For much of 2002, Iraq was a key variable in the global oil market equation. Whilst the possibility of hostilities will have a major impact on market developments in the near term, Iraq's huge oil reserves constitute the real market challenge for the future. Although Iraqi exports will be disrupted by military action, under most scenarios Iraq's oil will return quickly to the market and in rapidly increasing volumes.
We believe that this is the crucial challenge for oil market-makers in the coming decade. OPEC faces a huge task in accomodating Iraqi production against a backdrop of continued supply growth in Russia and other non-OPEC producers. Can the organisation maintain a prolonged period of restraint until it assumes its inevitable position of production dominance beyond 2010?
Resource to spare
In spite of its current pariah status, Iraq remains a major oil producer. Its exports are limited politically by the UN and physically by its dilapidated infrastructure, but still it has been exporting close to 2 M b/d. Wood Mackenzie estimates Iraq's total remaining recoverable oil reserves at close to 100 billion barrels, second only to Saudi Arabia. Of this total, only around 50 billion barrels are unequivocally commercial, i.e. reserves which are in production, in development or have established plans for their development. The remainder remains subject to appraisal, field expansions and secondary development initiatives which will undoubtedly confirm the country's huge ultimate potential.
Six-million barrels per day
Any argument over precise reserve volumes is largely academic in a market perspective. Iraq has the resources to achieve huge increases in production over the next two decades and whilst the oft-quoted target of 6 million b/d in five years is unrealistic, it is achievable within 10-12 years.
Following the end of the Gulf War in 1991, oil exports from Iraq were prohibited and production restricted to meeting domestic needs. By 1996, production was 0.6 Mb/d, paltry in comparison to historical levels of more than 3 Mb/d. In late 1996, the UN introduced the oil-for-food programme, which has since permitted exports to provide revenues for humanitarian aid. Export volumes have fluctuated greatly, reaching 2.5 Mb/d on occasions, although in 2002 the average dropped to around 1.4 Mb/d, as sales were depressed by the UN's attempts to prevent retroactive pricing and surcharges by the Iraqis.
This is partly balanced by illegal exports – it is estimated that there is the capacity for Iraq to smuggle up to 0.5 Mb/d of crude and oil products through unofficial routes, although on an annual basis, smuggled volumes probably average less than half of this. Given the minimal investment in the oil infrastructure of Iraq over the past ten years, Iraq's instantaneous production capacity is now just under 3 Mb/d. Conversely, a number of key projects are in preparation which could facilitate a rapid increase in sustainable capacity to close to 3.5 M b/d within 18-24 months of large-scale investment becoming available. In parallel to this work to restore shut-in wells and drill new ones while installing water management facilities in some of Iraq's giant producing fields, the restoration of the export infrastructure to accommodate close to 3 Mb/d should also be possible in this timeframe. Thereafter, two or three major field development projects (such as Majnoon and the next phases of West Qurna), should take production capacity over 4 million b/d within six or seven years. In the longer term, a realistic assessment of the pace of development suggests that a capacity as high as 6 million b/d could realistically be achieved within 10- 12 years.
The pace of Iraq's recovery will be critically influenced by the duration, impact and outcome of any conflict. There are a multitude of potential scenarios, each of which present a different view of the recovery period, the near-term oil market and the stresses on OPEC.
Oil prices would inevitably spike as a result of a military action, regardless of the level of physical damage to oil facilities. But the speed at which prices dampen and the enduring consequences for production will largely depend on the intensity of the conflict. It is valuable to consider two potential outcomes of hostilities in Iraq. The ideal US outcome is a short, intense campaign which results in the swift removal of the regime whilst minimising damage to Iraq's oil infrastructure and leaving supplies from Iraq's Gulf neighbours unaffected. Under this scenario, the price spike would be short. There is spare oil production capacity in OPEC to cover the loss of Iraqi oil and the OPEC members most likely to make up any shortfall have had plenty warning of the need to step into the breach.
