For the last few years the Federal Government of Iraq (FGI) has largely turned a blind eye to independent exports of oil from Kurdistan. In June, however, the FGI took legal action against the tanker "Neverland" which had just left the Turkish port of Ceyhan loaded with Kurdish crude. The FGI also stated publically that it would be taking legal action to prevent all independent crude exports by the Kurdistan Regional Government (KRG) and would target all third parties involved in the trade of such crude. We review below the legal and political position regarding the long-standing constitutional dispute between the FGI and the KRG and consider the key risks for companies involved in the export and sale of Kurdish crude.
5 SEPTEMBER 2017
Table of Contents
1. Introduction 2. Why the sudden escalation? 3. A brief history of KRG exports 4. The constitutional arguments 5. Risks of exporting and selling
Kurdish crude 6. Threats and proceedings 7. Conclusion 8. Contacts
1 1 2 2
3 3 4 5
On 13 June 2017, the Neverland was reported to have departed the Turkish port of Ceyhan carrying over 700,000 barrels of crude oil loaded by the KRG, allegedly destined for the U.S. On 21 June, the Neverland turned off its transponder. It then reappeared off the coast of Nova Scotia, Canada, with the Dutch company Vitol understood to be the prospective buyer and shipper of the crude. This was the first shipment of Kurdish crude to appear to head for North America since the FGI took steps to prevent the tanker United Kalavryta, from unloading around 1million barrels of Kurdish crude in the U.S. in June 2014.
Following the initial departure of the Neverland, the FGI immediately threatened legal action. In what appears to be a signal of the FGI's new intent, as well as a warning to third parties who might be tempted to trade or ship Kurdish crude, the FGI filed a substantive claim against Vitol and two subsidiaries for $32.5 million and obtained a seizure order over the Neverland from the Federal Court of Canada. The FGI alleges the cargo was unlawfully misappropriated by the KRG and sold to Vitol. Court documents allege that Vitol has refused demands to hand over the crude into the control of the FGI. At that point, the vessel changed course and headed back into the Atlantic Ocean. There have been reports that the Neverland was spotted off the coast of Malta in late July 2017, with its cargo rumoured to have been discharged. Its transponder is now on once more and it appears it is currently close to the end of its circuitous trip and returning to Ceyhan port.
2. Why the sudden escalation?
The action appears to have been prompted by the fact the Neverland was thought to be destined for the U.S. Had it been destined elsewhere (the KRG is believed to have been exporting to Europe, Israel and Asia for the past few years), the FGI might have felt able to ignore it but a successful delivery to the U.S. would undermine the FGI's
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legal and constitutional claims (which we explore briefly below) regarding the KRG's right to export Kurdish crude, and could also be seen as legitimising and encouraging the international trade of Kurdish crude.
The political landscape has also changed. Whilst the FGI has always fiercely contested the KRG's right to export oil, the two sides have been prepared to put their differences to one side whilst cooperating to combat the Islamic State (IS). That military cooperation, together with economic pressures facing both governments, has also led them to collaborate in exporting oil: in August 2016, the FGI and KRG agreed to the joint export of crude produced from the Kirkuk fields through the KRG controlled pipeline to Turkey on the basis that the sales revenues would be evenly split.
Now, with IS in retreat and the KRG in control of the disputed territories of Kirkuk, Khanaqin, Makhmour and Sinjar, there are indications that the temporary rapprochement between the KRG and FGI may have ended, and tensions will ignite once more. The situation has been exacerbated by the KRG's announcement of its plans to hold a referendum on independence on 25 September 2017 (which the FGI has rejected as unconstitutional), although the U.S. is currently putting pressure on the KRG to delay the referendum until after the FGI elections next year to avoid further confrontation in the region.
3. A brief history of KRG exports
Historically, the method used by the KRG for independent exports was to truck Kurdish crude across the border into Turkey or Iran and then either sell it locally or transport it to various ports to be sold internationally. The FGI claimed that this amounted to smuggling and it threatened to blacklist any buyers of such crude.
In November 2013, in the face of fierce opposition from the FGI and following an agreement between the KRG and Turkey on a strategic energy alliance, the KRG constructed a pipeline spur linking its three major producing petroleum fields (Taq Taq, Khurmala and Tawke) to the Iraq-Turkey Pipeline (ITP), which allowed the KRG to expand its ability to export Kurdish crude directly to Turkey, and then into international markets. On arrival in Turkey, the crude is deposited in storage facilities at Ceyhan, from where a number of tankers loaded with KRG crude have departed in recent years, generally bound for Europe, Asia or Israel (which Iraq does not formally recognise and against which it therefore has no legal recourse) and, indeed, this is where the Neverland began its journey.
