Potential Effects of Invading Iraq
Chadbourne surveyed power company executives, bankers and consultants in late September about what effects they foresee on the project finance market if the United States invades Iraq.
Many said the effects depend on how long the war lasts and see little effect if the war is of short duration. James Schretter, president of Beacon Energy, a gas consultancy, said perceptions are probably more important than reality.“If the war is over quickly,” Schretter said,“the impact will be minimal. But if the war — or the perception that a war is still in the offing — drags on, then it may depress the economy and have negative consequences for asset holders who are already experiencing tough times.”
A long prelude to conflict is potentially more disruptive than the war itself since people may place plans on hold pending the outbreak of hostilities.
In the last Persian Gulf war, oil more than doubled in price immediately after Iraq invaded Kuwait in August 1990 — from $15 to $33 a barrel — but then returned almost as quickly to pre-war levels by the end of the Desert Storm campaign in February 1991.
A consensus has taken hold in the press in both the United States and Britain that a change in government in Iraq would be good for world oil markets. Iraq is potentially a far more significant producer of oil than it contributes currently to the market. Iraq has averaged 1.18 million barrels a day of oil output so far this year, plus another 200,000 to 300,000 barrels a day of illegal output, according to the US Department of Energy. Iraqi output of 900,000 barrels a day in August was down 1.2 million barrels from production the year before. Iraq has the second largest known oil reserves of any country after Saudi Arabia. Iraqi reserves are 112.5 billion barrels. Saudi reserves are 261.8 billion. The other top 10 producers, in terms of known reserves are, in order: the United Arab Emirates, Kuwait, Iran, Venezuela, Russia, the United States, Libya and Mexico. US reserves are 30.4 billion barrels.
There is disagreement among experts about whether the price of oil already reflects a war premium. Spot oil prices had risen 15% by mid-September compared to last June. But some experts say this is explained by a 2% fall in supply and a 1% increase in demand during the same period. David Wheeler, an oil industry analyst at J.P. Morgan, told the New York Times that he does not believe war with Iraq would cause much of an increase in oil prices because the odds are “very, very long” that Saudi Arabia would fail to increase output to make up for any shortfall in supply caused by a drop in production in the war zone. The Saudis have the capacity to increase output by up to another four million barrels a day: almost four times current Iraqi output.
The oil price shocks were much greater when Iraq and Iran went to war in 1980. Oil shot up to close to $40 a barrel. However, the runup in oil prices began in early 1979 with a series of successive price increases put through by the Organization of the Petroleum Exporting Countries, or OPEC, and the oil price actually peaked just about the time that the fighting between Iraq and Iran began in September 1980. In the first 10 weeks after the war started, world oil inventories shrank about 30%. Fuel and power prices in 1980 rose 33% for natural gas, 23% for residual oil, 18% for electricity, and 9% for steam coal. The Saudis then flooded the market with inexpensive crude oil in 1981, causing a collapse in the OPEC pricing structure. In October 1981, all 13 OPEC countries agreed on a compromise benchmark price of $32 a barrel, but within two years, an oil glut had taken hold and prices continued to fall.
Measured in current prices, a price of $40 a barrel for oil in 1980 is equivalent to about $83.70 a barrel today.
The average spot oil price for West Texas Intermediate was $28.40 a barrel in August.
The US Department of Energy estimates that each one million barrel-per-day reduction in oil supplies causes oil prices to increase by $3 to $5 a barrel and shaves 0.3% off the annual rate of US economic growth.
The Last Persian Gulf War
Economists are still debating whether the Desert Storm campaign in 1991 helped or hurt the US economy. World War II is seen universally to have lifted the United States out of a decade-long depression. The United States was already in a recession by the time Iraq invaded Kuwait in August 1990. The recession had started in June. Many economists believe that it was prolonged by the war; the recession lasted nine months. Robert Hall, a Stanford economist and chairman of a committee of seven prominent economists that dates business cycles, said at the time that the initial contraction might never have evolved into a full-blown recession without the damage caused by the war. Hall blamed high oil prices for the contraction. Iraq invaded Kuwait in August and, although the United States began an immediate airlift of troops to Saudi Arabia, the US did not start bombing Baghdad until January 16, 1991 after it had lined up support in the international community and after the collapse of peace talks in Geneva between the American secretary of state, James Baker, and the Iraqi foreign minister, Tariq Aziz, aimed at inducing Iraq to withdraw from Kuwait.
One difference this time is the US could be forced to pay more of the cost. Estimates this time are that the effort will cost more than $100 billion. The US allies paid most of the cost the last time; indeed, according to some estimates, the US made a profit. The US office of management and budget estimated that the incremental cost of the war effort — or the amount the US had to pay above what it would have paid anyway in defense costs — was $15 billion. The gross cost was $61 billion. (The gross cost includes transfers from already budgeted military outlays to Gulf operations plus the estimated future costs of replacing equipment lost in the war.) US allies contributed $54 billion.
