How Will War in Iraq Impact Global Oil Markets?

Abstract: Forecasts for how war with Iraq will impact global oil markets range from a supply glut to a price shock--and include everything in between. One of them will probably be right.

Analysis: With expectations of war reaching semi-hysteric levels in some media outlets, surprisingly little discussion has been directed to potential impacts on the global oil market.

This is even more remarkable when considering that the last time prices for natural gas, oil, and gasoline reached this level just two years ago, the American public was in angst, elected representatives were conducting hearings on Capitol Hill, a presidential panel was cobbling together a national energy policy, and the terms "energy" and "crisis" became permanently conjoined in the mass market media.

Though there was early speculation about the impact on oil markets of war in Iraq last fall, the topic seems to have fallen by the wayside since.

One can hardly blame analysts for reticence. The fog of war extends beyond the battlefield. Besides, when it comes to oil, prices are hard enough to predict six months out even without conflict looming in the world's hydrocarbon breadbasket.

Forecasting the economic consequences of war has a dismal history when it comes to success. Invariably, expectations are for conflicts to be brief, easy, and inexpensive. The U.S. treasury secretary's 1862 initial cost estimates of what became the Civil War understated the impact for the North by a factor of 13. Then there were Pentagon estimates of costs for the Vietnam War. Not only did forecasts miss the cessation of hostilities by six years, the best and the brightest underestimated eventual costs by 90 percent.

When it comes to the consequences for oil markets of war with Iraq, forecasters have produced a range of possibilities. Early scenarios were primarily favorable. The war was seen as a cakewalk, lasting a few weeks at most. Then Iraqi oil would flow, nudging prices back to the low double-digit level. The immediate windfall from lower oil prices would amount to a $40 billion subsidy to the U.S. economy. The global economy would recover quickly with the consumer riding happily into the sunset as Iraq increased world capacity by four million barrels per day (mmbbls/d) over the next half-decade.

However, the initial rosy perceptions of how war against Iraq would impact the oil markets have devolved into uncertainty. Alternative scenarios look at the volume of petroleum that could be removed from the market either as a result of direct military action, terrorism, or political boycotts. The most pessimistic analyses look at the potential for another oil price shock, which would have a devastating impact on the global economy.

Most analyses of the present situation use the original Persian Gulf War in 1991 as a predictive model. In that case, oil prices doubled from $17 to $35 per bbl in the months leading up to war. But prices fell back to $20 per bbl as war got underway and progressed favorably for the allies.

Looking back at the Gulf War, Kuwait's production disappeared from world markets for a year, and it took two years to get the country's output back to its pre-war levels of 1.9 mmbbls/d. Up to 3 mmbbls/d of Iraqi crude was removed from the market. Global excess productive capacity was such that the question facing the oil industry in the mid-1990s was how to accommodate the return of Iraqi production without aggravating a serious oversupply problem.

This go-round, Iraq has reportedly moved explosives into the oilfields at Kirkuk, and possibly Rumaillah. War could therefore remove between 1.5 to 3 mmbbls/d out of the global market initially, with estimated costs of $30 to $50 billion to rebuild and expand Iraq's oil infrastructure to reach its full potential thereafter.

The world has gotten by without Iraqi production in the past. Current doomsday scenarios address the consequences of what happens if more than Iraqi oil disappears. A mid-range scenario implies that 7 mmbbls/d could be removed from the market, primarily from the Gulf states, with Organization for Economic Cooperation and Development stockpiles adding back 2.5 mmbbls/d for up to six months. The net impact, a loss of up to 4.5 mmbbls/d, represents about five percent of global supplies.

This lasts a year or so, then prices regress toward the mean at the rate of 20 percent per year. Such impacts could remove as much as $780 billion from the U.S. economy over the next decade and result in a three percent decline in GDP, according to a study by the American Academy of Arts and Sciences.

There are, however, important differences in today's oil markets as opposed to those existing at the time of the Persian Gulf War. Then, substantial excess capacity existed. Now, oil markets are tight. For every one percent decline in supply, prices have risen 20 percent. A five or six percent supply decline would produce prices of $75 per bbl. At some point between $35 and $75, higher energy costs slow productivity growth and trigger a recession.

There have been two other times when tight global capacity utilization was similar to the present situation. This was in 1973 through 1974 and 1978 through 1980. Both resulted in price spikes. A study by Abilene, Texas-based WTRG Economics suggests the same warning signs that existed prior to the energy price shocks in the 1970s exist today. These include political turmoil in oil-producing countries, low global oil stocks, concentration of imports into a small number of suppliers, declining U.S. petroleum production, and low industry spending levels.

The Saudis this week promised to make up any global shortfall from war in the Middle East. Indeed, OPEC was exceeding its 24 mmbbls/d quota in March by as much as 3 mmbbls/d, much of which originated in Saudi Arabia. Yet global markets were still undersupplied even without a conflict in Iraq.

No one knows ultimately what the future holds, but there is a karmic tendency for an action to set into motion other trends that result in unintended consequences.

For example, the question at the end of the next Iraqi war, assuming it occurs, will be the same as it was in 1995. How will global markets accommodate the return of Iraq to the international oil scene? Here is a nation with 112 billion barrels in reserves, second only to Saudi Arabia. It is a nation that has been underexplored. It will be a nation in desperate need of hard currency. Does Iraq return to OPEC with its old quota of 3.2 mmbbls/d intact? Or, does Iraq go it alone, producing as much oil as practical to salvage its own economy?

While the initial results would be beneficial for the consumer, it becomes another story longer term. Ultimately, someone in the world market must make room for Iraq. That someone is Saudi Arabia, which traditionally is the global swing producer.

The aftermath of war in Iraq could bring political stability to one nation while injecting more oil into a tight global supply situation. But too much oil--and a drop in global oil prices--has its own hidden consequences. A decline in oil revenues could exacerbate Saudi Arabia's one-dimensional economy and increase political turmoil because of a demographic situation where most of the population is under 30, underemployed, and restless.

While everyone is anxious to bid adieu to Saddam, a destabilized Saudi regime would be the last thing global oil markets need after he is gone.

Global glut, price shock, or minor blip over time? Email to the editor your scenario on how war in Iraq would impact the global energy market.

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