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Iraqi workers walk in South Rumaila oil field, in southern Iraq, December 2, 2009.


In the bright, open lobby of the Erbil International Hotel in the Kurdistan region of northern Iraq, Western businessmen in blue jeans huddle with regional officials in business suits. Sitting quietly nearby, their weapons checked at the door, is a gaggle of security men, many of them former Kurdish fighters, now in civilian clothes.

These days, Kurdish leaders and international investors assembling here speak a common language: oil. Kurdistan sits on plenty of it, and the region's current peace is a welcome feature for oil companies looking to explore here.

But Kurdistan's oil fields pale in comparison with the mega oil fields to the south. The Kurds are staking a potentially explosive claim on the area around Kirkuk, which holds vastly more rewarding, but risky opportunities.

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Just 90 kilometres south of Erbil, Kirkuk and its resources are at the centre of a power struggle between Iraqi Kurds and Arabs that threatens the fragile stability of the entire country. The resulting sectarian strife makes the region a dangerous place in which to do business.

Unlike Erbil, Western executives rarely venture to Kirkuk. When they do, they travel in three-car armoured convoys, accompanied by heavily armed private security forces, and they mostly stick to the outskirts to avoid trouble, like the car bomb that killed six in a market last month.

With nearly a quarter of the world's easily accessible, light oil reserves and huge tracts of unexplored land, Iraq's oil industry offers immense rewards, both to the country and the international oil companies that are warily pursuing deals.

And for a growing number of companies, the threat of political violence re-erupting in Iraq is a risk worth taking. International oil giants coming to Iraq are already looking past the days of war and regional conflict, as they jockey to secure a piece of the prize early.

On Dec. 11, the major oil players will have a key opportunity to place their bets on Iraq's future. Baghdad plans to auction off the right to develop 10 unexplored but highly prospective oil and gas fields, including some near Kirkuk, following a similar auction earlier this year.

Some 40 of the world's biggest oil companies are qualified to bid next week. Their ultimate success hinges on Iraq's ability to forge political compromises that will allow for peaceful development. The crucial test is Kirkuk, where Kurds and Arab Iraqis battle for control of the area, while coveted oil resources offer lasting economic benefits.

"Iraq is a high-risk place, there is no way around it," says Samuel Ciszuk, a Middle East energy analyst with IHS Global Insight. "But the opportunity for reward is also great."

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If things go well - an enormous if - Iraq could boost its production from 2.5 million barrels a day to more than seven million by 2016, making it the third-largest producer after Saudi Arabia and Russia.

That additional Iraqi supply would have a major impact on world oil markets, helping to moderate prices by replacing production from depleting reserves elsewhere and meeting rising demand from the developing world.

In Iraq, the usual geological and financial challenges for international oil companies are magnified by sectarian violence, legal minefields and political strife. The conditions are less than ideal, and some early projects will likely produce only a modest return on capital.

"It's like a prelude to a kiss," says Fadel Gheit, New York-based analyst with Oppenheimer and Co. But strategically, international oil companies "cannot afford not to be in Iraq so it's a bitter medicine they have to take in order to establish a foothold."

Mr. Gheit says all the major oil companies are struggling to maintain production as current fields decline and international opportunities remain limited. Companies like Exxon Mobil Corp. have to increase production by 200,000 barrels a day from new fields just to offset declines from existing production. That's the reason such companies are investing heavily in Canada's oil sands, even though costs are enormous.

From where Iraqi Oil Minister Hussain al-Shahristani sits - in the ministry's rundown office building on the north side of the capital, shielded by concrete barriers and layers of Iraqi forces - the country's oil policy looks due south.

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While the northern regions of Kirkuk and Kurdistan figure prominently in Baghdad's plan to boost its oil production over the longer term, it's the vast array of giant, proven fields in southern Iraq that are expected in the short term to catapult the country into oil's big leagues.

Those fields were the subject of Iraq's first auction. Bidding got off to a shaky start in June but has since resulted in a series of agreements.

In the south, international oil companies such as BP PLC, Exxon, Royal Dutch Shell PLC, China National Petroleum Corp. and Italy's Eni SpA have either signed contracts or reached a memorandum of understanding to dramatically boost production from operating oil fields.

Oil companies are coming into the country agreeing to work under service contracts that pay a fixed amount for every barrel of oil produced. With access to producing fields containing more than 30 billion barrels of reserves, they still stand to make a great deal of money.