4. The constitutional arguments
Although the political situation is highly complex, the legal position can actually be summarised relatively succinctly. The longstanding issues essentially relate to the KRG and FGI's differing interpretations of provisions of the Constitution of the Republic of Iraq (Constitution), which was approved by a referendum on 15 October 2005. Although, before the Constitution was enacted, it was indisputable that the FGI controlled the hydrocarbon industry throughout Iraq, the ambiguity in certain important provisions of the Constitution has allowed each side to assert a number of interpretations to suit their respective cause.
Although the arguments of both sides cover a number of articles of the Constitution, the focal point of the debate rests on the interpretation of Articles 111 and 112, which specifically relate to oil and gas matters:
Article 111 provides "Oil and gas are owned by all the people of Iraq in all the regions and governorates".
Article 112(1) provides "The federal government, with the producing governorates and regional governments, shall undertake the management of oil and gas extracted from present fields..."
Article 112(2) provides "The federal government, with the producing governorates and regional governments, shall together formulate the necessary strategic policies to develop the oil and gas wealth..."
The FGI argues that based on these provisions, the ultimate responsibility for "managing" oil and gas "extracted" from "present" fields in Iraq lies with the FGI but it must do so "with" the regional governments, including the KRG. Therefore, the FGI's position is that Article 112, when read in the context of Article 111, grants the FGI sole authority to determine oil policy and to explore, develop, extract, exploit and market oil and gas within Iraq, including the authority to engage with international oil companies (IOCs) to do so.
On the other hand, it is the KRG's position that the word "present" in Article 112(1) limits the scope of the provision to fields that were producing at the time of the enactment of the Constitution (whereas the FGI's argument is that it
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includes both fields producing and fields which were proven but not necessarily producing at that time). Therefore, the KRG argues that it has exclusive jurisdiction over any fields in Kurdistan that were not producing at the time that the Constitution was enacted. There is a further point of contention as to whether "extracted" should be construed as limiting the scope of the provision to dealing with oil and gas after it has been produced, which is the KRG's position, or to include development and exploration as well, which represents the FGI's position.
In addition, the KRG claims that, although Article 112(2) provides the FGI with the authority to set high-level policies regarding oil and gas, the KRG has authority to manage the detail of this policy with respect to fields within Kurdistan. The FGI instead construes this provision broadly enough to entitle it to dictate how all oil and gas development activities in Iraq should be conducted.
Compounding the lack of clarity in the Constitution is the absence of a federal oil and gas law in Iraq, which the Constitution requires to be enacted. Various draft laws have been proposed but have never been enacted.
The consequence is that the KRG claims it is entitled under the Constitution to enact its own oil and gas legislation and, in the exercise of this purported power, proceeded to pass Law No. 22 of 2007 (KRG Oil and Gas Law), under which the KRG granted itself powers to enter into production sharing contracts (PSCs) with IOCs. The FGI has consistently asserted that the KRG Oil and Gas Law and the PSCs entered into by the KRG are unconstitutional and are therefore invalid. The FGI also maintains that the State Oil Marketing Organisation (SOMO) is the only entity entitled to market and authorise the export of petroleum produced anywhere in Iraq.
The FGI commenced legal proceedings in August 2012 against the KRG before the Iraq Supreme Court relating to the interpretation of the constitutional position of the KRG's PSCs and its independent oil exports. Following the commencement of independent exports by the KRG, the FGI sought an emergency injunction from the Supreme Court to prevent these exports. On 24 June 2014, the Supreme Court declined to grant this injunction on procedural grounds, stating that it cannot prevent such exports unless they are first found to be illegal. The Supreme Court has been prevented from rendering a decision in respect of the main proceedings as the KRG has refused to attend any hearings.
5. Risks of exporting and selling Kurdish crude
The key legal risks of exporting and selling Kurdish crude are as follows:
Validity of KRG Oil and Gas Law and KRG PSCs: it is evident from the constitutional arguments of the two governments that there is an inherent legal uncertainty as to whether the KRG had the power under the Constitution to enact the KRG Oil and Gas Law and has the power to enter into PSCs to grant rights thereunder to IOCs to lift and dispose of crude produced in Kurdistan. A successful challenge to either by the FGI could result in the PSCs being found to be invalid (although a strong argument exists that such a challenge could not be made in respect of the four PSCs that pre-date the Constitution based on Article 141 of the Constitution).
