Tuesday, 25 August 2015

Unpleasant fiscal artihmetics in Iraq

The Iraqi government is struggling to finance its increasing deficit.

Things used to be simple in the Iraqi economy. The government received large revenues from oil exports. The revenue trickled down to the rest of the population through salaries to the large number of unproductive (and sometimes non-existent) civil servants employed by the government, with corruption taking a slice of the revenue as it moved down the pyramid.

But the world changed in June 2014 as the war with ISIS intensified and oil prices tumbled almost simultaneously. The government’s oil revenue fell by more than a half, and a significant chunk of the reduced income had to be spent on financing the war with ISIS. 

The new reality manifests itself most strikingly through the 2015 budget, where the government is struggling to finance an increasing deficit.

The initial budget law stipulated a deficit of around 26tn dinar ($22bn). But things have not exactly gone according to plan. Lower oil export volumes and delayed introduction of non-oil taxes mean that revenues are likely to fall short of their budgetary target. Expenditure is higher than anticipated as a $10bn payment to international oil companies was not adequately included in the budget. But the government plans to make up for this by cutting investment spending. As a result, the deficit is now likely to reach 42tn dinar, or around 20% of GDP. 

How is the government going to finance this deficit? It intends to raise around 8tn dinar through external borrowing. This includes borrowing from the International Monetary Fund and the World Bank, but also involves plans to issue bonds in international markets. Iraq has recently managed to obtain a credit rating from Fitch for the first time (hint: not a good one), which could facilitate its attempts to tap international bond markets.

But nearly half of the deficit (19tn dinar) is expected to be indirectly financed by the Central Bank of Iraq (CBI). This works as follows: commercial banks would lend the government by buying its T-bills, then sell these loans to the central bank and receive newly-printed money in exchange.

Getting the central bank to finance the government’s deficit is dangerous and could have painful implications for inflation and the value of the Iraqi dinar. And even with this, the government still admits a financing gap equivalent to a third of its deficit (13tn dinar) which it hopes to fill with unidentified “domestic and foreign sources”. 

The two shocks (oil prices and the war with ISIS) are creating a messy reality in Iraq. And with oil prices remaining low for longer, and the war with ISIS unlikely to end anytime soon, the shocks may turn out to be less transitory than first anticipated. The urgency of the situation could force a major overhaul in policy. But this remains more of a hope than an expectation.

Monday, 17 August 2015

Oil - shale giveth and Iran taketh away

Oil markets to remain over-supplied through 2016.

The consensus among oil analysts was that 2015 would be a bad year for oil prices, but things should improve after that. Their thesis was that lower oil prices would make the business of high-cost US shale oil producers unviable, pushing some of them out of the market. This should slow down the growth of oil supply, allowing demand to catch up and prices to recover. The consensus is now changing, and the reasons is: Iran.

Let’s take this step by step. In 2015, oil markets are expected to be over-supplied by around 0.8m barrels per day (b/d), even if OPEC sticks to its production ceiling of 30m b/d. Consequently, oil prices should remain low—in the $50s range—during the year.

How about 2016? US shale is doing its bit to rebalance the market. The US is expected to add only 0.3m b/d to existing production (compared to 0.9m b/d in 2015 and a whopping 1.4m b/d in 2014). As a result, demand growth was expected to outpace supply growth by around 0.3m b/d, reducing inventories and pushing up prices. This was the consensus before Iran.

Following the agreement on its nuclear programme and the prospect of lifting economic sanctions in 2016, Iran is expected to return to the oil market. Estimates vary on how much additional oil Iran could produce once the sanctions are lifted, but they range between 0.2-0.8m b/d. Whatever it is, it will almost certainly wipe out the 0.3m b/d of excess demand which was expected to drive the recovery in oil prices. With the return of Iran, inventories are expected to stabilise, or even increase, and prices will continue being low (again in the $50s range) into 2016.

