The New Law

The Kurdistan Regional Government (the “KRG”) recently passed the “Law of identifying and obtaining financial dues to the Kurdistan Region - Iraq from federal revenue” (the “Financial Rights Law”). The Financial Rights Law allows the KRG to independently export crude oil produced in the Kurdistan Region if the Federal Government fails to pay the KRG its share of revenues (including oil revenues), budget items, other national allocations and reparations.

This Update looks at the relationship between the KRG and the Federal Government, examines the relevant provisions of the Financial Rights Law and discusses the possible consequences of the law in terms of both the relationship between the KRG and the Federal Government and implications for international oil companies active in Iraq.

The Relationship between the KRG and the Federal Government

Iraq is a federal country comprised of provinces (also called governorates) and groups of provinces self-organized into regions. The Iraqi Constitution of 2005 recognizes the establishment of the Kurdistan Region (although there are disputed areas which may or may not be included in the Kurdistan Region) and allocates legislative authority between the various levels of government—federal, regional and provincial.

The Constitution includes many compromises, some of which create ambiguities leading to competing interpretations. The oil industry in Iraq generates a large percentage of the gross national product. Because the oil industry is so important to Iraq, it is not surprising that legislative authority over that industry was (and continues to be) a contentious issue and that there are differing interpretations of the Constitution on oil-related issues. The KRG asserts the Constitution gives it the authority over “future fields” in the Kurdistan Region, including the right to grant production sharing contracts, shared authority over “existing fields” in the Kurdistan Region, and the right to export oil and gas produced from the Kurdistan Region. A future field is commonly understood to mean any field that was undiscovered at the time the Constitution was adopted and would include all the discoveries made by international oil companies under the production sharing contracts granted by the KRG. The Federal Government asserts the Constitution gives it oversight over all fields (existing and future, wherever located), including the right to approve or reject the KRG's production sharing contracts (through the Ministry of Oil), and exclusive authority over oil and gas exports (through the State Oil Marketing Organization (“SOMO”)). Reducing this debate to its essence, it is a struggle between decentralized and centralized control over the oil and gas industry.

Although the KRG and the Federal Government have, on occasion, tried to resolve their differences over the oil and gas industry, their efforts have not been successful. Their inability to resolve their differences led to the KRG passing the Oil and Gas Law of the Kurdistan Region in 2007; this is a major milestone in the Iraqi oil and gas industry. To date, no federal Oil and Gas Law has been passed, mainly because, in practice, passing such a law requires the support of both the supporters of decentralized authority and the supporters of centralized authority. Since 2007, both levels of government have entered into petroleum contracts with international oil companies: the KRG has entered into production sharing contracts in the Kurdistan Region, and the Federal Government has signed a variety of service contracts in the other parts of Iraq.

The Federal Government asserts the Oil and Gas Law of the Kurdistan Region and all petroleum contracts entered by the KRG are unconstitutional and therefore invalid. Based on this position, the Federal Government has refused to pay the KRG the full value of the oil being produced from the Kurdistan Regional and sold for export by SOMO. The Federal Government has, from time to time, paid the KRG for the “cost oil” entitlement of the international oil companies operating in the Kurdistan Region on the theory that this is a reimbursement. Consequently, the KRG has not received sufficient funds to pay the international oil companies operating in the Kurdistan Region their “cost oil” and “profit oil” entitlements. In response to this non- or under- payment, the KRG has, from time to time, halted production from the Kurdistan Region.

These events have repeated themselves several times and exacerbated the claims of which government owes the other under Iraqi law. In response, the KRG has passed the Financial Rights Law to pressure the Federal Government to pay. Failing such payment, the KRG gives itself a legal basis for exporting oil directly.

The Financial Rights Law

In some ways, the 2013 Federal Budget may be seen as the last straw which led to the KRG passing the Financial Rights Law. This is similar to how the breakdown of negotiations in 2007 led to the KRG passing its Oil and Gas Law. On 7 March 2013, the Federal Government passed a 2013 budget that fell short of the KRG’s requested budget allocation by nearly US$3 billion. Unhappy with this result, the Kurdish representatives in the federal parliament were recalled. Shortly later, the KRG drafted the Financial Rights Law and presented it to the Kurdistan Regional parliament, where it passed into law on 23 April 2013.

The goal of the law is essentially twofold: first, to create a mechanism for determining the amount the Federal Government owes the KRG, and, second, to create a constitutionally-defensible self-help remedy (e.g., direct exports of oil and gas) to be used if the Federal Government does not pay. The law cannot unilaterally expand the authorities allocated to the KRG by the Constitution.

With respect to the mechanism for calculating the amount the Federal Government owes, the law focuses on several categories of obligations including:

  • a share of the federal budget derived from oil and gas revenue;
  • a share of crude oil refined and prepared for domestic consumption;
  • a share of the federal budget reserved for reconstruction and development projects;
  • compensation for repression of the residents of the Kurdistan Region by Saddam Hussein’s regime;
  • entitlements to grants, aid and international loans received by the Federal Government; and
  • a share of “any other” resources or compensation earned by the Federal Government.

