ANALYSIS – OPEC may face Iraq challenge sooner than expected

March 10 -2010
DUBAI/LONDON (Reuters) - The storm brewing on OPEC’s horizon over future Iraqi oil output could engulf the producer group sooner than it would like.

OPEC was unlikely to discuss Iraq at its meeting on March 17 but it may need to do so within a couple of years.

“There’s only one issue, but it’s a big one. It’s a tsunami. Iraq,” said Leo Drollas at the Centre for Global Energy Studies.

After years of sanctions and war, Iraq is exempt from the output targets OPEC uses to set supply levels.

But as Baghdad embarks on an unprecedented oil industry development, OPEC will at some point need to bring Iraq back into the fold to prevent millions of barrels of new oil supply undoing its work to balance markets.

OPEC officials and analysts have said the issue is not urgent, as it could be years before Iraq makes significant increases to current output of around 2.5 million barrels per day (bpd). Baghdad’s failure to reach past ambitious targets has fed the scepticism.

The consensus among analysts is that it would take around 5 years for Iraq to boost output by between 1 million bpd and 1.5 million bpd.

But output gains could surprise OPEC in their speed.

You could be looking at 1.5 million barrels in two years,” said a senior executive at one of the oil firms involved in Iraq. “That could make a huge difference to the supply and demand balance. Is there going to be that kind of demand pick up in that timeframe?”

Iraq’s deals call for foreign firms to boost output potential to 12 million bpd in seven years, which would leave it snapping at the heels of Saudi Arabia’s capacity of 12.5 million bpd.

Iraq faces huge political, security and logistical challenges in reaching that target. The first test will be how the new government that emerges from Sunday’s elections will handle contracts signed by oil firms.

But assuming the deals survive intact and work can go ahead, Iraq’s huge oilfields present little technical challenge to oil majors that have had to push into regions such as deep water and the Arctic to access oil reserves. There is nowhere else on earth where international oil firms have access to such cheap to produce, abundant reserves.

Reaching 12 million bpd in seven years appears improbable, but oil firms believe early gains will be easy.

The terms of the contracts Iraq has signed encourage firms to boost output quickly to recover costs. Once firms boost output from producing fields by 10 percent, they start getting paid.

“The way the contract is structured is to incentivise swift progress,” said Bill Farren-Price of consultancy Petroleum Policy Intelligence. “I’m fairly optimistic that we’ll see Iraqi oil output rising over the next 12 months as Rumaila and other projects get underway.”

Iraq has said it expects another 200,000 bpd of oil from fields leased under the new contracts this year. Its biggest producing field, Rumaila, should rise 100,000 bpd by July. BP and CNPC won the contract to boost output at Rumaila, the workhorse of Iraq’s oil industry to 2.85 million bpd from 1.07 million bpd.

WHAT CAN OPEC TOLERATE?

OPEC, which has weathered many difficulties in its 50-year history including a bitter war between members Iran and Iraq, will likely put off thorny negotiations on how to accommodate a resurgent Iraq as long as possible.

“It’s the last thing they want to do (tackle this issue), the want to sweep it under the carpet,” said Drollas of the CGES.

When the group calls on Iraq to rejoin the depends on how quickly oil demand rebounds after two years of contraction due to the global economic downturn.

“If the market is very tight, with demand rising and non-OPEC supply continuing to disappoint, then Iraq could be accommodated quite well … But if demand falls then it would be a very big challenge for OPEC,” said Bassam Fattouh at Oxford Energy.

Even if the market could absorb the extra production, other OPEC producers would have to maintain curbs on supply in place since late 2008, while Iraq pumped more.

This would create tensions within the group as other members effectively give up market share and billions of dollars of potential revenues to Iraq.

Baghdad has said that it believes OPEC should allow it to pump more without imposing a quota as it has lost market share and revenues to other members of the group as years of sanctions and war prevented Iraq from achieving its production potential.

OPEC officials have said they would need to think about quotas once Iraq showed it can consistently pump 3 million to 3.5 million bpd.

Some say the group would have to address the issue if Iraq’s output approached 5 million bpd — putting it ahead of Iran and making Baghdad the second largest OPEC producer after Riyadh.

That could challenge Saudi Arabia’s position as dominant producer with the flexibility to influence output significantly.

“As Iraq substantially exceeds Iran’s production level it will raise significant political problems for OPEC as a whole and for Saudi Arabia in particular,” said Edward Morse, head of global commodities research at Credit Suisse.

Iraq has strengthened its hand for future negotiations with the oil deals. Previous production targets have been based on reserves. Iraq’s reserves are a little smaller than Iran’s, so a renewed quota might be similar to that of its neighbour. Iran’s target is around 3.34 million bpd, although Tehran disputes that and is pumping around 3.75 million bpd.

But Iraq would likely refuse to be saddled with that comparison, as the deals it has signed would put it on a par with Saudi capacity, regardless of its reserves. It would likely use that as a starting point for negotiations, analysts say.