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By Stephen Ellis

Iraq is the bad boy of the global oil scene, callously pursuing its interests despite its impacts on others. Investors who want to understand how the global oil picture develops over the next few years need to be aware of Iraq's ambitions. The country risks incurring OPEC's ire as it seeks to grow production significantly over the next few years. At the same time, the country has inflamed tensions with the autonomous region within its borders, the Kurdistan Regional Government, or KRG, over oil sovereignty. Initially, oil and gas companies, lured by Iraq's enormous reserves, were willing to go on a first date, but the KRG's also-lucrative reserves and more attractive legal and operating environment have stolen many of Iraq's original suitors. Today, Iraq has made limited progress on a number of key initiatives since 2011 and faces significant infrastructural and institutional constraints if it wants to achieve its recently reduced target of 9 million barrels per day of production by 2020. We believe 5.5 million-6.5 million bpd by 2020 is more likely, but continued delays could mean as little as 4 million-5 million bpd of production. Still, in an environment of surging U.S. production, Iraq's barrels threaten OPEC's relevance like never before.

The Current and Near-Term Field Outlook
Iraq's oil production has certainly improved since 2009, but there has been a wide variety of outcomes and challenges both at the project and at the field level. Production levels have grown modestly, but projects have also stalled, with setbacks in the Common Seawater Supply Facility, export capacity, pipeline upgrades, and hydrocarbon laws. The Iraqi government is also admitting defeat to some extent, as it has introduced new goals of 9 million bpd by 2020 instead of 10 million-11 million bpd of production by 2017. We still think Iraq's new goals are unachievable, and despite some early successes, we believe that virtually all of the Iraqi fields will fall short of their production plateau goals by 2020.

Big Challenges Still Loom
We think Iraq has virtually no chance of meeting its 9 million bpd plateau target, and even our forecast of 5.5 million-6.5 million bpd by 2020 implies that Iraq overcomes a number of infrastructural, institutional, and political challenges. Specifically, we think there are critical issues with oil export capacity, the institutional capability required to approve necessary projects, and continued sovereignty tensions with the Kurdistan Regional Government that will cause Iraqi fields to miss production goals more than any specific field-level problem.

Export, Storage and Transport
Iraq's plans to improve its export, storage, and transport infrastructure haven't met expectations, and this area remains critical to the country's economic health. For context, Iraq's oil production is used as follows: 650,000-700,000 bpd through its refineries for domestic energy needs, about 300,000 bpd through the onshore Kirkuk-Ceyhan pipeline, 1.5 million bpd through the Al-Basrah oil terminal, and 442,000 bpd through recently constructed export terminals called single-point mooring terminals. The terminals are operating well below capacity and, once a third terminal is completed, will reach 8 million bpd. A key issue here is storage capacity, as the lack of oil storage means that poor weather can disrupt offloading the oil from a pipeline to a terminal, thus delaying oil exports. Improving storage will let Iraq better use its existing export terminals; during periods of poor weather, for example, Iraq can use stored oil to ensure exports continue. Iraq is working on boosting its oil-storage option in southern Iraq and plans to reach 8.5 million barrels of capacity by the end of 2013 from around 5.5 million barrels of capacity in 2012. If Iraq can get 8 million bpd of storage capacity by the end of 2013, which we think is reasonable, the country will be in good shape for foreseeable future, as we do not expect exports to top 8 million bpd.

Reviewing Iraq's pipelines and construction plans, one word comes to mind: disappointment. Iraq's major crude export pipeline, the 1.65 million bpd Kirkuk-Ceyhan pipeline, has been repeatedly disrupted, and only one of the twin pipelines is operational. As a result, the maximum available capacity is about 600,000 bpd, but actual flows recently were only about 300,000 bpd. The Strategic Pipeline (850,000 bpd capacity), which is supposed to provide oil to help the Kirkuk-Ceyhan pipeline reach full capacity, has only had actual flows well below 50,000 bpd recently and still needs repairs. Other major pipelines such as the Kirkuk-Banias pipeline (700,000 bpd capacity) and the Iraq pipeline to Saudi Arabia (1.65 million bpd capacity) have been closed since the 2003 and 1991 wars, respectively. Proposals on deck include a 1 million bpd pipeline to transport heavy oil via Turkey, a 420,000 bpd pipeline to transport oil to Turkey from the KRG, and a 2.25 million bpd pipeline to transport oil to Anbar Province from Basrah (the Iraq-Jordan pipeline).

