Global Policy Forum

Summary

After a year that can best be described as epileptic, oil markets are finally in for a protracted period of relative calm as the U.S. recovery and OPEC back-pedaling absorb nearly all fresh production from Iraq and Russia.

Analysis

Two primary themes will drive oil markets for the next year: OPEC's ability to manage the return of Iraqi oil to the market, and the U.S. economic recovery. Other issues will be a factor in the markets, but it is these two that will dominate movements at the highest level in the medium term.

Damage Assessment: Iraq

Iraq's return to the oil markets has been slower than the markets' best-case scenario anticipated, but the problems have not been due to war damage. The Army Corps of Engineers completed its assessment in the first week of July, revealing that total war-related damage to the Iraqi oil complex was a mere $250 million to $350 million -- an amount well within the $500 million contract initially granted to Halliburton's Kellogg, Brown and Root.

But from that high point, the damage assessment news turns sour.

New reports from the Iraqi Oil Ministry indicate that what began as random looting eventually took turn toward much more organization, with indications of flatbed semis and cranes being used in the wholesale theft of large "immobile" pieces of equipment. Though the looting has died down considerably since April and May, it continues to plague operations, particularly in the south. Looting alone has added some $750 million to the repair bill, and that excludes any of the recent sabotage attacks. Total income from Iraq's postwar oil sales to date totals $200 million.

Those sabotage attacks -- combined with what can only be described as sophisticated looting -- have hamstrung the sector's recovery. Recent attacks clearly have involved individuals knowledgeable about the sector's operation, who have targeted monitoring stations, valves and pipelines joints -- at times in synchronized attacks -- in an effort to maximize disruption with minimal effort.

Also complicating repairs is the substantial sanctions aftereffect, which will take months to overcome. Sanctions starved the Iraqi oil complex of equipment and spare parts for 12 years. The newest technology in Iraq dates from the 1970s, and much of the local equipment used to craft replacement parts is of World War II vintage. The dearth of equipment means that when a pipeline is damaged, it takes Iraqi repair crews weeks get the infrastructure back up and running. In the case of a well- apportioned oil complex, the necessary repairs would take hours, or at worst, days. Needless to say, this makes easy work for the saboteurs.

Location, Location, Location: A Safe Infrastructure with an Achilles Heel

For purposes of the oil industry, Iraq can be clearly delineated in three sections: south, central and north.

The south has suffered the least from sabotage attacks but the most from looting. The population of the region is predominantly Shia, the dispossessed majority that suffered greatly under the rule of Saddam Hussein. Initially, the Rumaila super-field suffered considerably from looting -- a manifestation of Shias trying to get whatever slice of the pie they could for themselves.

That situation has changed.

Now the greatest concern is theft of crude. Before the Iraq war, Hussein used hundreds of small shippers to smuggle crude out of the country through the Persian Gulf. Now some of those shippers are tapping into Iraq's export lines -- but instead of filling up buckets and pots, Iraq's thieves are filling up tanker trucks. They then drive the crude past Basra, fill up their ships and set sail through the Persian Gulf for other ports, where they can sell it. The United States has shown in the past that it can crack down on such smuggling, but these efforts require a political commitment from high up the U.S. chain of command that has not yet materialized.

Northern Iraq has been quiet in comparison. Unlike the southern Shia, Iraq's northern Kurds exercised de facto control over their own affairs before the war and have their own governing and security structures. Looting in the north has been minimal -- limited mainly to the cities -- and Kirkuk's fields have been left mostly intact. The Kurdish leaders also possess a very clear understanding that the future of their "state" depends upon both continued good relations with the Americans on one hand, and sustained income from oil revenues on the other.

It is in central Iraq, dominated by Sunni Arabs, that nearly all attacks against U.S. personnel and infrastructure have occurred. On the surface this is crushing; it is impossible to reconstruct a ravaged country without basic security. But a closer look reveals a more optimistic picture: More than 90 percent of the attacks have occurred in a triangular region bounded by Ramadi, Tikrit and Baghdad. With the exception of the East Baghdad field -- which is rather insignificant from an export point of view -- there is only one important piece of critical infrastructure in this region.

This item is the north-south Iraqi Strategic Line, a reversible pipeline that allows Rumaila crude to be shipped north and Kirkuk crude to move south. Though the line is still in partial use, U.S. forces during the war bombed a pumping station on it near Al Hadithah in order to disable an associated pipeline that exported crude through Syria. This effectively severed the Iraqi Strategic Line from an export perspective and dramatically limited its usefulness for internal distribution.

