Iraq and the future of world oil

Fadhil J Chalabi

Middle East Policy, Vol 7, Issue 4, Oct 2000

Iraq's dormant oil potential is so huge that once it is activated and released
it could cause drastic changes in world oil and energy politics. Iraq's
present recoverable reserves, amounting to 112 billion barrels (bbl), are
more than enough to sustain production at Iraq's preU.N.-sanctions levels
for over 100 years. But this is not all. A very in-depth study undertaken
by the Centre for Global Energy Studies (CGES) tries to prove that reserves
yet to be discovered exceed those known to be recoverable. Accordingly,
a totally rehabilitated and sanctions-free Iraq could expand its production
capacity way beyond 8 million barrels per day (mb/d), easily reaching 10
mb/d, and theoretically even 12 mb/d under certain conditions, when U.N.
sanctions are lifted or Iraq is allowed to develop oil under Security Council
resolution 1284.

It is a historical fact that, for various political reasons, Iraq's oil
is the least explored and developed. Following the discovery of the giant
Kirkuk field in 1927, the IPC consortium, which had three concession agreements
covering the entire territories of Iraq, did very little to explore further
or actively expand Iraq's oil industry. This was owing to conflict among
the consortium partners when BP and Exxon established restrictive rules
for investment in Iraq because they had a greater interest in expanding
the oil industry in Iran and Saudi Arabia. The result was a long period
of stagnation in Iraq's oil-industry development that lasted until the
early 1950s, when the Mussadaq crisis erupted in Iran and a concomitant
need arose for more Iraqi oil.

Following the 1952 agreement between the Iraqi government and the IPC consortium,
a broad activity of exploration and investment in new production and export
capacities was established, resulting in enormous strides in the development
of Iraq's oil industry. However, this expansionist phase was short-lived
because the dispute between the government of Iraq and the IPC group, which
had started after the 1958 Revolution, led to a disastrous, unilateral
measure taken by the government in 1961: the promulgation of Law 80, which
recovered 99.5 percent of the territories covered by the three concessions.
For various reasons, the government was not able to explore and develop
the recovered area, which later proved to be very rich in oil, nor was
the IPC group interested in any expanding activity in what Law 80 left
for them.

As a result, another long period of stagnation followed until the mid-1970s,
with the nationalization of Iraq's oil industry (which took place under
totally different conditions in the industrial oil sector), when the government
was very successful in investing in exploration with the help of foreign
oil-service companies. Huge discoveries followed, including many giant
oil fields, the most prominent of which were west of Baghdad (10 bbl),
the Majnoon (11 bbl), West Quorna (8 bbl), Halfaya (3 bbl) and Nahr Umr
(2 bbl). Iraq's oil reserves, estimated by the former IPC group at 35 bbl,
increased to its current level of 112 bbl and production went from about
1.7 mb/d (before nationalization) to 3.8 mb/d in September 1980, when the
war with Iran erupted, following which all expansion programs were brought
to a standstill.

No sooner had that war ended and oil activities started again, than the
U.N. embargo was imposed on Iraq as a result of the disastrous invasion
of Kuwait in early August 1990. All these developments brought the expansion
programs to a grinding halt. More important, heavy air strikes during the
Gulf War destroyed the bulk of the surface oil facilities and reduced the
Iraqi oil industry, in the words of the U.N. Seebolt Consultant Report,
to a "lamentable state." The air strikes destroyed virtually the entire
infrastructure of Iraq's oil industry, as well as surface facilities, the
work-over equipment for oil wells, water and gas separators, most refineries,
pipelines, storage farms, processing plants, pumping stations, etc. This,
together with the shut-down of oil wells for over seven years and a severe
shortage of equipment and spare parts, led to a drastic reduction in Iraq's
real production capacity. On the exports side, Iraq's Al-Bakr deepwater
terminal, which had a 1.65-mb/d loading capacity, was seriously damaged
during the early weeks of the Iraq-Iran War, while the other terminal,
Khor-Al-- Omaia (of the same loading capacity), was thought to have been
virtually written off. With the closure of the pipeline to the Eastern
Mediterranean by Syria, Iraq's export capacity was crippled: from over
5 mb/d prior to the war with Iran, this capacity was reduced to just over
I mb/d for many years during the war, until Iraq succeeded in increasing
export outlets by building another pipeline through Turkey and a twin line
parallel to the Saudi pipeline to the Red Sea ISPA at a capacity of 1.6
mb/d.

