Iraq's economy is on the precipice – reforming the energy sector is a key part of the solution

The publication of the following commentary follows a conversation between the IEA’s Executive Director, Dr Fatih Birol, and Prime Minister Mustafa Al-Kadhimi of Iraq, who recently took office. It examines one of the key topics of their conversation: the major impediments to the development of Iraq’s energy sector and, by extension, its economy.

Already in a fragile state, Iraq’s economy is today facing a major crisis resulting from the impact of the Covid-19 pandemic on global oil markets, underscoring the urgent need for reforms of the country’s energy sector. 

The twin shocks of severely diminished oil demand, caused by the pandemic, and significant oversupply have had an immediate impact on oil‑producing countries that rely on hydrocarbon revenues to finance state budgets and fuel their economies. In a prolonged period of comparatively low oil prices, Iraq is one of the most vulnerable producer countries because of its almost complete dependence on these revenues and paucity of financial buffers to soften the effects of a downturn.

If oil prices stay at their current levels, Iraq’s net revenues from oil will fall by at least 70% compared with last year. The country will run a large deficit of around USD 3.5 billion a month just to pay salaries and pensions and to cover essential expenditures for government operations. The World Bank’s most recent outlook forecasts that Iraq’s economy will contract by almost 10% this year and that the widening of its current account deficit will be among the most severe worldwide.

For Iraq’s energy sector – which is the cornerstone of the country’s economy – two key questions come to the fore: What impact will lower prices have on Iraq’s energy industries? And what lessons can best guide Iraq as it responds to this crisis and seeks to ensure that it is better prepared for future volatility in oil prices?

Examining Iraq’s response to the previous oil price cycle offers strong clues about the measures it will most likely take to cope with its current predicament. When global oil prices started falling in 2014, Iraq reacted by drastically cutting its capital spending. The impacts of these moves were still being felt in 2019 when the national government’s budget remained 20% smaller than it was in 2013. Due to the very limited participation of the private sector across the economy, the major contraction in public sector spending took a toll on virtually all essential services in the country as authorities deferred investments in roads, hospitals and schools.

The energy sector was not immune to these cutbacks. The average annual capital budget allocated to the Ministry of Oil was one-fifth lower in the 2015‑18 period than in 2013, affecting Iraq’s ability to pursue its long-term oil and gas development targets. The effect has been even starker for the Ministry of Electricity, where the budget for capital expenditure is down by more than 60% compared with 2013 levels.

There are preliminary signs that the current downturn in oil prices is already impacting capital budgets in the country. The government has not passed its 2020 budget, and as such, its spending is curtailed at a pro-rated level of 1/12 of realised spending from the previous year. There are also signals that all capital investments the Ministry of Electricity planned for this year have been indefinitely deferred. This puts at risk a slew of much-needed investment in the grid (transmission and distribution losses in the country are some of the biggest in the world) and affects an estimated 7 000 megawatts (MW) of planned generation capacity expansion (over 5 000 MW of combined-cycle gas turbines and 1 700 MW of renewables for which planning had already been conducted).

Furthermore, constrained budgets will call into question Iraq’s plans to capture and use natural gas. Last year alone, Iraq signed deals for an estimated 10 billion cubic metres a year of gas capture, which was to be used to feed its power stations. These projects would have gone a considerable way to reducing the huge volume of natural gas that is currently allowed to escape unused from the country’s oil industry. But any available capital will now almost certainly go towards investment in oil production operations, which are the priority because of the immediate revenues they generate. This means that in the absence of innovative investment agreements with oil-field operators, the plans to capture unused natural gas and put it to work generating electricity will face considerable delays.

The inability of Iraq’s national grid to fully meet demand has been a significant impediment to economic development, with power cuts causing considerable social tensions for many years. In a sense, Iraq’s dependence on oil is affecting its ability to invest in the very infrastructure that will help stimulate the industries and private sector enterprises that are so crucial to achieving broader economic diversification.

The current oil market dynamics suggest that it would be unwise to base an economic reform strategy on hopes that oil prices will recover imminently. There are a limited number of policy levers that Iraq can pull to shore up its current position. Electricity subsidies cost the state around USD 12 billion per year. Equivalent to around five months of total net revenues at current prices, this burden is particularly acute when the country’s fiscal health is as vulnerable as it is now. A carefully studied and well-implemented tariff reform should be an urgent priority for a number of reasons.

Firstly, it will help generate revenues for a sector that has been insolvent for years, making available to the government more resources to reinvest into the system. Secondly, tariff reform would also help send a price signal that could moderate the current high rate of electricity demand growth, which has been increasing at a rate of 10% a year. By mitigating growth and stimulating increased supply, such a reform is key to promoting a more sustainable electricity sector that, in turn, can provide the energy needed for broader economic recovery.

Iraq could consider new incentives to stimulate private investment in natural gas projects. The current model, which favours government financing of large infrastructure projects across the sector, is prohibitively burdensome at times of depressed oil revenues and risks indefinite delays to projects that are crucial to Iraq’s economic development. Iraq could explore mechanisms that would allow investors to market and export the liquids that can be stripped from natural gas that is captured from oil operations. Most of this gas is currently flared or not extracted. Putting it to profitable use would increase the appetite for investment, particularly when domestic natural gas prices are likely to remain relatively low. 

There has scarcely been a more urgent time for Iraq to pursue crucial reforms in its energy sector to ensure that investment continues even when government revenues have been decimated by low oil prices. The alternative of continuing to rely on direct state financing of large projects only increases the risk that these projects are delayed. Given how essential both natural gas and electricity are to economic prosperity in Iraq, such delays should be avoided at all costs. They hold the key to the diversification that would make Iraq more resilient to oil price movements in the future.

As Iraq’s newly formed government begins to tackle the long list of considerable challenges it faces, the IEA stands ready to support the country in its efforts to enact the reforms that will help its energy sector – and its economy – meet its vast potential.