Economical Cost and Benefit of Occupying Iraq

This article is a benefit cost analysis of the Iraq war. The aim here is not to show that money or oil were the motivation for the war. Instead, the aim is to show that money and oil cannot be ignored as part of the bigger story surrounding the war in Iraq. In addition to money and oil, the bigger story includes control of a strategic part of the world with a strategic asset, it involves a vulnerable nation that became vulnerable through the acts of its leadership and the acts of its neighbors. This article is mostly an economical analysis looking at the financial aspects of the bigger story. However, the larger picture is that the prize was and still is big, and it was unguarded. This is an attempt at quantifying that prize.

The day Baghdad Fell - Saddam's Statue Covered with American Flag

Development of an Oil Field

Oil fields projects commonly involve joint split of revenues (or revenue sharing) between the host country and the developing company. The basis for the split of revenues is that the host country owns the resource that is under the ground and the foreign company owns the technology and capital that is necessary to develop the resource and unlock its value. Typically a host country auctions plots of land with specified revenue sharing plans. The host country specifies the revenue sharing percentage based on how much it perceives the risk. For example, if a plot of land has low chances of finding oil or the oil requires significant capital investment and technology, the host country may offer lucrative percentage of revenues for an interested foreign company -- sometimes up to 75%. That happens also whenever the host country is desperate to attract foreign investment due to need of cash or security or other risks involved in the auctioned plot of land. Typically the foreign company's share is down if the perceived risk is low.

Range of revenue sharing values vary significantly. In the Gulf of Mexico, the US government collects royalties that average 25% leaving 75% to the developing company. In most offshore projects around the world that require significant capital investment, oil companies typically get about 50% with a range between 25-75% depending on risks involved.

Development of Subsea Oil Field Involves Massive Technology to Bring Oil from 2 km Below the Sea Level and More than 7 km below the ocean Bottom. Maximum Global Subsea Oil Production will be 10 MM barrel per Day. None of that is Needed in Iraq which Can Produce Equivalent or More than All Subsea Development in the World Combined. World Oil Companies Compete Aggressively to Develop 100,000 barrel per day in Subsea. What do You Think they Would Do for 8 MM Barrels per Day Onshore?

Costs and Gains in Iraq

Cost of the Iraq war so far is $265 B. Is the war really worth it? How much is the expected gain? If we look at the oil gains only, by most accounts Iraq is capable of producing 8 MM bpd (barrels per day) for 20 years at a cost of about $5/barrel. The estimates leading to that are very simple. Iraq has proven oil reserves of 112 billion barrels which ranks Iraq second in the world behind Saudi Arabia. This level of proven reserve by itself makes Iraq capable of producing 7.5MM barrels per day for 40 years or 15 MM barrels per day for 20 years. If I only assume that 50% of the proven reserve will fall under the revenue sharing agreement, then the 8 MM barrel per day figure is quite reasonable and in fact conservative.

On top of that, US Energy information Administration (EIA) estimates that up to 90-percent of the country remains unexplored due to years of wars and sanctions. Unexplored regions of Iraq could yield an additional 100 billion barrels. That is doubling of the reserve that we used in our calculations above. Only about 2,000 wells have been drilled in Iraq, compared to about 1 million wells in Texas alone. There is no other place in the world that has that size of an opportunity. The total size of subsea oil development in ultra-deep water which involves massive technological and capital risk, is about 10 MM barrels of oil per day...That is it. Iraq which now produces 2 MM barrel per day, is easily capable of 8 and may even go to 15 or more.

Iraq's oil production costs are among the lowest in the world. The most expensive subsea development is about $10-15 per barrel. It is safe to assume that Iraq's onshore development will be in the range of $5 per barrel.

If a long-term planning price of oil is $45 (which is sharply below the current level of $70/barrel but is considered a more realistic long-term price). This translates to a total profit over the 20 years of about $2.3 T (T is a symbol for trillion which equals 1000 Billion).

If we conservatively assume that the revenue sharing will have a foreign oil company getting 25% of the revenue and putting all the costs (which is captured in the $5/barrel cost). Therefore, foreign companies will be making about $584B in profit or $29B per year.