Institutional Challenges
The Iraqi treasury and related entities have no small task ahead of them. It's highly probable that they will need to manage and approve $530 billion in oil, gas, and electricity-related spending from 2012 to 2035. The institutions include the Iraq Ministry of Oil, the Ministry of Electricity, the South and North Oil companies, the Midland Oil Company, the Missan Oil Company, the State Oil Marketing Organization, and the North and South Gas companies. The Kurds also have their own regional Ministry of Natural Resources and Ministry of Electricity. The peak spending levels are likely to occur from 2012 to 2020, and managing the contracting and approving process for this level of work is easily more than enough to stretch the current capabilities of the various state agencies, as many employees lack the required experience. This inexperience and the number of institutions involved point to delays in obtaining financing, project sanctioning, approving vendors, and issuing required permits and licenses. Given the shortage of manpower and resulting delays in approvals, Iraq has managed to spend only about 60%-70% of its planned capital expenditures in recent years, meaning that its forecast of consistent fiscal budget deficits are routinely surpluses. As a result, at an average of $22 billion a year in spending going forward compared with just $9 billion in 2011, we see this as a considerable hurdle. If Iraq cannot resolve these issues, oil and gas companies might re-evaluate their project returns and move to greener pastures.

Another example of Iraq's struggles from an institutional standpoint is water. The major facility for providing water to the southern Iraqi oilfields is the Common Seawater Supply Facility, or CSSF. Given Iraq's lack of access to freshwater, the facility's full operational strength of 10 million to 15 million bpd of seawater from the Persian Gulf is very important. Originally, the $10 billion-plus project was awarded to Exxon Mobil (NYSE:XOM) in 2010, but it took until late 2011 before agreement was reached on an initial plan to proceed with the front-end engineering and design, or FEED, phase to resolve differences over cost projections. In another setback, ExxonMobil was removed as lead from the project in February 2012 because of tensions between KRG and Iraq and replaced by CH2M Hill in October 2012. Iraq has yet to file a design contract for the project, and as a result, the initial 2 million bpd phase has been delayed to 2017 from 2013. We think the series of delays underscores Iraq's institutional weaknesses in terms of reviewing and accepting key projects in a timely manner. As a result, we estimate that taking the facility to its full operational plan of 10 million-15 million bpd may take until 2030, instead of our original expectations of around 2020.

The Kurdistan Regional Government
The Kurdistan Regional Government is the ruling body in northern Iraq, and has been involved in a number of disputes with the Iraqi government; if the issues are not resolved, we think this represents another sizable risk to Iraq's overall progress, particularly as the Kurdish region is estimated to contain around 45 billion barrels of unproven reserves (the International Energy Agency estimates 4 billion proved), which is roughly 20% of Iraq's overall unproven oil reserves at about 214 billion barrels (a number provided by Iraqi officials).

The Kurds have awarded around 50 contracts for exploration in the region to companies such as Murphy Oil (NYSE:MUR) and Marathon (NYSE:MRO) in 2010; Hess (NYSE:HES), Repsol (OTCPK:REPYF), and ExxonMobil in 2011; and stakes in existing licenses to Chevron (NYSE:CVX), Total, and GazpromNeft in 2012. The problem is that without a national hydrocarbon law on the books, there's no formal policy that states what entities are responsible for and which ones can enter into hydrocarbon contracts. Iraq wants its hydrocarbon contracts to be run through the national government, while the KRG passed its own law in 2007. The region controls three key oilfields (Taq Taq, Tawke, and Shaikan) and shares part of Kirkuk with Iraq, and we estimate 2013 production levels at around 250,000 bpd (KRG's earlier forecasts were as high as 1 million bpd in 2012). Given KRG's uncertain status, there have been a number of bitter disputes between the region and the national Iraqi government.

