Iraq, under Saddam Hussein, was one of the world’s largest oil producers. Many experts predicted that with Hussein out of power, Iraqi oil production would only rise. This has not been the case. If anything, the war with Iraq has significantly harmed the production of oil and raised the price to record levels. Tensions in the area continue to grow, and recently the threat of an invasion by Turkey sent the price to its highest mark.

So that’s the bad news. Despite what many people think, there actually is good news coming from Iraq. This is news that should delight the very people who have been opposed to the war from the beginning. According to Gallup, the majority of Americans who oppose the Iraq war are Democrats. The same can be said for the majority of Americans who believe global warming to be a major problem. Based on those facts, it may be safe to assume that the same people who oppose the war are the ones asking for changes when it comes to global warming. Many of these people want the government to do something significant about this problem, but the free market should be figuring it out for them.

As more and more people talk about global warming, millions are looking for alternative forms of energy that are cleaner and more environmentally friendly than oil. The technology for alternative fuels is there. The solutions are just way too expensive.

Take hybrid cars, for example. Right now, the Honda Civic sedan starts at $15,010. The popular family vehicle gets 36 miles per gallon. The hybrid version of the Civic starts at $22,600. The hybrid operates at 45 miles per gallon. Clearly, owning a hybrid will have you fueling up fewer times a year and is better for the environment. But are the savings in gas consumption and environmental effects worth it for the average customer to pay over $7,000 more for the “green” vehicle? Based on an average of 12,000 miles driven per year and paying $3.09 for every gallon of gasoline, the savings you get by choosing the hybrid car are only $207 per year. It would take over 33 years to make up for that extra cost. That hardly sounds worth it to me.

One of the only ways these hybrid cars will become more affordable and then be used by more people will be if oil prices begin to rise. The higher oil gets, the more affordable by comparison environmentally friendly alternatives will become. Not only will rising prices balance the differences between oil and alternative energies, but the more expensive oil gets, and the greater a national emergency it becomes, the more incentives to improve energy technology rise.

The incentives will also rise when further political pressure is put on the government. When that happens, subsidies for alternative energy programs will increase. If political unrest continues in the Middle East and the countries that control OPEC refuse to step up production, Americans will have no choice but to curb their use of oil and will then be forced by the market to become part of the ecological solution.

You can already tell that the issue of government subsidies for alternative fuel is one that companies in the energy business are pushing for. According to the National Venture Capital Association, startup companies that focus on clean technologies attracted more than $800 million in venture capital last quarter alone. That shows that there are plenty of investors willing to put up their money hoping the winds are changing toward clean products.

In fact, just last week, the world’s most famous environmentalist, Al Gore, became a partner in Kleiner Perkins Caufield & Byers, a successful venture capital firm that backs many eco-friendly startup companies. Kleiner Perkins claims that Gore will be an integral part of the running of the firm, but many believe that he will be used for his vast connections in Washington. If Gore can help get more subsidies from the government, the money that a firm like KPCB stands to make could be huge. And of course, the politicians that will provide those subsidies will also be answering to the concerns of their constituents. If the price of oil becomes the biggest problem facing Americans, you can be sure that Congress will attempt to do something to appease the voting public.

What stands in the way of these companies is the threat that oil could somehow become cheap again. What if the U.S. leaves Iraq and tensions in the world begin to ease? What if that led to Iraqi oil production on the levels we saw before 2003? If such a thing would happen, then the American people would continue to drive their gas-guzzling cars and polluting the environment. That is the exact opposite of what many global warming activists want.

Of course, this rationale sounds absurd when compared with the money that could have been saved had we not gone to war. That money could have been used by the government to directly subsidize alternative energies sooner. But would they have used it that way? Probably not. Governments usually tend to respond to problems only when they become a crisis.

This goes to show you that by creating an oil crisis, the government may finally be able to solve it. It may be hard to swallow, but believe it or not, people interested in America cutting down on its use of oil and stepping up cleaner initiatives may have George W. Bush and the Iraq war to thank.

Until next time,
Jamie Ellis

November 23, 2007

Iraq Goes Green was originally featured on Whiskey and Gunpowder

“After almost four years of trying to build Iraq’s central government in Baghdad, the U.S. has found that what appears to work best in the divided country is just the opposite. So senior military officials are increasingly working to strengthen local players who are bringing some measure of stability to their communities…

“The logical result of the new policy is a profound shift away from the Bush administration’s original goal of building a multisectarian democracy in the heart of the Middle East. Instead, the new strategy seems likely to lead to an Iraq with a very weak central government and largely self-governing and homogenous regions. Over the long term, the goal is to connect these local leaders to the central government by making them dependent on Baghdad for funds. To qualify for U.S. assistance, local groups must pledge loyalty to the central government, though many Sunni leaders who are working with the U.S. complain the Shiite-dominated government is illegitimate.”

