SPY EYES

On Dec. 17, two days after the U.S. military cased its colors and formally ended its mission in Iraq, the brain trust of the Iraqi oil sector gathered for a symposium at Baghdad’s Alwiyah Club, a fortified concrete complex of meeting rooms and outdoor gardens. They were officially meeting to discuss “Challenges Facing the Development of the Extractive Industry.” The issues they grappled with held the prospect to transform the global energy marketplace and determine the course of Iraqi democracy.

A few top government officials sat on a dais while members of the audience — about 150 parliamentarians, technocrats, and academics — took turns at a podium, giving short speeches and asking questions of the panelists. Speakers often had to yell to be heard over the objections of audience members. A bit of shouting was to be expected: This was the first time in years that Iraqis were gathering without a foreign military occupation to outline their economic future. And in a country where 95 percent of government revenue comes from oil, any debate about oil is also a struggle for power. They addressed the most fundamental questions: How much oil should Iraq produce? What should happen to the revenue? Who should control the country’s oil strategy? You wouldn’t have known it by the volume of the rhetoric, but a lot of the talk was moot.

Much has already been decided. In 2009, the government started awarding contracts for the country’s largest fields, and the biggest names in oil have signed up. Companies like ExxonMobil and BP have invested billions of dollars, bringing the latest in technology and engineering expertise. Production has rebounded from just over 1 million barrels per day after the invasion to nearly 3 million today. Baghdad’s 11 international oil contracts promise to deliver a total of more than 13 million barrels per day within seven years — a figure that would make Iraq the largest oil producer, ever.

There are good reasons to doubt these projections. For one thing, the current political crisis has underscored Iraq’s failure to build the kinds of institutions — a credible judiciary, non-politicized security forces — that support a stable, functioning, democratic state. Even if Iraq weren’t plagued by daily bombings and political dysfunction, it would be hard-pressed to achieve what would be the most rapid oil expansion in world history.

Yet if the investment bonanza can even partially succeed, it promises to reshape not only Iraq but also the regional balance of power. Falah al-Amri, director of the State Oil Marketing Organization, showed the audience at the Alwiyah Club a PowerPoint presentation with figures that he had quoted to his Gulf counterparts at a recent OPEC meeting. By 2014 or 2015, he said, the country would reach the magic number of 4.5 million barrels per day of oil production, at which point OPEC would start trying to enforce quota restrictions.

Amri vowed that Iraq would negotiate hard for a larger national quota. He also provided a clue to the government’s contracting strategy, which appears to recognize that oil is a source of not only revenue but also geopolitical power.

“Our plan is not to flood international markets. This is not our goal. If we have a spare 2 or 3 million barrels per day, then so be it,” Amri said. He later clarified to me that he thinks Iraq will have this “swing capacity” — that is, the ability to drastically increase production on short notice — by 2017.

Saudi Arabia is currently the world’s only so-called “swing producer,” with an already-developed capacity that far exceeds its current production. This status gives the kingdom enormous power. If any other producer falters — if, say, rebels in the Niger Delta blow up a pipeline or Iranian oil is shut in by an embargo — the world economy depends on the Saudis to open the taps and keep prices from rising too high. This Saudi leverage also keeps its OPEC associates in check: Other cartel members can’t stray too far from their production quotas, lest the Saudis flood the market with a punitive deluge of crude, driving down everyone’s prices and profits.

Amri’s presentation contained the seeds for the disruption of this power dynamic. If Iraq develops 2 million or 3 million barrels per day of swing capacity, which is roughly what Saudi Arabia claims to have, OPEC will suddenly have a second enforcer. That could pave the way for a regional rivalry between Saudi Arabia and the Shiite-led Iraqi government. Relations between the two are already in the doldrums, as Saudi leaders have characterized Prime Minister Nouri al-Maliki as an Iranian puppet and continue to refuse to send an ambassador to Baghdad. Their worries are not unfounded. Maliki is no puppet, but he has taken dramatic steps to consolidate power by pushing aside all his major Sunni-backed rivals; as a result he is increasingly dependent on a Shiite political base with deep ties to Iran.

