Venezuela and Iraq Enhance the Prospects of an Oil Shock
(Gulf War II is Unlikely to be a Repeat of Gulf War I)
International Perspective
by Marshall Auerback
February 11, 2003
“The combined effect of Venezuelan and Iraqi disruptions has the potential to be the biggest shock in oil market history, even allowing for offsetting supply increases by other players.” – Jim O’Neill, Goldman Sachs
The financial markets remain incredibly complacent about an oil market which is tighter and more geopolitically threatened than it may have ever been in decades. There is still a widespread belief that the market is amply supplied with crude, that the U.S. will fight a war that will go as easily as the first Gulf War or Afghanistan, that foreign oil companies will invest and Iraqi oil production will soar after the 101st Airborne sorts out Saddam Hussein.
But capacity utilisation in global oil is almost as high as it has ever been. Crude oil inventories are lower relative to consumption than at any time in recent decades. In three of the six largest oil-producing countries oil supplies are at risk due to geopolitical factors. In Iraq, a U.S. invasion appears to be imminent and Saddam may have mined all of the oil wells, according to various reports from Pentagon intelligence sources. There is ongoing political instability in Saudi Arabia, the world’s largest producer. Venezuela’s oil dependent economy is staggering under the weight of a labour dispute, which has disrupted oil exports. In this context, a war in Iraq could tip the balance in favour of a sharply rising oil price, which in turn could be the nail in the coffin of a teetering global economy.
The prospects of an oil shock are therefore as high as they have been in decades. According to a recent report by Goldman Sachs, “More Perfect Storm than Desert Storm”, low global oil stocks and reduced exports from strike-torn Venezuela have boosted prices by more than 30 per cent since late November. The Venezuelan 'outage' has cost 125 million barrels of production, already the fifth biggest supply shock in history, 'which almost entirely explains the current high level of prices', according to the study. If the strike continues for a further two months and an Iraq war lasts a similar time, the cumulative outage will be 600 million barrels, far more than the 400 million taken off the market in the Arab-Israeli war.
Since this report was completed, the work stoppage affecting the Venezuelan oil industry has begun to dissipate. But tightness in the global oil markets remains much as Goldman described in its analysis. The Venezuelan government has sacked almost 10,000 striking workers and is labouring in its efforts to reactivate oil wells and refineries.
Since he swept into power in a landslide four years ago, former paratrooper Hugo Chavez has been a persistent irritant for the American government, but so long as his government kept the oil flowing, any acrimony between the two countries remained at a reasonably low intensity. Although not directly implicated in the 2001 coup attempt against the Chavez government, the Bush administration made little effort to conceal its approval of the impending change in administration. Unfortunately, the American government is now paying for this lack of discretion given Chavez’s successful return to power, during which he dismissed dissident officers largely favourable to US objectives. The army is now largely supportive of the government, giving Mr Chavez an uncomfortable whip hand in regard to developments in the oil market (“uncomfortable” at least from the perspective of the Bush administration).
The basis for the current dispute between the workers of Petroleos de Venezuela (PDVSA) and the government has been the government’s announced plans to divide PDVSA into two operating companies and essentially eliminate its presence in Caracas. In reality, this is above all else a political showdown between Venezuela’s country’s upper social class, which has shut down oil production in an attempt to unseat President Chavez, who was duly elected and who has the support of the masses. Because Chavez appears to have the full support of the military and the vast majority of the population, the lock-out is being gradually eroded and workers are returning.
However, given the age of Venezuela’s oil fields it is unlikely that the two new operating companies which will handle the country’s oil production can operate at anything like the 3.0 mmbd capacity of PDVSA before the strike, according to energy analysts Groppe, Long, & Littell. GLL also note that Venezuelan fields are mature and Venezuelan crude is heavy. The host rock is often “sandy”. This means that it may take a long time to bring shut-in wells back on stream. No one knows how great this lag might be, as it depends on geologic and engineering issues for which there are no clear precedents as well as on the amount of investment that will be thrown at the problem by a government in chaos.
In addition to the problems of Venezuela, one also has to consider the position of the oil market in the context of the increasingly tenuous position of the ruling House of Saud. Saudi Arabia is still the world’s largest producer, but the extreme Islamic movement associated with the Saudi Wahabi tribe dominates domestic institutions and has greatly influenced the thinking and sentiments of a disenfranchised populace with extremely high unemployment and declining per capita incomes. The ruling royal family, which has enjoyed the lion’s share of oil wealth, is perceived as corrupt, and repression of domestic discontent is high. Saudi oil production too is at risk because 1) conflict as has materialised in Venezuela is possible (given comparable social divisions and the corresponding extreme distribution of wealth between the country’s elites and its downtrodden masses) and 2) there is a terrorist threat by a global Islamic extremist movement that originated in Saudi Arabia.
