Answering Some of Your Mail
I am heading back to Harrisburg today to advise legislative staff and elected officials on the proposed Pennsylvania state severance tax for natural gas production (which I last talked about in “Marcellus Shale About to Take Off on One Sweet Ride” [May 12th, 2010]).
Seems like a good time to dip back into the mailbag.
As always, I’d like to encourage you to write to me at firstname.lastname@example.org. I can’t offer any personalized investment advice, but I can address your questions and comments in future broadcasts.
Recently, I’ve gotten two E-mails asking for comment on developments in Iraq and the Middle East. Since I am often advising public and private sector interests on the Persian Gulf and Caspian Basin, it seems particularly important that I answer them this time around.
Q: What place will Iraq take in OPEC? And just how will their formation of a government and the new valuation of the dinar affect the price of oil in the coming months? Are there any energy investments in Iraq that would be of interest to the energy investor? Thank you for all your work and information. ~ David L.
A: Thanks for reading, David. You are actually asking three questions here, so let me deal with them in order.
First, Iraq has always been a member of the Organization of the Petroleum Exporting Countries (OPEC). But it has not been a part of the organization’s monthly production quota system since March of 1998.
That should change, as oil production starts moving back on-line. After two rounds of field auctions (the second, held in December, far more successful than the first held last June), Baghdad is beginning to lay plans for rapidly increasing production. Current production is coming in at little better than 2.2 million barrels a day, or slightly below March 2003 and the beginning of U.S. military actions.
Iraqi officials are now claiming a rapid rise will take place over the next several years. But the aggregate goals from the completed auctions are just not possible.
Most of the world’s oil company majors have returned to Iraq, and all are working on 20-year service contracts. That means they receive payments on each additional barrel they lift from existing fields (no new fields are yet auctioned off), but they do not “own” assets as such. Altogether, the production levels required by the contracts signed call for between 10 million and 12 million barrels a day by 2015.
That won’t happen. In a show of considerable lack of focus, current Iraq Oil Minister Hussain al-Shahristani pledged at a recent OPEC meeting in Vienna that the country would honor a new production quota once extractions ramp up and OPEC decides what that level would be.
Additionally, several of the majors that have come back into Iraq – certainly Russian LUKOIL (OTC:LUKOF), Italian ENI (NYSE:E), and BP (NYSE:BP) – will need to balance new Iraqi production with existing volume from their fields in other regions, to avoid depressing their own prices.
The combination of an OPEC quota and the production concerns of several majors will limit the full Iraqi volume spike hitting the market. That is, assuming the political environment does not weigh down the process altogether… And that brings on your second question.
The primary problem remains the lack of an Iraqi government. The last parliamentary elections were almost seven months ago, and no one has been able to staple together a coalition and form a government. That is the single major obstacle to the oil sector stabilizing.
Iraq still does not have a national oil law. There is no consensus on dividing up oil sale proceeds or even whether there will be one or several national oil companies. And none of these questions is going to be decided without a government in office.
Everybody in Baghdad is now simply walking in place – not an optimistic prospect for bringing back oil production and revenues.
The valuation of Iraq’s local currency – the dinar – is not a primary concern to an outside investor. Oil sells internationally for dollars, not dinars. I have spent a fair amount of time advising on the problems of injecting considerable hard currency into the Iraqi economy in a short period of time. It will lead to significant sectoral imbalance and inflation. And while that will make living there more difficult, the oil investments are in dollars, for dollar returns, in the outside market.
Third, there are no attractive investments at the moment in Iraq, other than investing in the primary outside producers and field service providers going in. That, however, would be an investment in a company’s worldwide operations, not those only in Iraq. Neither the political nor the economic environment provides sufficient stability, and the lack of basic oil regulations makes the sector highly risky.
When matters have clarified, and the situation improves, I’ll let you know.
Q: Thank you for the most interesting details of your London meeting (“How the Little Guy Will Fix Oil Futures and Get in on the Profits” [March 16th, 2010]).
Your meeting concerned supply/demand and the price increases by 2015. By then, new supplies will have arrived…Will these fields supply sufficient oil to keep the price as it is? I have shares in Dragon Oil that have done nothing the last few months. What happens when Iran starts “acquiring” oil fields outside Iran? Will it restrict oil from Iraq and the Arab Emirates to the West? ~ Jeremy R.
A: Several questions here, as well.
The ability of new fields to provide sufficient supply is unlikely. Two developments of note on this issue. First, the new fields are primarily smaller and provide lower-quality crude. They are more expensive to develop, and prices will rise accordingly.
But secondly, and more importantly, the rate at which the demand (extracted from the market as a result of the global financial crunch) returns will in large measure negate the effect of new supply. The price pressure will continue upward, with the levels accelerating as industrial production picks up in developed countries (as it already has in other parts of the world).
Next, Dragon Oil (OTC:DRAGF; London: LSE:DGO) has been a primary producer in the Caspian Sea offshore zones of Turkmenistan. Its Cheleken development is producing well. With the government in capital city Ashgabat beginning to open the shelf to additional foreign investment, Dragon’s existing infrastructure and field success will place it in the center of some major volume expansion.
The Turkmen government does not allow foreign ownership of onshore fields (a major source of natural gas). So the shelf projects in the Caspian are the sole focus of foreign companies. Remember, however, while Dragon trades largely on the London and Dublin exchanges, it is controlled by interests in the United Arab Emirates.
As for Iran, there are some disagreements over ownership of some fields in far eastern Iraq, but Tehran will not be acquiring any fields abroad. Having huge reserves of its own, the problem is developing what it has at home (or offshore in the Caspian and Persian Gulf).
There is always the concern that Iran could close the strategic Strait of Hormuz and thereby effectively prevent regional production from moving into the global market via tanker traffic. Thus far, there has been no genuine probability that it would do so.
But the Iranian domestic economy is deteriorating. Crude sales are the main source of revenue, and the U.S. and U.N. sanctions have been having an impact lately. Cutting off the regional flow to market also means preventing Iranian production from leaving. Both its major export ports and its oil trading market are north of the Straits. Such an action would paralyze their economy.
I do not have a single source in the region that gives any credibility to the move. Of course, periodic suspicions will always increase the price of oil on global markets.