Whatever hope the Iraqi government had of quickly putting the Sunni-insurgency genie back in the bottle has gone up in flames.
The Islamic State of Iraq and al-Sham (ISIS) has consolidated its gains in recent weeks, including its hold over the country’s second-largest city, Mosul, which is close to significant oil fields. The June 10 capture of that city precipitated one of the largest spikes in the spot price of Brent crude oil in months.
The price of oil has stayed relatively calm in recent days, with Brent crude clinging to a nine-month high of $114 per barrel but not going any higher, even as the Iraqi government shows no signs of defeating the insurgents, who have been launching attacks as close as 20 miles from Baghdad. The vast majority of Iraq’s oil production occurs in the Shiite-dominated southeast part of the country, so Iraqi production has, in general, not been interrupted.
Francisco Blanch, head of commodities and derivatives research at Bank of America Merrill Lynch, says that his best case scenario has Iraqi oil production remaining relatively uninterrupted by the war, predicting that the conflict will settle into an impasse and that oil prices will hover around $116 per barrel this year and $113 in 2015.
But with the success of ISIS so far, it’s reasonable to ask what additional victories could do to upset global oil markets. Though it’s unlikely ISIS has the wherewithal to conquer Baghdad, it could wreak havoc in the city through bombings and attacks on critical infrastructure. An NBC News report Tuesday quoted an anonymous “senior US counterterrorism official” who believes that we should expect attacks on the capital in the coming days. According to the report:
“The most troubling aspect of the group’s recent operations has been its targeting of critical Iraqi infrastructure, like the Baiji oil refinery, the country’s biggest. Now, though Iraq sits atop one of world’s great oil reserves, you see long lines of cars at gas stations.”
Any serious disruption to Iraq’s oil industry—which is the second largest in OPEC—could drive oil prices higher, potentially hurting the U.S. economic recovery.
What could happen if the situation worsens? “If we see fighting spill into Baghdad … that could push the price of oil 10 or 15 dollars above current levels,” BofA’s Blanch says. If the conflict spreads even farther south of Baghdad, into the Shia South where most of the Iraqi oil is produced, however, that could be catastrophic for the country’s oil industry. “If those exports were to be disrupted, we could be talking about [oil prices] in the $160 range, and that’s a very dangerous level for the global economy.”
A good rule of thumb is that an oil price increase of $10 per barrel could lead to a decrease in 0.2% of GDP. Such an increase in prices could conceivably plunge the U.S. back into recession.
This worst case scenario appears remote. In addition, the recent explosion in domestic energy production has created a bit of a cushion for the U.S. economy. Brad McMillan, chief investment officer for Commonwealth Financial Network, points out in a research note that, “the U.S. is less exposed on a net basis to foreign imports.” This chart from the U.S. Energy Information Administration shows how domestic oil production has increased in the past couple years while imports have fallen.
The U.S. economy has become more energy efficient since the last oil crisis in the 1970s, which should also help matters. The chart below from the Federal Reserve Bank of San Francisco shows that energy consumption per dollar of GDP has been cut in half since that time. So, oil disruptions should cause less damage to output than they may have in the past.
But in the end, the oil market is global, and serious disruptions to Iraq’s oil industry will certainly be felt here in the U.S, which puts Americans in the odd position of rooting for Shiite forces in Iraq (and their Iranian allies) to at least hold their own against ISIS. War does indeed make for strange bedfellows.