Iraq’s Insurgency and the Threat to Oil

Oil markets are finally rattling after militants from the Islamic State of Iraq and the Levant took over a series of key Iraqi cities Tuesday and Wednesday, including the country’s second largest, and reportedly surrounded Iraq’s biggest oil refinery.

The insurgent drive poses little immediate threat to oil production or exports from OPEC’s second-largest producer, which explains why oil prices haven’t exploded. But Iraq’s disarray, coupled with a series of stubborn crude-supply outages in Libya, Sudan, Nigeria, and ongoing sanctions on Iranian exports, portends a summer of high oil prices with potentially dire effects on the global economy.

Depending on Iraq’s ability to rally its own security forces and successfully fight the group, the uprising could also upend Baghdad’s plans to increase oil production in other parts of the country and assert control over exports in the semi-autonomous northern region of Kurdistan. All that becomes hugely important when global oil markets are looking at growth in Iraqi production as the great hope to keep the world fully supplied.

"Iraq needs to deliver; it’s as simple as that. This is not good, irrespective of whether there’s a short-term impact or not," said Amrita Sen, an oil markets analyst at Energy Aspects Ltd, an energy consultancy in London. "You need a lot of incremental supply increase from Iraq, which the current dynamics are saying is not going to happen," Sen said.

The insurgent group, known as ISIL or ISIS, pushed Iraqi security forces out of Mosul — the second-most populated city — on Tuesday before driving further south to take Tikrit, Saddam Hussein’s hometown. On Wednesday, the group seemed to have taken over the Baiji refinery, the main domestic source of Iraq’s refined petroleum products.

After initially shrugging off the attacks, oil markets started to worry a bit Wednesday. Prices for Brent crude traded in London rose slightly, to just under $110 a barrel; crude traded in New York also inched up to about $105 a barrel in early trading, before slipping a bit in the early afternoon. Oil markets got no relief from OPEC, which concluded its regular meeting in Vienna pledging to keep output the same.

If oil prices haven’t skyrocketed even higher on news that a group so bad that even al Qaeda fights it has taken over a big chunk of territory in one of the world’s biggest oil-producing nations, that’s because Iraq’s oil production and exports are mostly in the south, far from the offensive. Iraqi government officials said Tuesday that the state of emergency declared after the Mosul takeover won’t affect Iraqi exports.

One reason: The 400,000-barrel-per-day northern oil-export pipeline that snakes past Mosul on its way to Turkey has been out of commission since March because of terrorist attacks anyway, so the ISIS offensive hasn’t taken any additional oil out of the export market yet.

In May, Iraq notched a near-record level of crude exports out of its Persian Gulf terminal in Basra, though overall Iraqi exports are still below the 2.8 million barrels a day reached earlier this year because of the damaged northern pipeline. Ongoing repairs on the pipeline have been disrupted because of the ISIS offensive, raising questions over just when that export route will again be safe and operational, despite Iraqi promises Wednesday that repair work continues.

But the bigger concerns are two-fold: The ISIS offensive comes at a time when global oil markets could soon look tight due to supply disruptions in a number of big producers, and it could have important knock-on effects on Iraqi oil production over the medium term.

Although OPEC seems content with global oil supplies, that’s largely because of continued growth in U.S. oil production, which has risen more than 1 million barrels a day since the beginning of last year. But traditional suppliers are faltering: Libyan oil production has fallen to about 10 percent of levels before militants took over eastern areas of that country; South Sudan’s modest oil production has roughly been cut in half by the civil war there; and Western sanctions are keeping roughly 1 million barrels of Iranian oil off the market.

Even before the latest news out of Iraq, oil-market observers were counting on Saudi Arabia, the world’s swing oil producer, to churn out record levels of crude later this year to cover the supply shortfall. It could be hard-pressed to make up those missing barrels and any additional Iraqi oil taken off the market by ISIS. And whatever effort Saudi Arabia makes will ensure that oil markets are tauter and jitterier later in the year, magnifying the price fallout of geopolitical disturbances.

If the Saudis produce an additional million or so barrels a day, "there is no spare capacity in the system. So ultimately, the situation is very, very bullish" for future oil prices, Sen said.

So far, other than the city of Mosul, the insurgents have steered clear of eastern Kurdistan, which is trying to ramp up its oil production and which has often touted its relatively better security situation as a way to attract foreign investment. One concern is that, if the militants turn east, they could threaten Kurdish oil fields and take out some Iraqi production.

For now, companies operating in the region appear calm. Chevron said, "Our activities continue as normal in the region." A spokesman for Genel Energy, a Turco-British firm operating in Kurdistan, said that because ISIS is apparently avoiding taking on Kurdish forces directly, "There should therefore be no disruption in oil production or shipment on the [Kurdish] side."

However, Baghdad’s efforts to fight the militants could have knock-on effects on the huge oil fields in southern Iraq that account for the bulk of Iraqi output. Every time the Iraqi government moves troops from the south to fight militants in other parts of the country, oil companies’ operations are disrupted because of security concerns. In fact, Sen said, the increased cost of security is undermining the appeal of Iraq’s massive and easy-to-extract oil reserves.

The ISIS offensive could have another, longer-lasting effect on Iraq’s oil sector. For months, Baghdad and the Kurdish region have been at loggerheads over Kurdish plans to export oil directly to Turkey; the central government says all Iraq’s oil belongs to it, while the regional government
figures direct oil exports are the only way it can get a fair share of Iraq’s oil wealth. Just before the ISIS attacks, in fact, Baghdad had threatened Kurdistan again over its oil exports.

All that could change if Baghdad has to call in the Kurdish cavalry, in the form of hardy Kurdish peshmerga troops, to quell the uprising. Some former Iraqi officers have already said the peshmerga, experienced in fighting guerrillas, are the only option; Iraq’s foreign minister said Wednesday that Iraqi and Kurdish troops could work together to recapture Mosul.

If Baghdad has to rely on Kurdish troops to end the ISIS offensive, that could well soften Iraq’s attitude toward Kurdish oil exports. It may not be great for keeping the country’s coffers full, but might be just the thing for keeping the country itself.