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The good, bad & ugly: three oil scenarios as Iraq crisis mounts

The good, bad & ugly: three oil scenarios as Iraq crisis mounts

Oil prices touched nine-month highs last week as the crisis in Iraq escalated.

The militant insurgency in northern Iraq has triggered fears of a supply shortage in the country, which is the second largest producer of crude in the Organization of The Petroleum Exporting Countries (Opec).

A barrel of Brent crude is now trading at around $115, rising from the $109 it started June on.

Capital Economics points out that thus far the Iraq crisis has only had a limited impact on the global oil market, given it is trading $5 above the level it hit when the 'Arab Spring' erupted in early 2011.

Capital's head of commodities research, Julian Jessop, said the muted response made sense as most of the fighting is contained to the north of the country, well away from the main oil facilities in the south.

Jessop believes the most likely outcome is a benign one, with the oil price dropping back below $100 per barrel within the next six-12 months.

While he does not expect the crisis to have any meaningful impact on the oil price over the long term, he is conscious that there are several scenarios which could play out.

The good

An improvement in the security situation across the Middle East should allow the oil price to drop below $100 within six to 12 months.

Jessop points out that there is even a chance the crisis could result in even lower prices.

'US intervention appears to be conditional on the Iraqi government doing more to ease sectarian tensions, which could prove a model for the rest of the region,' Jessop said.

'Meanwhile, the positive stance taken by Iran is already helping to improve relations between Iran and the West, or at least the EU, despite the reservations of Saudi Arabia and Israel. This could lead to an earlier lifting of sanctions on Iranian oil.'

The bad

Unrest in Iraq drags on in much the same way as the civil war in Syria, with the fighting ebbing and flowing and never far from the headlines. 

'In this 'bad' scenario we would still expect Western intervention and increased output from Saudi Arabia to keep a lid on oil prices, but they could plausibly settle at $120 for an extended period,' Jessop said.  

'While we would be wary of assertions that there is a single “magic number” for the oil price beyond which the world economy enters a danger zone, this would be the level at which global growth has faltered in the past.'

The ugly

In this third scenario, the crisis spirals out of control and Iraqi supply is significantly disrupted.

'Iraqi oil production is currently running at around 3.3 million barrels per day (bpd), which amounts to roughly 4% of global consumption,' Jessop said.  

'Of this, 2-2.5 million bpd is exported, mainly via ports in the Persian Gulf. The loss of this supply alone would not be disastrous, but offsetting it would use up most of the spare capacity in Saudi Arabia (estimated at 2.5-3 million bpd) and probably also require releases from official reserves in the West.

He added: 'What’s more, an extended conflict would make it even harder for Iraq to achieve its ambitious plans to increase output to as much as 7 million bpd within a few years.

'And if the crisis in Iraq worsens, instability could increase further in other parts of the Middle East. In these circumstances, it would not be difficult to imagine the price of Brent surging to new record highs above $140.'

Jessop stresses the final view is by some way the least likely outcome. 'We would assign a 70% probability to the 'good' scenario, 20% to the 'bad', and only 10% to the 'ugly'.

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