ENERGY FRONTIERS:

Tensions rise in northern Iraq as Kurds ferry more oil across border

KHOR MOR, Iraq -- About 65 tankers a day rumbled over the muddy green hills of northern Iraq in late January, dodging potholes and tractors as they hauled natural gas liquids on the first leg of their trip across the Turkish border.

The truckloads of gas condensate barreled toward a market that bisects Europe and Asia, inflaming tensions between the semiautonomous Kurdish government that runs the northern part of Iraq and Iraq's central government in Baghdad.

The Kurdistan region, which also borders Iran and Syria, sits on billions of barrels of untapped oil reserves and a lot of natural gas. The region is churning out enough oil for it to be used in the same breath as Texas and North Dakota when energy experts talk about the shifting dynamics of the global oil market.

The Kurds have been signing contracts directly with oil companies for around a decade. Executives prefer Kurdistan's more favorable contracts, business-friendly environment and relative safety.

Yet leaders here are also using the hydrocarbon windfall in a high-stakes battle with the Iraqi government over the region's sovereignty. The Iraqi government disputes the Kurds' reading of the constitution, which Baghdad believes allows only the central Iraqi government to oversee natural resource contracts and revenue. Stopgap agreements, pipeline cutoffs and delayed payments have kept tensions at a simmer, as Kurdistan increasingly uses the oil as a way to exert its independence.

Who gets to control the region's massive oil and gas fields remains a nagging question. Where will the money flow amid a drilling bonanza that has attracted Exxon Mobil Corp., Chevron Corp., France's Total SA and Russia's Gazprom OAO?

The Khor Mor liquefied petroleum gas plant, just southeast of the war-ravaged city of Kirkuk, is surrounded by land mines buried decades ago. It processes 330 million cubic feet per day of natural gas that is piped to electricity plants powering Kurdistan's growth and bringing unprecedented prosperity to a region that had been willfully underdeveloped for decades under the government of Saddam Hussein.

But the 15,000 barrels a day of gas liquids produced from the fields and now exported has become a big point of contention, along with the trucking of crude oil to Turkey from another field, Taq Taq, which started in January. They have solidified tensions with Baghdad, and intensified the contest to sign contracts with oil buyers and sellers and get the upper hand in any political resolution between Baghdad and the Kurdistan regional government, or KRG.

In a deal that goes against the grain of long-standing hostilities among the region's Kurdish groups and Turkey, Kurdistan and Turkey have swapped Khor Mor's gas liquids needed by Turkey's manufacturing sector for diesel.

'A zero-sum game'

Oil literally bubbles up from the ground near the Khor Mor plant, according to Paul Brown, a plant manager here. "The opportunities over the next five to 10 years are phenomenal," he said. "The reserves are incredible, all over Kurdistan."

Estimates have placed Kurdistan's oil reserves at 45 billion barrels, but commercially extractable amounts could be far less. The estimate is about one-quarter of the oil reserves in southern Iraq, but it is more than what the United States has, excluding unconventional resources, according to the U.S. Geological Survey.

Kurdistan produces about 225,000 barrels of oil a day with daily exports running at about 25,000 barrels, according to a source in Kurdistan's Ministry of Natural Resources. Until infrastructure is built and tensions with the Iraqi government decline, tankers instead of a pipeline will continue to take oil across the border. Exports reportedly reached nearly 200,000 barrels per day late last year before tensions put the brakes on most of that business.

The KRG received a big boost in late 2011, when it signed petroleum contracts with Exxon Mobil, much to Baghdad's chagrin. Before, Kurdistan had mainly attracted wildcatters and small exploration companies, and Exxon's entrance triggered a rush of majors in 2012, including Chevron, Total and Gazprom. The influx has given the Kurds significant leverage and has signaled international oil companies' willingness to move into what they view as a more favorable environment despite the risk that the government in Baghdad will shut them out of the rest of Iraq.

The payoff is potentially huge for oil and gas majors. But for all the excitement, the political situation shows no sign of abating.

When tensions rise between Baghdad and Erbil, the regional capital, payments sometimes stop coming from the Iraqi central government, which controls revenue from pipeline exports. Kurdistan, which has its own security force and social services, gets 17 percent of the federal budget, which is funded almost entirely by oil sales.

The uncertainty has kept companies from drilling blocks to their full potential. They are unsure they can monetize their product and recoup their costs.

Iraq and Kurdistan are "engaged in a zero-sum game. Baghdad will only want it on their terms, but the Kurds only want it on their terms," said Joost Hiltermann, an Iraq expert at the International Crisis Group, adding that there isn't a lot of willingness to compromise at this point.

Blocked in by geography and politics, companies in Kurdistan have sent much of their oil to the local market, which lacks refining capacity and is too small for Kurdistan's production potential. Most exports have traveled via a pipeline running from Kirkuk through non-Kurdish Iraqi territory to the Turkish port of Ceyhan.

