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Markets may be underestimating the risks to Iraqi oil

Rick Newman
Markets may be underestimating the risks to Iraqi oil

When the Islamic militants known as ISIS first began to conquer territory in northern Iraq in June, oil prices spiked by nearly $10 to about $108 per barrel for West Texas crude.

ISIS has since gained even more turf and become such a menace the United States has begun bombing its positions. Yet oil prices are back down to around $98 a barrel, with the whole “fear premium” erased. And financial markets as a whole seem to be shrugging off geopolitical worries such as an escalation of sanctions between Russia and the west over Ukraine, renewed skirmishing between Israel and Hamas in the Gaza Strip and an African ebola outbreak. U.S. stocks, on a losing streak since late July, rose modestly following news of renewed U.S. bombing in Iraq.

Traders seem to be betting that by provoking Washington’s ire, ISIS has met its comeuppance and perhaps even triggered its own demise. That may be wishful thinking. ISIS is no match for U.S. military power, but airstrikes alone won't drive it from new terrain it has seized. ISIS has also built a huge war chest by looting Iraqi banks of perhaps half a billion dollars, making ISIS the world's richest terrorist organization, by some estimates.

One unnerving ISIS victory was the recent capture of the Mosul Dam, Iraq’s largest, which could turn out to be a major strategic asset for the jihadists. The dam helps generate electricity for several million people in northern Iraq, giving ISIS another new source of revenue should it choose to extort municipalities in exchange for power.

ISIS could also use the Mosul Dam as a weapon of mass destruction by unleashing the water behind it, which would flood a vast area between Mosul and Baghdad, or stopping the flow of water through the dam to flood upstream areas. ISIS already pulled one stunt like that when it seized control of the Fallujah Dam in April and nearly stopped the flow of water downstream, flooding upland areas to slow the movement of Iraqi security forces. The tactic also deprived downstream residents of water. ISIS returned the water flow to normal levels only when the flooding threatened its own fortifications.

Kirkuk, the oil-rich region in northern Iraq, is another potential flash point. In June, as Iraqi security units were crumbling amid the ISIS onslaught, Kurdish peshmerga forces took control of Kirkuk from the Iraqi government. And in July, the Kurds began rerouting Kirkuk oil through their own territory, to capture the revenue it generates. Baghdad wants that money back, needless to say, and ISIS no doubt covets Kirkuk as well, which makes the region a key prize in a three-way battle.

The peshmerga are considered the most capable regular military units in Iraq, yet ISIS has defeated them recently in several tactical battles. That doesn’t mean Kirkuk is vulnerable, but it could certainly embolden ISIS to prioritize it as a target. Oil prices fell after the June spike because ISIS, despite its gumption, didn’t seem to threaten any oil infrastructure affecting deliveries outside Iraq. Further gains for the jihadists could change that.

Oil traders seem to feel that, with the U.S. military now on the case in Iraq, oil markets will be more stable, not less. Strong U.S. production and consistent output by troubled Libya are helping keep supplies healthy.

It’s also possible, however, that ISIS will retaliate against U.S. attacks by waging dam warfare and seeking other ways to simply wreak havoc. Should those efforts reach Kirkuk or even Baghdad—either through physical attacks or political blast waves—expect the fear premium to return. A few Americans bombs aren't nearly enough to calm Iraq.

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