Tuesday, May 30, 2017

The U.S. Vision of Iraq's Oil Production


The article The U.S. Vision of Iraq's Oil Productionhas 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 the focus was on Iraq's oil and gas #infrastructure development projects and on the global trends in #crude oil #trading in light of Iraq's increased #exports.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.
The Conference — Source: The C.W.C. Group Press Service
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.”  
The Panel "Iraq a Major Oil & Gas Power: Strategies for the New Energy Landscape" — Source: The C.W.C. Group Press Service
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.
What Did Norway Export in 2014? — Source: The Atlas of Complexity, Harvard University
What Did the U.S. Export in 2014? — Source: The Atlas of Complexity, Harvard University
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.
Marcus Antonini, Shell Iraq's Vice President & Country Chairman (right), and Alessandro Bacci (left) — Source: The C.W.C. Group Press Service

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