The secret history of the Shell gas deal

BAGHDAD - Eight months after Iraq committed exclusively to Shell for a controversial multi-billion-dollar natural gas venture, the company's top deal-maker had a frank discussion with American diplomats. Mounir Bouaziz told them that, in his assessment, the Iraqis didn't have the capacity to sit at the negotiating table.

"Bouaziz wryly remarked that Iraqis are still novices with regard to international business deals, but are learning how to deal with international oil companies such as his own," U.S. Embassy officials wrote in a cable on April 2, 2009, which was recently made public by the anti-secrecy group Wikileaks.

In order to avoid a deal that was "too lopsided in its favor," Bouaziz told the diplomats, Shell had found it necessary to provide key Oil Ministry officials with rudimentary economics training "to learn such concepts as net present value and internal rate of return, which had been unknown to them."

That cable — along with three others that have just been released, as well as interviews with Shell officials and people involved with the gas deal — paint an extraordinary portrait of Shell's controversial re-entry into Iraq. Even as the company was pursuing a project that would represent a massive economic and environmental boon to Iraq, it was doing so in secret, amidst the institutional disrepair of a post-conflict state that offered Shell an apparent opening to win lucrative export rights.

The contract is now awaiting the approval of the Iraqi Cabinet. If it passes, Shell and junior partner Mitsubishi will team up with Iraq's state-run South Gas Company (SGC) to form the Basra Gas Company (BGC), which would aim to capture massive volumes of natural gas that are literally burned off as waste (or "flared") from Iraq's southern oil fields.

The joint venture would benefit Iraq enormously. It would help stop the environmentally disastrous practice of flaring — and in the process generate billions of dollars in revenue and help alleviate the country's shortage of natural gas, which is the primary feedstock for the underperforming electricity sector.

Shell's head of Iraq operations, Hans Nijkamp, contends that all parties profit under the current draft contract, and says Shell would have been foolish to strike an unfair deal.

"I think everyone would agree it is a very sustainable deal for both sides. And that’s what you need to have. There's no point in thinking you can do an unbalanced deal that will last," Nijkamp said. "We won't work like that, but just as a principle that is not going to work."

But in contrast to the transparent and competitive bidding rounds that the Iraqi Oil Ministry held in 2009 and 2010 for oil and gas contracts, the Shell deal has been brokered behind closed doors. Critics have charged that the noncompetitive and secret process has put Shell's prerogatives — particularly its desire to export gas — ahead of Iraq's interests. And although the draft contract that now stands before the Cabinet is substantially different than the agreement that first drew widespread opposition, the deal remains haunted by its shadowy history.

"We needed quickly to utilize the gas. We needed the technology and the operational and financial instruments a joint venture would bring," said Abduljabbar al-Waggaa, senior deputy oil minister from 2004 to 2007, who was the ministry's point person with foreign companies. "But we did not need to enter the joint venture in the way the Ministry of Oil and Shell cooked up."

Shell's foothold in Iraq

Shell first entered Iraq before it was a sovereign country, as part of the Turkish Petroleum Co. (later the Iraq Petroleum Co.). The company enjoyed monopoly rights to the country's oil fields and dictated the terms of production and development until 1972, when Iraq fully nationalized its oil sector and kicked out the foreign oil companies.

After the U.S.-led invasion in 2003, Shell was among the many oil firms that sought a piece of the world's third-largest proven conventional oil reserves. Most notably, Shell participated in two contract licensing rounds in 2009, winning two deals for super-giant fields in Basra — a majority stake to develop Majnoon, and a minority stake along with ExxonMobil to develop West Qurna 1.

Like other companies, Shell also pursued smaller initiatives to help a fledgling Iraqi oil industry get back on its feet — and to reestablish a foothold in the country. Since 2003, the company has trained hundreds of Iraqi Oil Ministry personnel, conducted studies, donated equipment, and invested $100 million in evaluating and fixing existing gas infrastructure in Basra, which has reduced gas waste by 20 percent.

"Shell was among the early companies who signed an MoU (memorandum of understanding) with the Ministry of Oil. They invested a lot of money in financing projects under that MoU," said Waggaa. "Shell, like a lot of other (international and national oil companies) was hoping that, being a reputed oil company and generous in implementing MoU projects — that the Iraqi government will call on them to develop a major oil field on bilateral negotiations."

As Shell built relationships with Iraqi oil officials, one of its goals was a major southern gas deal.

