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Jan 28, 2016 | 09:30 GMT

Why Iraqi Kurdistan Is Struggling to Pay Its Bills

An oil refinery roughly 20 kilometers (12.4 miles) east of Arbil, Iraq.
(SAFIN HAMED/AFP/Getty Images)
Forecast Highlights

  • Despite the success of the Kurdistan Regional Government (KRG) in exporting oil independently of Baghdad, low oil prices have kept Kurdish energy revenue from rising alongside output.
  • Even though its weak financial situation probably is not sustainable, the KRG will prioritize making consistent payments to international oil companies to keep production from declining, although it likely will not be able to start paying off its outstanding debts to these firms.
  • Persistent financial strain will continue to drive the Arbil government closer to Turkey, whose infrastructure is crucial to the KRG's ability to export its oil. 
  • Many of the legal threats to the KRG's independence from the government in Baghdad will remain unresolved for the foreseeable future.

Low global oil prices are wreaking havoc on Iraqi Kurdistan's finances. Although the cash-strapped Kurdish government has managed to export oil independently of Baghdad since June 2015, it will increasingly rely on foreign support the longer oil prices remain depressed, regardless of how much control it has over its oil export revenue. The Kurdistan Regional Government (KRG) will rely heavily on Turkey to keep oil exports and revenues flowing as it struggles to address both its own disintegration and the profound effect that the financial strain is having on the morale of peshmerga fighting the Islamic State.

Even if oil prices rise enough to enable the Arbil-based government to meet its spending needs — or even start to repay its estimated $14 billion in debt, $4 billion of which is owed to oil companies alone — many of the legal challenges to the KRG's authority will remain. So far, Baghdad's attempts to use legal claims to dissuade customers from buying the Kurdish government's oil have been unsuccessful. However, Arbil's recent move to sell Iraqi oil from Kirkuk, which lies outside the Kurdish autonomous region, will invite further legal disputes with Baghdad. These challenges will push the KRG even closer to Turkey, paving the way for a greater role for Ankara in Iraq's Kurdish region.

An Unsustainable Drain on Finances

Arbil's financial concerns are great and growing. At its heart, Kurdistan is a region that supports its people by putting them on the government's payroll; roughly 1 in 6 Iraqi Kurds are considered employees of the KRG. Weighed down by a bloated public wage bill totaling $700 million to $800 million a month, Kurdish officials are struggling to find a way to pay the salaries of their peshmerga fighters, teachers, oil workers and other civil servants. At the same time, the KRG's budget must somehow fund the patronage networks that form the foundation of Kurdish society. All told, Arbil's spending commitments add up to about $1 billion to $1.1 billion per month (or $12 billion to $14 billion per year).

One way to pay this bill would be with financial assistance from Baghdad. During the first half of 2015, the Iraqi government had a deal with the KRG in place to provide just that. In exchange for Arbil's export of 550,000 barrels per day of crude through Turkey's Ceyhan port, where Baghdad's oil marketing company would sell it to foreign customers, Baghdad would give 17 percent of its budget to the KRG — roughly the amount needed to cover Arbil's monthly bill of $1.1 billion. Within the first month, though, the deal had fallen apart; Arbil delivered only 145,000 bpd of oil, and Baghdad reduced its payment to the KRG to $208 million. Still, Arbil managed to drag the arrangement out, arguing that the 550,000 bpd should be an average figure for the full year, until it decided in June to virtually halt oil transfers to the marketing firm entirely, cutting Baghdad out of its oil export process.

And so far, at least, the KRG seems to have had little trouble exporting oil by itself. Baghdad's threats of legal suits have not hurt the KRG's ability to find buyers. Since September 2015, the KRG has exported an average of 600,000 bpd. Between Nov. 1 and Jan. 17, some 43 percent of Kurdish oil exports from Ceyhan went directly to European customers, primarily in Italy. Another 17 percent transferred to ships off the coast of Cyprus, likely bound for other destinations on the Continent.

Arbil has already announced plans to continue the sales for the rest of 2016. But even if its recent successes continue, they might not be enough to fully fund the KRG's budget. In 2015, Kurdish oil revenue averaged between $361 million and $406 million per month, a shortfall that has caused the KRG to fall behind on salary payments for the past four months. This has led to strikes and protests in Sulaimaniyah and other areas with weak support for the ruling Kurdistan Democratic Party.

Absent funding from Baghdad, the only way for Arbil to make ends meet is with oil revenue, which accounts for as much as 80-90 percent of the Kurdish government's budget. Thus, ensuring that oil exports continue and, if possible, increase is a high priority for the KRG. However, this requires that Kurdish officials consistently make payments to the oil companies operating in the region so that upstream investment continues to flow into Kurdistan. But with oil prices at about $30 per barrel, the KRG's payments to oil companies have been sporadic at best, and, at worst, nonexistent in the first eight months of 2015. If the KRG hopes to balance its budget and start paying off its debts to foreign oil companies, it needs oil prices to surge to somewhere between $60 and $70 per barrel or for production to ramp up quickly.