Some five years ago, the Iraqi government announced a plan to reach a production
capacity of 6 to 7 mb/d, which could be achieved in cooperation with the
international oil companies. In fact, the government had negotiated a number
of agreements with French, Russian, Italian, German and other companies
to develop many oil fields that had been discovered during the 1970s but
had remained undeveloped. Their production targets could add up to more
than 3 mb/d of new capacity. The government's plan is based on these intended
agreements and on the full rehabilitation of Iraq's oil industry to its
level prior to the U.N. sanctions, when production capacity amounted to
nearly 3.5 mb/d. The implementation of these agreements is conditional
on the lifting of U.N. sanctions. Until then, Iraqi oil is limited by the
U.N. oil-for-food program, which permitted Iraq to start exporting oil
as of 1997. By 1999, Iraqi oil exports had reached 2.2 mb/d, and its production
rose to 2.8 mb/d. However, it is widely thought in the oil industry that
Iraq is stretching its production much beyond the capacity of its fields,
considering the long-inflicted damage to them.

It is not the intention of this paper to discuss the problems of the U.N.
sanctions and their impact on Iraqi oil, but to discuss Iraq's oil in relation
to the future of world oil and the extent to which Iraq can have a significant
impact on the world market and the price of oil. This will depend on whether
or not U.N. sanctions (imposed on Iraq on August 6, 1990, as a means of
drawing Iraq out of Kuwait) are to be lifted or alleviated in a way that
would allow Iraq to invest in its oil industry. The difference between
these two scenarios would have far-reaching results for the world oil industry.


If sanctions are maintained indefinitely, Iraq's oil sales would continue
to be confined to the U.N. Program of oil-for-- food in accordance with
U.N. Resolution 986, which was passed in 1995 but accepted and implemented
by Iraq only in 1997. This stipulated that initially Iraqi oil sales should
not exceed a ceiling of $5.6 billion for each phase of six months, although
later this ceiling was to be totally lifted by Resolution 1284. The proceeds
of the sales are channelled to a U.N. escrow account to which the Iraqi
government has no access.

More relevant to Iraq's oil industry is that the United Nations decided
that an amount of $300 million for each six-month phase of oil sales was
to be allocated to cover the purchase of spare parts and equipment to help
upgrade Iraq's oil-- producing capacity. This amount has recently been
doubled so that the value of the oil equipment and spare parts that Iraq
can buy would amount to $1.2 billion a year.

Iraqi sources assert, however, that actual delivery of spare parts and
equipment is largely delayed on account of restrictions imposed by the
U.N. Sanctions Committee. The amounts allocated cannot be totally used
up because the committee blocks purchasing contracts for equipment on the
pretext of "dual" use, i.e. military purposes could be ascribed to it.


When Iraq started selling oil under the oil-for-food program, it was widely
held that the maximum that Iraq could produce would amount to 2.2 or perhaps
2.4 mb/d, which would mean an export rate of 1.6-- 1.8 mb/d. The difference
represents oil for domestic consumption, exports to Jordan (with U.N. acquiescence)
and oil smuggled out via Turkey and Iran. However, Iraq has been doing
much better; by 1999 its production hit the 2.8 mb/d mark, while exports
reached 2.2 mb/d.2 In fact, Iraqi engineers and technicians with a degree
of Russian help have surprised the oil industry in reaching these targets
despite a dire need for equipment and spare parts and also by their relentless
efforts to overcome many obstacles.