The return on investment will be the profit per year divided by the total investment (which in this case, mostly the cost of the war). The return on investment from Iraq per year = 29/265 = 11%.

The typical acceptable level of return on investment is 15% (which is called the hurdle rate). 11% is slightly below that rate. However, given the conservative assumptions we made and given that there is no opportunity I know of that has the high magnitude of return ($29B/year in profit = total annual profit of the largest American company), Iraq represents an opportunity that is matched by none.

By the way, this is ignoring that the remaining 75% that would really go to the government of Iraq will have to be used also by the Iraqis in buying capital (aircrafts, electricity generation equipment, water treatment, ...) and consumer equipment. Assuming that of the remaining 75%, Iraq will allocate 50% to capital goods (which typically carry 25% margin or profit for the seller) and ignoring any profit from consumer equipment (TV sets, DVD players, ... which Iraqis will also buy from abroad), then:
Additional profits = 0.5*0.75*2300/20 = $10B/year

Total return on investment = (29+10)/265 = 15% - which is by all standards great return.

The Prize: Iraq has Oil Reserve that is Second Only to Saudi Arabia. Yet 90% of Iraq is Unexplored. Iraq has only 2000 Wells Compared to 1 Million on Texas Alone. Only with the Proven Reserve in the Picture, Iraq is Capable of Producing 7-8 MM (Million) Barrel Per Day, Not to Mention the Other Possibilities.

What If?

What if the cost of the Iraqi war is doubled? A doubling of the Iraq war cost will simply translate to foreign oil companies insisting on getting >25% share, which as we have seen is not unusual. In fact, it is not unusual to get up to 50% revenue sharing agreements.

I can easily conclude that it is manageable for the US to spend even up to $500 B to secure Iraq. How did I arrive at that?

Increase cut of oil to 35%. Also, margin on capital equipment also can be hiked to 35% and still be within the possible range.
Corresponding total return = $53/year. At $500B Capital, return on investment = 53/500 = 10% which is still acceptable given the magnitude of the opportunity.

At current rate of spending of $2B/month, this translates to 125 months or about 10 years more. The United States can afford to stay in Iraq for 10 more years and still the financial return will be attractive. I should mention that I am not obviously counting the blood tax in Iraq and the sad face of the story that lives (American and others) are being lost in Iraq. This is certainly sad but as I stated earlier, I am only looking at the economical face of the story.

Future Scenarios

There are 5 possible future scenarios one can imagine:

1- Secure fast: This is the most optimistic scenario. Iraq becomes secure in less than 3 years. Total US spending on the war is less than $300B. Return on investment is 10-15% assuming only 25% margin on oil and capital goods for American companies.

2- Secure Slow: In this case, it takes 10 years to make Iraq fully secure and stable country. US spending is $500B. To maintain a return on investment of 10% a margin of 35% will need to be paid. It is likely that a future Iraqi government after 10 years of strife will be compelled to attract foreign capital and pay above the conventional 25% revenue share and margin.

3- Partial security indefinitely: In this case, the security situation improves over time for example to a level comparable to Nigeria now in which rebel attacks happen every now and then but is never fully secure. The assumption here is that it will take 10 years to get Iraq to where Nigeria is right now and during these 10 years no development of oil fields happens. Foreign companies can invest under this scenario but will normally demand higher share of the revenue.

This is a case in which in addition to the 35% in scenario 2, additional $24B must be supplied by Iraq on an annual basis to pay for the ongoing cost of the war. The $24B exactly amount to 15% extra margin on top of the 35% in scenario 2. This can happen in one of two ways: either a future Iraqi government will pay $24B/year as a cost of the occupation or will be compelled in an environment in which security is lacking to pay foreign companies operating in Iraq 15% extra margin.

4- No security at all indefinitely: In this scenario, the current situation in Iraq will remain indefinitely and no oil company will be willing to invest at all. In this case, there will be no return on the war investment and oil companies will be too scared to invest under the current security environment in Iraq.

There is a chance this scenario may not persist on the long run. Why? Oil companies are starting to take position in Iraq and little by little they may get used to the current security environment. Also, if they get the right revenue sharing, the risk taking profile of oil companies may change and start taking the plunge into Iraq. So, scenario 4 may start over time looking more like scenario 3. After all, 10 years is a long time in both business and politics.

