Chartered Financial Analyst May 2003
Prognosis ofPost-war Era
A fter SaudiArabia in the Middle East, Iraqpossessesthe world’s second-largestoilreserves,estimatedat 112.5 billion barrels,or
11%of the world’s total—morethan five timesthe sizeofUSreserves.However,despitesitting prettyon suchhugereserves,thebeleagueredcountrycurrentlysuppliesonly3% of the world’s oil. The countryhasmassiveuntappedreserves;about90% remainsunexplored.Oil productioncosts areamongthe lowest,in ti~eworld, makingit anextraordinarilyprofitablesource.It also controlsnearly3.1trillion cubicmetersof naturalgastorankamongthetop 10 gaspowers,but mostof this wealthhasremaineduntapped.It is not a surprisethat thereis not an oilcompanyin the world that doesn’teyeIraq. Morethanadecadeof UN sanctionshavetakentheir toll on Iraq’s oilreservoirs.
Under the sanctions,Iraq was not assignedOPEC(Organizationfor PetroleumExporting Countries)quotaandthe oil-for-food programregulatedits exports.Underthis scheme,Iraq was allowed to sell up to 2 millionbarrelsper day,provided the revenueswereusedforhumanitarianassistanceto the Iraqi peopleand therepaymentof Iraq’swardebtsto Kuwait.
In thelast20 years,Iraq was unableto. expanditsexplorationprogrambecauseof the 1980-88 Iran-Iraqwar followed by UN sanctions,in. place since 1990.DespiteUN’s additional funds for oil spareparts,Iraqdoesnot havemodernrecoverytechniquesthat wouldallow it to raiseproduction without damagingitsreservoirs.
r!~OVER STORY
OIL
I
COVER STORY OIL: PROGNOSISOF POST-WAR ERA
On the other hand, the oilindustry by an extension—theAmerican industry; surprisinglyout of the five companiesthatdominate the world oil market,four are basedin the US andBritain. Exxon-Mobil, RoyalDutch-Shell, British Petroleum,Chevron-Texacoandthe fifth, TotalFinaElf,a French-Italiancompany.
The US outfacesany country in‘consumptionandimportsoverhalfof what it consumes,its marketmakesup a quarter of the world’sdemandfor oil. With just 3% of theworld’s population, it consumesmore than 25% of crude oil; about20 million barrelsa day,up from 15million two decadesago, roughlyequal to its share of the globaleconomy. The US economyrunson oil and in fact no othercommodity exerts as muchleverageover its financialhealth.
Going by thesefacts, it showsthe crucial role played by oilprices in the US economy. If oilpricestouch $40 a barrel andstaythere for a couple of months,theUS economy will beback to recession.Economistscalculatethat ‘ every $ 10-a-barrel oil priceincreasethat sticksfor a year reduceseconomic growth by0,5%. There is theimpact of oil pricesoutside the US.Countries such asJapan,Germany andFrance import all oftheir oil, so they arehighly vulnerable to priceincreases.
However, the InternationalMonetary Fund estimatesthata $10 a barrel rise in the priceof oil sustainedover a year—roughly what happened lastyear—reducesglobal GDP by0.6%. The impact varies from0.8% of GDP in the US, the euroarea and the d~evelopingcountries of Asia—more inmajor importers like Korea,India and Thailand.
Politics behind oilFor nearly half a century, the UShas been steadily increasinginvestmentsin the Gulf region.The investmentshave includeddirect and indirect forms ofintervention, massive armstransfers to allies and theacquisitionof military bases. Inthe wake of Iraq’s invasion ofKuwait, Iraqi and Kuwait oilsupplieswere lost and oil pricesspiked. Saudi Arabia pleasedworld oil marketsby steppingupits production close to 60% in1989-91.Following the Gulf war in1991, the US supplied SaudiArabia and allied Gulf Stateswith massiveamount of highlysophisticatedarmaments.
Though reasons behindAmerica’s presentwar against•Iraq, as the economicsuperpowerarticulates,are eliminating Iraqiweaponsof massdestruction,thecontinuationof the war on terror,andthe promotionof democracyinthe region. Critics of war suggest,
as they have alwayssaid, that the primaryobjective of the USwasnot the removalofSaddamor his allegedweapons of massdestruction,but Iraq’sprimary economicasset: Crude oilreserves.
