Oil price drop reveals Iraq’s structural problems

Oil price drop reveals Iraq’s structural problems

“Iraq’s state finances are increasingly vulnerable to a drop in oil prices and the government could have difficulty financing this year’s budget plan.” – IMF Mission Chief for Iraq, 27 Jan 2014.

Despite all the attention to falling oil prices over the last six months, the impact on the world economy has not and will not be as large as many pundits have predicted: no disaster for exporting countries, no panacea for importing countries.

Exporting countries in the Gulf will increase their budget spending to sustain economic activity. It now seems likely that Saudi Arabia has accepted the fall in oil prices. A few years of budget deficit because of low oil prices will not be a real problem given the size of the country’s reserves.

By contrast, for overly dependent and unstable Iraq, the situation is unfortunately not as easy and the impact of low oil prices on the budget is a hard hit.

Stable oil prices are key to Iraqi economy

At 143 billion barrels, plus an estimated undiscovered 215 billion barrels in oil reserves (excluding Kurdistan), Iraq is the 2nd biggest oil producer in OPEC after Saudi Arabia and has the 5th largest proven oil reserves.

Oil exports contributed 47% of Iraqi GDP in 2013 alone, more than 90% of government revenue and over 99% of total exports. Overall, every single macroeconomic indicator has oil as its basis: both the current account and the foreign exchange reserves seem to track Brent crude prices.

Nowhere will the collapse in prices hit Iraq harder than its budget revenues. With a budget so heavily dependent on oil (>90%) and with current spending representing 70% of total spending due to Iraq’s large public sector (5 million state employees, a third of the working population), the government does not have much flexibility.

Government spending in Iraq has indeed been growing 14% on average every year since 2004. According to the International Energy Agency, the budget breakeven (the oil price that would be required for the budget to be balanced) is at around $105 per barrel.

The market price is now half of the breakeven and the budget deficit – now at 5% of GDP – is getting much worse, while the forecast before the ISIS insurgency was a quasi-return to balance.

Iraq’s room to move on the fiscal side is meagre and that this impacts almost every single issue that the country currently faces.

The cost of financing the fight

2How falling oil prices reveal the structural political and economic problems of Iraq
against ISIS

“The recent collapse in world oil prices has added to the tensions caused by the ISIS insurgency and is complicating efforts to deal with it.” – IMF Director of the Middle East Department, 11 Jan 2015.

With Iraq facing major security problems as ISIS controls a big part of Western and Northern Iraq, expenditures rose very quickly this year. Since this increase in military spending needs to be balanced out by revenues on the oil side, Iraqi Prime Minister Abadi last week expressed his worry that these fiscal problems could jeopardize Iraq’s efforts to fight ISIS.

The drop in the price of oil threatens the government’s ability to pay troop salaries and purchase weapons. While this appeared an easy excuse at the right time to ask for more foreign aid to some, one should not overlook the fiscal challenges faced by Abadi’s government, with defence alone expected to take up 20% of 2015 budget spending.

Infrastructure bottlenecks are leading to negative feedbacks

Another way for the government to be able to raise revenues in a context of low prices would obviously be to increase oil production. However, the production capacity is constrained by serious infrastructure and institutional bottlenecks. The Iraqi bureaucracy managing the oil production is inefficient and corrupt, while infrastructure problems, including lack of pipelines, storage facilities, port capacity, and frequent generalised energy shortages, prevent production from reaching its full potential.

On the other hand, in hard times with a combination of low oil prices and narrow fiscal space, the government typically cuts the investment part of the budget to be able to pay its current spending – a much-needed water-injection system, for example, is not likely to be implemented soon. In brief, infrastructure problems will not be solved in the near future.

Oil prices and domestic political stability risks

Even beyond the problem of ISIS, the domestic political scene in Iraq is messy. While a new government representing the three big ethnic groups (Sunni, Shia, Kurds) was successfully created after the summer, there are constant tensions between the three groups, be it in daily life, in parliament, or at the highest levels of government.

This is particularly the case regarding the budget. Iraq failed to pass a budget in 2014. Sunnis, who are for the most part unemployed or employed in the public sector, want money for pensions and wages, as well as for a planned national guard, while Kurds are in a constant fight with the government over autonomy delegation, independent oil exports from Kurdistan, and fiscal transfers from Baghdad to the province.

The KRG (government of Kurdistan) managed to strike a welcome budget deal last November that included $500 million in funds to Kurdish civil servants, but falling revenues make it harder for Baghdad to meet these fiscal obligations.

All in all, when the sidebar of a newspaper announces a deal on a 2015 Iraqi budget that is both realistic (based on a forecast of $55 per barrel) and consensual (no punitive measures against Kurdish oil production), keep in mind that in an unstable Iraq, nothing is easy.

About Author

Etienne Lepers

Etienne has worked as economist for the OECD, the European Systemic Risk Board at the ECB, the European Parliament, and in the country risk department of Coface. He holds master degree from LSE and Sciences Po. The views expressed here are my own and do not represent the views of any institution I worked for.