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Given the U.S.'s deployment earlier this month of an aircraft carrier battle group to the Persian Gulf and comments that it may send up to 120,000 troops to the Middle East to deal with any untoward action by Iran, Tehran has been busy trying to build safety buffers through its allies. Having put in place a strategy to try to exploit existing divisions between the U.S. and Europe, Iran has now reached an agreement with the Federal Government of Iraq in Baghdad to expand co-operation between the two countries in the economically vital oil sector, including, critically, the sale of Iranian oil under the guise of Iraqi oil. This trick was first used when the last full-scale international sanctions were ramped up in 2012 but the scope of the new deal far outstrips that arrangement. On the face of it, the most obvious signal of this is the plan announced by National Iranian Oil Company (NIOC) director, Ramin Gholampour Dezfouli, last week for the state oil giant to open a representative office in Baghdad. The official line from Iraq's Oil Ministry is that: "The role of [the representative] office will be limited to technical and engineering services, such as establishing pipelines and engineering equipment, which Iraq favours given their very low prices...It will not involve oil trade." Oil Ministry spokesman, Hamza Jawahiri, however, did say that the office would also allow for joint organisational work to be done on the 12 fields that Iran shares with Iraq - some of the world's largest oil reservoirs - and that this type of co-operation is not strictly prohibited under the sanctions that the U.S. re-imposed on Iran late last year.  

The reality of the deal agreed between Iran and Iraq, though, runs much deeper. The immediate focus of the co-operation on shared fields will be the huge reservoirs of Azadegan (Iran side)/Majnoon (Iraq side), Azar/Badra, Yadavaran/Sinbad, and Dehloran/Abu Ghurab - a senior oil industry source who works closely with Iran's Petroleum Ministry exclusively told OilPrice.com last week. The first of these will be South Azadegan, across which the National Iranian Drilling Company announced earlier this month it will drill another 23 wells by the end of the 2020 Iranian calendar year (ending on 20 March). This will add to the 19 wells that it has already completed that are being readied for oil production by Iran's Petroleum Engineering and Development Company.

There are three reasons why South Azadegan has been chosen as the first focus of the new turbo-charged co-operation deal between Iran and Iraq. From the Iraqi side, more work needs to be done to bolster its side of the reservoir, the supergiant Majnoon field, which narrowly avoided catastrophic damage due to floods in March. The second reason is that for Iran the field has symbolic value in that an understanding had been reached with Total that the French oil giant would develop the field after it had made significant progress on Phase 11 of the supergiant South Pars natural gas field (SP11). Total's withdrawal from SP11 and from the corollary gentlemen's agreement that it would develop South Azadegan was the first tangible sign that the Joint Comprehensive Plan of Action (JCPOA) would be undermined by the U.S.

Related: The Beginning Of The End For British Shale Gas The final reason is that it is a key field in the West Karoun group of oilfields, the economic importance of which to Iran - especially in current circumstances - can barely be overstated. The West Karoun fields - also comprising North Azadegan, North Yaran, South Yaran, and Yadavaran - are conservatively estimated to contain at least 67 billion barrels of oil in place and, even more propitiously, have an average recovery rate of just 5-6%. This compares to average recovery rate across Saudi Arabia of at least 50%. "For every one percent increase in the average rate of recovery across West Karoun, the recoverable reserves figure would increase by 670 million barrels, or around US$34 billion in revenues with oil even at US$50 a barrel," the oil source told OilPrice.com. "With the right joint development, an increase in recovery rate across the site to at least 25% over a 20 year contract period could be expected to add US$838 billion in revenues for Iran, he added. Currently, West Karoun's oil output averages 355,000 to 360,000 barrels per day (bpd), with spikes to 380,000 bpd, compared to 120,000 bpd in 2017, according to the Iran source. Of this, South Azadegan is currently producing around 100,000 bpd.