But though the geopolitical implications of Iraq’s efforts to become an energy giant are dizzying, they will only become a reality if the country can meet Amri’s ambitious projections. And there’s no guarantee that the country can overcome the daunting challenges facing its oil industry.

Iraq has already come a long way. A Western oilman recently recalled for me the sorry state of Iraq’s oil sector shortly after the 2003 invasion. He had just arrived in the southern port city of Basra to get a key field back up and running, and he found that after decades of sanctions and underinvestment, some critical equipment was literally held together with duct tape. Thankfully, Iraqi engineers were experts at improvising improbable solutions, and after weeks of work, everyone was confident that the field could restart production.

“It’s time to light the flare,” the oilman announced.

In most modern facilities, when you need to burn off certain byproducts of crude oil production, you press a button on a control panel and ignite a flare atop a metal chimney. But in Basra, where no such mechanism existed, it was a slightly riskier proposition — and the responsibility for the task sparked a shouting match among the more junior Iraqi workers.

After a long argument, the Iraqis drew straws. The loser wrapped a wet T-shirt around his head, held a flaming torch in the air, and, crouching low, crept toward the chimney, which was hissing with invisible, flammable gases. When he got close enough, the air burst into a giant fireball and the man ran screaming back to his cohort, who doused him with water and laughed at his singed body hair. Soon after, the Western oilman introduced a slightly more modern ignition device: a flare gun, which could be fired from a safer distance.

Iraq’s oil sector has matured since then, but that kind of crazy improvisation remains a defining characteristic. Bureaucratic hurdles also continue to hobble the oil industry’s development. For several months in 2011, for example, many top Western oil company officials couldn’t enter the country because their visas took months to process. Amazingly, the government was preventing them from doing the work it had contracted them to perform. The problem turned out to be a simple backlog: In a bureaucracy that functions through the authority of only a few strong leaders, the visa applications had to travel all the way to the prime minister’s office for approval. Iraq’s current atmosphere of political crisis offers little hope that Maliki will relax his tendency to micromanage and govern through just a handful of loyal subordinates.

Similar delays have affected almost every aspect of companies’ operations: They have had problems getting paid on time; Oil Ministry officials have been slow to sign off on plans and subcontracts; and customs officials have held up the delivery of key equipment while waiting for authorization. One Western executive told me recently about a particularly troublesome holdup — a shipment had been waiting for weeks at the border, he said, and now they were running low on essential supplies, including ammunition for their flare guns.

It’s not just the facilities that are badly in need of modernization: The legal infrastructure for Iraq’s oil industry is also held together by the political equivalent of duct tape.

Shatha al-Musawi, a former member of parliament and one of the speakers at the Alwiyah Club, knows firsthand the murky legal foundations of Iraq’s oil sector. She had been the plaintiff in a 2009 lawsuit that challenged the legality of BP’s contract for the Rumaila oil field in Basra — the world’s second largest, which now produces about half of Iraq’s crude. Musawi’s complaint centered on the fact that the Oil Ministry had not submitted the Rumaila contract to parliament for approval, as Iraqi law appears to require. Instead, Maliki’s government unilaterally approved the Rumaila deal — and all subsequent contracts — without the legislative branch. Musawi’s case was a quixotic fight against this power grab.

“There is not a strong legal basis for these contracts,” Musawi said. “There is not any intention to build a new state, a democratic state.”

The Iraqi Constitution calls for a modern oil law, but political dysfunction has prevented one from being passed. In a country where petroleum is power, any law that dictates the structure of the oil industry is also bound to define the state itself. And in a political arena dominated by fear and identity politics, nobody wants to share power. In recent debates, the sides have split along largely ethnic and sectarian lines: Maliki’s Shiite-majority allies have backed centralized control of oil, while parties representing the minority Kurds and Sunnis say local governments should have more authority. No bill has yet survived parliament.

The Rumaila deal, Musawi argued, represented a textbook executive end-around. By commissioning billions of dollars’ worth of investment, the Maliki administration was creating irreversible facts on the ground. Parliament could not pass a law that would invalidate major contracts because that would scare away future business — and Iraq needs foreign investment for its reconstruction. Instead, future legislators would have to retrofit any new law to account for the existing contracts.