“Shell has carried on quiet negotiations with Iraqi officials outside Iraq for five years,” American diplomats wrote in a cable on Sept. 9, 2008, after a briefing from Shell officials in Basra. That timeline, which was confirmed by numerous officials involved in the negotiations, indicates that Shell began discussing a gas deal with Iraqi leaders in 2003, long before the country had ratified a constitution or elected a government, while it was formally under U.S. control.

The gas master plan

According to a former Shell official, who spoke with Iraq Oil Report on the condition of anonymity, the company's first key maneuver came in 2004. Shell convinced ministry officials to give it rights to produce a massive study of the country's gas sector and a master plan for its development.

All crude oil production generates some natural gas as a byproduct. In the modern oil industry, this so-called "associated gas" is typically captured and processed. In Iraq, however, where the oil sector has been ravaged by decades of underinvestment, huge volumes of associated gas are simply burned off as waste.

Iraq enlisted Shell to do a comprehensive survey of its gas sector, and then come up with a plan to modernize it.

"With the gas master plan, that was a piece of work done for the Iraqi government at the time because it was very much needed, and indeed Shell as a company has a lot of gas expertise," said Hans Nijkamp, Shell's current vice president and country chairman for Iraq.

After Shell presented its master plan, Iraq "asked a number of companies to come with complete project proposals" to capture the associated gas in Basra that was being flared, Nijkamp said.

But to the extent there was competition for the deal to capture Basra's associated gas, Shell had one enormous advantage: its master plan remained secret. Shell had spent thousands of man-hours studying Iraq's gas sector, while other companies were relatively blind. According to the former Shell official, this was part of the company's strategy.

"That's why Shell was in a unique position and pushed for that agreement — because they knew all about Iraq's gas needs," said one U.S. official familiar with the deal. "It would be a bit unfair, because who else could bid? And if you're not going to publish the results of the gas master plan, who else can study it and offer a counter-proposal?"

Other foreign oil companies were unhappy.

"I think it's fair to say the way in which the contract was negotiated raised some eyebrows," said one person who attended meetings in Basra between Shell officials and American diplomats. "As far as I am aware, Shell does have a good track record in this particular field so it did make sense that the Iraqis would hire them. But as the (southern oil) fields were going up for tender, I think people viewed (the Shell deal) in a less than great light."

The heart of the problem, according to the U.S. official, was the shroud of secrecy that covered the gas master plan.

"If Shell was contracted to do a gas master plan and the results were published — or at least (made available) for companies to purchase to do the analysis — that levels the playing field," said the U.S. official. "What happened was the playing field was never leveled and Shell continued to push for a gas deal."

Nijkamp, who began leading Shell's Iraq operations in March of this year, defended his company's conduct. Any final contract would depend on a detailed evaluation of Iraq's existing infrastructure. And after its gas master plan, Shell was well positioned to undertake such a study.

"The scope of this contract was not easily tenderable from the outset. We spent a lot of money to understand what the scope was, what the project was," Nijkamp said. "Now once we did the assessment of the facilities, then you could really put the contract together in a way that would work for the international investors, Shell and Mitsubishi, as well as the South Gas Co. as the Iraqi partner in there."

Iraqi officials, for their part, were persuaded that the company was highly qualified; indeed, even the deal's critics agree that, if Iraq was looking for outside help with gas development, Shell would be at or near the top of the list.

Waggaa, the former deputy oil minister who oversaw the international oil industry's training program of Iraqi oil staff, recalled meetings beginning in 2003, in which the company touted its industry-leading technology, detailed knowledge of the Iraqi gas sector, and experience developing gas for Oman, Iran, Syria, Saudi Arabia, and Kuwait.

"(They were) pressing hard to have a big slice of the cake in the gas market of Iraq. We knew they were qualified to gain that slice," said Waggaa. But he also criticized Shell for pressing for bilateral negotiations. "They should have encouraged the country towards competitive bidding."

The urgency of the situation trumped any Iraqi misgivings. From the Oil Ministry's perspective, time was of the essence. Iraq was losing 700 million standard cubic feet per day (scf/d); every day, by Shell's estimate, Iraq was watching $5 million go up in flames.

The play for exports

Shell's early maneuvers served one overarching strategic goal, according to the former Shell official: the company wanted to secure the rights for natural gas exports.

"We wanted to cater to a conclusion — to get the Iraqi government to come to a conclusion — that was up front before even finishing phase one of the gas master plan: that Iraq needed no more than 1.8 billion cubic feet per day of gas for local use, and the rest of it will be available for export," the official said.

