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. Last Updated: 07/27/2016

Will Iraq Prove to Be OPEC's Nemesis?

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OPEC member countries meet on Thursday with a view to reducing the current high production levels that, if allowed to persist, threaten a sharp fall in the oil price over the summer months.

On the face of it, it's easy to simply agree to stop cheating on official production quotas to restore supply-demand equilibrium to the market. However, as always with the oil market, it is not that simple and any decision will be based more on political considerations than on economics. At stake is OPEC's future relationship with its major customers (particularly the United States), the balance of power within OPEC itself and the possible reintegration of Iraq into the quota system. In all likelihood, the member countries will issue a vaguely worded statement of intent to comply with the existing quota regime but with a "get out clause" based, for example, on a need for supply to reflect changing demand.

For Russia, the stakes are equally high. Russia has lived very handsomely on the back of OPEC for the past four years, earning some $70 billion more in oil and gas exports than it did in the previous four-year period. If the OPEC-centered price and control structure remains in place, by 2010 Russia's combined corporate cash flows and budget revenues will probably be close to $100 billion annually -- assuming that planned production growth and pipeline capacity increases take place.

However, the time is fast approaching when Russia's "free ride" may come to an end and -- at a minimum -- Russia may have to choose between lending political support to the OPEC structure, which will help ensure a high level of future export revenues, or to side with the consumer countries in exchange for broader economic benefits elsewhere.

OPEC countries are currently supplying about 3 million barrels per day (bpd) in excess of underlying demand. That was a deliberate decision forced by the Saudi-led moderate faction in order to keep the market well-supplied in case of a major supply disruption due to war -- which could have caused a sharp upward price spike with the attendant risk of a political backlash from the United States and EU.

The fact that there has been no such disruption and that U.S. army engineers are now pushing very hard to restore Iraqi exports places OPEC at a critical crossroads. Add to that the fact that last year's surplus production went into building global strategic supplies to historic highs and Thursday's meeting has all the ingredients of being a historic turning point for OPEC.

If member countries cut current production too aggressively, then the oil price will stay above the targeted price average and this will force the United States to accelerate the rehabilitation and extension of Iraqi production while probably keeping Iraq outside the quota system. That could result, in two to four years, in the destruction of OPEC's central role in the global oil market. On the other hand, keeping the present level of over-production in place would suit the consumer countries but could expose the fragile political unity within OPEC and ultimately set it on a course either for radical change or self-destruction. This is especially so given that most OPEC countries are predominantly Islamic and right now none of those regimes wants to risk criticism for being openly too pro-Western.

While member countries clearly have a huge incentive to avoid risking either potentially destructive event, it is by no means certain that they will be able to.

Total world demand for crude oil is 78 million bpd. But, the important number is the residual demand, i.e. the amount of extra oil that net consumer countries require from net exporters. Right now it is 36 million bpd with the biggest residual demand coming from the United States (11.8 million barrels), the EU (8.6 million), Japan (6 million), South East Asia (5.2 million) and China (2 million). OPEC countries supply 75 percent of the total, while Russia supplies 11 percent (or 4 million bpd).

However, if normal oil demand growth resumes, then by 2010 this residual demand will have increased to 70 million bpd (partly due to an expected decline in North American and North Sea production rates) and even if Russia is exporting 7 million bpd by then, OPEC countries will see demand for their oil rise to about 50 million bpd. That will allow OPEC a significantly more powerful position than it occupies even today. And that is the main reason why OPEC must now tread very carefully. Its next moves could be the most decisive in determining whether it survives and if so in what form.

When you cut away all the hype, OPEC, an illegal cartel, owes its existence to the fact that it has in the past been a reliable partner to Western energy consuming countries. Despite the normal price volatility -- mainly influenced by the level of cheating by the more aggressive smaller OPEC countries -- OPEC has been able to guarantee stability of oil supplies within the framework of an agreed long-term average oil price. Both certainty of supply and price are critically important for Western economies that generally remain very vulnerable to both the availability and price of energy.

If the United States decides that OPEC is either no longer willing or able to continue its role as guarantor of supply at a reasonable price, then it now finds itself with the perfect weapon with which to ensure the destruction of the cartel: Iraq. Iraq's current reserve base, which is certainly underestimated due to the lack of modern exploration equipment in the past 20 years, could easily support production of about 6 million bpd. All it would require is cash and know how, both of which the United States has in abundance.

Anybody who thinks that developments will have to wait for UN permission and other legal niceties has only to look at what a determined United States can and has done recently when its national interests are at stake.

Iraqi oil could be a very significant part of the world supply within two or three years if the moderate OPEC countries, such as Saudi Arabia, bow to the pressure from smaller producers including Nigeria, Algeria and Venezuela to slash production now. That would send a clear signal to Washington that the reliable cooperation that has lasted for the past 20 years is now over.

If, on the other hand, Saudi Arabia refuses to bend to the wishes of the more aggressive members and keeps the pumps open (something that will become clear over the summer), the internal pressure, which is already quite high due to a growing quota allocation dispute, could become uncontainable.

Over the past four years, OPEC countries have earned about $1 trillion from supplying global residual demand. That is $300 billion more than they earned in the previous four years. This represents a very significant transfer of capital from Western economies to OPEC producers and is hardly a trend that the United States, EU or Asian economies -- all of which are in need of growth stimuli -- will be happy to see continue, never mind be extended. By 2010, that annual capital transfer could be $550 billion, not a sum that U.S. legislators, who will determine the immediate course of developments in Iraq, will be happy to contemplate going into predominantly Islamic countries.

Normally Russia attends OPEC meetings as a detached observer -- this time, however, the stakes are much higher.

Christopher Weafer, chief strategist at Alfa Bank, contributed this comment to The Moscow Times.