This is how governance works in Iraq: Strong leaders take action in the name of necessity when democratic bodies fail to function. As a result, the people in power have few incentives to compromise and many reasons to undermine public institutions. The Rumaila case, for example, was not allowed to proceed. Iraq’s highest court, which has made several suspiciously favorable rulings for the prime minister, said Musawi would have to pay a $250,000 court fee just to bring the case to trial. Unable to raise the money, she was forced to drop the suit.

Political power dynamics have determined the course of Iraq’s oil development far more than legislative policymaking. That volatility, however, hasn’t dissuaded oil multinationals — there’s simply too much oil under the country’s soil. So, many companies, from BP to ExxonMobil to Shell to Lukoil, have been willing to invest billions of dollars without the stability of a modern oil law. Companies have mitigated their risks by negotiating contracts that rely on international arbitration to settle major disputes, rather than Iraqi courts. But the overarching reason companies can operate with some confidence is that — in the laissez-faire political economy of Iraqi oil — their power rivals that of the divided Iraqi state.

Iraq’s oil powers are split between two governments. After the U.S. invasion, the semiautonomous Kurdistan region in the north grew fearful that the new government in Baghdad would, like Saddam Hussein, use economic power to oppress them. Kurdistan’s minister of natural resources, Ashti Hawrami, led an aggressive strategy to develop an independent oil sector, signing contracts without the central government’s consent. He divided Kurdish territory into a grid of several dozen exploration blocks and, over the past decade, has signed a whopping 48 oil and gas contracts.

To leaders in Baghdad, this looks like an affront to Iraqi nationalism. The most forceful objections have come from Hussain al-Shahristani, one of Maliki’s most powerful allies, who became oil minister in 2006 and now serves as deputy prime minister for energy. He argued that without a centralized system to manage oil, competing interests would tear the country apart along geographic, ethnic, and sectarian lines. He insisted that Baghdad should have sole authority over contracting and condemned the Kurdish deals as illegal.

Due to Iraq’s vague constitution and incomplete regulatory structure, it’s not clear which side has the legal upper hand. It’s certainly an urgent question. One of the George W. Bush administration’s biggest reconstruction benchmarks for Iraq was to pass an oil law, and U.S. Ambassador Zalmay Khalilzad spent months brokering negotiations. In 2007, a draft oil law passed the cabinet, and Khalilzad published a triumphant op-ed in theWashington Post proclaiming “the prospects for passage are excellent.” But negotiations soon died in parliament. There were many reasons for the failure, but the single biggest was the rivalry between the Arab majority in Baghdad and the Kurdish government. The final nail in the coffin came on Sept. 8, 2007, when Kurdistan signed a contract with the U.S. firm Hunt Oil, whose chairman, Ray Hunt, sat on Bush’s Intelligence Advisory Board. The definitive American influence, it turned out, was wielded not by the U.S. Embassy but by a private company.

Shahristani had to respond to this show of the Kurdish government’s growing clout. He also had to start generating the kind of revenue that could fuel Iraq’s reconstruction, with or without an oil law. One sure way to do both was to bring in even bigger companies to develop the vastly larger fields in southern Iraq. In October 2009, Shahristani signed a deal — without parliamentary approval — with oil giant BP to rehabilitate the Rumaila oil field. Then came ExxonMobil, with a contract for the 8.7 billion-barrel West Qurna Phase 1 field. Those two fields hold more proven oil reserves than the entire United States has, and if the terms of just those massive contracts are met, Iraq will reach more than half of Saudi Arabia’s current production before the end of this decade.

Shahristani’s contracting spree was driven at least in part by political motives, and his ambitious projections could easily run aground on some harsh practical realities. For one thing, if Iraq’s fields were to increase production any further right now, the oil would have nowhere to go. There aren’t enough pipelines, storage tanks, refineries, and export terminals. Iraq is building many of these facilities, but probably not fast enough for the production rates that the state is now contractually obliged to support.

Nor is it clear whether world markets could stand so much new supply. If Iraq were actually able to increase production to the unprecedented height of 13 million barrels per day within seven years, the price of oil would likely drop just as steeply. Not only would this destroy Iraq’s profit margins, but it would also provoke dangerous levels of anger from nearby producers such as Saudi Arabia and Iran, both of which possess superior military power.

