Last week, Nick spent two days in the Kurdish Iraq cities of Arbil and Sulaimaniyah (1), meeting officials from the private, public, and educational sectors. This is not the Iraq you know about. There's little violence or crime here. You can walk the streets safely. There is near universal appreciation that the US invasion significantly improved the fortunes of the Kurdish region. Total coalition deaths since March 2003 in the three governorates in Kurdistan total exactly two soldiers (2). During the entire trip, we never felt in danger, other than when riding in a car, given the propensity of our drivers to travel at high speed, a common frontier market trait. In fact, Nick was far more uneasy and on edge one week earlier when he spent a weekend in Venezuela, where crime and lawlessness are on the rise, than he was in Iraq. We travel to exotic places to see firsthand what conditions are like, and almost invariably we find that things are not as bad as what you hear and read from far away. This held true in Iraq, where we have about 1% of our fund invested. To be fair, we did not venture outside of Kurdistan. We did not travel to neighboring Kirkuk or Mosul, which have mixed Arab/Kurdish populations where violence has been high. Moreover, we did not venture to Baghdad. Thus, we only saw a portion of the country, and clearly it is the safest portion, and not yet representative of the country as a whole. Nevertheless, it offers an inspiring glimpse of what is possible.

The Other Iraq - An Unmitigated Success Story to understand where we were, some statistics, geography, and history are in order. Iraq's 31-million-person population is comprised 75%-80% of Arabs, 15%-20% of Kurds, with Turkmen, Assyrians, and others compromising 5%. These groups all follow the Muslim religion, with 60%-65% being Shiite Muslims, 32-37% being Sunni Muslims, and 3% following Christian or other religions. Effectively, then, there are three main sectarian groups: Arab Shiites, Arab Sunnis, and Kurds. Iraq has 18 governorates (i.e. provinces or states). From 1970 onward, three governorates in the northeast, Arbil, Dahuk, and Sulaimaniyah, formed the Kurdistan Autonomous Region, giving Kurds some self-government. We refer collectively to these three governorates as Kurdistan in this Observer (5).

In reality, though, prior to the first Gulf War in 1991, Saddam Hussein effectively controlled the Kurdish parliament. After that war, Kurds rose up against Saddam Hussein and Hussein retaliated harshly, as he had done previously in a late 1980s genocidal campaign where he used chemical weapons against Kurdish populations (6). This time, the US-led coalition put a stop to Hussein's aggression, implementing a no-fly zone over the northern and southern parts of Iraq (7). While the US reduced Hussein's influence, not all was peaceful. The two different Kurdish political factions, the KDP and PUK, controlled different territory and fought against each other during the 1990s, occasionally drawing the Iran and Iraqi government troops into the fray. Further, the central Iraqi government invested little in the Kurdish region. Change began with the March 2003 US invasion. Kurds celebrated the toppling of Saddam, and despite two significant bombings, one in 2004 and one in 2005, the region never descended into the looting and violence that occurred throughout the rest of the country. The 2005 Iraqi constitution explicitly recognizes Kurdistan as a federal region. The following year the KDP and PUK formed a unity government to lead the Kurdish Regional Government (KRG). With immediate political matters settled and peace at hand, investment has begun to flow into the region. Signs of construction were present throughout Arbil and Sulaimaniyah, with firms from neighboring Turkey the most prominent (9). Optimism and enthusiasm for Kurdistan's future are high among everyone we met with. The KRG has a long list of desired infrastructure, education, and healthcare projects. Importantly, they now have the means to pay for them as they receive 17% of Iraq's oil revenue, a formula based upon its population relative to that of the entire country.