  • Iraq plans to boost production at the Kirkuk field, which is at the edge of the KRG boundary, and KRG has claimed that it must approve any development plans. The field contains three large production areas, with Iraq operating two, and the KRG operating the third, which is causing the conflict.
  • Exxon Mobil was forced out of the Common Seawater Supply Facility project because of its contracts with the KRG, and Iraq has asked that the firm exit its West Qurna 1 stake if it wants to keep its KRG contracts.
  • Cost disputes over revenue sharing regarding exports from the KRG area through the Ceyhan-Turkey pipeline (about 175,000 bpd in 2012) led to the KRG suspending production exports in April 2012. Exports were restarted later in 2012.
  • State-owned Turkish oil firm TPAO was expelled by Iraq from an Iraqi exploration contract in 2012, probably because of tension between Iraq and KRG (even though Iraq denies it).
  • In March 2013, Iraq passed a $118 billion budget that allocated just $650 million to pay what the Kurds claim is a $3.5 billion debt that it owes oil and gas companies. In response, the KRG withdrew its politicians and only recently sent its lawmakers back to Baghdad in May 2013 after agreeing to resume talks.

KRG's landmark agreement in April 2013 to supply oil directly to Turkey has completely cut out the national Iraqi government and potentially lets Turkey take over the Kurdish government's stakes in its concessions. Exxon Mobil's concessions are mentioned as a possibility, and Turkey recently signed a joint venture with Exxon Mobil to develop projects in the KRG region, another worrying prospect for Iraq. The KRG is on track to complete a 300,000 bpd pipeline by midyear, which will carry oil from Genel Energy's Taq Taq oilfield to the Kirkuk-Ceyhan pipeline for direct export to Turkey. However, Turkey has said that it is open to a payment split where 83% of the oil revenue went to Baghdad and the rest to the KRG (a split that is in Iraq's constitution). In our view, Turkey is eager to both acquire Kurdish oil and help broker an agreement between the Kurds and the Iraqi government because being able to import cheap Iraqi/Kurdish oil and gas could cut its oil and gas import bill, which was estimated at $60 billion in 2012, by a third.

Energy Demand in Iraq
Iraq's energy consumption is markedly different than most Middle Eastern countries, and the changing energy mix over the next decade could have substantial implications for the country. The EIA estimates that in 2012, Iraq consumed about 884,000 barrels of oil per day and in 2011 about 31 Bcf of gas per year. About 60% of energy demand is for transport, 20% for buildings, 10% for industry, and the remainder for other uses. What's striking about Iraq's energy mix is its dependence on oil, which accounts for about 80%-85% of energy consumption, whereas most Middle Eastern countries have moved toward gas over the last several decades. We believe Iraq needs to pursue a similar route, particularly if it wants to resolve its pressing electricity challenges (blackouts are common).

We see Iraq's electricity situation as poor today.

  • Electricity demand was around 57 terawatt hours in 2010, but the country can generate only about 33 terawatt hours. As a result of the shortage, blackouts are common and can be anywhere from 12 to 16 hours a day.
  • Electricity generation is primarily with oil, with about 57% coming from oil in 2010 and 33% from gas.
  • In 2008, Iraq purchased 74 turbines, or 10 gigawatts of electricity capacity, from GE and Siemens (SI), but institutional delays have halted the projects. In fact, the delays have been longer than it would take to construct the turbines.
  • Enhancements must be made to the transmission, distribution, and natural gas networks to support the additional capacity. Just over half of Iraq's generation capabilities date from pre-1990. As a result, Iraq has had to import electricity from Iran and Turkey, while many citizens rely heavily on private generators, which provide an estimated 1 gigawatt of capacity. Most Iraqi citizens pay two bills for electricity--one for private generators and a second to the government. Privately generated electricity is naturally more expensive: a 2009 survey estimated that Iraqis paid 10-15 times more for generated electricity compared with grid electricity.

The Natural Gas Opportunity
In 2010, Iraq was able to satisfy only 58% of its electricity needs, and while outages lasting 16 hours a day are common, it flares almost 400 Bcf of natural gas a year because of a lack of infrastructure. As a result, adding low-cost natural gas generation improves overall power efficiency, boosts Iraq's ability to meet its growing demand for electricity, and frees up oil to be exported and sold at more attractive market prices. In fact, the natural gas opportunity--often overlooked given the more high-profile oil story--is large enough for Iraq that it's reasonable to think it could start exporting gas to other countries within the next decade.

