Bank of America believes the increasing geopolitical tensions in Iraq risk regional contagion, with the potential for negative spillover to global markets. If Iraq were to see further turmoil, in addition to the civil war in neighbouring Syria, we believe it could destabilize the region further, disrupt oil production and exports, and provide fertile ground for terrorist activity to extend its reach. They review the background of Iraqi turmoil, and discuss the political, economic and market implications in 10 questions; noting that the root of the problem is the central government’s non-inclusive and sectarian policies.
Via BofAML's GEM Economics Team,
So far, Kurds seem to be benefitting from the current situation the most. A rapprochement of a strange kind between secular Sunnis, Shia Arabs, Kurds, Iranians, Turks and the West still remains likely, and may prevent the situation from escalating, in our view.
The main risk is eventual partitioning of Iraq
While the situation has gone from bad to worse for Iraq followers, the wide coverage in mainstream media has amplified the initial negative market reaction. That said, market pricing may still be complacent if Iraq fails to remain nominally united. A breakup of Iraq would raise questions about ownership and timely servicing of external debt, in our view.
10 Questions...
1. What’s going on in Iraq? Failed policies, increased violence
The take-over of Iraq’s second largest city, Mosul, by the Islamic State of Iraq and al-Sham (ISIS) portends of a potential widening of sectarian tensions with the possibility of a full-blown sectarian armed conflict. In our view, the deep discontent with the central government’s sectarian policies is the fundamental issue that needs fixing.
ISIS: a rebranded al-Qaeda offshoot
ISIS is an active Sunni jihadist militant group with a stated goal to create an Islamic caliphate state spanning parts of Syria and Iraq, regions where it is currently most active. It is led by Iraqi Abu Bakr al-Baghdadi and its fighting strength could be around 10,000 men. The group was formed at the start of the US-led invasion of Iraq and pledged allegiance to al-Qaeda in 2004, originally as an al-Qaida group in Iraq, the Islamic State of Iraq (ISI). With the descent of Syria into civil war and porous borders, ISI expanded its operations into Syria, gaining foothold territory stretching from Eastern Aleppo, Idlib and Raqqa in Syria to Fallujah in Western Iraq. It rebranded itself as ISIS in April 2013. In February 2014, after an intense internal power struggle between ISIS and Jabhat al-Nusra in Syria, al-Qaeda’s leader, Ayman al-Zawahiri, publicly disavowed ISIS.
ISIS first major takeover in Iraq in Jan’14
Its first major takeover of territory in Iraq was its gaining of control over the Iraqi cities of Ramadi and Fallujah in January 2014, using the mismanaged and heavyhanded government dispersal of Sunni Arab Spring-inspired protests camps. Although ISIS’s control of Fallujah is total, its control of Ramadi has been partial given the fact that Ramadi was the epicenter of the “Sunni Awakening” Sons of Iraq tribal movement. The latter armed coalition movement was instrumental in defeating al-Qaeda in Iraq in 2006-07. Being de facto disbanded (rather than integrated into the army, among other promises) by the Shia political leadership, the Sons of Iraq tribal leaders have resented their treatment by the government, complicating efforts by the government to have them fight again fully by its side.
Government’s non-inclusive policies for Sunnis help the rise of ISIS
ISIS’ bold advances feed on wider Sunni disenfranchisement with the rule of PM al-Maliki, in our view. Senior prominent Sunni politicians have distanced themselves from ISIS actions but also blamed PM al-Maliki’s governance. The recent take-over of Mosul appears to have been carefully planned, and appears to have benefited from a population nominally hostile to the federal government’s army, and from support of Sunni Baathist insurgent forces.
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After taking over Mosul, ISIS stated its intentions of taking over Baghdad. The Iraqi army has, on paper at least, over 250,000 troops. However, the troop’s morale is reportedly low, could crumble under the weight of sectarian allegiances, and government control is fragile up to Baghdad’s outward skirts. Shia Grand Ayatollah Sistani issued a call to arms while Shia militias have been put on alert and could become increasingly drawn into the fighting, consecrating the breakdown of Iraq into sectarian entities, in our view.
