The battle for Iraq's oil

Royal Dutch Shell is talking to two of China's biggest state-owned oil companies with a view to pursuing a joint venture in Iraq. Although Shell would not confirm details of the talks, a possible tie-up with China National Petroleum Corporation (CNPC) and China Petrochemical Corporation (Sinopec) is reported to focus on a bid to develop the Kirkuk field in the north of the country. "Discussions with potential partners are at a very early stage," a spokesman for Shell said yesterday.

The putative deal is just the latest move as both international oil companies and their state-owned counterparts jostle for position in the vast and underdeveloped Iraqi oil market.

The prize is huge. The country has proven reserves of 115 billion barrels, the third largest in the world after Saudi Arabia and Iran. "Iraq is a jewel for the international oil companies and always has been," said Manouchehr Takin, a senior petroleum analyst at the Centre for Global Energy Studies. "Not only does it have large proven reserves but there are also big estimates for undiscovered resources. People agree or disagree on the detail, but many think there may be even more yet to be found."

But the country's oil sector is inefficient and under-resourced after years of war, upheaval and sanctions against Saddam Hussein's Ba'athist regime. Of the 80 known oilfields, only 15 are developed – between them producing about 2.4 million barrels per day.

China's motivation in the area is not purely financial. The past few months has seen the country's state-owned commodities giants embark on a shopping spree among recession-hit Western rivals, including Rio Tinto, Oz Minerals and Fortescue. Trying to secure access to much-needed raw materials, the most significant deals have been for oil. China Development Bank is lending $35bn (£23bn) to tottering state oil companies in return for 400,000 barrels of oil per day (bpd) for decades to come. A toehold in Iraq would provide yet more security.

For Iraq itself, oil exports make up 95 per cent of government revenue and are the only way to fund the rebuilding of the shattered country. With the price of crude back down to $50 per barrel from last July's unprecedented $149, making the most of the nation's vast resources is an even more pressing priority.

Oil companies large and small have been lining up for a piece of the action since Saddam was deposed in 2003 and there have been some isolated deals, often not involving putting people on the ground. From 2004, BP, for example, was involved in the Rumeila field in the south, analysing geophysical data and providing guidance on ways to boost recovery rates. But the unclear legal position of the new government, and the dangerous security situation, counselled against more serious involvement.

The first attempt to bring in foreign expertise, in the form of two-year service contracts, collapsed last year and was superseded by the current plan for a series of 20-year service and investment deals. Thirty-two companies are bidding for the first round of contracts, which will cover six oilfields and two gas fields. According to the timetable, the first deals could be signed by the end of the year, although insiders are sceptical. A second round, launched in December, is looking for developers for another 11 fields and has attracted a further nine bidders in addition to the original 32.

But the contracts are not of the production-sharing type common elsewhere in the world. The winning bidder will not take over the operations entirely. Instead, it will establish a joint venture with whichever Iraqi state company is responsible for the field, working with them to expand and develop it. The proposal may not be the free-for-all the internationals dream of, but it is still a significant chunk of business. An estimated $50bn in investment is needed to meet Baghdad's target to raise output to six million bpd by 2014, and the collapsing price of oil has already changed the dynamic between the government and its potential partners.

Under the proposed arrangements, a proportion of the investment will come from the oil major and a proportion from the Iraqi state company. Assuming success, and production improved in line with targets agreed at the outset, the international company will recover its costs and receive a fee. In February, the contractor's stake was raised from 49 per cent to 75 per cent, and the production targets demanded by Iraq have also been lowered.

But even with softened terms, the attraction of the deals is more the foot in the door than the contracts themselves. "These are quite sophisticated arrangements, but they are very, very different from the contracts you might have elsewhere in the world, where the reserves can be booked in your accounts," a source at one major oil company said last night.

There are two problems that need to be overcome before any greater involvement. One is that deals with foreign oil companies are a thorny issue. Saddam's nationalisation of the industry in 1972 is one of very few aspects of his rule that is not criticised within Iraq, and any sense that the country's resources are being sold out to the West would be viewed as a gross betrayal.

The other is Iraq's internal politics. Since 2003, about 30 smaller oil companies have signed traditional production-sharing agreements with the government of the semi-autonomous region of Kurdistan in the north, which has fewer than 10 per cent of the country's total oil reserves. But major companies including BP and Shell pulled out after Baghdad branded the deals illegal and threatened to ban any company pursuing such arrangements from bidding for work elsewhere in the country.

The row, which centres on whether the Kurdistan Regional Government (KRG) has the right to make deals in its own right or must get them signed off by Baghdad, shows little sign of resolution. As well as holding up investment in the region itself, the stand-off is also scuppering the progress of the post-Saddam government's planned hydrocarbon law, which would provide a framework for rights and revenues, not to mention the involvement of foreign oil companies, for the country as a whole.

Despite years of discussion, and numerous different drafts, the law is still not on the statute books and attempts to revise it may require a revision of the Iraqi constitution governing the relationship between Baghdad and the KRG.

"There is a huge internal debate in Iraq about whether the government should make these types of deal," Mr Takin said.

Against such a background, the oil ministry is trying to get on with increasing production – and raising revenues for the state – within its existing remit. As well as the long-term services contracts, it has also put together a number of isolated deals, awarded without a competitive tendering process. Last autumn, Shell joined a $4bn joint venture to collect and market the 700 million cubic feet of gas flared from 19,000 square kilometres of oil field in the Basra region.

In August, CNPC – now in talks with Shell over Kirkuk – signed a $3bn deal to develop the Ahdab field in central Iraq, thus agreeing the first oil deal since the fall of Saddam. But as Baghdad and the KRG do not even agree whether Kirkuk is in Kurdistan or not, even the smallest steps are worth taking.