For full text of the paper including end-of-paper tables and appendix, click PDF file.
I. Introduction[i]
The flaring of gas has been going on in Iraq for more than seventy years. In 2008, Iraq was classified as the fourth largest gas-flaring country (After Russia, Nigeria, and Iran), GGFR (2009). Furthermore, the utilization of produced gas has deteriorated from 30 percent during 1984-1990 to 12 percent only in 2004-2008; the rest is either flared (40, 57, respectively), re-injected, or shrunk in gas processing, Table (1). In terms of caloric content, Iraq has flared the equivalent of 3.5 percent of its oil production in 1984-1990 to increase to 5.7 percent in 2004-2008. In the absence of gas utilization schemes, the flaring would continue unabated in the future.
II. International Pricing of Gas
Pricing of gas is related to its trading mode and market structure in the different regions of the world. The way that gas is traded depends on technology, economics and distance. Currently, there are three modes of trading:
(1) Pipelines: this mode entails the movement of gas in its original state to nearby markets; onshore or offshore.
(2) Liquefied natural gas, LNG; where gas is liquefied at the origin, transported in tankers, then gasified at the end-user’s destination. This mode is used when gas needs to be transported overseas to usually far-away markets
(3) Gas to liquid, GTL; whereby gas is converted to very high quality diesel fuel.
Given technology, which mode to follow, depends on availability of markets and the economics of each mode. In general, pipelines are more economic at shorter hauls and, thus, are preferred in local and regional trade. LNG is usually preferred for long hauls, mainly overseas markets. GTL is only a potential competitor to LNG, as it is still more costly, (Jensen, 2004). For the HOA, It is understood that, apart from domestic consumption, exported gas would be in the form of LNG.
As for the market structure; different domestic-to-foreign sources shares and institutional set-ups have led to different pricing arrangements. These arrangements may converge in the future, in the different markets, but currently they are different. In Asian and most European markets, which depend on imported gas, pricing is usually linked to the price of crude oil or oil products. For instance, in Japan and in other Northeast Asian countries, gas price is linked to the cost of imported crude oil. Prices of Algerian LNG imports into Europe were first linked to the average price of a basket of crude oils, but later to the price of a mix of oil products.
In US, Canada and the UK, which have a high share of domestic supply; liberalization of the market has led the price of gas, largely but not wholly, to be determined by short-term commodity trading (Jensen 2009, 20, 21).
These two methods have led to diverging pricing for gas after 2005 in the related markets. The two figures below[ii] represent two markets with different mechanisms for pricing; US market where gas price is mainly determined in spot trading and European markets (excluding the UK), where Russian gas price is largely oil- or oil products-related. It is clear, in general, that before 2005 gas and crude oil prices were moving in tandem in both markets. Since 2005, however, the two prices diverged in the US market[iii] while continued their tandem movement with the oil price (though with a wider gap) for Russian gas in Europe.[iv] The divergence between oil prices and gas prices in the US market is expected to widen in 2010 and afterward (EIA, 2009b).
Figure 1: Prices of WTI and natural gas (boe) in USA
Figure 2: Prices of Brent and Russian natural gas (boe) in Europe
In the Mediterranean (Algerian and Libyan gas) and the Gulf (Qatar, S. Arabia and Iran) the gas is tied to crude oil price or netted back, depending on the market that it is exported to.
III. Heads of agreement, HOA
The HOA, between the Ministry of oil, MoO, and Shell, was arrived at as a way to utilize the largely flared gas in southern Iraq. As for all schemes in the oil sector in Iraq, it was exposed to political and economic criticisms, mainly:
(1) The invitation of Shell without involving other companies in a transparent bidding.
(2) The deal offers a monopoly to Shell that extends for twenty five years and includes the entire southern region.
(3) It imposes international prices on the domestic consumers, thus denying them energy subsidy that are followed by all oil producing countries. Even the WTO has not denied Saudi Arabia subsidizing its domestic consumers, (Zainy, 2008).