The biggest losers from any new invasion will almost certainly be the airlines. Surging prices for jet fuel dealt a crippling blow to the airlines after the last conflict. Passenger traffic was also down; traffic on trans-Atlantic routes dropped 50%. The airlines are already reeling from the dropoff in passengers after September 11.
Domestic Power Market
Many power company executives think the situation can only improve for them. “As it seems the whole industry is in the tank, how worse can the situation be?” asked Hezy Ram, an executive at Ormat and a former Israeli tank commander. “I mean, banks are not open to new business, everybody is scared of the refinancings coming due, and the rating agencies have only one mode of operation — down. So, what else can go wrong?” Eric McCartney, head of project finance at KBC Bank, a Belgian bank, said, “Things quite honestly are already such a mess that it would be natural to think that war with Iraq will only exacerbate our problems but, at this point, how worse can things really get?” A harried chief financial officer at a large US merchant power company said he has his hands full just trying to get banks to step up and provide for ordinary-course-of-business liquidity needs, leaving little time to think strategically. “When you’re up to your eyes in alligators, it’s hard to see beyond the swamp.”
Higher energy prices could create isolated opportunities in places like New England that rely more heavily on oil for generating electricity. One power company official said, “A war could have a beneficial effect on merchant plants insofar as some new gas-fired power plants that seemed destined, at current price levels, to run very few hours might find they can clear the market because older oil-fired units will not be able to compete.” However, he compared this to an “unexpected thunderstorm bringing just passing relief to a drought-stricken farmer.”
Natural gas prices tend to follow oil prices. The US government is already predicting a 12% increase in demand for gas this winter because of forecasts for an unusually cold winter and because it is projecting that the US economy will have started to rebound by the third quarter of 2002. It estimates that the increase in demand will lead to a one-third increase in average gas prices at the wellhead to around $3.20 per thousand cubic feet. That is an 80¢ increase above the price last winter. For all of 2003, the average wellhead price is expected to be about $3.28 per thousand cubic feet compared to $2.80 last winter.
Electricity prices remain weak. David Costello, an economist at the US Department of Energy who studies linkages among oil, gas and electricity prices, said he does not expect higher oil and gas prices to lead to significantly higher electricity prices in the US. Overall, the increase in wholesale electricity prices will not be “as bad as the spikes generally experienced” on a hot summer day, Costello said. Another government energy economist said he expects the effect on electricity markets to be “negligible.”
Many US power companies financed merchant plants with short-term debt; estimates are that at least $30 billion in such debt will come due in the next year or two. There is some nervousness among power companies that a war could add to bank jitters, particularly if there is a long period of uncertainty before a war is launched. The schedule announced by the United Nations weapons inspection team in late September envisioned negotiations over the protocols for inspections, to be followed by two months of sample testing to firm up procedures, to be followed by another four months of actual inspections. This schedule is unlikely to meet with US approval; the situation remained fluid as the NewsWire was going to press.
Almost without exception, bankers at US offices of European banks referred the question what effects they foresee from a war with Iraq to their European head offices. Most saw the most direct effect on banks that are lending directly to finance projects in the Middle East. They assume there will be a much smaller impact in other markets.
US executives based abroad or doing extensive business abroad remain worried about the safety of their employees in countries with large Moslem populations. One fund manager with operations in Africa said, “I believe it will make a difference whether the US goes it alone — in which case, the ramifications will be far worse against Americans and US companies, especially those with business in Moslem countries — or as part of a genuine consortium where, presumably the anger would be diffused and not all the blame would be directed toward the US.” An American based in London said, “All will depend on how the war is executed and if there are any surprises. A nuclear or chemical bomb and all bets are off.”
A general counsel at a large US multinational company said he is spending time studying the company’s insurance policies for potential gaps in coverage. Many insurance policies exclude losses caused by war. For example, conventional insurance policies in the London market typically exclude coverage for loss, damage or expense caused by “war or any hostile act by or against a belligerent power ... [and] any terrorist or any person acting from a political motive.”
Lawyers said that disruption to shipping, lack of insurance coverage, volatility in oil prices, and a continued weakness in the economy could lead to claims that contracts cannot be performed on schedule or even that parties should be released altogether from performance.
Bill Greason, a capital markets partner in the Chadbourne office in London, said that underwriting agreements to place shares or debt in the capital markets typically contain “market out” clauses that release the underwriter from performance if there is an outbreak of hostilities between the signing and closing of a deal.“They do not like doing this because they make no money, but if the financial markets are in disarray, the underwriter does not want to be left holding the stock or bonds,” Greason said. However, he said that the outbreak of war would have to be coupled with some other event, like a major disruption to the market, before a market out clause could be invoked. Noam Ayali in Washington said that the debt offerings that are the least likely to be disrupted are ones where repayment is guaranteed by the US government through the Export-Import Bank or the Overseas Private Investment Corporation.
