TURKISH AMBIVALENCE TOWARD KURDISH ENERGY: BETWEEN ECONOMICS AND POLITICS

Enerji Piyasaları ve Politikaları Enstitüsü Institute for Energy Markets and Policies TURKISH AMBIVALENCE TOWARD KURDISH ENERGY: BETWEEN ECONOMICS AND POLITICS Dr. VOLKAN ÖZDEMİR EPPEN7 NOVEMBER 2014

CONTENTS 1. INTRODUCTION...3 2. POTENTIAL OF THE REGION...3 3. ROLE OF TURKEY IN KURDISH ENERGY DEVELOPMENT...6 4. OIL EXPORT TARGETS...8 5. NATURAL GAS DEAL...10 6. CONCLUSION...11 8. ENDNOTES...12 Not: Bu makalede yazılanların içeriği tamamen yazara aittir. EPPEN in ya da makale yazarının görev yaptığı herhangi bir yerin kurumsal görüşünü yansıtmamaktadır. The contents of this paper are the author s sole responsibility. They do not necessarily represent the views of the EPPEN, or of the author s other affiliations. 2

TURKISH AMBIVALANCE TOWARD KURDISH ENERGY: BETWEEN ECONOMICS AND POLITICS 1. INTRODUCTION Turkey and the Kurdistan Regional Government of Iraq (KRG) have been developing a high level of energy partnership for last two years. Framework agreement between the parties was followed by a package agreement that regulates the exploration, production sharing mechanisms and exportation of oil and gas resources of the region independently from the Iraqi Central Government. Accordingly, oil from the region has been pumped since early 2014 and sold in the international markets in May of this year. In this article, Turkish energy policy vis-à-vis the ongoing energy partnership with the KRG is briefly analyzed with a special focus on the economics of oil and gas development in the region. 2. POTENTIAL OF THE REGION There has been a growing tension between Erbil and Baghdad over the utilization of Iraqi s energy wealth in post-saddam period. After withdrawing of US army from the country, this tension has tremendously increased. In fact, the Federal Constitution of Iraq regulates the oil revenue sharing mechanism and other features related to energy exploration and production. Accordingly, all petroleum exported from Iraq should be marketed through the country s State Oil Marketing Organization (SOMO) with the KRG receiving 17 % of the total revenues. 1 The KRG on the other hand, has claimed independent authority over energy resources in the region, including the right to sign oil field exploration and production contracts within its territory and export of oil and natural gas. This inevitably led a clash with Baghdad Government on which the Erbil dependent for oil payments. The KRG sought for an alternative that helps to cut this financial dependency, a prerequisite for political independence. 3

As 2014, Iraq s world share of oil reserves is almost 9 %, accounting for 151 billion barrels total, making Iraq the fifth biggest global oil reserve holder. Within the Middle East, Iraqi oil reserves rank third right after those of Saudi Arabia 265.9 and Iran 157 billion barrels. Iraq s oil production witnessed remarkable growth over last 5 years and exceeded 3 million barrels per day (bpd) in 2014 and total exports reached 2.6 million bpd with reservesto-production ratio of more than 100 years at present. 2 Together with this, it is noteworthy that Iraq is not a significant gas producer although it holds huge reserves. Within Federal Iraqi State, oil under the territory of KRG (excluding Kirkuk) has largely been untapped for decades unlike the case in other parts of the country. Average extraction cost is very low less than 10$ per barrel- and this attracts international oil companies (IOCs). It s assessed that the regional proved oil reserves to stand at more than 2 billion barrels of reserves recoverable on P1 and P2 bases, and total resources of nearly 18 billion barrels. The KRG officials similarly claim the regional oil wealth to be as high as 50 billion barrels. As for the natural gas resources, the region is said to be even more attractive. Within the region, more than 350 bcm of recoverable gas has been discovered on P1 or P2 bases, while total resource base is estimated at nearly 1.2 trillion cubic meters. 3 With necessary arrangements in place, the regional production could increase its capacity, reaching export levels of 1 million bpd by the end of 2015 and 2 million bpd for oil and 20 billion cubic meters (bcm) for natural gas by 2020. 4 However, the production growth of oil output is dependent on investments by oil companies as capital is necessary to support development. Not surprisingly, more than 50 oil companies from a number of countries including industry majors such as Chevron, ExxonMobil, Sinopec, Total, Genel Energy and Gazprom Neft, have been attracted to the region thanks to contractual Production Sharing Agreements (PSA) with high profit margins offered by the KRG s Ministry of Natural Resources. 5 4

