In the shadow of Iraq

09 August 2002

When Iraq invaded Kuwait on 2 August 1990, fears were expressed that oil prices would soar over $50 a barrel. In the event, the oil price quickly settled down after a brief spike, and stayed mostly below $20 a barrel until the market surge of 2000. Twelve years on, with the question of what to do about Iraqi President Saddam Hussein back on top of the global political agenda, the likely behaviour of the oil market in response to the Baghdad effect is once more a determining factor for the future of Middle East economies.

The US administration has stated that changing the Iraqi regime is now its top foreign policy objective. That could be achieved, the most forceful advocates of this policy say, by a swift military operation this autumn or winter, followed by the installation of a successor regime that would in due course be subject to free elections. If the regime change were to be effected in this fashion, the regional political and economic fallout could be limited. The political effects would probably be most pronounced in Syria and Iran, as the US could put up regime change in Damascus as a precondition for Arab-Israeli peace, and line up Tehran as the next target in the campaign to stop the spread of weapons of mass destruction. The economic impact would be beneficial in that an Iraqi economic boom would provide new business for regional companies, but there could be a downside in that Iraq would soon be pumping a lot more oil, with the result that prices could tumble on an oversupplied market.

In the event of a US military campaign failing to engineer a swift collapse of the Iraqi regime, there would be more serious economic and political consequences. A prolonged, inconclusive military campaign would be liable to keep oil prices high, as fears about the security of Gulf oil supplies would be combined with the effects of Iraqi production being choked off. A similar outcome could be expected if the US managed to topple Saddam Hussein only to see Iraq descend into civil war, sucking in Iran, Turkey and Syria.

There are other possible outcomes. These include the avoidance of military confrontation as a result of Iraqi concessions on the issue of UN inspectors, or because of the strength of domestic and international opposition to the Bush administration's war plans.

What happens in and around Iraq is not the only issue affecting the economies of the region, or indeed the oil market. Three years of high oil prices have produced real benefits for the GCC economies, even with the lower crude production levels that have been in force for the past 12 months, and have stimulated rapid growth in the non-oil sectors of these states. However, downward pressure on prices is likely to increase over the next 18 months.

The price of Brent crude is set to average just over $24 a barrel for 2002, roughly the same as last year. Rising tensions over Iraq could result in the average for 2002 ending up closer to the 2000 figure of $28.3 a barrel. Market fundamentals suggest that prices should edge lower in 2003. The global economic slowdown means that there is unlikely to be a significant increase in demand, and pressure is mounting inside OPEC for a relaxation of the tight curbs on output. A decision on this could be reached at the next OPEC ministerial meeting, scheduled to be held in Japan in mid September. Prices will also come under pressure from increased output from Russia and West Africa.

For Middle East OPEC members, the cuts in oil output have resulted in falls in the oil component of real gross domestic product (GDP) in 2002. This has tended to be offset by strong rises in non-oil sector growth, as improved government finances have acted as a stimulant for investment. In 2003, Middle East oil exporters should see higher growth as the continued strength of the non-oil sector will be buttressed by modest increases in oil production.

In Saudi Arabia, the buoyant oil prices of the past few years have helped the government to make significant progress with its economic reform programme. This has resulted in large areas of the economy - including telecoms, electricity and water - being opened up to private investment. This in turn has contributed to growth rates of 3-4 per cent in the non-oil private sector. MEED forecasts a growth rate of 1 per cent for Saudi Arabia in 2002, rising to 3.5 per cent in 2003. The Saudi current account is expected to show a small surplus in 2002, as lower oil production will result in reduced export revenues. The surplus should increase in 2003 on the back of higher oil output, unless prices fall precipitously. There is likely to be a small budget deficit in 2002, followed by a surplus in 2003.

The Saudi economic reform programme has some key milestones to pass in the next few months. In September or October, there are plans for an initial public offering of shares in Saudi Telecom, the largest deal of its kind in the Gulf. As the offering will be aimed primarily at domestic investors, it should not be affected by the Iraqi issue. This is not the case for the Saudi gas initiative, in which the key players are ExxonMobil Corporation of the US and the Royal Dutch/Shell Group.

What are described as 'final offers' from the two companies are now under evaluation by the Saudi authorities. The companies are seeking concessions from Saudi Arabia on the level of investment returns and on access to Saudi Aramco gas reserves. Given that granting such concessions could be construed as a positive political gesture towards the US, at a time when Riyadh has made no secret of its dismay with Washington's policies on Iraq and Palestine, the chances of a breakthrough on the gas initiative appear slim, irrespective of the technical and financial issues. Failure to agree with ExxonMobil and Shell would not spell the end of Saudi Arabia's plans for major investment in gas development and utilisation. Individual power, water and petrochemical projects included in the gas initiative could be tendered separately, and foreign companies could be enlisted to invest solely in upstream gas development, supplementing investments already being made by Aramco.

The Saudi pattern is expected to be replicated, with some variations, in the other GCC states. Qatar has recorded the strongest levels of growth in the GCC in recent years, mainly because of the start of production of a series of liquefied natural gas (LNG) projects. Qatari growth has now settled down, partly because the next LNG trains will not come on stream until 2004-05, but is still being sustained by a surge of activity outside the oil and gas sectors.

Non-oil sector activity has also been the key to the exceptionally high rates of growth enjoyed by the UAE in recent years, as Dubai has cemented its position as the services centre of the Gulf. Dubai's ability to sustain its growth in the face of political adversity has already been tested during the 1990-91 crisis and amid the uncertainty that followed the 11 September attacks on the US last year. In both instances, the negative effects were short lived.

Iran's ambition to achieve the high rates of growth needed to engineer a significant improvement in living standards could be compromised by the conflict over Iraq. The Iraqi crisis has had the effect of polarising the debate within Iran about rapprochement with the West, and complicated the task of economic reformers looking to open up the Iranian economy to foreign investment. Iran is likely to record growth rates of at least 3 per cent for 2002 and 2003, but this will result in only modest gains in per capita income, given that Iran's population is growing by about 1.7 per cent a year.

The prospect of war in Iraq is also an issue of serious concern for Egypt. The country's tourism sector, a vital source of foreign exchange, has managed to struggle back to pre-11 September levels, but now faces another setback, as war in Iraq would rekindle fears about personal safety. The Egyptian economy has been in difficulties since the late 1990s as the government has grappled with the problems of an overvalued exchange rate and a runaway budget deficit.

The tourism recovery and a sharp reduction in imports have eased the pressure on Egypt's balance of payments, and the rise of the euro against the dollar has helped Egypt to defend its dollar-based exchange rate peg. However, economic growth is still being dragged down by high domestic interest rates, and a fresh external shock would create serious problems for Egypt's balance of payments.

Also vulnerable to a rise in regional tensions is Lebanon, the country with the largest debt-to-GDP ratio in the Middle East. Prime Minister Rafiq Hariri has set ambitious targets for raising privatisation revenues to reduce debt. Lebanon is now looking to start this process with the sale of two mobile phone licences. This deal will be hard to sell given the poor state of the global telecoms market. The threat of a regional conflict that could well embroil Syria will only add to the difficulties.

Political tension has rarely been absent from the modern Middle East. This has undoubtedly exacted an economic toll, but major advances have nevertheless been achieved. The latest episode in the Iraq saga will also impose some costs, but the underlying course of economic development is unlikely to be radically altered.

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