Present production of gas, in the south, and possible order of magnitude for future production, are shown in the following table (T-1)[v]:
Table (T-1) Present and possible future production in the south
Oil Production, TBD |
Net available: |
||||||
Production minus 10% shrinkage & losses |
|||||||
Million CF/D |
Thousand BOE/D |
||||||
Min |
Max |
Min |
Max |
Min |
Max |
||
Actual |
|||||||
2008 |
1,671 |
856 |
54 |
||||
Jan-Oct 2009 |
1,655 |
855 |
54 |
||||
Projection |
|||||||
2016-2021 |
3,200 |
4,600 |
1,536 |
2,208 |
96 |
140 |
|
2022-2035 |
5,400 |
9,000 |
2,430 |
4,050 |
154 |
256 |
|
Source: Actual figures from Ministry of Oil’s Internet Site, http://www.oil.gov.iq/.
Note: Oil production for 2016-2035 is set in the light of 1st & 2nd rounds of licensing as of end- 2009.
Using oil-related price of $33.9/boe in 2009 (60% of Basra’s oil price); the value of net available gas could increase from $0.7 billion in 2009 to $1.2-1.7 billion, annually, in 2016-2021, to $1.9-3.2 billion, annually, in 2022-2035.
In the present notes we comment on pricing in the HOA, the consequences on the domestic consumer, and the expected situation that could arise in the WTO membership negotiations.
III.1 International price of gas in the HOA
In general, the pricing of raw gas (i.e. gas bought from the South Gas Company, SGC, by a joint venture to be formed between the SGC and Shell)[vi] in HOA is said to be linked to international or ‘world’ market prices for gas. The method or scheme of international pricing for the Iraqi gas is not mentioned in the HOA. Therefore, the scheme needs to be established first. This will be related directly to the main importing markets. It is clear from the above that there are different regimes of pricing in different regions. Would the price be referred to LNG spot pricing in UK/US or to oil-related long-term contract pricing? (See also Figures 1 and 2).
Which market would be chosen to price Iraqi natural gas would make a difference to revenues as long as various international markets follow different pricing mechanisms. With the expected rise in oil prices in the future and until pricing mechanisms converge in various gas markets (say analogous to the oil markets) the oil-related pricing (in Asia and most Europe) seems more advantageous to the Iraqi gas.
III.2 The link to the international price
The ‘link’ to international price itself needs to be looked into closely. Pricing of raw gas that the Joint venture will buy from SGC is to be determined according to a ‘mechanism’ described in g-k of clause 3 of HOA[vii]. The mechanism can be summarized in the following three equations/definitions (my symbols):
Compensation of Raw Gas = Fixed Percentage × Revenues, (1)
Revenues = (Sale of Gas, LNG, LPG, NGLs) × Pg, (2)
Pg: A value (price) linked to International Market Prices, (3)
It is worth noting that the ‘fixed percentage’ is less than one, which implies a discount, therefore, the smaller the percentage the higher the discount.
In the light of the limited elaboration given in HOA and quoted in footnotes 3 and 6 of this note, the following questions arise:
Questions: (1) How to determine the Fixed Percentage in equation (1)?
This is answered in (h) of Clause (3) in HOA by suggesting the development of an ‘Economic Model’ (see footnote 7) to be developed by Shell and Ministry of Oil (MoO). This is a loose end that invites the following observations:
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i. It is stipulated that the Model ‘calculate[s] cash flow based on projected gas volumes, capital cost and operational cost, Raw Gas compensation and taxes’. There is a circular problem here. This Model is supposed to calculate the compensation of Raw Gas yet in this statement compensation of Raw Gas is supposed to be an input in the calculation.
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ii. There could arise a clash of interests in a situation whereby Shell (a partner in the Joint Venture) is entrusted with the task of training the staff of the other partner (SGC) on an economic model that would affect the shares of the two partners (h of Clause 3). The lower the Fixed Percentage, for instance, the lower what the SGC gets for the sale of the Raw Gas[viii].
Question (2): How does Pg link with international market prices of gas in definition (3) above? International experience of gas project indicates varying percentages of discounts from the international price that are usually negotiated in the specific deals. For instance, in North Africa a 15% discount is applied, i.e. instead of using the ‘full’ international price in the calculations of the government’s and the foreign partners’ share, 85% of the international price is used.
