Middle East Economic Survey

 

VOL. XLVII

No 48

29-November-2004

 

The Iraqi Oil Industry: A Look Ahead

 

By Walid Khadduri

 

The following is the text of the lecture delivered by MEES Editor-In-Chief Dr Khadduri at St Antony’s College, Oxford University on 19 November. The presentation was part of St Antony’s College Fall 2004 Lecture Series on Iraq.

 

Despite the huge proven oil reserves in Iraq, the country has failed so far to manage its industry efficiently in order to bring production capacity to a level commensurate with its reserve potential. The reason is not difficult to understand. It lies in the political turmoil and wars that have engulfed Iraq throughout the past 25 years.

 

The post-Saddam era poses new challenges. While the current political quagmire adds more complicated factors that could delay any serious and significant capacity development for years to come, the will to move ahead and to develop the oil and gas sectors could at the same time open up opportunities that have hitherto been closed.

 

It goes without saying that much depends on the future political development of the country as well as the course to be adopted in planning the growth of the oil industry.

 

Pre-2003 War Experience

Iraq's oil production capacity reached new levels under the Saddam regime. The most important development was during the first five-year plan (1976-80) which resulted in an increase in production capacity to 3.8mn b/d in 1979, with a goal to reach 5.5mn b/d by 1983. However, the war with Iran put a halt to this plan and destroyed production and export facilities. The second five-year plan started in 1989 and brought capacity to 3.5mn b/d with a target of 6mn b/d by 1995. Once more, the invasion of Kuwait, followed by 13 years of sanctions and then occupation with the subsequent looting and sabotage interrupted this plan and degraded Iraqi oil facilities even more.

 

The Saddam regime had two main priorities for the oil industry, with devastating consequences: 

 

First, economic projects, including oil development, were seen as an instrument for enhancing the political authority of the regime. The principal objective was that the whole state and the Ba'th Party were there to serve the regime and its security. There were no exceptions and no one was excluded. The oil industry was part and parcel of this policy. This was particularly the case during the first and second Gulf war periods and throughout the sanctions.

 

The net result of this phenomenon was that, following a very rapid and extensive development of the upstream, midstream and downstream sectors in the seventies, the oil industry has faced destruction, a lack of investments, low priority in state objectives and degradation during the past quarter of a century.

 

The industry had to live from hand to mouth, at times cannibalizing equipment from one plant to make do in another. It lost hundreds of highly qualified and experienced experts and professionals who had to emigrate to earn a better living or to escape the wrath of Saddam’s dictatorship. Production capacity fell because of a lack of professional oil field management, while the downstream industry suffered from a lack of upgrading and spare parts, as well as repeated attacks. Basically, the industry was left to deteriorate, while its regional competitors were able to increase capacity, expand market share and develop their refining and petrochemical sectors.

 

Secondly, oil was used throughout the nineties to rescue the regime from the net closing around it. There were no oil exports throughout the first half of the nineties. When the oil-for-food program was set up in late 1996, it was envisioned by the regime as a means to reestablish contacts with the outside world as well as to provide basic commodities and medicine. However, it failed to prevent the deterioration in the people's standard of living and the disintegration of the country's institutions.

 

One of the questions that remains unanswered about the Saddam regime is why it persisted in challenging UN Security Council resolutions and continued to play a cat and mouse game with the UN inspection teams throughout the past decade and suffer sanctions if it had not possessed weapons of mass destruction since the early nineties? While this question is one for historians to answer, the fact remains that the regime relied on oil to rescue it from the difficult position it found itself in following the invasion of Kuwait and the UN sanctions.

 

Oil exports were one of the few cards left in the regime's hands during sanctions, and they were used to extract as many favors as possible from those purchasing the oil or exporting goods to Iraq. Various types of surcharges were levied on both imported goods and crude oil exports under the oil-for-food program. It is estimated by the CIA that Iraq netted approximately $9.2bn from cross-border oil trading with neighboring countries and around $229mn from the surcharges levied on oil exports. There are no figures available for the amount collected on surcharges imposed on imported goods.

 

Furthermore, the regime awarded upstream contracts to some of the permanent members of the Security Council (Russia and China) and some Asian states in order to win their support while knowing in advance that these agreements could not be implemented. More important, perhaps, Baghdad must have also known that following the end of the Cold War and the fundamental changes in relations between the US, Russia and China, the latter two powers were in no position to jeopardize their new and extensive relations with Washington for the sake of an intransigent and isolated regime like the one in Iraq.  

