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The Single Biggest Threat To An OPEC Deal Extension

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If OPEC fails to agree to extend their production cuts for another six months, Iraq could be a major reason why.

For many years after the 2003 U.S. invasion, Iraq was exempt from OPEC’s production quotas in order to help the country rebuild. But in recent years, Iraq has succeed in ramping up its output, overtaking Iran to become OPEC’s second largest oil producer. Today, production stands at 4.4-4.5 million barrels per day (mb/d).

As OPEC’s second largest producer, Iraq is pivotal to the success of the deal signed late last November to prop up prices.

But Iraq has lagged behind other OPEC members in its efforts to reduce output. It agreed to cut production by roughly 210,000 bpd from October levels, requiring it to average an output level of 4.351 mb/d over the course of the six-month compliance period between January and June.

Those figures were agreed on an October baseline (although Iraq has argued with OPEC over which numbers to use for months). In December, just before the deal was set to take effect, Iraq ramped up output to 4.642 mb/d. It then cut production by 166,000 bpd in January, but from that higher December level, taking it down to 4.476 mb/d, according to OPEC’s secondary sources, or only slightly below its baseline and still above its targeted level as part of the deal. No matter; the OPEC deal is a six-month average, so Iraq could still lower output in subsequent months and comply with its commitments. Iraqi officials reassured its OPEC peers that further reductions were forthcoming. Related: U.S. Shale Is Pushing OPEC To Breaking Point

But in February, the reductions were a bit underwhelming. Iraqi output dropped by just 62,000 bpd to 4.414 mb/d. Again, Iraq has more time to bring its average down, but it is one of the few countries not already complying with its production cap. The other is the UAE – a surprise development considering the country’s close alliance with Saudi Arabia. As a fellow member of the Gulf Cooperation Council, UAE policy closely follows what goes on in Riyadh. So, the UAE is less of a worry for compliance – it will likely fall into line soon.

(Click to enlarge)

Iraq remains more of a question mark. That uncertainty was all the more stark given the recent comments from Iraq’s oil minister, who said that that country would ramp up production capacity to 5 mb/d this year. "We achieved this great achievement of 4 million barrels per day ... middle of 2016, and now we have climbed up and we are reaching about 5 million barrels per day beginning of second half of this year," oil minister Jabbar Al-Luaibi said earlier this month at the CERAWeek Conference in Houston. When asked by CNBC how that would square with the possible extension of the OPEC deal for the remainder of 2017, Al-Luiebi said it would be “premature to comment,” since the extension is uncertain.

It is unclear if Iraq can actually achieve this lofty goal on such a speedy timeframe, but if it did, it would be a very large downside risk to oil markets for multiple reasons. First, if Iraq were to expand capacity by another 500,000 bpd, it is hard to imagine them keeping that volume on the sidelines. Because it would be very tempting to put that capacity into production, the minister’s comments suggest Iraq has plans to ramp up output this year. "Obviously, it's bearish,” John Kilduff, founding partner at Again Capital, told CNBC on March 7. “They're going to have to show considerable production constraint having that spare capacity. That's the kind of capacity historically only the Saudis have had.” Related: Growing Asian Oil Demand Could Drain The Supply Glut

Second, Iraq’s ability to bring higher capacity online would threaten the extension of the OPEC deal altogether. Saudi energy minister Khalid Al-Falih was reportedly already “fed up” with Iraq (and Russia’s) non-compliance with the deal, and he apparently spoke privately to his Iraqi counterpart in Houston at the CERAWeek Conference and “expressed his frustration with their slow progress,” according to the WSJ. If Iraq continues down this road, it would not only reduce the effectiveness of the original OPEC deal – the cuts from January to June – but it would also make an extension very difficult. Saudi Arabia boosted output in February, and some are interpreting it as a warning sign from Riyadh that a price war could resume if others don’t make more of an effort.

Publically, Saudi energy minister Al-Falih is trying to reassure the markets. He spoke with Bloomberg last week and said that OPEC would be willing to extend the cuts for another six months “if it’s needed.” If global crude oil inventories remain above the five-year average, he said, OPEC would “do what it takes to bring the industry back to a healthy situation.” He also downplayed the lack of compliance from Kazakhstan and Russia, citing the fact that some of the non-OPEC countries “are trying to learn the process of controlling production not having done it before.” He said they are “fully committed.”

Iraq, however, could be a cause for concern, especially if they are targeting higher production capacity. Iraq’s addition of 500,000 bpd, if it came online, would alone exacerbate the global glut and push down prices. But it wouldn’t happen in a vacuum. Such a move would likely derail the OPEC deal, at which point, all bets would be off. Goldman Sachs says its base case scenario for the oil markets is that OPEC’s production cuts “will be followed by new production highs.”

By Nick Cunningham of Oilprice.com

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