Indeed, the USrelies on the importsto meet almost 60% ofits oil needs,a figurethat is expectedto goup in the next few
years, and Iraq’s figure beingsecondonly to SaudiArabia inuntapped oil reserves, it istemptingto dismiss the war as awar for oil.
They further add that the realreasonis an oil currencywar, topreventfurther OPEC momentumtowards the euro as an oiltransactioncurrencystandard.Toregain control over the Iraq oilmarket, which the US and Britainlost when the Iraqi Government
whether Iraq remains inOPEC.
nationalizedits oil industry in1972, is the key to maintain theirdominance over this criticaleconomicresource.Thus, the USis seekingto promote alternativesto SaudiArabia andthusgain overOPEC price setting mechanism.However, Glen Burns, Editor, INSNews, Sydney,contradicts thisview. He says,“the US oil industrywill find it difficult to reducethedominant position that SaudiArabia holds in the foreseeablefuture. They havethe bulk of theworld’s reservesand after the war,evenif the United Statesgainsadditionaloil reserves,it appearsitwon’t be enoughto challengeSaudiArabia.
Whatsoever the reasonsbehind the war, Yale University’sProf. William Nordhausfactors inthe impact on oil and the worldeconomy to reach a high-endestimateof $1.92 tn. He furtheradds, followed by the quickvictory in Iraq, the stability in theregion could lead to increasesinoil production capacity in Iraq,Iran and othercountrieswill putdownwardpressureon oil prices.
An El Dorado for the US?Once UN economicsanctionsonIraq are lifted, the questionwhich
The effects of regimechange on world oil marketswill depend very heavily on
Justin Wolfers andEric ZitzewitzAssistant Professors ofEconomicsStanford Business SchoolUS
If oil prices touch$40 a barrel andstay there for a
couple ofmonths, the USeconomy will be
back torecession
Chartered Financial Analyst - May 2003
COVER STORY OIL Pf~OGNOSISOF POST-WAR ERA
-would emergeis, who will controlIraq’s vast oil reserves?In a post-war Iraq if a pro-US governmenttakesoverthe reinsof the country,whosechancesare strong, it couldbe a bonanzafor US oil companies.Iraq’s vast oil reservesremain apowerful prize for oil companies.However, developmentof thoseIraq reserveswill not be a smallproject.After yearsof havoc, Iraq’soil infrastructure will requiretremendoushardwork andbillionsof dollars in investment.The oilindustry is in terrible shape,thepipelines are leaking lakes of oil,refineriesaredumping toxic waste,in short, it is a broken downindustry.
Oil production, currently2 million barrelsa day, evenin thebest-casescenario, this cannotreach more than 2.5 millionbarrels a day by 2005. CurrentIraqi production capacity is. notan immediate threat. It will beyears before they can pumpsignificant amounts of oil.However, Dr. L Y Yueh,EconomicsDepartment,LondonSchoolof Economicsopines thatthe operationsof the Kirkuk oilfields are expectedto revivewithinweeksandcan produce9 millionbarrels per day—nearly. half of Iraq’spre-war productionlevels.
Oil expertssay, inthe long-term thecountry has great-untappedoil reservesand its output couldeventually reach 6million barrelsa day.The AmericanAcademyof Arts andSciences estimatesthat over 10 years,warand the reconstruction of Iraqcould cost as much as $2 tn—almostthe equivalentof the entireannualfederalbudget.-The US oil companieshavebeen stuck on- the sidelinesbecauseof Iraq’s oil rush. EvenifIraq wanted to engage US oilcompaniesin the rebuilding of
Iraq’s oil infrastructure, UNsanctionsas well as US laws havebarred US oil companiesfromdealingwith Baghdad.According toa reportby the Council on ForeignRelations (CFR) and the JamesBaker Institute of Rice University,Iraq’s oil is not the prize it seemsfrom afar.