Despite the precarious position of the oil market, financial markets remain extraordinarily sanguine in regard to the prospects of another major oil shock. There remains the perception of an amply-supplied crude market being artificially propped up by a “war premium”.
This outlook is symptomatic of a broader ingrained optimism which sees the impending war itself as the proximate cause of the trouble even though most stock markets peaked almost 3 years ago, well before Saddam became an issue. At its most basic level, there lies an unstated desire for war in order to rid the markets of the bearish uncertainty supposedly engendered by the threat of war.
This is not to suggest that today’s market practitioners are all blood-thirsty warmongers. Instead, what appears to be “priced” into the markets is an image of conflict (largely absorbed by the television images of Gulf War I or Afghanistan) that now bears almost no resemblance to the bloody chaotic experience that has historically been war's gory reality.
Of course, if the first Gulf war conflict or the more recent Afghan experience has engendered such tremendous complacency, it becomes harder to argue that concerns over Iraq have been a major factor in discouraging investment, as Mr Greenspan appeared to suggest today in the text of testimony to the Senate Banking Committee:
“The intensification of geopolitical risks makes discerning the economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far better whether we are dealing with a business sector and an economy poised to grow more rapidly--our more probable expectation--or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory.” (Our emphasis)
We are inclined to the latter option outlined by the Fed chairman: that is, a global economy still “labouring under persisting strains and imbalances that have been misidentified as transitory.” In fact, we have great sympathy with the view expressed by market commentator Richard Russell to the effect that Iraq has become the “hook”, which has induced the public to hang on to their shares, despite the increasingly ominous political/economic backdrop and the catastrophic losses already sustained by most who have tenaciously held on throughout the 3 year bear market. The widespread perception of a relatively cost-free battle and the corresponding fear of missing a “war rally” has become the factor precluding a final capitulation sell-off in Russell’s view, rather than fears of a bloody, messy, economically disruptive conflict holding up pent-up investment demand.
But for those who believe in the image of a bloodless techno-war, the recent Columbia shuttle disaster should provide pause; it provided a horrific illustration of the limitations of modern technology, the profusion of which on the American military side has persistently been cited as the leading basis for a quick, decisive victory over a poorly armed Iraqi army. Indeed, the more one draws comparisons to the period preceding Gulf War I, the less comforting appears the precedent. Consider the political context today: As the US contemplates a second Gulf war, it faces unprecedented terrorist threats, a fraying transatlantic alliance (including perhaps the biggest split in NATO’s 50 year history), and antagonistic relations with virtually the entire Islamic world. None of these conditions pertained in 1990/91.
Nor is the economic backdrop remotely comparable: consumers in the US, Europe and Japan still have record levels of debt, accumulated long before any prospect of war with Iraq became a reality. To quote Morgan Stanley’s chief economist, Stephen Roach:
“The world economy has changed a lot since 1990–91. Perhaps the most significant change has been the emergence of a lopsided, US-centric global growth dynamic. In the late 1980s, there was much greater balance to the global economy than there was in the late 1990s. Back in the earlier period, the industrial world was drawing support from three engines — the US (3.4% average GDP growth over the 1985–90 interval), Japan (4.8%), and even Europe (3.0%). The developing world was benefiting from the East Asian “miracle”(8.1% average growth over the six-year period ending in 1990) as well as from moderate growth in Latin America (2.9%). Drawing its sustenance from multiple sources of growth, the world had more legs to stand on in the event of a shock. Nor was the global economy of the late 1980s plagued by serious external imbalances. In 1990, for example, current-account deficits (and surpluses) in the broad global economy amounted to only about 0.5% of world GDP…
In fact, never before has the modern-day world economy been saddled with such extraordinary disparities between outsize current-account deficits and surpluses. In retrospect, the balanced global economy of the late 1980s was well positioned to withstand the pressures of a shock. By comparison, today’s unbalanced world is at a distinct disadvantage in coping with such a disturbance”
– “Two Different Worlds”, Feb. 10, 2003
In light of these serious external imbalances, the huge profusion of debt, a prompt resolution of the Iraq problem is unlikely to lead consumers and businesses to start borrowing and investing heavily again. That’s especially the case if such an unbalanced world can no longer rely on the impetus of its main growth engine, the US.
