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What ISIS insurgency in Iraq could mean for global oil supplies and energy options

Baiji oil refinery in northern Iraq under attack. STR

Recent tensions progressing to conflict in Iraq have raised concerns that world prices for oil will rise after a period of relative price stability that’s masked significant changes in supplies.

Conflict between Iraqi government forces and Sunni militia group ISIS to the north of Baghdad has prompted some headlines to talk of “soaring prices”. Friday’s Financial Times was more measured, reporting that Brent Crude, “has seen only modest gains, rising just over US$5 a barrel to a nine-month high of $115 since the onslaught by Sunni militia began two weeks ago”.

Iraq has always played a very significant role in world oil markets. The steady rise in production from the conflict of 2003 to recent levels of 3.3 million barrels a day meant Iraq provided 3.7% of world oil in 2013. The short-term view is that Iraq’s production lies south of the current conflict with Baghdad in between. The time to worry about a significant spike in oil prices of potentially $40-50 per barrel is if the current conflict spreads into the south, or if power in Baghdad changes so that who owns the oil and gets paid for it breaks down.

The rise in shale oil

So what about the broader context? Last week also saw the release of BP’s annual “Statistical Review of World Energy”. The company’s chief economist, Christoph Rühl, pointed out that world oil prices have been relatively stable at around the $110 per barrel level for the past three years.

But this apparent calm is on the surface only – underneath there have been two competing forces working in opposite directions. There have been significant supply disruptions in the Middle East & Africa, the worst of which have been the military upheaval in Libya and sanctions on Iran. But this has been offset by a steady increase in US oil production as part of what’s often called the “shale revolution”. The scale of decline on one side and the rise on the other have been remarkably similar, which explains the stability of world prices.

Arab Spring pressure

There’s another factor at play following the Arab Spring political events in 2011. The social unrest across North Africa and the Middle East forced leadership changes in Tunisia, Egypt, Libya and Yemen. For governments across the region with oil and gas revenues to afford it, one result was a significant increase in domestic spending to address popular concerns about living standards and opportunities.

The result is the price that many oil-producing countries now need to balance their national accounts has risen significantly for countries in the region. The average break-even price for OPEC members is reported as $105 per barrel. While it varies significantly between countries, many have seen this price rise $30-$50 per barrel over the last five years due to raised spending following the Arab Spring.

So oil prices at $110 per barrel have served the economic needs of producers in recent years. On the other hand, there is only so high the price can go before oil consumers turn to alternatives in the long run.

More than half of the world’s oil is used in transport, and more fuel-efficient vehicles vie with alternatives such as bio-fuels and electric vehicles. The answer may vary by country; Brazil uses 18% of bio-fuels in its transport system; Germany may direct its growing solar capacity to be stored in electric vehicles; and gas may be used in certain other transport markets. But the key point is that high oil prices will ultimately encourage substitutes.

While the trade-off between US shale oil and disrupted production in countries such as Libya and Iran has led to price stability over the last few years, the longer-term view is a steady rise. Global population growth and rising economic standards will require us to use steadily more expensive sources of energy so that the International Energy Agency predicted last year a price of $128 per barrel in 2035.

But that assumes a progressive climb of the sort that we can adjust to. Last year the IEA forecast a 2020 price of $113, which we’ve already exceeded, illustrating the conflict between long-term trends and market sensitivity to short-term changes. There will be disruptions along the way and it’s unlikely they will cancel each other out as they have over recent years. It was as recent as the summer of 2008 when a lack of confidence in managing short-term challenges led to the sudden climb to $147 per barrel.

Iraq implications

Losing Iraq’s production would nearly double the level of disrupted supply that has grown in recent years. It would match or exceed the spare capacity that OPEC members are believed to hold. While US oil production is expected to rise, it’s unlikely to happen as quickly as conflict could shut down Iraqi production. And spikes in oil prices have typically preceded recessions as long-term economic balances fall victim to the pressures of the day.

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