Is it really a good idea to make local communities “dependent on Baghdad for funds”? I don’t think it is. How is this different from a welfare state?

Unfortunately, this question wasn’t explored by those who believed that replacing Saddam Hussein’s dictatorship with a democratically elected government would lead to immediate peace, prosperity, and gushing oil production.

No matter where you stand on future U.S. policy in Iraq, it’s tough to deny that this occupation has been the most complex government program in U.S. history. Those living within a nation — not by a foreign military force, can only achieve “Nation building.” The U.S. didn’t become the country it is today by having a powerful central government from the outset. Rather, it became successful in spite of ever-growing government influence.

Iraq, like any other country, cannot achieve peace and prosperity by way of government edict and bribes to local tribal leaders, but through nurturing its values, community institutions, work ethic, and respect for basic human and property rights. And the country is sorely lacking in many of these qualities because of a mind-set that the government will do everything, including creating a vibrant economy and oil industry.

Now, the British military is withdrawing from its position in the vital oil port of Basra, and it’s likely that a violent intra-Shiite struggle for power will ensue. Radical Shiite leader Muqtada al-Sadr knows that “power creates the law” in Iraq. This reminds me of the themes I discussed in my June 25 Whiskey article “Corruption Smothers Oil Industry in Iraq.”

U.S. troops are making noble sacrifices in their mission to help stabilize Iraq. But there’s little hope of achieving complete success if Iraqi politicians can’t compromise, power keeps consolidating into the hands of militias, and Iraqi security forces moonlight as militia members.

This doesn’t bode well for future Iraqi oil production.

Meanwhile, the oil industries of Venezuela, Nigeria and Kazakhstan remain hampered by radical socialism, corruption and technical challenges.

Venezuelan dictator Hugo Chavez is making all the right moves if his goal is to destroy his country’s currency. His policies continue to restrict investment and promote social spending, a classic prescription for runaway price inflation. Chavez may soon discover that hyperinflation destroys incentives to produce anything — including oil.

The past month has also brought news that the president of Nigeria is attempting to restructure NNPC, the corruption-ridden state-owned oil company. Nigerian officials and bureaucrats are notorious for siphoning money into personal offshore bank accounts, so this development will likely lead to plenty of backlash and infighting.

Finally, in yet another blow to the oil supply picture, the Kazakh government announced, “From today, work on Kashagan will be frozen.” This “megaproject” is attempting to produce highly sulfuric crude oil in a remote, often-frozen offshore environment. It was expected to produce 1.5 million barrels of crude a day by the year 2019, but will now, obviously, produce somewhat less on a delayed time frame.

The Kazakhs, fed up with delays and cost overruns encountered by the Western oil companies managing the project, expect to change the terms of the production sharing agreement after a few months of hardball negotiation.

This is exactly what Chevron CEO Dave O’Reilly refers to when he says, “The era of easy oil is over.” There may be lots of great oil field technology and untapped global reserves, but given the state of the world today, many promising, untapped oil and gas resources will likely remain untouched by the best technology.

To learn more on the world’s oil situation, I’ll be attending the Houston World Oil Conference. Industry experts will likely discuss vital oil projects, including those like Kashagan and Cantarell, that are experiencing major difficulties. The conference is open to the public. If you’d like to attend, check out the website here.

In the end, a tight long-term oil supply scenario is coming into focus, and the stock market will push energy stocks higher. Smart investors should recognize this trend now and look to add the best ran oil and energy companies to their portfolios.

Best regards,
Dan Amoss, CFA

P.S.: There are a few oil companies that stand above their competition. In fact, I’ve recommended a total of seven direct oil plays to my Strategic Investment readers. All seven are current winners, with an average gain of 61%. To learn which oil companies I believe are worth owning, click here.

September 27, 2007

The Future of Iraq’s Oil Production was originally featured on Whiskey and Gunpowder

Beyond these basics, free markets work optimally when everyone follows the “Golden Rule” and treats everyone else as they’d like to be treated. Corruption — including the use of political influence or violence to achieve results — smothers free markets and the civilized societies they nourish. Once corruption gets out of control, everyone forgets about serving their fellow man and focuses their full attention on how they can game the system.