Travelogue Given the general interest in what it is like to travel to Iraq, we devote more space here than usual to the trip itself. Later, we provide further analysis on the political and security situation and the state of the stock market.Our party of seven met at the airport gate in Istanbul, Turkey on a Sunday morning for the two-hour flight to Arbil, on Atlasjet, a Turkish carrier with four weekly flights to the Kurdistan capital. Other carriers provide service to Arbil from cities such as Bahrain, Beirut, Damascus, and Vienna, along with a few Iraqi cities. Arbil's airport opened in 2005 and the KRG is presently expanding it. Americans do not need a visa to fly to Kurdistan, even though a visa is necessary to visit the rest of Iraq. Among our group were David Grayson, co-founder of Auerbach Grayson, a New York-based agency broker; Shwan Taha, owner of Rabee Securities in Iraq, and a former portfolio manager with Soros Fund Management and Templeton Asset Management; Erin Burnett, a CNBC anchor in the US; Erin's producer, the Los Angeles Bureau Chief for CNBC; an emerging markets investor from a multi-billion-dollar US asset manager who had not yet invested in Iraq; a consultant from a global consulting firm with private equity interests in the Mideast; and myself. After we landed at the Arbil airport, KRG representatives instantly whisked us into a VIP waiting area. Tea was served; pleasantries exchanged, small talk ensued. We never saw the inside of the terminal. Eventually, we were led outside to five shiny new Lexus SUVs that took us to our first meeting with the KRG's Chairman of the Board of Investment. Hearing of our trip, the KRG splashed out to ensure they pampered us and made us feel secure. Security was present everywhere, but no more than in other countries such as the Philippines. Checkpoints were numerous, but fewer than in Sri Lanka. Our suspicion is that the security presence will linger far beyond its need, this is probably already the case in Kurdistan-both due to inertia and as a means of providing employment. While the security provided a reassuring presence, by the end of the trip we doubted it was necessary. In Arbil, we had a rotating mix of handlers, drivers, security guards, and liaisons, that at times exceeded the size of our group.

Later in Sulaimaniyah, one of the companies we met with, Asiacell (more on them later), looked after us, and we survived with only two chaperones, one to drive each vehicle, with one of the drivers also being our host. We felt no less safe. Exiting the airport, we saw a large, newly built go-kart racing track and a recently finished conference center. The roads were landscaped, with fountains at the intersections. These are not the signs of civil war. The KRG's Minister of Investment, and for that matter everyone we met with, displayed a genuine eagerness to do whatever necessary to receive foreign investment. Their attitude contrasted sharply with the more standoffish approach we experienced last year while visiting Angola, another post-conflict oil-rich country, which actually is in greater need of foreign investment than Iraq. Running with the Moose At our first meeting, an eighth person joined our team, an NBC camera operator from Egypt, nicknamed Moose. Moose was constantly filming everything, always running ahead to get a shot of us entering or exiting each meeting or rounding every corner at a place we toured. At times, it was as if we were in a reality show on The Travel Channel. From these hours of footage, CNBC will air a several-minute feature on Iraq next week, eventually making it into a 30-minute special. Large corporations being what they are, NBC insisted on their own security, swelling our already large party with several additional people. As you might imagine, NBC's Western ex-special forces type security personnel from Baghdad and the local KRG guards each had their own methods and views on how to handle things, providing some insight of how difficult it must be for the coalition and the Iraqi military to coordinate issues where more is at stake.

In Sulaimaniyah, we met with Asiacell, one of three mobile phone operators in Iraq and the largest by revenue with just under half of the market. The most recent license auction in August 2007 requires that Asiacell list 25% of their shares on the stock market within four years (10). With $1 billion in revenue and a 49% EBITDA margin, Asiacell would have a multibillion-market cap, making it about as big as the rest of the Iraqi stock market combined. Asiacell is majority owned by the Faruk Group, with Qatar Telecom (Qtel) holding a 30% stake. Several Middle Eastern public companies we know from their listings in their home markets, like Qtel, have significant minority investments in Iraqi companies, providing useful foreign capital, knowledge transfer, and oversight. Additionally, HSBC owns Dar Es Salaam Investment Bank, the largest company by market cap on the Iraqi exchange.The Faruk Group is likely Iraq's largest holding company with diverse interests in telecom, cement, housing, healthcare, and other areas. Eventually, we expect it may list several of its subsidiaries other than Asiacell, or perhaps even the group itself, further growing Iraq's capital markets. Roaming on the Asiacell network, our mobile phones worked fine in Iraq, although we could not receive e-mail. Asiacell told us that they would introduce local Blackberry service in mid-2010, while an agreement to provide e-mail roaming to US AT&T customers will be available before then. With regard to other travel conveniences, credit cards are not widely used, although we did notice some Master Card/Maestro signs and ATMs. One of our two hotels took Master Card; we paid and received change in US dollars at both as we carry only Visa, which had no presence that we saw. In-room internet service was available in each hotel via a LAN cable. The connection was fast enough to make a good quality Skype call. Upon departure, the airport at Sulaimaniyah had the tightest security that anyone in our group had ever experienced. At the airport entrance, everyone had to exit every car while bomb-sniffing dogs searched each vehicle. Further ahead, but before the terminal, guards screened and searched your baggage. You went through security again at the terminal. The checks were lesser in number, but more thorough and more efficient than the multi-step, overly bureaucratic security that India employs. Still there were cracks in the process. Although guards searched every car at the airport entrance, they waived through a garbage truck without a check. Further, screeners allowed liquids to pass through security at the terminal. The Sulaimaniyah airport also opened in 2005 and has service similar to that in Arbil. The KRG is also expanding this airport. We again flew Atlasjet to Istanbul. Investment Considerations Our trip had fewer company meetings than normal. One of the participants commented that the kebab-to-meeting ratio was rather high, referring to the generosity of our various hosts in taking us to well apportioned meals featuring local cuisine. The Iraqi custom appears to be that it is rude to serve any less than three to five times the amount of food that could we could actually consume at one sitting. The paucity of company meetings was okay, though.

