Iraq’s Disintegration and What it Means for Oil Markets

Another week, another geopolitical flashpoint affecting global oil markets. This week saw the takeover of Mosul, Iraq's second largest city, by an insurgent Sunni group bent on erasing the borders between Syria and Iraq. At the time of this writing, the militants had swiftly moved on and took Tikrit and were on the verge of capturing Samarra - putting them within striking distance of Baghdad.

Known as the Islamic State of Iraq and Syria (ISIS), the group was battle-hardened in Syria and has been festering in western Iraq for more than a year. The Iraqi government should have seen it coming, after ISIS took over Ramadi and Fallujah at the beginning of 2014. But they didn't, and now ISIS militants are waving black flags over Mosul. They took officials from the Turkish Embassy hostage and the Turkish government issued a clear threat that they would retaliate if any Turkish nationals were harmed.

For the entire second quarter of the year, energy watchers have been busy talking about Russia, Ukraine and what the ongoing conflict in Eastern Europe will mean for natural gas markets. Attention will surely shift to the troubled Middle East, where market analysts have yet to come to grips with how important Iraq is for global energy markets - and how truly unstable it is at this point.

Iraq is OPEC's second largest producer. It produces 3.3 million barrels per day (bpd), which accounts for over 3.5% of global supply. Iraq has the fifth largest oil reserves in the world, and in reality, it is one of the last places on earth that has utterly enormous amounts of underexplored oil at low cost.

As Iraq stabilized after years of war and internal strife, the Iraqi government, oil companies, and investors grew confident that Iraq would finally become the world class producer that it has the potential to be, if it only could provide basic security.

The International Energy Agency published a landmark report in late 2012 that looked exclusively at Iraq's energy sector, a tribute to how vitally important Iraq is as a global energy player, and an indication that the investment community thought Iraq had arrived. The report predicted that Iraq would triple - yes, triple - its oil production over the next two decades, from 3 million bpd to almost 9 million bpd. Not to be outdone, the government of Prime Minister Nouri Al-Maliki confidently issued plans to triple Iraq's output to 9 million bpd…by 2020.

That is looking increasingly fanciful as militants have taken over sections of Anbar province, and just this week captured Iraq's second largest city of Mosul, sending an estimated 500,000 residents fleeing the city. On June 11 ISIS militants took Tikrit, the hometown of Saddam Hussein and a Sunni stronghold. ISIS closed in Iraq's largest oil refinery in Baiji, raising fears of a disruption in supply.

Maliki may yet pacify ISIS and retake capture parts of the country, but Iraq is suddenly looking much less stable than investors thought, to say the least.

If the ISIS onslaught incubates further resistance to the Shiite government in Baghdad, Iraqi security could deteriorate. The nightmare scenario for Iraq and energy investors is if infrastructure is violently attacked, major oil projects have to be put on hold, or significant volumes of production are taken offline. In the short-term this would lead to a price surge - potentially up to $20 per barrel, according to Saxo Bank, a Danish investment bank. Over the long-term, the failure to achieve oil production targets laid out by the government due to violence - or the slightly more modest projections published by the IEA - will mean lower profits for companies involved and sustained high oil prices worldwide.

But for now, let's stick with the short-term. While most of Iraq's oil production is located in the south, there are oil fields in the north. The main pipeline that connects Iraq to the Ceyhan port in Turkey has been damaged and out of operation for several months now. That will slow the flow of oil from the oil fields near Kirkuk, which the Kurds seized on June 12. The fighting will put off any attempts to fix the pipeline running to Ceyhan.

The violence in Iraq and the abdication of government control over large sections of the country will affect several companies operating in the north.

Hess Corporation (NYSE: HES) has significant operations in northern Iraq, particularly in Kurdistan. It is the lead operator in Dinarta and Shakrok blocks, and has already reported several drilled wells coming up dry. The disappointing results for Hess in Kurdistan have only been compounded by political problems. Kurdistan succeeded in setting off two oil tankers from Ceyhan, but pressure from Baghdad has it scrambling for buyers. The destination for its oil tankers are unknown, and Baghdad could yet force buyers to avoid Kurdish oil, which it deems to be illegal. While spirits in Kurdistan were high a few weeks ago, the enthusiasm has been tempered recently with the failure thus far to land the tankers.

ExxonMobil (NYSE: XOM) is also operating in Iraq's north. After butting heads with Baghdad over its decision to sign a bilateral deal with Kurdistan several years ago, ExxonMobil began drilling at several Kurdish sites earlier this year. It spudded at the Pirmam block in Erbil province in January 2014, according to the Iraq Oil Report. But more troubling for the world's largest publicly traded oil company is its plans for Ninewa province. Ninewa, after all, is where Mosul is located, which is now in the hands of ISIS fighters. The al-Qush and the Bashiqa blocks in Ninewa province are two sites at which ExxonMobil had been erecting rigs to begin drilling operations. Their future is now in doubt.

On the smaller side is Genel Energy (LON: GENL), the feisty pioneer in Iraq's Kurdistan area. Former BP CEO Tony Hayward now serves as the CEO and Executive Director of Genel, which has secured 7 licenses across Kurdistan. It hopes to achieve 200,000 barrels per day in production this year. Its future is heavily dependent on the success of Kurdistan exporting oil, which, at this time, the semi-autonomous region is trying to do unilaterally. The pipeline the Kurdish government constructed to Turkey connects directly to Genel's Taq Taq field. The violence has yet to spread into Kurdistan, but with Kurdish militias gearing up for battle, anything is possible.

For now, ISIS fighters are concentrated north of Baghdad. This is important since 60% of Iraq's oil production is located in the south, where it is exported via the Persian Gulf. This is where companies like BP, PetroChina, China National Petroleum Corporation, and Lukoil are producing at the supergiant oil fields of West Qurna-1, West Qurna-2, and Rumaila. These fields are the heart of Iraq's oil production and if they were disrupted, it would be catastrophic not just for Iraq, but for the global economy.

It is unlikely that ISIS will reach as far as Basra and its surrounding oil fields. As a militant Sunni organization, ISIS has much more support in the western and northern Iraqi provinces. In the south, which is predominantly Shia, it is generally assumed that the Shia led government could put up a much stiffer fight than it has shown thus far.

With that said, everything is up in the air right now. After years of violence, Iraq had become the darling of the energy world. Now, it has been thrust right back into the abyss.