Sadly, corruption is a serious problem in Iraq — a problem that started out as a way to “get things done” within the bureaucracy of Saddam Hussein’s gradually decaying dictatorship. Now it threatens the future economy and stability of the entire Middle East.

Pipeline Thefts and Violence Plague Northern Iraq

The giant Kirkuk oil field in the Kurdish region of northern Iraq has been fought over since it began producing oil over 70 years ago. The Baath government realized that control of Kirkuk was necessary to solidify its grip on the Iraqi oil industry, so in 1975, it initiated an “Arabization” program. Over the next few decades, Arabs from southern Iraq were incentivized by the government to displace ethnic Kurds in Kirkuk. Ever since the 2003 ouster of Saddam, the tables have turned, and the Kurds have fought for as much autonomy as they can get.

Yet despite the autonomy they’ve gained, the Kurdish leadership — even with the help of the Iraqi government and the U.S. Army — can’t ensure that Kirkuk’s crude oil gets shipped to market into reliable fashion.

The Wall Street Journal recently published a front-page story about uncontrollable pipeline siphoning in Iraq. The pipeline system delivering oil out of the Kirkuk region is too widespread to protect, so it’s an ideal target for a wide range of unsavory characters: “unruly desert tribes, bomb-planting insurgents, corrupt security forces, cross-border smugglers, and operators of small domestic refineries. At those refineries, U.S. officers believe, raw oil is turned into fuel and sold on the black market, where it’s used in vehicles and to power home generators. This loose confederation has all but crippled production in Iraq’s northern oil fields, even as the political future of this ethnically mixed city and its underground riches hangs in the balance.”

In the midst of this free-for-all, how can an Iraqi government that relies heavily on oil export revenues remain financially viable? The WSJ article continues:

“In the second half of [2006], one stretch of pipelines connecting Kirkuk with the Turkish Mediterranean port of Ceyhan — the main outlet for Iraq’s northern oil exports — pumped oil for only 43 days. The rest of the time, the pipes sat idle, leaking crude through dozens of holes drilled along their 200-mile run through the Iraqi desert. One pipeline has been broken into 39 times so far this year, according to U.S. military officials.

“The holes help explain why, four years after the U.S. invasion, Iraq hasn’t been able to match its prewar crude production levels of 2.5 million barrels a day. This year, Iraq is averaging 1.9 million barrels, mostly from southern oil fields that haven’t suffered the unrelenting sabotage seen in the north. Kirkuk currently produces 180,000 barrels of oil a day, but under normal conditions, it could produce an additional 400,000 barrels a day.”

Sectarian and tribal loyalties complicate the situation even further:

“The Northern Oil Co. has found itself at the center of the ethnic tensions. Of its 12,000 employees, only a few hundred are Kurds…

“Mr. Abdullah, the Northern Oil director, has been hiring Kurds, though he admits only 500 or so have come to work. Being an oil worker here has become increasingly dangerous. Pipeline repair crews have been hit by roadside bombs and shot at. Sunni insurgents have been dropping leaflets in Kirkuk telling all government employees, including oil company workers, to quit or face a bloodbath.

“Last summer, Adil al-Qazaz, Northern Oil’s director-general at the time, went to Baghdad to visit the Oil Ministry. After his meeting, he was snatched by gunmen on the street, never to be seen again…

“Among the Iraqi security forces, the strategic infrastructure battalions have one of the strangest histories. In the aftermath of the U.S. invasion, Northern Oil tapped the Sunni Arab tribes to protect the pipelines running through their turf. Mr. Hussein used a similar system, mixing intimidation and rewards to secure cooperation of the tribal sheiks. After 2003, the oil company started direct payments to the sheiks, who would in turn distribute the money to the tribal guards. Essentially, the tribes were being paid to refrain from attacks on the pipeline.”

Despite the fact that southern Iraq hasn’t suffered the “unrelenting sabotage” occurring in the north, there’s little reason to expect a much better long-term outcome.

Smuggling and Iranian Control Plague Southern Iraq

Ghaith Abdul-Ahad, a journalist with the U.K. newspaper The Guardian, crafts very insightful articles from interviews that are clearly difficult and dangerous to get. In “Oiling the Wheels of War,” he takes us into the underworld of oil smuggling in Iraq:

“On the banks of the Shatt al-Arab in southern Iraq, a family business is thriving. For the Ashur, a small clan of about 50 families, it’s worth several million dollars a week. Costs are steep, especially for security. But profits are tidy and business is booming.

