Further Social and Political Fragmentation and Descent into Civil War in Iraq Could Send Global Oil Prices Skyrocketing

Further Social and Political Fragmentation and Descent into Civil War in Iraq Could Send Global Oil Prices Skyrocketing

The current crisis in Iraq is a sobering reminder of the vulnerability of the United States to the inherent instability of the global oil market.

The situation in Iraq has deteriorated rapidly over the past week, with significant implications for regional security and oil markets. Sunni militants aligned with former Baathist elements and tribal groups have captured major portions of Iraq’s north and west over the past month, culminating in the fall of Mosul last week. Though the militants’ progress toward Baghdad has slowed, the Islamic State in Iraq and Syria (ISIS) continues to capture new territory in the north, solidifying its gains. In Iraq’s Shia south, militias have formed to augment government forces in preserving security. Meanwhile, Iraqi government forces have ceded significant control over the Kurdish autonomous region, raising the specter that the country is dividing into three homogenous political units.

Near term oil market implications are potentially serious. Crude exports from Iraq’s Kurdish north, which were as high as 460,000 barrels per day in 2009, were effectively ceased on March 2, contributing to total global oil supply outages of 3 million barrels per day (mbd).  Nearly 100 percent of Iraq’s 2.5 mbd of crude exports currently exit the country through its southern oil complex centered on Basra. While the predominantly Shia south has remained relatively secure, political disintegration in Iraq along sectarian lines would add to the current oil price risk premium and the potential for significant upside would remain.

Any meaningful disruption to Iraqi crude exports would lead to a sharp elevation in oil prices. OPEC spare production capacity currently stands at just 2 mbd, according to the Energy Information Administration (EIA), with the bulk concentrated in Saudi Arabia.  While this buffer could replace a portion of lost Iraqi exports, this must be placed in context. Numerous global market forecasts suggest that OPEC—principally Saudi Arabia—will already have to pump an additional 900,000 barrels per day in Q3 2014 versus April levels to meet rising global demand.  Therefore, the loss of even one third of total Iraqi production—1 mbd—would essentially eliminate global spare production capacity. In that event, oil prices would likely reach or exceed the highs reached in July 2008. This is consistent with prior work by SAFE and the Commission on Energy and Geopolitics, which found that the loss of 1 mbd of Iraqi oil supplies in 2014 would generate an oil price increase of $37 per barrel relative to the base case.

Longer-term market implications are potentially more concerning. It is difficult to overstate the importance of Iraq to the long term outlook for oil markets. In its baseline scenarios, the International Energy Agency (IEA) forecasts Iraqi crude oil production to grow from 3.3 mbd in 2014, reaching nearly 6 mbd by 2020 and nearly 8 mbd by 2035.  Between today and 2020, the IEA expects Iraq to account for 60 percent of the increase in OPEC crude oil production capacity.  After 2020, Iraq accounts for the majority of oil production growth within OPEC, is the major driver of crude oil production growth globally, and is effectively a necessary component to meeting rising global demand growth in an even modestly cost-effective way.