Title to Kurdish crude: any finding that the KRG PSCs are invalid would essentially invalidate the transfer of ownership of Kurdish crude to IOCs pursuant to the terms of the PSCs. This is a potentially material risk so far as the IOC selling is concerned and also for any entity seeking to off-take, whether directly or indirectly, from such sellers.
Rights to export Kurdish crude: these arguments also impact on the KRG's authority to export Kurdish crude and to authorise other parties under the PSCs to do so on their own accounts and on its behalf.
Title warranties: if any of the above risks materialise, this may impact on any title warranties received on acquiring or given on selling Kurdish crude.
Any commentary on the legal risks is incomplete without mention of the wider political and potential reputational risks for companies involved in selling or buying Kurdish crude.
6. Threats and proceedings
Following the construction by the KRG of the pipeline spur to the ITP, the action taken by the FGI escalated and resulted in the export and sale of Kurdish crude becoming an internationally politically sensitive issue.
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In May 2014, the FGI commenced ICC arbitration proceedings against Turkey and the Turkish state pipeline operator BOTA, seeking to force them to stop transporting, storing and loading Kurdish crude without its consent, and to pay $250 million in damages. The FGI claims Turkey's transportation, storing and loading of Kurdish crude oil violates the intergovernmental agreement (IGA) that governs the ITP and is therefore illegal. Although a third party (such as a buyer of Kurdish crude) would not be directly liable for a breach of the IGA by Turkey, it is possible that the FGI could seek interim measures in relation to the assets of third parties in support of the arbitration proceedings. There is also a risk that if the FGI's claims are successful, Turkey may be required to stop allowing Kurdish crude from being transported through the ITP (therefore stopping the only current significant route to market for Kurdish crude).
Around the same time as the commencement of the arbitration proceedings, SOMO wrote to certain IOCs, trading houses, refining companies and other third parties warning them from facilitating the export and sale of Kurdish crude through the ITP without SOMO's authorisation. The main threat made by the FGI has been to blacklist companies ie prevent companies from purchasing crude from SOMO or from participating in upstream bid rounds conducted by the FGI. The FGI has also commenced legal proceedings in certain jurisdictions against third parties, including proceedings in the Greek courts against the owner of a number of tankers chartered by the KRG.
In July 2014, the FGI challenged the KRG's right to sell crude to a U.S. based customer and commenced proceedings in Houston federal court to prevent the United Kalavryta from discharging its cargo at a terminal in Galveston, Texas. An arrest warrant was issued but the ship remained off the coast of Texas outside U.S. waters while the legal battle continued. The following January, the Southern District Court in Texas affirmed that it had jurisdiction to hear the case and that the federal Oil Ministry had a plausible claim. The KRG filed an appeal but in the meantime sent the tanker to offload in Israel. The KRG's appeal was denied on the grounds that the disputed cargo could no longer be sold in the U.S. and the court did not therefore rule on the merits of the case and in particular on whether or not the KRG can legally export oil. However the lower court decision remains in place and that decision leaves the FGI in a strong position to contest any further exports of Kurdish crude to the U.S.
The Neverland saga provides some lessons. Clearly, the FGI adopted a tougher stance than it has since 2015, when it tended to turn a blind eye to independent exports of Kurdish crude. Commentators have suggested that the reason for the FGI's aggressive response to the Neverland is the potential for the KRG's petroleum exports to access the U.S. market. A successful offloading of Kurdish crude in the U.S. would be viewed as undermining the FGI's legal and constitutional position regarding centralised control of oil marketing while, at the same time, legitimising the KRG's oil trade and thereby encouraging IOCs and traders to look past the perceived risks and seek to engage more openly with the KRG. However, it is not yet clear whether the response to the Neverland represents a one-off incident, largely due to the circumstances, or whether it is part of a trend in FGI and KRG relations, which had already shown signs of fracturing due to the KRG's proposed referendum on independence and the position of both governments regarding the disputed territories.
Against this backdrop, it is clear that the risks involved in the independent export and sale of Kurdish crude remain significant. These risks include the uncertainty regarding the validity of the transfer of title to the crude and the right of the KRG to export the crude. In addition, there are also a number of practical risks, including the commercial and reputational risks of being blacklisted by one of the biggest global oil producers, as well as the threat of being the subject of legal proceedings by a newly focused FGI.
It appears that any resolution to the uncertainty regarding the risks involved in the export and sale of Kurdish crude is unlikely to be resolved as a legal matter, and it will likely depend on a political solution being achieved. The actions of the FGI and the KRG over the next few months will be key in determining whether such a political solution is feasible.
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Herbert Smith Freehills LLP 2017
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