The Kurdish Peshmerga has already taken position to secure disputed territories outside the Kurdistan borders, and its territorial claims may be hard to concede back to the federal government. While a material fighting force to launch into the battle against ISIS, the difficult relations between the Kurdistan Regional Government (KRG) and the federal government preclude use of Kurdish armed forces until a political compromise between the two forces is reached, in our view.
2. Why it matters - Iraq is a major oil producer
Iraq is a strategically important country in the region, with enormous potential to develop into an oil giant, against the backdrop of fragile and volatile ethnosectarian local dynamics (Chart 1 & Chart 2). It is one of the most populous states in the Middle East and borders important regional countries. Its steady and rapid increase in hydrocarbon exports until recently has helped balance global oil markets. A potential increase in turmoil in Iraq, after the civil war in neighbouring Syria, could in our view further destabilize the region, disrupt oil production and exports and provide a fertile ground for terrorist activity to spread further.
An oil giant in the making with ambitious targets
The country sits on 150bn barrels of proven oil reserves, the fifth-largest in the world, but also has been little explored until recently (Chart 3 and Chart 4). It further benefits from a low cost base and market proximity to Asia and Europe. Iraq held two oil licensing rounds in 2009, in which oil majors have pledged production increases of 9.6mbpd within 13 years. The Iraqi Ministry of Oil revised production plateau targets towards 9mn bpd of production capacity by 2020, from the 13mn bpd targeted previously. We see oil production at 6.7mbpd by 2024, assuming the political and security picture stabilizes. An increase in Iraqi oil production on that scale would likely bring about changes to OPEC quotas.
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Iraq’s oil production targets remain difficult to achieve in the near term. Kurdish independent oil exports have started, but there has been no willing buyer for now and large scale exports may be discouraged by the launch of international litigation by Baghdad. The relationship between Baghdad and Kurdistan may yet be subject to further changes, in our view. Iraq oil production has disappointed over the past year versus Iraqi goals due to sabotage, political instability, bad weather and technical infrastructure issues. After peaking at 3.2mn bpd in August 2013 and coming down since, Iraq’s crude oil production was 3.1mn bpd in April. Similarly, oil exports peaked at 2.6mn bpd in April 2013 and totalled 2.5mn bpd in April, weighed down by the shutdown of Northern oil exports.
3. Is Iraq splitting up? Tail risks have risen
Sectarian fault lines in Iraq are getting deeper, especially following recent events, increasing the tail risk of the country splitting up, in our view. However, we should keep in mind that Iraqi politics present a constant struggle over power, territory and resources among the country’s feudal political class. And that has been the case for quite a long time even there have been periods of relative calm.
Sectarian fault lines deepen but reconciliation still possible
While the dispute and the split are generally defined along sectarian lines, this contention has gone through many phases and has multiple layers. Many surprising alliances have been built and broken apart over time. If one looks at the even more fragmented sectarian picture in Lebanon, the potential they have for overcoming the differences and forming alliances despite rooted sectarian and feudal hurdles suggest that local dynamics are much more complicated.
Soft federalism gives way to concerns that Iraq will split up
One of the roots of the Iraq split up argument goes to the 2005 constitution, which describes the country as a federal state. Not only Kurdistan is granted a strong autonomy, but also potential future regions are promised to enjoy from that. That’s partly the reason why federation carries different meanings for Kurds and Iraqi Arabs, the latter of which sees it same as partition.
The decentralization view has made a strong comeback in policy circles following the recent events. However, the support for sectarian federalization is weak outside Kurdistan and oil rich southern provinces such as Basra, who think they receive much less than what they contribute to federal budget. Sunni Arabs are in favor of federalization, but that’s more because they have significant discontent over the lack of services and resources from the central government in Baghdad.
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The political vacuum in the aftermath of the elections not helping
The political vacuum after the elections is not helping. A wholesale reform and redrafting of the constitution to bridge the gaps between Baghdad and regional and provincial leaders is very difficult in our view. However, a deal on oil between Baghdad and Erbil, a national compromise to amend the constitution to prevent other regions going autonomous a la Kurdistan, and some simultaneous decentralization empowering local governments can help to stop the slide into what’s called soft-partition of Iraq under sectarian regionalization.
