Beyond Oil: Restoring Iraq's Economic Sovereignty
This is the first article of two focusing on the Iraqi economy until 2030. Part one looks at oil prices and power generation. Part 2 will look at the electricity sector and different approaches to privatisation
Scepticism of privatisation is an enduring global phenomenon. Sceptics sometimes imply that since profit is a questionable motivation, governments are better placed to deliver excellent service at low cost to growing populations (mainly in the developing world) and ageing populations (mainly in the developed world.) Policy makers across the globe face the challenge of striking the right balance, or facing a backlash. Iraq is no different, where one of the biggest secular parties is the Iraqi Communist Party.
Left wing thinkers in the West once championed Iraqi resistance to the “corporate takeover” of Iraq, a point repeatedly argued by Naomi Klein in her book “The Shock Doctrine.” On the face of it, such concerns may have seemed reasonable: in 2003 there was justifiable scrutiny over some no-bid reconstruction contracts signed by Halliburton, KBR, Bechtel and others. Concerns over Coalition Provisional Authority (CPA) policies heightened the fear that Iraq was being sold off under occupation. But the sums disbursed in early reconstruction contracts, though totalling billions of dollars, were small in comparison to the revenues from oil that would later come to the Iraqi state.
In 2004 Swiss development NGO CETIM released a statement on the CPA’s legislation in Iraq:
"Among the orders promulgated by the civil administrator is Order 39, which deals with foreign investments. This order plays a leading role in the forced march of Iraq toward a neo-liberal economy. This order, according to its preamble, aims at “…the need for the development of Iraq and its transition from a non-transparent centrally planned economy to a market economy…” In fact, it is designed to deprive future Iraqi authorities of all economic sovereignty and prerogatives"
The great irony here is that a politically sovereign Iraq never came close to these recommendations to build a “market economy,” leaving behind a generation of Iraqi entrepreneurs. Without fully consulting Iraqis, the CPA’s recommendations at first failed and were then abandoned. Since then, Iraq has never had significant economic sovereignty. This is not because of foreign control. It is because the state dominates Iraq's economy, while an Iraqi and international effort continues to change this status quo (efforts explored in pt.2)
Why then, is Baghdad not fully sovereign over economic matters? Unless there is deep reform, Iraq’s economic fate will be decided not in Baghdad, but by global market forces--namely, supply and demand for oil. Economic sovereignty will not exist until Iraq escapes from oil dependency.
Another irony is that (as Joel Wing highlights) CPA Order 39 forbid foreign direct investment in the oil sector. Therefore, despite its failed privatisation drive in other sectors, the CPA almost doomed Iraq to majority state ownership of oil and gas, something that usually opens the door to inefficiency on a grand scale in most oil rich developing nations, most recently the collapsing socialist state of Venezuela.
Ever since the rapid expansion of Iraqi oil production in the 1970s, almost everything that moves in Iraq has depended on oil and gas revenue, from the turbines of state run power stations to the state-run factories that weave the power cables and the wages of the workers that operate those machines, workers who make up the vast majority of employment in Iraq. It is theoretically possible to look at Iraq’s projected demographics and projected oil prices and identify the approximate period when the next crisis might occur, and what might be required to avoid this. Demographics most certainly are destiny. Without reforms, Iraq’s fortunes will depend as much upon what happens in the Bakken shale play in Texas (among others) as much as what happens in Iraqi parliament.
Like many MENA nations, Iraq faces the challenge (and opportunity) of a young demographic. According to Booz and Company, approximately 290,000 people per year entered the labour market from 2016 onward, while 64% of the population is of 24 years or younger. The next government in Iraq will have to address this with a credible plan because the state can no longer afford to create jobs.
The magic number in 2017 was $4.75 billion required to pay salaries and at times during the year, oil revenues dipped below this sum, leaving Iraq dependent upon foreign loans and where possible, freezing government expenditure in line with an IMF program.
