Oil & Gas: The guessing game

11 October 2002

As US President Bush pushes his case for military action against Iraq, a suspicion persists that control over oil, rather than weapons of mass destruction, lies behind his plans. There is more to this than wild conspiracy theory. Since the early days of his administration, energy security has been a central policy goal, with the dependence on a handful of Gulf producers seen as particularly harmful to US interests.

Fears of an Arab or Muslim oil embargo, while ridiculous to those who know the region, have been fuelled by deteriorating relations between the US and many Middle East states since 11 September, largely over the Palestinian issue. Even the loyalty of Saudi Arabia, long the US' staunchest ally in the Middle East, has been called into question by a hostile press. In public, a number of officials and commentators have thrown around the idea of a post-Saddam Iraq as the new bedrock of US/Middle East energy policy.

The hypothesis goes something like this: a pro-US regime rapidly rebuilds Iraqi production and export levels to the 3.5 million barrels a day (b/d) enjoyed in the glory days of the late 1970s. Soon after, Iraq announces plans to push production to about 5 million-6 million b/d. Because it cannot afford to do so alone, it opens up its fields - the second richest in the world - to international oil companies, mainly from the US. The extra oil cannot be accommodated within the OPEC quota, forcing the other members of the organisation either to rapidly reduce their own output or see the oil price collapse. Perhaps Baghdad even decides to quit OPEC, dealing the organisation a near-fatal blow.

The result: Washington wins unprecedented control over regional oil supplies, bypassing its need to consult with Saudi Arabia on matters of foreign policy and allowing it to take an even more pro-Israeli stance. OPEC is dramatically weakened. The oil market would be tight for the next year or so, followed by a period of increasing supply and falling prices that settle around $15 a barrel.

Tempting as some elements of this scenario are for US officials, it falls down in several key areas. Iraq's ability to become a world-class producer quickly is doubtful. The policy of a new government to OPEC is uncertain. And the forging of a special relationship with the US is unlikely to result in an American stranglehold over Iraqi oil.

A post-war Iraqi government will be financially constrained. And while increasing oil revenues is a priority, the cost of increasing production and export facilities will be exorbitant. Vera de Ladoucette, a senior analyst at the US' Cambridge Energy Research Associates, says that Iraqi production capacity is already falling and will take time to increase. 'Iraqi capacity is this year about 2.8 million b/d and next year it will be 2.7 million b/d,' she says. 'We think that once the situation in Iraq is stable, it will take three years to get production back to 3.5 million b/d. It would take a further two years to push production to 4.5 million b/d.'

Exports are made legally through the pipeline to Ceyhan in Turkey and by tanker from Basra. Illegal exports are also reported to be passing through the Iraqi/Syrian pipeline. In a post-sanctions era, the other main export option would be the now defunct Iraq Pipeline through Saudi Arabia (IPSA), which was opened only a few months before the 1990-91 Gulf war. The kingdom appropriated the line last year, but it is conceivable it could return it to a new government, providing - after an expensive overhaul - up to 1.6 million b/d of further export capacity.

From capability, the question moves to politics. Would Iraq stay within OPEC and how far would it press for a large share of the OPEC production quota?

While the US would have a strong hand in setting up a government, the new regime would be anxious to establish good relationships with its most powerful neighbours: Saudi Arabia and Iran, both major OPEC producers. Staying within the organisation, even at the cost of some oil exports, would reap a high dividend in regional politics. In the longer term, it could also re-establish Iraq as an OPEC lynchpin, gaining more power as field depletion weakens other producers.


To some extent, Iraq's position in the world oil markets has been exaggerated. While its reserves are second only to Saudi Arabia's, they are not significantly higher than those of Iran, Kuwait or the UAE. Based on Saudi Arabia's ratio of production to reserves, Iraq would have a case for demanding an OPEC production quota of about 3.2 million b/d, roughly in line with Iran's.

Reserves are not the only element weighed in setting quota levels. Countries with larger and poorer populations have greater output leeway than those with smaller, wealthier populations (see box). Given Iraq's development requirements after more than two decades of war and sanctions, Baghdad could even have a case for pumping around 3.5 million b/d or more.

