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Frank Knuettel, an oil industry observer for thirty years, is a securities analyst associated with Prudential Securities.

Baghdad has on several occasions since 1992 indicated its readiness to negotiate with the United Nations to sell oil and use the proceeds for emergency food and medical supplies. In retrospect, it is clear that each of those past efforts failed because of a lack of Iraqi seriousness or because of unexpected events (such as a new Iraqi feint toward Kuwait or the defection of top regime leaders).

The discussions that began on February 6, 1996, are different. This time, Iraq will agree to abide, with only slight modifications, by U.N. Resolution 9861 (even if it does not admit to doing so).

NEW CIRCUMSTANCES

Six factors have changed the situation since late 1994, when the Iraqis last indicated an intent to sell oil for food and medicine. These changes suggest that unless Iraq or the United Nations (or a permanent member of the Security Council) remains intractable on some relatively minor aspect of Resolution 986, Iraq will by mid-1996 be producing vastly larger volumes of crude oil.

Unless Iraq or the United Nations (or a permanent member of the Security Council) remains intractable on some relatively minor aspect of Resolution 986, Iraq will by mid-1996 be producing vastly larger volumes of crude oil.

Sharply reduced funds. A year ago, Saddam Husayn still had access to funds in a variety of international accounts, which he could freely tap to purchase commodities, armaments, or other imports. These funds have been largely drawn down since mid-1995, causing a significant decline in Iraq's liquidity. In itself, this change could prompt the Iraqis to review their policy on the issue of selling oil under the U.N. auspices.

Reduced trade with Jordan. The Jordanian route is Iraq's only approved lifeline to international trade. In late 1995, Jordanian authorities announced an immediate reduction in trade with Iraq by 50 percent, to only $200 million annually. Recent changes in the Jordanian cabinet, including the appointment of Prime Minister `Abd al-Karim al-Kabariti, signal a move away from the Iraqi orbit and instead toward Israel and the United States. Combined with the financial problems noted above, these changes in Jordanian policy suggest that Iraq no longer enjoys the financial flexibility it earlier had. And these same factors point to an even more grave social and financial situation ahead.

A continuing embargo. The secret data that Husayn Kamil's defection made available to the West brought to light new revelations about Saddam Husayn's still ambitious military agenda. The French and Russian governments had until then taken a more lenient line regarding Iraq's reentry to world oil markets, but the new information caused them quickly to adopt tougher positions.

Apparently, virtually all five of the permanent members of the Security Council (China's position is unknown but likely to be more lenient than that of the other four members) have told Baghdad not to expect any permanent opening of the country's oil production during the foreseeable future. In effect, they made it clear that Iraq's only option for revenues any time soon lies in emergency oil sales as directed by the United Nations. This ended Saddam's hope that he could hold out until the embargo was lifted.

Iraqi circumstances are increasingly desperate. Western media have not reported that hundreds, if not thousands, of Iraqis have died in the quest for food and other staples. Recent medical statistics, for a country only a few years ago reasonably well advanced, are appalling. The World Health Organization has indicated that infant mortality in Iraq has increased sharply in recent years and is now almost equivalent to that of interior Africa. To make matters worse, in early January, the authorities instituted financial measures to curb inflation and other maladies by freezing salaries, raising taxes and import duties, reducing budget spending (including military expenditures), and -- very telling -- selling off government property. Saddam's record does not suggest that the welfare of Iraqis stands at the top of his priority list, but he is crafty. But if he must bend to U.N. demands in order to retain power, he will do so.

Saddam's record does not suggest that the welfare of Iraqis stands at the top of his priority list, but he is crafty. But if he must bend to U

A search for new policies. Five years after the war to liberate Kuwait, many leaders in the Middle East and the West have commented that the embargo is not working -- Saddam is still in power, the situation in Iraq is worsening, nothing is changing -- and so should be lifted, at least to the extent of exchanging oil sales for food and medicine. Crown Prince `Abdullah (who was the acting head of Saudi Arabia for a few months in late 1995 and early 1996 as King Fahd convalesced) has a prominent voice in this rising chorus.

