The article “The U.S. Vision of Iraq's Oil Production” has been initially published by Oilpro, a professional network for the oil and gas professionals
May 30,
2017
LONDON —
Last week, I attended Iraq Petroleum 2017, a conference organized every year by
The C.W.C. Group, which is the world-leading events and training producer for the oil, gas and infrastructure industries — still with
reference to Iraq/K.R.G., The C.W.C. Group is currently organizing in Beirut,
Lebanon, Basra Oil, Gas & Infrastructure
Conference (planned for Oct. 2017) and in London, U.K., Kurdistan-Iraq Oil
& Gas (planned for Dec. 2017).
This
year’s edition of Iraq Petroleum (the eleventh edition) gathered over 200
senior industry professionals and government representatives with the main goal
of discussing new strategies for Iraq’s energy sector. In specific, this
edition focused on Iraq's oil and gas infrastructure development projects and on the global trends in crude oil trading in
light of Iraq’s increased crude oil exports.
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Very interesting, and in a certain way quite direct and
frank, was the speech of Mr. Alan Eyre, director of the Office of Middle East
and Asia of the Bureau of Energy Affairs with the State Department. Mr. Eyre
clearly defined what the U.S. vision of the new energy landscape is. He was
part of the panel called “Iraq a Major Oil & Gas Power: Strategies for the
New Energy Landscape.”
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The State Department’s position — and consequently the
position of the U.S. government — supports the U.S. shale oil and gas producers
to push ahead as much as they can with their shale operations on the American
soil, no matter what an increased U.S. shale oil production might mean to the
oil price internationally. Technological advances in the past few years have
made U.S. shale oil production now profitable at $40 to $50 per barrel.
In other words, the U.S. government calls for an oil
price based on a pure free market approach. If U.S. shale oil producers make a
profit, they stay in the market, if they don’t, they have to exit the market.
It’s a simple but very clear approach. This vision does not make room any
longer for cartel restrictions, such as those that OPEC has always tried to
implement over the course of its existence.
In specific, with reference to the last two years and a
half, since the end of November 2014 OPEC has been playing a commercial battle
with the U.S. shale producers with the final goal of pushing them out of the
market. In fact, despite plunging oil prices, in November 2014, OPEC members
decided not to cut output. At that time, cutting output was a move required to support
oil prices, but strategically OPEC members preferred to maintain (if not to
enlarge, this, at least, was their initial idea) their market share. As a
consequence of their decision, oil prices bottomed out in January 2016 when Brent
was less than $30 per barrel. Then, in November 2016, with the Brent price partially
higher at around $45 a barrel, OPEC ministers secured a cut in OPEC’s oil
production from 33.8 million barrels a day (b/d) to 32.5 million b/d for the
first six months of 2017 to prop up prices. Then, just a few days ago, at its
May 2017 meeting, OPEC decided to extend its production cut by nine months. At
the time of this writing, Brent is around $52 a barrel. Currently inventories haven’t stopped rising and supply
continues to outstrip demand — this explains why the price of oil is not really
rising. In addition, shale production is increasing at the same rate as it was
before 2014. To counter its lost political power, OPEC might try to expand its
base and access to producers.
The U.S.
vision of the new energy landscape is well in line with the new U.S.
administration’s concept of “America First” (implemented at the energy level as
well) and with the present inherent value of fossil fuels. With reference to
the first point, the White House has clearly affirmed that it wants to maximize
the use of American resources, freeing the U.S. from dependence on foreign oil.
Here, putting politics aside, this economic target makes sense: If U.S. shale
oil producers are able to generate profits, they will be on the market and this
will be beneficial to the U.S. economy overall. The second point, the present
inherent value of fossil fuels, needs to be consistently enlarged.
Time
after time, Arab countries have always released statements where it was written
that the correct price of oil was a certain amount of dollars per barrel (for
instance $70, $90 and so on). And they have always closed their statements
affirming that the stated price per barrel could guarantee a sort of win-win
agreement between producing/exporting countries and importing/consuming
countries.
