By Marin Katusa, Chief Energy Investment Strategist

The connections between oil, money, and power are very well established. These three factors can elevate individuals to office, give Big Oil companies major sway with national governments, lead countries into war with one another, and influence or control any number of major relationships and conflicts.

But can oil bequeath statehood? It’s a chicken-versus-egg question. Sovereign nations control the resource wealth in their lands, but what about the reverse: if a government controls the resource wealth in its region, is it in fact at the helm of a sovereign state?

It may seem a confusing question, but in the autonomous region of northern Iraq called Kurdistan it’s a question that deserves some thought. Kurdistan has been a country within a country for years, both part of Iraq and separate from it. The Kurdistan Regional Government (KRG) governs the region, supported by its own armed forces, but the KRG still relies on the central Iraqi government in Baghdad for its budget. It’s a reliance of necessity, based on the fact that Baghdad has aggressively retained control over all Iraqi oil revenues, depriving Kurdistan of the oil revenues that would otherwise fill its coffers. And it’s a reliance from which Kurds cannot wait to escape.

That escape is starting to materialize. After nonstop civil wars and genocidal attacks from 1970 to the early 1990s scattered the population and devastated the area’s environment and infrastructure, Kurdistan has in recent years emerged as one of the most successful and stable parts of Iraq. It is relatively isolated from the sectarian violence that still plagues southern Iraq, and it is looking forward to a prosperous future.

To realize that vision, Kurdistan needs control over its own resources. However, despite Kurdistan’s growing autonomy, Baghdad steadfastly refuses to relinquish its claim to Kurdistan’s oil fields.

Now the KRG has had enough of asking, waiting, and hoping for Baghdad to change its mind. Instead, the Kurds are simply negotiating their own oil deals with foreign firms… and in a turn of events that few would have predicted even a year ago, big international oil companies are signing up.

Exxon Mobil, Chevron, and Total – three of the world’s biggest oil companies – have now signed oil accords with Kurdistan, adding to some 35 other production-sharing agreements that the KRG previously signed with smaller companies. To Iraq’s central government, the deals are more than simply illegal – they are a direct challenge to Baghdad’s authority. Any company working with the KRG risks losing out on current and future opportunities to work in the rest of Iraq. Baghdad has already barred Exxon from its latest auction and formally banned Chevron from bidding for any further contracts anywhere else in Iraq. Total was the most recent of the three to sign a contract with the KRG; and now the Iraqi central government says it is working to cancel the French energy giant’s stake in the producing Halfaya field in southern Iraq.

This balance between risk and reward is at the very heart of the oil industry. After calculating their potential losses in Iraq and their potential gains in Kurdistan, these three oil giants threw their hats on Kurdistan’s table. In doing so, they are actively supporting Kurdistan’s right, as a nation, to control its own resources. They are also staging a de facto rebellion against Iraq’s stingy oil contracts, which direct the vast majority of revenues to the state while the operator receives only a small payment.

Oil and money regularly lead to power. In Kurdistan, the world may be witnessing a global first: oil money working to tip the scales in favor of empowering a fully autonomous Kurdish nation.

The Backdrop

The battle for oil rights is just one part of a broader conflict between Iraq and Kurdistan that has many facets. At its foundation are ethnic differences between Iraqis and Kurds, two groups that have been fighting each other for years. For their part, the Kurds have generally been fighting for a homeland, as Kurds are the largest ethnic group in the world without a home country. When Kurdistan was created as a semi-autonomous region in 1971, however, the problems did not stop. The exact border between Kurdistan and Iraq is one point of contention, especially because the border region includes several wealthy and important oil towns, and huge numbers of Kurds living in neighboring Turkey have also caused significant agitation.

But the longstanding ethnic dispute became truly entrenched in the second half of the twentieth century, when Iraqi leaders spent decades persecuting the Kurds. The worst of that came during the 1980 to 1988 Iran-Iraq War, when Saddam Hussein’s government pursued a campaign of systematic genocide against the Kurdish people (who, Saddam worried, might side with the Iranians). The campaign included the use of chemical weapons, the wholesale destruction of some 2,000 villages, and the slaughter of roughly 50,000 rural Kurds. The campaign also included an attempt to “Arabize” the oil-rich city of Kirkuk by driving Kurds away and replacing them with Arab settlers from central and southern Iraq.

