Market Insider

Oil prices head higher as Iraq tensions flare

Iraqi workers are seen at the Rumaila oil refinery, near the city of Basra, in 2009.

Surging U.S. oil production was expected to drive oil prices lower this year, but a confluence of geopolitical events—particularly a Sunni militant uprising in Iraq—could now drive already high prices even higher and keep them there.

The situation in Iraq has become increasingly tense and violent with Al Qaeda-linked groups seizing control of two key cities, Mosul and Tikrit, in the past two days. The group, the Islamic State of Iraq and Syria, so far has targeted a northern pipeline—the Kirkuk-Ceyhan oil pipeline, but the activity has so far not spread to other energy infrastructure.

"On balance, what's happening at the moment seems, at least so far, some ways removed from the major producing regions of Iraq," said Citigroup analyst Eric Lee.

Geopolitical risks in the oil market

Citigroup upped its price forecast for Brent crude several weeks ago to an average $109 per barrel this year, and $105 for next year, based on a cluster of geopolitical events.

Crude prices have been trading near 52-week highs. Brent was up slightly Wednesday, hovering at $110 per barrel. West Texas Intermediate has been moving higher with it, closing at $104.40 per barrel Wednesday afternoon.

Outages in Libya, which now provides nothing to the world oil market; the ongoing boycott against Iranian crude; and security concerns in Nigeria are all adding to worry that global oil supplies could become tighter. Russia's foray into Ukraine also has added slightly to the price premium since it is a major source of oil to Europe.

Another factor driving prices is China's growing demand for oil as it builds a strategic reserve similar to the U.S. Strategic Petroleum Reserve, Lee said.

Read MoreOil prices boosted by stockpiles, Iraq

But at the same time, U.S. oil production continues to surge. The latest U.S. government data, released Wednesday, shows domestic oil production rose to 8.46 million barrels a day last week, up from 7.2 million barrels at the same time last year and 8.38 million barrels just a week earlier.

So far, with OPEC pumping 30 million barrels a day and the U.S. producing more oil now than it imports, prices have risen but not spiked on fears about Iraq. Yet, that could change.

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"With Libyan production set to be offline for a significant period and the return of Iran's sanctions-restricted barrels likely to be slow, Iraqi oil is an important swing factor," according to Barclays analysts.

Hopes were high for Iraqi oil production this year, with the government forecasting 4 million barrels a day, up from just over 3 million last year.

The Barclays analysts point out that the repeated bombing of the 600,000 barrel a day Kirkuk-Ceyhan pipeline makes it difficult to repair or return to operation, given its proximity to ISIS strongholds.

"A big question for the Iraqi oil sector is whether groups like ISIS will seek to expand their attacks on other energy infrastructure. While these groups have not specifically targeted any southern energy facilities, they have carried out periodic bombings in and around the Basra area in the past year," they wrote, adding the southern region is not beyond the reach of the militants.

Michael Leiter, former director of the National Counterterrorism Center, said there is no simple fix for the situation in Iraq. He said it is compounded by the weakness of the Shia-led Baghdad government, which has failed to reverse ISIS control of Fallujah, seized earlier this year.

"This is one organization. Their name is the Islamic State of Iraq and Syria, and this is what they're trying to accomplish," he said. "Their view is there should be no Syrian-Iraq border this is one big Islamic stateand because of the weakness in Baghdad right now, it is. They don't represent the entire operations in Syria but they are the most militarily capable, and their success in Syria directly led to success in Iraq."

Turkey Wednesday called for an emergency NATO meeting after its consulate was seized in Mosul and its staff detained. Leiter said NATO will not take action within Iraq, but it could fortify the borders with Turkey, Lebanon and Jordan.

Read MoreTurkey calls for emergency NATO meeting

"You're seeing some instability in Lebanon. Syria is creating a huge degree of regional instability. The question is what reverses this? I have to say it's not all that clear. They are desperate for U.S. assistance but they didn't want us there, and the Administration didn't want to be there.

...In the long run, you have to hope that the lraqi government can get the Sunni population in Iraq to see that ISIS is even more dangerous than the Shia-dominated government in Baghdad," Leiter said.

Lee terms the confluence of events the "new abnormal" of geopolitical disruptions.

"We've made comments before that these disruptions are challenging old borders and boundaries, and that you could see a redrawing of some of these oil producer countries on factional lines, that never really lined up well with the national boundaries that ended up being set," Lee said in an email to CNBC.

Oil analyst John Kilduff of Again Capital, said the Iraq situation overshadowed Wednesday's OPEC meeting, which agreed to keep production unchanged.

"If the Iraq situation gets even the slightest bit worse, (prices) will break out to the upside," Kilduff said, noting the lack of oil from Libya has been supporting prices. "But for that, the price would me much lower."

"If things keep going where they're going, there's another $5 to the upside," he said, but Brent could quickly reach $125 if the situation worsens.

—By CNBC's Patti Domm