Photo: Ivor Prickett

Drawn by new discoveries, energy giants like Exxon Mobil and Chevron are flocking to Kurdistan in northern Iraq. But their presence is provoking tensions with Baghdad and could help ignite a deadly conflict.

May 06, 2013

If you head up the northern highway that cuts through Iraq’s semiautonomous region of Kurdistan, a turnoff to the east leads you into the picturesque mountain village of Al-Kush. There, on a chilly afternoon in March, a monster traffic jam formed outside the local gas station, which had just received its first fuel delivery in days. As the wait to fill their tanks dragged on, the drivers grew edgy, so police erected a checkpoint, fearing violence. “Where are you going?” an officer snapped in Arabic, a language unknown to my Kurdish translator and driver. “Aren’t we in Kurdistan?” I asked. “No, this is Iraq. Take a look,” he said, cocking his head at Iraq’s black, white, and red flag flapping in a stiff wind behind him.

So it goes in Kurdistan: In one of the world’s hottest oil booms, even the territory in which the exploration blocks sit, such as this Exxon Mobil site, is a matter of intense dispute. (And gasoline lines are possible on top of oilfields.) Ten years have passed since President George W. Bush’s “shock and awe” bombs pummeled Baghdad and toppled Saddam Hussein. The long Iraq War is finally over, and the last American soldiers are gone. But a new battle is unfolding on the ground: the struggle for control over oil resources. American power this time is not military but corporate, with Fortune 500 companies like Exxon (No. 2) and Chevron (No. 3) acting as boots on the ground. Yet like the war, the contest could drastically reshape Iraq, and potentially blow it apart, by disturbing a precarious equilibrium that has lasted for more than 80 years and perhaps sparking a civil war.

When U.S. forces rolled into Iraq in March 2003, they found a country ravaged by decades of sanctions and fighting. A creaking oil infrastructure was pumping about 1 million barrels a day, a fraction of Iraq’s output in the late 1980s. Iraq was bankrupt, with doctors and university professors earning about $50 a month — in a country whose proven oil reserves of 143.1 billion barrels are the fifth largest in the world, and which is estimated to have recoverable resources of 197 billion barrels. Arriving in Baghdad on the day Saddam’s regime fell was like stepping back in time; even mobile phones were nonexistent.

A decade on, things have changed hugely. Iraq hit more than 3 million barrels a day in production late last year, its highest level in decades. And the International Energy Agency estimates output could rise to 8.3 million barrels a day by 2035, close to the current level of Saudi Arabia. In coming years, Iraq could become the biggest contributor to increased world oil supplies, perhaps transforming the country into a major power in global trade.

But estimates of Iraq’s oil resources may turn out to be conservative in light of new discoveries in the three northern provinces that make up the semiautonomous region of Kurdistan, home to about 5 million people. There, in the hilly farmlands set between Turkey, Syria, and Iran, oil companies have reported major finds since 2006, with seismic results exceeding their wildest predictions. Kurdistan officials now estimate their reserves are at about 45 billion barrels of oil and about 10 trillion cubic feet of natural gas. While those figures might be overblown, the sheer number of discoveries in Kurdistan is exceedingly rare. “These companies are going in and starting to make very significant discoveries at a time when the industry is struggling to replace its resource base,” says Peter Hitchens, an oil analyst at HSBC in London. “Kurdistan is still very unexplored.”

The area’s tantalizing oil potential has led more than 50 companies — including Hess, Marathon, Ross Perot Jr.’s HKN Energy, Gazprom Neft, Total, and various Turkish operators — to cut deals with the Kurdistan Regional Government, or KRG. The Kurds offer far more favorable production-sharing agreements than the central government in Baghdad. The KRG has its own President, Prime Minister, and Parliament in its Kurdish-speaking capital of Erbil, but is nonetheless part of Iraq.