Worst of all, perhaps, Iraq has lost full control of its production strategy. The deals don’t just require the companies to boost production aggressively — they require Iraq to pay for the contracted volumes. If the companies hold up their end of the bargain, but the government has to make cuts for any number of reasons — infrastructure constraints, market pressures, or OPEC politics — Iraq could be forced to pay companies for oil they’re not producing. As the gatekeeper of the world’s third-largest oil reserves, Shahristani is hardly powerless to renegotiate these deals. Still, the contracts do surrender a remarkable degree of economic sovereignty for a government still struggling to formalize its own powers.

One dramatic expression of Iraq’s declining power over the oil giants came on Oct. 18, 2011, when ExxonMobil signed a massive exploration deal with the Kurdistan region. The move directly violated Shahristani’s policy of unitary authority. In past cases, Shahristani punished oil companies for signing with Kurdistan by blacklisting them from his contracting auctions. But now, with ExxonMobil pumping more than one-tenth of Iraq’s crude from the West Qurna Phase 1 field, the government found itself with much less leverage. (ExxonMobil has not acknowledged any contract with Kurdistan and has declined to comment, though multiple officials in the Kurdish and central governments have confirmed the deal.)

Baghdad is now left with two bad options. It could banish ExxonMobil, risk a loss of production, and probably provoke a lawsuit that would stoke the anxiety of other investors. The more likely scenario is that the federal government will seek some sort of compromise that will eventually validate some of the contracting powers Kurdistan has already claimed.

Nevertheless, Kurdistan isn’t likely to win the complete autonomy that it desires anytime soon. Baghdad continues to hold two trump cards. First, it controls the pipeline network to the Mediterranean port in Ceyhan, Turkey, through which any large-scale exports must travel. Second, it controls the sale of oil and the collection of export revenues — and therefore the flow of money from oil sales back to both Kurdistan’s budget and its contractors. Hawrami, the natural resources minister, has suggested that he wants to increase Kurdish oil exports from their current level of about 175,000 barrels per day to 1 million barrels per day within five years. For that to become a reality, he needs a deal with Maliki and Shahristani.

Indeed, a truce between Kurdistan and Baghdad could be in the works. When Maliki visited Washington in December, he met privately with Exxon CEO Rex Tillerson. One of Maliki’s advisors, speaking anonymously, confirmed to me that Maliki asked Tillerson to “freeze” the Kurdish contracts. The advisor said the government is proposing a quid pro quo: If all parties agree to a new oil law, then Baghdad will endorse a mechanism to recognize ExxonMobil’s Kurdish contracts. Maliki is essentially trying to borrow ExxonMobil’s new leverage with the Kurds, asking the company to pause its new deal in order to force the Kurds into a grand oil bargain. This could be a pragmatic solution that uses ExxonMobil’s influence with both governments to reconcile the two sides. But, assuming it would even work, this plan would transform the oil giant into one of three main parties, alongside the federal and Kurdish governments, that shape the country’s oil sector.

ExxonMobil is hardly to blame; Iraq is simply too divided to realize its potential strength.

If the state were functioning well, then politicians and technocrats would fight their battles within policymaking bodies and through private debates. On the international stage, they would speak with a single voice to the oil majors and neighboring countries. Such a unified front would help Iraq enormously. Its negotiating power would rise and likely its production too. This kind of successful policymaking would probably look something like the passionate arguments at the Alwiyah Club — and indeed, many of the speakers there pointed out that, with strong institutions and a dose of compromise, everyone would benefit.

But this isn’t how it works today. In the arena of Iraqi identity politics, leaders don’t trust each other — often for good reasons — and power looks like a zero-sum proposition. Such perceptions can be self-fulfilling. For the oil sector, the dysfunction of the government has already set projects back; ExxonMobil’s willingness to risk its relationship with Baghdad is one sign of well-informed pessimism. As we look ahead, the atmosphere of crisis and improvisation seems unlikely to break, and the outlook for Iraqi production seems uncertain at best. But in a fledgling country where everyone is still jockeying for power, this much is still clear: Oil is king.