Of late it has been reported that Iraq has further increased its production
to 3 mb/d and plans to reach the pre-embargo level of 3.4 mb/d some time
during the 2001. However, many experts believe that Iraq cannot sustain
this high production level and consider it has been stretching extraction
from oil wells way beyond the levels permitted by sound practice, with
consequent damage to the oil fields. It was also reported that even if
the United Nations relaxed the restrictions on contracts for the purchase
of these materials, their actual delivery would take time, which would
make sustaining this high level of production very difficult. Technically
speaking, however, it is only a matter of time before Iraq can reach its
target of 3.4 mb/d (once oil equipment and spare parts are made available).
Despite the damage inflicted on the oil fields, especially on surface facilities,
the state of oil reservoirs is still good enough to enable the government
to achieve its planned production capacity.

Even if we assume that Iraq will be able to reach its pre-sanctions level
by next year and can sustain this for some time, its impact on the world
market would be very limited. The gradual, small increases in demand for
OPEC oil can absorb a small expansion in Iraqi production, so that exporting
at the Iraqi government's new target levels would not create any surplus
in the market or any serious problem for OPEC in reallocating production
shares. So far Iraq has been kept outside the production agreements.

The only effect that Iraq can have on the market (if it so chooses) is
to cut or reduce drastically its exports, in which case it could create
shortages and send prices higher than their already high levels. This is,
however, a remote possibility because of the need for the fund to cover
the necessary purchase of food, medicine and humanitarian supplies under
the U.N. program strictures.

In addition to the oil-for-food program, Iraq is resorting to smuggling
increased quantities of oil, mainly through Iran, where a growing number
of cargoes are sent to Dubai and Sharja in the UAE. Recent reports indicate
that this kind of traffic can add some 100,000 barrels per day, although
net proceeds gained by the Baghdad regime are much less than its real value
because of the heavy price discounts and the shares of the various dealers
whose hands the smuggled oil passes through.

Far more important is the other assumption that Iraq is allowed to develop
its oil potential with the help of foreign investors, which would lead
to a totally different situation. In this case a major problem could arise
in the world oil industry, given that Iraq can so easily reach a target
of 6 to 7 mb/d within a period of five or six years, as mentioned earlier.
In this event, the question would arise as to whether or not the world
market could absorb the additional output without disrupting the present
balance of supply and demand and pushing prices to an all-time low. To
answer this question requires a brief description of world trends of supply
and demand and a bit of speculation on what might happen during the coming
decade. Generally speaking, if future demand for OPEC oil were to grow
at robust rates, the re-entry of Iraq with a large amount of oil could
easily be accommodated without any problem for OPEC and the world market.
Conversely, if such demand were weak, Iraq's oil would create a very serious
problem with which OPEC would hardly be able to cope, provoking an oil
surplus that would increase enormously the downward pressure on prices.


Many widely divergent forecasts have been made of future world supply/demand
balances and the need for OPEC oil, and especially that of the four major
Gulf producers. Some of these forecasts, in particular those made by the
International Energy Agency (IEA) and the U.S. Department of Energy (DOE),
predict such strong demand for the coming 10-20 years that Iraqi oil is
seen as being much-- needed during that period. In fact the IEA predicts
that world demand for oil from the Middle East OPEC members could reach
as much as 41 mb/d by 2010, a level more than double the present level
of about 19 mb/d. Forecasts made by the DOE are similarly high, although
lower than those of the IEA (i.e. 28 mb/d).

Given such an eventuality, increases in production required annually from
those countries would be 2.1 mb/d and 0.8 mb/d respectively. This is to
be compared with actual production performance during the 1989-1999 period,
when the annual increase in those countries' production was less than 0.5
mb/d. If these forecasts are to be believed, the expansion of Iraqi oil
production would be a prerequisite for satisfying world oil demand.

History shows that energy forecasts have no real value and that those made
in the past have invariably proved to be wrong. The reason for this is
that forecasts are made on assumptions based on market conditions operative
at the time the forecasts are made. These conditions are bound to change
with economic, technological and political developments in ways that no
one can predict. More meaningful is to observe current trends and how they
can affect supply and demand. Those trends indicate that oil supply/demand
movements are not in line with the IEA or DOE forecasts.

Over the last 20 years, developments have led to far-reaching changes in
the structure of the oil industry, to the detriment of demand for oil from
OPEC, especially from the large resource base in the Middle East. Members
with a limited oil resource base did not suffer much.