Enerji Piyasaları ve Politikaları Enstitüsü OIL MAP OF THE REGION Source: Genel Energy Web-site 5

3. ROLE OF TURKEY IN KURDISH ENERGY DEVELOPMENT Nevertheless, for oil companies it is risky to invest billions of dollars to develop the fields taking into consideration of the fact that region is lacking secure infrastructure and legal regulations to deliver the crude to world markets. The only solution to realize oil exports to international markets is through pipelines owing to the land-locked geography of the region, While relations with Baghdad remains problematic, unpredictable with Iran and imprecise with Syria, Turkey remains the only viable option to ensure exports of oil to international markets via pipeline. On the other hand, with remarkable economic growth over the last decade Turkey has become one of the world s rapidly emerging energy markets. Against the backdrop of a rising need for energy, Turkey is clearly in a situation of energy insecurity as domestic resources are meeting only one fourth of its total energy demand. Unable to pursue policies to utilize the domestic sources of energy, Turkish decision makers focus on to diversification of imports and to gain from reduced prices which might be a remedy for current account deficit of the country. 6 Turkey also started to encourage investments and acquisitions of oil and gas fields outside the country with an active role played by Turkish state energy companies. Since the Kurdistan region of Iraq is located at the doorstep, the region is seen as a strategic gateway to meet future energy demands and drive the country s energy policy 7 Within this context, rapprochement between Turkey and Iraqi Kurds has been observed for recent years despite the fact that relations between the two were characterized by political tension after US invasion of Iraq in 2003. After 2008, the two have developed economic partnership and Turkish exports to the region increased significantly. The current relations reached a new level with the commencement of oil and gas flow from the region to Turkey: The first consignment of KRG oil was transported through the Turkish port of Ceyhan on the Mediterranean Sea on 22 May 2014, with Israel becoming the first buyer of KRG crude delivered by tanker to the Ashkelon port. 8 Although the fundamentals of energy cooperation between Turkey and the KRG had been defined in 2012, it was only on 25 March 2013 that the deal was finalized in the form of 6

a framework agreement between the parties that paved the way for export of Kurdish crude from Turkey for 50 years 9. In order to handle the energy deal that envisages the investment of a Turkish energy company in the upstream development of the region, Turkish Government decided to establish a new oil company that specifically responsible for the realization of this aim while would not engage in any energy projects in other parts of Iraq. Since the state owned Turkish Petroleum Corporation (TPAO) has a series of operations in the southern part of Iraq, a subsidiary of this company, Turkish Petroleum International Company (TPIC), was transferred to another state owned Turkish Pipeline Corporation (BOTAŞ). Within TPIC structure, Turkish Energy Company (TEC) was created for operating on energy development in the KRG on behalf of Turkey. 10 In conjunction with the framework agreement that was signed in March, a series of energy deals between Turkey and the KRG came to an end after long negotiations on 27 th of November 2013. The parties wrote up agreements to govern export pipelines, sale of gas, oil trade, acquisition of oil fields by the TEC, and the revenue sharing mechanism. 11 For the pipeline dimension of the energy deals, long-term logistic preparations have been guaranteed. The KRG has completed a domestic crude pipeline to the Turkish border. The first section of the pipeline begins at the Taq Taq fields and runs through to Khurmala, near Kirkuk. The second section goes up to the border city of Feyshkabour, near the Turkish border, staying within the KRG territory. On the Turkish side of the border, crude flows into the existing Iraq-Turkey (ITP) or Kirkuk-Ceyhan oil pipeline, firstly constructed in 1974 with 70 million tons of annual capacity, which is actually composed of two parallel lines: the 46 inch line is currently being used to transport federally controlled Iraqi oil from Kirkuk to the Ceyhan port. The second line, 40 inches in diameter, has been inactive due to poor maintenance but it was not difficult to recover this line. The new KRG pipeline is connected into this line just before the Turkish border. After completing the testing phase, crude from Kurdistan region of Iraq entered the ITP and flowed through Turkish infrastructure to facilities at Ceyhan in first quarter of 2014. Before being traded to international markets, the first cargos were held in oil storage facilities in Ceyhan. As for gas, Turkey has begun preparing for imports from the region, by extending its gas pipeline network towards the KRG border. BOTAŞ has already begun construction of a pipeline 42-inch in diameter, enough to carry 20 bcm gas annually, 7