 

The Occupation Period

In the 13 month rule of the Coalition Provisional Administration (CPA), ambassador Paul Bremer avoided proposing new oil policies or introducing any structural changes to the industry. The fact that the oil industry was left to operate on its own, with very little change in senior personnel, is in sharp contrast to the extensive and radical changes in the rest of the economy that included the promulgation by decree of new banking, investment and commercial laws, as well as the appointment of scores of expatriates to senior executive positions.

 

The main goal of the US authorities during the May 2003 – June 2004 period was to restore Iraqi oil production capacity to its pre-war level of 2.8mn b/d. This task was entrusted to the US Army Corps of Engineers, which contracted Halliburton's subsidiary Kellogg, Brown & Root and Parsons to do so. The program involved a survey of the state of the industry and the rehabilitation of destroyed and looted infrastructure and equipment. Another objective was added shortly afterwards, involving the US financing imports of petroleum products from neighboring countries to meet rising domestic demand for gasoline as restrictions on car imports were lifted and as the domestic refineries, because of their dilapidated state and frequent sabotage of the feed and distribution pipelines, were unable to meet  increased consumption.

 

However, there were several unsuccessful attempts in the chaotic conditions after the war to introduce new elements to this hands-off policy.

 

One proposal was to establish an international board of advisers, composed of Iraqis and foreigners, to oversee and even run the industry. This idea was mooted in the summer of 2003 but did not take off. Instead, the CPA appointed American and British advisers to coordinate with the oil ministry. Consequently, regulations were introduced to maintain transparency regarding oil exports and revenue, as decreed by Security Council resolutions. In fact, however, and as the auditors later showed, these measures were not implemented fully.

 

Another attempt was made by some Governing Council members to invite international oil companies (IOCs) to operate in Iraq. Once more, the idea was not well received and hence not adopted.

 

In fact, there were good reasons to maintain a hands-off policy towards oil at this juncture. There has been, and continues to be, worldwide criticism of the Americans’ alleged ambition to control Iraqi oil, so it was thought to be wiser not to provide any more fodder for the critics.

 

More important, perhaps, oil constitutes a focal point in domestic Iraqi politics, and the control of natural resources by the state is a fundamental principle of the country's political ethos. Any interference by the occupation authority at this stage would have served as a rallying point for the opposition and opened a new front against the already battered US administration in Baghdad.

 

This clear and well-defined policy does not mean that confusion has not surrounded US intentions and motives as far as concerns the oil sector in Iraq. The different opinions, statements and reports aired in Washington at the time of the war in the spring of 2003 did not help matters much. Conservative think tanks in Washington proposed several ideas that were well wide of the mark in terms of the Iraqis’ experience. Some called for the full privatization of the industry and opening it as much as possible to the international oil companies. Others advocated adopting the Alaska and Alberta Province models of distributing part of the oil revenue to the public through checks sent by mail. The State Department-sponsored Future of Iraq Project (Oil Policy Subgroup) also reached the conclusion that privatization is the way to save the country's oil industry. It even went a step further to blame the ills of the industry on nationalization and the public sector, ignoring completely the impact of the wars and sanctions. A more balanced study, which recognized the problems ahead and proposed more pragmatic solutions, was the joint study prepared by New York's Council on Foreign Relations and the Baker Institute.

 

These reports, whether officially sponsored or not, reinforced the belief in the public's mind – in the US, Iraq and worldwide – that the war was about oil. This impression was reinforced by some of the public assumptions made about Iraqi oil prior to the war, even though most of the projections by senior US officials proved to be wrong. Among the ideas floated was the proposition that Iraqi oil revenue would be more than enough to pay for the reconstruction of the country immediately after the war, ignoring both the devastated state of the economy after 25 years of wars and sanctions and the approximately $200bn owed in debt and compensation. It was also argued that shortly after the US won the war, Iraqi oil would flood world markets, bringing world oil prices down. Or that Iraqi oil reserves would replace Saudi spare capacity and end the dependence of the US on Saudi oil. Finally, there was the campaign which actually got under way as early as June 2003 and lasted until April 2004 that promised lucrative contracts to US firms. In fact, with the exception of awards to firms such as Halliburton and a few others, most of the funds allocated for Iraqi development and reconstruction were not disbursed because of the lack of security in the country.    

 

Despite these myths, which received wide publicity and acceptance because of the quick military victory, the US authorities did not alter overall oil policy. The CPA focused on the rehabilitation of the industry to bring it back to the pre-war production level of 2.8mn b/d on the first anniversary of the war in April 2004. This program has been delayed and its goal will not be met by the end of the year.

 

Furthermore, the US authorities have had to take on the additional task of importing sufficient petroleum products from neighboring countries to bridge the gap between rising local demand and declining processing capacity.  This has been no easy task, since despite the fact that the oil facilities were not destroyed during the invasion, unlike the situation during Desert Storm in 1991, there was extensive looting, theft and sabotage after the war. It is estimated that the oil industry alone lost around $1bn in this systematic and organized theft in the first few months after the war. The smuggling of products from Iraq to neighboring countries continues to this day.