The growth rates of oil demand have been severely curtailed because of
improvements in the efficiency of fuel utilization and the shift to other
sources of energy. Furthermore, OPEC's high prices triggered a series of
changes in favor of investment in high-cost oil outside OPEC, which has
been growing at the expense of OPEC oil. OPEC's high price regime and pricing
system, based on the quota and production cuts, were behind the spectacular
increases in non-OPEC oil supplies. The result was that the share of oil
in the world's total primary energy consumption declined, and OPEC's share
decreased dramatically. From a peak of 32 mb/d in 1974, OPEC production
fell in 1999 to about 27 mb/d. The following chart shows that, excluding
the former Soviet Union, production outside OPEC 25 years ago was less
than half that of OPEC. Now it is appreciably higher! The chart shows the
extent of the loss of OPEC's share in world oil supplies.

Trends in world oil demand in the recent past suggest that the slowdown
in growth will continue into the future and perhaps become even more marked.
Over the period 1989-99, the average annual growth rate of global demand
was 1.3 percent. The growth rate of demand during that period was higher
if the former Soviet Union is excluded (2.1 percent) because of the collapse
of oil consumption in that area after the end of communist rule. Certain
developments in technology, the environment, world economic growth, fiscal
policies in consumer countries and continued high OPEC prices may call
into question the continuation of this very low growth rate in world demand.


Recent, technological progress in fuel efficiency, especially in the transportation
sector, is slowing the growth of oil consumption, in particular in the
United States, where gasoline accounts for about half of its giant oil
consumption. Hybrid engines, based on mixing fuel and batteries, could
increase efficiency by more than 150 percent. The invention of fuel-cell
vehicles could have a significant impact. It has been reported in the U.S.
oil industry that commercial manufacturing of this type of vehicle could
start by the year 2005. Other things, such as the use of Liquid Natural
Gas, LPG and GTL (production of clean fuels for gas) could reduce gasoline
consumption even more rapidly. Furthermore, the revolution in information
technology, especially with the Internet, means that a vast number of transactions
and communications are made without moving the product, reducing the volume
of traffic, among other things. Another important development related to
the technology revolution that could have a great impact on oil consumption
is the shift in the generators of economic growth in the industrialized
nations (especially the United States) from oil-intensive sectors like
automobiles to non-oil-intensive sectors like information technology. This
sector, which today absorbs about 30 percent of total investment in the
United States, is a consumer of electricity, which is dependent on non-oil
energy sources, especially natural gas. The share of fuel oil in the total
U.S. oil consumption came to only 5 percent in 1999. This means that economic
growth, the stimulus for oil consumption, will require much less oil in
the future than in the past. The growth of the world economy will be further
decoupled from oil in the future,3 putting greater downward pressure on
the growth of oil demand.

Environmental pressures, which have an increasing political significance,
are also adding impetus to the decline of oil consumption. Although not
easy to achieve, the targets of the Kyoto Protocol, radically reducing
carbon dioxide emissions, are considered as a real threat to the consumption
of fossil fuels (especially of coal and oil) in favor of renewable sources
of energy that are free of these emissions, such as nuclear energy or natural
gas, which has far less COz content than oil does. The carbon tax adopted
in the EU, which has been in effect for more than a decade, is indicative
of the environmental impact of oil consumption.

Consumption of oil, especially in the industrialized countries, has been
adversely affected by increasing taxation, which makes the price paid by
the end-consumer so high as to affect consumption. The tax component in
the internal price of gasoline tion. The following chart shows that historically
the incremental consumption of oil goes in the opposite direction to the
price: the lower the price, the higher the consumption and vice versa.
If OPEC continues with present price levels, there is every risk that demand
will decline even more. The most important area that could be hit by high
prices is Southeast Asia, whose economy started to rebound recently after
the financial collapse. It should be borne in mind that the bulk of incremental
demand 1992-97 was from that part of the world. Of 6 mb/d of global incremental
demand during that period, 5 mb/d came from Asia.

Higher oil prices accelerate the shift to in most European countries is
as much as 80 percent. The price of the composite barrel in Europe now
has a 63-percent tax component, as against 40 percent in 1980.