The KRG ministries charged with determining the amounts the Federal Government owes are given a limited amount of time to complete their tasks and report to the KRG Cabinet. Similarly, the Cabinet is given a limited time to approve the report. Once the Cabinet approves the report, it is to approach the Federal Government to seek payment. It appears that the Cabinet may have some discretion whether to make such approach.

The Financial Rights Law sets two deadlines for the Federal Government. The first deadline requires the Federal Government to reach an agreement with the KRG on payment of the amount owed within 30 days of the Cabinet's payment request. The second deadline requires the Federal Government to pay the amount owed to the KRG within 90 days of the Cabinet’s payment request. The Federal Government’s failure to meet either deadline triggers the KRG’s right to take actions it considers appropriate, including the export and sale of oil and gas to pay the amount owed.

Implications of the Financial Rights Law

Increased tension between the KRG and the Federal Government

We expect that one effect of the Financial Rights Law will be to further polarize and entrench the positions of the KRG and the Federal Government on oil issues. The law is designed to provide the KRG with the legal authority to unilaterally determine the debt owed by the Federal Government and additional leverage to collect the amounts the KRG claims are due. The Ministry of Finance of the Kurdistan Region claims that this debt is more than US$20 billion, of which US$6 billion would go to the KRG, US$4 billion to oil companies operating in the Kurdistan Region. The rest would go to the people of the Kurdistan Region as compensation for the atrocities committed by Saddam Hussein’s regime. “It’s an insurance policy - that we lawfully get what is rightfully ours, one way or another,” said Qubad Talabani, the KRG Minister for Coordination. In response to the KRG’s objectives, Iraq’s Deputy National Security Advisor Safa al-Sheikh Hussein stated “Kurdistan is almost independent and they want more gains now. They are a little over-confident and overly ambitious.”

Turkey

Whether the KRG can be successful with direct oil and gas exports, largely depends on whether Turkey is willing to buy oil and gas from the KRG or act as a transit country for such oil and gas without the approval of the Federal Government. Turkey is the most obvious market / route for oil and gas exports from the Kurdistan Region; Iran and Syria represent more difficult alternatives. If the Federal Government refuses (as it is likely to do) to pay the billions of dollars the KRG claims are due, and the KRG moves toward direct oil and gas exports, Turkey will come under pressure from the KRG and the Federal Government, and other stakeholders.

Relations between Turkey and each of the Federal Government and the KRG wax and wane. Turkey’s relations with the KRG currently seem to be stronger than its relations with the Federal Government. The Turkish government is increasing its involvement in the oil and gas industry in the Kurdistan Region. The KRG have already trucked some cargos of crude oil and condensate to Turkey directly from the Kurdistan Region. This involvement has led to the Federal Government revoking Turkish technical service contracts in southern Iraq and banning the Turkish state oil company from participating in the oil and gas industry in southern Iraq.

In addition, Turkey has further proposed an arrangement which would allow revenue from all Iraqi oil exports through Turkey to flow into a Turkish-controlled escrow account. The funds in this account would be divided between the KRG and the Federal Government. This would give the KRG direct access to revenue from its oil exports. This proposal would see the net revenue transferred directly to the KRG (as to 17%) and the Federal Government (as to 83%). This allocation is based on the relative populations of the Kurdistan Region and southern Iraq and is an accepted (but not unassailable) interpretation of the Constitutional provisions on allocation of resource wealth.

Further cooperation between Turkey and the KRG will further strain relations between Turkey and Iraq. Federal Government officials have publicly denounced Turkey’s willingness to facilitate independent exports from the Kurdistan Region as a violation of Iraqi sovereignty. The Federal Government has threatened to retaliate with legal actions against exporters for smuggling, economic measures such as withholding payments owed to the involved parties under the federal budget, and assessment of further penalties for continued violations of Iraqi sovereignty. The Federal Government is even considering shutting down the oil pipeline to Turkey, if Turkey supports the KRG’s plans for direct exports. Shutting down the pipeline to Turkey is a double-edged sword. The Federal Government, through SOMO, currently exports about 250,000 barrels per day from Kirkuk and through the Kurdistan Region to the Turkish port of Ceyhan. This is an important export route and stream of income as all other Iraqi oil exports must go through the Basra Oil Terminal at Al Faw Port and are subject to the Iranian threats to close the Strait of Hormuz. Other export options, notably the pipeline to Jordan, are in early stages of planning.

Implications for International Oil Companies

As the Financial Rights Law and other developments continue to strain the relationship between the KRG and the Federal Government, international oil companies face an increasingly polarizing choice. A choice between working in the Kurdistan Region, under the more lucrative production sharing regime and the more risky exploration blocks (without clear export rights), and working in the rest of Iraq, under the less rewarding and less risky technical service contract regime. Similarly, the Federal Government faces the difficult task of deciding the fate of the international oil companies who have acted against federal directives and “moved north” to the Kurdistan Region. There will be greater pressure for the Federal Government to penalize the companies who “moved north” if the KRG starts direct oil exports.

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Through the Financial Rights Law, the KRG has taken an expansive view of its Constitutional authority and an assertive approach towards an independent oil policy which is intended to allow it to overcome some of the political and economic hurdles it faces. If successful, the direct oil exports proposed by the law would give the Kurdistan Region greater financial autonomy. This could have serious implications for Iraq, its provinces and regions, international oil companies and neighboring states.