Iraq’s flood of ‘cheap oil’ could rock world markets

First of two parts.

The U.S. is not the only nation experiencing a renaissance in oil production.

Sidelined for two decades by war, sanctions and political instability, Iraq passed a critical milestone last year by producing 3 million barrels a day of crude oil for the first time since 1990, before the Persian Gulf War, reaching 3.4 million barrels a day by December. Given its access to vast reserves at low costs, Baghdad is poised to play a pivotal role in determining whether the world’s growing thirst for oil drives up fuel prices to debilitating levels in coming years.

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“Iraq has a potential as a game-changer” in the volatile global oil market, said Maria van der Hoeven, executive director of the Paris-based International Energy Agency (IEA). Already, she noted, Iraq has moved up to be the world’s third-largest oil exporter and is now on a path to be much more, becoming a “strategic source of world oil supply” in the years ahead. Iraq even has hopes of supplanting Saudi Arabia as the globe’s biggest oil producer.

Iraq is perhaps the only country left in the world that has huge stores of what insiders call “cheap oil” — untapped reserves that can be extracted through relatively inexpensive, traditional drilling techniques rather than having to employ costly technologies such as hydraulic fracturing and deep-sea exploration — as in the U.S. — to tap reserves of oil found offshore or in deep underground shale formations.

The boon of cheap oil is the ironic result of Iraq’s many years outside the economic mainstream, when ongoing wars and an international oil embargo enforced by the United Nations ensured that the nation’s oil treasures were left mostly untouched in the ground.

The gusher of oil starting to flow from Iraqi wells couldn’t come at a better time. Demand for oil is escalating in quickly emerging markets such as China and India, where the use of cars is surging, and other major oil exporters such as Russia and Saudi Arabia appear to be reaching limits of their abilities to ratchet up production in major ways.

In fact, the IEA is projecting that most of Iraq’s oil production — which Iraq’s leaders hope will top Saudi Arabia’s 11 million barrels a day at 13.5 million barrels eventually — will be funneled to China and other expanding Asian markets rather than its traditional markets in the U.S. and Europe, filling a critical gap in world oil supplies that should alleviate pressure on prices in the years ahead.

Surging demand

Even using conservative estimates, the IEA expects Iraq to more than double its current production to 6.1 million barrels a day by 2020 and 8.3 million by 2030, enabling the country to supply 45 percent of the increase in global oil demand by 2035. Within two decades, IEA analysts expect Iraq to surpass Russia to become the second-largest oil exporter.

Iraq is coming back on the scene just when demand for oil was poised to surge in a way that threatens to drive up oil and gasoline prices to destabilizing levels. The world got a glimpse of what surging demand in emerging markets can do to oil prices when the price of premium crude shot up to an unprecedented $145 a barrel in July 2008 — the last time the world economy was experiencing robust growth. Economists say the 2008 spike in oil prices played a role in sending the U.S. economy into recession even before the global financial crisis hit months later.

The global economy has been too weak since 2008 to stoke such high prices, with demand for oil in the U.S., Europe and Japan — still the biggest consuming blocs — stable or in decline. Still, even in a weak economy, premium crude on the London exchange has been trading well above $100 for several years.

The IEA said Iraq will need to boost production to prevent another destabilizing spike in prices the next time the world economy is firing on all cylinders. It estimates that if things go well and Iraq is able to make the hefty $530 billion of investments needed to triple production in coming years, world oil prices still will rise gradually to $215 a barrel by 2030 because of fast-growing demand in emerging countries.

But it could be much worse. Should Iraq fail to realize its potential, the world could face a future punctuated by oil crises, with prices skyrocketing as new sources of supply are unable to keep up with robustly growing demand.

“Success is not assured, and failure to achieve the anticipated increase in Iraq’s oil supply would put global oil markets on course for troubled waters,” said Fatih Birol, the agency’s chief economist, adding that the “health of the global economy” is at stake.

Obstacles to overcome

But it will not be easy for Iraq to scrape up the mountain of cash needed to upgrade its tattered oil-producing facilities and overcome a legacy of instability and violence that has hindered production in the past. Years of war and neglect have left Iraqi oil fields with considerable damage that will require major efforts to reverse. Iraq also will have to make large investments in its electrical, natural gas and water systems as well as in better oil transport, storage and drilling facilities.

Iraq will have to make some hard choices to come up with the cash to make these major upgrades. Iraq’s $115 billion of yearly revenues from oil exports provides nearly three-quarters of the income that the government and the nation’s citizens depend on for basic needs and services. The nation would have to devote a significant share of those revenues — about 10 percent — in the next decade to improving its oil fields and facilities.

