The Future of Iraq’s Oil Production

Earlier this month the front page of the Wall Street Journal reports that the Bush administration is going forward with yet another attempt to solve Iraq’s problems. These problems are rooted in cultural, religious and territorial issues, and in my view, they cannot be resolved by free elections and big government. But this has never stopped U.S. policymakers from trying. The WSJ reports:

“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 Daily Reckoning