The likelihood of a sharp price spike in oil being followed by a big decline (as was the case in 1991) is also much less likely this time around. Were the work stoppages in Venezuela conclusively ended, AND all went well in the Iraqi conflict (i.e. no major supply disruptions occur), then much of the existing shortfall could be made up out of the world’s Strategic Petroleum Reserves. Iraqi oil production will probably stabilise for a year and then rise by perhaps 1.0 to 1.5 million barrels a day over a two year period.
But over the longer term, it is unrealistic to expect huge amounts of additional Iraqi oil to come flooding onto the market. A recent working paper co-sponsored by the Council on Foreign Relations and the James A. Baker III Institute for Public Policy makes many of the same points that we have expressed in the past in regard to the difficulties in vastly increasing Iraqi oil production to offset existing tight supplies in today’s oil markets:
“Notwithstanding the value of Iraq's vast oil reserves, there are severe limits on them both as a source of funding for post-conflict reconstruction efforts and as the key driver of future economic development. Put simply, we do not anticipate a bonanza.
The U.S. approach should be guided by four principles:
Iraqis maintain control of their own oil sector;
a significant portion of early proceeds is spent on the rehabilitation of the oil industry;
there should be a level playing field for all international players to participate in future repair, development, and exploration efforts; and
any proceeds are fairly shared by all of Iraq's citizens. If de-politicized, the UN oil-for-food distribution mechanism is a useful starting point for distributing oil revenues throughout the country.
It is also important to note that Iraqis have the capability to manage the future direction of their oil industry. A heavy American hand will only convince them, and the rest of the world, that the operation against Iraq was undertaken for imperialist, rather than disarmament, reasons. It is in America's interest to discourage such misperceptions. While Iraqi technocrats are likely to be attracted to American technology and assistance, the United States should be prepared that negotiations with future Iraqi representatives on foreign participation will be prolonged and hard-fought. In addition, Iraq's highly experienced, nationalistic oil executives will be motivated by Iraqi national interests and are unlikely to agree to one-sided terms that transfer effective control of Iraq's oil reserves to foreigners.
How quickly Iraq's oil production capacity of 2.8 million barrels per day (bpd) can be increased depends on several variables, such as the political environment that develops after the war and the price of oil. U.S. policy should be informed by a realistic assessment of how Iraq will attract the estimated $30 billion to $40 billion in new investment it needs to rehabilitate active wells and to develop new fields.
Iraq's oil industry is unlikely to be able to immediately deliver recovery in oil production and, depending on damage sustained during hostilities, may find its ability to export oil reduced. It is in dire straits with existing production levels declining at a rate of 100,000 bpd annually. Significant technical challenges exist to staunching the decline and eventually increasing production. Returning to Iraq's pre-1990 levels of 3.5 million bpd will require massive repairs and reconstruction of major export facilities, costing several billions of dollars and taking months, if not years. Service contractors are likely to secure most initial oil sector contracts. The best-case projections of 6 million bpd will take several years to achieve and depend on a multitude of factors including ongoing international oil market conditions.
Any damage done to the industry during conflict will have to be addressed immediately in order to ensure that oil revenues continue to flow back to the Iraqi people. American military planners must be well-briefed on Iraq's oil infrastructure, in order to avoid inadvertently harming Iraq's recovery.
Finally, the legality of post-sanctions contracts awarded in recent years will have to be evaluated. Prolonged legal conflicts over contracts could delay the development of important fields in Iraq and hamper a new government's ability to expand production. It may be advisable to pre-establish a legitimate (preferably UN-mandated) legal framework for vetting pre-hostility exploration agreements.”
(“Guiding Principles for U.S. Post-Conflict Policy in Iraq”, www.bakerinstitute.org, December 2002)
In short, there is no quick fix to the problem of high oil prices even if an oil shock is avoided. A best case scenario allows for stabilisation and perhaps a modest decline in the price of crude, but an imminent return to sub-$20 oil, as was the case in 1991, appears unlikely. Venezuela adds to the severe problems of a market on the knife’s edge of a price explosion. To many, Iraq remains a relatively untouched jewel in the crown of the Middle East. Yet this “jewel in the crown” could yet prove to be no better than a crown of thorns in the event that invasion plans do not adhere to the optimistic outcome now assumed by the markets. Markets today view war as something akin to cogs in a machine. Armchair strategists squeeze out the human element in a clash between independent wills to a point where it is almost invisible -- at least, until something goes wrong. Only the most deluded optimist should therefore expect certainty and good times to return to the markets once the first cruise missiles are launched.
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