The $4.75 billion figure is linked to the fiscal break even price, the estimated minimum oil price Iraq needs to maintain basic government functions--including keeping the lights on. In Iraq, electricity pricing starts at 10 dinars per kilowatt hour for Iraqis who fall into the bracket for paying for power. At the moment however, a great many do not pay, which is why the Ministry is working with the World Bank to reform the system, especially since Iraq’s population is expected to soar (electricity and demographics will be explored further in part 2.) According to one recent study,
“The end-user metering in Iraq is very poor, with a combination of outdated or malfunctioning meters and widespread theft or unmetered connections. Estimates suggest that around 23% of the total electricity generated is lost to theft via illegal connections to the system. In addition, the majority of the existing end-user meters, around 80%, are more than 30 years old and some of them have never been recalibrated. The poor end-user metering is compounded by the absence of effective billing and collection systems and procedures, which in turn leads to widespread thefts, non-billing and payments. Of the estimated total system losses, about 50% is non-technical losses.”
Iraq is paying for wasted power generation with funds that could be used for schools or hospitals, by one recent estimate at least $900 million per month in 2017. Left unaddressed, a combination of irregular oil revenues and population rises could cause this system to collapse from inefficiency. Therefore, private finance is vital to ensure sustainability. For this reason, the Iraqi Ministry of Electricity writes (in its own strategic planning)
"Un-metered usage tends to be excessive when compared to metered usage, although this does depend significantly upon the set level of tariff. However it is expected that a meter installation programme (along with the required systems/procedures for meter reading and customer billing) would encourage more energy conservation amongst domestic consumers.”
But there is a gulf between these plans and the Iraqi street. Like people all over the world, Iraqis worry about private finance and corporations lacking accountability. There needs to be a debate in Iraq about the status quo however: a state dominated economy that is the employer of choice, dependent upon oil revenues that will one day fall catastrophically and may never recover. Private finance must be attracted to Iraq, or Iraq will face, at the very least, a severe energy crisis. Below are some of the issues to consider regarding oil revenue dependency in Iraq.
Riding the oil markets
In the near term, the oil market is expected to continue its path to recovery, although analysts differ on whether we will see another bull market soon, or whether oil will be range-bound by shale growth for the foreseeable future. OPEC and some non-OPEC partners have succeeded in upholding prices, but once again US shale is benefiting. As a result, rising shale production could again hit prices --and investor confidence in shale. This could again contribute to bearish sentiment.
Either way, if oil remains in the $55-70 range, Iraq’s budget will be low but relatively stable, with some investment slowly re-emerging through 2018. This would still be a precarious situation if unforeseen global production growth coincides with a drop in demand, perhaps due to problems in the Chinese economy. Demand is already expected to grow by 1.3 million barrels this year, compared to 1.5 million in 2017. Alternatively, it is also possible that a short term supply disruption, perhaps in Venezuela or Libya, could send prices spiking. Even in that case, international aid will still be a major requirement for Iraq’s reconstruction.
Longer term, more analysts are coming around to the idea that the great energy investment collapse of 2014 to the present will cause a serious supply gap. In June 2016, the NAMEA consultancy released a report suggesting that, “All oil fields lose at least 6% of their production each year if there is no investment in increasing production. There has been no major investment in any oil field for two years now. So averaged across the whole industry we must see at least a 6% reduction in production over the next 12 months.”
The NAMEA report also noted problems with U.S. shale, including staggering debt in the industry. The fear is that if the price does indeed rise due to the supply gap (something that appears to be happening) the market will then correct itself back towards oversupply and be faced with strengthening renewable energy growth (at some point in the 2020s) which will herald the last years of oil. The latter scenario may be distant enough for Iraq to take decisive precautions, and a reform effort in the power sector is underway, albeit reforms facing strong resistance.
There are two current points that support NAMEA’s analysis: Firstly, there is evidence to suggest the “second shale revolution” may be losing momentum and secondly, over the summer, we saw the fastest mature oil field decline rate globally in 25 years. At the same time, rising oil prices, while seemingly rescuing US shale, (with its high extraction costs) are likely to continue pushing up oil services costs, meaning extraction costs for shale will rise again. This should also apply to production growth in areas such as Canada and Brazil.
Much of the “efficiency” gains of US shale were simply due to a collapsing market after late 2014, although some of the efficiency gains are real. Those gains are, in turn, helping attract continued investment in shale under new financing vehicles and as a result, the EIA predict hundreds of thousands of barrels of new shale on the market next year. But shale still faces short term challenges, including a lack of skilled labour following a migration of workers during the slump. These points may all seem minor in relation to Iraq's financial situation, but they will all move the oil price up or down.
