Because of Iraq's vast potential oil and natural gas resources, questions surrounding the legality of contracts related to its petroleum sector are commanding great attention.
The legal issues related to these contractual arrangements need to be clarified to facilitate the orderly development of the Iraqi upstream sector.
Background
In 1972, the Republic of Iraq nationalized its oil industry and formed the Iraq National Oil Co. (INOC). The government, dominated by the Baath Party, used its oil wealth during the 1970s to fund numerous social and industrial development projects as well as for military purposes. Starting with the war with Iran in 1980, the oil sector in Iraq has suffered continuously, with oil production dropping from 3.5 million b/d to 2.4 million b/d before the US-led invasion last year and further dropping to 800,000 b/d in May 2003.
On May 22, 2003, the United Nations lifted the economic sanctions on Iraq and accepted the US-led occupying forces, known as the Coalition Provisional Authority (CPA), as the current authority in Iraq. For now, Iraq's short-term oil policy will be determined by the CPA. Meanwhile, Iraq's Ministry of Oil, successor to INOC, continues to operate. Iraq's Oil Minister, Ibrahim Bahr al-Uloum, was appointed to his position by the Iraqi Governing Council, a 25-member board of Iraqi representatives selected by the CPA.
Although Iraq's long-term oil policy is nonexistent, both CPA and the oil ministry have stated their intent to begin making contracts for boosting production as well as service contracts for repair, spare parts, and environmental remediation.
The CPA in Iraq is considered by the UN to be an "occupying power" subject to the 4th Geneva Convention of 1949 and the Hague Regulations of 1907. In the US military, these conventions are followed as part of the Law of Land Warfare. Consequently, the CPA and the remaining military forces are obligated to stabilize the situation, begin reconstruction, and allow for a transition to local rule. Under these rules, the CPA does not own Iraq's oil, which is considered to be realty. The oil can be used to support the obligations of the occupying power, but it cannot be sold for profit, wasted, or destroyed. For example, during World War II, Japan was not allowed to use the oil in occupied Indonesia for general war purposes.
Contract rights
Contract rights also must be honored by the occupying power. The UN already has determined that Iraq's future oil revenues be dedicated and paid into a development fund for humanitarian needs, reconstruction, and civilian administration. Although the occupying power could drill new wells in existing fields, it has been debated whether, under the Law of Land Warfare or other internationally accepted conventions, an occupying power can search for or develop new oil fields that were not discovered or developed before the war.
One unavoidable issue for the new government in Iraq is whether contracts between foreign oil companies and the old regime will be honored. Because of its invasion of Kuwait, Iraq was prohibited by the UN from exporting its oil, except for oil exported under the UN's Oil-for-Food program. Under the shadow of sanctions, some companies were able to negotiate with the Oil Ministry, although many contracts were presumably conditioned on the end of the sanctions.
The legal status of many of these contracts is unclear. The contract with Russia's OAO Lukoil to develop West Qurna oil field was voided by Iraq in late 2002 because of the company's slow progress in developing the field. The Russian company vowed, prior to the war, to pursue its claims through international arbitration. The Oil Ministry confirmed in May that the Lukoil contract still would be terminated.
The contract with Chinese state firm China National Petroleum Corp. to develop Al Ahdab field also was "frozen" prior to the war, according to the oil ministry. The contract with supermajor Total SA to produce undeveloped oil reserves in Bin Umar and Manjoon fields apparently was left unsigned in anticipation of the end of sanctions. Other, less-significant deals, possibly as many as 30, were signed at the end of 2002.
Regime change
Generally speaking, an otherwise valid contract is not invalidated by a change in regime, and the new government is forced to abide by the contract terms.
A parallel to the current situation in Iraq existed with the short-lived Tinoco regime in Costa Rica. Minister of War Federico Tinoco Granados overthrew the government of Costa Rica in 1917, but he himself was deposed 2 years later. The reestablished Costa Rican government adopted a Law of Nullities to eliminate the acts of Tinoco, which included deals with a British bank and other concessions to British interests. The dispute was taken to international arbitration, where US Chief Justice William H. Taft served as arbitrator and ruled in favor of the British interests and upheld the contracts.
The Tinoco example demonstrates how the international community continues to equate sovereignty, legitimacy, and the authority to contract with political control, an idea that has been criticized by supporters of human rights, although a new paradigm of state sovereignty has not been fully developed or recognized.