This was a trip to gain an impression more than one to perform in-depth company analysis. Logistically, the companies are in Baghdad, and as adventurous as we are, we're not quite ready to travel there. As we've said in our monthly comments, we view our Iraq holdings as an option. We expect to make several times our investment, but we are prepared to lose it all. Overall, we think the risk/reward is favorable, but we stress that the risk is high. Unlike the rest of our portfolio, Iraq is exclusively a macro bet. We've taken a basket approach, holding numerous positions that we view as one position: Iraq equities. Our advantage is that we are early, we are one of the first US institutions to invest. Nevertheless, the market has already worked through many of the issues common to new markets. The bourse reopened as the Iraq Stock Exchange in 2004 after the previous Baghdad Stock Exchange closed in 2003. We've followed the market since our inception in 2007, and observed numerous advances since then. They include the market opening to foreigners, dematerialization of paper shares to electronic shares, the switch from whiteboard trading to electronic trading, and the emergence of a reliable broker, Rabee Securities, who understands the needs of Western investors. A few months after an acquaintance of ours in Turkey introduced us to Rabee, Auerbach Grayson, the agency broker with the largest global network, further validated Rabee when they selected them as their Iraqi partner. This trigger caused us to invest in Iraq in July 2009. The economic statistics box on page 2 merits comment as Iraq's projected fiscal and current account deficits for 2009 are horrendous. This is likely only a temporary condition. Both were solidly in surplus in 2008 and the IMF projects the fiscal balance to be in surplus in 2012 with the current account to follow in 2013. At its early stage of recovery, Iraq's figures are quite volatile and thus this year's data does not bother us as it would normally, considering the country's vast oil reserves. Still, we would become alarmed if the projected improvements do not materialize. This does bear watching. Iraq has benefited from substantial debt relief and some further debt relief reduction from the figures shown is possible.

Market Microstructure
To date our experience has been this. Account setup took about one week. In other frontier countries, this process runs anywhere from one day to many months. Overall, the process was smooth and worked as advertised, with no surprises. Trading is straightforward. Liquidity varies, with banks being the most liquid. Industrial and agricultural companies are illiquid. The market trades between $1 million and $2 million most days, with trading occurring three times per week on Sunday, Tuesday, and Thursday. Earlier this week, though, the exchange announced they would expand trading to five days per week next month. Total market capitalization is $3 billion. These liquidity and market cap figures, while low, are already above some markets we trade, including many in Africa. Commissions are extremely high at 4%; double what we pay in the next highest market, Zimbabwe, and about four times what we pay across all countries. This will decline with time. Wiring cash into the country takes only a few days—more quickly than what we would expect considering the money passes through four different banks. Foreign exchange (FX) rates are good, slightly above the official rate, so there is no negative FX slippage (11). The wiring/FX process is more efficient than what we experience in African frontier markets. Iraq is the one country at present where we do have counterparty risk, in that if our local broker set out to defraud us, they could. Trading through Auerbach Grayson mitigates this risk somewhat. A central securities depository holds our stock, while North Bank, an Iraqi bank, holds our cash. Rabee has power of attorney over this account. All trades must be prefunded. Tanzania is the only other country in our portfolio with this requirement, although there are other emerging and frontier countries that require pre-funding. We get monthly statements from Rabee within a couple days of month end. Unresolved Issues Some political loose ends do remain in the Kurdish regions, most notably those related to Article 140 of the Iraq constitution. This will determine who governs Kurdish areas, such as Kirkuk and Mosul, which are presently outside of Kurdistan. The central Iraq government has already delayed the referendum to decide this several times. This issue is complicated by Hussein's historical Arabization of these areas (Arabs encouraged to move in, while Kurds were forced out), and wording in the constitution that the distorting effects of Arabization are to be accounted for with regard to any vote. If this seems an intractable issue to resolve, add to the mix that these areas in question are prime oil-producing locations. One can see that this could be a decades or generations long source of conflict like Israel and Palestine, but with oil. Kurds want Kirkuk and Mosul within Kurdistan and Arabs do not. Unlike the Israel and Palestine analogy, however, there may be a third way. These mixed Kurdish/Arab regions could become their own separate autonomous region, just as Kurdistan is now. Our stay was far too short to appreciate all of the nuances of this issue, but this middle way might be the only solution acceptable to both Kurds and Arabs, even though it would not be the first choice of either.