In short, the Iraq war wouldfurther disrupt Iraq production,resultinggreaterpower for OPEC.Another report from Center forStrategicandInternationalStudies(CSIS) observes that, after aregime change,there would bemany competingclaims for moneythat would slow investmentin oil,buying food, financingreconstruction,and keeping thepace.Iraq also has debts of over$100 bn. Someoil expertssay it isunlikely that US companieswill beleft empty-handed,going by US oilindustry’s unusually strong tieswith the White House.
Critics say the oil companiesare driving Bush’s war. The WallStreet Journal reported onJanuary16, this year, that officialsfrom the White House, State
- Departmentand DepartmentofDefense have been meetinginformally with executivesfrom
Halliburton,Slumberger, Exxon-Mobil, ChevronTexacoand ConocoPhillipstoplan the post-waroilbonanza.
However, a lotdependson just whatkind of governmentwill be in power whenUN sanctions arelifted and also largelyon the extentto whichpost-warIraq respectsthe pre-war
exploration contracts; most ofwhich are with EuropeanratherthanUS oil companies.
Prof. Ste-phenG Cecchetti,Departmentof Economics,TheOhio StateUniversity,US, says,“IfIraqi oil resourcesareto be usedtobenefit the Iraqi people, as theBush administration says they
I expect in the coming yearsoil price will stay relativelystable in the lower end of theOPEC price-band ($22-28per barrel) as it has beenshown that the actions in thiswar have no real impact onthe supply-side.
should be, the outcome forAmerican oil companieswill beneutral. My hope is that theorganizationof production andownershipwill mirror that of thestate-owned,but privately run,Mexicanoil companyPemex. If, asI believe, oil pricesremain in the$20 to $25 range for the next fewyears,American oil companieswillnot gain any particular benefit.Should prices rise, then all oilcompanieswill benefit, and UScompanieswill be no exception.But we can all hopethat this doesnot happen,as it would havedireconsequencesfor everyoneelse.”
However, any productiondecisionsof Iraqi oil are still underthe jurisdiction of the UN SecurityCouncil, basedon the sanctionsagainst the Saddam regime,which the US so forcefullybrokered over -the years.Ironically, thesesamesanctionsmust now be lifted and their’removalis subjectto the votesandvetos of countriessuchas France,Russiaandf~hina,which not onlyopposedthe war butalso haveverylargeinterestsof’ their own in theIraqi petroleumindustry,.alreadyin place.
Alexander WostmannDirector, ContentAlexander’s Gas & Oil ConnectionsGermany
US oil companieswill not gain any
particular benefit.Should prices
rise, then all oilcompanies’
benefit, and theUS companies willbe no exception
Chartered Financial Analyst - May 2003
COVER STORY - -‘ OIL: PROGNOSIS OF POST-W ERA
OPEC — Fading power?With the end of the Saddam-regime, US has achievedits twingoals: Removing Saddamfrompower and reducing oil cartelpower in manipulationof prices,engineering embargoes andotherwiseharmedconsumers.Arevitalized Iraqi oil industry willposenew problemsfor the mightyOPEC, whose10 memberscurvedup Iraq’s productionquotas whenUN sanction took hold. OPEC’smanipulationonceheld the worldto ransom,prompting the 1973 oilshock, which sent the worldeconomyinto turmoil. Now thetrend has changed,the futuredirectionof oil priceslies out of itshands.The cartel’s leadershavebeenopenly telling the world thattheir days of power are numbered.
During 1970s,OPEC controlledhalf the world’s oil market, thismay havebeeneven true yearsago,but OPEC’ssharehas beeninsteadydecline. The cartel is on theverge of losing its ability to setworld prices, a power known ineconomicsas price leadership.Ifthat market share‘drops below30%, OPEC’s dominancecouldofficially becomea mererelic ofhistory.
By some estimates,a rebuiltIraqi oil industry can produceas
Estimated Impact of Oil PriceIncrease of $10 a Barrel
RealGDP change
World -0.6
Industrial Economies -0.6
US -0.8
EuroArea -0.8
Japan -0.4
Others -0.2
Developing Countries -0.4
Latin America -0.2
Asia , -0.8
Europe and Africa +0.2
Source: www.gIobaldimensions.com
much as 6 million barrels a day,secondonly to SaudiArabia as topOPEC producer, would bedevastating for the Saudi-controlledoil cartel. A freshwaramongproducersis not ruled outbecauseof the fact that OPECmight be forcedto changeits policyof defendingprices in order todefendits marketshare.
