The Iraq Nightmare Scenario That Could Send Oil Prices Surging

Oil prices have been on a strong run this month, as the situation in Iraq has deteriorated, but over the last few days, prices have taken a bit of a breather.

From a market perspective, we haven't seen the real nightmare scenario yet.

The real nightmare scenario would be if ISIS Jihidas (the Sunnis who are powerful in the north) were able to make major progress towards oil infrastructure in the south.

Oil strategist Michael Wittner at SocGen explains that the real assets are in the south, and that in recent days, the ISIS momentum has stalled a bit. And furthermore, whether ISIS wants to take all of Iraq (and Baghdad) is unclear.

Wittner's full thoughts on this scenario are worth reading.

Prices went up last week because of the fear and possibility of a much larger volume of crude produced in the southern Iraqi oil fields and exported through the Basrah port complex. Exports of Basrah crude have been in the 2.5-2.6 Mb/d range in recent months, and that is what is at risk. This volume of crude is greater than Saudi Arabia's spare capacity, which we currently estimate at 1.75 Mb/d (9.75 Mb/d of crude output in May vs. capacity of 11.5 Mb/d available within 30 days).

In other words, Saudi Arabia would not be able to replace a total disruption of Basrah exports on its own; a release of IEA strategic reserves would also be required. As noted above, the threat of this happening is not imminent, but it is serious, in light of the audacity, speed, and success of ISIS gains in the last week. How likely is a disruption of Basrah flows? There are many factors to consider.

In recent days, ISIS has started to meet with some resistance from Shiite forces in Iraq, with the fighting becoming less one-sided. ISIS has been losing momentum. Iraqi Shiite militias may have been at least as important in this regard as Iraqi government troops. In addition, in order to help its Shiite ally, Iran has reportedly deployed at least three battalions of its elite Quds forces to the fight against ISIS; these units are part of the Iran Revolutionary Guard Corps. One battalion was already in Iraq, and two were moved from Iran's western provinces.

The US is also considering military assistance to Maliki's Shiite government, with air strikes and other options being considered (though Obama has ruled out American boots on the ground). Importantly, the US has said that it will only provide military assistance if the Iraqi government undertakes political reforms, including representation of Iraq's Sunni and Kurdish populations. Regardless, the US Navy moved an aircraft carrier and other ships into the Persian Gulf over the weekend. In addition to a slowdown in the pace of advance of the ISIS forces, it is not even certain that their goal is to capture Baghdad, overthrow Maliki's Shiite government, take over the country, and continue to move into southern Iraq.

In fact, this would be an expansion of the goal they've stated in the past, which is to establish an Islamic Caliphate in the region that spans eastern Syria and western and central Iraq (northern Iraq is Kurdish). It is also not at all clear if ISIS wants to disrupt or even try to take over Iraq's main southern oil production and exports. In intelligence terms, ISIS has demonstrated a military capability, but their ultimate intentions in Iraq are still unknown.

Wittner goes onto note two key reasons why oil assets in the south are fairly safe: They're in strong Shiite regions, and Iraq has 30,000 security forces whose job is to solely protect these assets. That being said if there were a disruption (which is possible), prices could surge to the $120-$125 range.

Wittner's view is shared elsewhere on the Street.

Here's the quick and dirty summary of things from Morgan Stanley's Adam Longson:

Near-term geopolitical premium may fade with time, but impacts on long-dated oil could persist. Headlines, escalating violence, short covering and prior underinvestment will likely continue to lift Brent near term. However, we do not expect material disruption to oil exports. Without an outage, market fatigue will likely lower the geopolitical premium in the coming months and allow fundamentals to drive pricing again. Moreover, higher prices should further pressure refining margins, limiting sustainable upside. That said, persistent headline risk could change the psychology of oil markets by jeopardizing supply growth and removing complacency about oil prices (especially medium term).

From Longson's report, this simplified map of where the insurgents are, and where the key oil assets are offers some perspective.