For old oil hands, drilling here has been a little like wandering into Texas a century ago. Though production is currently a modest 170,000 barrels per day, oil analysts expect a steep trajectory. Kurdistan aims to export 1 million barrels a day by 2016 and 2 million a day by 2020. “In virtually all countries, the easy stuff has been locked up,” says David Kennedy, a retired Chevron petroleum engineer who moved to Kurdistan last year as country director for Afren, a London-based independent oil company. “A year ago we had two people on staff and no office, and now we have 350 people,” he says, looking at the construction cranes outside his office building. “This might be the last great onshore exploration find in the world.”

Despite the excitement, there is good reason for Western companies investing in Kurdistan to worry about escalating tensions with the central government. The Kurds’ contracts have infuriated Iraqi officials in Baghdad, who deem them illegal under the Iraqi constitution, since they bypass the national oil authority. The constitution is in fact ambiguous, but the real rift is political, not legal. Deeply uneasy over the Kurds’ newfound oil wealth, Iraqi officials suspect, perhaps rightly, that the KRG is maneuvering to create a breakaway state by forging trade links that do not depend on Baghdad — especially with the economic giant to the north, Turkey. In December, Kurdistan began trucking its oil to Turkey, and more recently, it is believed, has secretly signed a deal with Turkey for an independent oil pipeline.

These provocations have riled officials in Baghdad (with the notable exception of Iraqi President Jalal Talabani, who is Kurdish and has been in Germany for medical treatment since suffering a stroke last year). The Iraqi government says it intends to blacklist any company drilling in Kurdistan from working in non-Kurdish Iraq, and last December the KRG stopped exporting its oil and gas through Baghdad’s pipelines. After months of the two sides wrangling over Iraq’s 2013 budget — on which Kurdistan depends heavily for revenues — the Parliament in Baghdad voted in March to give the Kurds just $644 million for the year. That was less than 20% of what the KRG had requested.

When I visited the KRG’s Foreign Minister Falah Mustafa Bakir a few days before the vote, he launched into a 15-minute diatribe against the Iraqi government. “The days when Baghdad wants to control this region, to decide everything from the center, are over,” he fumed. He vows the Kurds will never be pressured into folding their oil industry into Iraq’s national authority. “When oil companies saw that the KRG was welcoming, they came here, and we welcomed them,” he said.

But there was one arrival that pushed tensions to within a hair’s breadth of war: Exxon Mobil. In October 2011 the oil and gas giant quietly signed six exploration deals with Kurdistan, at least two of them to drill on land whose ownership is disputed between Kurds and Arab Iraqis — a source of violent conflict for decades. The Exxon contracts enraged Iraqi officials, who gave the company until the end of 2012 to either abandon them or sell off its stake in the supergiant field of West Qurna 1 in southern Iraq, where Exxon currently pumps about 495,000 barrels a day. The company held fast, calculating that Kurdistan’s prospects were too promising to pass up and betting that Baghdad would not risk burning its relationship with Exxon. “Exxon thought about it long and hard,” says Gen. James Jones, the former national security adviser for President Obama who now runs the U.S.-Kurdistan Business Council in Washington, which promotes the region to American companies. Jones says he has spoken with Exxon CEO Rex Tillerson “several times” about Kurdistan. “They decided that they would go where the opportunity took them,” he says.

Iraqi officials had good reason to shudder at Exxon’s Kurdish deal: It appeared to be a seal of approval for the KRG’s nascent oil industry. “For Exxon to risk forgoing its projects in the south was a huge statement,” says Qubad Talabani, the son of Iraq’s President, who is a top aide to Kurdistan’s Prime Minister. “Exxon, with its thousands of lawyers, is not going to engage in something that is unconstitutional.” Total and Gazprom Neft signed KRG deals soon after, while Chevron acquired two existing concessions from Reliance Industries. (Exxon offered no comment and declined my requests for interviews, as did Total and Chevron.)

Exxon installed staff temporarily on two floors of Erbil’s swank Divan Hotel, while they discreetly scouted the city for more permanent digs and waited for the controversy to blow over. That might have occurred, had Iraq’s tensions with Kurdistan not flared up last November, when a skirmish erupted in Kirkuk between Iraqi police and the KRG’s armed force, called peshmerga, killing one person.

