Critical Review of UNCC Award for Lost Production And Lost Reserves

0
87

A UN panel has recently awarded some $15.9 billion to Kuwait as compensation for oil which was “lost” as a result of the Iraqi invasion. That sum is implausibly large, given facts available from the public domain. It is not contested that reserves were burned off or that Kuwait’s oil production was throttled down é the issue is the magnitude of the economic losses, not the fact.

The report was produced by the UN Compensation Commission (“UNCC”), the body established after the Gulf war with the mandate to determine the reparations to be paid by Iraq to all parties. This report, analyzed here, deals specifically with the losses suffered by Kuwait because production was reduced during the occupation and as a result of oil field damage and, secondly, for the loss of the reserves which were burned off.

Actual damages to Kuwait are overstated by at least $12 billion The Panel made major errors in its calculations. We present here an independent recalculation of Kuwait’s losses in that matter. This estimate is based entirely upon public sources. The UN treats all documents, calculations, and consultants’ studies as confidential, even though the underlying information may well have been in the public domain. Thus, a direct test of the UNCC’s arithmetic is impossible.

Nonetheless, by drawing upon the sketchy data in the published text of the report itself and upon other data from public sources, it is possible to check the credibility of the UNCC’s report. We shall show that the Panel seriously overstated the damages suffered by Kuwait. It is estimated here that the quantum of damages, determined by the UNCC, is at least four times too high.

The largest errors can be traced to two conclusions made by the Panel which are readily subject to verification:

The UNCC Panel concluded that Kuwait did not produce more oil after 1992 than it would have if there had been no invasion. More specifically, the Panel concluded that Kuwaiti output after 1992 was not higher than it would have been if Iraq had not been sanctioned.

This is demonstrably incorrect. Kuwait, together with other OPEC members, increased its oil output, taking advantage of the void left by Iraq, which was unable to export oil until well after the end of the war..

The Panel also concluded that any oil reserves which were lost would otherwise have been produced immediately, i.e. lost reserves reduced production instantaneously, barrel for barrel.

This is technically false. A reduction in reserves is manifested in low production only over time and often with considerable delay.

These two major elements in the calculation of damages trigger immediate concern. In both instances simple, back-of-the-envelope computations suggest that each of the errors results in serious overstatement of the losses. The bulk of the damages were associated with two separate claims é one for lost production and the other for lost reserves. We discuss each in turn.

The first part of the claim is for revenues lost while production was reduced. The UNCC determined that Kuwait lost $14.8 billion because its production and exports were reduced after the invasion by Iraq in August 1990.

It is correct that production was lost, but that is incomplete. Kuwait subsequently gained extra production and exported extra volumes as a consequence of the truce/peace terms.

The countervailing advantage é the extra production exported later — must be included in the calculation of net damages. The later “gains” are an offset to the earlier, direct losses. This was not reflected in the UNCC report, where it appears that the panel truncated the analysis of impacts prematurely. UNCC expressly articulated the principle that gains can offset losses; it accepted the principle that such later gains must be considered as an offset — but it then failed to factor those gains into the calculation. It stopped calculating impacts precisely at the point in time when Kuwait began to profit from the sanctions against Iraq, i.e. when its production exceeded its pre-invasion share of OPEC’s production window.

The blow-out damage was also overstated. The panel erred in calculating the opportunity cost of the oil which had been burned off during the period while the well fires were being extinguished. It valued the lost reserves as if they were immediately producible, even though those lost reserves affected only “tail-end” production.

It is incontestable that significant volumes of hydrocarbons were irreversibly lost. It is also highly probable that some irreversible damage had been done to the reservoirs. This damage could at some point limit maximum production in the future. The economic question is the value of those volumes, not the fact of their having been burned off.

Any such losses would have been producible only in the remote future. Kuwait’s oil reserves are very large é even without considering additional volumes which might be discovered in the future. The existing, proven reserves reported by the Government suffice to cover more than 100 years of production at current levels é i.e. some one percent of total official reserves were lost.