Pressure on the U.S. government. The United States and United Kingdom, those states that have carried the anti-Saddam banner, are increasingly feeling the pinch financially to pay for aid to Turkey and to the Kurds in northern Iraq.2 There would be less need for Turkish and Kurdish foreign aid were the pipeline that links Iraq to the Turkish coast reopened and were the portion that transits Kurdish territory made secure, which can be accomplished with relative ease. Also connected to this, I suspect: the ever hardening American sentiment toward Iran, part of the United States's dual-containment strategy with regard to Iran and Iraq. This may explain why comments from the Department of State about Iraq show some slight flexibility.

IRAQI OIL EXPORTS WILL TAKE TIME

Should Baghdad finally accept that it cannot dictate the method of distribution of food and medical supplies to its people, the chances of an emergency oil sale would be something like three out of four. Also in question here is the U.N. attitude: will it be prepared to show some flexibility (for example, on exports via Iraq's Gulf port as well as via the pipeline through Turkey)?

For two main reasons, Iraqi oil will probably not start flowing as rapidly as some have suggested (oil traders, for example, expected negotiations to be completed within several days) because some issues will take time to resolve.

* Pipelines and other facilities need to be repaired; assuming Iraq is able to import supplies and hard goods to service these facilities, this is not an onerous or time-consuming aspect of the negotiations. But repairs are not likely to start until a final deal is signed.

* The second stage of negotiations between the United Nations and Iraq again involved the "second team" for both sides rather than top officials; before a permanent agreement is signed, Iraq's Deputy Prime Minister Tariq Aziz will need to be involved. As a result, it is unlikely that sales will commence quickly, although that is a minor issue in the context of larger Iraqi exports' commencing during a period when there are already numerous price pressures.

The United Nations will have to address other nuances as it continues discussions with Iraq. While the portion of oil revenues going to Kuwait, the United Nations, the Kurds, and other parties is apparently not negotiable, how the food and medicine are distributed probably permits some U.N. flexibility.

OIL PRICES COULD DROP SHARPLY

For these reasons, increases in Iraqi oil will probably come on line about mid-year, a period of the year when seasonal demand is the weakest as economic activity in some developed countries subsides. This combination will place a further burden on the members of the Organization of Petroleum Exporting Countries (OPEC).

Helped by cold weather throughout the entire Northern Hemisphere (weather added about 0.2 million bpd to this year's call on petroleum), 1996 world oil demand might rise nearly 1.8 million barrels per day (bpd), to about 71.4 million bpd. Spring and summer demand, however, I expect to fall to about 70 million bpd, 2.7 million bpd below estimated first-quarter demand. Although supplies were snug this past winter, partially because the oil industry has now adopted just-in-time inventorying (stocking the minimal possible of supplies), there is no shortage of crude oil. Hence, at current rates of OPEC and non-OPEC output, there already is a problem of surfeit, irrespective of seasonal considerations, as seasonal demand falls.

Oil demand will also likely weaken in the spring owing to considerable refinery maintenance and turnarounds (shutting down a refinery to clean, maintain, and repair it). In contrast to the past winter, when the onus was on the refiner to insure that sufficient product was available on the coldest days of the year, the spring problem switches to the producer. That is because winter demand is generally between 1 and 2 million barrels per day higher than world production; by spring, world demand drops owing to seasonal factors, and production generally is more than 2 million barrels per day ahead of demand.

Non-OPEC production is rising sharply. If there is not substantial North Sea repair work this summer (and various changes in how facilities are now being operated suggest repair-related production interruptions may be less than in earlier years), then non-OPEC production growth will be at least 1.5 million bpd. Irrespective of Iraq and other OPEC producers, the growth in non-OPEC output is apt slightly to exceed the growth in world oil demand this year.3

All this points to declining oil prices in the latter two quarters of 1996. Even without the Iraqi production, oil prices, using North Sea Brent as our reference point, are not likely to rise appreciably this year -- despite the recent spike caused by low inventories and a colder than expected winter -- from last year's average price of $17.04 per barrel.