Chadbourne lawyers were divided about whether there could be significant “material adverse change” or force majeure claims in the near term as a result of the war. War has the potential to disrupt shipping and the production of goods. “A war could interfere with the shipment of equipment either because of the location of the project — for example, in the Gulf — the lack of available ships — perhaps because commercial vessels are being used to carry equipment needed for the war — or even because factories are being shifted to production of equipment needed by the military,” Lynne Gedanken said from London.
Loan documents and acquisition agreements make it a condition to performance that there have been no “material adverse change” in circumstances. This is normally an ongoing covenant to each future draw on a loan. Material adverse change is “difficult to assert but may be possible if the outbreak of war directly affects the company in question — for example, the main manufacturing plant is located in a war zone,” Bill Greason said.
Construction contracts and other agreements to supply goods or services have force majeure clauses allowing for delays in performance due to acts of God, war, weather and similar events outside the control of the parties. There does not have to be have been a formal declaration of war before these clauses can be invoked, said Denis Petkovic in London. “Whether war exists is usually a question of grim reality rather than a technical nicety.” John Baecher in New York said “increased costs and delays in transportation or insurance and perhaps with respect to possible price increases or fuel shortages or embargoes” could result in force majeure claims under construction contracts. However, “many if not most, force majeure provisions only allow a party to claim force majeure as a result of a war if the war is in the country in which the project is located or sometimes if that country is a participant in that war,” Lynne Gedanken said from London. “I suspect that whether parties can claim force majeure in the event of a war will be a source of dispute.”
Fuel price increases have the potential to squeeze one or the other parties to power sales agreements. Few independent power companies in the US use oil to generate electricity. However, gas prices tend to move in the same direction as oil prices. Some offtake contracts pass through price increases. In those cases, the burden will be on power purchasers to find the extra money to cover the higher costs. Other contracts may not properly track fuel price changes. In those cases, the burden is on the power supplier. “Decreased net revenue associated with higher fuel and other input prices will reduce coverage ratios and may trigger cash traps” in loan agreements, Lynne Gedanken said. Higher transportation costs due to problems with insurance cover or lack of ships are another cost that will fall differently on the parties depending on the contract terms in particular deals.
“The problem of insurance will re-emerge with a vengeance even more so than after the September 11 tragedy,” said Noam Ayali in the Washington office. Ayali said he suspects that US and UK developers may want the cover of a multilateral agency when doing projects in developing countries where the US might be unpopular because of the war. He also expects the burden will fall on multilateral lending agencies and export credit agencies — rather than private insurers — to come up with creative new ways to address the risk of political violence. “This may lead to interesting developments in the agency products, risk allocation, and interaction with the private sector.”
Two US tax credits — one for windpower and the other for landfill gas and synfuel projects — are linked to energy prices. One is a so-called section 29 credit of $1.083 an mmBtu for producing landfill gas or synthetic fuel from coal. If oil prices return to levels reached during the Arab oil embargo in the 1970’s, then this credit would automatically phase out. However, the phaseout is tied to the average annual wellhead price for domestic crude oil in the United States. The average domestic oil price would have to reach $49.15 a barrel for an entire year before a phaseout would start.
The other credit is a so-called section 45 credit of 1.8¢ a kilowatt hour for generating electricity from wind. This credit could also phase out automatically, but the phaseout for it is tied to domestic electricity prices and not to oil.
One executive said he hoped, with the potential for renewed volatility in energy prices, that California officials might see the folly of moving so quickly to burn bridges to merchant power suppliers by tearing up contracts. The state signed long-term contracts to buy electricity last year during the period power was in short supply and then quickly regretted locking in electricity purchases when prices were at a peak.
Renewable energy companies hope that the reminder that oil supplies are uncertain might give an additional boost to renewable energy. However, The Washington Post reported on September 29 that the possibility of war with Iraq and disruption to oil supplies appears to have had no effect on the energy policy debate in Congress. Both houses of Congress have passed a national energy bill and are working to reconcile differences in the two versions before Congress adjourns for the year in early October. At this point, Gene Peters, chief lobbyist for the Electric Power Supply Association, said, the conferees will be happy just to have anything they can call an “energy bill” regardless of content. The Senate version of the energy bill would require US utilities to ensure that at least 10% of the electricity they supply is from renewable sources by 2020. However, the odds for this renewables mandate have not been affected by the talk of an Iraq conflict, Peters said.
Jack Greenwald, a former Chadbourne partner now practicing law in the Middle East with Greenwald & van de Kraats, reported from Dubai that it is business as usual — at least for now.“Our legal practice has been as busy as previous Augusts and Septembers, as business in Dubai tends to be driven more by Dubai events than by tensions elsewhere in the Middle East. The members of the American community here are not noticeably nervous or keeping their bags packed,” he said, but an outbreak of war in the region would probably lead the US Navy to evacuate Westerners and their dependents.
by Keith Martin, in Washington