Thus, a barrel of reserves “lost” today is not an immediate loss. The physical effect is immediate, but the financial impact is deferred. Such lost reserves in the case of Kuwait would have been expected to be produced only many years from now. The present value of such remote barrels must be estimated in the light of several factors which were not duly weighed in the UNCC award:

Reasonable ranges for these factors are consistent only with a low, net present value for an incremental barrel of reserves under Kuwaiti conditions. The present value of such losses accordingly is quite small é again, a conclusion which is specific to circumstances such as those in Kuwait where most reserves will lie fallow for many years.

Elements of Damages - Critical Review of UNCC Award to Kuwait for Lost Production And Lost Reserves during Gulf War with Iraq

The major elements in the damages and the time periods when damages were incurred or gains were enjoyed are displayed in Figure I. The figure is stylized in order to highlight the key relationships é “when” and “how much” happened to “whom”. The lost production is seen as the dip in years 3 through 5. The stippled area shown first above the baseline is the production which made up for the loss during the “dip” period. This is deferred production, so that Kuwait’s loss on these volumes is the interest cost of the income which had been forsaken while production was stopped or reduced in the aftermath of the invasion.

The next component of additional production is shown as the cross-hatched area. That is “accelerated production”. It is the production which constituted the countervailing advantage é the “extraordinary profits” due to Kuwait’s ability to capture part of Iraq’s market share once its own production capacity had been restored.

These are the extra volumes which Kuwait produced, after making up for lost production, while Iraq was still “off line”. That quantity is shown as decreasing over time, which reflects the fact that Kuwait, along with other OPEC producers, have been forced to reduce its market share back towards prior levels in order to make room for Iraq, once Iraq’s production began to resume under the “oil-for-food” programme. The “countervailing advantage” still continues, since Iraq’s production is constrained by lack of equipment and spares. The figure shows that advantage declining towards zero, recognizing the likely scenario that Iraq ultimately resumes its historical place within OPEC.

That “extra” production is accelerated production é it represents volumes which would otherwise have been produced at the end of the reservoirs’ lifetimes. In the figure the arrows show how that volume was advanced in time. The value to Kuwait for this component is the interest gained by producing earlier, rather than later. These two elements make up the PSL claim é damages due to deferral of income and profits due to accelerated income. The two elements are in opposite directions, so that the extra income very much reduces the initial losses from reduced production.

Finally, the figure also shows the reserves which had been burned off during the “blow-out” period. The loss of these reserves impacts production only very late in life. The physical loss is immediate but the economic loss is deferred. The economic loss is the present value of that production, discounted back from the time when producibility would have impaired because of lost reserves or reservoir damage.

The Panel committed two further errors é but in the opposite direction, i.e. errors which resulted in an understatement of the damages. One of the errors leading to an understatement of damage can be quantified é the “missing” barrels. The other é reservoir damage — can only be highlighted, since quantification relies upon reservoir models which the Panel has kept in camera.

A third error was in the other direction é in favour of Iraq and understating the damages suffered by Kuwait. In trying to quantify the financial loss the UNCC’s report undercounts the number of barrels which were burned off. This leads to an understatement of that element of the total damages. There were thus two errors in the calculation of “blow-out” losses, i.e. the value of the burned off reserves: 1) one one hand, the Panel overstated the value, not noting that the barrels would have been producible only much later; and 2) one other hand, it lost track of 90 percent of the barrels. The net effect is that it understated the losses to Kuwait.

The volumetric arithmetic is opaque. The Panel had determined that 912 mn barrels were lost during the well blow-out period; this was a smaller volume than claimed by Kuwait. The Panel had identified errors in Kuwait’s submission and scaled down the volume accordingly to 912 mn. However, the Panel then proceeded to reckon the financial loss based upon only 79 mn barrels, a very much smaller number.

The logic underlying this step can only be inferred. It appears that the Panel misunderstood the difference between production, producibility, and reserves. Predicated upon that misunderstanding, the Panel seems to have thought that the “missing” barrels, i.e. the 835 mn, were some of the same barrels which would have been produced in 1990-92 in the no-invasion scenario. These were excluded to avoid what the Panel seems to have viewed as possible double-counting. From the figure, one can see which barrels were lost or gained when, an overview which is not reflected in the report, where pieces were discussed separately, leading to the failure to keep track of all of the separate pieces.

