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Hope for global crude supply despite Iraq's disintegration

The country is vital to the global crude supply, but the market has not panicked

With the world's third largest trove of conventional oil and by far its most ambitious production growth targets, Iraq is essential to global crude supply.  Almost half of the extra oil due on stream by 2020 will come from Iraq, the International Energy Agency (IEA) predicted in 2012. If the country failed to deliver this supply on time, said Fatih Birol, the agency's chief economist, global energy markets would be heading into troubled waters.

The advance of the Islamic State of Iraq and the Levant (ISIL), capitalising on a more widespread Sunni protest movement in northern and western Iraq, now threatens the entire future of the country. A rerun of the sectarian war of 2007-08 could be about to begin, and a bloody partition may follow. Iraqi Kurdistan, now in control of all disputed lands along its border with the rest of Iraq, seems destined to realise its dream of independence.

Thankfully, the market has not panicked. Shipments of oil from the mega-projects in the Shia-dominated south have been untouched by the violence elsewhere. ISIL, now the self-styled Islamic State (IS), will gain no territory there. As new loading infrastructure comes on line around Basra shipments could even rise this year as expected by the government, with exports reaching 3.4 million barrels a day (b/d), compared with a high in May of almost 2.6m b/d. Global supplies remain adequate to prevent a spike. Saudi Arabia has reassured the market that its spare capacity of around 2.65m b/d is available, should it be needed. The blockade of some Libyan oil-export terminals is about to end. North American supplies continue to cushion the market. OECD industry stocks are higher than normal.

Iraq flag

But as the violence rises in Iraq, it is time to start ringing alarm bells. The world should not count on Iraq to dominate global production growth in the next 10 years. The government's own target, of 9m b/d by 2020 (already a revision on the original wildly optimistic goal of 12m b/d), will not be met. Reflecting its assessment of the country's trouble, in mid-June the IEA scaled back its forecast for Iraqi output by 2020, too, saying it would now come in at 4.54m b/d, or almost 500,000 b/d beneath its assumption and half the government's target.

Even before the advent of IS, only the most optimistic observer could have expected Iraq's oil output to rise in line with these targets. Bureaucracy, corruption and poor investment terms have damaged investor enthusiasm. Yet Iraq needs more than $500 billion in upstream spending in the next 20 years, says the IEA. Another sectarian war will make it more difficult and expensive for Iraq to draw in this investment.

Prime minister Nuri al-Maliki has overseen the country's collapse. His credibility, and that of the foreign powers -- chiefly the US and Iran -- that have supported his rule in Iraq is in shreds. His antagonism of Sunni leaders and communities since 2010 is one of the sources of IS's strength in parts of Iraq. But his departure, if it comes, doesn't mean Iraq's other problems can be fixed quickly, either. Basic electricity provision is still lacking (some expensive turbines that should be providing power remain in warehouses), leaving millions of Iraqis in misery. A large contract to gather flared gas and use it for electricity has yet to yield results. Graft blights the country: Transparency International's index ranks Iraq as the world's seventh most corrupt country. It was a bad place to do business before IS declared a caliphate in northern Iraq. It is worse now.

Reasons for hope

Amid this gloom, there are some glimmers of hope - for the for the oil market, if not immediately for Iraq. Conspiracy theories variously suggest the ISIL advance was a Saudi-backed and -funded plan to destabilise a country that threatened its regional and oil-market hegemony; or an Iranian project; or a Kurdish-Sunni plot to ruin Iraq. In reality, Iran, Saudi Arabia - which has just deployed troops along its Iraqi border to guard against spillover - and the US all share a common interest in preventing Iraq's implosion and the spread of IS in the region.

For Iranian-US relations, this is an opportunity to improve ties, and loosen the embargo on Iranian oil. So far, Baghdad has asked for help from both countries. Iran has been the more willing. China, the country most exposed to the loss of future Iraqi oil, has every reason to promote Iran's full-scale re-entry into the global crude market, too. President Barack Obama's Congressional opponents won't like it, but more engagement with Iran would be sensible if he is to play a part in preventing Iraq's disintegration.

For Kurdistan, a smaller producer but a relative paradise for oil investors compared with the rest of Iraq, the advent of IS is also an opportunity. Exports from the region have been held back by its disputes with Baghdad over the right to sell oil. But events this summer have changed that political balance in favour of Erbil. Small cargoes of Kurdish oil are now being shipped from Turkey's Ceyhan port. Unfettered by the Baghdad government, Kurdish exports could rise from 125,000 b/d now to 1m b/d next year. This could include Kirkuk's oil, which Kurdistan (its peshmerga troops now control the city and other disputed areas) says could flow through its infrastructure into Turkey, bypassing the Iraq-Turkey Pipeline. Sabotage in IS-controlled areas in the north of Iraq shut that pipeline in March. If Iraq is to export oil from its north anytime soon, the Kurdish route may be the only option.

Western governments, especially the US, have been opposed to independent Kurdish exports, fearing legal challenges from Baghdad and that if such a trade route were established, it would undermine Iraq's unity. But IS has now blasted apart that pretence. Israel's foreign minister, Avigdor Lieberman, was probably right when he told US secretary of state John Kerry that an independent Kurdistan was now a foregone conclusion, not least because Turkey has implicitly accepted that outcome. 

As the US rewrites an Iraq strategy that was based around Maliki, it should also reverse its opposition to independent Kurdish exports. With doubts about Iraq's ability to deliver the long-term supply growth the global market will need, the world could do with Kurdish supplies, too. Trying to stop them while chaos grips the rest of Iraq no longer makes sense. 

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