Crude oil outlook: Crude oil prices can rise above $120 if Iraq crisis escalates

Over the past week, Brent crude prices have increased by close to $5 a barrel ($2.5 a barrel for WTI), introducing a clear Iraq risk premium. The one-year high in oil prices was triggered by the sudden eruption of an Al Qaeda-linked militant insurgency in northern Iraq last week, raising fears of supply shortages and a civil war that might also draw in oil-rich neighbours. Iraq is the second largest producer of crude oil in the Organization of The Petroleum Exporting Countries (Opec).

The successs in northern Iraq of the Islamic State in Iraq and al-Sham (ISIS) clearly demonstrates the extent to which the country is at risk of fracturing along religious and ethnic fault lines. ISIS poses a threat not only to Iraq's stability but also to Iraq's oil supplies and energy infrastructure. The refinery at Baiji, near Mosul, is now under ISIS control. With a capacity of 310,000 barrels a day, it is the country's biggest. It supplies oil products to Baghdad and most of the northern provinces. Baiji is also a major provider of power to Baghdad. By targeting Iraq's oil facilities, as it did with the Kirkuk-Ceyhan pipeline in the past and Baiji now, ISIS is undermining both government revenue and essential energy supplies (fuel and power).

Nevertheless, with the majority of Iraq's operational oil infrastructure located either in the Shia-dominated far south or the northeastern Kurdish autonomous region (guarded by 190,000 troops), it is unlikely that Iraq's oil supply will be materially affected, unless the conflict escalates substantially. What is more worrying is the risk that ISIS might advance into Baghdad, threatening the potential breakdown of Iraq as a sovereign entity.

We expect strong support for Brent prices over the next few weeks, due to the Iraq-related risk premium. Were there to be a withdrawal of a substantial portion of Iraq's 3.3 million barrels a day crude oil supply from the market, this could take global spare capacity dangerously close to zero, suggesting an increase in crude oil prices well above $120 a barrel. Events in 2007-08 (see chart) are clearly our closest guide to how high prices could go in such a scenario. In the summer months, Opec's remaining spare capacity would be insufficient to meet peak demand. Saudi Arabia is currently producing close to 9.75 mn barrels a day, with spare capacity of only 2.5 mn barrels a day.

High oil prices pose a significant threat to the Indian economy. Being heavily dependent on imported crude oil, a rise in oil prices would damage the government's fiscal balance and widen its current account deficit. The rupee would then weaken and the combination would result in higher inflationary pressure.

Over the longer term, once the Iraqi crisis is resolved, there are good reasons why oil prices should fall. The need for Western powers to work closely with Iran could lead to a swifter resolution of the latter's nuclear ambitions, thereby releasing additional Iranian oil on global markets once the US and European Union embargoes are lifted. There is also the prospect of greater autonomy for the Kurdish regional government in Iraq, whose attempts to export crude via Turkey have so far been thwarted by Baghdad.

The author is an analyst at London-based Natixis