Perhaps even more important is OPEC's high-price policy, which is preventing
the healthy growth of oil consumpother sources of energy, especially natural
gas. The following chart shows the price effect on the consumption of gas
vis-a-vis oil in Japan. The price shocks of the 1970s and 1980s produced
a dramatic change in the energy pattern, when oil's share in total energy
requirements fell from 80 percent in 1979 to 51 percent in 1999, in favor
of both natural gas and nuclear power, whose combined share increased to
about 30 percent compared with only 4 percent twenty years earlier.

On the supply side, both technology and OPEC's high prices are reinforcing
the increase in new, high-cost oil (oil produced outside OPEC, the United
States and the FSU). Technology in exploration, especially the three and
four dimensional seismic survey, has made the drilling of new reservoirs
almost risk-free. The identification of reservoirs has become more and
more exact. This has the effect of drastically reducing the cost. Technology
in developing discovered oil has reduced the cost by no less than 40-50
percent over the last ten years. Because of the OPEC price shocks, the
new oil produced outside OPEC, the United States and FSU has grown from
7 mb/d in 1973 to 27 mb/d in 1998 (i.e. from 20 percent to over 40 percent
of total world production outside these three areas).

Chart 4 shows how the non-OPEC share in world supplies reacts favorably
to higher prices.

With these trends of mounting downward pressure on demand and increasing
incentives to invest in more supplies, future requirements for OPEC oil,
especially Gulf oil, should not be so high as to create a real need for
additional Iraqi oil. If we leave aside the IEA and DOE forecasts, and
see what has happened in the past ten years and what may happen in the
future, in taking into consideration the supply/demand trends as discussed
earlier, we may reach different conclusions. Over the period 1989-99, the
average annual growth rate of world demand has been 1.28 percent. This
very low growth rate is partly distorted by the collapse of oil consumption
in the FSU, following the collapse of communism. If we exclude the FSU
from global demand over that same period, the average growth rate of demand
has risen by 2.1 percent annually.4

Many forecasters tend to extrapolate growth rates of the past years' performance
of oil demand in order to project these rates into future trends and in
doing so attempt to demonstrate that world demand by the year 2010 would
amount to over 87.4 mb/d, or about 18 mb/d more than in 1999.1 However,
such extrapolation is misleading and invariably gives wrong results, especially
in light of changing technology, social lifestyle, political pressures,
investment, etc.

Due to these downward pressures on demand, it is inconceivable that past
growth rates will persist into the future. A lower growth rate should be
envisaged. If we assume that future global demand will grow by a lower
rate of 1.5, which might be doubtful, non-FSU world demand by the year
2010 could reach 82.1 mb/d or 5.5 mb/d less than the other scenario, based
on an extrapolated increase of 2.1 percent per annum, or an increase of
about 13 mb/d on current demand.

World demand for OPEC oil depends also on the extent of supplies outside
OPEC because of OPEC's persistent policy of being the last-resort producer,
i.e. producing only such volumes of oil as will make up the difference
between world demand and supplies from outside OPEC, or what is usually
referred to as the world's swing producer. In this case the higher the
supplies outside OPEC, the lower the demand for OPEC oil and vice versa.


A wide divergence of views exists concerning future oil supplies from outside
OPEC. An IEA official speaking at a recent Asia Oil and Gas Conference
estimated that non-OPEC supplies will grow by 5 mb/d from now until the
year 2010, or an average of 0.5 mb/d per year.6 If these estimates are
to be accepted, then the incremental demand for OPEC oil will by that year
be 8 mb/d. Some other estimates now give a higher number for non-OPEC oil
suppliers because of significant discoveries in Kazakhstan, Russia and
other regions. Higher estimates for nonOPEC supplies would also stem from
the fact that new technology and high prices have hastened the replacement
process of depleted oil by new oil and at a low cost. If we take this factor
into account, those higher estimates of non-OPEC supplies cast doubt on
the earlier predicted decline in production rates of both the United States
and the North Sea. Instead, their present production may more likely be
sustained by the replacement of oil through greatly enhanced recovery,
new discoveries, etc. However, even if we take the IEA estimates of non-OPEC
supply, the incremental demand for OPEC oil by the year 2010 will amount
to about 7 mb/d, or an average of 700,000 b/d per year.