When the Second Gulf War rolled around in 2003, Kurdish military forces joined forces against the Iraqi government and played a key role in the overthrow of Saddam Hussein’s government.

Iraqi Kurds can be viewed in two ways. The first and more common way is to view the Kurds as victims, both of the central government and of neighboring powers, particularly Turkey. From the opposing perspective, Kurds are provocateurs who have acted as proxy forces for states opposed to the sitting regime in Iraq (a list that has included Iran, the United States, and Russia). Both views are overly simplified, but what can be stated as simple truth is that distrust, grievances, and even hatred between Iraqis and Kurds stem from a long history of violence, and that neither side will likely forgive or forget anytime soon.

From that foundation, it is no great surprise that Baghdad wants to retain control over Kurdistan’s bank account. It is also no surprise that Kurds believe Baghdad should leave them and their oil alone.

New Developments in an Old Battle

Iraq and Kurdistan have lots of reasons to dislike each other, but most stem from historic events that cannot be changed. Control over oil, however, is both very current and very important to each side’s day-to-day operations. As such, the battle over oil has become the focal point of the entire dispute.

For much of the last decade, foreign oil companies distanced themselves from Iraq, there being little to be gained and much to be lost in trying to operate in a country at war. Two years ago that started to change. Keen to breathe new life into its old oilfields and thus bring new monies into its depleted bank accounts, the central government signed a raft of multibillion-dollar deals with foreign oil operators to develop its southern oilfields.

With Baghdad proclaiming a lofty goal of producing 8 million barrels of oil per day (bpd) by 2017 – up from just 2.4 million bpd in 2010 – foreign oil companies fell over each other to stake their claims in Iraq. But as is so often the case when a new government tries to revamp a national oil sector, greed has slowed progress to a crawl.

The problem boils down to this: Baghdad operates under the mentality that its vast oil resources will draw investors in regardless of the specifics of the deals it put on the table. However, when the world’s biggest energy company turns its back on a country with 115 billion barrels of proven oil reserves, that is a strong sign that the devil is in the details. Vast resources or not, if Exxon can’t make money off of an Iraqi investment because the contracts are too stingy, it’s not going to bother. The fact that 40 companies have signed on to work in Kurdistan is a strong sign that more and more energy firms are coming to the same conclusion: working in Iraq is not worth the effort. At Iraq’s latest oil auction in May, only three of twelve blocks on offer found buyers.

Global oil companies are especially not going to bother with Iraq if there is a similar opportunity just to the north that comes with much better terms.

Here’s where our chicken-versus-egg question becomes even more interesting. The fact is, Big Oil doesn’t care much about historic grievances among a country’s ethnic groups or about the sovereign aspirations of a victimized minority. Big Oil cares about money, and that is where Baghdad with its oily arrogance seems to have shot itself in the foot.

Exxon, Chevron, Total, and some 35 other foreign oil firms – including Russia’s Gazprom Neft – did not sign deals with the KRG to show their support for Kurdish independence. They signed on to work in Kurdistan because the KRG is willing to negotiate production-sharing contracts, which as the name implies give operators a share in oil profits. That share generally results in a government take of roughly 80%, giving operators access to as much as 20% of the profits. This may not sound great, but it’s leagues better than the deal available down south.

Baghdad only offers service contracts, under which operators are paid a flat fee per barrel produced. The fee translates to an operator take of less than 1%. The Iraq government takes the other 99% of profits.

The low payments on offer in Iraq’s oil fields essentially turn Big Oil companies into mere hired hands, even though Iraq’s old and debilitated fields desperately need Big Oil’s investment and expertise. In short, Baghdad wants even more than to have its cake and eat it too: It expects expert foreign bakers to buy the ingredients and bake the cake for minimum wage, then hand it over without complaint.