With vast oil reserves, Kirkuk is the most intensely disputed piece of land in all of Iraq and is situated a few miles from Exxon’s new block in Qara Hanjeer. As the incident escalated into a fierce standoff, Iraqi officials vowed to fight if drilling occurred on Qara Hanjeer’s disputed land. “If Exxon lays a finger on this territory, they will face the Iraqi army,” said Iraqi M.P. Sami al-Askari at the time. “We don’t want war, but we will go to war for oil and Iraqi sovereignty.” Each side deployed thousands of troops to the area. In an effort to cool the situation, Exxon CEO Tillerson flew to Baghdad in January to meet Iraqi Prime Minister Nouri al-Maliki, and the next day met Kurdistan President Massoud Barzani in Davos during the World Economic Forum.

When I drove to Kirkuk weeks later, the area was still bristling with tension. As we neared the city, my Kurdish travel companion, Hoshang Ishmail, community development manager for the United Arab Emirates oil company Crescent Petroleum, said he believed war would erupt if Iraq attempted to block Kurdistan’s new drilling. “There are many who would be prepared to fight, me included,” says Ishmail, who was raised in Erbil during Saddam’s era. “Nothing binds us to Iraq, except the status quo.”

If all this war talk puts a damper on Kurdistan’s prospects, you would hardly know it in Erbil. Here, the sensation of not being in Iraq begins the moment you land at Erbil International Airport — on one of the world’s longest civilian runways — and step inside the ultramodern glass and steel terminal. The last time I flew here, in 2006, the airport was a ramshackle converted military air base dating from the 1970s. The new facility, which opened in 2010, was built for a staggering $550 million and is run with help from Dubai’s Dnata Corp. and South Korea’s Incheon Airport. Kurdistan’s message to visitors, blatant and relentless, is “This is not Baghdad.” (The FAA recently lifted a 16-year ban on U.S. airliners flying to Iraq, but only for Kurdistan.) An immigration officer waves me through when he sees my U.S. passport, no questions asked, a sharp difference from Baghdad, where visas are required and can take weeks to obtain. Although non-Kurdish Iraq is a short drive away, the contrast is disorienting for anyone who has logged time in Baghdad. When a taxi driver gets lost one night taking me to a dinner party, my host suggests I get out and walk, in the dark — unimaginable in Iraq, where 271 people were killed in bomb attacks in March alone. “When I came here I felt really nervous,” says Shawn Emamjomeh, a tall, Iranian-born Californian from Palo Alto who arrived in 2011 as the Kurdistan manager for the Claremont Group, a Manhattan-based real estate development company. “I came straight from the U.S. and had no idea what to expect,” he says. “But I feel more unsafe in parts of New Jersey than I do here.”

That sense of security has been a key selling point for the KRG, which has marketed Erbil as an alternative base for Iraq-wide operations to violent, blackout-prone Baghdad, using the slogan “the other Iraq.” While Baghdadis have struggled with only six hours or so of electricity a day ever since the U.S. bombed their power stations in 2003, here electricity runs for about 18 hours a day, and the window is expanding. The property market is struggling to keep pace with demand, and the KRG’s GDP growth target for 2012-16 is 8% a year. A complex of townhouses called English Village, built in 2004, sold quickly to foreign companies, including Baker Hughes and PricewaterhouseCoopers, at the time for about $125,000 each. Now they resell for $750,000 — a 600% profit.

One high-profile new development is the five-star Rotana Hotel, whose $400-a-night rooms are booked solid and whose lobby is ground zero for the oil industry in Kurdistan. At night the Rotana’s couches and coffee tables fill up with oil executives and investors in from Houston, the Emirates, and elsewhere, sipping gin and tonics while discussing deals. A new Marriott is planned nearby, and Claremont is building a Hilton Doubletree, set to open next year. Claremont has also sold about 500 units of the 640 townhouses and 10 apartment towers it is building on the outskirts of Erbil in a gated community complete with a health club, shopping mall, and two schools. The homes are advertised on billboards as AN AMERICAN OASIS FOR A MODERN ERBIL.