“The Ashur smuggle oil. For years under Saddam Hussein, they worked as mere guards at Abu Flus terminal at the mouth of the Gulf. But as the state collapsed after the U.S. and British invasion in 2003 and economic anarchy set in, they took over the port and became the quasi-official authority there. Never have the family’s fortunes flourished as in the last three years. They built their own underground oil tanks in their farms, where fuel tankers empty their cargoes to be pumped later into small pontoons. A cousin of the family estimates that they make about $5 million (£2.5 million) a week from smuggling oil.

“When another tribe tried to take over the ports, the family hired gunmen from outside Basra to defend its fiefdom. ‘We were paying $250,000 every week for gunmen just to make sure that we keep our terminals and preserve our rights,’ said the cousin, Abu Harith.

“The family operation is a dispiriting example of how large swaths of Iraq’s economy and mineral wealth have vanished into a legal vacuum, where the state is absent, law enforcement is nonexistent, and the spoils are shared by politicians, militias, and smuggler gangs.”

Groups like the Ashur clan seem as powerful as any organized crime ring in history. Militias fight over neighborhoods in oil-rich southern Iraq as fiercely as mafia elements defend their “turf.” Only their effect on society is even worse, because they control politicians and police officials. So the authorities wouldn’t want to do anything about this smuggling problem, even if they could. Abdul-Ahad provides a bit more color on a society that’s corrupt to the core:

“Oil is not the only industry steeped in corruption. Businessmen in Basra say anything connected to the state requires payments to militias and parties. In construction, for example, Abu Harith said: ‘There are two deals with parties and militia; one, they give you the contract for a price, but then you have to provide your own security; the other deal is that for a certain percentage of the contract, they will provide you with gunmen. No other militia will attack you.” In his last four contracts, he has paid $500,000 in bribes.

“But oil is the biggest racket of all in a country with the world’s second largest reserves. Oil worth millions is being smuggled out of southern Iraq every day and sold on the black market. The proceeds fund militias, mobsters, and corrupt politicians with cash that far outstrips the state’s financial resources.

“The smuggling also fuels factional fighting around Basra as each group tries to control its portion of the supply.

“One tanker captain, who is in his second decade of oil smuggling and owns his own ship, told The Guardian how lucrative the trade could be. ‘The big profits are to be made in crude oil,’ he said. ‘You rent an oil tanker, and after your first trip, you can buy the tanker.’

“The infrastructure of smuggling was set up under Saddam in the late 1990s, during the U.N. sanctions, when illegal oil shipments became the main method of getting cash into the country. Smuggling was an officially condoned policy…

“The captain, who specializes in crude smuggling, explained the process: ‘It depends on the officials manning the terminal when your tanker arrives. Usually it’s a committee of three-four; they are all of one [political] party. Your contact with that party arranges everything in advance.’

“Once the tanker is filled, another official usually arrives — a surveyor hired by the government to inspect the cargo — who is bribed to pass everything off as legitimate. The route of the tanker then differs, depending on its papers.

“The main risk is being stopped by patrolling U.S. or British vessels. ‘If I have official papers then all is fine, even if I am carrying twice the stated shipment,’ said the captain. ‘When I don’t have papers, we cross into Iranian waters, we carry an Iranian flag and bribe the Iranian coast guard. It’s a great business for them too. If we are arrested by the Iraqi navy, it’s easy. They are involved in the party, after all.’”

So every politician in southern Iraq has his hand in the till. We shouldn’t be surprised that the Iraqi parliament is making little progress in initiatives to secure the country. Most Iraqis are positioning for what they expect will be a violent land grab once the U.S. eventually withdraws its forces.

The violence in Baghdad may be getting all the press, but a far more significant development for global oil markets is Iran’s strengthening influence in Shia-dominated southern Iraq. In “Welcome to Tehran,” Abdul-Ahad’s interviews in Basra paint a picture of a critical port city now controlled by militias — including several Iranian proxies. According to a senior Iraqi military intelligence official, “In Basra, Iran has more influence than the government in Baghdad…If a war happens, [the Iranians] can take over Basra without even sending their soldiers.”

Union Heritage of Iraq’s Oil Workers

Considering all the turmoil in the most oil-rich area of the world, it’s hard to argue that there shouldn’t be a geopolitical premium in the price of crude oil. The price of oil should embed an “insurance” component that fluctuates with the odds of a major supply disruption. To argue otherwise is to ignore the conditions under which most of the world’s oil is produced.