Analystssayas Iraqi productionrises,oil pricesare likely to fallunless OPEC cuts backelsewhere. The Iraqi peoplewould be better-off from higherrevenuesand people aroundtheworld would benefit from asignificant drop in oil prices. Butit is not clearhow closely Iraq willcooperate with OPEC oncesanctions are lifted. JustinWolfers and Eric Zitzewitz,Assistant Professors ofEconomics,Stanford BusinessSchool, US, observe,“The effectsofregime- change on world oilmarketswill dependvery heavilyon -whether Iraq remains inOPEC. Of course, if Iraq remainsin OPEC,then this will suggest-areturn to somethingcloser to‘business as usual’ in thelong-run, although Iraq mayultimately negotiatea somewhatlarger quota. Even if Iraq doesleave OPEC, there is a chancethat increasing Iraq supplywould still be somewhatoffset bylower OPEC production.”But inthe short run, very little oil willcome from Iraq without significantinvestment.
Stability of the oil marketwillcontinueto dependon the ability ofOPEC to control production—theend to political strife in Venezuela,and the stability of the PersianGulf region.
However, Glen Burns saysthat Iraq will be in the sameposition as SaudiArabia, it willwant to keepthe oil priceshigher,to protect its long-term future.OPEC will continueto play apart;andthat Iraq canjoin OPEC.Theoutcomeof a post-Saddamregime,if it happens,is unclear. If Iraqdoesn’tjoin OPEC, outstandingoil
happen if speculators keepincreasing their very highshort positions on the crudecontract.
Matthew R SimmonsChiefExecutive OfficerSimmons & CompanyInternational(Investment Bankers to theEnergy Industry)
Ucontractsare likely to be honoredand any new capacitywon’t reachthe marketfor many months,afterthe war to allow time to rebuildIraq’s oil capacity.
Oil prices: Post-war scenarioAs pre-war surgeended, the oilprices plunged currently tofour-monthlows or lessthan $25 abarrel after almostreaching$38 abarrel in the trading week ofFebruary24-28, 2003. Unlike inthe past, the war-on Iraq hashadfar lessimpact on oil prices; timingandthe factis that Saddamhasnotmanagedto wreak havoc in theoilfields ashe did in 1991.
As the war ends like acakewalk, once the Iraqi oil startsflowing into the world markets,nudgingpriceswill be backto lowdouble-digit level. JustinWolfersandEric Zitzewitz predictthat “oilpricesare-almostcertainly goingtofall backto pre-warlevels, once itbecomesclear that not only themilitary, but alsopolitical disruptiondissipates.”Theyfurther add, “Ourcalculationis that oil prices areprobably about $11 per barrelabove levels they would otherwise
“I-
As for thenotion thatonce thewar is over,prices will fall, this can
Chartered Financial Analyst - May 2003
be at, with the delicate situationinVenezuela is also a factor.Moreover, our guessis -that thisprocessof re-equilibrationwill berelatively quick, with the warpremium disappearing withinabout a year of the end, ofhostilities.”
If onegoes back to history, oilprices soaredwhen Iraq seizedKuwait’s oil fields in ‘August 1990.The benchmarkUS crude oil rosefrom just over $21 a barrel inAugust to more than $40 inOctober, as -the administrationbegan preparations to retakeKuwait. But from that peak, oilpricesbeganfalling, andthelaunch -
of the allied offensivein February -
1991 cut $10 a barrel off the UScrude prices. By the end of thatmonth, oil prices were below $20again.
It is true that oil pricesplungedquickly after the Gulf war. Worldoil markets and the supplyequationare very different today;oil expertssay that in this crisis,PresidentBushfaceschallengesinglobal energy marketsthat hisfather did not. In the earlier Gulfcrisis, gasoline prices did notincreaseas much ascrude oil pricesbecause gasolineinventories wereadequate.