The political quarreling can threaten production in other ways, too. In November, Iraqi and Kurdish troops squared off after a shootout in a disputed city about a dozen miles from the Khor Mor plant. Three thousand Kurdish soldiers and tanks rolled straight through Khor Mor just yards from the plant, where the bright orange flare burns surplus natural gas.

"Think of it as dollar signs flaring up," said Brown, the plant manager.

Production has largely pressed on at Khor Mor, which since 2007 has been operated by the United Arab Emirates' Crescent Petroleum and its affiliate Dana Gas, which have poured around $1 billion into Kurdistan.

The region has benefited from a burgeoning diplomatic and economic relationship with energy-starved Turkey, a natural market for Kurdistan's oil. Meanwhile, the U.S. government remains committed to a unified Iraq, its eyes on ensuring Iraq's enormous oil supply makes it to the global market.

Gambling with the Kurds

Signing a contract with the Kurdish government risks angering the central Iraqi government in Baghdad, where lawmakers consider the Kurdish region's circumvention of the Iraqi Ministry of Oil a threat to national sovereignty.

But an increasing number of companies are taking that gamble, as executives take advantage of the Kurds' production-sharing agreements, which give companies a larger stake in total profits once they recoup their recovery costs. Baghdad's technical service agreements give companies a set fee per barrel after covering recovery costs, according to Jessica Brewer, an analyst at the research firm Wood Mackenzie.

Producers get $2 to $5 per barrel in Kurdistan but less than $1 in the rest of Iraq, Brewer said.

Logistical challenges like delivering large rigs to a landlocked territory became less complicated as larger companies moved in and the size of the oil-services industry ballooned. The sheer size of companies like Exxon Mobil and Chevron, and their financial flexibility, has convinced many oil executives here that political tensions between Erbil and Baghdad will inevitably be overcome.

Hunt Oil was the largest American company in Kurdistan when it arrived in 2007. It seemed that Baghdad had blackballed it from the start, said Wyndell Caviness, Hunt's general manager in Kurdistan.

"The potential here is to have several million barrels of oil production a day. That's going to be multibillion-dollar investments," Caviness said. "If someone comes in and spends a lot of money here and they have a million barrels per day of oil production shut in because of the political issues, someone's going to have a way to get that out."

Pipelines and other game-changers

Gulf Keystone Petroleum Ltd., a London-listed exploration and production company with operations exclusively in Kurdistan, struck it big with a 2009 discovery in its Shaikan block of 13.7 billion barrels of gross mean oil in place -- the largest discovery to date in the region, according to the company.

The company is expanding its operations, hoping politicians will resolve their differences. It aims to produce 40,000 barrels of petroleum a day by June and until recently had been selling its test production of 5,000 barrels a day for more than a year on the local market for an average of $41 to $55 per barrel, well below the international market price.

"You can't do it with trucks or airplanes. Pipelines would be necessary from a technical point of view," said Umur Eminkahyagil, Gulf Keystone's country manager in Kurdistan. "Export, getting paid, whether there are means, is important to every single company."

A pipeline directly from Kurdistan to Turkey is reportedly in discussion, a potential game changer in the Erbil-Baghdad dispute.

Kurdistan's drilling success rate is more than 70 percent, compared to 30 percent elsewhere, according to Asos Dizayee, the Kurdistan regional manager for the Korea National Oil Corp., which has held stakes in five blocks in Kurdistan since it started operations here in 2008.

South Korea's national oil and gas company hasn't been quite as successful as other companies so far.

"We are not very lucky like other operators who have had made major discoveries, so in that sense we are disappointed, but we are happy," said Dizayee, an Erbil native. "We have a commitment to be here long term."

'Irreversible' growth meets age-old problems

The oil boom has transformed Kurdistan's cities, most notably Erbil. A brand-new airport, five-star hotels and shopping malls have sprouted up over the last half-decade.

The newfound prosperity has yet to fully impact the poorer, more rural areas, where fewer skilled workers have less of a chance of finding jobs in the flourishing oil and gas field. The KRG puts pressure on companies to hire locally, but the relatively small population of 5 million to 6 million has had trouble keeping up with the breakneck speed of the hydrocarbon sector's expansion, said Nevin Tosun, a managing partner at Morgan Polaris Solutions, an Erbil-based job recruiting and training company.

Over the long term, companies like those that operate the Khor Mor gas field aim to transition to Kurdish-run facilities despite trouble finding skilled workers today.

"Everyone wants to work in an oil and gas company," Tosun said. "It doesn't matter which position -- they just want to work in oil and gas."

Age-old problems like tribalism and corruption may hold back Kurdistan's potential, though, said Riad al Khouri, a Jordanian economist who previously served as dean of a business school in Erbil.

"Oil and money are one thing, but genuine sustainable development is something else," al Khouri said.

Still, the region's taste for reliable running water, luxury cars and newfound international respect may be enough to keep it moving on the path forward.

"This kind of growth is irreversible," said an oil executive in Kurdistan. "You can't take away someone's car, diesel, electricity."