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Title: Economist.com | Iraq's oil
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Iraq's oil

Don't mention the O-word
Sep 12th 2002
From The Economist print edition


Reuters
Reuters


If America goes to war against Iraq, what will become of all that oil?

Get article background

AMERICA'S chief interest in going after Iraq's president, Saddam Hussein, is doubtless to save the world from his actual or potential weapons of mass destruction. Another large consideration, secondary as it may be, has attracted less attention than it should have: the effects that would follow from the opening up of the country's enormous reserves of oil.

Iraq's reserves are the second-biggest in the world, after Saudi Arabia's (see table). At present, thanks to UN sanctions and Mr Hussein's attempts to evade them, the country is producing a fraction of its potential. If it were to produce oil at a rate to match its reserves, say some geopolitical strategists, it could end Saudi Arabia's domination of world oil markets.

That would not come too soon for the United States. America is by far the world's biggest oil-user, burning up a quarter of the total consumed. Its imports have risen in recent years, to more than half its total consumption. Since Saudi Arabia is the chief supplier of those imports, successive American presidents have gone to great lengths to cultivate the unsavoury and dictatorial House of Saud. They have also tolerated Saudi Arabia's command of the Organisation of Petroleum Exporting Countries (OPEC), which keeps oil prices much higher than they would be if market forces prevailed. Now America's leaders increasingly feel—as Winston Churchill remarked of converting the British fleet from coal to petroleum before the first world war—that “safety and certainty in oil lie in variety, and variety alone.”

In hopes of finding such variety, George Bush is now changing American policy. He has openly embraced Vladimir Putin's goal of expanding Russia's oil industry, with talk of increased exports and a big ministerial conference on energy planned for Houston in October. Another opportunity, openly acknowledged or not, is the present showdown with Iraq. Rumours of war are likely to dominate the meeting of OPEC ministers on September 19th in Osaka, in Japan.


Conventional wisdom says war drums are good news for OPEC and the Saudis today, but bad news in the longer term. Talk of war always heats up the oil price, giving producers an instant windfall. Yet tomorrow, if America succeeds in toppling the bully-boy of Baghdad, the world could be awash in Iraqi oil. Look closer, and matters are more complicated.

In the short term, jittery traders are already handing oil producers a handsome windfall profit. Last week, on ill-founded rumours of a huge air strike by American and British planes in western Iraq, prices shot to their highest level in a year, passing $30 a barrel for West Texas Intermediate, America's benchmark crude. Daniel Yergin, head of Cambridge Energy Research Associates (CERA), an industry consultancy, estimates that the “fear premium” on each barrel of oil is now $3-5.

As war gets closer, prices seem bound to go higher. During the Gulf war, a decade ago, prices spiked past $40 a barrel in nominal terms. Phillip Ellis of the Boston Consulting Group, who has analysed the history of oil shocks and their impact on prices, argues that prices fall into two ranges. The peace curve, as he calls it, “forms around an average of about $22-24 in today's money. The war curve forms around a price north of $50.”

Some would put it higher. Sheikh Zaki Yamani, Saudi Arabia's oil minister during the shocks of the 1970s, gave warning last week that if America invades Iraq, Mr Hussein could attack Saudi Arabia and Kuwait and so send oil prices to $100 a barrel. Iraq's vice-president, Taha Yassin Ramadan, stirred the pot further this week by goading fellow Arabs to strike American targets in the Middle East if Iraq is attacked.

High prices are clearly a nightmare for consumers. Paradoxically, and here is where the complications begin, they are bad news for producers, too. Prices much above Mr Ellis's “normal” range act as a brake on economic growth. There are signs of this happening already, especially in Asia. Some economists worry about an oil-induced global downturn. As the earlier oil shocks have taught OPEC, prolonged periods of high prices only kill the goose that lays the golden egg.

Another reason why sky-high prices are bad for OPEC, and especially for Saudi Arabia, is that they spur oil production from uneconomic places. In a genuinely free market, most of the world's oil would be produced by Saudi Arabia and its neighbours, where the cost of exploration and production is a dollar or two a barrel. In contrast, trying to force drills through rocks in the Arctic or beneath deep water can heap up costs to $10-12 a barrel.