The point of all this is that the violence, the nucleus of opposition to the U.S. occupation and the source of damage to infrastructure is not within areas that are critical to the export of crude oil. The northern route lies primarily in Kurdish territory; the southern route deep within Shia territory. In both cases, local forces have an interest in protecting the energy assets. The fields themselves are no longer in direct danger and the routes are relatively easy to patrol and fairly limited in distance. The entire southern route, for example, is on land for less than 70 kilometers. Within two months, some 20,000 additional foreign troops (Poles, Japanese, Filipinos, Italians and others) will arrive in Iraq to assist with security. That alone should prove more than enough to provide basic patrols for the two export routes. If security personnel limit their focus to these two routes -- which from a revenue standpoint are clearly the most significant chunks of infrastructure in the country -- the security task becomes much simpler.

The one exception to this is the city of Baiji, some 200 km north-northwest of Baghdad. Baiji not only is predominantly Sunni, like the elevated risk zone, but it lies only 50 km from Hussein's hometown, Tikrit. Whereas the identity of the population in the north (Kurdish) or the south (Shia) keeps a lid on potential sabotage, Baiji's population is predominantly Sunni, and its people may be willing to shelter those opposing the U.S.- imposed order. Although U.S. troops in Baiji have come under very little fire compared to their counterparts in the elevated risk zone farther south, there have been at least three infrastructure attacks on the northern export route in the immediate vicinity of the town. Baiji is also home to Iraq's largest refinery, making the city a target in its own right for those seeking to disrupt U.S. plans in general.

Iraqi and OPEC: Muzzled Pooch?

The bottom line is that the obstacles to the return of Iraqi crude to the market are quite real, but they are also manageable. Pipelines can be patrolled, pumping stations can be protected, oil refineries can be placed under surveillance, and there is really only one exposed location. New shipments of equipment will drastically reduce both the reaction time to respond to infrastructure attacks and the losses from those attacks, and the arrival of new foreign forces should help shore up shoddy security.

But dreams of a rapid return of Iraqi crude to global markets are dead. The Army Corps of Engineers now expects only 1.0 million bpd of total production, about half earmarked for exports, by the end of the summer -- up from the 800,000 bpd being pumped currently. That is a realistic, if conservative, estimate, given the security circumstances. It will take that long for the first contracts for which the Army Corps of Engineers is currently seeking tenders to begin having any effect. From that point, production rates will begin rising more sharply, but not with such speed that the markets will be unduly disrupted.

Such an incremental return -- as opposed to a tidal wave of new production -- is the type of homecoming that OPEC can manage. The cartel can easily match Iraqi production increases with its own barrel-for-barrel reductions, so long as the monthly Iraqi increase is less than 250,000 bpd, as appears likely. Problems with OPEC discipline inevitably will lead to price drops, but the relative sloth with which Iraq is re-entering the equation rules out price crashes.

This does not mean that OPEC has nothing to fight or fret about. Political instability will continue to wrack two of its bedrock members, Nigeria and Venezuela. For Nigeria, this is par for the course, since the country has an inherent ability to tolerate an impressive level of violence with only minimal impact on oil production. Stratfor expects sporadic production reductions in response to occasional flare-ups, but Nigerian President Olusegun Obasanjo has proven adept at solidifying his political control in the aftermath of his re-election. That alone should limit any discussion of serious Nigerian "disruptions" to mere talk.

Venezuela's situation is as quiet as Nigeria's is loud. Since the labor strikes in early 2002 that shut down state-run Petroleos de Venezuela, President Hugo Chavez has felt it necessary to root out any source of opposition from within the company. As a result, more than half of the company's staff has been fired. PDVSA now lacks the ability to develop new fields, complete advanced maintenance at existing heavy crude production sites, efficiently operate its refinery network or even file its taxes on time. The result is and will continue to be a slow, steady decline in total Venezuelan crude exports until the company can regenerate itself. Even in the best-case scenario -- the immediate ouster of Chavez, the immediate instatement of a skilled, responsible management and total domestic tranquility in Venezuela -- this would take years.

Other OPEC states are not particularly worried about Nigerian and Venezuelan problems, since any troubles they have keep crude off the market -- translating into more market share and profits for the other members. Of greater concern is the fact that a number of OPEC states are implementing plans to vastly increase their production capacity. Of these, the plans of Algeria and Kuwait are the only ones of mid-term interest. Combined, the two states hope to add just less than 1.0 million bpd of daily production by the end of 2004, compared to the beginning of 2003.

Several other members also have expansion plans, but these are much longer term. These plans -- all in sharp contrast to OPEC's avowed goal of market management -- will produce a great deal of behind-closed-doors shouting within the cartel, but will have only minimal impact on markets during the next year.

This reasonably balanced state of affairs will last until Iraq reaches its pre-Kuwait invasion production level of 3.0 million barrels per day, which most likely will happen in mid-2004. At that point, OPEC's production cuts will cease to be easy, and all of its members will be itching to cheat. Iraq's itch will be the most notable. No matter who is in charge, Baghdad has an interest in maximizing its oil revenues. Since it boasts the world's cheapest lifting and transport costs, this almost by necessity means maximizing production as well.

