Iraq is facing a desperate financial situation: obliged to pay billions of dollars in state salaries, pensions, and other disbursements whilst its ability to generate revenue to do so is severely constrained by a low oil price environment and OPEC+-mandated production quotas. Making matters worse is that the government of the semi-autonomous Kurdistan region in the north – the KRG – is using Baghdad’s deteriorating financial position to advance its own agenda and, by extension, the agenda of its principal state-sponsor, Russia.

Baghdad had little choice earlier this year but to overshoot its OPEC+ crude oil production quotas, given that by the middle of the year its oil revenues had fallen by nearly 50 per cent, while the government still derives 90 per cent of its revenues come from crude oil sales. At the same time, the then-new Prime Minister, Mustafa al-Kadhimi, needed IQD12 trillion (US$10 billion) just to pay the next two months salaries of more than four million employees, retirees, state beneficiaries, and the food relief for low-income families. It was believed in Iraqi government circles that any failure to pay any of these obligations could result in the sort of widespread protests that occurred at the end of last year.

The problem for Baghdad is that these payments are regular ones, the price of oil has not improved, and it was already quietly censured by OPEC+ for breaking its quota. Given Iraq’s unusually high level of economic dependence on crude oil sales, the IMF recently stated that it expects the country to see a 12.1 per cent drop in its GDP for 2020. These factors also mean that any opportunity that Iraq has to raise money in the international capital markets will come at a preclusively high price, with yields on its dollar-denominated bonds having risen to more than 10 per cent, the highest in the region.

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To ease the burden of adhering to the OPEC+-mandated production quotas, Baghdad had been looking to the KRG, based in Erbil, to make cuts from its own output in the semi-autonomous region. In response, the KRG last week made it clear that it would consider doing so only on two conditions. The first is that the Federal Government of Iraq (FGI) in Baghdad pays what the KRG says it owes by dint of the long-standing ‘oil-for-budget payments deal’. The second is that this is augmented by further money that compensates the KRG for the loss of revenue from not producing the output that it was previously producing. In other words, not only would Baghdad lose revenues from not producing to its own full capacity in the south but it would have to spend more of these vastly reduced revenues on paying the north not to produce to capacity as well.

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This scenario for Baghdad gets worse for two reasons. Firstly – and having learned a trick from Russia and Saudi in the run-up to setting production quotas based on previous output – the Kurdish region dramatically ramped-up its crude oil production last month. Kurdish crude oil exports for September increased by 5.6 per cent month-on-month, to 450,000 barrels per day (bpd), according to industry figures. In the meantime, its compliance with the OPEC+ production quotas for August/September was just 79 per cent, compared to the 102 per cent compliance in the south of the country (as a result of it having to make up for the earlier overshoots). Indeed, according to industry figures, in order for the south to make up for the overproduction earlier this year, it will have to underproduce by 698,000 bpd to the end of this year.

Secondly, aside from the opportunity cost payments to be made to the region for not producing to previous capacity, the additional payments ‘owed’ by Baghdad to the KRG under the standing ‘oil-for-budget payments deal’ have been matter of high contention ever since the structure of the deal was formulated in 2014. Originally this deal envisaged the KRG exporting up to 550,000 bpd of oil from its own fields and Kirkuk via Iraq’s State Oil Marketing Organization (SOMO), in return for which Baghdad would send 17 per cent of the federal budget after sovereign expenses (around US$500 million at that time) per month in budget payments to the KRG. From the start, both sides relentlessly cheated on the deal, with the KRG at various times stopping all oil shipments to SOMO and preferring instead to try to sell it to a range of other countries. Baghdad has sought to take the KRG to court repeatedly to stop such activity on the basis that it is illegal. Related: Oil Prices Jump On Large Crude Inventory Draw

Crucially in this context – and absolutely vital in understanding another key development last week – is the very different legal view that Erbil and Baghdad have on the ownership of oil rights and export sales rights in the KRG area. According to the KRG, it has authority under Articles 112 and 115 of the Constitution to manage oil and gas in the Kurdistan Region extracted from fields that were not in production in 2005, the year that the Constitution was adopted by referendum. SOMO, however, argues that under Article 111 of the Iraq Constitution oil and gas are the ownership of all the people of Iraq in all the regions and governorates.

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In addition, the KRG maintains that Article 115 states: “All powers not stipulated in the exclusive powers of the federal government belong to the authorities of the regions and governorates that are not organised in a region.” As such, the argument runs, the KRG says that as relevant powers are not otherwise stipulated in the Constitution, it has the authority to sell and receive revenue from its oil and gas exports. Moreover, the Constitution provides that, should a dispute arise, priority shall be given to the law of the regions and governorates.

Given the KRG’s legal view, then, news last week that it is considering transferring its oil assets to the federal government in Baghdad in exchange for it paying its public sector salary bill, is entirely consistent. Consistent also with KRG views is that, in reality, according to a senior oil and gas industry source who works closely with Iran’s Petroleum Ministry spoken to by OilPrice.com last week, the KRG has little intention of allowing the full and meaningful transfer of assets to the south. Even those which it does partially transfer will only be done for a very short time indeed – just long enough to get it over the current financial hump it also faces. “The KRG will negotiate on the basis that the additional financial payments from Baghdad are delivered in large part first, before anything happens with the KRG assets,” he told OilPrice.com.

Ensuring as much of these payments are upfront is vital for the KRG as its current deficit is around U$68 billion, in significant part representing months of unpaid sector salaries (three out of four workers in the region are state employees in some way). This figure compares to the current US$270 million per month that Baghdad is supposed to be paying Erbil under the ‘oil-for-budget payments deal’ in exchange for the KRG supposedly handing over to SOMO for export at least 250,000 bpd. The remainder of the KRG’s oil – nearly the same amount again – goes for export via a pipeline under KRG control to the Turkish port of Ceyhan.

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This degree of chaos is a perfect arena for Russia to exploit, which is precisely what it is busy doing. Moscow gained effective control over the Kurdistan region in 2017 by dint of a series of deals done by its corporate proxy Rosneft and since then it has been looking to leverage this presence into a similarly powerful position in the south of the country. Russia has looked to achieve this by striking new oil and gas field exploration and development deals with Baghdad as part of Moscow’s role in intermediating in the ‘budget-disbursements-for-oil’ deal. These ambitions were put on hold for some time, as Russia did not want to be obviously associated with the increasingly Iran-driven anti-American militancy in southern Iraq that resulted in a number of deadly strikes against U.S. military installations over the past couple of years. However, a sign of Russia’s renewed determination to press ahead with its Iraq plan began with the recent deal to develop Iraq’s Block 17 by Russia’s Stroytransgaz, which Moscow intends to be part of an energy and transportation corridor from Iran through Iraq and into Syria, with an additional export route south east via Basra port to the East.

By Simon Watkins for Oilprice.com

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