Corruption Smothers Oil Industry in Iraq

Free markets are the lifeblood of a civilized society. But they are fragile. If they are to survive, contracts must be honored and property rights must be protected.

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

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