Iraq Regime Change Could Weaken OPEC

You would think that a war in the Middle East would send oil prices skyrocketing.

And initially, it most certainly would. But in what could prove to be a surprising twist, a regime change in Iraq could have the opposite effect on the world’s oil markets over the long haul.

As the storm clouds gather over Iraq, the Organization of the Petroleum Exporting Countries faces what could be the biggest test since its birth in Baghdad 42 years ago: a decade or more of swelling production and sliding prices.

It might not be the primary objective of a U.S. offensive, but one important consequence of toppling Saddam Hussein would be a substantially weakened OPEC. Even if military action produced an initial spike in oil prices, government officials, industry analysts and energy experts believe that Iraq would need to maximize oil production to finance reconstruction. OPEC’s 10 other members would have little choice but to go along, experts say, and their own cash-flow needs would limit their ability to prop up prices by reducing output.

The likely result would be several years of oil prices in the neighborhood of $20 a barrel or less, compared with nearly $30 recently, forecasters say. Some believe prices could fall even further as Iraq’s production capacity expanded.

“OPEC faced many challenges in the past, but was able to control itself and restore some kind of price stability,” said Fadhil Chalabi, a former OPEC and Iraq oil ministry official who heads the Centre for Global Energy Studies in London. “Iraq will be the biggest challenge.”

OPEC’s fundamental problem is that it is bucking the forces of supply and demand.

Not counting Iraq, its members have the capacity to pump as much as 29 million barrels of oil a day, but they have adopted quotas totaling 21.7 million barrels in an effort to keep prices high. Most of them are flagrantly exceeding their self-imposed limits, however, and they might be unwilling to slam on the brakes as Iraq’s production rises from less than 2 million barrels a day now to as much as 6 million barrels in several years.

Some industry analysts say the restoration of Iraq’s production capability over the next decade might be enough to break OPEC’s grip on world oil markets, even if Iraq remained a nominal member.

“It’s tough to see Iraq under any circumstances really participating closely with OPEC in the next five years,” said analyst Raad Alkadiri of Petroleum Finance Co. in Washington. “If you have a government in Iraq that is closely tied to the United States and dependent on the United States for its continued power, it is conceivable that it will feel pressure to leave OPEC.”

Opening the Spigot

OPEC’s loss would be others’ gain.

U.S. Undersecretary of State Grant Aldonas cited the potential economic payoff during a recent trip to Poland. A regime change, he said in Warsaw, would “open up the spigot on Iraqi oil, which would have a profound effect in terms of the performance of the world economy.”

Officials at OPEC headquarters in Vienna did not respond to requests for interviews.

Of course, even pessimists acknowledge that other outcomes are possible. Oil prices could surge and stay high for years if Hussein managed to torch his oil fields in the dying days of his regime. Iraq’s ability to maintain even its current production could be disrupted if the country splintered into hostile factions after a war. Political instability in other oil-producing Arab states could roil markets and raise prices.

But most analysts consider those longshots. A more likely scenario is an era of rising production in which about the best OPEC could hope for would be to keep the price of oil from falling too far below its target of $22 to $28 a barrel.

If events broke the wrong way and OPEC botched its response, prices in the single digits would not be out of the question, experts say.

It would not be the first brush with disaster for OPEC, which was founded at Iraq’s prompting in 1960 after the big multinational oil companies lowered the posted price of crude without bothering to consult the countries whose economies depended on petroleum exports. The founding members were Iraq, Iran, Kuwait, Saudi Arabia and Venezuela. They were joined later by Qatar, Indonesia, Libya, the United Arab Emirates, Algeria and Nigeria.

OPEC achieved notoriety a decade later, when prices soared in response to the Yom Kippur war and the Arab oil embargo of 1973, the Iranian revolution in 1978 and the Iran-Iraq war that began in 1980. Taking off from about $3 a barrel in the early 1970s, prices reached a high of about $35 in 1981.

Then came OPEC’s first big crisis. The price increases of the 1970s caused a drilling boom, leading to increased production, and created incentives to conserve, causing consumption to decline.

In 1985, Saudi Arabia decided it no longer would bear nearly the entire burden of restricting production to shore up prices. When it opened the spigot, oil tumbled to $11 a barrel. Other OPEC members agreed to abide by production quotas, and the price gradually recovered.

Another collapse occurred during the Asian financial crisis in 1998. OPEC misjudged the market and increased production. The price fell to less than $10 a barrel, and it took substantial quota cuts, along with a global recovery, to restore balance.

Energy experts say rising Iraqi production after a regime change, when combined with other problems, would present OPEC with its third big test.

Ron Gold, vice president of the Petroleum Industry Research Foundation in New York, said he believed Iraq would remain a member of OPEC. “But they won’t accept any significant limits on their production for some time,” he said. “The others will have to accommodate, and not without some pain.”

Gold said he believed OPEC would be able to adjust. “When the wolf was at the door, they’ve always managed to come together somehow,” he said. “They seem to do best when things get really desperate.”

Much would depend on the composition of a new Iraqi government and the degree of influence exercised by the United States, experts say.

The signals have been mixed. A prominent Iraqi opposition leader declared this month that a new government would expand oil production and exceed Iraq’s OPEC quota to generate revenue to pay off debts and finance reconstruction. But he also said a post-Hussein regime would work with OPEC and try not to undermine the organization. Whether it would remain a member was unclear.

OPEC on Agenda

A more definitive forecast may be forthcoming. The State Department is preparing to host a two-day meeting of opposition leaders to discuss, among other things, the restoration of Iraq’s oil production capability and its future role in OPEC. U.S. officials have said they do not intend to dictate the outcome.

Ed Morse, senior advisor at Hess Trading Co. in New York and a former State Department official, said he believes Iraq would choose to remain a member of OPEC, and the United States would not attempt to prevent it from doing so.

Baghdad will need the help and deep pockets of its OPEC neighbors to rebuild its production and export infrastructure, he said. After Hussein invaded Kuwait in 1990, Saudi Arabia shut down a pipeline capable of moving 1.6 million barrels a day of Iraqi oil to export markets.

“I find it unimaginable that the U.S. government is going to tell any Iraqi government what it ought to be doing in or outside OPEC,” Morse said.

Yet many analysts, including Morse, expect the price of oil to slide to the low $20s even if OPEC hangs tough and Iraq stays on board.

“OPEC faces problems not just from Iraq,” said Petroleum Finance Co.’s Alkadiri. “Global demand isn’t increasing that rapidly. You have a lot of non-OPEC production coming on. Within OPEC, you have countries that are well over their production quotas. You have a whole bunch of problems that point to a struggle within the organization and, ultimately, to the unsustainability of present prices.”