But Mr. Birol noted that the payoff is enormous if Iraq makes the required investments: a near doubling of its oil revenues to $5 trillion in the next decade. He said Iraq also could become a major exporter of natural gas if it makes needed investments.

But perhaps the most nettlesome problems the nation will have to overcome are political. In particular, it must resolve a festering dispute between the government in Baghdad and the Kurdish regional government over control of the nation’s northern oil fields in Kurdish territory.

Authorities in the semiautonomous Kurdish region defied Baghdad’s wishes in recent years and negotiated contracts with major oil companies such as Exxon Mobil Corp. to develop the fields — a move made possible by the lack of a national law or consensus governing who controls the oil fields and how the revenues that come from them are to be divided among the regions.

The conflict recently boiled over into armed clashes, with tensions in particular centered on a plan by Exxon Mobile to drill in an area of disputed territory claimed by Baghdad. The national government threatened to send in the army, if necessary, to prevent the drilling, and raised the threat of a wider war with Iraqi Kurds if the company did not back off.

Much intrigue has swirled around Exxon Mobil because of its conflict with the Baghdad government, including reports that the oil giant might sell its stake in the mammoth West Qurna oil field in the south to the China National Petroleum Corp. for $50 billion.

Baghdad also has showed its displeasure with other oil companies doing business with the Kurds by refusing to include them in deals to develop Iraq’s super-giant southern oil fields around Basra, which contain the largest reserves of oil.

“Chevron was recently told it was not qualified to do business with Iraq because of deals with Kurdistan,” Ben Lando, editor of the Iraq Oil Report, said on Platt’s TV. The territorial dispute has put global oil companies in a difficult position, he said. The Kurdish authorities offer more lucrative production-sharing agreements, but the most plentiful oil reserves are in the south, where the Baghdad government is offering them skimpy fees for assistance in exploiting the oil.

“They have to decide whether to invest in Kurdistan or the rest of Iraq,” Mr. Lando said. “It’s really a political issue more than anything else.”

Violence hampers drillingOil companies for years avoided working in Iraq because of the threat of violence against company personnel and facilities. That is still a concern, although the level of violence is down from the peak during the U.S.-led military mission in 2006, Mr. Lando said.

“Violence continues to be horrible for Iraqis,” but “it hasn’t really gone into the oil sector that much. You haven’t seen attacks on refineries,” he said. A recent kidnapping of foreign oil company workers was tribal-related rather than the work of the al Qaeda terrorist network, he said.

The global standoff with Iran that has raised fears about disruptions of oil traffic in the Strait of Hormuz, the shipping lane for most of Iraq’s oil, is also not much of a concern in Baghdad, he said. Iran frequently threatens to shut down the strait in retaliation for the West’s sanctions over nuclear activities, but the Iraqis “don’t think it’s going to happen,” he said.

Regardless of the violence and political feuds, Iraq represents one of the last and most promising unexplored territories on Earth for oil companies at a time when conventional oil production is declining in most other nations, he said.

Iraq has the fourth-largest proven reserves in the world of 143 million barrels of crude, but “the country is only about 30 percent to 40 percent explored,” said Mr. Lando. “There’s a lot of opportunity to find more oil.”

Prior to the clashes that broke out in November, Baghdad and Kurdish authorities had reached some tentative compromises in their dispute, including a move by Baghdad to tolerate some Kurdish exports through a pipeline going through Turkey that had been shut down for years.

“Washington is the only outside actor with the power and experience to push Baghdad and the [Kurds] toward formalizing the compromises achieved this summer,” Mr. Henderson said, adding that this should “be a priority for the second Obama administration.”

James Jeffrey, a former U.S. ambassador to Iraq, agreed.

“The U.S. has been very active trying to work out arrangements where everybody cooperates and oil and eventually gas from the north is exported in cooperation with Baghdad,” he told Platt’s Energy Week. “The latest deal has fallen through. People are back arguing, and more needs to be done to ensure that a solution satisfactory to everybody can be achieved because this involves military as well as energy politics.”

Despite the public rhetoric, he said, the Kurds and central government have cooperated on the shipment of oil when it benefits them.

“Everybody is playing a veiled as well as open game here,” he said. “A great deal is at stake, not only in energy, but in the political stability of Iraq, where we lost so many people, and therefore I know the U.S. government is very energetically engaged in trying to find a solution.”