Oil prices rise as Iraq crisis threatens OPEC oil balance

Oil prices jumped Thursday morning on fears that violence in Iraq could disrupt output. The unrest could send oil prices even higher and undermine the balanced oil supply and demand OPEC has enjoyed in recent years.

The oil market has balanced out quite nicely for OPEC in recent years. Now, upheaval in Iraq shows that balance may be more precarious than it has seemed.

Dramatic changes in oil production around the globe have offset each other instead of wreaking havoc. This has helped world oil prices stay high enough to provide OPEC countries with robust income, but not so high that they scare customers away from buying more of their precious product.

One major stabilizing factor has been rising production from Iraq. But that output is suddenly threatened by an outbreak of violence by militant groups, who seized two cities this week and have threatened to march on Baghdad. Brent crude, the most important international oil benchmark, rose nearly 2 percent in trading Thursday morning to $111.30.

Brent has hovered in the range of $110 per barrel over much of the last 4 years, with remarkably low volatility for oil markets. That has also led to stable gasoline prices for US drivers, who have been paying in the neighborhood of $3.50 per gallon over the period.

"It's comfortable for everyone," says Judith Dwarkin, chief energy economist at ITG Investment Research. "The global economy has recovered, oil demand is growing at trend, and prices are high and stable."

Or, as Secretary General Abdullah Al-Badry said in Vienna Wednesday after the Organization of the Petroleum Exporting Countries decided to maintain its current output of 30 million barrels a day: "Everybody's happy."

But this happy, stable market masks some difficult realities that OPEC has been fortunate to skirt. There have been production booms in some areas of the world that could have sent prices plummeting. And there have been shortages in other areas, including in OPEC countries, that could have sent prices rocketing higher.

OPEC is fortunate, experts say, because the organization would be hard-pressed to adjust if this precarious balance were upended. OPEC members have a very limited ability to either raise or lower production to steady the market, they say.

Instead, "OPEC hasn't had to make difficult decisions," says Michael Levi, Director of the Program on Energy Security at the Council on Foreign Relations.

Production from non-OPEC countries, driven especially by a boom in US shale oil, has risen by 4 million barrels per day over the last four years. That's more than the entire output of Canada, the world's 5th largest producer, and more than enough to push oil prices lower.

At the same time, Iraqi output has risen 22 percent since 2011 to 3.3 million barrels per day, further adding to supplies. That too could have pushed oil prices lower.

But prices haven't fallen, in part because production from other OPEC members has fallen though not because of a concerted effort by OPEC. Libyan production has been almost completely held out of the market due to political and labor unrest in the country. Western sanctions against Iran, once the world's second-largest exporter, have reduced Iranian output by about one-fifth. And production from Venezuela and Nigeria has slipped because of economic and political difficulties.

Prices haven't jumped, either, because the surprising rise in production in the US and elsewhere has matched almost exactly the rise in world demand from 88.5 million barrels a day in 2010 to an estimated 92.8 million barrels a day this year. It also helped cushion the market from surprise disruptions.

In early 2011, when Libya descended into violence, Brent crude spiked to nearly $126 per barrel. While Iraq's violence this week isn't as widespread, the oil market's reaction — a rise of 2 percent — is likely much more modest than it would have been years earlier.

Changes to this scenario would put OPEC in a difficult spot. Analysts believe OPEC nations, other than Saudi Arabia, are producing as much as they possibly can, so they aren't in a position to boost output substantially to meet a spike in demand or another unexpected production outage.

Nor would OPEC members be willing to agree to and then follow through with production cuts because member countries are especially desperate for cash to run social programs and pay for national defense.

Recently, the little balancing the market has needed has come from Saudi Arabia, the world's largest exporter. As the one OPECnation with a healthy oil industry, enormous reserves and a relatively stable economy, it has acted on its own to keep the market in balance despite official OPEC production levels. For example, forecasters expect OPEC production to rise by about 500,000 barrels per day over its official quota in the second half of this year to meet a seasonal rise in demand, all of which will likely come from Saudi Arabia.

But these adjustments have only been possible, and palatable to the Saudis, because they have been relatively minor.

"If the cutbacks you need are modest, Saudi Arabia can take care of it," Levi says. "If there's a surge in global supply at what point does Saudi Arabia say 'We shouldn't be the only ones cutting back.'"

Iraq, for example, has not been assigned a quota as it works to push production higher to boost its recovery. Members would find it difficult to convince Iraq to constrain its output, or to convince others to cut back to allow Iraq to recover.

"OPEC rarely if ever constrains or influences the oil production rate of its member states," writes Jeff Colgan, a professor at the School of International Service at American University in a study soon to be published in the journal International Organization. "A cartel needs to set tough goals and meet them; OPEC sets easy goals and fails to meet even those."