4. Is Iraq back to civil war? nOnly if national unity fails
The memories of civil war are quite fresh and bitter for Iraqis, which should act as a social emergency break to stop the recent increased wave of al-Qaeda incidents. Since the US/UK led invasion back in March 2003, Iraq has gone through a roller coaster of high-low intensity armed conflict and Iraqi people have suffered dearly. This collective memory may help to step back from the brink.
The escalated conflict that turned into civil war in 2006 cost Iraq dearly
According to the Iraqi body count, documented civilian deaths from violence in Iraq is close to 140,000 (c.190,000 including combatants). The peak of casualties was in back 2006-2007, just before the US-led “Surge”. Together with successful co-optation of regional tribal leaders along with military might on the ground brought a period of relative security by end-2011, when US forces left the country. That actually marks the trough for causalities and together with the deteriorated situation in Syria and the rise of radical Islamic groups, the security situation has deteriorated sharply since mid-2013.
Iraq needs political reconciliation to counter ISIS
The security situation is far less violent compared to 2006, up until now. However, the recent defections in Iraqi Security forces and the rapid rise of ISIS raises concerns regarding a potential quick turn in security situation to the worse. One of the most concerning signs is that part of the local Sunni population welcomes ISIS, reportedly due to the mistreatment they suffered under PM Maliki’s dominantly Shia security forces.
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We believe the security threat posed by ISIS could be countered more easily if local actors leave aside their differences and unite against the common terrorist threat. That could require a great deal of effort, though. External help from countries such as US, Iran, and Turkey could make it relatively easier to counter ISIS. However, in our view the undercurrent of deep discontent from the central government is the fundamental issue that should be fixed.
A soft partition along sectarian may push Iraq into deeper conflict
One way to go forward is an inclusive approach. If we assume the opposite that Sunni Arabs and Shia would enjoy the same autonomy as Kurdistan, the survival of the central government and the Iraqi state could be really difficult. Also given the mixed demographics of the country, a soft partition along the sectarian lines could potentially trigger nationwide violent clashes and ethnic cleansing, in our view. But now it’s also becoming clear that turning a deaf ear to rising discontent by PM Maliki has also brought Iraq close to boiling point, in our view.
Do not underestimate the rising Iraqi nationalism
A notable trend over the last 8 years in Iraq has been Iraq nationalism which may transcend the sectarianism. Regardless of their ethnic background, the shared history, their collective suffering and their concerns over foreign intervention strengthens that nationalist stream. Iraqi nationals think that breakup of Iraq is not best for Iraq, region and the West. Hence rather than a divorce, they want to see a more inclusive central government that will institutionalize a more functional revenue sharing and give local governments a greater say on policies.
5. Will Kurds go independent? Full autonomy more desirable
Kurdistan has always seen as the most likely breakaway region from Iraq given their historical strong desire to do so. This view has especially strengthened as the gap between KRG and central government widened lately. The direct pipeline to Turkey also eased the economic constraint of independence by offering an exit to the landlocked Kurdistan.
Kurdish independence remains very complicated
Even the Kurds’ recent move to control Kirkuk seems another step in the direction of independence, we believe that still remains a very challenging goal for Kurds to achieve. And it might not be desirable at this point for four reasons.
First, with Kurdish minorities spread out in the neighbouring countries and having the only exit through Turkey into the Mediterranean Sea, KRG would be increasingly at the mercy of its neighbours if it goes independent. Second, breaking away from Iraq with the oil and gas riches in disputed areas would possibly trigger violence, not least with Iraqi Arab nationalists. Third, given the fragile geopolitical balances in the region, the West is unlikely to throw its support behind KRG’s independence, the repercussions of which may cause a wider Middle East confrontation. Fourth, the economics of independence barely reach the breakeven for the 17% budget support KRG receives from Baghdad on paper (Chart 9 and Chart 10). Even with the inclusion of Kirkuk that may double KRG production above 500kbd.
