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The future of the fledgling oil and gas sector in the Kurdish Region Government (KRG) is in jeopardy as it struggles with payment delays and ongoing international oil and gas companies’ arbitration cases against it. The KRG is risking losing its reputation for being more business friendly than its neighbors.

International investors and companies fled Kurdistan for several months after the Islamic State took Mosul in June 2014, and to overcome the financial impact of this the KRG turned to Baghdad to mend their differences over export rights to Kurdistan’s oil, hoping to generate more income. The KRG maintains that it has exclusive authority under Article 112 and Article 115 of the Iraqi Federal Constitution “to manage oil and gas in the Kurdistan Region extracted from fields that were not in production in 2005”—almost all the fields in production today. But according to Baghdad, the Iraqi state oil marketing organization (SOMO) is the only agency entitled to sell crude oil internationally. After six months of negotiations, Iraq’s 2015 Federal Budget Law holds the KRG to export a minimum of 250,000 barrels per day of crude oil through SOMO (though it remains unclear whether the KRG retains the right to export excess production). In return, the Iraqi government transfers 17 percent of the national budget to the KRG per month. In the past, this 17 percent accounted for roughly 95 percent of KRG revenue.

However, neither side has fully complied with the agreement. The KRG did not deliver the agreed amount of oil to SOMO between January and March—expecting to make up for the production later in the year but demanding full payment from Baghdad in advance. SOMO has also not been transparent regarding the total crude oil delivered and sold in Iraq, which varies per month and affects the KRG’s proportional monthly budget. In May 2015, for instance, the KRG received only 508 billion Iraqi dinars ($450 million), half the 17 percent Baghdad owed it. The same goes for other provinces: Baghdad owed an estimated $320 million to Kirkuk for January–May 2015 and $750 million for 2014, leading the Kirkuk Provincial Council to market its oil through the KRG instead. This led the KRG to resume selling most of its oil independently. In June, Kurdistan sold around 12 million barrels of oil through the Turkish port of Ceyhan, of which only 5 million was allocated to SOMO, a major blow to SOMO’s credibility and Iraq’s standing as a crude oil exporter.

While no relief is expected from the Baghdad, the war with the Islamic State and the continuing decline in global oil prices have added to the KRG’s financial burdens. The presence of more than 875,000 Iraqi internally displaced persons (IDPs) and another 240,000 Syrian refugees in the Kurdish provinces of Dohuk, Erbil, and Sulaimaniya has increased local demand for power, water, education, food, and health services. In this precarious economic situation, Kurdistan needs more than Baghdad’s 17 percent to stay afloat. It needs more than $8 billion per year just to pay local salaries, to say nothing of the cost of war against the Islamic State, remuneration for oil and gas exploration activities, and public spending on development. Furthermore, the export pipeline to Ceyhan—the government’s only economic lifeline—is increasingly going offline due to sabotage by the Kurdistan Workers’ Party (PKK).

This shortfall has particularly impacted the KRG’s ability to pay oil companies for their share of production. Kurdish production sharing agreements have a standard royalty of 10 percent of the total oil produced and offer up to 40 percent of oil produced to some contractors for cost recovery. These terms, along with Kurdistan’s reserve potential, initially proved attractive to international oil and gas companies. But these growing financial burdens leave small, independent oil producers in a predicament. Companies such as Genel Energy, DNO, and Gulf Keystone have sunk their costs setting up shop, exploring wells, and extracting millions of barrels of crude for export. Yet they have been meagerly compensated for all the investment and production. Since it started independently exporting in 2013, as of August 2015 the KRG only paid these companies $100 million, even though the sales generated billions in revenue. The Ministry of Natural Resources authorized an additional $75 million in payments to these companies on September 7 and pledged to pay them on a monthly basis to cover their operating expenses, but this still falls far short of the royalties these companies are due.

The KRG is facing immense financial challenges, but its worsening reputation in doing business is severely damaging to the future of the oil industry in Kurdistan. Dana Gas, part of the Pearl Consortium and one of the first international companies operating in the Kurdistan region, has been in arbitration with the KRG over the contractual and payments rights it is due. The London Court of International Arbitration (LCIA) is currently meeting to determine how much the KRG owes to the Pearl consortium, having confirmed the latter’s contractual rights back in June. The independent exploration and trading companies, which have so far been cooperative and patient with the KRG on the payment delays, are watching for the KRG’s reaction. The possibility the tribunal will demand a full payout by the KRG could trigger other operators in the region to open their own cases. Since the Pearl consortium’s case began, the KRG has blocked expansion and drilling at Dana Gas fields and stopped all payments to Pearl partners. And its likely refusal to accept international arbitration rulings will send negative signals to all players in the Kurdistan region’s oil industry—including exploration companies, services companies, and trading houses—in addition to already jittery investors in other industries. At stake is investors’ confidence, not only in the Ministry of Natural Resources but also the KRG and the Kurdish economy as a whole.

Major international companies, such as Exxon, Chevron, and Total, have so far only been active in exploration, leaving them unaffected by the KRG’s unreliable production-sharing payments. Their deep pockets could withstand payment delays if they expected the KRG to pay its operators eventually. But with oil prices slumping, they are less likely to risk going into production if they are uncertain about recovering their costs. The KRG’s political outlook (the Kurdish parties’ inability to agree on a president) together with tensions with Baghdad, the threat of the Islamic State, and the instability in southern Turkey that threatens Kurdish exports via Ceyhan will soon push oil companies to look into other nearby opportunities. Some smaller companies have already sold their crude oil to Iranian refiners, which have a greater production capacity than Kurdish operators. Since the Iranian nuclear deal, oil companies are now considering Iran’s promise of lucrative and competitive deals and the enormous potential of the Iranian petroleum industry.

The KRG is in a precarious position. It has to keep expending resources to fight the Islamic State, pay government employee salaries, and provide aid for refugees, IDPs, and its own people. But it cannot continue to jeopardize its oil exports during a global oil price recession by alienating the international oil companies. For a decade, the KRG’s competitive advantage has been its stable, friendly pro-Western government that offers attractive fiscal terms. Mismanaging how they honor their contractual agreements and resolve differences with oil companies will put the future of Kurdistan’s oil industry in jeopardy, and with it the region’s economic and potential political independence.

By Hadi Fathallah | Published in Carnegie Endowment for International Peace | September 29, 2015