Funding Problems Strain the KRG's Relationships

For foreign energy firms, operating in Kurdistan is no easy task. Arbil's relationships with international oil companies have long been complicated by the fact that one of Baghdad's core imperatives is to keep the KRG under its control. To this end, Baghdad has threatened to blacklist energy companies doing business with the KRG, refusing to recognize any contracts that Arbil has entered into. The Kurdish government has tried to counteract Baghdad's efforts by presenting itself as a more attractive and stable partner for these companies, offering generous terms through its production-sharing contract model. The KRG also has the advantage of pointing to Kurdistan's favorable geology, which in some places is cheap enough to develop that total break-even costs are below $10 per barrel.

Although a few major oil companies such as ExxonMobil have done some exploratory work in the region, the most successful foreign firms have been smaller companies that focus almost exclusively on Iraqi Kurdistan. These include Norway's DNO, Turkey's Genel Energy and the United Kingdom's Gulf Keystone Petroleum, which operate three of Iraqi Kurdistan's four largest producing fields: Tawke, Taq Taq and Shaikan. Together, they produce nearly 300,000 bpd, most of which the KRG exports and sells.

Arbil currently owes these firms quite a bit of money in back payments. Its debt to DNO stands at approximately $992 million; to Genel Energy, $378 million; and to Gulf Keystone Petroleum, $283 million. Each figure represents export revenue that Arbil should have transferred to the companies under the terms of production-sharing contracts during the ill-fated attempt to work with Baghdad's marketing company. (The KRG has been able to meet its monthly payments to the firms since it began exporting oil on its own in September 2015.)

Despite its many other financial burdens, the KRG will make paying off oil company debts one of its top priorities. Toward the end of 2015, upstream activity began to decline, causing total production growth to taper off. DNO, Genel Energy and Gulf Keystone Petroleum have all announced that they will readjust their 2016 budgets if Arbil cannot make its payments consistently — a move that would likely lead to reduced output and drive the KRG's revenue down even further.

Even though the Kurdish government has met its obligations over the past four months, Genel Energy has already revised its production estimates downward for 2016. Instead of producing 84,000 bpd, as it did in 2015, the company expects to produce 60,000-70,000 bpd in 2016. Its output has already begun to fall, indicating that the blocks Genel Energy is active in are not seeing the upstream activity needed to keep production figures up. Since Genel Energy is a leading partner in Kurdistan's Tawke and Taq Taq blocks, the KRG could lose as much as 60,000 bpd of output from those two fields alone. Other KRG-controlled fields will probably see similar problems between now and mid-2017 as they struggle to keep output high.

Lawsuits Loom if Arbil Cannot Pay

Despite fulfilling recent payments to foreign oil firms, Arbil could still face legal action in the long run if it fails to make significant strides in paying off its outstanding debts to those companies. It has already been dragged into the courtroom for precisely that reason: Dana Gas, one of the earliest companies to enter Iraqi Kurdistan, has filed multiple lawsuits against the KRG, claiming it is owed more than $2 billion in unpaid natural gas invoices.

The London Court of International Arbitration has already ruled in favor of the Dana Gas consortium, ordering the KRG to pay $100 million and $1.98 billion in two separate cases. Enforcement in the first case was appealed to the High Court of England, which struck down the KRG's defense based on sovereign immunity and reiterated that the Kurdish government must honor its payments. But the KRG refuses to accept the ruling, which may ultimately mean that it could fall to Turkey — the main conduit for Kurdish oil flows and the location where Kurdish revenues are deposited — to uphold and enforce the court's decision.

The Dana Gas dispute is an important one to watch for both current and prospective investors in Kurdistan. One of the biggest selling points the KRG has in generating interest among international oil companies is its relatively attractive fiscal and contractual terms. But if other companies are forced to follow in Dana Gas' footsteps by taking the KRG to international courts to get the money they are owed, investors will likely become more reluctant to pump funds into Iraqi Kurdistan. To avoid this, Arbil will probably try to settle its disputes with Dana Gas and start repaying its debts to other firms sooner rather than later. However, it might not be able to do so until oil prices rise or it receives significant backing from foreign patrons.

If investors lose confidence in the KRG, it could begin to hurt the region's prospects more broadly as firms pull out of larger infrastructure projects. For example, Genel Energy is lined up to be the primary financial backer and builder of a proposed natural gas pipeline connecting Iraqi Kurdistan to Turkey. (The pipeline would eventually send between 10 billion and 20 billion cubic meters of natural gas annually to Turkey.) The deal could be lucrative for Genel Energy if the KRG can guarantee that it will make its payments, but it would be even more important for Kurdish leaders because it would form another crucial energy link between Turkey and the KRG. As it stands, Arbil has little leverage over (and a heavy reliance on) Turkey, but a large natural gas pipeline would boost the KRG's sway and finances — especially as Turkey comes to distrust Russia, its traditional energy partner.

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