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Kurds may be better off in the short-term with full autonomy
KRG is likely to be better off in the short-term by staying with federal Iraq as long as it sorts out its problems with the central government, in our view. The recent events have given them a stronger bargaining power to affect Baghdad. And that should not be downplayed. Kurds are likely to prefer a strong lever on Iraqi central government to an independence, in which they may have next to no influence on their gate keepers in Ankara, in our view.
6. Can Iraq pay back its debt? Fiscally sound, politically weak
In the absence of dissolution of the country, Iraq has the ability and the willingness to service its external debt, in our view. The Paris Club deal and bilateral negotiations have brought down the external debt stock to a much more manageable level and the external amortization schedule remains modest. Official gross reserves represent twice our estimated outstanding postrestructuring EXD stock, though we note that the institutional integrity of the Development Fund for Iraq (DFI) may have been recently compromised.
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The risk scenario is Iraq’s breakup, which will affect ownership of debt
In case the territorial integrity of Iraq comes under question, and ownership of the external liabilities becomes disputed among the various emerging territorial entities, the timely servicing of external debt may not be guaranteed. Servicing of external debt will essentially be determined by the security situation and a potential institutional breakup, as well as the ownership of Southern crude oil production (located in majority Shia parties) which are sufficient to maintain creditworthiness, in our view.
Paris Club provided Iraq major relief
In terms of the existing external debt stock, Paris Club debt treatment and subsequent bilateral negotiations brought the public external debt stock from US$142bn in 2004 (389% of GDP) to US$34bn in 2012 (15% of GDP). Paris Club (PC) creditors agreed with Iraq in 2004 on a comprehensive debt treatment of public external debt, providing a total amount of debt reduction of 80% in three phases.
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The first two phases respectively entered into force on 21 November 2004 and on 23 December 2005 and have lowered the public external stock of debt due to Paris Club creditors by 60%. The remaining third phase of an additional 20% debt reduction, conditional upon the successful completion of the last review of the IMF Stand-By Arrangement, was granted in December 2008.
Iraq’28s only 8% of EXD
The breakdown of external debt is also favourable, as the Iraq 2028 bonds represent just 8% of the total external debt stock. We estimate the bulk of external debt is owed to non-Paris Club creditors (cUS$18bn or 50% of total). Additionally, we exclude a portion of GCC debt to Iraq. This is because a material portion of claims owed to the GCC has not been recognized, nor forgiven, nor serviced, given the political economy implications of such a move and the lack of normalization of regional relations despite the holding of the Arab League Summit in Baghdad for the first time since 1990.
The robust macroeconomic performance of recent years owes much to high oil prices rather than progress towards broad-based structural reforms. The sensitivity of fiscal and external accounts to oil price and export volumes remains large. Fiscal accounts are most vulnerable to a sustained shock given sticky expenditures, high breakeven oil price, small fiscal buffers, in our view.
Fiscal accounts breakeven at 100$/bbl
Fiscal accounts currently breakeven at cUS$100/bbl, one of the highest levels among MENA credits. This is due to the structural rigidities of large, sticky current spending (67% of total) and elevated security-related expenditure (6% of GDP). Oil production at current levels should keep the fiscal breakeven oil price under control, to the extent spending remains prudent. The 2014 budget has still not been approved and we would assume continued underspending. This would not be unusual given that the average underspending was 45% over 2010-12.
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The rainy day funds about to rock-bottom, but FX reserves plenty
The DFI balances stood at US$20bn in June 2013 (8.9% of GDP and six months of spending on salaries and pensions), yet surprisingly came down to just US$5bn in March 2014 (Chart 13). While there is no high-frequency fiscal data to corroborate this, DFI cash flow statements appear to show a large increase in transfers to MoF and in letters of credits to Iraqi ministries. Disbursements from the DFI require a double signature (MoF, PM) and both institutions are now essentially reporting to PM al-Maliki, weakening institutional integrity.
