Iran and Iraq: New Oil BFFs

Buried in the rationale for going to war with Iraq was the idea that the United States would win itself another oil-producing ally in the Middle East.

Why, then, is Iraq helping Iran shirk U.S. sanctions?

According to a recent report by The New York Times, Iran has been able to use Iraq to gain access to the International banking system and U.S. dollars. The two countries have also conspired to smuggle oil and oil products throughout the region. U.S. officials also believe that Iranian oil is being shipped out of Iraqi ports.

The news comes as a disheartening blow to the United States, which pulled the last of its combat troops out of Iraq no more than eight months ago.

Sources told the Times that Iraq’s Prime Minister, Nuri Kamal al-Maliki, is at the center of it all, having essentially taken over Iraq’s central bank.

U.S. officials are aware of the problem, but there’s little they can do without further inflaming one of the world’s most volatile regions.

The United States did bar Iraq’s Elaf Islamic Bank from any dealings with the American banking system. President Obama said Elaf had “facilitated transactions worth millions of dollars on behalf of Iranian banks that are subject to sanctions for their links to Iran’s illicit proliferation activities.” A rare acknowledgement of a situation that’s usually discussed behind closed doors.

Still, the effort to punish the bank will only have a limited effect. The Iraq Central Bank has already given Elaf the green light to participate in its daily auction – where commercial banks can sell Iraqi dinars and buy U.S. dollars. It’s through these auctions that Iran has been able to access the financial system.

Now that Iraq is pumping more than three million barrels of oil a day, the country has some $60 billion in foreign exchange reserves. Indeed, Iraq’s burgeoning production has returned the country to prominence. It’s once again a political player with a louder voice on the world stage and within OPEC.

Iraq’s production grew by 115,000 barrels per day to 3.08 million in July – boasting the best growth among OPEC countries. Iran’s output, for instance, dropped by 173,000 barrels per day to 2.82 million. And while the two countries have a bloody past, they’ve grown much closer since the U.S. invasion. They stood side by side – along with Libya, Ecuador, Venezuela and Angola – calling for production cuts and higher oil prices in June.
Of course, Saudi Arabia – still OPEC’s highest-producing and most powerful member – resisted those calls. That country produced 9.875 million barrels per day of oil in July.

Still, Saudi Arabia’s power is waning. In its annual Statistical Review of World Energy, BP PLC (NYSE: BP) said that Venezuela has overtaken Saudi Arabia as the world’s largest holder of proven oil reserves.

BP puts Venezuela’s proven deposits at 296.5 billion barrels, or about 18% of the global supply. That compares to 265.4 billion barrels, or 16% of the world’s proven reserves, for Saudi Arabia.

Furthermore, it’s not even certain that Saudi Arabia has as much oil as it portends. American diplomats in Riyadh warned in confidential cables written between 2007 and 2009 that Saudi Arabia’s overall crude reserves may have been overstated by as much as 40%.

One cable written during the 2008 oil shock (when crude prices spiked to nearly $150 per barrel) warned that Saudi Aramco, the Saudi state oil company, no longer appeared to have the ability to raise production sufficiently to affect global oil prices. Another correspondence suggested that escalating electricity demand in Saudi Arabia could further constrain oil exports.

Indeed, Saudi Arabia gets 65% of its energy from oil. And between 2000 and 2010, oil consumption in the kingdom rose by 1.2 million barrels per day – growth that placed second only to China. In fact, oil consumption in the entire Middle East region rose 56% during that decade. That’s four times the global growth rate, and double that of Asia.

So even if Saudi Arabia has something left in the tank – and it’s not a given that it does – a greater portion of its reserves will be staying home rather than exported. And in the meantime, smaller OPEC producers are steadily increasing output.

Iraq is now the group’s second-largest producer. And Venezuelan President Hugo Chavez recently pledged to more than double his country’s oil-production capacity to six million barrels a day by 2019.

Bottom line: Producers that are hostile toward the United States are gaining more influence in the oil market, while the country’s lone ally is being surrounded by enemies that are growing in number and power.

This power struggle is only going to escalate over the next several years.

And that means more volatility for oil prices.

Still, that’s not necessarily a bad thing. To the contrary, volatility can be an investor’s best friend.

For instance, if you’re a trader willing to take big risks by shorting the market, you can clean up regardless of which way oil prices go. And even if you’re not, market downdrafts will take some energy stocks down to bargain levels – before price spikes send them drastically higher.

So be sure to stay tuned.