Iraq's oil supply vital for stability

A.F. Alhajji, Project Syndicate

In recent months, Iraq's oil production has grown to more than two million barrels per day. At this rate, current oil output and oil exports now exceed post-invasion predictions. Experts had argued that funding shortages, lack of security, the problems of stabilizing a legitimate government, and technology shortfalls would severely limit Iraq's output. Despite the odds, Iraq's daily output reached a post-invasion record of 2.5 million barrels in March.

A number of factors enabled Iraq to increase its output. Most significantly, the Bush administration gave Iraq US$2.3 billion to restore its oil production. After the invasion, no one expected Iraq to get loans, let alone outright grants.

Instead, $2.3 billion was invested directly into the Iraqi oil sector. To protect the oil fields and other facilities, the Americans dedicated a massive, overwhelming force of soldiers and private contractors. The level of protection was unprecedented even compared to Saddam's regime.

On the technical side, the Bush administration hired the world's best oil service companies to revamp Iraq's technologically challenged oil fields. They still have a long way to go, but significant improvements are already evident. Moreover, the war didn't change the quality of Iraqi fields, which are still among the richest in the world and can produce oil with relatively little effort and investment.

Finally, high oil prices in the past 12 months provided an unexpectedly large windfall to the Iraqi budget, allowing for the financing of other sectors without slighting the oil industry. High prices also enabled the Coalition Provisional Authority to add even more private security personnel to protect refineries and pipelines.

Granting Iraq the money to restore its oil industry was one of the best post-war decisions that the Bush administration has made. The money allowed Iraq to begin to address security, production, and technology issues throughout its oil system. But the question remains: Will output growth continue following the transfer of sovereignty to an Iraqi government at the end of June?

Despite massive injections of funds and unprecedented security, insurgents have still managed to halt or reduce oil production and exports several times since the invasion. The bombing of a pipeline or other oil facility somewhere in Iraq remains almost a daily occurrence, and the transfer of power has not reduced these attacks so far.

Like the Bush administration and Saddam himself, the insurgents understand that whoever controls Iraqi oil controls Iraq's destiny. The new Iraqi government, even supported by U.S. military might, will simply not be able to guarantee a predictable flow of oil, and output will remain quite volatile.

At the same time, maintaining the flow of funds into the Iraqi oil sector is essential, not only for its growth, but for its very survival. Money brings technological regeneration as well as security. Under even the best circumstances for Iraq, with oil prices remaining high, the funds available to maintain and modernize the oil industry are limited. If oil prices decline in the future, the oil industry will suffer severely.

This makes for an interesting relationship between Iraq and Saudi Arabia. Only Saudi Arabia can manage the global output of oil in such a way that will make room for Iraqi oil and keep prices high. In contrast, only Saudi Arabia can flood the market and reduce prices far below their current level.

A decline in oil revenues could be devastating to the fledgling Iraqi government. Current oil revenues are barely enough to cover state expenses, let alone pay for reconstruction, debt, and war reparations.

Even if President Bush wins reelection, it is highly unlikely that the U.S. will make another outright grant to a sovereign Iraq. Theoretically, international loans could be an alternative, but who would lend to an unstable government, let alone a government whose legitimacy has not been fully established? Likewise, privatization is out of the picture for now.

The new government will have to make do and chart a slow path for its oil recovery, just as Saddam's regime did. At the same time, the logic of renewed American support for the Iraqi oil industry remains powerful. Normal financing is not forthcoming. Only grants from the U.S. will reduce output volatility.

Saddam's regime caused most of the volatility in the oil market in the last 30 years. In fact, every peak in oil prices since 1973 was caused by an event related to Iraq. One would hope that his removal would reduce market volatility and stabilize oil prices.

Unfortunately, Iraq appears set to continue to be a major source of high oil prices, owing to highly erratic output. For the foreseeable future, one of the principal outcomes of the invasion of Iraq will be greater volatility and thus higher prices.

The writer, a widely published oil analyst, is Professor of Business at the College of Business Administration, Ohio Northern University.