OPEC's sustainable crude production capacity is estimated at around 29.7 Mb/d, excluding Iraq. Venezuelan production is currently shut in by strikes, but even without Venezuela, capacity is around 27 Mb/d. OPEC production needs to be around 25 Mb/d to meet current demand. There is however, a difference between sustainable and instantaneous capacity – it could take some weeks to rack-up production and without Venezuela, the market would undoubtedly be tight. However, if necessary the US could draw down its strategic oil stocks and provide over 4 Mb/d day for up to three months.
An unlikely and less predictable scenario is that of a prolonged and expansive war. The Iraqi military could disable not only the country's own oil facilities, but also those in Kuwait or elsewhere in the Gulf. Political considerations would inevitably assume greater importance. The escalation of Israeli-Palestinian tensions has already distanced the US from the Arab world. If a prolonged conflict in Iraq were to further inflame Arab opinion, the replacement of Iraq supplies by other Gulf producers may become unacceptable in the face of popular opposition. As always, much would depend on Saudi Arabia finding the delicate balance between its domestic politics and the need to manage the threat posed to the fragile recovery in the world economy, oil demand growth and OPEC's long-term market position.
No conflict – business as usual
Alternatively, if no military action transpires and Iraq remains isolated, then it is likely to continue struggling on, with oil production being maintained at best and its infrastructure deteriorating. However, in time, there is likely to be increasing pressure to ease sanctions on the country to give Iraqis some respite from economic hardship.
Initially, production is expected to return to the levels prevailing under the UN programme in 2000 and 2001. Undoubtedly, production and export volumes would continue to fluctuate and 2003 production would still be below capacity. Beyond 2003, a gradual easing of the political constraints on exports and investment would result in a steady rise in capacity.
A return to the prospect of over-supply
Looking to the medium term, under most scenarios the result will be a change to a more co-operative regime in Iraq. Maximising oil exports will be key to generating revenue for re-construction. This will present OPEC with a dilemma that it will have to face sooner or later. Iraq is not currently part of the quota system and therefore OPEC will have to find a way to reinstate Iraq if prices are to be maintained within OPEC's $22-28/bbl target range. But this accommodation will be hugely difficult. Over the next few years, Wood Mackenzie estimates that production increases in non-OPEC countries will be almost equivalent to the expected growth in world demand, especially if Russian production goes on rising at its recent rates. If it intends to maintain its role of balancing the market, OPEC will have to accept that its crude production will increase modestly between now and 2010.
Wood Mackenzie believes that restoration of Iraqi production capacity to 3.5 million b/d by 2005-6 is likely under most scenarios. Whilst sanctions have precluded US companies from any involvement in Iraq, Russian, French and Chinese companies have entered into agreements that should provide up to 800,000 b/d of new capacity within six or seven years. These projects would inevitably be reviewed to allow some significant level of US-participation and key infrastructure reconstruction could be remarkably rapid.
Even if Iraq was restored as a full member of OPEC and accepts its share of production as we have illustrated, Iraq's desperate reconstruction needs and reparation obligations will present an on-going threat to the quota.
The crucial challenge for OPEC
We believe that speculation on short-term events are understandably distracting attention from more significant medium and long-term considerations. While any short-term spike in oil prices is a threat to recovery in the fragile global economy, it is likely that oil prices will be back to 'normal' within six months. The challenge then will be OPEC's ability to manage the forecast expansion of Iraqi supply and to balance the market. This will become increasingly difficult given the current renaissance in Russian and other ex-Soviet production. All of this points to the prospect of over-supply and lower prices, rather than the shortages and higher prices which dominate current market concerns.
But then, in the very long-term beyond 2010, OPEC is set to return to the driving seat. By this time, non-OPEC supply growth will generally have slowed and mature regions such as the North Sea will be in significant decline. As oil consumption continues to grow, OPEC's vast reserves of crude oil will result in its assuming a steadily more dominant share of global production and a progressively stronger hold on the market.
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