In effect, the official said, Shell used its position as the author of Iraq's gas study and master plan to shape the Oil Ministry's understanding of its own gas sector.

The master plan and the BGC deal composed a tactical two-step: Shell's study clarified the upper limit of potential Iraqi demand, while simultaneously outlining a development plan that aimed for a much higher production level. The logical conclusion was that Iraq should plan for massive exports.

In 2006, after the completion of the master plan, Shell "started suggesting options" to the ministry, according to Waggaa. The lines blurred between Shell's negotiations and its training initiatives.

Bouaziz told American diplomats that his company had needed to teach its Iraqi counterparts how to use the tools required for such negotiations. Shell had provided six ministry employees with free laptops "and taught them to operate analytical software to be used to assess the financial impact of differing terms and pricing," according to a cable.

Others at Shell gave a higher assessment of Iraqi capacity. Nijkamp emphasized that the ministry had many resources at its disposal.

"The Iraqi government had very capable advisers working with them to put this deal together, including a number of U.S. law firms, some very reputable companies, to look at the economic model, and so I think on the whole the Ministry of Oil was very well equipped to participate in putting this deal together," Nijkamp said. "There is no point in having the illusion that you can be cleverer than the other guy on the other side of the table. The Iraqis know what they're doing."

Shell's negotiations and training sessions led to a meeting in Lebanon in late Aug. 2008, at which Shell reached a framework agreement with Iraqi officials.

Shortly after that meeting, Shell officials told American diplomats that they had won a key provision: half of the gas would serve the domestic market, and half would be exported.

"Over the 25-years of the project, Shell expects to set up an entire natural gas production system, starting from a single base and spreading out, all the way to gas liquefaction plants and port facilities," a U.S. Embassy cable reported. "They cited their 40-year contract for natural gas production with Oman, which has recently been renewed for an additional 40 years, as an example of the successfully proven investment model they hope to use in Iraq."

In another conversation with American diplomats later that September, described in another cable, Bouaziz characterized the export plan as a necessary aspect of the BGC project: "A floating LNG (liquefied natural gas export) facility would allow excess gas to be sold that would otherwise need to be flared or require shut-down of oil-producing wells."

If Iraq developed its gas production as rapidly as Shell's projections suggested, then the country did indeed have to start planning for exports right away. The question was whether the optimism of the gas master plan reflected an unbiased assessment of Iraq's likely trajectory, or whether it described the path of development that would most benefit Shell.

Public opposition

On Sept. 22, 2008, the deal went public as Shell signed a Heads of Agreement (HoA) with the Oil Ministry. The terms of the agreement, however, remained secret — sparking protests about the opacity of the deal, especially in contrast to the open and competitive contract licensing rounds, which the ministry was promoting as a symbol of transparency in the new Iraq.

Iraq Oil Report obtained a copy of the HoA and published it in November 2008. While the document was only a starting point of a final deal that would likely be substantially altered, it did contain several controversial terms.

For one thing, the HoA essentially committed Iraq to moving forward on the joint venture and banned it from discussing associated gas capture or LNG exports with any of Shell's competitors. Other foreign companies were not enthused.

"I think some of the other IOCs were unhappy about Shell taking their flared gas," said one person who attended meetings between Shell and U.S. officials in Basra in 2008.

Moreover, beyond the capture of associated gas in Basra, certain clauses in the HoA seemed to grant Shell the possibility of gaining exclusive rights to the country's entire natural gas reserves, the 11th-largest in the world. According to the HoA, the BGC would be the "sole gas company engaged in business… and providing gas for domestic and export markets and generating revenues from gas marketing activities."

A vocal opposition began to arise. Nationalists disputed the deal outright; Basrawi officials demanded a seat at the negotiating table; and citizens protested that any development should serve the domestic market first. Political opponents of Prime Minister Nouri al-Maliki and his top energy deputy, Hussain al-Shahristani, have rallied against the Shell deal.

The Parliament, led by Oil and Energy Committee Chairman Adnan Janabi, is a leading critic. Janabi has suggested Parliament should officially ban all new oil and gas deals until Iraq can approve new oil legislation, specifically naming the Shell joint venture.

The issue of exports proved to be an especially acute point of controversy. At the time the HoA was signed, Iraq's electricity supply was about 4,200 megawatts, which met 53 percent of estimated demand — a gulf of more than 4,000 megawatts, according to the U.S. State Department's Iraq Weekly Status Report dated Sept. 24, 2008.

