Royal Dutch Shell, in particular, is counting its blessing that Baghdad has
opened up the world’s third-largest oil reserves more than 30 years after
they were nationalised and six years after Saddam Hussein was overthrown by
a US-led invasion force.

Shell, out of all of its peers, is struggling most to step up its production
as old, profitable fields decline and new reserves are proving increasingly
difficult to secure.

Reserves
Moreover, the Anglo-Dutch oil group carries a very large extra burden. Shell
has to fill the void left in 2004 when it was forced to cut its proved
reserves by about a quarter after realising the company should never have
booked those reserves with the Securities and Exchange Commission, the US
regulator, in the first place.

Shell has since tried to spend its way out of the gaping hole the error has
left in its explorations and production portfolio. Shell has the sector’s
biggest capital expenditure budget of between $30bn and $33bn (£20.6bn) this
year. BP, Shell’s closest competitor and another entrant in Iraq, has capex
of $20bn this year. On a per barrel basis, Shell spends more than twice as
much as BP.

But Peter Voser, Shell’s new chief executive, has promised to rein in costs,
making the task of finding new reserves and production even more
challenging.

So it must have been with some relief that Shell on Friday found it had put in
the winning bid to develop Iraq’s Majnoon oil field.

“Psychologically, Iraq was more important to Shell than BP because they
[Shell] are really struggling to stabilise production, let alone grow it,”
says Peter Hitchens, an analyst at Panmure Gordon in London.

At 12.6bn barrels of reserves, Majnoon is not only one of Iraq’s biggest
untapped fields, it is one of the biggest in the world. Shell has promised
Iraq that it will increase the field’s production to 1.8m barrels a day from
just 46,000b/d today. The plateau is more than double the 700,000b/d minimum
Iraq had insisted was possible.

Shell holds a 45 per cent stake in the venture, Malaysia’s Petronas a further
30 per cent and Iraq the remaining 25 per cent.

Investors are not exactly applauding the deal with gusto as it will do little
to boost Shell’s profitability.

Neil McMahon, analyst at Sanford Bernstein, points out that booking reserves
and boosting production does nothing to help big oil companies’ tackle their
inability to develop organically: that relies on finding oil through
exploration that can be developed profitably.

“These [Iraqi] deals are for booking barrels and showing production growth,
but investors see right through this. This is not what investors want these
companies to do and will dilute the profitability of their portfolios in a
high oil price environment,” Mr McMahon says.

Service contracts
That is because in the Iraq auctions, the winning bidders have agreed to
service contracts, which give them no exposure to potential profit windfalls
if the price of oil rises. Shell will only get $1.39 for every incremental
barrel it produces.

To counter such complaints, the companies point out that they will not need to
spend much capital on the projects because they can reinvest the cash flow
from the fields as they expand production.

The main argument in favour of accepting such stringent financial terms to get
Iraq’s oil sector back on its feet is the long-term political upside.

They believe that entering Iraq now will give them a seat at the table when
Baghdad decides to hand out the rights to explore for oil in the vast
stretches of its desert that have remained untouched by geologists who were
stopped in their tracks in 1972 when the country nationalised the oil
sector.

“It’s all about the future,” says Mr Hitchens, noting that the companies are
counting on getting better terms for exploration contracts for taking on
more geological risk.

However, Christophe de Margerie, chief executive of Total, the French oil
company that lost the Majnoon field to Shell, believes that hope may not
materialise.

Mr de Margerie warned that the low terms being offered in the auction could
set an unattractive fiscal precedent for any future exploration agreements.

Total didn't pay the price
Total, he went on, was not prepared to pay the price needed to win the
auction at the weekend even though he had said earlier that “not being in
Iraq seems impossible”.

If the Total chief’s prediction proves correct, the terms Shell and its peers
accepted for the deals they agreed at the weekend and earlier this year will
prove a lot less attractive than they appear now.

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