Will war mean disaster?

www.sundayherald.com A short war could stall recovery but, say Ian Fraser and Mike Woodcock, a longer one could bring the economy to its knees

AS THE first few Tomahawk cruise missiles rained down around Baghdad last Thursday morning there was a distinct sense of d?jˆ vu among seasoned economic observers.

After all, there's a George Bush in the White House, Saddam Hussein clinging onto power in Baghdad and uncertainty about the conflict's duration and long-term economic repercussions clouding the global economic picture, fear of terrorist reprisals under mining the tourism and aviation sectors, and financial markets in limbo after an astonishing 'war rally' that started when the diplomatic wrangling ended 10 days ago.

Economic commentator Anatole Kaletsky was last week unremittingly gloomy about the conflict's possible impact on all our economic futures.

Writing in the Times, Kaletsky said: 'It may seem callous to suggest this when people are about to die, but the worst consequences of the Iraq crisis may be economic.'

If the current war is short and successful, the consensus is there will be a strong economic rebound worldwide.

But should the war drag on for longer than markets are expecting -- as George W Bush warned in his eve of hostilities address -- commentators are united in feeling the outlook would be distinctly more hairy.

Kaletsky said a 'bad' war would not only be catastrophic for Bush and Blair, but would also provoke a doomsday scenario for the global economy.

'[In the UK] tumbling financial markets would hit London property prices and the contagion would quickly spread to regional housing markets, causing a collapse in consumer spending, recession and a dramatic deterioration in fiscal policy. Gordon Brown would be forced to choose between cutting public spending, raising taxes or accepting huge deficits. Britain could find itself sucked through a time warp back to the days of Denis Healey.

'[In the US] the stock market and the economy would plunge, almost certainly triggering a double-dip recession. Fiscal policy would be unable to compensate. The dollar would fall sharply. Trade policy would lurch towards protectionism in response to recession and Europe's perceived betrayal of the US. Export industries would be devastated around the world. Unemployment in continental Europe would rise to a level last seen in the 1930s. And who knows what Rough Beast might arise again?'

Not a particularly happy scenario for our future economic well-being.

And, even if the war is short and successful, the diplomatic schism between 'old Europe' and the USA may take years to heal, with disturbing consequences for economies and financial markets in France and Germany. Their aerospace industries, for example, could be grounded as they find themselves frozen out from US-related joint ventures and technology transfer.

This would accelerate the current weakening of the European economy, with repercussions for UK and Scottish exporters which on average distribute 50% of their exports to other EU member states.

The Ernst & Young Item club is also warning that even a short war could knock the stuffing out of UK growth during 2003 and beyond.

Adrian Cooper, managing director of Oxford Economic Forecasting and an adviser to E&Y's Item club said: 'Businesses are being unsettled by the continuing uncertainty. Many are delaying decisions to invest or take on new staff until they have a clearer picture of how the war will pan out. The recovery from the bursting of the new economy investment bubble has so far been very subdued. The Item club is now forecasting a pause in growth through this year rather than the continued acceleration one would previously have expected.

'If the war is protracted, if oil supplies are interrupted and if there are significant terrorist reprisals then it is going to be very, very costly -- and would certainly lead to recession across Europe.'

The most obvious and immediate lightning rod from the conflict in Iraq to the global economy is through the oil price. After all, it is the channel through which most damage to global growth could be done.

So far, the omens are good. Even with seven oil wells alight around Basra in southern Iraq, the price was still coming down after the impressive 26% falls last week, with Brent crude selling for around $25 per barrel on Friday.

Traders seemed confident this war would be short, decisive and would leave Gulf producers unscathed.

However if the war proves does turn out to be prolonged and the oil price starts to rise frighteningly towards the $40 per barrel mark, central banks around the world will almost certainly take concerted action to reduce interest rates further.

The conflict's effect on the oil market would be easier to fathom were the precedent set by the previous Gulf war anything to go by. However, this is an altogether different conflict and, for example, the support from the Arab world has been much more muted than last time around.

The Boston Consulting Group (BCG), a management consultancy, believes Iraq will sharply increase oil production once the war is over as a means of restoring its battered economy as swiftly as possible, and that Opec countries will follow its lead.

