Iraqi Domestic Gas Pricing: Is Reform Needed?

According to Iraq’s Integrated National Energy Strategy (INES), published last year, which projects total energy investment of $540bn (in 2011 dollars) in 2013-30, $95bn, or 18%, is earmarked for natural gas investment.

This is intended to increase production, primarily to meet growing domestic demand. In its projection of gas supply/demand balance for 2013-30, INES does not include an equilibrium pricing mechanism. Instead, it calls for a ‘comprehensive study’ to review present wholesale and retail pricing with a view to abolishing universal subsidies in favor of targeted subsidies. Therefore, until such time when a ‘comprehensive’ scheme is in place, INES suggests ad hoc measures/principles for pricing. Its main thrust is for energy prices to cover costs.

AVERAGE/UNIT COST OF RAW GAS

Given the planned increase in gas production, investment, and operating costs contained in its ‘Medium Scenario,’ INES calculates gas unit costs as in Table 1.

These unit costs compare to the current domestic price of raw/dry gas of $1.04/mn BTU. Two comments are in order. First, the cost of non-associated gas can be considered a long-term marginal cost of producing gas in Iraq. Although not highly relevant in the short/medium term, after development of the necessary infrastructure to utilize gas and minimize flaring, the marginal cost of gas production will have increasing influence on pricing in the longer term. Secondly, the marginal cost, so defined, is close to the unit cost of tight gas in some other parts of the world. For instance US gas prices averaged $3.8/mn BTU during 2009-13 (World Bank data for commodity prices), mainly reflecting the cost of producing tight gas. In Algeria, tight gas unit cost is $4.7/mn BTU (for Timimoun gas-field, according to Ali Aissaoui – MEES, 1 July 2013).

INES APPROACH: ADJUSTED PRICES TO GRADUALLY COVER COST

Iraqi domestic energy prices are much lower than world prices (see Table 2). Nonetheless, with the nominal price of crude oil supplied to refineries at $2.3/B, oil products’ prices are above their cost of production. Prices of electricity and raw/dry gas, however, are below cost. INES’s approach, although not clearly developed, rests on upward adjustment of domestic prices rather than going all the way to introduce equilibrium (for which read ‘world-related’) prices. In its Executive Summary, INES states, specifically for electricity “once a publicly acceptable level of supply reliability is established after 2016, Iraq will begin to increase tariffs, aiming toward a gradual alignment of price with cost.”

Accordingly, apart from fuel oil, raw/dry gas, and electricity, INES suggests maintaining current prices for crude oil (to refineries) and oil products until such time when a ‘comprehensive’ study is carried out. It is worth noting that if crude oil was supplied to refineries at export rather than nominal prices, then cost-related and world-related pricing would coincide. On the other hand, if a two-tier system was maintained whereby, unlike public refineries which pay the nominal price, future private refineries paid the export price (minus 1% discount), according to Law 64 of 2007, then the latter could logically only serve export markets for oil products.

For raw/dry gas, INES recommends a price above the current level of $1.04/mn BTU. For instance, concerning industrial demand, including supplies from Basrah Gas Company (BGC), INES suggests $2-3/mn BTU. BGC’s contract, however, allows for a higher price (see below). Generally, one needs to differentiate between short/medium and medium/long terms. Due to the inadequacy of gas gathering and processing facilities, in the short term, gas has no alternative use apart from limited domestic consumption and flaring. Therefore, being above the gas opportunity cost of zero, $1.04/mn BTU is a relevant price. After commencement of gas imports from Iran and as gathering, processing, and export facilities develop and demand rises in the medium/longer term the picture changes drastically. The current price, or even INES’s $2-3/mn BTU become less relevant, because they are lower than the price that should by then be charged. This lies between the long-term marginal cost ($4.2/mn BTU) and ‘world-related’ price. (Noting that we take this to mean the average border price of exports from or import to Iraq through pipelines and as LNG, whichever applies.)

BGC’s RAW GAS PRICE

Assuming a 15% internal rate of return (IRR) for the BGC, and given other costs and revenues, INES calculates that BGC pays $1.5-3.0/mn BTU for raw gas. The assumption of 15% IRR in the calculations, however, is arbitrary. Apart from specific escalation clauses, the reference price of the raw gas formula in BGC’s contract does not impose a limit on IRR. It relates raw gas price to the value of BGC’s final sales (dry gas, LNG, LPG, and condensates). Using the author’s own model, which simulates BGC’s contract terms without assuming a limit on IRR, indicates higher prices for raw gas. Specifically, if we assume that 2011-13’s output price determinants (the prices of fuel oil, Dubai crude, dry gas, LNG and LPG) will continue to apply during 2013-30, then the simulation model produces an average raw gas price, as paid by BGC, in the range of $3.2-3.5/mn BTU. This is higher than INES’s $1.5-3.0/mn BTU. If the limit of 15% IRR is assumed, then the resulting price is $3.9-4.4/mn BTU.

