Prognosis for Iraq

The report of the Iraq Study Group was released just over a week ago. As expected, it contained no silver bullets, but rather a list of 79 recommendations that are no less controversial for their practicality. Setting aside the national-strategic questions the report poses, I believe its implications for energy markets fall into two categories: what happens if the ISG's recommendations are implemented, and what happens if they aren't, or can't be put into effect? Either way, there isn't a lot of upside here, by way of factors that would promote increased oil production from Iraq, while easing the growing risks of regional instability that are weighing on the market.

The ISG explicitly recognizes oil as the engine of Iraq’s future growth, and its recommendations for the oil sector are generally sensible and straightforward. At the highest level, they propose reducing the centrifugal influence of the Iraqi constitution's provision allowing the country's regions to claim the full benefit of future oil discovered on their territories. This would be achieved via a proportional revenue sharing mechanism, which is in the works, and the reorganization of the oil industry along commercial lines, incorporating international standards and practices. The report also highlights the need to reduce oil-related corruption, which siphons off between 5-25% of the country’s production, though that upper bound stretches credulity. Metering oil volumes at both ends of the pipelines, as the ISG suggests, would at least increase transparency and reduce the opportunity for large-scale smuggling.

Some of the ISG’s oil-related recommendations are more problematic. Although the US learned its own bitter lessons about the consequences of holding gasoline prices below market-clearing levels in the 1970s, de-controlling petroleum product prices in a dysfunctional Iraqi economy might easily make things worse, rather than better, and add to civil unrest. At the same time, the proposal to increase the involvement of the US military in securing Iraqi oil assets would create visible contradictions to the suggested reiteration by President Bush that the US does not seek to control Iraq’s oil. Proposals for improving the country’s legal framework to promote international investment in the oil sector are important, but wouldn’t be effective as long as the security situation remains unsettled.

That last point is the crux of the whole problem. The impact of the report’s good ideas for the oil sector will be entirely secondary to the success of its primary recommendations for resolving the unfolding civil conflagration in Iraq, and for creating the basis on which the US can withdraw its forces—sooner or later--while leaving behind a stable, self-governing country. If the Baker-Hamilton Report represents the blueprint for achieving these goals, as many believe, then the initial reaction of the Iraqi government--which must be a full partner in the implementation of these recommendations--isn’t a good sign.

At best, if every recommendation of the Baker-Hamilton team were put in place, the report suggests that oil production might return to its pre-war potential of 3 million barrels per day or so. That would enable exports to increase from their current level of 1.3-1.7 million barrels per day to well over 2 MBD. Otherwise, the downside ranges from bad—the steady deterioration of the industry from the stresses of war and corruption—to spectacularly bad, if Iraq’s instability spreads to its oil-producing neighbors, or if its central government collapses and US forces must fight their way out of the country, echoing Britain’s First Afghan War. In the worst case, the US could find itself backing Iraq’s Shiites in a full-blown civil war against Sunnis supported by Saudi Arabia.

Many of the fundamentals in the global oil market seem to be bearish, just now, with OPEC trying to find the right formula for cutting production to avert a glut next year. But overlaying the likely scenarios for Iraq onto this picture, we have all the ingredients for a highly volatile, risk- and news-driven market throughout 2007 and into 2008. Expanding capacity in Saudi Arabia and elsewhere may buffer the impact of events within Iraq, but if they spill over, oil prices could spike higher than this summer’s peak of $77/barrel.

Note: Publication of this blog was delayed by technical problems accessing the internet.