There are also question marks over the EIAs shale forecasts and at the end of 2017, there was more evidence of rising costs for US shale. Investment in Texas could continue to slump. Others point to the rapid depletion rates in shale patches, as Schlumberger Executive Vice President Patrick Schorn has said,
“The ability of tight (shale) oil to influence global supply dynamics, and therefore price, will diminish over time.” In any case, OPEC and the US will be locked more confrontation through 2018, with OPEC cuts and extra US production in the range of an extra million+ bpd range (OPEC hope to cut 1.2 mbpd in 2018, US may increase production by at least 1 mbpd including non-shale.) Outside of that fight, there are many wild cards, including continued uncertainty over China’s economy and its oil demand. So to the influence of the Bakken shale patch on Iraq’s economic sovereignty, we can add demand in Beijing.
What if the oil price spikes?
If bullish factors converge, what would high oil prices actually mean for Iraq? In the short term, higher oil prices would push Iraq’s monthly revenues more consistently above $5 billion, allowing for more reliable salary distribution to government employees and making way for the return of an investment budget, restoring the confidence of lenders and Iraq’s many partners who are interested in exploring reconstruction opportunities and possible investment.
Also in the short term, more consistent salary allocation will keep markets and malls in Baghdad bustling, while foreign loans go towards power projects to keep the lights on. This means that large street protests and general political instability are less likely in the short term. This is more good news for Abadi. In Mosul, reliable salary distribution is essential to maintain recovering economic activity--the busy markets and restaurants we read about in the east side of the city.
If Iraq can repeat the reduction in security costs that it achieved in the 2015-2016 period, combined with higher oil prices, this means that not only will Iraq be looking at a financial light at the end of the tunnel for the short term, but will have vital available funds for reconstruction and rebuilding the decimated education budget. Regarding the recent bill to raise PMU salaries to the level of ISF salaries, this is important but means that spending on higher end equipment must come down.
Since Daesh are now effectively reduced to a scattered insurgency, in the near term there would appear to be little justification for Iraq to spend vast amounts on new main battle tanks (MBTs), including a large consignment of T-90 tanks recently ordered, in addition to fighter jets and other high cost items for conventional warfare, especially since Iraq is now in the process of stabilization. The main priority would be ensuring salaries are distributed on time for fighters up and down the country who are now risking their lives to track down Daesh holdouts, and ensuring they are logistically supported in remote areas.
Since many of these fighters in towns such as Tikrit and Haditha are Sunni, including entirely Sunni Hashd al-Shaabi brigades, salary distribution becomes a key pillar of local security and a deterrent to organised crime, which undermines local policing and opens the door for terrorism. There is strong evidence that this is the case from the 2003-2011 period, and similar logic applies in Basra, and even the Kurdish region.
Therefore, even a slightly less optimistic forecast-- the EIA expect $60 average in 2018 for Brent, would still stabilise Iraq’s budgetary situation, provided the government keep up the effort to remain on track with IMF loan conditions. The EIA’s forecasts reflect continued warnings about rising U.S. production pushing the price down. (Note, in November, average Iraqi oil prices for Kirkuk and Basra Light were $57 per barrel, according to the Iraqi State Organization for Marketing Oil (SOMO) compared to $62.71 average for the Brent benchmark. This reflects competition among oil exporters.
To break away from this dynamic, Haidar al-Abadi is attempting to change the fundamental character of the Iraqi state, opening the door to privatization in the electricity sector. This is vital because Iraq faces a problematic situation where, if oil prices rise, more money circulates in the economy and subsequent demand for new electrical goods soars, a problem outlined by Frank Gunter. This has been a consistent issue since the end of the sanctions era, as increasing salaries allowed Iraqis to imported purchase “white goods.”
Furthermore, predicting oil prices is often described as a “fool’s errand.” According to one energy analyst,
“long range (20 years or so) forecasters of energy affairs have missed every important shift in the past two generations. With rare exceptions, medium and long range forecasts become largely worthless in a matter of years.”