Even in the absence of even partial security in Iraq, the process will be self-correcting: a future Iraqi government in the absence of security will be compelled to give up more to get foreign capital all the way potentially up to 50% or more of the revenues. The higher the security risk the more money there is to make for those who have the capital and take the risk.

5- Cut and leave: This would be the worst case scenario in which the US leaves Iraq prematurely without reaping any economical benefits. This means that all the cost is lost without any benefit. The return will not be the zero financial return, but it will also be negative. The US will lose its control of the vast oil resources in the whole region and may lose its world status as a super-power. In a recent vote, the US Senate overwhelmingly defeated a measure to withdraw US troops from Iraq. The US will attempt to avoid any precursor to this scenario. Causes of this scenario are: significant erosion in US public tolerance of the war or significant losses on the battlefield to the extent that the US position in Iraq becomes unmanageable. This scenario is really unlikely to develop unless there is a dramatic turn or escalation.

Scenes Violence in Iraq: The Goal of Any US Administration is to Contain the Violence in Iraq, Dry Its Sources in the Arab World, Isolate Iraq from its Neighbors to Help Seal it From the Fuel of Violence (Youth and Ideas) Around It, and Finally Avoid US Public Opinion Tipping Against the War

Therefore, under any scenario except for scenario 5, the economical return on the war is attractive. This is the hallmark of robust business strategy. The US therefore will have to target achieving any of the first 4 scenarios and avoid the pitfalls or risks that could lead to scenario 5.

What Are the Likely Scenarios?

We just concluded that the United States can afford to stay in Iraq for 10 or even more years and still the return on investment will be attractive. This is only based on economics. But there is the political and human side of the picture that we have so far ignored.

Although the fourth scenario can be the most financially lucrative, it also carries significant perils and risks:
1- It creates problems for the US in the whole region and may continuously challenge its position there. This is probably the most critical of all the risks.
2- US public opinion support for the war could erode significantly within years. The longer the conflict draws, the more that is likely.
3- There are no guarantees that continuous operations of oil flow can be secured, therefore, there is no guarantee of the revenues.
4- After all, many US companies may continue to be hesitant, as is the case now, to operate in Iraq.

This Type of Marches and Demonstrations Will Be Nightmare for An Iraq Policy. Causes of Such Public US Wide Uproar Will Be Avoided.

Consequently, scenario 4 may not in the best interest of the US.

Although less lucrative on paper, scenarios 1 and 2 are more attractive. However, given the current status of the US budget deficit and the current state of public opinion in the US, scenario 1 may be the most desirable for any US politician. Nevertheless, it is likely that the US will be drawn into scenario 2 given the current level of violence on the ground in Iraq.

It can be concluded that although scenario 1 is the most desirable for the United States, there are facts on the ground that makes scenario 2 to be the most likely scenario. Still, scenario 2 is as financially attractive as scenario 1 despite the protracted conflict increases the chances of scenario 5 to emerge. Therefore, US policy will have to include parameters that would neutralize risks that could eventually lead to scenario 5.

How to Minimize Risks Involved in the Most Likely Scenario

Pictures Like This Can Cause Erosion of US Public Tolerance of the War in Iraq. These Pictures will be Kept Away from the Public Eye. The US Public Resent the Iraq War but Tolerate it Simply Because UnliVietnamman, It Doesn't Affect the Average American. DuriVietnamnam, America had Universal Suffrage and Every American Household Had Kids Serving in the Army. That is Not the Case Now. The War Only Affects Those Poor Enough to Volunteer in the Army. Analogy between Vietnam and Iraq is Common in the Arab World but Is Utterly False. US Public Opinion Resent the War but Tolerate It Since it Doesn't Affect the Majority.

How would the United States minimize risks arising from scenario 2? We need first to recap those risks. They are:

1- Premature erosion in US public tolerance of the war that forces a pull out of US troops before reaching a point of stabilizing Iraq enough for foreign capital to flow in. This can result from any of the following:
a. Ongoing and constant drain of resources and lives that causes uproar in the US public opinion
b. Catastrophic events resulting in significant loss of lives
2- Regional and Iraqi interests who are continuously fueling violence in Iraq and attempting to force scenario 4 or even 5 instead of 1 or 2.
3- Erosion in the US position across the region particularly in key countries (such as Saudi Arabia) as collateral damage from the ongoing conflict in Iraq. This erosion of position and public image has already reached a difficult nadir because of Abu Gharib and continuous US support for Israeli policies and practices.

