The Iraqi time bomb in the global oil market

Iraq’s energy future looks just as bleak as its future as a viable country. Given that the current political deadlock is likely to continue despite the recent ouster of controversial Prime Minister Nouri al-Maliki, the prospects for energy production in the country are not encouraging at all. The fallout in the global oil market will not be positive either.

In February, Iraqi output was at a historical peak, with oilfields pumping 3.6 million barrels per day (bpd) – a level not seen since 1979. Iraq, however, has witnessed a series of political crises since the 1980s – namely the Iran-Iraq war, the Iraqi invasion of Kuwait in 1990, and the toppling of Saddam Hussein by the US in 2003 – and the country’s oil production has undergone serious disruptions accordingly.

During the US occupation, Iraq’s oil industry struggled to boost output amid widespread sectarian violence. Later, 2009 and 2010 marked a turning point as new contracts for the development of giant oilfields in the south were awarded to major international companies. Since then, firms including BP, Shell, ExxonMobil and PetroChina have invested billions of dollars to revive Iraqi production. In the first half of 2014 Iraq reached an average 3.4 million bpd, equal to 4% of global oil output.

The country has thus become OPEC’s second largest producer after Saudi Arabia. With the fifth-largest proven oil reserves in the world, Iraq is considered one of the last reservoirs of low-cost crude. Furthermore, a conspicuous amount of its resources is still unexplored. The most striking aspect, however, is epitomized by the international expectations for future oil production in the country.

According to a questionable “average scenario” released by the International Energy Agency (IEA) at the end of 2012, Iraq should provide no less than 45% of the global growth in oil production by 2035, becoming a key supplier to big Asian consumers like China. Simply put, this potential “failed State” should increase its oil production from the current level to eight million bpd by 2035. A “delayed scenario” in which Iraq provides only 5.3 million bpd by that date would imply a significant increase in the international oil price, reaching almost $140 per barrel in real terms in 2035 (the current price hovers near $100).

The point is that current levels of Iraqi oil seem hardly replaceable in the global market. Together with the boom in US shale-oil production, growing Iraqi output has helped stabilize prices amid an increasing global demand and serious disruptions in places like Libya, Sudan, Nigeria and Syria. In the first half of 2014 Baghdad exported 2.5 million bpd. Should this oil disappear from the market, joining the 3.5 million bpd that have already been lost due to political crisis in other producing countries, and the 3-4 million that must be brought into production each year just to keep pace with the depletion of existing oilfields, international prices would climb considerably. The booming US output and Saudi Arabia’s waning spare oil capacity simply would not be enough to prevent a spike, in turn endangering the already fragile global economy.

This explains much of Washington’s concern over the deteriorating security situation in Iraq, but the White House is not alone in being worried. With its energy firms holding more than a fifth of Iraq’s oil projects, China is indeed Baghdad’s largest oil client. Beijing has repeatedly expressed anxiety about the upsurge of violence in the country. Anyway, China remains a low-profile political player in the Middle East, despite its reliance on the region for a huge part of its energy needs.

In July and August, oil prices went down a little bit as the offensive of the “Islamic State” (IS)  stopped before reaching Baghdad. The Shiite-dominated south, where the majority of the country’s key oilfields are located, remained unaffected by the fighting. Moreover, Iraq’s oil exports flow to the global markets overwhelmingly from the southern port of Basra, coming from the southern giant fields of Rumaila and West Qurna.

However, IS and other militant groups have been trying to attack the southern Iraqi oil infrastructure for years, and are likely to redouble their efforts in order to cut Baghdad’s revenues. This in turn would prompt the foreign oil companies’ flight as well as the almost certain loss of the $15 billion of investments which, according to IEA estimates, are needed every year in order to ensure the previously mentioned level of production growth in Iraq.

Iraq’s energy wealth is inevitably shaping the conflict within the country. In June, as the Iraqi army fled in front of the IS offensive, the Kurdish armed forces – the Peshmerga – stepped in and took over oil-rich Kirkuk and other disputed areas. Then, they linked the Kirkuk oilfields to a newly-built pipeline to Turkey, which bypasses the Baghdad-owned pipeline running from Kirkuk to the Turkish port of Ceyhan. The latter pipeline has been closed since March, due to repeated attacks by the Sunni militants.

Earlier this year, Erbil increased its own oil production and began trying to sell the crude sent to Turkey abroad. As the Iraqi constitution requires all oil revenues to be funneled through the central government, the Kurdish move represents an overt challenge to Baghdad. This is in fact a real gamble that could encourage Erbil’s ambitions of independence and push toward the partitioning of Iraq, but could even plunge the country in a new civil war.

As for the Sunni regions of Iraq, they cannot count on substantial oil wealth. Nonetheless they own a significant part of the country’s energy infrastructure – particularly, almost the entire length of the Kirkuk-Ceyhan pipeline and the Baiji petroleum complex, including a 310,000 bpd refinery providing roughly a third of Iraq’s refined oil. From the early stages of its advance, IS forces not only tried to seize the Baiji refinery, but it also took control of a number of small oilfields, which in turn began providing the Islamic State with as much as $3 million a day from the smuggling of crude, according to some estimates.

Generally speaking, in a country polarized along ethnic and sectarian lines, each community is trying to sabotage projects that may benefit the others. In such an environment, the endeavour of building a unified energy infrastructure – for instance, the project of an oil pipeline stretching from Basra in the south to Haditha in the Sunni province of al-Anbar, then to Jordan and to its port of Aqaba on the Red Sea – faces huge obstacles. Moreover, oilfields stretching across different provinces are bound to engender legal disputes about ownership. Should Iraq head toward partition, such disputes could in turn provoke fresh armed conflicts as well.