Because OPEC's “price-defence” strategy has kept prices above $18 a barrel for three years, argues the Petroleum Finance Company (PFC), an industry consultancy, projects in non-OPEC regions—the frozen wilds of Russia, the turbulent Caspian basin, the deep waters of the Gulf of Mexico—have attracted many billions of dollars in investment. High prices have already inspired the development of 2.6m barrels per day (bpd) of non-cartel oil, besides investment in projects that promise to deliver another 5.2m bpd from alternative sources by 2008. This new supply, says the PFC, “has and will continue to eat up all the increase in global demand, leaving OPEC no room to expand its own output and making the cartel's price-defence strategy increasingly difficult to maintain.”

However, the pain is not equally shared among cartel members. It is felt mostly by Saudi Arabia, the self-appointed “swing” producer. That is because higher prices have also encouraged some of the smaller fry in the cartel, such as Nigeria, Algeria and Libya, to develop new production capacity and to bypass existing production quotas set by OPEC. John Mitchell, an energy analyst at Britain's Royal Institute of International Affairs, offers a more fundamental reason to suppose that the cartel's “aggressive collusion” will not endure: the ratio of production to reserves varies greatly among cartel members, and so the incentive to increase output rather than keep it flat also varies greatly.

The result, according to estimates by Deutsche Bank, is that new supply could outstrip expected demand by as much as 1m barrels a day by 2004. The only country that has historically been willing to reduce its own output—and revenue—by such a large volume to “balance” the market and prevent a price collapse is Saudi Arabia.

Reuters
Reuters

With years of graft and heaps of money, they may be a force again

All this explains why Saudi Arabia has long advocated a moderate stance on prices. Yet when ministers meet in Osaka next week, they face a dilemma. Thanks to fears about war with Iraq, prices are high and the markets are anxious. Winter is on the way, and with it a seasonal upturn in demand for oil. On September 11th the International Energy Agency (IEA), a quasi-governmental watchdog set up by the world's biggest oil consumers, said that stocks of crude were “uncomfortably low” going into the winter, and the whole situation “every bit as precarious” as in 1999, before a notably volatile spell for oil prices.

This being so, the Saudis might argue at Osaka for a modest increase in quotas. On the other hand, as Venezuela and Iran point out, the greatest risk facing the cartel is not high prices but a price collapse. That could happen if OPEC releases oil into a weakening global economy. It did precisely that in the run-up to the Asian economic crisis a few years ago, and oil prices fell to around $10 a barrel.

Even if Saudi Arabia somehow smooths over the meeting in Osaka, some argue, the longer-term picture for the cartel is bleak. The expulsion of Mr Hussein, which looks likelier than not, could turn the oil market upside down. This is because Iraq, with its vast reserves, is the only country that could challenge the Saudis by throwing open the taps.

If a post-Saddam regime did that, Saudi Arabia's strategy of keeping OPEC prices between $22 and $28 a barrel would be under threat. If the flood of Iraqi oil continued indefinitely, goes the argument, the Saudis would have no choice but to abandon price (and, with it, their allies in OPEC with higher costs and smaller reserves) and go for volume instead. Though politically difficult, that need not be economic folly: Deutsche Bank calculates that Saudi Arabia could maintain oil revenues at $60 billion or so either by producing 6m bpd at around $30 a barrel, or by cranking out 10m bpd at about $17 a barrel.

Will the flood of Iraqi oil occur? It is possible. Any future government in Iraq, needing vast amounts of money to rebuild the country, will try to expand the oil sector as fast as it can. At least some oil executives believe that this bonanza could draw much foreign capital into Iraqi oil production. Even if the new government did not break ties with OPEC, as the United States might like, it would probably argue—bearing in mind the years of UN supervision of its oil exports—for a lengthy exemption from quotas.


It might seem, then, that knocking out Mr Hussein would kill two birds with one stone: a dangerous dictator would be gone, and with him would go the cartel that for years has manipulated prices, engineered embargoes and otherwise harmed consumers. Yet several factors suggest that the transition to a post-Saddam oil world will be messy—and that such a world could still have a forceful OPEC in it.

