The war on Iraq and oil price scenarios
How high could oil prices rise if the war on Iraq does take place in the days or weeks ahead would depend on how long the fighting lasts and how much damage Iraq’s oil fields sustain. The most likely scenario is for oil prices to surge toward the $40 a barrel for Brent crude before assuming a declining trend in the second half of the year. The uncertainty associated with the looming war on Iraq has pushed oil prices above $33 a barrel for Brent crude from less than $20 a year ago. On the supply side, there has been a sizeable cutback in petroleum production by Venezuela because of the political crisis there while, on the demand side, the exceptionally cold winter in the US and Northern Europe boosted consumption of heating oil. Furthermore, the US administration has given orders to increase America’s strategic petroleum reserves ú estimated at 700 million barrels ú enough to meet US needs for 63 days. The process of boosting reserves is expected to be completed by early March 2003. The US, which has only 2 percent of world oil reserves imports 55 percent of its total oil consumption needs, with 25 percent of that coming from the Middle East region. The best scenario for Iraq and the region is for the ongoing policy of containment aimed at ending the crisis peacefully to succeed. Under this scenario, the process led by the UN would eventually vindicate Iraq of having weapons of mass destruction, leading to the removal of economic sanctions on Baghdad. With no damage inflicted on Iraq’s oil wells, the country would be able to resume its oil production and execute projects signed with major oil companies to expand the country’s production capacity. Oil prices will lower back to $22 a barrel once the war premium, believed to be around $7 a barrel, is taken out of current prices. Unfortunately, the most likely scenario today is not a peaceful solution but that of a US-led war on Iraq. From what has been leaked so far of the battle plan, American troops hope to descend on Iraq’s oil fields in the early hours of the war to gain control and prevent any sabotage action. Under this scenario, Iraq’s oil production is likely to shut down, perhaps for two to three months, during which the oil fields will be checked for mines and other hazards. During this period, oil prices are likely to peak at $40 a barrel before starting to decline. The prospects of Iraqi crude returning to the market following a short and decisive war and the likelihood that the country will be able to boost production in the coming few years will act as a psychological force on markets, shifting the mood from bullish to bearish. Market participants will start discounting higher future oil production levels, bringing a steep decline in crude prices. Brent crude is forecast to drop below $20 a barrel by summer. The third scenario is that of a war on Iraq dragging on for months. While this scenario is considered by many to be less likely, it should not be ruled out. In this case President Saddam Hussein and his close lieutenants would go underground while troops led by the Republican Guard continue resistance from densely populated sections of Baghdad. Large-scale battles will tail off after a few weeks, but sporadic attacks on enemy forces will continue. Fearful workers and engineers could refuse to operate Iraq’s oil fields, closing them down for several months. In this case oil prices would trade up toward $45 a barrel for Brent crude before falling gradually by year’s end to around $30 a barrel. If troops loyal to the current Iraqi regime decide that it is both a defense and a form of revenge to sabotage Iraq’s oil fields and were able to do so, the world’s oil market could lose a good portion of Iraq’s output. This would put more upward pressure on oil prices, add to the cost of rehabilitating Iraq’s oil production capacity and severely handicap the country’s post-war economic recovery. After the end of the crisis, Iraq is expected to pursue the expansion of its crude oil production in two phases. The first phase, the recovery phase, is likely to last one to two years and would cost up to $5 billion. Major oil service companies would help Iraq restore its production capacity from the current 2.5 million barrel per day (mbpd) average to the 3.5 mbpd level that prevailed in July 1990, just before Iraq invaded Kuwait. The second phase, the development phase, will take much longer and will be aimed at doubling Iraq’s production capacity to 7 mbpd by the year 2010. Here the world’s largest oil companies including those from the US, the UK, France, Russia and Italy, will compete for lucrative contracts with the new government of Iraq. Baghdad’s desperate need for money to rebuild an economy ravaged by 13 years of sanctions and a heavy debt burden of $140 billion will lead it to accept to sign production sharing agreements with the major oil companies. Iraq has an estimated 112.5 billion barrels of proven oil reserves, the world’s second largest after Saudi Arabia. However, only 15 of its 74 discovered oil fields have been developed and just 125 of the 526 known oil deposits have been drilled. This is why the potential for Iraq to almost double its proven reserves is quite high once the entire acreage is mapped. Unlike the Caspian region that saw sizeable increase in crude oil production in the 1990s, Iraq’s crude oil is easier to access and to export. The country has the added advantage of being able to transport much of its output through the Mediterranean sea via pipelines to Turkey, Syria and Lebanon and through the Red Sea via pipelines to Saudi Arabia. Iraq is believed to have contracts worth about $38 billion pending with companies such as Italy’s ENI, UK’s and Holland’s Royal Dutch-Shell, Australia’s BHP, France’s TotalFinaElf, and Russian giant Lukoil. However, no development work has actually started on these deals because of the UN sanctions imposed on Iraq which have also precluded American companies from doing business in the country. France is by far the biggest player. The giant TotalFinaElf has development rights to roughly 25 percent of total Iraqi reserves. In theory, France’s long relationship with Iraq’s national oil company could put the French in a good position for more deals after any war. But at the moment, many French industry officials remain convinced that the Americans will not allow French oil companies to work in Iraq if France fails to support the war effort. That’s why French observers believe that when the final decision is to be taken by the UN, France is unlikely to block it with a veto, in order to protect its future oil interests. Russia is in an equally delicate position as well. While wanting to constrain US power, it is unlikely that Russia will jeopardize lucrative oil contracts signed with Iraq. Baghdad owes Moscow $8 billion in Soviet-era debt. In 1997, Lukoil signed a $3.5 billion, 23-year deal to revive Iraq’s Al-Qurnah field, which has 7.8 billion barrels of proven reserves. But the accord was put on ice after President Putin’s support for the US-led sanctions drive. The short- and medium-term outlook for oil prices and their impact on economic growth prospects both of the region and the world will, therefore, depend on the outcome of the present Iraqi crisis. The worst scenario is clearly the status quo, whereby the crisis continues to drag on for months without a solution, leading to a protracted period of uncertainty associated with higher oil prices and weak world economic growth.
Henry T. Azzam is the Chief Executive Officer at Jordinvest. He wrote this commentary for The Daily Star