This incremental call on OPEC oil in ten years' time is too small to create
a need for additional Iraqi oil. In OPEC there now exists some 3.5 mb/d
of unused capacity, mostly in Saudi Arabia. According to OPEC countries'
planned expansion of production capacity, an additional 9 mb/d could be
put on stream by 2010 within OPEC, apart from Iraq's 3.4 mb/d. If realized,
those plans could add more oil than the incremental demand for OPEC oil
by the year 2010.

>From the above analysis of present and likely future trends in world oil
supply and demand, it is apparent that a need for Iraqi oil will not arise.
The trend of incremental supplies inside and outside OPEC tends to outstrip
incremental demand, with the result that the world oil market will witness
in the future a huge potential oil over-- supply, and hence weaker prices.
However, the crucial factor that may change those trends is whether OPEC
will be able to control supplies in order to keep prices high. With a low-oil-price
scenario, investments in high-cost alternatives will have to slow down,
creating more demand for Gulf oil, including Iraqi oil.

All things being equal, time does not favor Iraq's oil, implying that it
is in the interest of Iraq to do its utmost (and much sooner than later)
to create conditions that would allow the investment contracts and agreements
mentioned earlier, which depend in the final analysis on lifting sanctions.
U.N. Resolution 1284 has already opened a door for Iraq to do so. According
to this resolution, Iraq should accept the re-entry of the new U.N. inspection
team (UNMOVIC).7 If Iraq's cooperation with the latter proves satisfactory,
sanctions could be suspended for a certain period (six months) and renewed
or not depending on the judgment of the inspection team. In such an event,
the U.N. resolution would allow Iraq to open its industry to foreign investors
and start operations that would add new capacity of more than 3 mb/d (besides
completely rehabilitating pre-war oil-production and export capacity, which
foreign investors would assist). Because of the cost advantage in favor
of Iraqi oil, investing in Iraq could be more attractive for those investors
than investing elsewhere. The sooner Iraq's investors start this operation,
the greater the chances that investments in high-cost areas will decline.


Thus, accelerating Iraq's acceptance and implementation of the U.N. resolution
could have the effect of slowing down investment in new capacity elsewhere.
Although the Iraqi government did not formally reject Resolution 1284,
it made it quite clear that Iraq is not ready to accept the re-entry of
the U.N. inspection team, a sine qua non for the creation of the favorable
conditions required for oil investments to commence. It seems that the
Iraqi government is not in a hurry for investment in its oil, perhaps because
it is under the illusion that the world will sooner or later need it.

1 A recent statement from the Oil Ministry of Iraq suggests the partial
repair of that terminal, allegedly restoring almost half of its original
capacity. The credibility of this statement can be tested only by actual
performance. It is to be borne in mind that some such statements are made
to serve certain political objectives.

2 From the Al-Bakr deepwater terminal that has been partly rehabilitated
to take 1.2 mb/d and also via the Turkish pipeline at the rate of 0.9 mb/d.


3 The effect of price shocks and technological progress on the relationship
between economic growth and oil consumption was enormous. Prior to the
price shocks, an increase of one unit of GDP entailed more than one percentage
point increase in the demand of oil. This high "oil coefficient" factor
has now declined with the result that oil demand in the IECD area was decoupled
from economic growth. In 1999 combined oil consuption in the OECD (United
States, Western Europe, Japan, Canada, Australasia) was only 0.8 mb/d higher
than 20 years ago, yet during those years the cumulative economic growth
of those countries exceeded 50 percent.

4 BP Amoco Statistical Review, 1999.

5 Non-FSU oil consumption in 1999 was 69.57 mb/d. Ibid.

6 Middle East Economic Survey, Vol. 63, No. 27, July 3, 2000.

7 This new U.N. body for arms inspection has been created to replace the
defunct UNSCOM, which ceased practically to exist following the Desert
Fox Operation in December 1997, launched by both the U.S. and the U.K.


Dr. Chalabi is the executive director of the Centre for Global Energy Studies
in London.

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