The downside of offering a cheap oil deal to Iraq begins to sink in

Oil companies rushed into Iraq, offering to rebuild its huge and dilapidated fields for such low fees (around $2 a barrel) that it made executives wince. Almost every big oil company did it. Executives argued quietly that they hoped Baghdad would remember their generosity in getting the country back on its feet once Iraq was ready to give them a chance to explore for new patches of its oil. The other upside of offering such services for a pittance was that Iraqi politicians gearing up for presidential elections next month may find it more difficult – though by no means impossible – to argue Iraq got taken for a ride from big bad oil and to overturn the deals.

But there is a very big, potentially global, downside people that in the industry are now beginning to quietly admit.

Executives, including those who struck deals in Iraq, and bankers are worried the oil companies’ generosity last year could set a terrible precedent in Iraq and further afield, showing oil-rich countries just how desperate the energy companies are to grow and how willing they are to accept service contracts that pay them a flat fee. Service contracts, such as those signed in Iraq, shut companies out of any earnings upside that could come from technology improvements or a run up in oil prices.

“They basically showed they were willing to accept the kind of margins you get paving the streets of Surrey [a leafy area home to many London commuters] for the local council,” said one analyst. One fiery French executive could hardly contain his frustration, arguing that far from giving the companies an edge when exploration acreage finally came up for auction, their past generosity would simply prompt Iraq to demand just as stringent terms even for geologically riskier projects.

Helge Lund, Statoil‘s chief executive, also voiced concern, telling the FT today that too many such low-margin deals would hamper the industry’s ability to continue making big investments in infrastructure and technology. “We will look more at being overweight in the technically challenging part of our portfolio, but, like in Iraq, we will take contracts that are like service contracts. ”

He noted that Iraq was a special case and that other countries would have a tougher time pushing the industry to such favourable terms. “There are very few examples, if any, with such limited geological risk and such large resources,” he said.

So far Statoil is doing relatively well ensuring there are not too many Iraq-like contracts in its overall portfolio. Too many low margin deals would drag down the company’s overall return on average capital employed (Roace), a metric analysts use to measure how efficiently a company invests its money.

Here is how Jason Kenney, analyst at ING, ranks the world’s biggest western oil companies by market capitalisation in terms of Roace:

ExxonMobil, the champion of value investing: 20.8 per cent

BP, the company that set off the rush of generous deals with Iraq: 13.6 per cent

Total, the company that only stuck a toe in Iraqi waters: 13.2 per cent

Statoil, the company lacking growth but looking for value world wide: 10.4 per cent

Chevron, the company that ignored Iraq altogether, but stuck with volatile Venezuela: 11.4 per cent

Royal Dutch Shell, the disorganised company with a solid, but high cost portfolio: 7.4 per cent

ConocoPhillips, the company struggling most among its peers in the US: 6.5 per cent

No-one knows for certain what kind of returns the oil companies will get in Iraq. BP argues their margins on the giant Rumaila field project will be comfortably within double digit teens. Others are not so sure the returns made by companies in Iraq will make it past single digits. That is a far cry from a few years ago when many companies were targeting returns of at least 17-18 per cent and some were gunning for more than 20 per cent.

If Iraq really does set a bad precedent, returning to the days of such robust returns will become very much more difficult.

Related links:

Oil companies mobilise to launch their Iraqi invasion (FT Energy Source)
Will Iraq achieve a massive oil output boost? For and against (FT Energy Source)

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