Whilst accepting that other scenarios are possible, BCG believes this would probably lead to a break-up of Opec and cause the oil price to crash to $10-$12 per barrel. BCG's Stephan Dertnig said: 'It's already difficult for Opec member states to restrain production because of population growth and increase in governmental subsidies.'

One reason that oil prices fell so soon after hostilities broke out in 1991 was because it soon became apparent that nearby Saudi oil fields would remain unscathed. This time it is what happens to the fields in Iraq that is more critical, according to Professor Alex Kemp, a petroleum economics expert at Aberdeen University.

He said: 'This time the uncertainty is over the question: will the Iraqi fields be damaged?' he said.

Bruce Dingwall, president of the UK Offshore Operators' Association (UKOOA), who spent nearly 10 years working in the Middle East, points out that the already crumbling oil infrastructure in Iraq is now 12 years older than in the previous conflict and that -- given interruption to production in Venezuela -- the supply side of the equation is harder to forecast.

'The days of simply being able to turn on an oil field are gone. If they are already full on, and only really Saudi Arabia can do that, the oil price might not go down as much as we think.'

A key issue is whether Iraq remains a member of Opec, the Saudi-led cartel of oil-producing states. If it does, Iraq's output quotas could be no more than Iran's three million barrels per day. That would make wholesale development of its huge reserves unviable in the short to medium-term.

An Iraq outside Opec would produce much more oil and invite significantly greater Western investment. But such a turn of events might also send oil prices tumbling. Even the US, with its dislike of high oil prices, would not necessarily want a collapse in the market.

But what about reconstructing and rehabilitating the Iraqi oil industry once peace returns? The prospect of a $1.5 billion rehabilitation programme in a post- sanctions world is already getting oil companies salivating.

As one senior oil executive said: 'There is no reserves constraint in Iraq. It is the second biggest holder of oil in the world next to Saudi and it is not difficult oil. There isn't 3000ft of water, and it isn't jungle. This is desert. It is easy oil.' The US Agency for International Development (USAID) has, reportedly, established a shortlist of five companies to bid for a $900 million contract to rebuild Iraq, with the likes of Kellogg Brown & Root, part of Halliburton, which helped bring 320 oil wells under control in the last Gulf war, believed to be in the frame.

According to Deutsche Bank's global oil analyst JJ Traynor, Halliburton, of which US vice president Dick Cheney was chairman and chief executive from 1995 to 2000, and Schlumberger Oilfield Services, are 'almost certain to play an early role in upgrading the technical facilities of Iraq's oil fields'.

However, the level of participation and the types of contracts that could be offered will not be clear until a new government takes office.

Martin Purvis, Middle East energy consultant at Edinburgh-based energy consultants Wood Mackenzie, said the potential for foreign oil firms will depend on the types of contracts on offer. He said Saddam's government set up several Production Sharing Contracts (PSCs) following the previous Gulf War, notably with France's TotalFinaElf and Russia's Lukoil, but that new contracts called Development and Production Contracts (DPCs) have since become more fashionable in neigh bouring countries such as Kuwait and Saudi Arabia.

Under DPCs, foreign investors are paid a fee for participating in the development of a prospective oilfield, after which the field reverts to state control. 'What is certain is that Iraq has only exploited a few of its large discoveries,' said Purvis.

While US companies jostle for position in an unseemly fashion, British and European companies are being more circumspect. Speculation has been rife that the US will seek carve up oil contracts between itself and its principal allies, including Britain. That would infuriate the Russians and the French, some of whose oil companies already have PSCs in Iraq.

It is entirely possible however that the successor regime in Iraq will prove reluctant to open its doors wide to international production partners.

Middle Eastern nations such as Iraq, Iran and Saudi Arabia nationalised their oil industries in the 1970s, and while they have pledged to invite foreign producers to bid for contracts, the oil majors have in fact made very slow progress in establishing themselves in these countries.

This is partly because the countries concerned have such a strong desire to retain control over their own black gold. 'If they get a new government why should they think any differently?' said one well-placed source. 'Iraq has been denied capital investment for many years, so they may insist that they can do it themselves.'