What we can be sure of, is that Iraq’s population has risen very rapidly, and is set to continue rising. In 1991 for example, Iraq had a population of 14 million, in 2003 this was thought to have been 25 million, it is currently at 38 million and may reach 50 million by 2030. Saudi Arabia, Iraq and Egypt are leading the region with this population boom, and these countries also face the problem of young populations and high youth unemployment. This means that, unless reforms continue, and more revenue can be brought back to the Ministry of Electricity, (constraining electricity demand, meaning fewer blackouts) and fuel prices can reflect the cost of refining, Iraq will have less funding for vital services.
In this scenario, spending on state-run power generation and artificially cheap fuel will continue to outstrip both security and education expenditure. Unless there is reform, not only will this situation continue, but it will get worse, and the demand for energy, fuel, housing and food, in addition to government jobs, will far outstrip supply. The question then changes from the short term, “will Daesh return,” to a host of other problems. The short term solution can be reduced to one word: privatisation. Abadi’s term will long be over before the worst scenarios occur but he needs strong support to ensure current reforms continue. But privatisation is a long term challenge, something that will be examined in pt.2
If Iraq fails to implement thorough and wide ranging reforms, embracing a low corporate taxation and discarding over-complex investment regulations, there is only one other scenario where Iraq can maintain stability.
This is the International Energy Agency high oil price scenario for 2040. The IEA predict, “In the High Oil Price case, the price of Brent crude in 2016 dollars reaches $226 per barrel (b) by 2040, compared to $109/b in the Reference case and $43/b in the Low Oil Price case.”
Any expectation of a high oil price would be dangerous, and in fact, even conservative expectations of oil prices can mean little when an economy is completely dependent on oil, especially if spending cannot be controlled.
One positive here is that the Iraqi government are aware of the demographic challenge. Abdul-Zahra al-Hindawi, spokesman for the Ministry of Planning, remarked how “A number of population-concerned official institutions are closely following this matter, such as the Supreme Council for the Population, headed by Prime Minister Haider al-Abadi, and the National Committee for Population Policies.”
But what about the worst case, which might involve the IEA’s low oil price scenario in 2040, with the commodity falling into the $40 range? As it is, Iraq struggled to maintain social stability while fighting Daesh when oil prices collapsed, but the terrorists were nonetheless defeated. But $40 oil in 2040 would coincide with a high population and a demand for electricity possibly exceeding 50 GW--well over the current capacity, which is around 15 GW, although this capacity is set to rise in the near term. Without very high non-oil investment, unemployment would be dangerously high and electricity supply would be almost non-existent.
At the current time, most indicators point to a low price scenario, after a period of high oil prices, perhaps lasting until the early 2020s. A major reason for this (and estimates of the adoption of electric vehicles/ EVs, differ significantly) is that by some estimates, most vehicles will be electric by 2040. Critics of these figures point to the high cost of EVs in the West which deter even wealthy buyers. Others counter that the most intensive investment in EVs in the world is currently in China and India, the great drivers of global oil demand. A growing global backlash against plastics is another issue for Iraq to factor into long range planning.
Finally, even outside of US shale, there is the potential for shale supply growth in the vast Bazhenov region of Western Siberia, which could theoretically start producing in the mid-2020s. This would presumably present the risk of another price collapse. Whomever is correct, the reality is that the era of big oil is coming to an end and Abadi is right to prepare Iraq for this challenge. But he faces a very hard task convincing populists and many ordinary Iraqis that privatisation is the right choice. At the end of the day, when there is still high poverty, its easier to promise free stuff. But this does not help alleviate poverty.
According to one study on energy subsidies in Indonesia, “Forty percent of subsidy benefits go to the richest 10 percent of households, and less than 1 percent goes to the poorest 10 percent. Fuel subsidies are, in fact, generous transfers of taxpayer money to the rich.”
The good news for Abadi is that early privatisation trials in Baghdad have actually succeeded in bringing down electricity bills (mostly going to privately owned generators) and facilitated fewer power cuts due to less strain on the grid. The challenge now is to convince the rest of Iraq.
Part 2 will examine the challenges of privatisation including political opposition, and how Iraq might be able to deal with these challenges.