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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Iraq Could Kill The OPEC Deal

Iraq Oil Rig

OPEC made an early New Year’s resolution when it promised the world that it will get thin – or more accurately that it will thin its output in an effort to help support prices. As anyone who has ever had a New Year’s resolution knows, those promises can be hard to keep. OPEC is about to find that out.

The issue of challenging production cuts starts with OPEC’s second biggest producer – Iraq. Iraq has agreed to cut 210,000 barrels per day from its production levels. That sounds simple in theory – just switch off a few pumps. In reality it’s much more difficult than that.

In particular, Iraq faces a thorny issue because it has contractual commitments that it has made with international oil companies which operate its massive southern oil fields. Those companies are not just going to go along with an edict issued by the Iraqi government – they have contracts to fulfill and they are going to try and maximize their own profits according to those contracts. Thus unlike Saudi Arabia, Iraq is not really in control of its own production.

Adding a further complication for Iraq is the fact that it has only tenuous control over the northern portion of the country which is controlled by its Kurdish minority. The Kurds may or may not be willing to go along with the production cuts agreed to be the national government. In some senses, a second agreement between the Iraqi government and the Kurds is needed to decide who will bear the brunt of the cuts. The Kurds would prefer that the Southern oil fields absorb all of the cuts while the national government prefers the opposite.

Iraq’s overall production has grown substantially in the last five years as a degree of normalcy has started to return to the country. Following the Iraq war, the government brought in a myriad array of third party contractors – including U.S. firms – to work the oil fields.

Today, Iraq probably has more internationally operated production than any other producer. Adding all of those layers and specializations to the production process has helped Iraq efficiently jump from 2.65M barrels per day in production in January of 2012 to roughly 4.5M barrels today. But it also means the country has a complex task in reducing production with many competing parties all pushing their own agenda. Related: Oil Majors Prepare For Mega Tender In Lebanese Levant Basin

The Iraqi government’s contracts with foreign drillers also include provisions that require them to compensate producers when production is curtailed for reasons beyond the producer’s control, which presumably would include production cuts. In other words, the Iraqi government will have to pay producers not to pump oil – a proposition that will be financially very difficult since the country is already cash starved after two years of low prices.

What’s potentially even more worrying for oil bulls is that so far there are no clear signals from major producers in the country that they have reached a deal with the Iraqi government to cut production. BP, Exxon Mobil, and Royal Dutch Shell all have a significant presence in Iraq and none of them have reported significant production curtailment to their own investors. Given this, investors need to be very careful of their positioning in the days leading up to the first OPEC compliance conference later in January.

By Michael McDonald of Oilprice.com

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