whereas on the Kurdish side construction of a parallel gas export pipeline has commenced accordingly. 4. OIL EXPORT TARGETS Amount of oil exported from KRG through ITP has reached to 350.000 bpd as mid of November 2014. Under current development scenario, it is planned that up to 500,000 bpd will be pumped into the export pipelines by the end of 2014 and a second new pipeline will be constructed for heavier crude. 12 This number is critical for economic independence of Erbil. Even with an average price of $ 80 per barrel, the KRG would totally compensate the $ 12 billions loss, an annual amount it gets from the Baghdad Government for financing its budget, from 17 % share of total Iraqi exports. After first export cargo from KRG through ITP realized in spring 2014, the Maliki government severely criticized this deal and threatened both the KRG and Turkey with a legal action for violating the latest ITP agreement in 2010, which gives exclusive right to SOMO to use the pipeline. This was followed by the collapse of Maliki government and emerging threat of ISIL. The ISIL attacked northern Iraq in June 2014 and after the retreat of Iraqi Federal Army from Mosul without resistance, the KRG did not miss the opportunity to send its Peshmerga forces to hold oil rich region of Kirkuk in the same month. As a result, oil fields of Kirkuk, namely Avana Dome and Bai Hassan, which were formerly controlled by the Iraq Oil Ministry, are now under KRG control and the KRG is pumping approximately 120.000 bpd. Moreover, excess oil production from Kirkuk is partly used for domestic refinery of Kalak and partly is flowed through KRG export line. According to Iraqi Oil Report, taken together with the capacity expansion plans of the IOCs producing oil in KRG for pipeline export (DNO Tawke and Genel Energy Taq Taq), the 500.000 bpd export target can only be reached if oil from Kirkuk is either blended with crude from KRG crude for export, or is consumed within domestic refining sector, freeing up oil from the Tawke, Taq Taq and Khurmala fields for export 13. On the upstream level, TEC and the KRG have finalized terms for Production Sharing Agreements in some of exploration blocs in the region. As a result, for the first time since its foundation, BOTAŞ has become an upstream player through its recently established 8

subsidiary TEC. According to the agreement which was signed by the parties on 27 November 2013, the TEC has become the stakeholder of some fields in the KRG: Pulkhana, Jabal Kand, Arbat, Choman, Hindren, Khurmala and Khalakan. In addition, the TEC became minority partner in all of ExxonMobil s exploration blocs, namely Bashiqa, Pirmam, Betwata, Qara Hanjeer, Arbat-East and Al Qush. 14 Another crucial aspect of the deal that remains to be solved is related to financial revenue sharing mechanism. According to the framework agreement, the KRG agreed to open a bank account in the Turkish state bank, the Halkbank, for revenues generated by oil and gas transactions. 15 Baghdad insists on a bank account to be opened in the US while Turkey and the KRG opt for a Turkey-based account. At the end of the day, Halkbank was selected as the for payments of exported oil and Ceo of Genel Energy claimed that Turkey get five percent of total amount of oil that has been sold through transport and custom duties 16. However, this is a speculated remark and whether Turkey helds such kind of a commission from exported oil is not clear. Negotiations for transfer of payments between Erbil and Baghdad are ongoing. The parties might find an interim solution for oil exports and revenue sharing mechanisms but in the long run this seems not sustainable without a well-defined solution. Oil$exports$from$the$KRG$of$Iraq$through$Turkey$ (bpd)$ Critical(level(for(economic(independence(500000(bpd( 2000000( 350000( 500000( 1000000( November( 2014( End(of(2014( End(of(2015( (est)( End(of(2020( (est)( 9

