Presentation before the Middle East Policy Council

EPRINC President Lucian Pugliaresi gave a presentation on Gulf oil and gas before the Middle East Policy Council on April 22 at the Rayburn Office Building in Washington, DC. The event, entitled Gulf Oil and Gas: What are the Producers Thinking is part of the Capital Hill Conference Series on U.S. Middle East Policy.

The following is the transcript of Mr. Pugliaresi’s presentation:

 

As the chairman said, I’m a substitute for Herman Franssen, who is a trustee of our organization, the Energy Policy Research Foundation. EPRINC has long roots in oil and gas analysis going back to our founding in New York City in 1944. We moved from New York City to Washington only in 2007. This is a bit of a different audience for us as our presentations are generally before a more narrow community focused on developments in oil and gas markets.

Part of the motivation in the name change for EPRINC, from a focus on petroleum to a broader focus on energy was a sense that we needed to take a broader outlook, although research in petroleum markets remains our central focus. We do tend to try and take a hard look at areas where we think the conventional wisdom may be wrong and in this regard we’ve identified five areas worthy of more in depth research.

These areas include unconventional gas, which I think we can all agree has overturned conventional wisdom on U.S. gas reserves. Another, you may recall just a few years ago, was the concern that we faced a worldwide shortage in refining capacity, and now we face a major surplus. Another area is Latin America. Latin America is probably the most under-explored region in the world. Demand in the developing world is another area that deserves a careful review. Conventional wisdom is that oil prices take up 6 to 7 percent of GNP in the OECD it is impossible to drive prices any higher as demand contracts. In the developing world the view is that this particular rule does not apply. We’re not so sure. And we have a project to look more closely at the specific elements of fuels demand in the developing world, particularly what happens when subsidies start to disappear.

The final area where we may be facing a major game changes is, of course, Iraq. I want to start with two interesting statistics. When they held the auctions in December 2009, it was the largest transfer of assets — productive reserves — into the production stream from the non-production stream — on a single day — in the history of the petroleum era: 60 billion barrels. This is a phenomenal event. It’s interesting that, outside the oil and gas community, you don’t really read a lot about this. And I’ll give you one other interesting statistic. If as a result of everything that’s happening in Iraq, the price of oil is $20 less than it would be in whatever your business-as-usual case is, the net present value — real money to the U.S. economy — is a trillion dollars. The joke around town is, well, we could have paid for the war for this.

I think you can no longer dismiss out of hand what is underway in Iraq. It also pushes back again concern over peak oil, and if there are any peakers in the room, please don’t send me any mail as we already get plenty of mail of this issue. We can no longer dismiss out of hand that we could have a supply shock. We’re used to price shocks, but we may now face a supply shock. And managing that supply shock could be a challenge for OPEC and also an opportunity for all the researchers that used to do the modeling of OPEC behavior, which went out of fashion over the last twenty years.

I also think it is important to point out that the Iraqis held a very sophisticated auction and this is something I know a bit about as my first job in the government was working on an offshore leasing program on the U.S. OCS. The Iraqi auction was a very sophisticated auction. When you have an auction you want to ensure that the bidders do not game the system and that the incentives are structured so that the bidders end up paying full “expected value” for the right to develop the reserves. In this regard, the Iraqis did a very interesting thing. They said, okay, in order to qualify to bid in this round, you have to make an estimate of the reserves. And when we get that estimate of the reserves, we’re going to share it with all the bidders. And you ask, why would they do something like that? Well, the reason they did that is they don’t want any gaming in the auction process. And if you have to make an estimate and then share it with everybody, the only thing you can do is give your best guess. You give your best estimate because any other strategy is a loser for you because everybody else is doing it.

Although these are technical service contracts, they are bid in a way where the companies can book the reserves because they have a contractual right to a percentage of this production. It’s a very small percentage because the revenues that the Iraqis receive are going to be close to 95 percent. And from private communications we’ve had with the firms the rate of return expected from these projects are close to a 15 percent internal rate of return.

We also don’t view these TSCs as a loss leader for the companies. We do think that companies are going to look for opportunities to provide more production at lower depths, perhaps extend the reserves. There’s going to be lots of opportunities out there. And there is of course a long list of things that can go wrong. I will try to give you a rough estimate of the magnitude of the possible production profiles from Iraq, and I also want to point out these conclusions are on our website and will also appear in the May issue of World Oil.

If we start with a base case, that is, no auction, we estimate that the Iraqis could move from around 2.5 million barrels a day to close to 4 million by 2020. But if we took the contracted volumes as specified in the contracts that number could go to as high as 14 million barrels a day. That’s what’s in the contracts. Even under more realistic scenarios, where we delayed implementation of the contracts, Iraqi production could reach in the range of 10-12 million barrels/day. These are large numbers. We are not saying they are going to happen. We need to look more closely at the infrastructure requirements, political obstacles, etc.

