The new Iraq, the US and oil markets

Iraq’s strategy to consistently increase its oil production is likely to reshuffle power among OPEC members, introducing a further element of tension and drastically reducing Saudi Arabia’s role in the organization. This could even raise tensions between Saudi Arabia and Iran – which is trying to limit Riyadh’s regional clout as well as its role in OPEC. US support for the reconstruction of the Iraqi oil industry, along with the decision to open vast expanses of American coastlines to oil and natural gas drilling, spurred Saudi Arabia to look toward emerging Asian economies for its oil exports.

Over the last few months the Iraqi government has launched a new strategy aiming to raise its oil production from the current 2.5 million barrels per day to 10-12 million barrels within 2020. Even though the country has great potential and could significantly increase its oil output in coming years, this plan faces several obstacles.

Firstly, politicians are divided at both local and national levels in different ethnic and religious groups, and this led to a battle for control of the Kirkuk region, which is rich in oil fields. These divisions are slowing down the approval of the petroleum bill, which would establish a new legal framework for foreign investments in the oil industry.

Secondly, Iraq does not have the required technology and expertise to properly develop such a strategic sector. To overcome this problem, the Iraqi Oil Ministry has granted development contracts to multinational energy groups including both state-owned and private companies. In particular, to sustain the Iraqi government strategy, these contracts are structured in a way that spurs companies to extract as much oil as possible in the short term through the allocation of extra revenues.

Even if Iraq manages to raise its oil production to six million barrels per day, instead of the expected 10 million, by the end of 2020 it could surpass Iran’s production, which is lagging just behind Saudi Arabia among OPEC producers. This scenario would consistently reshuffle power among OPEC members.

So far Saudi Arabia, due to its overwhelming oil production, has acted more or less as the single price maker within the organization, increasing or decreasing its oil production in order to stabilize the market prices. One of the most telling episodes occurred during the Gulf War in the early 1990s: due to the Iraqi invasion of Kuwait, oil prices skyrocketed and Saudi Arabia raised its production to some one million barrels per day to stabilize the price.

Even though Iran can be seen as the second most important OPEC member, its production is just 38% of Saudi Arabia’s and thus has never been able to strongly affect world markets.

Iraq, however, due to its larger and unexplored fields, has the potential to challenge Saudi power in the oil markets. This could increase competition in the sector, decreasing the upward pressure on prices caused by the growing Chinese and Indian demand for fossil fuels. At the same time this could even lead to a direct clash between Baghdad and Riyadh as they compete for leadership within OPEC.

The increasing Iraqi oil extractions will also affect Iran, whose oil sector has not been properly developed over the last two decades due to US and UN sanctions. Even though the Ahmadinejad establishment has planned to invest a large amount of capital to upgrade the oil industry, it is likely that oil exports will continue to decrease gradually due to the growing domestic demand for fossil fuels and the declining extraction rate.

Assuming that there will be a persistent increase in oil demand worldwide, driven by emerging Asian economies, any contraction in world oil production caused by either political instability or natural disaster, would put upward pressure on prices which would be in Iran’s interest. Indeed, Teheran could continue earning the same amount of revenues in the coming years even if its export volumes fall.

Over the past few years, Riyadh has in fact been managing price increases precisely to prevent Ahmadinejad from finding new revenues. The expanding Iraqi policy could help Saudis in their strategy, reducing the possible upward pressure on oil prices. However considering the strong influence Iran has over a large part of the Iraqi population and the unresolved dispute over the Shatt al Arab borders between the two neighbors, the Iraqi oil strategy could at some point also create tension with Saudi Arabia.

The rapidly-growing oil and gas demand affecting emerging economies – and possibly the continuing tensions in the Greater Middle East – prodded the Obama administration to approve plans for the expansion of US offshore oil and gas drilling. Even though this decision was also interpreted as a tactical move to obtain Republican support for the so-called climate bill, it has major consequences for US energy security. Indeed, the Obama administration officially considers improving US energy security and reducing dependency on foreign oil as key policy goals.

The possible recovery of oil prices could lead the US economy, still affected by dramatic financial turmoil and the risk of a credit crunch, into a double-dip downfall caused by an insufficient oil supply on world markets. Analysts estimate that as the global economy exits from the recession, oil demand will quickly overcome the current production level of more than 80 million barrels per day, which is already a 4% increase in comparison to last May’s production.

Even though many experts consider 80 dollars per barrel a fair price, many of them forecast that oil will go beyond 100 dollars per barrel, reaching a peak of 120 dollars by the second quarter of 2011. Such a scenario could dramatically affect the world economy, reducing the positive effects of Obama’s “American Recovery and Reinvestment Act” and possibly generating a new financial earthquake on the US dollar.

Under these assumptions it is reasonable and desirable to expect that the Saudi and Iraqi governments renegotiate the OPEC production quota system to better suit Iraq’s fast-growing oil production, while accommodating the basic interests of both countries. In order to avoid a three-way clash between Iran, Iraq and Saudi Arabia, Saudis and Iraqis will have to act gradually and smoothly to renegotiate OPEC quotas. Due to the fact that OPEC typically delays policy decisions in reaction to market shifts, the US administration should focus more decisively on alternative energy sources. Obama could turn out to be the first president of a superpower leading his country into a new era truly scarce of fossil fuels.

In case of failure, the US economy could again be driven into a deep recession, doing away with the short-term American dream of a relatively quick recovery.