The
reality is that we don’t know what the correct price of a barrel of oil should
be, especially on a medium- to long-term basis. According to a free market
logic, the price of an item, oil as well, should be based on the balance
between supply and demand. In other words, the price of oil is a moving thing.
Of course, when talking about oil there are also political and security considerations
that enter the picture. But, in times of oil abundance in the U.S., these
political and security considerations can be played down. See at this regard, President Donald Trump's proposal to sell half of the
U.S. strategic oil reserve. This proposal well highlights a reduction in the
U.S. reliance on imports — and a weaning off OPEC crude — exactly when the
domestic U.S. production soars.
Another layer of complexity for those who invest in oil,
but this is also true for natural gas and minerals, is the long lead time of
the projects, i.e., the time between the initial stage of a project and first
commercially viable production. In other words, from the final investment
decision (F.I.D.), but, in reality, an investor has already used important
economic resources at this stage, to the moment when the first barrel of oil
will be commercially produced, there could easily be 7 years, 10 years, if not
longer times. And this means that the profitability envisaged at the F.I.D.
time could no longer be present when you have the first barrel of oil. This is
a real problem for commodities — instead, a manufacturer who produces for
example t-shirts has very a short lead time between the ideational phase and
the production phase thanks to reduced entry barriers.
But let’s put aside political considerations, security
considerations, and long lead times, and let’s focus our attention on the
concept of the price oil deriving from the balance of supply and demand.
Persian Gulf’s oil producers artificially would like a high oil price, which on
the basis of the number of oil producers across the world and the pace of the
world economy in 2017 is not achievable right now. If in the coming months
there were a war in a major oil-producing country, a complete reduction of the
inventory levels of crude oil, or difficulties maintaining the present level of
oil production because of the reduced oil investments of the last two years,
things could be very different and the oil price could spike again also
consistently. Indeed, the decline in upstream investment in 2015 and 2016 ($450
billion and less than $400 billion respectively from around $650 billion in
2014) could materialize in a severe shortage in the medium-term.
Business theory tells us that with a successful
differentiation strategy, a company is able to offer products or services
perceived to be distinctively more valuable to customers than are competitive
offerings, while maintaining more or less the same cost structure used by
competitors. But with commodities this is not possible. With commodities, and
crude oil is a commodity, a producer (especially if it works only upstream)
cannot differentiate its product in order to present it as more attractive to
buyers. It’s true that crude oils are different according to different A.P.I.
grades and sulfur content, but it’s also true that the final products deriving
from crude oil are exactly the same (for instance at the pump station when you
fill your tank it doesn’t matter what gasoline brand you use) and that we can
consider the A.P.I. grades and sulfur differences as just initial cost
differences and not as a real final differentiation of the product. For more
information about the concept of competition please see the extensive research done
on the topic by Professor Michael Porter of Harvard University.
So, logic wants that with commodities in a competitive market
low-cost producers are the winners. With reference to crude oil this means that
if there is a place in the world where crude oil should ideally be produced,
it’s exactly in the Middle East and in particular, in Iran, Iraq, and Saudi
Arabia as a consequence of their finding and development (F&D) costs, which
are probably less than $10.
In a perfect world, these three countries should be the
hard-core oil producers at world level. In addition, although they would not be
able to satisfy all the world’s oil demand (they would not be monopolists), they
would still gain a lot from being price takers. In fact, all their low-cost oil
production would be sold at the price asked to cover the production cost of the
highest-cost producer necessary to satisfy the last barrel of oil required by world
demand.
Arab countries want high oil prices because their
economies are almost exclusively based on the export of oil and gas. But, under
the current circumstances, for Arab countries, obtaining, let’s say, $100 per
barrel of oil in order to balance their fiscal budget is impossible. In this
regard, at the conference resounded quite loudly the idea of diversifying
Iraq’s economy. Personally, I think the expression “diversifying the economy”
in relation to Persian Gulf’s producers is not correct. I believe it would be
more correct to say “partially reducing the dependence on O&G exports.”