Oil giant BP, led by CEO Lord Browne of Madingley, is one major that is keen to become involved in any post-war deals in Iraq. But despite reported meetings with the UK government on the opportunities, the company was reluctant to comment while a post-war settlement remains some way off. A spokesman said: 'If sanctions are lifted and if the Iraqi government wants foreign investment in the oil sector, then we would could consider any opportunities there as we would anywhere else in the world.'

Last week, the chairman of Royal/Dutch Shell, Philip Watts, said he hoped there would be 'a level playing field' for the international energy industry in a post-war Iraq if Saddam Hussein is removed from power.

The most direct opportunities are likely to be available to oil services firms (in Scotland these would include Weir and Wood Group), especially those with experience of rebuilding crumbling infrastructure. Aberdeen-based Wood Group was, for example, involved in the rebuilding process in the Kuwaiti oil fields following the last Gulf War.

Kemp said: 'I have no doubt that a number of North Sea companies could participate in either rehabilitation, if that were necessary, or in redeveloping the fields. If there is no damage to the fields because the American troops get there and protect them, the question would be if they still want to expand the sector.

'It currently produces about two million barrels a day but it could become much larger. This would create opportunities for the oil companies themselves and the contractors.'

Overall, however, many North Sea firms seem to prefer to keep their powder dry until the conflict is resolved.

But Dingwall sounds a note of caution. He suggests that any turn round in production could take up to five years as new legal and fiscal frameworks are put in place by the still unknowable post-war regime.

'There will be no grab and steal,' he added. 'I think it will be done in an incredibly orderly and sensible fashion. The Iraqis are a very intelligent bunch and they understand the oil business intimately. There will be no bonanza, but they will take a year or two to see what the new fiscal and legal regime will look like.'

Lessons to be learned from the first gulf war... IN the six months between Saddam Hussein's 1990 invasion of Kuwait and the beginning of the Gulf war in January 1991, the build up to war had a worse effect on global stock prices than the actual war itself.

The over-reaction of equity markets was linked to talk of another 'Vietnam'. The US Standard & Poor's 500 Index declined by 19.2% and the FTSE-100 by 16.2%.

The only market areas almost immune from the jitters were defensive stocks such as utilities, telecoms, consumer staples, energy and healthcare.

After the Gulf war concluded there was a 20% leap in the US equity markets, however this jump has to be seen in the context of a US and global economy which was entering a recession. The post-conflict rally could also be linked to a more stable economic and political environment, where the dollar was stronger and the US had an 18% excess capacity for oil.

The movement of oil prices in 1990/1991 was erratic, with crude prices increasing by 160.1% during the conflict. At its highest level the price of a barrel reached... but once the land war commenced, prices had already started to decline, and by the end, had come down to around 53% from the peak to levels reached prior to the invasion. Tourism revenues have not declined for a single year since the second world war, but the Gulf war was a benchmark of gloom, with growth in global revenues from 21.5% in 1990 to just 3.2% in 1991. However, the sector's resilience combined with aggressive pricing and marketing to achieve a growth figure of 13.5% in 1992. In Scotland, the value of tourism expenditure in Scotland during 1991 increased by 8% to £1.7bn -- despite the Gulf war.

The international airline sector reported that transatlantic bookings suffered the most in 1991. After the Gulf war, three US airlines folded as fuel prices soared amid fears about supplies from the Middle East. These were Eastern, Midway and Pan American. British Airways saw profits plunge from £156m to just £9m before tax in the aftermath of the war.

The financial difficulties were exacerbated by airlines over-ordering aircraft in the boom years of the late 1980s, leading to significant excess capacity in the market. International Air Transport Association member airlines suffered cumulative net losses of $20.4bn in the years from 1990 to 1994.

The construction sector in the US hit a low point in 1991. The US economy had been in recession since July 1990, with contractions in real estate and commercial property. In the UK the sector, which contributes around 10% to GDP, struggled through the early 1990s as investment levels dropped as a result of generally poor economic conditions.

By 1991 the US economy was so big and the scale of fighting so small that extra military spending did little to boost the economy. Global sector consolidation began, R&D levels rose and defence spending increased.