But that is for the future. Internal OPEC dynamics, combined with Iraq's painfully slow return to the markets, should provide for 12 months of relatively stable, if slowly declining, oil prices as OPEC sans Iraq steadily reduces output.

Enter the Bear

Beyond Iraq and OPEC, the only player to watch is Russia. Total Russian oil exports -- including those delivered via pipeline, rail and barge -- as well as refined products topped 6.0 million bpd on production of more than 8 million bpd in the second quarter, clearly marking Russia as the world's second-largest exporter and producer. Though Russia's exports normally surge in the summer months as new export routes open up, this summer's production increase has been much more than simply a seasonal spike. Low interest rates in the West, combined with fiscal probity in the Kremlin, have given Russian companies the ability to tap foreign capital and know-how to expand their domestic operations. This has led to sharp and sustained production increases, a steady modernization of the Soviet refining complex and increased capacity for Russia's pipeline network.

None of these factors will go away within the next year. In fact, most will intensify while the state expands the export network. By 2005, pipeline firm Transneft plans to triple the current 240,000-bpd capacity of its Baltic Sea export point of Primorsk. Meanwhile, Russian crude producers in July gained access to the primary Kazakh export route -- the Caspian Pipeline Consortium line -- that terminates on the Black Sea. These two factors alone will add about 500,000 bpd within the next 12 months.

This is not to say there is no movement in non-OPEC oil beyond Russia -- mild increases by Angola and Oman, for example, roughly cancel out Norway's decrease -- but it does mean that Russia is the one player with the ability to move markets in appreciable ways. All told, the country's total production will brush against 9.5 million bpd by the middle of 2004, with all but 2.5 million bpd of that amount tagged for export. That will translate into a net increase of approximately 1.0 million bpd of production from non-OPEC members. But even with the expected increases, Russia is not positioned to overturn global market stability yet.

That will happen in 2005, when it surpasses Saudi Arabia as the world's largest exporter.

The Other Side of the Coin: US Demand

On the demand side, there is really only one show in town: the United States.

Much has been made of low U.S. commercial crude inventories, which were down 15 percent in first quarter 2003 as compared to the 2001 average. Largely ignored, however, is the fact that non- U.S. OECD crude inventories are actually up slightly more than 1 percent for the same period. Stratfor has no argument with the generally held belief that U.S. crude inventories are a heavily bullish factor affecting the markets. What has been missed, however, is that inventories elsewhere -- while perhaps not as robust as they could be -- are well out of the danger zone.

Similarly, there is a disconnect between the United States and the other economic powers in both past and future demand growth. Despite the "recession" that U.S. media have been obsessing about, U.S. economic growth continues to outpace that of Europe and that is reflected in the country's energy demand. The International Energy Agency expects global demand to grow by 2.5 million bpd from the beginning of 2002 to the end of 2004, of which 1.0 million bpd is expected to be in the United States -- versus only 0.4 million bpd from the rest of the developed world combined.

In the cases of Europe and Japan, poor economic growth and the steady switch to natural gas as a cleaner energy source are to blame. The European Commission again downgraded EU growth prospects July 7, this time to a mere 0.8 percent for the year -- which would mean a rather sharp acceleration from current activity. Similarly, the Japanese government expectation for GDP growth remains less than 1.0 percent. By comparison, U.S. economic growth for 2003 is now projected to be between 2.5 and 3.0 percent.

In Japan, there is an additional factor in play that indicates weaker oil demand. Seventeen of Japan's fleet of 51 civilian nuclear power reactors have been offline for the past three quarters, due to revelations that officials at Tokyo Electric Power Company (Tepco) had fabricated safety reports. The capacity reduction has increased Japan's oil intake by some 650,000 bpd as Tepco has been forced to rely on mothballed thermal plants to meet electricity demand. Now that the necessary inspections are nearly complete (the first of the reactors are already back online) that surge in demand is about to evaporate, leading to some slack in Pacific energy markets that the U.S. West Coast will happily lap up.

The Short Version

When all the numbers are counted, the markets will be left to examine two basic trends during the next 12 months.

* First, OPEC will do a rather competent job of cutting its production to make up for Iraq's return. Increases from Algeria and Kuwait will outweigh Venezuela's protracted decline, leading to a small net production increase by OPEC.

* Second, global consumption should raise demand about 1 million bpd, mostly because of an increase in U.S. and developing world demand -- if Stratfor's sources at the U.S. Energy Information Administration have crunched their numbers right. This will not unbalance markets, since Russia will increase its exports by a mathematically convenient 1 million bpd.

The end result is a market roughly in balance for the first time since 1995, so long as U.S. forces don't invade another major oil-producing country. Prices are doomed to fall as Iraqi and Russian production strengthens, which by default will weaken OPEC's market control. But the gradual rate with which those increases are happening, combined with the black-hole nature of U.S. commercial reserves, will keep the price declines gradual.

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