Iraqi Oil Production and Exports to Continue Declining Without Infrastructure Overhaul

The escalating conflict in Syria and OPEC crude oil supply disruptions appear to have sent a mild panic to the oil markets. While Syria may not be a defining factor of price jumps, oil production cuts from Iraq and Libya by 170,000 barrels per day (bpd), in spite of increased output in Saudi Arabia, play a larger role. Worker protests in Libya brought the production down to 400,000 bpd in early August. Meantime, the second largest oil producer in OPEC with oil output exceeding 3 million bpd (mbpd) in 2012 and 2.4 mbpd going to exports, Iraq’s oil sales in 2013 have fallen below last year’s average, with July 2013 exports hovering at 2.25 million bpd. With Iraq’s increasingly important role as an oil exporter in the years to come, it is worth examining why its oil exports are on the decline and are unlikely to make a big jump without fixing the security and infrastructure problems.

This year’s decline in Iraq’s oil exports was largely due to the repeated insurgent attacks on the Kirkuk-Ceyhan (Iraq-Turkey) oil pipeline as well as other infrastructure failures. According to Iraqi officials, production disruptions due to repairs of de-gassing stations at the country’s oldest and largest Rumaila oilfield contributed to the recent cutbacks. Iraq plans to increase production by 360,000 bpd by the end of 2013 or early next year from new oil fields Majnoon, West Qurna-2 and Garraf and install three new single point mooring platforms in the Persian Gulf for additional export capacity.

But it is unlikely that the exports will increase further with a planned maintenance of Iraq’s major export terminal in the south – al-Basra Oil Terminal and Khor al-Amaya Oil terminal – which could cut output by 500,000 bpd for four to six months from September, despite assurances of Iraqi oil officials that disruptions would be minimal. Besides, the increase in export capacity is subject to tanker traffic in the Gulf, weather challenges, and the current export infrastructure taking turns between a shut-down and slow re-starts. At the end of the day, Iraq’s antiquated and neglected energy infrastructure is a critical obstacle to oil production and exports. This August, Iraqi officials chided Royal Dutch Shell for delayed start-up and for the inability to meet production goals of 175,000 bpd from the giant Majoon oilfield in the south. The row points to the infrastructure challenges confronting international oil firms operating in Iraq. Shell attributed delays to health and safety concerns, stressing that additional work was required to safeguard existing facilities. Similar problems exist in every part of the country’s energy value chain. Thus, Iraq’s new ambitious production figures of 9 mbpd by 2020 and exports of 4.5 mbpd in 2014 will be further curtailed with recurring infrastructure failures that beg for a complete renewal of the infrastructure, and inevitably cause disruptions while renovations take place. Constant terrorist attacks on the Kirkuk-Ceyhan export pipeline will not help the increase of exports either.

New Verse to a Refrain on U.S. Energy Independence

There is a lot of euphoria that America maybe moving towards energy independence with the boost of shale oil production. Latest news headlines say that the U.S. oil boom will render OPEC irrelevant and OPEC loses power as U.S. shale boom keeps prices down. Some observers argue that the U.S. could stop importing energy, particularly from politically unstable countries of the Middle East and Africa, thereby reducing its involvement in these regions.

Taking a longer view, it is not a fact yet that shale oil boom will not meet hurdles along the way. It is a fact that both shale gas and oil wells decline much faster than their conventional counterparts. Drilling new wells will be the only way to keep the anticipated high level of shale oil production. Further, even with the rising domestic oil production and a drop in overall U.S. crude imports, oil supplies from Canada, Saudi Arabia and Iraq increased to a 15-year peak in 2012. These three countries plus Venezuela remain top exporters of oil to the U.S.

Greater energy self-sufficiency is a possibility for the U.S., but the real questions are whether absolute energy independence is ever possible for America given rapid peaks and declines in unconventional oil wells and the nearly bygone era of its conventional oil production; the relatively expensive development of unconventional sources of energy compared to conventional oil and gas; whether the country's transportation sector, which accounts for close to 93% of all petroleum consumption, is able to reduce its addiction to oil; and whether it is ever possible to be immune to fluctuations of global energy prices given the increased financial and physical interconnectedness of major global energy markets. 