By Shell's estimates, the gas then flared from the southern oil fields could produce 3,500 megawatts of electricity, nearly the same as the supply-demand gap. Iraqis largely opposed the notion of allowing a foreign company to lift a key electricity feedstock and sell it abroad when they were spending more than half of each day without power.

In response to the outcry, the Maliki administration repeatedly pledged that Iraq would begin selling gas abroad only after meeting local demand.

But that guarantee did not assuage the Shell deal's critics. They pointed out that Iraq had several options for the potential export of natural gas – most promisingly, through northern pipelines towards European markets – and the BGC deal threatened to prematurely lock Iraq into a method of export it might come to regret.

Still, Bouaziz told American diplomats on April 2, 2009, that there were "no real hurdles to forming the joint venture by year's end." In a July 9, 2009 meeting, Bouaziz was even more optimistic, projecting that the Cabinet might approve the deal by the end of that month.

By the end of 2009, however, the parties remained at an impasse. Shell wanted guarantees that it could export gas as a core method of compensation, but Iraqi law and government policy — not to mention the political climate — dictated that the State Oil Marketing Organization (SOMO) should have sole rights to export hydrocarbons.

A deal takes shape

The HoA had sketched the outlines of the deal, but the two sides did not yet agree on financial and technical terms, nor on the export issue. Shell and Iraqi officials met periodically to push forward the negotiations.

After months of incremental progress, on July 12, 2011, officials from Shell and Mitsubishi met with Iraqi leaders to finalize a draft contract that would be sent to the Cabinet for approval. In contrast to the signing ceremonies that had celebrated deals awarded in Iraq's competitive bidding rounds, this meeting was not public.

The draft contract has not been published, either, though Iraq Oil Report has obtained a copy. In that document, Shell's export ambitions remain alive, but Iraq has limited the scope of the project and gained considerable control.

If the deal is passed as it is currently drafted, the BGC would build a massive offshore facility in the Arabian Gulf to export LNG, which Shell will have sole rights to purchase. Such exports would begin between four and seven years after the start of the project.

The contract does not stipulate that domestic demand must be met first, though it does give Iraq the power to adjust the export timetable.

"The focus of the company in the first instance is to satisfy the domestic market," said Nijkamp. "The process has indeed the provision to put LNG projects into being as well. But the decision to do that is essentially a decision between the international investor and the Iraqi government – the South Gas Company as a shareholder – and they have a veto on whether or not they want to go that way."

Iraq's state-run South Gas Company holds a controlling 51 percent stake in the joint venture, while Shell holds 44 percent and Mitsubishi five percent.

In a recent interview, Ali Khudhier, the director general of the South Gas Co. and signatory to the HoA, said "I would expect the export of invested gas will not begin before 2017."

The BGC would capture and process associated gas from the Rumaila, Zubair, and West Qurna 1 oil fields — a reduction in the project's scope, which originally covered all associated gas production in Basra. Still, the contract anticipates that those fields, whose crude oil production is set to skyrocket, will eventually reach a production plateau of 2 billion scf/d of associated gas.

Some of that supply will be used for reinjection and power generation at the field facilities; much of it will feed the domestic market. And, if exports are fully activated, Shell will have the rights to liquefy 600 million scf/d in feedstock gas and sell it abroad.

Ultimately, the terms of the draft contract give Iraq the option – if it so chooses – to forestall exports until domestic market is fully fed. In effect, Shell has doubled down on its own master plan, which projects that Iraq can boost its gas supply well above demand.

Shell has also made a bet on maintaining good relations with its Iraqi counterparts, who would retain significant authority to shape the project even after a contract is signed. In this sense, even if the terms of the final contract are favorable to Iraq, the controversial history of the deal could itself pose a risk.

"I think Shell should have been wiser to pave the way for a competitive bidding process," Waggaa said, "to gain the approval of the Iraqi oil industry and, importantly, the Iraqi public."

Nijkamp, for his part, was optimistic that skeptical Iraqis would warm to the project once it was under way and its benefits became clear.

"Yes, we run a business like every other oil company, so we need to do projects that have an economic return that works for us," Nijkamp said. "But I think it is the way you go about doing a project that in the end makes a difference."

Ben Van Heuvelen contributed from New York. Ali Abu Iraq contributed from Basra.