Despite multiple allegations of abuse by the regime of former President Saddam Hussein and the Baath Party, the legitimacy of the prewar Iraqi government was unquestioned by the UN.
In a paper entitled, "Guiding Principles for US Post-Conflict Policy in Iraq," New York City-based Council on Foreign Relations and Houston-based James A. Baker III Institute for Public Policy of Rice University called for a legal framework for vetting prehostility exploration and development agreements. Who makes any decision regarding oil contracts is a crucial question by itself. Certainly, the CPA, the oil ministry, and eventually the new Iraqi government will be faced with tough political decisions on whether to honor the contracts.
It has been claimed that the prewar contracts were made under terms favorable to the foreign companies, and the new Iraq should be not be forced to honor them as a result.1
Whoever decides, legal questions surrounding each contract could be contentious. Given that the content and the execution of these contracts remain confidential, establishing a legal framework prior to the review of individual contracts could lower tensions surrounding the process.
Iraq's oil contract regime
During the regime of Saddam Hussein and the Revolutionary Command Council (RCC), Iraq's oil and gas legal regime was not developed, and production sharing agreements (PSAs) were employed to establish the relevant terms between the parties. The state, through the Ministry of Oil as of 1987, had full control over oil.
Like some other producing countries, Iraq adopted a nationalistic approach to its natural resources. Its constitution proclaimed that natural resources and the basic means of production were "owned by the people" and that "public ownership and properties of the public sector are inviolable."
In 1990, the oil ministry adopted the curious position that its contracts with foreign companies did not entitle them to any claim on Iraqi oil and such contracts were neither service contracts nor PSAs.2
Once the oil ministry signed a deal, it became legally binding when approved by RCC, which included the president. It may be assumed that approval of the contract by RCC decree elevated it to private commercial law.
Existing contracts' status
With this background, it may be argued that many existing contracts are invalid because they fail to meet the authorization requirements of the legal system. Certainly, contracts that are unsigned by either party are void ab initio. Contracts that were signed by the foreign company along with the oil ministry also are void if not approved by RCC or President Hussein, or because the binding decree was never issued.
To the extent contracts previously agreed to by the oil ministry are later approved and ratified by a new government, they will be respected. One company, Petrel Resources PLC of Ireland, claims that it has an exploration contract in Iraq's western desert that was signed by the oil ministry in 2002.3 Apparently, the Petrel contract was not approved by RCC. Petrel has reportedly reopened its offices in Baghdad and has initiated its contractual exploration commitment. Moreover, Petrel suggests that it intends to enforce the rights it claims to have under the contract.4
Under the Unidroit (International Institute for the Unification of Private Law) Principles of International Commercial Contracts, which establishes international contract law principles, a signatory can void a contract for reasons of fraud, mutual mistake, threat, and unfair terms due to gross disparity between the parties. However, such reasons are fact-intensive and politically charged. A claim that Iraq was defrauded by any particular company would be hard to prove. It is difficult to see how a new Iraqi government would be able to prove that the prior regime was manipulated unfairly or forced to accept contractual arrangements.
Ahmad Chalabi of the Iraqi National Congress (and current member of the Iraqi Governing Council) previously has argued that all oil contracts signed by Saddam Hussein were illegal because they were in violation of UN sanctions. In other words, the UN stripped Iraq of its sovereign authority to make contracts that would violate the UN sanctions imposed after the invasion of Kuwait. UN Resolution 611 specifically forbids activities by foreign nationals that would promote exports, so PSAs could have violated the sanctions. Consequently, it is likely that signed contracts after 1990 were conditioned on the removal of sanctions.
The Unidroit Principles do not address contract invalidity due to lack of authority or illegality, but the initial impossibility of performance by one party does not invalidate the contract. Although the removal of sanctions would be a condition precedent to performance, the failure by the previous regime to work in good faith and comply with the UN resolutions likely would not justify a future Iraqi government dishonoring the contract.
Oil contracts that are valid could be voidable under certain circumstances. Decisions not to honor valid contracts will be difficult, but contract law might well offer decision-makers certain legal avenues of escape. The contracts already may have termination rights that Iraq could exercise. Or the new Iraqi governement could argue that the foreign contractor already has breached the contract because of its failure to begin work, just as Iraq did in 2002 with the Lukoil contract. More contentious would be a claim that a particular contract is voidable because it was a product of bribery or corruption.
UN politics may have played a role in whom the Iraqis negotiated with, as France, Russia, and China hold seats on the UN Security Council.
