Influx of Iraqi Oil May Hit Prices

The Street.com By Rebecca Byrne Staff Reporter 04/10/2003 11:28 AM EDT

What a difference two months make. Back in February, economists were fretting about a jump in oil prices, saying it could spark another recession. But today, with the end of Saddam Hussein's regime in sight, analysts are wondering whether oil prices could be in for a prolonged slump.

A couple months ago, oil prices shot up to $40 a barrel as tensions with Iraq began to intensify and a strike in Venezuela reduced supplies amid strong seasonal demand. The spike up severely weakened the U.S. economy, leading it to contract in February and March, according to some economists. But now, the Venezuelan strike is over, demand is set to fall off and an end to the Iraq war seems imminent.

While crude oil already has fallen to under $29 a barrel, analysts say prices could continue to drop, possibly to as low as $22 a barrel over the long term, particularly if there is an influx of Iraqi oil into the world markets.

A decline in oil prices is certainly good news for the economy, as higher energy prices often act as a tax on the consumer. Still, economists warn that higher fuel prices haven't been the only factor hampering the economy in recent months, and a big decline in oil prices won't necessarily cure all of the market's ills.

"The mini-inventory cycle that has recently gripped the automotive industry ... is currently depressing factory activity," said ABN Amro chief economist Steven Ricchiuto. "The tightening of lending standards being applied to the consumer sector by domestic financial institutions is also a significant growth concern, [and] the seemingly endless corporate cost-cutting initiatives are clearly sapping the vitality from the recovery."

Still, a fall in oil prices wouldn't hurt. Iraq holds the world's second-largest oil reserve after Saudi Arabia, with more than 112 billion barrels of oil. Because about 90% of the land is unexplored, some experts believe that the reserves could be even larger. And because Iraq will need billions of dollars to repair its infrastructure after years of sanctions and economic weakness, some analysts think Iraq will be given a free pass to export as much oil as possible once the war is over.

"It's obviously going to have a long-term dampening effect [on oil prices] because it's going to increase supply, or replace supply that hasn't been in the market for 12 years," said Paul Larson, an energy analyst at Morningstar. "Iraq has the second-largest reserves, and it's not even in the top five in terms of production."

Before the war began, Iraq was exporting roughly 2 million barrels of oil per day, down sharply from around 3.5 million barrels before the first gulf war, according to the Energy Information Administration. The EIA, a statistical agency of the Department of Energy, said that the country's production capacity is no higher than 2.9 million barrels per day, with export potential of 2.5 million barrels per day.

One major impediment to producing more oil -- besides U.N. sanctions -- has been that the country lacks the necessary tools and systems. But analysts say new state-of-the-art American technology could help to increase production capacity sharply over the next few years.

"The industry has been in a chronic state of underinvestment for roughly 10 years, so you have immediate rehabilitation needs that are very pressing," said Tyler Dann, an analyst at Banc of America. "The rehabilitation phase and the care of existing assets will take place over the next 12 to 15 months, and then I expect Iraq will come back toward sustainable production of 3 million to 3.2 million barrels per day."

Although it will take some time to negotiate contracts -- some foreign contracts to expand production in Iraq already exist -- and to repair oil facilities, analysts said prices could fall in anticipation of an increase in production.

Iraq has stopped exporting oil since the war began, partly because the buyers of oil weren't sure who they should pay. Saudi Arabia has made up the shortfall, and was recently producing more than 9 million barrels of oil per day, according to industry sources. Once the war is over, however, analysts expect Iraqi production to ramp up again.

Vice President Dick Cheney said Wednesday that he expects Iraq to produce between 2.5 million and 3 million barrels of oil per day by the end of the year -- a number that Fahnestock analyst Fadel Gheit called "conservative."

"Once we get this mess cleaned up, Iraq will open up its oil sector to investment, we're going to lift the sanctions and sponsor all sorts of programs for economic development," Gheit said. "If we apply our technology and expertise, Iraq will have incredible upside potential."

After the steep climb earlier this year, Nymex crude oil is now back down to $28.80 a barrel, and Gheit and Larson said they expect prices to fall to between $22 and $24 going forward. Of course, it's not just Iraq that is prompting talk of lower oil prices. Production in Venezuela is getting back to normal, Nigeria has started pumping oil again and seasonal demand is due to fall in the coming months.

Still, analysts believe Iraq is likely to pressure oil costs over the long term, although prices will ultimately be supported by production cuts from the Organization of Petroleum Exporting Countries. Typically, OPEC considers intervening when the price of oil moves outside a band of $22 to $28 a barrel.

OPEC "tried before to pump as much oil as it could into the market and at the end of the day they got less money for it," Gheit said. "They would rather see a modest cut in production and a modest decline in prices."

On Tuesday, OPEC president Abdullah Hamad bin Al-Attiyah said he is worried about a glut of oil and requested an emergency meeting April 24 to reconsider how much the cartel is producing. OPEC often produces more than its stated goals.

Meanwhile, amid the speculation that oil prices could sag, shares of energy companies have moved lower, with the AMEX Oil Index down 3% for the year. Exxon Mobil (XOM:NYSE - news - commentary) is down 1% year to date, while ChevronTexaco (CVX:NYSE - news - commentary) is off 3%. Oil-service firm Schlumberger (SLB:NYSE - news - commentary) is down more than 10%, although Halliburton (HAL:NYSE - news - commentary) is up 11%. A Halliburton unit won a U.S. government contract to assess and extinguish oil-well fires in Iraq, but missed out on a larger contract for reconstruction in the country.