  • Iraq's natural gas reserves stand at 112 trillion cubic feet, which is the 12th largest in the world, and about 60% of those reserves lie in southern Iraq.
  • According to the U.S. Energy Information Administration, about 75% of the southern reserves are associated with oil, whereas the nonassociated gas reserves are mainly in northern Iraq in the KRG region.
  • Production levels are around 1.8 Bcf per day, and about 1 Bcf per day is flared due to lack of pipelines and other infrastructure, leaving the majority of Iraq's gas processing facilities (nearly 2.2 Bcf per day) idle.

The IEA is forecasting that natural gas could make up 90% of the electricity generation market by 2035 from just about 33% today, as adding combined-cycle gas turbines offers one of the cheapest and quickest ways to generate electricity (a cost of around $1,200 per kilowatt and 2.5 years to construct one). This situation will lead to a much more attractive energy mix over time, and we expect that gas will make up around 39% of Iraq's overall energy mix by 2035 from about 17% in 2010. What's remarkable about the situation is that a huge portion of the value created by this shift over the next two decades will be captured by a single project--the Basrah Gas Project--51% owned by the state-owned South Gas Company, 44% by Shell (NYSE:RDS.A), and 5% by Mitsubishi (OTCPK:MSBHY).

Following a 2008 initial agreement Shell, Mitsubishi, and South Oil Company signed a 25-year $17.2 billion deal in 2011 to capture and process currently flared gas from the Rumaila, West Qurna Phase 1, and Zubair fields. About $12.8 billion will be spent on the infrastructure needed to process the gas and an additional $4.4 billion on the construction of a 0.6 Bcf per day liquefied natural gas facility that can export any gas that exceeds domestic demand.

When fully operational in 2017 (the project was officially launched in May 2013), gas processing capacity will be about 2 Bcf per day from around 0.4 Bcf per day currently, but we think that as oil production from the three fields expands, there's room to grow processing capacity further. We believe the Basrah Gas Company is very likely to be hugely lucrative for its partners, while Iraq will benefit from being able to free up substantial oil volumes for export at higher prices. At 2 Bcf per day of gas-processing capacity, about 380,000 bpd of oil (worth $14 billion per year in revenue at $100 per barrel) will be freed up for the export markets.

We see the deal as an enormously attractive one for both the foreign partners and Iraq and expect returns for the partners to be in the 20% range. Iraq cannot raise domestic gas prices because of the poor state of repair for the electricity market, which means that the cost for the raw gas for the Basrah Gas Company cannot be based on the market (currently subsidized at about $1 per mcf). Instead, South Oil Company will provide the raw gas to Basrah for about $1.50 per mcf initially and pay a bit more than $2.50 per mcf (or a $1 per mcf spread) for the processed gas, and will then sell the gas back to the Iraq market for the subsidized $1 per mcf. However, after an initial five-year term, the gas price will reset to more market-based rates and be based on a percentage of fuel oil prices. At current prices, we think the processed gas price will move to around $6 per mcf while the raw gas cost price will be adjusted to about $2.85 per mcf (or a more than $3 per mcf spread). There are similarly lucrative opportunities for price resets on liquefied petroleum gas, or LPG, and condensates. Furthermore, once the liquefied natural gas, or LNG, processing capabilities are on line, Iraq can seek to export gas to Egypt, Turkey, Kuwait, Saudi Arabia, or Asia among other options for prices between $10 and $15 per mcf with production and transportation costs of $1 to $4 per mcf.

As for the venture's challenges, Basrah has to manage some technical challenges as the gas is primarily associated gas (we estimate 90%-plus of volumes), which means it cannot be stored. Since the gas is associated, the company also depends highly on the growth of oil production for its gas volumes, and we don't expect Iraq to pursue stand-alone gas drilling. Furthermore, the venture needs to see the related gas turbines installed to provide an output for its gas.