The stock of CBI gross foreign assets appears adequate on a number of metrics, in our view. They stood at US$73bn as of early May 2013, up from US$70.3bn in December 2012 (we note that article 26 of CBI 2004 Law prevents Central bank lending to the government).The existing sizeable stock of reserves coupled with a modest amortization schedule suggests that external debt service is unlikely to be a concern going forward, in our view (Chart 12).
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The debt amortization of $2bn annually is highly manageable
The EXD amortization schedule appears modest. There is no published timely data on ST EXD, but MT and LT external amortization needs appear to be in the order of around US$2bn annually. This reflects modest payments to the IMF and bondholders, as well as the restructuring of Saddam-era external claims.
7. What are the tail risks? Wider MENA conflict, high oil prices
A potential flare-up in Middle Eastern conflict in the region and shaking up oil prices is one of the 10 risks to spoil your summer. In our view Iraq is a fertile ground for proxies to operate in the country and involve further regional countries in the turmoil. Iran could send IRGC forces to support the Shia-led government, while Sunni militants could obtain support from private sources in the GCC. Unless a counter-offensive is commanded by a united Iraqi army with coordination from the Kurdish Peshmerga, the risk increases that the fighting will increasingly take place across sectarian lines (Sunnis versus Shias) and, potentially eventually, across ethnic lines (Arabs versus Kurds). PM al-Maliki thus holds the key and will need to convince other stakeholders that he can transcend his ethnic and sectarian background and build bridges with other political leaders.
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South Iraq holds the key for oil prices
Our commodity research team believes that, in the unlikely event that ISIS invades the South and the entire 2.6 million b/d Southern oil production is lost, oil prices could face $40-50/bbl upside. Immediate further risks to production seem limited. After all, the bulk of Iraq’s oil fields are located in the Shia South, far from where the latest escalation in violence is taking place. Plus most of the recovery in production since 2003 has happened south of the country, with Iraqi output hitting 3.2 mn b/d in 2013, up from 1.3 mn b/d 10 years ago in 2003.
The latest area targeted by ISIS is strategically important for the oil sector due to the Kirkuk-Ceyhan export pipeline. It holds large oil reserves too. Yet the export pipeline has been offline since March 2 when an attack shut it down, so Northern Iraq has been producing fewer than 400 k b/d to supply local refineries for months, down from 630 k b/d in January.
As such, the physical global oil market impact of rising Iraq violence has been modest so far. For now, the violence will likely affect investments into Iraq negatively, suggesting risk of a flatter Iraqi output growth profile and continued support to long-dated oil prices. More long term, should ISIS manage to turn its current foothold in Northern Iraq into a stronghold there, it could compromise the long term integrity of both the KRG and the Southern oil production due to investment cuts by IOCs.
8. What are the trigger points? United response, Baghdad falls
With the situation remaining fluid, we would scrutinize two potential near-term trigger points that could point to the way forward: 1) whether PM al-Maliki manages to obtain wide cross-sectarian support for a counter-offensive; and, 2) whether ISIS makes further territorial gains, particularly into the capital Baghdad.
A national unity sounds good, but hard to deliver
Obtaining a national cover for a robust counter-offensive is likely to be crucial for Iraq to remain nominally united. There are however already worrying signs in our view: 1) PM al-Maliki was not able to obtain parliament to declare a state of emergency and give him full powers (due to the lack of quorum); 2) senior Sunni politicians have already blamed PM al-Maliki’s authoritarian governance style for the crisis; 3) ISIS fighters have been joined reportedly by Sunni former Baathist insurgents; 4) the local population in ISIS occupied cities has grown much more hostile to PM al-Maliki’s rule, and dislodging ISIS fighters may provoke a large number of civilian casualties and increase sectarian tensions; 5) Shia militias have been put on alert; and, 6) Kurds have used the opportunity to de facto seize disputed territories, including oil-rich Kirkuk, which will likely increase tensions with Arabs (both Sunnis and Shias).