5. NATURAL GAS DEAL Another important pillar of the deal is natural gas purchase-sales contract. The KRG is initially to supply 4 then, 10 bcm natural gas (in 2025 20 bcm) annually to Turkey from the Miran natural gas field and the Genel Energy is likely to be the first company to export gas by 2017. Turkish desire to reach KRG s gas fields emerged almost a decade ago and now Turkey is also showing interest to satisfy international needs through the re-exportation of gas from the KRG to Europe under Southern Gas Corridor. BOTAŞ signed long term contract in which the price of gas is indexed to oil products with 9 months leg. The gas price significantly undercuts other major suppliers such as Russia and Iran (As 2014 BOTAŞ pays $410/mcm to Gazprom and $492/mcm to NIGC) 17. However, taking the low cost of extraction, transportation and first entrance of KRG to Turkish gas market into consideration, one could basically argue that Turkey is overcharged even if the price is cheap relative to Iranian and Russian gas. More importantly, Turkey could have used this gas deal to negotiate for better conditions from its traditional suppliers in a time when the gas market is transformed from seller s market to buyer s one. As one of the biggest gas importers in the world Turkish BOTAŞ opted for oil-indexed gas pricing mechanism with a formula that is outdated. Unlike European importers, BOTAŞ has not been able to adopt the structural changes in natural gas market. It avoided transition from oil price indexation to the spot market one in which hub based gas-to-gas competition has become widespread in European market. In that sense, Turkey could have not only used the opportunity to delink gas prices from oil products as a bargaining tool against Gazprom and NIGC to decrease its gas bill but also it could have formed a domestic gas hub for determining the price of a broader region by starting from the gas deal with the KRG. 10

6. CONCLUSION To sum up, the KRG benefits from the energy deal with Turkey more by securing financial independence from Baghdad thanks to the oil exports through Turkey. On the other hand, despite some economic opportunities by developing bilateral energy partnership with the KRG, Ankara plays a risky game. The energy deal offers Turkey unprecedented economic gains in energy field but it politically antagonizes Baghdad and more importantly paves the way for Kurdish independence that could have severe political consequences for Turkey itself in the long run. Also it s noteworthy to mention US position toward evolving Turkey-KRG energy partnership. By pretending itself as the supporter of federal unity of Iraq, the US has finally found a suitable partner, which it could show as the initiator of the possible division of Iraq to the orld public opinion. By gaining access to the ITP pipeline the Kurds have secured a corridor to open seas, namely Mediterranean. One could assert that with this energy deal historical Mosul question of Turkey has been revitalized under the changing status quo in the region. For the time being, it seems that economic benefits prevail over political anxieties for Ankara. However, if economic gains are more important, then Turkey could also demand its abondaned historic rights from Iraqi oil. By signing 1926 Ankara agreement Turkey ceded the region to Iraq, which was under British mandate that time, under the condition of getting 10 % royalty from all oil produced in Iraq for 25 years. First payments started in 1931 but then it was interrupted many times by Baghdad. Turkey was only able to receive 3.5 million out of 29 million pounds for its total royalty 18. The current price of remaining 25.5 million pounds of Turkish royalty could be calculated differently but it is legitimate for Turkey to compensate its violated royalty right for all Iraqi oil with adjusted prices from Halkbank account. Nevertheless, political dimension is more complicated than the financial provisions of 1926 Ankara agreement: If Iraq disintegrates one of three sides to this agreement disappears and political appearance is not clear after this likely disintegration process in which territorial integrity of Turkey itself is under threat. 11

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