Key Issues to Understanding the Flawed Oil Pricing System

Following the news earlier this month that some of the world's major oil companies may have manipulated the Brent oil prices, some energy observers noted that it was a bomb that was waiting to explode. On May 14, 2013, the European Commission launched an investigation on BP, Statoil and Shell on suspicion of their involvement in manipulating oil prices since 2002. A U.S. commodity trading house, Prime International, filed a class-action lawsuit in New York against these companies on May 24, 2013. The scandal also involves one of the major independent oil price reporting agencies (PRAs), Platts, which collects and reports key international benchmarks on a regular basis. The prices that Platts reports provide grounds for long-term contracts, futures contracts, and derivatives and spot market transactions. Information that Platts provides to its subscribers, which range from oil companies to traders to banks to futures exchanges and governments, is used to help set prices for derivatives contracts and physical delivery of oil worth billions of dollars. According to the French oil company Total, “as much as 80 percent of all crude and oil-product deals are linked to reference prices including those published by Platts.” Even a minor mistake in price reporting carries significant implications on the energy markets. Several issues should be pointed out about PRAs and the energy market that may help understand the current mess.

First, some reporters immediately drew parallels between PRA oil pricing and the Libor-rigging scandal of last year. Libor, which stands for London Interbank Offered Rate, is a collection of rates designed to gauge the cost of borrowing between banks. Libor rates are used as benchmarks for nearly $10 trillion in loans and close to $350 trillion in derivatives. But comparing Libor-rigging to the oil price scandal is wrong. PRAs compete with each other for accuracy of price reporting, which is their bread and butter. Loss of credibility and reputational damage to their reporting would put them out of business. Unlike banks, they are not tied to energy trading apart from reporting about it. The key point on PRAs is they receive pricing information, everything from offers, bid and transactions, from energy market participants (i.e. buyers and sellers) purely on a voluntary basis. In other words, market participants are not required to share their trading data, but if and when they do so via PRAs, the latter must verify the accuracy and correctness of the data they receive.

Second, a lingering criticism of Platts has been its use of a market-on-close (MOC) methodology. Under the MOC mechanism, Platts establishes a time window and only trades transacted within this window are utilized to assessing the price of oil. According to Bassam Fattouh's seminal study of the oil pricing system, “the main criticism of the MOC methodology is that the Platts window often lacks sufficient liquidity and may be dominated by few players which may hamper the price discovery process.” Critics also point out the paucity of volumes traded within the Platts window, which is arguably not representative of the larger volume of trade taking place outside the window. As Fattouh argues, Platts favored the MOC methodology over what it previously used – the volume-weighted average of oil prices– believing that MOC most accurately reflected time sensitivity of assessed prices. However, there is no regulatory authority to oversee the behavior of PRAs or to address any dispute over PRA price assessments.

Third, given the varying levels of transparency between and within various layers of oil benchmarks, whether it is Brent, WTI or others, the current system of oil price discovery is quite imperfect. It will be interesting to see whether allegations of collusion among suspected oil companies to manipulate the Brent oil prices will bear evidence. A proof of such allegations is likely to result in evaluations of potential regulatory measures against market manipulation and a review of current methodologies used by PRAs to discover prices as well as transparency and accuracy of their assessment of energy prices.

Lastly, the current market-based system of oil pricing has existed since the 1980s, with oil prices set by the “market” and PRA reporting on prices based on their assessment of physical and financial transactions. Despite the known imperfections of the existing system, market participants (oil producers, oil companies, traders, refiners, financial actors, etc.) and governments have been hesitant to change it. It is highly unlikely that this system will be replaced with something else. But changes to PRA reporting methodology and transparency, which have come under increased scrutiny in recent years, might occur over the long term.

Gas-to-Liquids Potential of the U.S. Uncertain

The U.S. is exploring the potential of monetizing its copious shale gas supplies by converting them to petroleum distillates through the gas-to-liquids (GTL) process. My recent article published with Oilprice examines the promise and challenges of GTL's commercial application in the U.S. in light of an interest from South African energy company Sasol to build the second-largest GTL plant in Louisiana. The article argues that the high cost of the GTL technology, volatile oil and gas prices as well as carbon emissions from GTL plants will meet stronger resistance in the U.S. than compared to Qatar, which is now a leading GTL produer in the world. Here is a link to the full article.

