Shell Moves Forward on Southern Flared Gas Project

UNCLAS SECTION 01 OF 03 BAGHDAD 000955 SIPDIS SENSITIVE AIDAC STATE ALSO FOR EEB AND NEA/I E.O. 12958: N/A TAGS: EPET EAID EINV PGOV IZ SUBJECT: Shell Moves Forward on Southern Flared Gas Project REF: A. Baghdad 90 ¶B. 08 Baghdad 3101 ¶C. 08 Basrah 84 ¶D. 08 Baghdad 2891 Sensitive but unclassified; contains business proprietary information. Please protect accordingly. ¶1. (SBU) Summary: Although the media trumpeted news of the September 22, 2008, signing ceremony to end flaring of associated natural gas from southern oil fields, Shell and the South Gas Company only signed a heads of agreement commitment to form a joint venture to execute the 25-year project. Since then, Shell and Ministry of Oil, including South Gas Company, representatives have been negotiating earnestly on details of the joint venture contract. During an April 2 meeting, Shell executives foresaw no real hurdles to forming the joint venture by year's end, other than the magnitude of the necessary preparations and shortage of time. Ernst and Young will conduct an asset valuation of existing gas processing infrastructure by the end of May. In the meantime, Shell has spent $100-150 million to upgrade existing facilities and provided a grant to two Basrah vocational training institutes. End Summary. Gas Joint Venture Plans -------------- ¶2. (SBU) During an April 2 meeting with Oil Minister Shahristani, Deputy Minister Ahmad al-Shamma told EMIN Wall that Ministry of Oil (MoO) negotiations with Shell to form a joint venture to end flaring of associated natural gas from Iraq's southern oil fields were proceeding satisfactorily. The two sides had drawn up a short list of three companies and then selected Ernst and Young to conduct an appraisal of current South Gas Company (SGC) gas processing facilities to determine the value of the infrastructure that SGC would be contributing for its 51% share of a joint venture (JV) with Shell. Later on April 2, Energy and Infrastructure Team Leader met with three Shell executives to confirm the information and obtain an update on the progress of negotiations. ¶3. (U) The Shell executives, based in Dubai, with whom we met were Shell Gas and Power Vice President Mounir Bouaziz (leading the negotiations for Shell),Shell Exploration and Production logistics manager Ayman al-Shukr, and security specialist James Youston. In addition to Ministry of Oil (MoO) and South Gas Company (SGC),they met with Deputy Prime Minister Barham Salih, and the Minister of Transportation, the UK Ambassador, and MNF-I's Deputy Commanding General (DCG) during their Baghdad stay. Next Step -- Asset Evaluation -------------- ¶4. (SBU) Bouaziz stressed the enormity of the task that Shell and South Gas Company (SGC) confront in forming the joint venture, but was confident that Ernst and Young could finish the asset valuation on time, i.e., by the end of May. The process was familiar to the firm, which provides similar services regularly for other mergers and acquisitions. Ernst and Young's experts would establish the current market price to replace SGC's facilities and then depreciate the replacement value based on the facility's age. The several dozen gas oil separation plants (GOSP) would have a standard configuration, but Ernst and Young's engineers would need to make visits to evaluate the actual equipment and condition of the Khor al-Zubair natural gas liquids (NGL) and the North Rumaila NGL plants. ¶5. (SBU) Bouaziz remarked that he wanted the evaluation process, which would be part of SGC's investment in the JV for its 51% share, to be as transparent as possible. He was frankly concerned that the Qto be as transparent as possible. He was frankly concerned that the valuation would be low, requiring the MoO to make a large cash payment, since the facilities were in poor condition. Gas that was supposed to be compressed to 40 bar was only at 17 bar. (Note: A bar is a metric pressure measurement that equals approximately 14.5 pounds per square inch, psi, which is approximately one atmosphere.) The SGC's recent purchase of GE turbines for gas compression, however, could boost the valuation. Timeline -------------- ¶6. (SBU) Bouaziz wryly remarked that Iraqis are still novices with regard to international business deals, but are learning how to deal with international oil companies such as his own. Shell was conscious, however, that any deal too lopsided in its favor would not survive for long. Shell had actually provided six MoO employees BAGHDAD 00000955 002 OF 003 drawn from various parts of the Ministry with their own laptops gratis, and taught them to operate analytical software to be used to assess the financial impact of differing terms and pricing. The program had helped the MoO officials to learn such concepts as net present value and internal rate of return, which had been unknown to them, Bouaziz commented. ¶7. (SBU) Bouaziz said Shell was now in the process of hiring a local Iraqi lawyer to register the new JV. In addition to asset valuation, Shell and MoO were continuing with defining the project and setting a work timeline. Shell was pushing for submission of a detailed JV proposal to the Cabinet (Council of Ministers) by the end of June, with the idea of getting final approval well before Iraq's national elections. The proposal would include the Shareholder Agreement, the