HOW MUCH WILL IRAQ PRODUCE?

While Resolution 986 determines the dollar amount and time frame for the sales, it does not fix the price per barrel. This creates a downward price spiral; as the price falls, Iraqi production rises, providing further impetus to weaken the prices. Press reports suggest that the $1 billion of oil Iraq would be allowed to sell over a ninety-day period is equivalent to 700,000 bpd of additional output. But that estimate is based on the higher oil prices that prevailed during the coldest days in the first quarter; at a lower oil price, $1 billion might mean closer to 800,000 bpd.

There may also be factors that would permit Iraq to produce volumes leading to more than $1 billion in revenues over a ninety-day period. For example, Iraq may produce an additional 25,000 bpd to cover the cost of Turkish and Kurdish pipeline tariffs. If OPEC adopts its usual practice of waiting until oil prices weaken before coming to an agreement (and the prospect of a contentious OPEC meeting must be taken seriously), oil prices may well decline an additional several dollars per barrel before they hit bottom -- leading to even larger Iraqi production volumes.

OPEC's BIG PROBLEM

The problem of Iraqi oil's entering the marketplace during a period of oversupply could be relatively easy to resolve; every state would cut back so that their total comes to the existing 24.52 million bpd quota.4 But politics and economics are likely to interfere with this approach.

The problem of Iraqi oil's entering the marketplace during a period of oversupply could be relatively easy to resolve; but politics and economics are likely to interfere with this approach.

This is a time of rising surpluses, when non-OPEC production and OPEC capacity are both rising more rapidly than is world oil demand. Even the prospect of Iraq's selling on the international market, especially given the ill-will of almost all the Persian Gulf states toward Baghdad, is worsening financial and social tensions. Iraqi sales could well lead to a decline in oil prices that the OPEC members will not quickly adjust to, causing national budgets to become severely impaired and possibly leading to the destabilization of some governments, principally Saudi Arabia, but also including such key states as Venezuela and Mexico.

* In the mid-1980s, oil prices collapsed from $34 to $10 per barrel; today, the financial situation in all OPEC countries is grave. The wealthier producers are less wealthy than before, while the poorer OPEC producers are now almost impoverished. Both have urgent needs for current revenues. These OPEC members are preoccupied with dollars' coming in the door, and for them, total revenues matter more than per-barrel receipts.

* Politics will play an extremely important role in an eventual OPEC meeting, or series of meetings, to develop a consensus on production reduction. Regardless of who benefited from the elimination of Iraq's almost 3 million bpd from August 1990 onward, several producers consider that the past should not be a factor in the forthcoming deliberations.

* Kuwait, which obviously bore the brunt of the Iraqi invasion, is not likely to give up any of its production to Iraq. Its position appears intractable.

* Iran, which is locked in a political battle with Saudi Arabia for the hearts and minds of Muslims, and which is suffering because of cash-flow constraints and the inability to obtain sufficient Western technology to service its aging oil fields, is also not likely to give up portions of its quota. Only if the wealthier and (from Tehran's perspective) more profligate OPEC producers give larger shares of their production would the Iranians consent to this.

* Several OPEC producers, principally Venezuela, Algeria, and Nigeria, have chosen a production path completely independent of OPEC. Venezuela, for example, is overproducing its quotient by more than 20 percent. And others in OPEC are not far from going "independent" themselves. That also will make it more difficult for OPEC to reach a consensus on production reduction in a timely way.

Overall, emotions are hardening, making consensus more difficult and time-consuming to achieve. Still, a point will come when entrenched feelings collapse in the face of a severe drop in the oil price, so severe as to call regime maintenance into question. As the price of oil falls, and reducing output no longer suffices, a loss of confidence in the stability of prices will develop. This process will feed on itself and will frequently cause prices to fall faster and further than supply-and-demand estimates would predict. Such problems must probably come to pass before OPEC develops a consensus; accordingly, it may take more than a single OPEC meeting to achieve reductions in output.