Some of Iraq’s fields are so incredibly large that even a 1% take is profitable, as is the case for BP in the Rumaila field. In many cases, though, the profits are slim, especially relative to the challenges of operating in a war-torn country. Many of the world’s oil companies initially went along with Baghdad’s terms in the hope that the government would reward them by offering production-sharing opportunities down the road. A few years in, that reward has yet to materialize, and Big Oil’s biggest companies are turning away.

It was Exxon Mobil that made the first move. Usually a conservative player in the oil game, in October Exxon signed a deal with the KRG to explore six blocks in Kurdistan. Everyone knew the move could well push Baghdad to revoke Exxon’s stake in West Qurna, a field that holds more than 8eightbillion barrels of oil. But Exxon did its risk-reward calculations made the move regardless.

In June Chevron followed Exxon’s lead, buying 80% stakes in two Kurdish oil fields. The US oil company does not hold any ground in Iraq, so Baghdad punished the company by barring it from all future Iraqi oil auctions. The punishment must have seemed reasonable to French energy giant Total, which in late July announced a deal to buy stakes in two blocks in Kurdistan. Baghdad again warned that it considers any deals with Kurdistan illegal and told the French company is would be punished. Total has an 18.75% stake in the Halfaya oilfield, a joint venture with PetroChina and Petronas that produced its first oil in June; Baghdad is now working to cancel Total’s ownership:

“We will punish companies who sign deals without the approval of the central government and the oil ministry,” said Faisal Abdullah, a spokesman for Iraq’s Deputy Prime Minister for Energy. “Unless Total reviews the deals, it will face severe consequences …Total will be blacklisted for violating Iraqi law.”

Another government spokesman added to the comments, saying his government “will disqualify and terminate the contract of any company signing a deal with the Kurdistan region without the approval of the oil ministry.”

Spokespeople from Exxon, Chevron, and Total have generally been unwilling to speak publicly about the issue, so as not to further inflame a burning issue. However, an official from one of the three companies told reporters, on condition of anonymity, that they saw the situation like this:

“We understand completely that if we enter into a contract in the north, we’re probably going to be blackballed in the south. So the question is, ‘Have we exhausted all our options for getting a deal in the south on terms that we find acceptable?’ The answer for companies heading for the door is yes.”

Kurdish production-sharing contracts are so much more attractive than Baghdad’s service contracts that these oil giants are choosing Kurdistan even though the northern region is only home to about 30% of Iraq’s proven oil reserves. In this case, bigger is not necessarily better: Iraq’s southern fields may hold immense quantities of oil, but if foreign oil firms can only pocket a tiny fraction of the revenues from those oil riches, it is not worth the effort. By contrast, the revenues they could earn by investing in Kurdistan’s smaller reserves are much more attractive.

Better oil contracts are the main magnet drawing oil companies to the north, but Kurdistan’s infrastructure and security advantages also warrant mention. The region is prone to far less violence than the rest of the country and offers functional airports, highways, trains, and electricity.

Whether Kurdistan’s oil aspirations will live up to the hype or drown in a sea of greed and bickering is yet to be seen. What is clear right now is that several of the world’s biggest oil companies are betting on Kurdish oil success, and they are doing so in full knowledge that investing with the KRG could well annihilate their chances of working Iraq’s immense oil fields.

Exxon, Chevron, and Total did not make these moves lightly, but used decades of experience balancing risk and reward to inform their decisions. For these oil giants, Kurdistan offers an economic opportunity that Iraq does not.

While their decisions were economic, the ramifications are political. Iraq’s prime minister took his complaints over the Exxon and Chevron deals straight to the White House; while Obama responded by discouraging oil dealings with the KRG, his administration admitted that companies have to make decisions based on economic opportunities.

Kurdistan has put Baghdad between a rock and a hard place. The Iraq central government can continue with the status quo, offering low-paying service contracts on its fields and blackballing companies that deal with the KRG. Doing so will force Big Oil to choose sides, and every foreign oil firm that inks a deal with Kurdistan will add to the region’s growing autonomy, whether or not the oil firms intend to make a political statement.