South Gas Development Agreement, and a pricing mechanism. Even with the JV agreement signed, however, Bouaziz said there would be a transition period of six months to a year, with the JV taking full control no later than the end of 2010. Shell, however, would make necessary investments in accordance with the JV plan once the JV agreement was concluded. Planned Management Structure -------------- ¶8. (SBU) An Executive Committee, which Bouaziz compared to a board of directors, would make key operational decisions regarding the JV and could include other investors, such as Mitsubishi, should Mitsubishi become a future partner. Shell was also proposing the formation of a National Gas Council, since Iraq has no gas regulatory authority. The National Gas Council would count among its members representatives of the Ministries of Electricity, Interior, Planning, and Finance, and would have the final decision authority on matters such as gas pricing. In addition, a Corporate Social Responsibility Advisory Board would be formed outside the formal JV structure. Shell's Lobbying Efforts -------------- ¶9. (SBU) Bouaziz said he and his colleagues had intensified their public relations efforts, with Bouaziz appearing for an interview on an Iraqi news program. While Parliament would not need to approve the actual JV agreement, one of the three MoO members on the Shell-MoO joint management committee to form the JV had briefed the Oil and Gas Committee during a three-hour formal session. The MoO official had found the Oil and Gas Committee members generally to be supportive of the flare gas deal. Shell had also engaged with local stakeholders in the Basrah area, holding two "town hall" sessions, with the participation of groups such as labor, local businessmen, civil society, and farmers. In a more direct effort to win public support, Shell had signed a contract with a U.S.-based NGO, International Relief and Development (IRD) (which is also a USAID grantee),to provide technical training through two Basrah vocational training centers. The funding allows the training centers to teach youth to install solar-powered street lighting, which would also be a permanent improvement for the community, and to refurbish a workshop. ¶10. (SBU) Bouaziz said Shell already had about 40 employees in Basrah and had spent $100-150 million on "quick win" projects described reftels, but was reaching its spending limit without certainty that the JV would be formed. The projects included installation of equipment to improve gas processing quickly, such as a compressor for the North Rumaila field, a condenser, and a slug Qa compressor for the North Rumaila field, a condenser, and a slug catcher. Of note, Shell would start construction of a 50MW power plant at the Khor al-Zubair NGL plant, with construction to begin the second half of 2009, which would start the process of taking SGC facilities off the national power grid. Joint Venture Operations -------------- ¶11. (SBU) Once the JV was formed and operational, Bouaziz noted, SGC would become a holding company. The JV would purchase gas from upstream operators (comment: presently South Oil Company and North Oil Company, but potentially also the JVs formed as a result of first bid round contracts) and then process the gas for sale to domestic consumers or for export. The new JV Basrah Gas Company would repair existing assets, build new ones, carry out gas processing operations, and be responsible for training and development of JV personnel. Bouaziz said he was careful to discuss pricing in terms of market pricing, and not international pricing, since natural gas prices vary from market to market. Shell recommended that natural gas be priced at the equivalent cost per BAGHDAD 00000955 003 OF 003 BTU (caloric content) of the most readily available alternative fuel, which, in Iraq's case, would be heavy fuel oil. This would be half the average cost of natural gas in the European Union or North America, which incorporates an additional transportation cost. Benefits to Iraq: JV Revenue -------------- ¶12. (SBU) Bouaziz observed that Iraq, with its massive plan to increase electric power generation, has a pressing need for the additional dry gas that the JV would provide, but that the JV would also produce additional natural gas liquids (NGL),including liquefied petroleum gas (LPG) (primarily propane and butane). Additional LPG production would allow Iraq to reduce its LPG imports, now at 4,000 tons per day. Bouaziz noted that the direct financial benefit to Iraq would be Shell's 15% corporate tax payments, SGC's 51% share of JV revenue, and feed gas payments to the MoO upstream operating companies, less operating expenses. He also said that Iraqi gas is rich in pentane, an important feedstock for the production of polystyrene. The pentane component of the NGL would be an important industrial resource. Comment: Meeting Energy Needs While Reducing Environmental Damage -------------- ¶13. (U) For all the reasons that Bouaziz noted, the formation of Basrah Gas Company will be an important milestone for Iraq. Halting the damage to the environment alone would make this an urgent task. In addition, however, the 700 million standard cubic feet per day of gas being flared from southern oil fields contains enough energy to produce 3,500 megawatts of electricity, more than half of Iraq's current production. Butenis