But the challenges facing future Iraqi oil production don’t end with corruption and sectarian violence. International oil companies with state-of-the-art technology have meager chances of gaining — and holding — concessions to produce Iraqi oil. Not only would they have to operate in the midst of warring militias, but they’d also have to go through the 26,000-member Iraqi Federation of Oil Unions.

In "Iraq Oil Union Has Storied Past", Ben Lando from United Press Intl. highlights the strong feelings Iraq’s oil workers have about the oil law under development:

“Hassan Jumaa Awad wants Iraq’s oil to stay under state control, and the unionists, who have long worked the rigs, to be supported in developing the national resource. But this is no request from the president of the Iraqi Federation of Oil Unions.

“It’s a demand.

“‘Since we are working to make progress in production, we need a real participation in all the laws that are related to the oil policy,’ Awad told United Press Intl., speaking on his mobile phone from the southern port city of Basra. ‘We are the sons of this sector and we have the management and technical capability and we have the knowledge on all the oil fields.’

“The IFOU represents more than 26,000 workers organized under various unions in the oil-rich southern and northern areas of Iraq. Shiites, Sunnis, and Kurds, together they’ve operated Iraq’s oil sector before, during, and after Saddam Hussein. Their rights to officially unionize are still denied under a 1978 Saddam law, one of a few of the former president’s laws the U.S. occupation and the Iraqi Parliament upheld…

“Kurdish and central government negotiators reached a deal last month on the framework for a law governing Iraq’s oil. Details on ownership rights and revenue sharing are still far from finalized. The Iraq National Oil Co. would restart, but compete with foreign oil companies, who could win contracts giving them partial ownership of the respective fields.

“INOC ‘should have full privileges,’ Awad said, ‘and we don’t agree on the production partnership.’

“Iraq’s oil has been nationalized for four decades. Iraqis view it with a pride of ownership, something the law would reduce if the contract language allowing for foreign ownership stands.

“‘We think that to reserve sovereignty of Iraq is to be able to control the oil wealth,’ Awad said, and foreign investment should be limited to technical assistance. ‘I wish if the foreign companies were to come into Iraq, that they help us,’ Awad said. ‘Not to suck the blood of the Iraqi people.’

“The unions were kept in the dark, as were most members of Iraq’s parliament, until the draft law was leaked to the media. Even then, it was still out the reach of most of Iraq’s citizens…

“The IFOU could shut down Iraq’s production if the draft hydrocarbons law stands. With oil revenue funding 93% of the federal budget, that’s a large bargaining chip…”

Iraq’s oil industry will probably resemble Saudi Arabia’s in the future, with no foreign ownership of resources in the ground — not good for those hoping for endless cheap supplies of oil from the Middle East.

And what exactly lies under the ground in Iraq?

Nobody knows for sure. But institutions like the Energy Information Administration and BP act as if they do. They publish OPEC reserve figures as if they were concrete facts.

So I’ll leave you with a set of figures from BP’s recently published Statistical Review of World Energy. I drew BP’s estimates of oil production in Iraq and Iran since 1965 into this chart:

I included dotted lines to draw your attention to the eight years in which the horribly destructive Iran-Iraq war occupied the full attention of the entire fighting-age generation. The war also consumed the economies of both countries. Production dropped dramatically and recovered very slowly.

Yet it’s an amazing coincidence that during this same time period, while fighting a war involving millions of soldiers, both Saddam Hussein and the Iranian mullahs had the resources and ability to conduct what appear to be massive oil exploration programs. At least that’s what you’d think looking at the chart of stated crude oil reserves below:

The real story behind these reserve numbers is that they are simply fudged out of necessity and likely overstate recoverable resources by a significant amount.

Sure, oil field technology developed in the 1980s allowed for the production of oil that would previously have been out of reach. But these reserve increases have more to do with OPEC production quotas than reality. In the 1980s, OPEC decided to tie production quotas to reserves. This created a huge incentive to overinflate reserves, especially for the cash-strapped Iraqis and Iranians desperate for oil revenues to fund their war.

We have every reason to question these figures. And we have every reason to expect that no matter how much oil lies under the ground in Iraq, it will be produced in an erratic, unreliable fashion.

Good investing,
Dan Amoss, CFA

June 25, 2007

Corruption Smothers Oil Industry in Iraq was originally featured on Whiskey and Gunpowder