For Iraq as well, the economic benefit is clear. For a long time, there has been growing concern on the Iraq side that Iran has been pursuing a zero-sum game policy in exploiting its part of the shared fields as fears of re-imposed U.S. sanctions mounted, including extensive slant drilling. In addition, Iraq in part blamed the recent flooding around Majnoon on the structural damage done to the area by the erosion of subsoil across over one million hectares of forest and brushland by Iran's Islamic Revolutionary Guard Corps (IRGC) as a result of its building programmes. Iraq also believes that it was made worse by the redirection of many of the natural water flows through the building of dams and by Iran's irrigation systems that have been sending clean and wastewater into Iraq for decades.

The key corollary part of the co-operation agreement - which relates to joint pricing and marketing - is also going to be of huge monetary benefit for Iran, whilst bolstering Iraq's burgeoning status as a top five global oil player. At the most basic level, from Iran's side, the increased co-operation on shared fields means that it will be impossible for U.S. monitoring organisations to distinguish - and thus sanction - Iranian oil flows from Iraqi oil flows when both originate from the same field. This then will allow Iranian oil - rebranded as Iraqi oil - to make its way unfettered through Iraq's extensive export channels. This includes China, previously one of Iran's biggest customers and a customer that is desperate to continue importing its oil.

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"Previously, the trick involved Iranian oil arriving at various points along the Iraq border in unmarked trucks, which were then loaded into Iraqi trucks, and sold unhindered as Iraqi oil, but this tactic is much more effective, as the volumes can be exponentially higher," a senior legal source in Geneva told OilPrice.com. "Even if you knew what was going on - which everyone senior in the oil industry did, including the U.S. - it was impossible to prove," he added. "Effectively, this means that a vast proportion of all Iran's oil can be shipped to wherever Iraq oil is welcome, which is every major export destination in the world," he underlined.

The benefits of joint pricing mechanisms are also enormous. Currently, Iran has no choice because of the sanctions but to sell its oil - including from the shared fields - at massively reduced pricing that is comprised of its official selling price (OSP) minus the sanctions discount minus the incremental risk discount. This has resulted in Iran offering 'cost, insurance, and freight' cargoes for 'free on board' pricing, with the difference between the two covered by Iran. "Under this new agreement, Iranian oil from these shared fields will be sold based on Iraq's much higher three month moving average OSP pricing for cargoes, with no discounts at all, and the three month moving average for the effective spot market that Iraq has created and now controls," said the oil source.

"In sum, this agreement means that Iran will be able to generate twenty to thirty percent more in U.S. dollar terms for the oil from these shared fields than it can from the oil it has to sell sourced from non-shared fields that it can't redirect to the shared field flows," he underlined. At the same time, he concluded, Iraq will be able to bolster its presence in the oil trading markets by effectively controlling the price of more oil flowing into the markets and to safeguard its own oil flows from the shared fields. This will give it more chance of achieving the oil ministry's production targets - 6.2 million bpd by 2021 and 9 million bpd by 2023 - closer to the target dates.  

The key political change that has occurred to enable this co-operation agreement is the pragmatic policy being implemented by Iraq's effective ruler, Moqtada al-Sadr. The head of the leading power bloc in the country (Sairoon, 'Marching Towards Reform'), al-Sadr and his close advisers determine the policies that are then fronted for international consumption by the nominal prime minister, Adil Abdul-Mahdi. "The main principle is an ultranationalist one that Iraq should not be controlled by any one country," said the oil source. "In practical terms, it means that Iraq has reached agreements in the past few weeks with companies from the U.S,, China, Iran, and Russia, to undertake various projects in the country, aimed at clearly demonstrating to each of them that Iraq will deal with whichever partners it wants," he concluded.

By Simon Watkins for Oilprice.com

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Simon Watkins

Simon Watkins is a former senior FX trader and salesman, financial journalist, and best-selling author. He was Head of Forex Institutional Sales and Trading for… More