Events unfolding in Iraq over recent weeks have provided an unfriendly and gruesome reminder of the geopolitical risks that investors continually face. With Iraq being the seventh-largest oil producer, oil markets predictably rallied 4% as the gravity of the situation became evident. In addition, concerns of an oil shock to the economy led equity markets to sell off, albeit briefly, and gold markets to rally.
Although the situation in Iraq is fluid, our baseline expectation is that the fighting stays confined primarily to the areas with high Sunni populations, leaving the biggest oil-producing region in the south intact. We expect a relatively small impact on prices for the rest of the year once the dust settles and sectarian lines are drawn. These events, however, call into question Iraq’s ability to keep increasing oil production over the next few years, which will likely support elevated prices in the years to come.
On the 9 June, the Islamic State of Iraq and Syria (ISIS) began an offensive within Iraq to take control of a large area of land from the Iraqi government led by Shiite Prime Minister al-Maliki. Although small in number, local Sunni tribes alienated and disenfranchised by the policies of al-Maliki’s government appear to have enabled ISIS to seize a large swath of northwest Iraq.
These events have effectively divided the country into three areas: the already semi-autonomist, resource-rich Kurdish region in the northeast governed by the Kurdistan Regional Government (KRG); the predominately Shiite southern region, including Baghdad, where 80% of Iraq’s oil output resides, led by the al-Maliki government; and the now chaotic, predominately Sunni northwestern region bordering Syria and Jordan.
Our baseline: A stalemate develops and the media moves on
The support of the local population and an already large presence in Mosul beforehand were critical to ISIS’s successful march into Iraq. Expanding this success into the rest of the country would be a considerable challenge as the Kurdish region is protected by the well-trained Peshmerga, and both Shiite militias and the army will be much more formidable opponents as ISIS nears Baghdad.
Although fighting remains fierce and sporadic terrorist attacks in Baghdad and the south would not surprise, we expect frontiers to become better defined in the coming weeks and months as ISIS encounters this resistance. Unfortunately for the inhabitants of the Sunni area inhabited by ISIS, images of North Waziristan and Somalia come to mind.
In this baseline scenario, output already disrupted back in March in the now-contested area will remain offline, but little new outages will occur. If anything, output could modestly increase as the Kurds have gained additional leverage over Baghdad to uncork output constrained by politics.
In addition, the Kurds have reportedly neared completion of a new pipeline linking the Kirkuk field to the KRG-controlled pipeline flowing to Turkey. Therefore, further price appreciation will likely be limited. If anything, prices could retrace as Iraq moves from the front-page headlines to the second page.
The worst case: The conflict escalates, engulfing southern Iraq and even neighboring countries
While the baseline is already bleak, it is by no means as bad as events can get. As dormant Shiite militias in the south are mobilized and Iran and the U.S. (always the lightning rod for jihadists) engage, violence can spread. This could threaten the region’s stability, particularly as neighboring countries would likely get dragged in either through supporting their co-sectarians or through a likely refugee crisis.
Although previous civil war has already separated much of the population by sectarian lines, a “religious” war would hold unpredictable outcomes. In addition, given the Kurds now control Kirkuk, a historical cultural capital for the Kurds but an oil-rich region and a potentially valuable source of revenues for the ISIS and Sunni tribes, the relative quiet along the northern border could quickly end.
Given Iraq exports roughly 2.6 million barrels per day (b/d) from the southern Basra port, nearly twice our estimate for spare Saudi production capacity, any extension of unrest that leads to a disruption of this output would have profound implications for oil prices. A rough rule of thumb is that a 1 million b/d loss of output for a year would increase oil prices by $12–$15 per barrel (bbl), requiring the release of global strategic petroleum reserves to meet demand and prevent higher prices. A full cessation of Iraqi supplies would cause prices to spike to a level at which demand is destroyed. While such a tail event is unlikely at this juncture, prices could rally up to $140/bbl or $150/bbl, damaging economies and increasing inflation.
The best case: Necessity drives cooperation and reconciliation
Not all outcomes of the recent unrest have to be bad for oil supplies and risk markets. (That felt good to write.) It is possible, as unlikely as it seems, that events could lead to a grand reconciliation between different interests within Iraq and between regional powers.
ISIS poses a threat to nearly all regional leaders, and a failed Iraqi state would have grave implications for stability. It is also not obvious that ISIS’s religious views will prove popular with the local population, which could turn on ISIS as other Sunni groups have done in Syria.
Events in Iraq could also influence the ongoing nuclear negotiations with Iran, to the dismay of several Sunni Gulf Cooperation Council (GCC) members. There is precedence for cooperation, as witnessed in Afghanistan and in Iraq following the U.S. invasion. Any cooperation fostered in Iraq could strengthen the currently thin layer of trust in the nuclear negotiations. Without additional oil from Iran, we envision this positive scenario to potentially add 500,000 b/d over the next 12 to 18 months, with the number increasing as time goes on and investment dollars flow.
While we would assign a modestly higher likelihood to this positive outcome than to the worst case scenario, the implication for prices would be considerably less as most forecasts already assumed growing Iraqi supplies.
Geopolitics suggests a role for oil in portfolios
Back in January, we discussed in another Viewpoint how the risk to output in 2014 from geopolitics was more symmetric than in previous years; Libyan output was already close to zero, and the interim agreement between Iran and the P5+1 (Germany, France, the U.K., Russia, China and the U.S.) signed in late 2013 was likely to lead to additional Iranian oil being sold. Flash forward five months: Libyan output has actually managed to go lower, not higher, but Iranian oil has increased by a non-trivial 400,000 b/d. Although a final agreement between Iran and the P5+1 by the 20 July deadline is unlikely, a likely extension of the negotiations for another six months would allow Iran to be a positive source of supplies.
Iraq is a “new” piece to this supply uncertainty puzzle. Although in the near term we could see prices retrace as the picture clears, the longer-term implication for the oil market is undeniable. Iraq is supposed to be one of the key sources of production growth over the next decade as investment following the Iraq War of 2003 bears fruit. With what is effectively a disintegration of the state and production already lagging expectations, Iraq’s future oil potential is likely diminished.
Adding Iraq to the long list of disappointing producers, including Kazakhstan, Angola, Nigeria, Libya and even Brazil, to name just a few, increases the odds oil prices will remain elevated. Even with North American output increasing at a historic pace, oil production globally just does not seem to be able to make the leap forward that other commodities, such as coal and base metals, have made.
Therefore, we believe owning oil as a portfolio defense presents an interesting opportunity. We favor owning 12-month forward oil contracts as active producer hedging has led to these contracts pricing 10% below front-month contracts for West Texas Intermediate (WTI) and 6% below for Brent. Owning deferred contracts offers some downside protection should the positive supply scenario develop.