Abu Gharib: These Unfortunate Pictures Harm Image of the United States in the Middle East.

How would the US manage these risks?
1- Take the conflict out of public eyes to minimize the possible erosion in US public support.

2- Drain or divert energies in the region that could otherwise go toward sabotaging the US effort in Iraq. For example, divert regional youth away from the conflict by focusing on democracy, open markets,... This can be made easier by the current flow of cash in the region especially if it is accompanied by general democratization and openness or at least the perception of that.

3- The US will continuously try to find partners to co-fund activities in Iraq without asking for a share of the revenues. This may be tough but some regional partners may be in the end willing to do so.

4- The US will attempt to completely seal the Gulf region from Iraq and Iraq from the rest of its surroundings. The sealing will be attempted both at the security and the political level, and most likely starting at the security level and gradually creeping to the political, therefore stopping the passage of goods, people (particularly youth), and more importantly ideas.

Calls for Democracy While Touring the Region (Secretary Rice On the Left) and the Cash With Which the Middle East Is Now Flush (Burj Al-Arab, Dubai on the Right) Should Help Alleviating Pressure on the US in Iraq and Should Help Dry Sources of Violence in the Region.

None of these risk management techniques can have a short-term impact. They all will take years to bear fruits. It is likely that under a new administration another risk management technique could be explored and tried which is to de-escalate the Arab-Israeli conflict or muscle Israel to make wider concessions. Israel may be willing to give up more in the West Bank (to a limit) in exchange for foothold next to the United States in the Gulf region or in Iraq. The problem with this approach from a US point view is that the limit that Israel is willing to give is far below Arab aspirations. Therefore, there is no guarantee that it will truly result in de-escalating the regional tension or in drying up of the sources of violence in the minds of Arab youth. Moreover, a US president cannot --for domestic political reasons-- pressure the Israelis to give up East Jerusalem and all of the West Bank for example. Not only that, there is no guarantee that if that happens, that Arabs will not perceive that as a victory over the west and a launch pad for other activities that result in even more concessions. However, the idea of peace in the Middle East has always been intriguing to a sitting US president and there maybe further attempts in the future, although nothing may be at the scale seen before during the Clinton era, not at least for the foreseeable future. These attempts will certainly make a difference in the image of the United States and will have a collateral effect in securing Iraq on the long run particularly given that Israel already is putting what appears to be a solution on the table.

Conclusions

Under any scenario, the United States is poised to gain financially from the war in Iraq. The likely scenario is that there will be a long term conflict followed by relative stabilization that perhaps reaches a situation as in Nigeria in which rebels launch attacks every now and then that certainly increase the risk profile of doing business there but not to the extent of totally eliminating the flow of capital into the oil sector. It can take up to 10 years to reach that point. However, even if that is the case, the war still makes sense from a financial point of view, not to mention the strategic consequences of securing Iraq at the heart of "oil land."

Future US Adminstration Can Get Back Involved in De-Escalating the Arab-Israeli Conflict or In Reaching Quasi-Agreements Aimed At Reducing Tension in the Region Which Helps Stabilizing Iraq and the Gulf Region. It May Be Even Likely that the Current Adminstration Will Find Itself Back Doing What President Clinton Did at the End of His Adminstration.

However, in doing so, the likely scenario carries key risks and challenges particularly the loss of lives, erosion of image in a key region, and the constant energizing of youths in the Middle East against the US. These risks can be managed by keeping the conflict away from public eyes, linking it constantly to 9/11 and the threat of terrorism, utilizing the flow of money into the Middle East to draw these nations' youth into more useful avenues such as democracy and open markets, and finally de-escalating or attempting to solve the Arab/Israeli conflict as a measure to enhance US position in the region.

Finally, a hint to Arabs. Powers no matter how wealthy they are, always make benefit cost analysis. What is yours?