In October, following a referendum on independence for Kurdistan, central government forces seized oil fields near Kirkuk and cut in half the oil production controlled by the Kurdistan Regional Government. When combined with a continued stalemate over resumption of the pre-2014 revenue-sharing framework, the reduction in KRG oil revenue left the KRG unable to pay the public-sector salaries that are the linchpin of the regional economy.

Contention over oil has roiled Baghdad’s relationship with the Kurdistan Regional Government for a decade, long before Kurdish fighters blocked ISIS from taking Kirkuk in 2014 and simultaneously gained control of the nearby oil fields. Both governments are almost completely dependent on oil: in 2016 oil accounted for 85 percent of central government revenue, and the KRG is directly or indirectly just as oil-dependent.

The oil conflict is layered and complicated. To reach a long-term solution, the two sides will have to negotiate to find compromises on the two key areas of dispute: the extent of KRG autonomy in oil policy and the terms of the central government’s revenue-sharing with the KRG within the national budget. Some of the complications include:

Customers and Creditors: The KRG has pre-sold its oil production to oil trading companies and to Rosneft of Russia, which in 2017 prepaid for future Kurdistani output. The KRG’s contracted commitments to deliver oil that has already been paid for will complicate negotiations: Baghdad’s insistence that all oil exports be sold through the Iraqi state oil marketing company risks provoking these powerful players in the international markets.

Pipeline Through Turkey: Oil from the Kurdistan Region and Kirkuk is exported to world markets via a pipeline through Turkey, giving Ankara a potential lever to curb Kurdish nationalism in Iraq. Given that the only functioning conduit for exports from the Kirkuk fields runs through the Kurdistan Region, the KRG in theory should have some leverage over Baghdad. However, to reduce that potential influence, the Iraq Oil Ministry has chosen to forego use of the pipeline, selling only what it can truck—very inefficiently—to Iran.  

Clash of Contracts: Another contentious issue will be the treatment of the foreign oil companies operating in the Kurdistan Region. Baghdad only permits technical service contracts, under which the oil company acts as a service provider and is paid a fee per barrel of oil produced. The Kurdistan Region pursued a different course, signing production-sharing contracts that provide more of an upside incentive for the operating company to increase production. Baghdad opposes the KRG’s approach on philosophical grounds but also argues that the KRG lacked the authority to even sign contracts without Baghdad’s approval. If Baghdad were to nullify the KRG contracts, however, it would damage Iraq’s business climate just when Baghdad is keen to attract private sector investment for post-ISIS reconstruction.

With the central government’s resumption of control over the Bai Hassan and Avana fields near Kirkuk, the remaining oil fields under KRG control produced over 300,000 barrels a day in December. This is roughly half what the KRG controlled until October 2017 when, following the KRG’s pro-independence referendum, Iraqi forces moved into Kirkuk. At recent oil prices, the newly reduced level of KRG production would yield about $500 million in gross revenue each month. However, the net revenue that accrues to the KRG after reimbursements to oil companies for their costs is considerably less.

Battle of the Budget: Baghdad and the KRG are locked in a dispute over population figures that have long been used to determine how much of the national budget the Region will get. The amount transferred to the KRG depends, to begin with, on the Kurdistan Region’s share of Iraq’s population. That was estimated at about 17 percent in 2005. The proposed 2018 budget attributes only 12.7 percent of the population to the region, a figure that has angered Kurds. Prior to 2014, the net transfer to the KRG – after deductions for a variety of “sovereign expenditures”— was about 11 or 12 percent of total Iraqi government spending, compared with about 6 percent in the budget now under consideration. Whatever figure for the transfer is ultimately agreed upon, it is desperately needed by the KRG: In 2014, amid collapsing oil prices and Baghdad-KRG acrimony, Baghdad suspended the transfer entirely, making revenue from the Kirkuk fields a lifeline for the KRG.

Reconstruction Funding: The Kurdistan-related fiscal issues are only one of the central government’s budgetary challenges; viewed as a whole, it is clear that Baghdad has powerful incentives to transfer as little money as possible to the KRG. To encourage funding from donors and investors at a mid-February reconstruction conference in Kuwait, the Iraqi parliament needs to pass the 2018 budget that should unlock approval from the International Monetary Fund (IMF) board for another review under Iraq’s IMF program. Although oil prices helpfully rose in recent months, fiscal austerity remains the core IMF requirement at a time when the government faces high costs of post-ISIS security, as well as massive humanitarian, stabilization, and reconstruction needs. Foreign sources are unlikely, even in the best case, to cover more than a fraction of the estimated $100 billion reconstruction bill. Meanwhile, parliamentary elections in May will only add to spending pressures and the temptation to cut the transfer to the KRG. The only counterweights to the prime minister taking a hard line with the KRG are international pressure and the political incentive of the potential of getting Kurdish parties to join in forming a post-election government.

Baghdad Inches Towards Paying KRG Civil Servants

Even before the loss of the Kirkuk fields, the KRG could only manage partial payments to KRG employees. The public sector is estimated to account for about half of total employment in the Region; it is the primary driver of the Region’s economy.

Given the delays in passing a budget and the difficulties in agreeing on the size of any transfer to the KRG, Prime Minister Haider al-Abadi has expressed a willingness to pay KRG civil servant salaries to mitigate the hardships in the Kurdistan Region. But Baghdad will only pay after auditing the KRG’s payrolls. The central government has slowly begun to make payments, starting at the end of December, with officials who work at the KRG’s water facilities. Baghdad and Erbil are currently negotiating payments to cover the much larger workforce in the KRG’s Heath and Education ministries. The speed with which Baghdad moves to make payments to public employees in Kurdistan will be a key factor in determining the severity of the Region’s economic crisis and could set the stage for wider accommodations in the future.