In theory, Iran should not matter for the oil market. After all, it is a member of OPEC and the cartel has a production ceiling of 30m b/d. If Iran produces more, other OPEC members should produce less to maintain the ceiling. But this is unlikely to happen in practice: OPEC producers will probably continue pumping as much oil as they can to meet their financial obligations in an environment of low oil prices.

The latest production data support this. In July, Iran’s supply increased to its highest level since 2012. As a result, OPEC production reached a three-year high of 31.5m b/d, well above the self-imposed ceiling.

If this is a sign of things to come, then whatever shale gives to reduce excess supply and rebalance the market, Iran will take away. Oil markets will remain over-supplied through 2016.

Monday, 10 August 2015

The puzzle of electricity in Iraq

Weak infrastructure, corruption and lack of fuel are behind the chronic power shortage in Iraq.

The ongoing protest movement in Iraq is developing fast and, judging by the list of reforms proposed by Prime Minister Haider Al-Abadi yesterday, is shaking up the political landscape. The movement was triggered by power shortage amid a scorching heatwave that is engulfing the country. It is a puzzle why electricity remains in short supply more than 12 years after the fall of Saddam. Iraq earned large financial windfalls from the oil price boom of recent years, and directed a lot of resources towards investment in the electricity sector. Iraq is also one of the world’s largest and fastest growing oil producers, so it should not have trouble finding energy to operate its power plants. So where is the problem?

A recent study by the World Bank on the electricity sector in Iraq clarifies some aspects of the puzzle. I summarise the main points below.

·         What is the extent of problem?

There is a serious shortage of electricity in Iraq. Demand for power in Iraq was estimated at 13.7 gigawatts in 2010, but supply fell well short at 8.3 gigawatts. This restricted electricity supply to eight hours per day on average. The problem is clearly one of insufficient supply rather than excessive consumption. Iraq’s electricity consumption per capita (1,187 kilowatt hours) is much lower than countries with similar income level such as Serbia (4,359 kilowatt hours) and South Africa (4,581 kilowatt hour).

·         What are the causes of the problem?

1. Weak and inefficient infrastructure. Iraq’s nameplate power generation capacity in 2010 was 15.3 gigawatts, but it has one of the most inefficient generation systems in the region. This meant that the maximum technical capacity was 12.3 gigawatts. Shortage of water and fuel reduced production by 3 gigawatts, and aging by a further 1 gigawatt. Beyond generation issues, the transmission and distribution infrastructure is very weak due to under-investment and depreciation.

2. Widespread corruption. Electricity projects require many signatures and approvals, encouraging bribes and short-cuts at every step of the way. This slows down the investment process, and results in the under-execution of capital budgets. So although large allocations were made to the electricity sector, a big share were returned unspent to the central government at the end of each year. Corruption also comes in another variety: In 2011, the Ministry of Electricity signed contracts for electricity generation with a company that was bankrupt and another that did not even exist!

3. Shortage of fuel feedstock supply. 37 out of 47 power plants operate on natural gas. Former Prime Minister, Nouri al-Maliki, famously complained on TV about importing gas-operated power plants, when Iraq had no gas to supply them with. In reality, Iraq does not lack natural gas: large quantities of associated gas are produced but then flared due to the lack of infrastructure to refine and consume it. The government has therefore resorted to importing natural gas from Iran, but there are issues with the stability of this supply and the logistics required to transport it to the power plants.

·         Is the electricity shortage problem likely to be resolved anytime soon?

The issues here are structural and systematic. The problems of weak infrastructure, inefficient use of resource, red tape and corruption take time to resolve. There have been many false dawns and many broken promises. The World Bank report cites the Ministry of Electricity projections of meeting all demand by 2014, which seems laughable now. Abadi’s reforms include a clause calling for coming up with “a set of measures to end the problems of electricity production, transmission, distribution and tariffs within two weeks”. To say this is unrealistic would be an understatement.