 

According to Oil Minister Thamir Ghadhban, Iraq currently consumes 20mn liters/day of gasoline, producing 12mn liters/day and importing 8mn liters/day. Prior to the war, gasoline consumption was 15mn liters/day while production capacity was 16mn liters/day. The US Army Corps of Engineers spent around $1.5bn on petroleum products purchases since May 2003. It is costing Iraq now around $200mn a month to import petroleum products, or $2.4bn a year, approximately 15% of the annual oil revenue. These imports are expected to continue for at least two more years, until new units are built in the refineries.

 

The situation was further exacerbated by the fact that while the US authorities used Iraqi oil revenue to fund US firms, it withheld financial resources from the Iraqi authorities. A study published last September by the Open Society Institute's Iraq Revenue Watch (IRW) suggests that the CPA awarded US firms 74% of the value of the $1.5bn in contracts paid for with Iraqi funds and together US and UK companies received 85%. Iraqi firms, by contrast, received just 2% of the value.

 

Meanwhile, about $1.5bn has been spent on the reconstruction of upstream and downstream facilities, with the majority of the work being carried out in the south. However, most of the $18.4bn of US aid earmarked for Iraqi reconstruction has not been spent yet, despite the fact that the Project Management Office was specifically established to take over the CPA's work in supervising the allocation of US aid.

 

The oil sector has been no exception. The record shows that very few funds, if any, were appropriated to the Ministry of Oil during the first 12 months after the war. There were Iraqi funds available to the CPA, but these were not used until it transferred power to the Iraqi government in June 2004. In fact, the CPA had a surplus of around $8bn at end 2003 which it kept in its coffers instead of disbursing it to the ministries.

 

Finally, when orders were given in the spring of 2004 to distribute funds to the Iraqi ministries, the security situation deteriorated and development halted.

 

Under these circumstances, it was not surprising that the IOCs, which were anxious to maintain contacts with the Iraqi oil authorities, were reluctant to attend the international oil conference sponsored by the Ministry of Oil planned in Basra in early April 2004. In the end, the meeting was cancelled because of the breakdown of security that same week in Basra and throughout most of the country.

 

The deterioration of the security situation after April 2004 has closed the door to any meaningful IOC involvement for the time being. The majors, without exception, have stated publicly that while they would like to play a role and have a share in the country's oil industry, they cannot do so unless there is a legitimate and recognized sovereign government. Meanwhile, contacts continue between the majors and Iraqi oil executives through joint steering committees and meetings outside the country. This type of work involves technical studies, reevaluation of data and training – all done gratis. Several independent firms have bid for the handful of contracts that the State Company for Oil Projects (SCOP) has tendered lately. No awards have been made yet for lack of funds. This situation is expected to change in 2005 with the unprecedented $3bn appropriation to the Ministry of Oil.

 

Future Options

The progress of the Iraqi oil industry will play a critical role in determining the country's future, since oil constitutes the core of the country's economy. However, the oil industry can only move forward if there is security and political stability throughout the country. The protracted conflict since the beginning of 2004, particularly since April, has limited the possibility of any meaningful change. Moreover, even if security is restored at some point soon, the oil industry faces many obstacles before it can resume progress towards normalcy.

 

One of the major challenges will be how to assess in a meaningful and pragmatic way the many ideas that have been floated by Iraqi oil experts on how to change the country's oil structure and administration and how to define the terms of reference for the new oil policy, as well as the roles to be played by the Iraqi National Oil Company (INOC), the Iraqi private sector and IOCs.

 

In early September Prime Minister Ayad 'Allawi outlined to the Supreme Council for Oil Policy his broad policy guidelines and asked that they be studied before submitting a final draft to the Council of Ministers for action.

 

Dr. 'Allawi placed special emphasis on the acceleration of oil production and revenue, and highlighted four main principles of the new Iraqi oil policy (MEES, 13 September 2004):

There is near unanimity among Iraqi oil technocrats that IOCs should be invited to participate in the country's future oil development. The question is not one of principle, but timing, scope and mode of cooperation. The debate revolves around whether this be done before the election of a parliament and the adoption of a hydrocarbon policy, or afterwards? And, what should be the relation between the Ministry of Oil, INOC and the IOCs? These are questions that are crucial to the future of the industry. They must be studied carefully and by a wide range of experts before a formal policy is finally approved.