In any case, Iraq would need to stay outside the quota system for several months after sanctions were rescinded - and OPEC would most likely accept a quota holiday while the country re-established itself. 'There would be a definite OPEC holiday,' says George Beranek, manager of market analysis at Washington-based Petroleum Finance Company (PFC). 'Any nascent Iraqi regime will need to get money badly.'

The signs are that Iraq will seek to increase its oil revenues through co-operation with OPEC, rather than in competition against it. 'Any calculation of whether Iraq will open the pumps full and keep them there as capacity is expanded needs to take into account the reactions and counter-actions of others,' says Ed Morse, executive adviser at the US' Hess Energy Trading and a senior energy official in the Clinton administration. 'Will an Iraq trying to rebuild itself readily accept the lost income a battle for market share implies and not co-operate with other producers on a new pro-rata market-sharing arrangement?'

For OPEC, the question is how to reintegrate stable Iraqi production into a market where instability has boosted other members' revenues. At its 19 September Osaka meeting, the organisation decided to roll over production levels even though the oil price was pushing the upper limit of its preferred price band, set at $22-28 a barrel.

While the decision was ostensibly made on the basis of market fundamentals, it also indicated an eye on events in Baghdad. Iraqi exports are rising in advance of a potential attack - partly as a further discouragement to action - and would rise again after one. Keeping production steady means Iraqi increases will be mopped up by rising demand growth, put at 1.1 million b/d in 2003, while the remainder will be accounted for by non-OPEC increases.

Quota compliance has steadily diminished over the course of the year, culminating in August with overproduction of 1.9 million b/d. With the oil price so high, the organisation can afford to be lax, partly in the knowledge that it can tighten up if Iraqi exports recover (see figures 3 & 4).

But while dealing with increasing Iraqi supplies was one area of discussion in Osaka, it was easily eclipsed by the question of compensating for a halt in Iraqi exports. OPEC has about 5 million b/d of spare capacity, easily enough to cover the loss of Iraqi crude. It has also proved over the past two years that it can provide extra oil during short-lived Iraqi export moratoria in June 2001 and April 2002.

Reassurance is the name of the game. Saudi Arabian Petroleum & Mineral Resources Minister Ali Naimi went so far as to assert the kingdom would increase production alone if other producers put political opposition to US action above market stability. 'We really like to work with consensus if we can,' he told reporters in Osaka. 'But we feel we have a responsibility if we see a strong reluctance to do what we believe is moderate and right. OPEC will continue to play an important role in this balancing act of trying to maintain stable oil markets at a reasonable price and equilibrium in supply and demand.'

The organisation now has other matters to address. If the political tension remains, the oil price could stay above the OPEC target ceiling for some time. According to its 2000 agreement, the organisation has an established mechanism to alter production by 500,000 b/d if the oil price stays outside the price band for 20 consecutive days. The question is whether it will implement this policy.

'The OPEC price band deals with real market situations - with equilibrium of supply and demand,' said Naimi. 'If the disequilibrium is for some other reason, such as a premium for war, then there is no benefit in putting additional oil on the market. The whole idea of the band and the trigger mechanism is to keep supply and demand in balance.'

So far, so clear. However, on 1 October, Indonesia's Oil Minister Purnomo Yusgiantoro implied that the kingdom was tilting the other way. 'If the oil price rises above $28 a barrel for 20 days, OPEC will add production,' he said. 'Saudi Arabia is ready for that.'

Iraq is dominating both headlines and discussion among oil producers and consumers. But given the meagre quantity of exports so far this year, and in view of future capacity and political constraints, it will have a less profound impact on the market than many believe.


The effect of the political situation on the world economy will have a more durable effect on the oil market. While a global recovery is still forecast, it could be thrown off course by war. If the war proved quick and relatively painless, the economic impact could be minimal or even positive. If the war was drawn out and contained nasty surprises, the knocks to confidence could cause the second dip in a double recession.

There lies the danger for the market. Global demand, so poor throughout late 2001 and early 2002, could be damaged again, creating a surfeit of oil as non-OPEC producers continue to increase output. The price consequences for producers could be painful, particularly in view of OPEC's already restrictive quota, market share concerns and rising Iraqi output.

For now, the market seems relatively unconcerned. The main fixture for the coming quarters, as it was for the last, is volatility. A glance at analysts' price forecasts shows a high degree of agreement on oil prices in the fourth quarter, matched only by a high level of disagreement over 2003 average prices (see figure 6).

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