Iraq's Impact on the Global Oil Markets Over the Long Run
Iraq's oil-production aims are undoubtedly positive for Iraq, but for the global oil markets and OPEC, we see Iraq's growth as mixed for several reasons. We expect tensions within OPEC to emerge over time between Iraq and Saudi Arabia, thanks to surges in both Iraqi and U.S. oil-production levels. Key sources of tension:

  • Based on our forecast, Iraq and the United States should contribute around 60% of the incremental oil supply over the next few years. Both countries, in our view, will be relatively immune to Saudi Arabia's influence, because the United States is not part of OPEC and Iraq needs the oil revenue to rebuild itself.
  • Given the size of the incremental supply additions, Saudi Arabia can't lower its own production levels far enough to balance the markets, and other OPEC members are unlikely to stick to a quota. We think this scenario raises the possibility of an oversupplied global oil market and more infighting within OPEC.
  • Tension between Iran and Iraq is likely to flare up if Saudi Arabia wants to return to a specific quota system for individual countries, given Iran's production losses to international sanctions, further limiting Saudi Arabia's influence.
  • Iran, Iraq, Algeria, and Venezuela should become a more vocal group of price hawks going forward, given that Iraq needs higher oil prices to contribute incremental revenue to aid in its reconstruction efforts, further splintering the organization between hawks and doves (Saudi Arabia, Kuwait, United Arab Emirates).

Iraq has not been assigned an individual OPEC quota since 1998, but it is part of OPEC's 30 million barrel per day ceiling that the 12-member group first agreed on in December 2011 and reaffirmed in later meetings when members couldn't agree on individual quota limits. Initially, the decision has benefited Saudi Arabia because as the only supplier with substantial spare capacity, it can balance the markets without having to enforce quotas or haggle over changes. However, the agreement also puts off a very difficult decision regarding Iraq's quota. Before the 30 million bpd quota system, quotas were based on reserves. As a result, reserve changes are particularly meaningful to OPEC members.

This scenario is increasingly dangerous for OPEC, in our view. As Iraq's oil production increases, other countries will have to reduce production levels to accommodate Iraq, or more likely Saudi Arabia will have to make deeper cuts to its own production levels. The alternative is that Saudi Arabia increases production to push down oil prices like it did when Venezuela threatened to increase oil production to 7 million bpd in the 1990s, and pushed down oil prices to $10 per barrel from $27 per barrel in the late 1990s, ultimately breaking Venezuela. However, today, it is more of an open question whether Saudi Arabia can ramp up its production levels fast enough to break Iraq in a similar scenario, which we think makes a repeat of Venezuelan punishment in the 1990s unlikely. As a result, Iraq's increases in oil production should result in a direct increase in global influence for the country while Saudi Arabia has to accommodate it.

Forcing Iraq to heel may be impossible, especially as it may become more concerned about maintaining oil prices at a stable level as its production grows, but complicating matters is the United States. We think U.S. crude oil production will reach 8.9 million bpd in 2016 from 6.5 million bpd in 2012 and 7.2 million bpd in February 2013.

Combined, using our own and IEA forecasts, Iraq and the United States could add 6 million-7 million bpd by 2018, or 60% of the incremental world supply from 2012 to 2018 versus Saudi Aramco's 380,000 bpd of additions over the same time frame. As a result, we expect Saudi Arabia and the rest of OPEC to cede share.

Given the share losses, we would expect internal OPEC tensions to ramp up, as an increasingly confident Iraq along with traditional price hawks face off against the price doves, which are Saudi Arabia, Kuwait, and the United Arab Emirates. In May 2013, OPEC dissolved its committee for making recommendations on output policy, which has been in existence since the late 1990s. OPEC defended the decision by pointing out that members now simply reviewed the OPEC monthly reports and the committee was not needed. However, the dissolved committee also likely means that OPEC will remain on the collective production ceiling model (currently 30 million bpd) instead of returning to individual member quotas, which recognizes that members can no longer agree on individual quotas in an environment with Iraq and U.S. production surging. In short, the addition of U.S. barrels to the world oil supply picture at a time when Iraq is driving sustained increases in its own production could create serious cracks within OPEC.

Source: Iraq Is Still A Game Changer, And OPEC Should Be Scared