The bidding process began inauspiciously, with only BP and its partner, China's CNPC, participating in the round, winning the right to develop the Rumaila field, which is located near the Kuwait border in an area populated almost exclusively by Shia tribes.

Eager for more development, Mr. al-Shahristani went back to the international companies and offered sweeteners that neither the companies nor the government will reveal.

Recently, Exxon and Shell agreed to a deal to develop the giant West Qurna 1 field, with its estimated 8.6 billion barrels of reserves, while Eni is leading a group that will boost production in the Zubair field that has reserves of 4.1 billion barrels.

Those three fields lie in areas of the country that have been relatively peaceful of late. But challenges remain, including the potential for renewed violence.

Of immediate concern, however, is the fact that Iraq has not updated its laws covering the oil industry since the era of Saddam Hussein. Companies must count on the commitments of Prime Minister Nouri al-Maliki's government, which faces a difficult re-election bid slated for January but likely to be postponed for a few months, adding further uncertainty.

Political opponents have criticized the government for allowing foreign companies to develop Iraq's resources.

The al-Maliki government had hoped to showcase the country's new-found security as part of its election platform. However, the massive double bombings in Baghdad in August and again in October, have made that a shaky proposition.

This has meant that item two in the platform - the promise of economic development driven by oil - has taken on even greater importance.

Mr. al-Shahristani was determined to "front load the bid round to get the companies committed" prior to the election set for January, says Greg Priddy, an analyst with Washington-based political risk consultants, Eurasia Group. That's why the best, proven fields were offered at auction first.

To reduce public opposition, the Iraqi government offered only service contracts that confer no ownership of the resource, rather than "production-sharing agreements" that provide companies more revenue if prices rise and allow them to include the reserves on their books - a major selling point with investors in publicly traded oil companies.

With service contracts, the minister has concrete answers for political critics who complain the government is "giving away the oil to foreigners," Mr. Priddy says. "They say they are hiring service providers only."

Analysts note that the Oil Ministry has been reluctant to divulge some of the details of those arrangements, but the companies are not required to start spending serious money for several months after signing the contracts.

As a result, they aren't putting serious investment at risk until after the election, at which time they can assess whether Mr. al-Maliki or his successors remain committed to the deals.

Meanwhile, Iraq's current oil-producing infrastructure is decrepit, and it's debatable whether the country has the labour force, the transportation network or the power grid that would be required for the massive investment boom.

Iraq does, however, plan new infrastructure aimed at helping the country achieve its oil ambitions. Four new floating oil terminals and three new undersea oil pipelines are planned for completion in 2011, an oil official said last week.

The Game of Risk The election next year will provide an indication of the country's immediate future, including its ambitious plans to boost oil production.

"We think the development is going to go much more slowly than most people believe," Mr. Priddy says.

The fragile Sunni-Shiite coalition stitched together by Mr. al-Maliki - a Shiite himself - has largely fallen apart, and several parties are now vying for power, representing either narrow sectarian interests or new versions of Mr. al-Maliki's coalition.

Tensions between Kurdish and Arab Iraqis remain high, notably around the issue of control in the oil-rich province of Kirkuk. The absence of a federal oil and gas law poses an additional concern.

The chairman of the Iraqi parliament's natural resources committee has warned that the oil contracts entered into by the current government might not be accepted by the government that will be formed after the election.

Washington-based Mr. Priddy points out that foreign investment still is very unpopular with the Iraqi public, and opponents of Messrs. al-Shahristani and al-Maliki will push those populist buttons to win power.

The government hopes that the commitment of billions of dollars in investment brings the promise of jobs for a population that has had little good economic news in the past 20 years.

Kurdish Roulette In Iraq's Kurdish region, a flock of mainly smaller players, led by Canadian-listed firms such as Heritage Oil Corp. and WesternZagros Resources Ltd., have staked their ground and are exploring.

Kurds have built a prosperous enclave in war-battered Iraq, and now maintain their own, semi-autonomous state within a state, largely free from the sectarian warfare that has bedevilled the country since the U.S.-led invasion of 2003.

In the Kurdish provinces, companies have been dealing directly with the regional government, which has been awarding exploration licences. Now, those firms find themselves in the middle of a battle for control of the industry between Baghdad and Erbil.

In Kurdistan, companies are "trying to enter Iraq through the window," says Oil Ministry spokesman Asim Jihad, conveying the image of a thief in the night. "They should come in through the front door. They should deal with the central government, not the KRG," the Kurdistan Regional Government.