D.  Reservoir damage

A fourth error is one of omission, not commission. The Panel omits calculation of any longer-term reservoir damage due to loss of solution gas, bypassed oil pockets, wellbore degradation, or other effects of a large-scale blow-out. The report is silent on this matter; apparently Kuwait did not raise that claim, and the Panel did not itself recognize on its own that the issue could be of concern.

Such reservoir damage was to have been expected. However, this impact was not included in the Panel’s analysis. In the UNCC’s award the only impact upon the reservoir which is quantified is the loss of the oil and gas which flowed to the surface when the wells were out of control. That omission is naéve

Any quantification of this impact is beyond the scope of the present study. It cannot even be approximated without access to detailed reservoir models. We can only note here that this is a possibly serious error of omission in the UNCC’s analysis. Numerically the effect might be small é because the impact might well have been detected only in the remote future, given the large siye of Kuwait’s fields. Nonetheless, the omission is potentially important and must be noted. It cannot be summarily dismissed.

We summarize here the results of rectifying the larger errors which have been discovered in the Panel’s report. We note again that there are four major errors, two in each direction. The impacts are shown separate for each component of the overall computation of damages. The “Fluid Loss” claim (“FL”) is that related to the blow-out period and its consequences. Within that part of the report three errors have been identified.

The “Production and Sales Loss Claim (“PSL”) relates to production income which was lost because of the occupation and subsequent damage to the fields. There only one major error has been corrected.

Three of the elements of loss have been recomputed, eliminating the major errors committed by the Panel, while the fourth é the damage to the reservoir itself é cannot be quantified. It is noted here for the record as an element which should have been reviewed and quantified by the Panel with the resources which it had available.

The corrections are large. If the three quantifiable errors are rectified there results a very much smaller figure for the net damages suffered by Kuwait:

($ billions)

The first two errors are large in the direction of overstating damages, while the third error is relatively large as well, but in the opposite direction. The effect of reservoir damage cannot be quantified without extensive supplementary information, but, presumably, if knowable, would add to the net damage figure.

The rectified damage quantum is very much less é an upper bound for the amount is $4 billion, and it might well be as low as $ 2 billion, or even less. The net loss, as corrected here, lies between $3 and 4 billion. The discrepancy is very large. The UNCC calculated damages of $15,900 million, excluding interest. The difference is at least $12 billion dollars.

The ultimate figure is likely to be still less because of another consideration. The Panel included a large element of lost profits from the refineries. Those profits were predicated upon KPC’s earning very large refining margins. It is far from obvious that such margins were in fact sustainable, given the intense competition in product markets, even allowing for the depth of processing in several. This component has not been analyzed in any detail here, but the adjustment might be as much as another $2 billion or so, further reducing any final, more precise recomputation of the real damages.

The range reflects the range in possible discount rates. Since the panel failed to consider the time periods over which damages occurred, or over which gains were realized, it did not address the choice of discount rates. It perceived all impacts as being almost instantaneous, so that no time cost of money was relevant. Here we make no determination as to the proper discount rate and show the corrected values based upon upper and lower bounds for the discount rates which are likely to have been applicable.

The difference is material. The UNCC panel overstated the quantum of compensation by a factor of at least four. This distortion resulted from a set of errors are simple enough that they can be estimated reasonably accurately using information which is freely available, without any recourse to non-public information.

This analysis is, however, necessarily approximate. It is intended to illustrate the potential magnitude of the UN’s error, using simplified models and the limited data which is accessible in the public domain. The simple calculations suffice to show the magnitude of the errors. Until such time as the UNCC releases its own work papers or consultants’ reports, a more precise rectification of the errors is neither possible nor additionally informative. It remains to be seen whether any of the consultants and experts upon whom the UNCC relied will publically endorse the results with which they could be associated. At the present time the UNCC hides behind the experts, and the experts are cloaked with anonymity.

Notes:

1. Report and Recommendations Made by the Panel of Commissioners Concerning the Fourth Installment of “E1” Claims, United Nations Compensation Commission, 36th Session, Geneva, June 2000 (Document S/AC.26/2000/R.14).

2. This includes the effect of correcting both the volume and discounted value.

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Comment moderation is enabled. Your comment may take some time to appear.