With Erbil’s Western-friendly flavor, it is tempting to forget that you are, after all, still in a violent, dysfunctional country. Yet critics point to aspects all too familiar to Baghdad’s Iraq — conditions that could turn toxic when brewed with new oil wealth: corruption, nepotism, and repression. In February, Human Rights Watch issued a report detailing how Kurdish security forces had arrested at least 50 journalists and activists in 2012, including for investigating how some officials were siphoning off public funds. Human Rights Watch says that when they met the KRG in Erbil last November to report their findings, a top official told them, “Talk of corruption cannot be tolerated.” Embarrassed by the report, the KRG then published a response admitting “there are individual situations which may have been mishandled,” and that it has “much to learn.”

Inexperience is not the only problem, however. The leadership of the KRG is deeply inbred. In decades past Kurdistan was largely controlled by two families: the Barzanis and Talabanis. Each had its own political party and armed force, and they fought a bloody war during the 1990s. Jalal Talabani, of course, is President of Iraq. Meanwhile Kurdistan’s Prime Minister, Nechirvan Barzani, is the nephew of President Massoud Barzani, who is the son of the nationalist hero Mustafa Barzani. Says one Westerner living in Erbil, who (tellingly) did not want to be named, “Kurdistan is still run by a half-dozen guys.” Little wonder, then, that many locals fear being forgotten in the oil boom. “If the foreign oil companies are coming to make a difference to poor people, they are welcome,” says Loqman Ali, standing outside his electrical-supply store in the town of Chemchemal, near Exxon’s Qara Hanjeer site. “But we are concerned that they will just benefit the high-up people.”

On my last day in Kurdistan I drive three hours north to visit an old associate, Tahir Ezeer Omar, the chief of Tawke, a tiny mountain village close to the Turkish border. In 2006, when I last sat in his living room, with its panoramic view of Turkey’s snowcapped mountains, the Norwegian oil company DNO had just begun drilling on Omar’s land. DNO’s seismic results were stunning: about 771 million barrels of oil reserves. That helped set off the rush of Western oil companies into Kurdistan and brought Tawke’s 30 families piped-in water, school desks for the children, and well-paid jobs for some, including three of Omar’s sons. “We always knew there was oil, but we were amazed there was so much of it,” Omar says, as we sat cross-legged on the carpet, enjoying a breakfast of freshly made sheep’s cheese and flatbread. And yet, he says, many Kurds, including him, have doubts about whether the oil boom will be worth the intense upheaval it is likely to bring. “We don’t count on the company to improve our lives here,” he says. “We have our cattle and sheep and wheat and almonds.”

The sense that oil could drastically rewrite the Kurds’ history suffuses this entire region. As Baghdad digs in against the KRG, the Kurds have increasingly cemented deals with their old enemy Turkey, whose 73 million people are in urgent need of more oil and gas. For months the U.S. has attempted to stall the growing relationship, fearing — as Baghdad does — that the Kurds are angling to break away from Iraq.

On the drive up to Tawke, that effort by Washington seems largely futile: Countless lengths of pipe lie scattered across the fields as work crews lay the network enabling more and more of Kurdistan’s oil and gas to be exported without Baghdad’s authority. And in land claimed by both Kurdistan and Iraq, there are moves to shift control to the KRG: In Al-Kush, Jesuit nuns say their electricity bill recently switched without explanation from Iraq’s government to the KRG. “I guess we are in Kurdistan now,” one tells me.

In April, the newsletter Iraq Oil Report reported that Turkey was considering separate oil payments to Iraq and Kurdistan through an escrow account. That would be in direct opposition to U.S. policy, which calls for a federal oil authority. But these days Washington is less and less assured of getting what it wants in Iraq. As oil begins to flow, Kurdistan finally has the means to create something closely resembling an independent country. The question now is whether its gushers can be pumped without an outpouring of blood too.

This story is from the May 20, 2013 issue of Fortune.

Editor’s note: A previous version of this story incorrectly stated that Incheon International Airport is located in Singapore. The airport is in South Korea.

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