While the Kurdish dream is for the mixed areas to join Kurdistan, we wonder if that would upset the tranquility they now enjoy, by bringing conflict and violence into Kurdistan. Of course, Kurdish politicians cannot state that they favor any position other than the expansion of Kurdistan (12). US Presence Another key question of debate is what happens when the US forces leave. The present schedule has them doing so by the end of 2011. Although recent talk in both the US and Iraq has entertained an even earlier departure, say mid-2010, one only needs to look around the world to see US forces still in Germany, Japan, and Korea to realize that the other extreme, an extended stay, is also likely. To us, though, the question is not one of when the last US soldier leaves (likely after 2011), than one of when does the magnitude of the US presence greatly diminish. The present weak fiscal condition of the US (13) combined with low public support for an extended presence makes the near-term dates (either 2010 or 2011) realistic, we think. The US already pulled out of Iraqi cities at the end of June 2009. Prominent attacks after this caused some diminished enthusiasm on the Iraqi side for a further reduced US presence. Nevertheless, despite these well-publicized attacks, overall violence in Iraq has markedly declined since the mid-2007 peak as the nearby graph shows. In short, the 2007 surge, along with other factors, worked, and it is premature to say that these gains are being reversed. It is also premature, however, to say that no reversal can occur.

The Kurdish Iraqis we talked with generally hope the US stays, but saw this as more of an issue for the rest of the country than for Kurdistan. In fact, the one person we met most adamant that the US should leave was an American civilian in Iraq, who thought the US departure would force Iraqis to take more ownership of their country. The most pessimistic outlook we heard came from Western security personnel based in Baghdad. They saw a return to past levels of violence once the US left. Our view is this. We think most US troops will probably depart within the two years as planned. There's some chance this timetable could stretch out a bit longer, say until just before or just after the 2012 US Presidential election. Any longer presence for large numbers of US troops may have to involve a pay-to-stay arrangement where, following the precedent of the first Gulf War, foreigners pay for US military costs. In this case, most likely Iraq would foot the bill from their oil exports. We don't think the US has the will or the means to pay its own way for a large-scale extended stay. Whenever the US presence does scale back, we expect increased violence. The reporting will be that Iraq is descending back into chaos, and for a while that may appear to be the case. But we expect the violence will eventually ebb again and the country will resume its recovery, an event that will be greatly underreported. Such violence is unlikely to affect Kurdistan, which we expect to continue its rapid economic advancement. The Article 140 issues probably will not be resolved anytime soon and represent a wildcard that carries more downside than upside, we fear. If either side, Arab or Kurd, tries to force their will on the other, they could disrupt the tranquility in Kurdistan.

Overall, though, the situation is very fluid, and anything is possible, we think our optimist scenario here has about a two in three chance of prevailing. The next significant political milestone is the January 2010 parliamentary elections. We expect increased violence around these elections. We do not think the investment case for Iraq relies on the country doing anything brilliant, however. Consider their last three decades of history: Iran-Iraq War 1980-1988; Kuwait invasion 1990; Gulf War 1991; sanctions and various additional US military strikes 1990-2002; US-led coalition invasion 2003-present, with a decrease in violence beginning only in the second half of 2007. It's no wonder that Iraq produces less oil now than in 1980. Iraq has the world's fourth largest oil reserves behind Saudi Arabia, Canada, and Iran, but its production ranks only 13th due to underinvestment. Further, how much oil lies undiscovered since there has been little exploration for the past three decades? All we think Iraq needs to do is move away from decades of destructive warfare and crippling sanctions and toward some form of normalcy and recovery. If it can do that at which we grant is not assured, but which ought to be more likely than not we think our Iraq investment will be successful.
Sunday / October 18 / 2009