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Why chaos in Iraq won't send oil prices surging - yet

Rick Newman
Senior Columnist

The Islamic uprising in northern Iraq took oil traders by surprise, just as it startled nearly everyone else. But after a delayed reaction, oil prices have shot upward and could go higher still depending on how explosive the new civil war in Iraq turns out to be.

Al Qaeda-style jihadists calling themselves the Islamic State in Iraq and Syria, or ISIS, have seized two major cities in northern Iraq and might attempt a run on Baghdad. There’s an oil refinery in the region they now control—used for domestic purposes—but no major oil facilities. Those are mostly in southern Iraq, with a few in areas of the north controlled by ethnic Kurds. So ISIS hasn’t done anything that directly affects world oil supplies, and doesn’t seem likely to soon.

Still, oil prices have shot up by about $4 per barrel to new highs for the year. Brent, the benchmark for Europe, is trading around $113 per barrle, while West Texas crude, the U.S. benchmark, is at about $107. The recent price hikes reflect a fairly typical “fear premium” seen when unpredictable events occur in the Middle East, as Jeff Macke and I discuss in the video above. If the Iraqi government unravels, rebels seize Baghdad or other surprises ensue, oil prices will undoubtedly rise further. Meanwhile, here are 5 things to know about Iraq and oil prices:

Iraqi oil production is already below potential. Iraq produces about 3 million barrels of oil per day and exports about 2 million. Total global consumption is about 90 million barrels per day. So while Iraq is an important oil producer, it’s responsible for far less oil than Saudi Arabia, Russia or the United States. Iraq does have additional untapped reserves that could up its production by 1 million barrels per day or more, but instability and other problems have so far prevented that oil from being drilled.

Other factors were pushing oil prices up before the revolt in Iraq. There have been supply disruptions in places like South Sudan, Nigeria and Libya, plus oil flowing out of new U.S. fields has been slow to get to market, on account of logistical limitations. That had pushed up oil prices up by roughly $10 per barrel since the start of the year. As the mayhem in Iraq unfolded during the last few days, there was already upward pressure on oil prices, at the same time world demand remains strong.

The Islamic revolt will prevent the development of other oil fields in Iraq. One hope following the U.S. “liberation” of Iraq in 2003 was that western firms would help Iraq tap new fields and modernize its aging energy infrastructure, leading to a much greater flow of oil. But many of the untapped fields are in or near the region now controlled by ISIS. “Iraq has an incredible amount of reserves, but the jihadis really make it impossible for western oil firms to partner with the Iraqi government to develop those fields,” says Chris Lafakis, a senior economist at Moody’s Analytics. “That’s too much risk for established players to take on.” And Iraq probably can’t develop that oil on its own, leaving the country stuck far below its economic potential.

U.S. gas prices will probably rise no matter what. Higher oil prices usually translate directly to higher gasoline prices, and Lafakis expect pump prices, now averaging about $3.65 per gallon, to rise close to $4 during the summer. That’s due to overall tight oil supplies, plus limits on refinery capacity in the United States and a normal surge in demand during the summer.

Domestic oil is no panacea, yet. There’s certainly plenty of it, with U.S. oil production rising from 8.3 million barrels per day in 2006 to 12.3 million in 2013—and probably going higher still. But there’s a lack of pipelines for getting oil from Canada, the Dakotas and other new drilling regions to refineries in the east, west and south, and to Gulf Coast export facilities. Rail handles some of the load, but has become controversial on account of several prominent spills. And building new pipelines is politically difficult, which means an abundance of U.S. crude won’t always alleviate pain at the pump caused by supply problems elsewhere.

There’s probably no quick fix to the latest civil war in Iraq, since the Iraqi military seems to lack the capability to conquer the rebels, the United States isn’t likely to put boots on the ground, and the Iraqi government itself is viewed as corrupt and abusive. If there’s any good news, it’s that Middle East turmoil is something the world is used to.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.