Whether the oil contracts were issued to curry political favoritism is unclear, and the implications associated with combining oil and politics likely will not, in and of themselves, taint a contract.
Iraqi authorities also might argue that the war and the change of regime constitute changed circumstances that require renegotiation of the prewar contracts. The concept of changed circumstances has been advanced in the Unidroit Principles. It is intended to be a more flexible standard than that of commercial impracticability, which would forgive performance only when such is rendered impossible. Under the theory of changed circumstances, the contract is dependent on the stability of the circumstances at the time of contract. A radical and unforeseen change of circumstances can force renegotiation of the contract. Pursuant to Unidroit Principles, a radical and unforseen change is one that changes the value of performance by 50%.5
Even if an oil contract is valid as a matter of contract law, Iraq still retains the right to void the contract consistent with its rights as a sovereign state to control the use of its natural resources. The rights of a sovereign were recognized by a UN resolution in 1962 known as establishing Permanent Sovereignty over Natural Resources (PSNR).6 . The cancellation of a contract for reasons of sovereignty is essentially the same as expropriation. As approved by the UN, PSNR requires the national government to pay compensatory damages if it elects to void such a contract. The damages either would be agreed to by the parties to a contract or determined through international arbitration. The actual amount could vary, based on the facts and circumstances surrounding the cancellation. The presence of a stabilization clause in the contract would bolster the claims of the foreign company seeking damages.
Model PSA
Most of the Iraqi oil contracts are confidential. These contracts are likely to be based on a model-form PSA proposed by the Ministry of Oil in 2001. A review of this model form provides insight into possible terms as well as the approval procedure.
A contract, once signed by the company and the ministry, has an effective date that does not begin until the contract is approved by the government of the Republic of Iraq. The company is bound by all laws and regulations in force in Iraq, except that the company is exempt for all taxation. Thus, the model contract has a stabilization clause limited only to taxation. The contract also required the company to work diligently to begin production—a definite problem, as sanctions were in effect at the time of execution. The model contract was to be interpreted under Iraqi law, and contract disputes were to be resolved under the Iraqi rules of arbitration.
Before the war, the Kurdish region in northern Iraq allegedly began making its own oil contracts. The Kurds, supported by the US, signed a "final statement" in 1998 that asserted the Northern Iraq Federative Administration (NIFA) owned the oil within its territory.7 The Sulaymaniyah Regional Governorate, a subpart of NFIA, allegedly has executed a PSA with a Turkish company. Although the final negotiated terms are unclear, the model contract provided that the contract would remain valid if NFIA became part of the Iraqi government. What is interesting about NFIA is that a decentralized oil policy is one possible arrangement in Iraq, particularly as the Kurds will attempt to assert a voice in the new government.
Oil sector needs vs. politics
The Iraqi oil sector requires immediate rehabilitation to allow for increased production.
A group of experts sent to Iraq by the UN in 2000 to evaluate the oil sector reported that the oil infrastructure was in a "lamentable" state.8 The cost to repair existing infrastructure has been estimated at $5 billion, and the return to pre-1990 oil production levels of 3.5 million b/d was estimated to cost another $5 billion.9
These problems were exacerbated by rampant looting of oil facilities after the collapse of the Baath regime. A lack of security in southern Iraq has prevented some fields from resuming production. Sabotage remains a persistent and credible threat to Iraq's pipelines and oil facilities, particularly in northern Iraq. Four months after the lifting of sanctions, oil exports rose to 1.5 million b/d.
Political disputes may generate problems in the interim government. A new, 25-member Iraq Governing Council has been appointed, although CPA has insisted that it has the authority to determine economic policy. Already the debate has begun regarding the timetable for a full return to an independent Iraqi government. In terms of oil, relations between the oil ministry and the advisory board set up by the CPA may sour over long-term policy.
Despite rumors that Iraq may leave the Organization of Petroleum Exporting Countries, US officials and the oil ministry have confirmed that any decision regarding OPEC should be reserved for a sovereign government of Iraq, and it would not appear that Iraq will abandon OPEC. Iraq sent a delegation, headed by Oil Minister Ibrahim Bahr al-Uloum, to OPEC's September meeting in Vienna, where OPEC decided to cut member output.