Baghdad has two other options. If it started offering better terms in its oil contracts, foreign energy companies would stop turning to Kurdistan. The Exxons and Chevrons of the world do not make politically contentious decisions unless the economics truly compel them to do so, which means if Baghdad changed its side of the economic equation, these oil giants would return.

Iraq’s final option is to negotiate a handover of resource rights to Kurdistan, a move that would cement the region’s autonomy. Given Baghdad’s fiery rhetoric on the situation to date, this seems highly unlikely.

Interestingly, all three options bode well for Big Oil (not to mention energy investors). If Iraq continues with the status quo, Big Oil can turn to Kurdistan. If Baghdad offers better terms, Big Oil might get a real opportunity to participate in Iraq’s mammoth oil fields. And if Iraq and Kurdistan were to resolve their oil dispute, Big Oil would have access to both regions.

As for Kurdistan, it too stands to benefit. By tempting Big Oil to choose its contracts over those offered by Baghdad, the KRG has enlisted Exxon, Chevron, Total, and a list of other oil firms in its fight for full autonomy. Whether Big Oil intends to fight that battle is not the point: by choosing to negotiate with the KRG for rights to Kurdish oil, they are throwing their weight behind Kurdistan in its fight for control over its resources. Since authority over resources is an intrinsic component in national sovereignty, Big Oil is supporting an independent Kurdistan.

Will the same story play out in South Sudan? How about in the Falkland Islands, or along the coast of East Africa? These are but a few of the places where massive energy resources look set to play a role in international disputes. Our upcoming Casey Energy Opportunities newsletter will investigate some of these regions, the disputes that are keeping their resources locked up, and how control over energy riches might parlay into national sovereignty.

Whether the chicken or the egg came first, I do not know. What I do know is that oil, money, and power have acted as incredibly strong forces in the course of history, and there’s no reason for them to stop now.

I also know that Big Oil almost always wins. Most of the time this is not because of an intended collision with politics – Big Oil avoids politicking as much as possible, but when it does enter a political fray, it comes with force. The world’s biggest oil companies know that their moves can topple politicians and spark wars, so the calculating minds behind Exxon, Chevron, and Total would only have made these moves if they were certain it would work out well. And when Big Oil does step into the ring, its sheer size makes it near impossible to stop. That is why the Casey Energy Opportunities newsletter focuses on big companies –Big Oil companies can provide stable, dividend-paying exposure to some of the world’s most exciting oil developments, if you have the right picks in your portfolio.

Additional Links and Reads

Ottawa’s Policy Vacuum Undermines its Oil Sands Rhetoric (National Post)

Canada’s oil sands are home to half of the known oil reserves in the world that are not controlled by a national government. It is unique: a massive oil resource that is open for business. However, the path forward is far from clear, primarily because Canada’s oil will remain landlocked unless more pipelines are approved and built… and that is far from a sure thing.

US Seeks $3 Billion for Sudan Oil Deal (Financial Times)

The United States wants China and Arab states to help foot the $3-billion bill for a deal designed to unlock oil production and set Sudan and South Sudan back on the path to peace. The warring neighbors recently reached a deal on how much South Sudan should pay to export its oil via Sudan’s pipelines. South Sudan also agreed to transfer $3 billion to Khartoum to plug part of the funding gap that has emerged in Sudan after decades of civil war, but that still leaves Khartoum short another $3 billion which it is seeking in compensation for the loss of revenues from the oil-rich south. Now the US, which cannot fund Khartoum directly because of sanctions against Sudan, is looking for other donors.

Middle-East Uranium Sale Gets Go-Ahead (Sydney Morning Herald)

Australia has agreed to sell uranium to the United Arab Emirates. A new safeguards agreement between the countries, intended to guarantee that the uranium is only used for peaceful purposes, has paved the way for Australian exports to the UAE. The move comes as one of the Middle East’s richest oil nations switches to nuclear power, in order to save its oil reserve for export.

Euro Coal Prices Rally to $95/T, Highest Since April (Reuters)

A strike by workers on one of Colombia’s key coal railways has pushed coal prices to a 3.5-month high, helping to cement the growing notion that the coal market has seen the lowest prices it is likely to see this year and that prices will recover gradually over the coming months.