III.3 Subsidizing domestic gas consumption and WTO membership
The price for the dry gas and other forms of gas sold to the domestic consumer is specifically mentioned in HOA to be linked to international market prices. [ix] Even with this stipulation, it is possible to subsidize the sale of dry gas to domestic consumers through the budget. However, there is a serious problem that could arise with the WTO in the membership negotiations.
In the accession negotiations between Saudi Arabia and WTO it seems that WTO has accepted that Saudi Arabia to subsidize the sale of Ethane and Methane to domestic consumers on the ground that these elements of natural gas ‘had no international reference price in the Gulf region’[x]. Establishing an international price as is explicitly suggested in HOA, therefore, would make the Saudi precedent irrelevant and could lead to objections on the subsidy by other WTO members.
To mitigate this, the natural gas used domestically should not be linked to international market prices of gas. Alternatively, it needs not be part of the agreement between MoO and Shell, altogether. It is better being procured by the Ministry of Oil and used directly to domestic customers at subsidized prices.
IV. Recommendations
(1) Establish the method of international pricing of Iraqi gas. With the expected rise in oil prices in the future and until pricing mechanisms converge in various gas markets in the world, oil-related pricing seems more advantageous to the Iraqi gas.
(2) Spell out the elements of the ‘economic model’/mechanism through which the gas price is related to the international price. Minimize or eliminate possible discounts.
(3) Subsidize selective domestic consumers.
(4) Pegging the price of domestic industrial and commercial consumption to international levels would deny the Iraqi industries an important advantage over foreign competitors.
(5) In anticipation of objections in WTO membership negotiations, for subsidizing domestic consumption, domestically consumed gas needs not be part of the agreement between MoO and Shell.
References
Energy Information Administration, EIA (2009) Annual Energy Outlook 2010: Reference Case, 14 December,
http://www.eia.doe.gov/neic/speeches/newell121409.pdf, Accessed 17 December, 2009.
Gas Flaring Reduction Partnership, GGFR (2009) Estimated flared volume from satellite data,
http://209.85.229.132/search?q=cache:kHa0Pl5BAdcJ:www.medemip.eu/Calc/FM/MED-EMIP/OtherDownloads/Docs_Related_to_Climate_Changes/200905-MENA_Carbon_Forum_2009/Day2/PANEL_Oil_%26_Gas/HeikeLingertatVF.pdf+Flaring+Iraqi+Gas,+GGFR+2009&cd=2&hl=en&ct=clnk&gl=ly, Accessed 26 December, 2009.
International Monetary Fund, IMF (2009) International Financial Statistics, IFS, Online, Commodity Prices 1960-2009, http://www.imfstatistics.org/imf/, Accessed 2 December 2009.
Jensen, J. (2004), The Future of Gas Transportation in the Middle East: LNG, GTL Pipelines, a presentation to the Annual Conference of the Emirates Center for Strategic Studies & Research, ABU DHABI, September 27, www.JAI-Energy.com
_______(2009), Fostering LNG Trade: Developments in LNG Trade and Pricing, Energy Charter Secretariat, Boulevard de la Woluwe, 56 B-1200 Brussels, Belgium
WTO (2005), Report of the Working Party on the Accession of the Kingdom of Saudi Arabia to the World Trade Organization, Document WT/ACC/SAU/61, 1 November.
Zainy, M. A. (2008), Al-gas Al-tabii: Hadr Am Istighlal Limaslahat Al-watan, [Iraqi Natural Gas: Wastage or utilization in the Interest of the Country], Unpublished call submitted by the writer to the chairman of the oil and gas committee in the Council of Representative on 25 October 2008.
Contributor’s details
Mr. Ali Merza, Ph.D., has worked for the Iraqi Ministries of Oil and Planning as Economist/Senior Economist and for the United Nations Department of Economic and Social Affairs as Expert/Chief Technical Advisor in the Middle East and North Africa.