I would note that yesterday, Weatherford held a conference call — and you probably don’t know who Weatherford is. Weatherford does a lot of downhole services on well sites. They said they could only describe the initial bids that were coming into them as astounding. They had never seen anything like this. Schlumberger is in the process now of building a massive camp in the south. We also understand that this is a massive effort and one that hasn’t been matched in the past. In no time in the history of the modern petroleum era do we have a period of time when this much increase in production occurred. We can go back to the Russia in the mid-2000s and Saudi Arabia in the ’70s, both of which ramped up their production by very large amounts. Here my point is that from the perspective of the technology and the reserve base, a large ramp up in Iraqi production is not out of the question and actual levels will be determined by a host of political, regional, and bureaucratic factors unrelated to the reserve base.

In terms of internal Iraqi support for the foreign companies involved in the development program, it is important to recall that the Iraqis held two rounds of bidding. The first round failed miserably. In fact, all the bids were rejected. The bidders had a lot of problems with the tax regime. But the Iraqis made some adjustments in the first round and by the second round they got really phenomenal bids. Although the legal basis for the bid rounds is not fully established, there is a working assumption from the Ministry that revenues will be shared on a per capita basis. So this means that even Kurdistan will receive about 17 percent of the revenues — which, by the way, is more than they’re getting from their development projects locally.

In both the first and the second bid rounds, the bidding companies far exceeded the target volumes proposed. One of the ways the process worked was because you got a recovery — you got a fee one to two dollars a barrel which you bid at, you could get an advantage by bidding a higher volume. But once again, I’d like to point out, these are contracted volumes. The companies could not just willy-nilly bid these higher volumes. They’re not going to get their cost recovered if they miss the targets.

Perhaps the most critical problem is installation of adequate infrastructure, but this is not insurmountable. But building and operating adequate capacity in export pipelines and rehabilitation and expansion of the ports remain critical pieces of the effort. Keep in mind that the auction represents the first significant break from the prevailing way business has been done in the Gulf over the last 40 years. Since the wide-scale nationalization in the ’70s, the IOCs have had limited ability to exploit and develop the reserves in these countries with the national oil companies.

There have been comments that the companies over paid and have made a mistake in entering Iraq with such lucrative bids. For example, Total should have gotten a project there. They did not. And I think we’ve seen them go back now, thinking that, well, maybe we did make a mistake. You know, maybe these terms aren’t too onerous. And so I think some of the companies that didn’t get in there are now looking back at it again.

So where does this leave us? In much of the debate over the last few years over peak oil we have moved from a discussion of below-ground issues — geology, which you can’t do much about — to above-ground concerns — politics and resource nationalism. And while the geology is sort of difficult to change, the above-ground issues can change quickly and this is the story in Iraq. We don’t know how the story will play out, but we have clearly gone from a period of negative expectations to a period of positive expectations.

The role of expectations in the oil market is important. We did a piece that appeared in the Oil & Gas Journal on why oil prices went so high in 2008 — and we have a completely different view. We need to constantly challenge the conventional wisdom and this regard you should also look at a piece on our website on how the Hubbard of forecasting oil production missed the mark in the two most drilled provinces in the world. Finally, I always explain to my trustees that the most downloaded document on our website is a primer on gasoline blending. (Laughter.) It’s not these more arcane issues.

I don’t want to leave you with the impression that we are unaware that the Iraqis, although clearly moving in the right direction, face a portfolio of risks. And I think that’s where, given the stakes for the United States, for the world economy — that’s where the attention ought to go: these portfolio risks. Some are obvious and some not so obvious and range from politics to contract sanctity. You could get to the point down the road where even meeting cost recovery obligations, that there becomes internal resistance to providing the funds for the cost recovery.

There’s also the struggle for political leadership, of course. We’ve heard a little bit about this already. The Arab-Kurdish conflict remains outstanding. And then there are these outstanding debts — the Iraqis still owe money to Kuwait, Saudi Arabia and they haven’t resolved the U.N. debt. And this all needs to be worked out. There is also the stability of the tax regime. I think some of the companies are nervous about that, some of those that didn’t bid. The carried interest that the Iraqis had was 25 percent in some cases. The infrastructure remains formidable. We’ve got a lot of rigs to move in there, a lot of things that still have to happen. But as we say — none of these uncertainties really are insurmountable. That’s the thing to keep in mind.

I was reminded of these obstacles yesterday, as I spent some time with Raja Sidawi, the publisher of the Energy Intelligence Group. And I gave him a list of 25 reasons the Iraqis could fall short, and without hesitation he provided me with 50 more. We are well aware of these risks, but our pitch now is look, you can no longer dismiss this out of hand. And the interesting thing is when you look at how valuable this is to the U.S. and the world economy, it sort of raises a question about what is the administration doing? They’re out here working on biofuels and solar, which largely eats money for the economy, particularly in an era of fiscal fatigue. And here we have an event taking place halfway across the world which can generate enormous benefits for the U.S. that is getting little attention.