Challenges Facing International Energy Companies

In light of the terrorist attack against the In Amenas gas field in Algeria two weeks ago, which ended in deaths of nearly 80 people, there is a renewed sense of vulnerability among international oil companies (IOCs) to security challenges in politically unstable countries. Wall Street Journal blogged this week that “energy firms are re-evaluating their presence in the [Middle East and North African] region” after the attack in In Amenas. While the attack was unprecedented, it is unlikely to that IOCs will pull out altogether from one of the most the prolific and profitable regions in the world. In fact, the security situation is just one of many pressing challenges that IOCs confront at this point. While the challenges are many, it is worth looking into five of the most prominent ones.

Number one challenge for IOCs is something that was mentioned in the last post on this blog – resource nationalism and the rise of national oil companies (NOCs). High oil prices and the rise of NOCs since the 1990s have significantly reduced the bargaining power of IOCs and weakened any leverage they formerly had on energy-rich countries. As a result, IOCs have learnt adapt to less favorable contract and investment terms and take greater risks to operate in more unstable geopolitical environments. 

A related, second, challenge is political instability (e.g. Arab spring), weakening of energy-rich nation-states and terrorism (e.g. Nigeria, Algeria). Many energy-rich countries in the Middle East, North Africa and Sub-Saharan Africa, for example, Nigeria, Sudan, Iraq, and Libya, face grave security problems, which are not only due to the lack of the rule of law and security, but a more fundamental issue of weak nation states with weak governments that wield little influence and legitimacy in their respective countries. Some energy analysts point out that there have been a growing number of attacks against Western interests since 2000. Because of that, companies are likely to continue to invest in extensive security needs in physical workplace, including Algeria.

The next challenge facing IOCs is tight supplies of economically extractable oil and gas and competition to produce energy sources in geologically difficult, remote, harsh and economically costly areas (e.g. unconventional sources such as shale and tight gas and oil, oil sands, exploration of the Arctic) ultra-deep waters, or tar sands. Developing unconventional energy sources in such challenging environments require significant investments in technology.  But even heavy investment in technology cannot guarantee successful finding of oil or gas, as was the case with the deep-water drilling in Gulf of Mexico’s Alaminos Canyon or the recent outcome of shale gas drilling in Poland that turned up dry wells.   

Fourth challenge is cyber security threats and cyber espionage (hacking on energy companies to obtain vital information on energy activities). Energy companies are increasingly targeted by hackers aiming to obtain valuable information on new oil findings or other valuable corporate data. For example, coordinated hacking in 2010 via malicious e-mails sent to employees of ExxonMobil, ConocoPhillips and Marathon Oil evidenced that hackers aggressively seek proprietary information. There is also politically or ideologically driven hacking to disrupt petroleum operations not only against IOCs, but also NOCs.  For instance, perpetrators of a massive cyber attack on Saudi Aramco in August 2012, which damaged 30,000 computers and aimed to stop production of oil and gas, reportedly blamed Saudi Arabia for “crimes and atrocities” in Syria and Bahrain. Highlighting ideological motivations of cyber attacks, it was reported in August 2012 that an Anonymous hacker group planned an attack on computers of energy companies developing Canada’s Alberta oil sands. This group invoked environmental harm from oil sands operations as its motivation to attack. Hacking is more sophisticated now than a few years ago and protection of data of energy companies and critical infrastructure from cyber attacks appears is becoming a serious concern for corporate and government interests. 

Fifth challenge is addressing climate change and pressures from environmental groups to regulate the energy industry. While political debate over global warming goes on, executives of major IOCs appear to have come to accept the scientific consensus on climate change and to expect that regulations to cut greenhouse emissions would be inevitable. The current challenge for energy majors is to have a strong voice in the climate-change policymaking and work out the levels of regulations through a coordinated national approach to cut greenhouse gases as opposed to a multitude of regulations devised by various local governments, at least in the U.S. Another layer of challenge here is an increase in shareholder resolution filings in the U.S. to pressure energy companies on sustainability and climate change issues, sometimes even tying executive compensation directly to a company’s sustainability metrics. With many other challenges facing IOCs, as well as NOCs, this list is hardly exhaustive. But could this be a first-tier list?