They also find themselves not far from the emerging conflict between Kurdish and Arab Iraqis, and can't rule out the risk of physical violence.

Simon Hatfield, chief executive officer at Calgary-based WesternZagros, was among the first to begin exploration in Kurdistan, back in 2005, when the U.S.-led forces were still battling a major insurrection in the south. "If we had waited two or three years like other companies, we'd have had lots of competition," he says. Now, "it's like a California land rush. … We went north because it was less dangerous than the rest of Iraq. It felt like a different country."

His company has never had a terrorist incident, he says, yet it continues to employ heavy security. There are shifts of several guards around the drilling site and at the company office in Suleymania. When company executives visit, they travel in convoy and are accompanied by armed guards at all times.

"It's better to present a hard target," Mr. Hatfield explains, even if the risk seems low. "Terrorists will always go for the soft target."

When oil exports from the Kurdistan region started flowing on June 1, it looked as if the wrangling between Baghdad and Kurdistan was settled. The federal oil sales agency agreed to handle the exports, and the Kurds agreed to a federal revenue-sharing formula that, reportedly, gave the KRG 17 per cent of the revenue.

Two months after the export taps were turned on, Heritage Oil announced it had struck a $2.5-billion deal to take over Genel Energy, a Turkish oil player and among the very first to invest in the Kurdistan region.

The new Heritage would be among the region's biggest players with excellent access to prime oil fields.

It was, by all accounts, a huge vote of confidence in the region. But what no one had reckoned on was the determination of the federal government not to honour the KRG contracts.

While the feds allowed their export agency to sell the KRG oil abroad, it didn't pass on any of the proceeds to Erbil or the companies.

"How can we approve payment when we have no knowledge of the terms of their contracts?" asked Oil Ministry spokesman Mr. Jihad.

"We will only resume export with guaranteed payments," says a resigned Asti Hawrami, the KRG's Minister of Natural Resources.

Since Oct. 14, all the oil produced in Kurdistan has been distributed to domestic users.

But Heritage Oil isn't scared off. "We remain committed to the Genel Energy merger," Heritage CEO Tony Buckingham said in a statement a week after the exports ceased. Mr. Buckingham, reportedly a former mercenary and deep sea diver, appears to be comfortable with the risk.

The legal clouds, however, explain the absence of the major oil companies in Kurdistan - all except China's Sinopec.

"The Chinese are more willing to take risks, like operating in a very murky legal framework," Mr. Priddy says.

WesternZagros, meanwhile, is still exploring but would be reluctant to develop discoveries, should it strike pay dirt.

"The big capital expenditure is in development costs," Mr. Hatfield says. "We won't do that until there's agreement [between the KRG and Baghdad.]rdquo;

Ground Zero A settlement for Kirkuk is the most pressing political issue Iraq faces, making it one of the two most physically risky provinces in which to operate.

The Kirkuk region is one of Iraq's major oil-producing centres, and Shell is quietly negotiating with Baghdad on a deal to boost production from the nearby fields. But security remains a major stumbling block.

"Kirkuk is our Jerusalem," says Jalal Talabani, leader of the Patriotic Union of Kurdistan and President of Iraq. It was the PUK that took custody of Kirkuk in 2003, and largely holds sway there today.

But the matter is far from settled, given Baghdad strengthening its power, the Iraqi troops now amassed in the province and Prime Minister al-Maliki's strident centralism.

Meanwhile, Kurdish administrators have helped thousands of Kurds move back to Kirkuk, and provided financial incentives, and not-so-subtle pressure, to encourage Arab residents to leave.

The realignment of Kirkuk's population, first by Saddam Hussein, and now by the Kurds, has become "the main flash point in Iraq," says IHS Global Insight's Mr. Ciszuk.

And its outcome will determine who gets Kirkuk - its territory and its wealth.

"If there is a part of Iraq where the future does not look bright currently, it is that part of Iraq," Mr. Ciszuk says.

"And these [major oil]fields would be smack-bang in the middle of high tensions between the Kurds, being the most organized single faction, and the central government."

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About the Authors
Global Affairs reporter

As Global Affairs Writer, Patrick Martin’s primary focus is on the turbulent Middle East, to which he travels regularly. He has twice been posted to the region – from 1991-95 and from 2008-12. More

Global Energy Reporter

Shawn McCarthy is an Ottawa-based, national business correspondent for The Globe and Mail, covering a global energy beat. He writes on various aspects of the international energy industry, from oil and gas production and refining, to the development of new technologies, to the business implications of climate-change regulations. More

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