Iraq’s Overly Optimistic Oil Plans

11 April 2010  – Forbes

Oil prices have been on a tear of late, rising almost 6% in a week to close at close to $87 per barrel on April 5. Despite a subsequent sell-off and oil’s rather frothy prices, there do seem to be some short-term advantages, especially since oil market fundamentals kept prices within a narrow trading band from mid-2009 through the end of the first quarter of 2010. Strong growth in emerging market economies and accommodative monetary policy globally, as well as a more balanced oil market, should continue to provide modest support for oil prices. But if oil prices remain above $100 per barrel for long, higher prices could begin to choke off weak consumption, especially in the U.S. and in dollar-pegged commodity importers, in turn dragging oil back down.

Supply should continue to creep upward, likely at a faster pace than still sluggish demand. Oil production is rising slowly, OPEC continues to provide more supply, albeit at higher prices, and Russian output is at a recent peak. While prices can diverge significantly from oil market fundamentals, in the long term a number of new sources should be available, including offshore oil in Africa and Brazil, and the oil sands–though the economic viability of these sources depends on the price of crude.

We take a look at the energy sector prospects of Iraq, whose government aims to more than double oil production in the coming five years. While security and political constraints abound, production is inching up in Iraq, and recipients of 2009 oil-servicing contracts are beginning operations. Severe infrastructure shortfalls remain, however, and the pressure to maximize oil revenues could complicate the political and regulatory landscape.

As Iraqi officials vie to form the next government and violence continues to sporadically shake the country, the quest to develop Iraq’s oil riches is picking up steam. In late March the successful bidders of the first oil servicing contract (BP and China National Petroleum Co.) began subcontracting out drilling operations in the Rumaila field. While this represents incremental progress, obstacles to full-scale oil sector development remain great. As the new government emerges and the U.S. troops continue their withdrawal, the energy sector’s development will likely proceed at best in fits and starts.

Notably, foreign commercial interest has not been the problem. Despite the political uncertainties and deteriorating security situation, companies have flocked to invest in Iraq given the relatively low costs of production, favorable operating terms and lack of other investable oil fields in the region. International oil companies (IOCs) are eager to invest in Iraq, but the political, economic and regulatory hurdles are causing delays. The issuance of long-term servicing contracts, granted in 2009, is one way in. But the lack of clear guidelines about foreign ownership and property rights in the form of a petroleum sector may deter further development.

The protracted political talks aimed at forming a coalition out of the hodgepodge of parties who won parliamentary seats in last month’s elections could lead to a deadlocked government, or simply a long power vacuum, as negotiations proceed slowly. This almost certainly will expose energy contracts to challenges at the federal and local levels. The power vacuum has also prompted more attacks. It remains to be seen if a stable coalition will be able to pass key stalled legislation, including bills relating to the energy sector. Key issues for the new government to address include the governance of the resource-rich and ethnically divided northern province of Kirkuk; the sharing of oil and gas revenues between federal and regional governments; the passage of a fiscal 2011 budget; and preparations for the final U.S. troop withdrawal in 2011. Companies and investors will hope for policy continuity and the ratification of signed contracts. In our view, many of these contracts will be upheld, as all political groups in Iraq benefit from these issues. But the legal obstacles could be significant, delaying output.

Iraq has the potential to be a major source of new oil in the next five to 10 years, but the process of scaling up production faces many obstacles. Modernizing and expanding the country’s energy infrastructure will be costly, given Iraq’s fiscal position, which may tempt Iraqi governments to extract as much revenue as possible to meet its fiscal vulnerabilities. Finally, as Iraq’s oil production gradually climbs, it will face additional pressure from OPEC (Iraq is currently a nonvoting member of the bloc) to adhere to quotas. Given these uncertainties, Iraq’s plans to more than double output within five years seem very optimistic.

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