This time, however,-consumersare not as-
fortunate. Gasolineprices have closelytracked the climb incosts of crude oil fromwhich the gasolineismade. The average-pumpprice of $1.71pergallon on -March 10,2003 was the highestever for thistime of year, 49 cents abovethelevelof ayearago,saysthe EnergyInformationAdministration,US.
However, Justin Wolfers -andEric Zitzewitz opine that- “therewill be a dramaticprice collapse—but initially only to pre-war‘levels.And whethera long slow declinedrawn out over a year or so isdramatic, ‘or orderly,- is of coursea
questionof personaltaste.In themuch longerrun thereis still somediscussionaboutwhether this warwill increaseIraq’s supply enoughto havean impact on world prices.Our assessmentis that therewillbe someimpact, but that it will berelatively small, and the long-run(10-year)effect maybe to reduceoilpricesa further $1.2 per barrel,which strikes us as small.” Thelonger-term view is that oilcompanieshave little to worryabout; demand- is steadilyincreasing, while supply isconstant,meaningthat the priceswill rise.Any suddenchangesin oilsuppliesif they happenwill beshort-termand appearsunlikely.Nevertheless,Stephenpredictsthatoil pricesarelikely to fall backto somewherebetween-$20 and$25 a barrel from the current levelof $28.
They further add, there is noflood of Iraqi oil andthereis likelyto be none for the coming years.The price is under pressurebecause everyone has beenhoardingoil over the lastmonthsandas the war seems.to be almostover without too greatan-impact,-‘ there is just an
enormousamount ofoil in storage,floating
- or fixed.
The oil-economicsHigh oil andgasolineprices are of grea-tconcern to worldeconomy. Since theyweaken’ consumers’-ability to spend onother things -andraise
- costs for businesses.‘All the big -oil spikesin
the past 25 -years or so haveresulted in recessions,and someeconomistshaveworried, that therecent spike could result inanotherone.
The recentdrop in prices, then,shouldbe something-of-a relief. Butthe spike already may havecontribut-ed to - a dramaticslowdown in growth earlier thisyear, helping to dri-ve consumer-
OIL: PROGNOSIS OF POST-WAR ERA
“I
There isunlikely to -
be an oilprice shockat this time. Oil prices arenot rising but falling, furtherreducing the scenario of asupply shock.
Dr. L Y YuehEconomics DepartmentLondon School ofEconomics
confidenceto -lows not seeninabout a decade.High prices willcontinue to depressthd worldeconomy,and is severeenoughtoplace the economy in recession,until ‘the economyis able to reactto this reality~’~Stephen”echoessimilar views, “If oil pricesweretodouble or triple, the problemswould be severe.- While oil is lessimportant today than it was 30yearsago, a significant increaseinenergy prices does have animmediateand largeimpact on the
- world economy.The weak growthwould turn into an - almost-immediaterecession.”
History tells that sustainedoil-price rises have a big negativeimpact on- economic growth;similar effectswere seenafter the.next big- pricehike- in 1978-79.Thecontinuationof oil prices in- 1990saffected to -end the long boomwhich, in the US and parts ofEurope and Asia,- turned intorecession.Since thenrecoveryhasbeen‘so tentative. This explainswhy the- recentsurgein priceshasalarmed the world economy.Economists-opine that the overallimpact on world demanddependson whetheroil exporterssavetheirwindfall or spendit on-importsfrom oil-consuming countries,
COVER ~STORY’ -
In the earlier Gulfcrisis, gasolineprices did not
increase as muchas crude oil pricesbecause gasolineinventories were
adequate
Chartered Financial Analyst - May 2003
COVER STORY - -, - --
In the post-Iraqwar regime, the
global oil industryis on the verge ofa major structuralchange in the waythe price of oil is
determined
OIL: P~OGNOSISOFPQ$t.~WMERA
However, on the otherside,drop inoil price could also havea dominoeffect on other sectorsof the ‘oileconomies,leading to economic-s]owdown and a growingunemploymentproblem.