JUSTIFICATIONS FOR THE GRADUAL APPROACH

In the short/medium term, INES’ approach of gradually increasing domestic energy prices instead of fully liberalizing them can be justified on the following grounds:

• The economic system and management

in Iraq are largely fragmented and in a state of transition, during which time overlapping and in many instances conflicting laws, measures, and rulings are in place. Furthermore, institutional rigidities may prevent the prices of final prices of goods and services from changing in line with changing energy input costs.

• Industrial demand for gas is currently low; therefore raising energy prices to world-related levels immediately could chock future industrial growth.

• Calls for industrial protection, including

subsidizing energy prices, have been gaining ground.

• A gradualist approach in the short/medium term would serve as a learning and adjustment process during which time conflicting laws and measures would be harmonized, institutional changes made,adequate protection mechanism instated, promising activities/industries identified and nurtured, efficiency measures implemented, etc.

SUPPLY AND DEMAND: EQUILIBRIUM PRICING

Notwithstanding the relevance of INES’ gradual approach, undue postponement of the introduction of world-related prices, after an adequate transition period, would be bound to create shortages and disequilibrium. Let us contemplate these possible eventualities by considering a supply/demand-type balance drawn up in INES’ ‘Medium Scenario’ (see Table 3).

In this balance no obvious relationships between production/demand components and prices were elaborated on in the INES. More than 81% of the increase in gas production between 2012 and 2030 is associated with crude oil production, which is generally independent of domestic or world-related gas prices. Secondly, the different components of demand, as projected by INES, are estimated in relation to growth in non-oil GDP, with no reference to prices. Thirdly, non-associated gas production is projected to bridge the gap between associated gas production and domestic demand, especially after 2030. Fourthly, it seems that ‘exports’ in this balance are only intended to absorb the surplus between production and domestic demand before 2030.

Consequently, as a result of largely divorcing the supply/demand balance from an equilibrium pricing mechanism, domestic demand grows by twice as much as production between 2012 and 2030. Furthermore, although growth of both production and domestic demand slows down during 2020-30, demand keeps growing at 6.6% annually while production almost stagnates. This state of affairs is made possible only because of the wiping out of surplus/exports. Beyond 2030, and short of applying equilibrium (world-related) prices, such differential growth between supply and demand cannot be sustained without spiraling costs and rationing. Similar situations were observed in gas consumption in other countries; eg Ali Aissaoui (2013) finds that in Egypt continued low subsidized prices wiped out the surplus for exports and created shortages in domestic supplies.

DEMAND MANAGEMENT

The high growth in Iraqi domestic gas demand contained in INES’ 2012-30 projections risks the possibility of shortages before 2030, when additional (mainly associated) gas production fails to materialize, and after 2030 when supplies do not keep pace with growing demand. Although development of non-associated gas is a possible solution, it can only be obtained at much higher cost. Furthermore, even with realized projected supplies, surplus/exports will vanish by 2030 (in contrast the ‘central strategy’ of the IEA’s 2012 Iraq Energy Outlook posits a gas surplus/exports continuing well beyond 2030). Maintaining adequate surplus for exports is advisable. Exports assist in recouping part or all investment costs. Therefore, to attune domestic demand to supplies and leave adequate surplus for exports, demand management becomes necessary. As demand for gas is usually determined by such variables as income growth, price and efficiency, then some of these determinants can be used to rein in demand; mainly increasing price and implementing efficiency measures and possibly some rationing.

The influence of price is a function of the demand elasticity of price which is usually low for energy. Therefore, for price increases to be effective, they must be tangible. In the short run, however, because of political, institutional, and social constraints, the size of the increase cannot exceed certain limits. Therefore, increasing efficiency can be an additional tool in demand management. Through such measures as better equipment, better insulation in buildings, and reducing electricity; demand growth for energy, including for gas, can be constrained. Enhancing efficiency had been gaining prominence in advanced and emerging countries in rationalizing energy demand.

CONCLUSIONS

• Apart from targeting activities/industries and low-income groups, it is advisable to gradually introduce world-related prices well before 2030. Notwithstanding the relevance of INES’ gradual approach, if divorced from world-related levels domestic gas prices will likely lead to shortages in the medium/longer term even if they cover costs.

• The continuous decline in exports after 2020 in INES’ balance affects negatively the recovery of investment and the financing of subsidies to targeted activities/industries and low-income groups.

• Demand management, including efficiency measures, have been effective in rationalizing energy demand in many countries.

*Dr Merza had worked for the Iraqi Ministries of Oil and Planning and for the United Nations Department of Economic and Social Affairs in the Middle East and North Africa. [email protected]