A Violent End to Iraq's Brief Economic Rebound

By Matthew Philips   June 12, 2014

Kurdish Peshmerga forces and Iraqi special forces deploy their troops outside of the oil-rich city of Kirkuk, Iraq on June 12

Just when things were starting to look so promising, Iraq has tipped back into a state of violence and chaos that threatens to undo years of economic progress. After a blitz campaign that no one saw coming, a Sunni militant group called the Islamic State in Iraq and Syria (ISIS) now controls three key cities in northern Iraq: Mosul, Tikrit, and Baiji, home to Iraq’s biggest oil refinery. Although militants hold the town, Iraqi special forces are guarding the refinery, keeping it in government control for now.

Even though most of Iraq’s oil production and export facilities are in southern parts of the country, far from the new conflict, oil prices are starting to react in a big way. Both Brent crude and its U.S. equivalent, West Texas Intermediate, rose more than 2 percent Thursday morning.

BloombergBrent crude prices surged recently in reaction to violence in Iraq.

“The Iraq development is the main driver for oil prices today and increases nervousness over the security of supply from the country,” Carsten Fritsch, an analyst at Commerzbank in Frankfurt, told Bloomberg News. Iraqi officials have reportedly requested U.S. airstrikes in Northern Iraq against the militants, which the White House has so far declined. The possibility of U.S. intervention in Iraq “is another sign of how desperate the situation is and how weak the government has become,” says Fritsch.

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BloombergThe majority of Iraq's oil is exported out of the southern port of Basra.

We may look back on this week as the start of a new civil war in Iraq and, if so, the end of whatever optimism existed about the country. Yet so much had been going right recently. After eight years of war and decades more of economic sanctions, Iraq had made progress rebuilding its energy industry. In 2012 it passed Iran to become OPEC’s second-largest oil producer, behind Saudi Arabia. This spring, Iraqi oil production hit a 35-year high at 3.4 million barrels a day. Government oil officials talked about being able to produce as much as 9 million barrels a day by 2020. Iraq’s borrowing costs were down; economic growth was up. Earlier this year the International Monetary Fund forecast that Iraq’s economy would grow 6.3 percent this year and 8.25 percent by 2016, the fastest of all 22 economies it surveyed in the region.

BloombergIraq's oil production is up 40 percent in the past 4 years, making it OPEC's second largest producer

 

“This definitely marks the end of the brief period when we could feel good about progress in Iraq,” says Kenneth Pollack, a senior fellow in the Saban Center for Middle East Policy at the Brookings Institution. “Things won’t come to a crashing halt, but it’s likely that the violence will simmer for some time.” It’s also possible that this could spark what many have always feared: that Iraq breaks up into its tribal areas along ethnic lines.

For now, the big questions are how far south ISIS can move and whether it will eventually be able to seize control of Iraq’s larger oil fields. These are tough, battle-hardened fighters we’re talking about. Some reports from Syria suggest that ISIS is so violent and extreme, it was disavowed by Al Qaeda. The worst-case scenario would be something akin to what’s happened in Libya, where militants took control of the country’s ports and succeeded in shutting down the country’s entire oil system. Considering that the south of Iraq is mostly held by Shias, that seems unlikely, “but it’s not unimaginable,” says Pollack.

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If ISIS stays in the north, it may not be able to disrupt current oil prodiction, but it can do a lot to kill Iraq’s plans for growth. Most of the extra oil Iraq was hoping to pump over the next decade is in the northern and Kurdish regions of the country, where there’s lots of untapped, easy-access crude. Continued fighting between ISIS and the army will “make it largely impossible to develop the resources in the northern and eastern parts of the country,” Tom Pugh of Capital Economics, wrote in a Thursday note. That would severely reduce Iraq’s ability to lift output.

American oil companies have been gradually trimming their operations in Iraq because of the risk of precisely this kind of instability. ExxonMobil (XOM) has decided that the Kurds are a better bet than Baghdad. Chinese oil companies, however, don’t have that luxury, because China needs oil so badly. PetroChina(PTR) bought a large stake in southern Iraq’s West Qurna oil field from Exxon last year. The most recent violence could leave them in a geopolitical pickle.

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Meanwhile, the American companies look prescient. The rise of ISIS in the north could actually further strengthen Kurdistan’s hand relative to Baghdad, says Simon Wardell, an energy analyst at IHS in London who thinks we may actually see higher export volumes flow out of Kurdistan in the near term. “Baghdad has even less leverage now that the army has folded in the north,” says Wardell. “That gives the KRG more sway and could ultimately result in them boosting their exports.”

The current instability also almost certainly tables the negotiations Iraq’s central government was having with the Kurds over how to share the country’s oil revenue. The Kurds have essentially decided to go it alone, Baghdad be damned. The Kurdistan Regional Government just signed a 50-year energy deal with Turkey to export its oil through Turkey, basically cutting Baghdad out altogether. The loss of that revenue doesn’t bode well for a central government that, in any circumstances but especially now, doesn’t need a budget crisis on top of everything else.

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Philips is an associate editor for Bloomberg Businessweek in New York. Follow him on Twitter@matthewaphilips.