Relative to the major recession-causingoil pricehikes in the 1970s,this one is likely to be bothsmallerin absolutemagnitude,but moreimportantand’ far less persistent.As such,it is unlikely to causethesamesort of economicdislocationthat past oil price shocks havecaused.
Justin Wolfers and Eric-Zitzewitz opine, “we still seefirst-order macroeconomicimpactsflowing from this war—we justaren’t sure thatoil prices will bethe mediating mechanism.Ourbest estimate is that the stockmarkethaspricedin a 15% penaltydue to the war (nowperhapscloserto 10%). This strips away about$1tn from US stock marketwealth,and similar effects are seeninother major economiesaroundtheworld. While oil and gold stockshavedone well, this ismore than offset bylarge declines inc o n S u m e rdiscretionaryspending,and IT, notto - mention moregeneralized losses.These-lossesare likelyto have - immediateimpacts throughconsumption andinvestment on thefuture courseof -GDP.”
They further add,“Our guessis that this reflects acombination of direct economiceffects (consumersentimentetc.),and political economyeffects. Thewar may have substantiallycompromisedthe ability of Bushadministrationto work effectivelyin international foray,- includingnot only the UN, but also theWTO, or evenin simply bilateralcontexts.”
On the US front, in the post-war regime, the importance of
reconstructionof Iraq should benoted,of which the situationof itsoil industryis a majorpartbutonlyonepart. A plan for reconstructionoffers both opportunities andchallengesfamiliar to those who-have worked in transitioneconomies,especiallyto thosewhohave worked on issues - ofinternationallaw.
Beyond this, the key challengesare the damage done tointernational institutions andrelations with its Westernallieswhile at the sametime tampingdown the fierce anti-Americanismthat has sprung up around theglobe. Succeedingat thosetaskswould go a long way towardlesseningtensionsin the MiddleEast and elsewherearound theglobe and muting criticism of theUS for the unilateral approachittookto the war. But failure to do sowould likely increase globaltensions and further fuelanti-Americanism—anoutcomethatposeshuge risks for business.
OutlookIn the post-Iraq warregime, the global oilindustry is on theverge of a majorstructural changeinthe way the priceof oilis determined.In thecoming months,onlytwo producerswill setthe world price of oil—SaudiArabia andIraq.This shift in pricingpower will - occur- - because non-OPECproductionis projected
to be flat or- down in the yearsahead,while SaudiArabiaandIraqwill be the only producersthathavethe resourcebaseto permit.an economic - expansion ofproductivecapacity. For 30 yearsnow, the price of oil has beencontrolled primarily by SaudiArabia.
OPEC membersare requiredtoproduceonly an agreedquotaof oilto keepthe price high enoughtomake a good profit but not high
The To~Ten Oil ~conor~ies
Res’erves’ Pr~uction(billion (millionbarrels) barrels
per day)
SaudiArabia 261.8 8.8
Iraq 112.5 2.4
UAE 97.8 2.4
Kuwait 96.5 2.1
Iran 89.7 ‘ 3.7
Venezuela 77.7 3.4
Russia 48.6 7.1
US 30.4 7.7
Libya 29.5 1.4
Mexico 26.9 3.6
Source: BP Statistical Review of World Energy
enoughto force the West to seekother suppliers.
However, Iraq’s oil industry iscapableof far higher productionandcould breakthe Saudihold onOPEC. If Iraq were underwesternoccupation,this could allow the bigconsumingcountrieslike the US,Japanand Western Europe—tocall the shots. Furthermore,thereare powerful interestsboth withinthe US andoutsidewho don’t wantto seeoil pricescollapse.
American oil giants areexploring new fields in remoteregionsof Alaska, Colombia andCentralandSouth-EastAsia thatwill only be profitable to exploitat prices above about $22 perbarrel. Then there is Russia, anon-OPECoil power in its ownright. The Soviet oil ‘industrycollapsedjust before the USSRdid, but Russia’sis now back andalreadysparringwith the Saudisbecausethey have no use forOPEC quotas. So the oil is anissue—in a-complex, long-termand very real way. If any onedenies this, it is to deny thereality. ~
N Janardhan Rao
-oReference# 1-2003.05.04
Chartered Financial Analyst - May 2003
