companies to consider final investment options in order to tap into the region's resources. Even companies that have already signed contracts in the KRG are still waiting to decide on when to move from the exploration phase to the production phase of field development. With the Iraqi government considering unilateral exports of oil from Kurdistan as smuggling, and threatening legal action against the buyers,14 uncertainty over export-oriented producers is growing. On the other hand, Turkey and the KRG have been defending the oil trade from Erbil to the Mediterranean terminal at Ceyhan, ignoring the legality of arbitration proceedings by the Federal Ministry of Oil in Baghdad.15 As the Baghdad-Erbil dispute is heating up, the issue of oil-transport security is looming in the background. It is enormously risky to invest billions of dollars to develop the fields, considering the fact that the region lacks secure infrastructure to deliver the crude to world markets. To ensure the exploration and production activities of the major oil companies, whilst upholding their investment plans, the KRG needs to prove that oil companies can reliably export and be paid for their products. Owing to the land-locked geography of the KRG, the only solution is through pipelines. While relations remain problematic with Baghdad, unpredictable with Iran and unclear with Syria, Turkey remains the only viable option for exports to international markets via pipeline. Nevertheless, energy cooperation with Turkey is poised to further enhance the KRG's financial standing and, while the disagreement with Baghdad continues, to improve the viability of a Kurdistan that is independent of the federal government of Iraq. In the face of the ISIS threat to the unity of Iraq, the economic facts on the ground created by the Turkey-KRG agreement are the only promising security arrangement for the KRG. As much as the oil trade could be a positive force, some critics argue that the cementing of these exports might also threaten the future of Turkey-Iraq relations.16 With remarkable economic growth over the last decade, Turkey has become one of the world's rapidly emerging energy markets. The state has been experiencing a surge in demand in every sector of the industry, which may be difficult to sustain at current levels of supply. Its primary energy consumption, which has increased sharply in recent years, is expected to double in the next decade.17 Against the backdrop of a rising need for energy, Turkey is clearly in a situation of energy insecurity. Only around one-fourth of its total energy demand is being met by domestic resources, while the rest is being satisfied mainly through imports of oil and natural gas from Iran and Russia. It is no surprise that Turkish energy policy aims to diversify its sources of imports to gain reduced prices.18 Compatible with its energy policy, Turkey has also started to encourage investments and acquisitions of oil and gas fields outside the country with Turkish energy companies playing an active role. Since Middle Eastern energy reserves constitute its nearest option geographically, the country is uneasy about aligning its foreign policy and energy strategy to this region.19 Not surprisingly, the Kurdistan region of Iraq, located at the doorstep of the Turkish energy market, is seen as a strategic gateway for meeting future energy demands and driving the country's energy policy.20 Furthermore, energy cooperation with the KRG has the potential to offer Turkey an opportunity to decrease its energy-import deficit, around $60 billion annually in 2013.21 In light of this, a significant reversal in Turkish foreign policy towards the KRG has been observed over the past few years, helping to open up the geographically landlocked region as a new source of oil and natural-gas supply. While the region is officially part of federal Iraq, a century-long Kurdish quest for independence has increased in the post-Saddam period. As the ties between Baghdad and Erbil weaken, the latter is poised to bind itself to its northern neighbor, Turkey, to pursue further economic integration and political stability by offering it a suitable investment environment. Nevertheless, the issue is complicated by Ankara's problems with its own 30-year Kurdish insurgency. While the main Kurdish opposition to Baghdad has been the Kurdistan Democratic Party led by Barzani, Ankara has been struggling against Kurdistan Workers' Party (PKK) terrorism since 1984. Nevertheless, the PKK and the Turkish government started a peace process in 2013 that ended in summer of 2015. Turkey has become the number-one investor in the region, incurring significant financial costs to upgrade relations between Ankara and Erbil to a strategic level. Annual trade has exceeded $8 billion and, thanks to rapprochement between the state and substate actors, Iraq has become the second-largest market for Turkish exports after Germany.22 As Turkey's energy demand grows, production capacity in Northern Iraq for future economic partnership is very high.23 This has caused the lessening of political tensions between Ankara and Erbil, running high at one time. The Turkish Army was threatening to invade the KRG region to counter the terrorism threat posed by the PKK.24 In addition, the current good relations, unimagined six years ago, are about to be elevated to a new level with the start of oil and gas flows from the region to Turkey. The first consignment of KRG oil was transported through the Turkish port of Ceyhan on the Mediterranean Sea on May 22, 2014; Israel was the first buyer of KRG crude delivered by tanker to the port of Ashkelon.25 Further oil shipments are expected to continue through Ceyhan later this year.26 With the Turkey-Iraq border becoming more