In fact, for a commodity producer, and especially for one
located in the Middle East, reaching economic diversification and maintaining
it, is never an easy task. In confirmation of this point think of Norway, which
has always been considered the poster-boy of how an O&G producer should develop
its petroleum sector. As oil prices started to fall in 2013, it became apparent
that the Norwegian economy had become incredibly unbalanced. "The oil and
gas industry became too strong in our economy, especially during the last four
or five years” said Prime Minister Erna Solberg in an interview with the BBC
News website in 2016. And then she added that the Norwegian economy had
to diversify. Norway has the same problem as the Arab countries. In fact, Norway’s Johan Sverdrup field
(expected resources of 1.9 to 3.0 billion barrels of oil equivalents),
a huge field that will start production in 2019, now could probably reach breakeven at $20 to $30 per barrel, but the government requires $70 per barrel oil to balance its fiscal budget.
Also Norway is a one-path economy, mostly dependent on oil and gas exports (around 60 percent of exports).
The two pictures below show Norway's unbalanced export
sector and the U.S. much more balanced export sector.
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In practice, at the conference the State Department’s suggestion
to Iraq was to produce more oil, i.e., to develop a real economy of scale in
the petroleum sector. The idea was to try to make up for the decreased
government revenues of the last years with more millions of oil exported on a
daily basis. But the implementation is not easy. Indeed, infrastructural
problems are among the most important hurdles. In fact, in the last years Iraq has
already lowered its ambitious oil production targets. When the technical
service contracts (T.S.C.s.) were signed, the federal government and the IOCs
had set an initial production target of more than 12 million b/d by 2017 from a
dozen oil fields. Later, after renegotiating the signed contracts, the federal
government and the companies planned to reach 9.0 million b/d by 2020. It’s now
probable that Iraq will lower the target down to 6.0 if oil prices stay low. In
fact, in addition to infrastructural problems, Iraq has been forced to revise
its expansion plans because under the current T.S.C.s low oil prices have
a particularly damaging effect on the government’s income.
The State Department’s suggestion to Iraq echoed David
Ricardo’s theory of comparative advantages. For the most part, countries all
try to do what they are relatively best at and trade for everything else. A country
has an absolute advantage in relation to those products in which it has a
productivity edge over the other countries. This means that it takes this
country fewer resources to produce a certain product. A country has a
comparative advantage when a good can be produced at a lower cost in terms of
other goods. Countries that specialize based on comparative advantage gain from
trade. A country has an absolute advantage in producing a good over another
country if it uses fewer resources to produce that specific good. Absolute
advantage can be the result of a country’s natural endowment — and this is the
case of Iraq with oil.
The concept of comparative advantages doesn’t want to
deny the idea of the importance of economic diversification in order to reduce
economic risks (this principle is absolutely valid for personal investment
portfolios, for companies’ operations, and for countries’ G.D.P. composition).
But when considering Middle Eastern oil producers, if on the one hand economic
diversification is important, on the other hand it has to be taken cum grano salis. The reason is that for
these countries diversifying their economy will be extremely difficult. So, oil
and gas will continue to be for these countries the main pillar of their
economies. And, if this weren’t the case, these countries would fall into chaos
more than they are now. Consequently, a more realistic approach is needed
otherwise we risk falling into pure wishful thinking. One thing is what we want
to do, another thing is what we are able to do.
In addition, the State Department’s invitation to Iraq
seems to underline one point: Oil producers have to export oil now that it has
a value. Maybe it doesn’t have the per-barrel value that Arab countries would
desire, but it has a value. In twenty or thirty years many things could change.
It’s true that according to many forecasts there will be an increase in energy (and
petroleum) consumption globally, but forecasts on a long-term basis are never
easy and could contain a higher probability of fallacy.
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