Consider again Sheikh Yamani's fear: that Mr Hussein, in a desperate last act, may attack the Saudi and Kuwaiti oil infrastructure and bring the global economy to a halt. The oilfields could be set ablaze, as they were during the Gulf war. Refineries and terminals could be contaminated with radioactive or biological agents. With help from outsiders, Mr Hussein might be able to shut down shipping lanes such as those in the Straits of Hormuz, preventing Saudi Arabia from getting its oil to market.

On balance, though, the risks of a prolonged physical disruption seem small. One senior European oilman insists that it would be very difficult to engineer a complete shutdown of all Middle Eastern oil: “That's a bit like thinking you could shut down all North Sea production by firing SCUD missiles from Germany.” CERA's Mr Yergin says it is difficult to target all the oilfields, pipelines and export terminals that matter in the area. Saudi Arabia has plenty of spare capacity and transport options for its oil; besides, pipelines are pretty quickly patched up.

The world also holds emergency stocks of oil much bigger than those it held back in the 1970s. These should not inspire complacency; as the chart shows, they cover only a few weeks of disruption, and a prolonged war could still mean disaster. Yet the world at least has the IEA, monitoring oil markets and emergency stocks and engaging OPEC in “consumer-producer dialogues” (another one will take place in Osaka next week) to encourage stable prices. If oil supplies are suddenly threatened, as Robert Priddle, the IEA's boss, explains, governments have even given him the extraordinary power to release oil stocks unilaterally.

Fears of a physical disruption to supply are therefore overblown. More worrying, however, is the possibility that Saudi Arabia will decide it does not want to get extra oil to market. Historically, the Saudis have always acted as the market's guarantor of last resort. During the Iran-Iraq war, for example, they stepped into the breach and increased output to smooth prices. As they intentionally keep a whopping 3m bpd or so of spare capacity to hand, their country alone can easily compensate for the loss of Iraq's current output.

But the Saudis do not like the way the Bush administration is setting about Iraq. The regime also faces great anger on the “street” for its cosiness with the American government. Add to that the Saud dynasty's precarious grip on power, and the ruling family might find it politically impossible to crank up production to help the Americans. The result could be chaos in the world markets, and OPEC left firmly in control.

Another reason to doubt that an invasion would kill off OPEC is the state of Iraq's oil infrastructure. Thanks to a dozen years of UN sanctions, and many more years of mismanagement and over-exploitation, the country's petroleum industry is in pitiful shape. Even in its best times, the country produced only 3m-3.5m bpd: a third of Saudi Arabia's peak and half of Russia's. As one American oil executive says, “Under the very best scenario, Iraq might manage that peak again.” To do better, the country would need massive investment from the world oil industry.


That, says the same senior oilman, will be slow in coming until companies are sure that the new regime will be stable and will respect the rule of law. Realistically, experts say, it will take Iraq perhaps five years of hard work, western know-how and big money to turn its oil industry into a serious force again. CERA puts it bluntly: Iraqi output can only increase from today's low levels, but that does not mean “a massive, rapid increase in production that will depress prices, displace other Gulf producers and render OPEC impotent.”

In short, a “regime change” of the sort that Mr Bush has in mind for Iraq might rewrite all the rules of the oil game—on paper. The president's new friendship with Mr Putin also heralds an important change in the geopolitics of energy. In practice, however, the second Bush to take on Mr Hussein will probably be long gone from the White House before the oil markets are transformed by Iraqi oil. Don't write off Saudi Arabia, or OPEC, just yet.









Why Iraq's oil exports are collapsing
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Life in Iraq
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Iraq's arsenal
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Mr Bush's UN speech
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Country Briefing: Iraq, United States

More about...

Iraq and the UN

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The US Energy Association publishes details of its “US-Russia Commercial Energy Summit”. See also OPEC, Cambridge Energy Research Associates, the Petroleum Finance Company, the Royal Institute of International Affairs and the International Energy Agency.




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