porous, oil and gas deals between Ankara and Erbil have directly challenged Baghdad's claims to exclusive control of Iraq's natural resources, with Turkish and Kurdish leaders engaging in trade rather than conflict.27 Although the fundamentals of energy cooperation between Turkey and the KRG were defined in 2012, it was only on March 25, 2013, that the deal was finalized in the form of a framework agreement between the parties. In order to commercially realize the project, the Turkish government decided to establish a new oil company that only deals with this project and does not engage in energy development in other parts of Iraq. Since the state-owned Turkish Petroleum Corporation (TPAO) has a series of operations in the southern part of Iraq, a subsidiary, Turkish Petroleum International Company (TPIC), was established and transferred to another state-owned company, the Turkish Pipeline Corporation (BOTAS). Within the TPIC, the Turkish Energy Corporation (TEC) was created specifically to handle energy development in the KRG on behalf of Turkey.28 In conjunction with the framework agreement signed in March, a series of energy deals between Turkey and the KRG came to an end after long negotiations in November 2013. The parties wrote up agreements to govern export pipelines, the sale of gas, the oil trade, the acquisition of oil fields by the TEC, and the revenue mechanism.29 For the pipeline dimension, long-term logistical have been The KRG has nearly a crude pipeline to the Turkish The first at the fields and to Kirkuk. The goes up to the border of within KRG On the Turkish side of the crude will into the existing which is of two the is being used to Iraqi oil from to the Ceyhan The in has been to and of crude supply. The new KRG pipeline is into the the Turkish After the crude from Kurdistan will the and through Turkish infrastructure to facilities at bpd were into the export pipelines by the end of and a new pipeline will be for In Erbil and Ankara be half of the for KRG despite from Baghdad. Turkey has already begun for gas imports from the region by its gas pipeline the KRG has already begun of a pipeline to handle 20 bcm of gas imports On the Kurdish of a gas export pipeline has and the KRG have finalized for production-sharing agreements in some of its exploration As a for the first time since its has become an through its subsidiary, to the agreement signed by the parties on November 2013, the has become the major in in the and In addition, the will in all of exploration and The parties an agreement that Turkey to oil from Kurdistan at a In addition, will be paid 1 percent for all oil through the pipelines as the for Turkey. However, on a logistical it remains to be seen will at the Turkish port of Ceyhan, for federal Iraqi oil It is likely that Turkey may need to crude from the KRG into and ensure it is not with oil by The agreement that regulates the of the to exclusive to the the Iraqi side Turkey and the KRG of oil smuggling, that be from any other Iraqi crude or or by important of the deal is the gas The KRG is to supply up to 20 bcm annually to Turkey mainly from the natural-gas the oil company Genel Energy is likely to be the first company to export the Turkey's to reach KRG gas fields a and Ankara is an in international needs through the of gas from the KRG to The other major such as and Although Turkey could the gas it from the deal to from its it to be this Turkish has for the a the trade in natural gas. This is to that used in the gas trade, rather than a has increased in importance in markets and the of the gas the could the opportunity not only to gas from oil as a against Gazprom and the but also to establish a domestic gas for the for a region. of the deal that remains to be is related to revenue After the first federal Iraqi oil been to a mechanism that with the to From there it flows to the Federal of an order it from On the other hand, to a framework the KRG to open an in the Turkish state for future by oil and gas Baghdad on a to be in the United States, while Turkey and the KRG have for a negotiations are being Baghdad and Erbil to the of the and a revenue-sharing mechanism between Iraq and the KRG. The of Iraqi oil continue with a new of in Turkish energy policy a substate the Kurdistan Regional Government of Iraq, are in an political and strategic Due to the extent of reserves under the KRG's the oil and gas from the KRG are likely to the energy security dynamics in the region and The extent of Iraqi oil and gas including the production and r/p for oil at over 100 years of current is to the future of the KRG. with to security for the north of Iraq in the face of an ISIS Turkish energy demand is transforming the regional to new sources of oil and gas at is the key of Ankara's energy policy the KRG. The energy demand is further by Turkey's of the country into one of the world's by Turkey's for energy security has for trade in natural gas with and imports of KRG gas are likely to Ankara's to demand with and, Iran while increasing the market for energy trade, As for the KRG, Erbil to its political standing through oil and, in the absence of a deal with and the Turkish energy is as the of the regional energy deal between Ankara and Erbil are likely to other sources of energy via Turkey to the uneasy emerging between Ankara and Erbil of the Iraqi state while the Kurdish to independence should the trade between the two parties continue in the absence of a regional the very energy deal between Ankara and Erbil a political for Turkey's future of the status of its own Kurds and could a long-term threat to the of Turkey The goes for Ankara's As future exploration and development of oil and gas in the KRG production allowing Turkey to diversify from the of the by remain to be