Courtesy Reuters A U.S. Geological Survey satellite image shows smoke rising from the Baiji refinery near Tikrit, June 18, 2014.

Iraq and the Oil Market

How Much Will Prices Rise?

It stands to reason that one of the effects of the turmoil in Iraq will be a change in oil prices. Indeed, the violence in OPEC’s second-largest producer has already sent oil prices to ten-month highs. A recent report from the International Energy Agency (IEA) put it well: “while Iraq’s production is huge, so are the political hurdles it is facing -- and nothing provides a clearer example of that risk than the military campaign.”

Yet this is no time to panic. For one, Iraq is not the only dark cloud hovering over the world oil market. Libya, with its 48 billion barrels of reserves, is pumping a mere ten percent of what it can, the lowest level since September 2011. Sabotage has significantly reduced the flow of oil out of Nigeria as well. And, if Iran and the West can’t reach a deal on Iran’s nuclear program in July, Iran could soon be facing renewed sanctions on its oil industry. In other words, Iraq might be the least of the world’s worries.

Further, despite some weaknesses in production, world oil supply is actually fairly healthy at the moment -- up a million barrels a day over just a year ago. It isn’t because of OPEC. (At a recent meeting in Vienna, OPEC members decided to keep producing 30 million barrels a day, as they have for nearly three years.) Rather, supplies are up because of North American production. In addition, China has diversified its sources of oil imports and stockpiled sizeable amounts of oil in recent months, mitigating the risk of a global shortage from the loss of Iraqi oil production.

That said, if Iraq sees a major supply disruption for a prolonged period -- one that wiped out nearly all of its export capacity over multiple months -- and if other countries in the region continue to see falling production, there are several things that Saudi Arabia, OPEC, and the United States can do to fill the void. Saudi Arabia, the country with the most surplus production capacity, could revert to its traditional role of bringing up extra oil. And, in case of market panic, the United States could release additional oil via its own strategic reserve. Of the two options, Saudi Arabia’s role is more important.

SAUDI SUPPORT

It wasn’t too long ago that Saudi Arabia, the world’s largest oil exporter, was called on to help stabilize the global oil market and contain price increases in the wake of supply shortfalls in Libya. The country increased its production in mid-2011 and then again in 2012. As a result, supply surged and prices started declining after a spike.

This year, too, Saudi Arabia has increased crude oil output to an average of 9.7 million barrels a day, nearly five percent more than the same period in 2013. Even absent added pressure from Iraq, Saudi Arabia will have to continue to ramp up production, since its break-even point -- the price of oil per barrel required for an oil-exporting country to balance its budgets -- is increasing year after year. The kingdom is still sitting on more than 2.7 million barrels a day of unused output capacity -- the result of years of investment in oil infrastructure -- and is committed to adjusting supply as demand requires. No other country could do the same.

Apart from Saudi Arabia, other OPEC countries could play a role in shoring up the world energy market as well -- but on that front things don’t look promising. OPEC members were able to come together to make the recent decision not to change output, but, these days, cooperation is rare. There is no price for oil that suits all the members, since their break-even points vary widely. Those with high points want to see high oil prices, even if very high prices would eventually diminish demand. Those with low break-even points don’t want to see their OPEC quotas being slashed to appease other members.

Barring Kuwait, whose production costs sank in 2013 due to declining investment, the break-even points for all major oil producing countries are estimated to have risen over the last few years. Algeria, Iran, Iraq, and Nigeria all require oil to be above $120 per barrel. As of 2014, Angola, Saudi Arabia, and the United Arab Emirates have a break-even point around the mid-$90 mark. For all of these countries, if oil prices sink, oil production decreases, and expenditures increase, deficits will be eventually settle in.

Beyond Saudi Arabia and OPEC, some have looked to the United States for guidance in the energy market. But the truth is that the United States has little leverage besides diplomacy. For one, the United States cannot match Saudi Arabia’s surge capacity. Although the United States is poised to eventually make billions exporting energy, it has a long way to go before it becomes the supplier of last resort, if it ever does.

Further, the United States’ energy sector does not have a significant impact on Middle Eastern oil markets yet because the United States doesn’t export any oil. Beyond that, the view from the Gulf is that, as the United States is becoming less oil-import-dependent, it doesn’t even need to involve itself in the Middle East as much. Why go to Kirkuk and Mosul when shale plains in Colorado, North Dakota, and Texas beckon? Indeed, there won’t be much for the United States to do if oil markets start to destabilize -- it can deploy its strategic petroleum reserves, which hold about two months’ worth of supply (when accounting for domestic production), but that’s about all.

For now, the Arab Gulf countries will continue to watch and wait as the situation in Iraq plays out. Higher oil prices as well as higher production will provide fiscal support for all. And oil prices aren’t likely to drastically change unless fighting spreads and Iraqi production goes offline for more than just a few months.

INJURED IRAQ

The relatively stable outlook for world oil markets doesn’t translate into good news for Iraq, or the Iraqi government, which depends on oil revenue. The country’s largest oilfields and main export pipeline are in the south, where fighting hasn’t yet spread. But given recent events on the ground -- and since the oil infrastructure was never properly prepared after the Saddam Hussein regime was toppled and would be such a big prize for all the competing groups in Iraq -- even the most recent predictions about Iraq’s future production seem a bit too rosy. As of 2012, the IEA estimated that Iraqi production would grow to six million barrels a day by 2020 from 3.3 million now. But meeting those output targets will be a challenge. The main northern export pipeline between Kirkuk and Ceyhan, in Turkey, has been out of action since it was bombed in March.

And all bets are off if ISIS pushes south toward Baghdad. That will only increase instability in the country and possibly threaten the operations of existing refineries and oilfields. ISIS already controls the 310,000 barrel-a-day Baiji refinery, the country’s biggest. That and other oil and gas infrastructure in ISIS-controlled areas will be vulnerable to repeated attacks, and the risk of disruptions to domestic product supply is high. That is not good news for ExxonMobil, BP, Royal Dutch Shell, and Chevron, which have made significant investments in the southern Iraqi fields and the Kurdistan region of northern Iraq. All these companies can do is reassure investors that events in Iraq have yet to affect their operations. And deterioration of the security situation won’t make that an easy sell. 

In the end, the real winners from the most recent crisis in Iraq might be the Kurds. In recent days, the Kurds have increased their reach into disputed territories, including into resource-rich Kirkuk, which is estimated to hold some 45 billion barrels of crude, and it’s one of the largest frontiers for oil exploration. Kurdistan has pressed ahead with a new pipeline, enabling it to export oil independently to international markets (although Kirkuk oil is unlikely to be produced for now). Much of Iraq’s additional capacity is expected to come from underdeveloped northern and Kurdish regions of the country. But continued fighting between insurgents and the army will make it impossible to develop Iraq’s ability to increase output.

As it stands, the mess in Iraq won’t dramatically alter the oil market unless things get far worse inside the country. Iraq has been in trouble for quite some time -- but the world has only just started to pay attention. The U.S. departure from the country left a political and military vacuum that has been filled by militants. The outlook for Iraq’s oil sector is increasingly nebulous, but Saudi Arabia, with support from OPEC and the United States, will be able to do what is necessary to fill the oil void, if and when there is a need to do so.  

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