A point will come when entrenched feelings collapse in the face of a severe drop in the oil price, so severe as to call regime maintenance into question.

Despite individual country finances that would suggest no price collapse, emotions are likely to overtake wisdom. Oil prices, at least for a short period, may fall to as low as $13 per barrel. And the longer they remain low, the longer it will take to reinstall confidence in an OPEC agreement. That will create a public-relations challenge; only a quick and convincing resolution to this oil-production dilemma will keep prices from backsliding.

WASHINGTON'S ROLE

A wide chasm now exists between the way most of the world, including most key European states, looks at the Iraqi situation and the American view. While the U.S. government continues to adhere, at least outwardly, to the notion that all the terms of Resolution 986 are inviolate, others see them as mere guidelines for discussion. If, for example, an agreement with Iraq falls through because of minor differences owing to Washington's holding to an intractable stance, the Clinton administration could easily be placed in an uncomfortable political position. For example, the distribution of food and medicine in those northern provinces not under Saddam's control is likely to be one of the most contentious issues in the deliberations. Resolution 986 calls for the United Nations to be the distributing agent; will Washington permit distribution jointly by Iraq and the United Nations, as is the general plan in all but the three Kurdish provinces? If an agreement fails because the U.S. government is inflexible, recriminations against Americans could follow.

Oil companies already feel particularly at odds with the U.S. government, the Clinton administration and the Congress alike, for its view that embargoes are the only way to curb rogue states. The protestations of oil companies -- who point out that embargoes have not worked in restraining outlaw regimes -- have fallen on deaf ears. A near total embargo against Iraq has not brought Saddam Husayn down. Further, as examples from Cuba to Libya have established, U.S. embargoes only hurt domestic corporations and employment, and help foreign competitors, for there is an increasingly great body of talent lying outside U.S. borders.

INVESTMENT IMPLICATIONS

If Iraq comes to an agreement with the United Nations, oil prices will probably decline, possibly quite sharply, although for only a relatively short period of time. OPEC will have difficulty adjusting to Iraq's return to the organization's production scheme, particularly in light of its existing internecine friction.

OPEC will have difficulty adjusting to Iraq's return to the organization's production scheme, particularly in light of its existing internecine friction.

For these reasons, we see this as a period when oil securities are not appropriate as short-term investments. Oil service companies, however, are central to helping oil companies lower their exploration, development, and production costs in the widening list of nations that are inviting oil companies to search for oil and gas. As a result, any substantive weakening of oil prices is likely to have a less depressing effect on oil service companies than on the producers.

The poor state of national balance sheets, whether it be the wealthier Saudi Arabia or the poorer Venezuela, nevertheless suggests a battle over the OPEC oil barrel. However, the fight is not likely to last long because of country finances, notwithstanding mounting social and political pressures when oil revenues fall significantly short of expectations. Should oil prices decline appreciably for a period, with oil securities probably weakening as well, that may set the stage for profitable long-term investing in oil stocks.


1 Resolution 986 permits Iraq, under very strict terms and conditions, to sell as much as $1 billion of oil over a 90-day period. Proceeds are to be directed to the purchase and distribution of food and medicine for the entirety of Iraq, with some $140 million going toward the United Nations's administration costs for the three Kurdish provinces in the northern part of the country, and additional money going to reimburse Kuwait for war-related damages.
2 There are also substantial direct costs: the Department of Defense is asking for $140.4 million to maintain the no-fly zone in northern Iraq in FY 97, plus $449.7 million for the no-fly and no-drive zones in southern Iraq.
3 The International Energy Agency perceives an even larger increase in non-OPEC supplies this year, although their non-OPEC supply forecasts are likely to be ratcheted downwards.
4 OPEC's production in most months since this agreement was forged more than two years ago has been over 25 million bpd, reaching as high as 25.8 million bpd on several occasions. In not one month has it produced at the agreed-to quota level.