 

While there is considerable support for the development of the industry, there are serious worries that if this is done in the current atmosphere of political uncertainty, there will be neither sufficient study of all the possible options nor the necessary legitimacy and transparency.

 

There are many political groups that do not want to see the introduction of any fundamental changes, including in oil policy, before there are elections and a parliament. Indeed this position is enshrined in the Transitional Administrative Law Annex, which states specifically that the "present government is prohibited from making deals that impact the long-term development of the country, with the exception of negotiating debt reductions." Thus any proposal to introduce a major change in oil policy would be seen as a suspicious and illegitimate attempt to preempt parliament, and it is doubtful whether the major IOCs would want to be involved in such a controversial move.

 

Another contentious issue is the future administrative structure of the country. At the moment, public opinion appears to favor a federal state. The question is: what does this exactly mean? What powers would the central government retain, and what authority would be distributed to the provinces? There are many federal experiences around the world, so it should not be impossible to adapt one for Iraq. The problem is that while the principle of federalism is accepted by a majority of the Iraqi population, there are no specifics.

 

There are already problems on this score. It was originally thought that federalism would provide for the continuation of a central oil industry which would consult with the provinces. The distribution of oil revenue is another matter and would be considered on a federal basis, taking into consideration many factors, including the number of provinces, location of oil, etc. However, Kurdish groups have preempted this process and started signing deals and memorandums of understanding with minor energy firms. The Ministry of Oil has threatened to blackball these firms. This problem has prompted calls for federalism in the south, where the major oil fields are located.

 

It is simply not practical to draw-up and enact oil laws that would define the industry's future course of action while the country is in transition and lacks security. Major oil proposals need to be well prepared by groups of experts, deliberated upon extensively and approved by a legitimate authority. This is the only way to ensure their sustainability and international acceptance. Any shortcuts would simply mean future changes to the laws and policies, doubts about the legitimacy of the whole program and accusations of corruption and lack of transparency.

 

The oil companies themselves will obviously continue to take an interest in Iraq's oil industry, but they cannot sign credible and executable contracts while the authority is not clear and security is lacking. However, to say that they should wait for a parliament to be elected and a new hydrocarbon policy adopted does not mean doing nothing in the interim period.

 

Iraq's oil production capacity today is around 2.5mn b/d, compared to 3.5mn b/d before the 1991 war. Plans can be put into action, through technical and service agreements and through national effort, to restore this capacity over the next two to three years from semi-developed fields or fields that have been left idle during recent years for one reason or another. What is also needed during this period is to undertake reservoir studies to determine the amount of damage suffered by producing fields, if any, and how to remedy the situation. Plans are already in place to deal with these two issues, circumstances permitting.

 

Other action that can be taken during this period includes the following:

Whether these steps can be taken, and in this order, will be a function of the political dynamics of the country in the coming period. Much will depend on whether the transitional government  is able to incorporate dissident voices into the political process before the coming elections, or whether these forces remain excluded, and if so, whether they take up arms to resist the occupation and the government by every means possible. If it is the latter, then the main task of the Iraqi oil industry in the coming period will be to increase capacity on its own and put off major reforms.

 

If the transitional government is able to involve as many of the opposition forces as possible in the political process, there is a fair chance that the oil establishment will be able to lay the proper grounds for the reforms. This would be done, first, through national effort, independent oil firms and engineering companies – basically to return to the 3 – 3.5mn b/d capacity by 2006. Then, and after the election of parliament and the drawing up of an oil policy, by inviting international oil companies to participate in building a new petroleum industry in Iraq with a production capacity of around 6mn b/d by 2010.

 

Oil policy today is firmly in the hands of the Supreme Council for Oil Policy, which was established last July, and which is headed by the Prime Minister and the Deputy Prime Minister. Its mandate is comprehensive, including: medium and long-term planning; major investments and projects, and the way they are financed; contracts and agreements with foreign parties; crude oil marketing policy; the pricing of products for domestic consumption, and the Ministry of Finance's share of these sales; and the terms of service in the Ministry of Oil and the companies related to it.

 

The major unknown factor in the coming months is what oil policy parliament will legislate, taking into consideration that there are two parliamentary constitutional elections scheduled for 2005. There are strong and contradictory trends in Iraqi public opinion today, and there is no way of telling what the majority will choose in free elections. There is a strong belief, which should not be underestimated, that the whole purpose of the war was to gain US control over Iraqi oil. There is also a strong tradition in the country of retaining the oil sector under state-ownership

 

While there are many voices calling for the oil sector to be opened to international oil firms, it is going to take a good deal of persuasion and a great deal of transparency to convince a majority of public opinion that the gradual privatization of the oil industry is for the good of the people and neither a war prize nor a way for carpetbaggers to get rich quickly.