E-mail: merza.ali@gmail.com
[i] The analysis in this paper is based on an unpublished 16-page document titled ‘Heads of Agreements’, no issuing authority, no date. The term ‘Heads of Agreement’ stands for a non-binding document outlining the main issues relevant to a tentative (partnership or other) agreement
[ii] These figures are constructed using data on prices from IMF (2009).
[iii] During 2009, spot gas prices have remained under pressure as a result of negative GDP growth, together with weakening consumption, and rising gas output. Spot prices, therefore, have fallen faster than oil-related gas prices. For instance, spot US (well head) price has come down from $10.62/MCF in July 2008 to about $2.92 in September 2009, a drop of 72%. By contrast, the Russian gas price has come down from $13.4/MCF to $6.3, a drop of 53%, in the same period. Data used are from (IMF, 2009).
[iv] The widening gap after 2001/2002, in the oil-related gas pricing, is most likely the result of lagged adjustments to changes in oil prices and also to S curve arrangement (whereby a floor and a ceiling for oil price are established within which the slope of the relationship between gas and oil prices are adjusted) . This can be ascertained, from figure 2, by the narrowing of the gap in 2009; when crude oil prices fell tangibly from their average in 2008.
[v] Except for the summary table (T-1) in the text, Table (1) in this paper is placed at the end.
[vi] ‘Raw Gas’ means any gaseous effluent in its natural state at the gas/liquid phase separation.
[vii] ‘(h) the compensation of Raw Gas purchased pursuant to clause 3. G) will be linked to international market prices through the following mechanism: compensation for Raw Gas will be set as fixed percentage of the revenues received by the Joint Venture for selling products (gas, LNG, LPG and condensate) that result from processing and treating the purchased Raw Gas. The products will be sold at prices linked to international market prices and therefore any change in international market prices will directly impact the Raw Gas compensation. There will be appropriate audit rights for the Ministry on the realized revenues.
The parties will determine the fixed price percentage based on an Economic Model developed by Shell and the Ministry. The Economic Model will with a reasonable degree of certainty calculate cash flow based on projected gas volumes, capital cost and operational cost, Raw Gas compensation and taxes. The purpose of the Economic Model is to assist the parties in a transparent way in the decision –making. Shell will provide the Economic Model and provide training to the Ministry representatives who participate in the formation of the Joint Venture or the JMC.
The compensation for Raw Gas will be adjusted (both upwards and downwards) if certain economic parameters such as the fiscal regime or cost structure of the Joint Venture undergo significant changes resulting from e.g. changes in the industry cost environment, gas composition and gas pressure.’
[viii] One could argue that what SGC forgoes from the sale of raw gas regains on the sale of treated gas. But what the SGC forgoes on Raw Gas would be shared by SGC and Shell; a clear loss of a half by SGC.
[ix] ‘i) the Parties anticipate that:
– The joint Venture will, following a jointly agreed planning process, sell to the Ministry its products (dry gas, LPG and condensate) for domestic consumption at prices linked to world market prices, which the Ministry then sell to (end-) consumers;
– Upon a formal request of the Ministry to be preceded by a jointly agreed planning process, the joint Venture will directly sell to (end-) consumers its products (dry gas, LPG and condensate) for domestic consumption at prices linked to world market prices;
– The Parties agree that any delivery points for domestic sales are the battery limits of the joint Venture installations; and
– The Joint Venture will export its products (dry gas, LNG, LPG and condensate) at prices linked to world market prices;
j) Shell (and/or its affiliates) will off-take and purchase any LNG produced by the Joint Venture; and
k) The Parties acknowledge that, in view of the economics of the gas industry, the long term planning and optimization and substantial investments to achieve an optimal solution for Iraqi gas development, the Joint Venture will be the sole gas company engaged in business, as defined in Clauses (1) Purpose and (2(Scope and in Clause (3), in the South of Iraq (Basrah), and providing gas for domestic and export markets and generating revenues from gas marketing activities.
(The joint Venture and activities described in Clauses 1 to 3 are together referred to as the “Co-operation”)’.
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