Baghdad is not Mosul
Although ISIS may have difficulties operating over large territories of land, it has so far managed to hold territories and increase its ranks and arms. Baghdad remains key, and is some 100km away from current progress of ISIS fighters in the North. Baghdad is also 60km away from Fallujah, which has been controlled by ISIS since January. Baghdad would however likely be a battle that is much more difficult to conduct for ISIS, given the much larger Shia population and heavy fortification and defences, in our view.
9. Who benefits the most from the turmoil? Kurdistan
The current turmoil is likely to help Kurdistan achieve material gains in their core dispute with the federal government. Kurdistan has long been enjoying its autonomy shrined in the constitution but suffering from how central government in Iraq has been interpreting that constitution. Three of the main problems between KRG and federal government have been KRG’s direct oil and gas exports, the faith of disputed regions such as Kirkuk and the payment to Peshmerga from the federal budget.
KRG’s hand getting stronger
It is highly likely that KRG will have a stronger hand on the negotiation table in the next round on all these issues. They have already moved into oil rich Kirkuk and have taken control of it. The rapid fall of Iraqi Security Forces against ISIS compared to Peshmerga’s firm stance has made it clear that the latter serves for the nation in the hour of need and an asset for Iraq. The humanitarian help to those that fled from the areas captured by ISIS also gives a moral higher ground to the KRG in its dealing with the federal government. In our view PM Maliki’s poor handling of the situation and his reduced credibility could also suggest that his brinkmanship is likely to come to an end.
Kurds power grab in the recent conflict should also help to their direct oil exports via Turkey. A cargo of Taq Taq crude (300k boe) from the port of Mersin has been sold to Ruhr Oel, a refining JV between BP (operator) and Rosneft, delivered to Trieste in Italy, and shipped via the Trans-Alpine pipeline destined for a refinery in Germany. We believe this to be a key symbolic step forward for KRG; finding a new buyer in place of the usual purchases from OMV.
Two tankers with c. 1mn barrels of crude each have been loaded in Ceyhan (Turkey), 1st lifting on the United Leadership, with the tanker currently off the coast off Morocco, and the 2nd lifting on the United Emblem, sailing off the coast of Italy with Malta listed as the checkpoint destination. Whilst still reportedly looking for a buyer, a sale could be an important operational catalyst in the near term, though could be overlooked by the market in light of the increased instability in the region.
10. How badly is Turkey affected? Not much
Iraq has become Turkey’s number two export market after Germany. Turkish exports have amounted to $12bn in 2013, some 8% of total. While there is no further official breakdown for further destination of exports in Iraq, the anecdotal reference is that the two thirds of Turkish business in Iraq is with Kurdistan and the rest is dominated by the south. While the troubled West Iraq seems to be the commercially least important region for Turkey, there is likely to be some negative spillover to the Kurdish regions through sentiment and refugees and to the south by trade routes. Needless to say, the impact depends on the duration of the conflict. Assuming that the import dependency of Turkish exports to Iraq is very low, every 10% fall in exports to Iraq will widen the CAD by some 0.2ppt, all else equal.
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1/3 of crude imports are from Iraq
A key link in Turkey-Iraq trade is oil. Turkey (i.e. Tupras as the sole refining company of the country) imports almost 90% of its crude need. Sanctions against Iran made Iraq Turkey’s main oil supplier. Iran, Iraq and Saudi Arabia are Turkey’s major oil suppliers. The country mix of crude oil imports has changed in the past three years with the US sanctions against Iran. Turkey was importing almost 50% of its crude needs from Iran in 2011. With the sanctions, this has almost halved and with its increasing output, Iraq has made up for most of lost Iranian supply. Turkey’s total crude imports from Iraq were 6mn tons (120k b/d) in 2013 (2x the level in 2011).
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Turkey is able to replace Iraqi crude if needed
Turkey gets Iraqi crude from either Kirkuk via pipeline or Basra through vessels. The crude oil flow from Kirkuk pipeline has seen disruptions from time to time. This year the flow has been disrupted from the Kirkuk-Ceyhan pipeline since March. Accordingly, the weight of crude from Basra would increase. Alternatively, in case of a problem with the crude supply from Iraq totally, Tupras, the sole refining company of Turkey, has a number of suppliers and would likely be able to find replacements.