Despite the existing uncertainty in Iraq, one oil company has decided to move forward on its prewar contract, with the apparent blessing of the oil ministry and the Iraqi Governing Council. Officials from Pertamina, the Indonesian state oil company, visited Iraq in August 2003 and received approval from Iraqi officials to begin exploration and development work in a small field south of Baghdad, based on its April 2002 contract.10 . The "approval" of the Pertamina contract does not answer the larger questions surrounding the contractual authority of Iraq during the occupation or the legitimacy of prewar contracts. The oil ministry has previously indicated that it would examine the old contracts upon request, but it also indicated that negotiations on many prewar contracts were years away, while the ministry focuses on rebuilding infrastructure and combating sabotage.
On the other hand, economic forces could preempt any strategic planning in Iraq's oil sector. Iraq faces a massive foreign debt crisis and war-compensation claims from Kuwait. The resolution on how to address the enormous foreign debt could influence Iraq's review of the existing oil contracts. Last month, the Ministry of Oil and the Governing Council appeared ready to reverse their earlier stance towards Moscow and revive Lukoil's contracts for West Qurna and other oil fields in exchange for concessions by Russia on the $8 billion debt owed by Iraq. By yearend, no agreement had been signed, and it was unknown whether the US or the CPA would take a position on the Lukoil contract.
Although the existing oil contracts may be eventually honored or dishonored without legal dispute, a careful review of legal issues surrounding the contracts in Iraq is important for another reason: Continuity of the successor Iraqi government cannot be assumed.
A new sovereign government, even with expanded oil production, may be unable to maintain authority, and Iraq could splinter. Thus, the contracts honored today could be challenged by a future Iraqi government. Foreign oil companies would be wise to move cautiously as they negotiate and draft the next wave of contracts.
Finally, it should be noted that while Iraq faces many problems in restoring its oil sector, the upside is tremendous. Iraq has the second largest proven conventional oil reserves in the world at 115 billion bbl, with undiscovered resources estimated at a further 250 billion bbl.11 Long-term estimates have Iraqi production reaching 6 million b/d.12
For now, US Sec. of State Colin Powell has said that "the oil belongs to the people of Iraq" for their benefit pursuant to international law. The end of Saddam Hussein's regime did not change the ownership of oil, but Iraq now has the opportunity to forge a stable, modern, and productive oil industry. No one doubts that foreign investment will be a critical element to Iraq's development. Whether disputes over Iraq's oil contracts hinder that development remains to be seen.
References
1. Whalen, Jeanne, "Russia Tallies War Costs in Iraq," Wall Street Journal (Europe), Nov. 7, 2002.
2. Republic of Iraq, Oil Ministry, government statement of Feb. 20, 1990, on oil investment incentives.
3. Townsend, David, "Honoring Deals," Petroleum Economist, June 2003, p. 6.
4. Ibid.
5. Principles of International Commercial Contracts, art 6.2.2, cmt. 2 (Unidroit 1994).
6. United Nations General Assembly Res. 1803, 17th Session (1962).
7. On Sept. 17, 1998, the Patriotic Union of Kurdistan and the Kurdistan Democratic Party together with the US Department of State signed the final statement that asserted the rights of the Kurds to limited self-rule in northern Iraq.
8. Report of the Group of United Nations Experts established pursuant to Paragraph 30 of Security Council Resolution 1284 (2000).
9. Guiding Principles for US Post-Conflict Policy in Iraq, a report of an independent working group cosponsored by the Council on Foreign Relations and the James A. Baker III Institute for Public Policy of Rice University (2000).
10. New York Times, Sept. 12, 2003.
11. Cassidy, John, "Letter from Iraq: Beneath the Sand," New Yorker magazine, July 14, 2003, p. 64.
12. Guiding Principles, supra note 9, p. 11.
The authors
Andrew Derman is a senior partner with international law firm Thompson & Knight LLP. He is the international practice office leader, residing in Dallas. He represents public and private companies and host governments in oil and gas transactions and has assisted the governments of Russia and Kazakhstan in developing oil and gas legislation. Derman previously worked at Oryx Energy Co. and has been an officer or director of the Association of International Petroleum Negotiators, Rocky Mountain Mineral Law Foundation, and the Southwestern Legal Foundation. He has written five books and many articles on the international oil and gas business. He has a BA from New York University and a JD from Temple University and attended INSEAD's advanced management program in Fountainebleu, France.
Scott Hounsel is an associate with Thompson & Knight. He works in the real estate and banking section in the firm's Dallas office. Previously, he worked as a senior planner in the City of Houston Planning and Development Department. Besides receiving his JD, Hounsel also graduated from the University of Texas at Austin with a master's in Latin American studies and a master's in community and regional planning.