Unlike recent geopolitical threats in Syria and Ukraine, Iraq's current sectarian conflict may have a lasting impact on oil markets that goes beyond short-term price action, Morgan Stanley argues.
Sustained violence in Iraq may result in several structural changes for crude oil, namely increased volatility and the return of oil into portfolios, the group said in a report on Monday.
"Recent events in Iraq may finally lift volatility and bring fund flows back to oil. We also see a catalyst to lift underpriced long-dated Brent as producer selling may abate and renewed supply concerns may bring consumers back to the market," the report said.
Rebels from jihadist group Islamic State of Iraq and the Levant (ISIL) took control of another town on Monday, Saqlaqiya, west of Baghdad, with the help of allied Sunni tribesmen. In the past week, the group has seized the country's entire northern region, including Kirkuk, home to the Kirkuk-Ceyhan oil pipeline.
But what makes Iraq's crisis more critical than tensions in Syria or Ukraine?
"The unrest is entrenched and unlikely to be resolved soon in a country where a large amount of oil is truly at risk. Global supply and demand fundamentals are also improving as the market moves towards peak summer demand, both of which make a large retracement unlikely," Morgan Stanley analysts said.
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Expect higher volatility
According to several analysts, markets have become too complacent about oil prices and geopolitical risk as a result of low volatility. Over the past five years, Brent crude has largely hovered around $110 per barrel.
"Volatility in markets remains at all-time lows, even the pricing of risk is still quite low so at this point, investors are not yet pricing in significant problems [from Iraq]. They are slightly fearful but they have not yet reacted," Vadim Zlotnikov, chief market strategist and co-head of multi-asset solutions at AllianceBernstein told CNBC on Tuesday.
But Morgan Stanley warns that volatility could rise if violence continues. Brent has already spiked to a nine-month high of $113 a barrel in recent days and the bank reckons prices could jump as high as $116.
"Beyond the near-term short covering, new concerns about supply and prices may finally break volatility and oil prices out of a range and disrupt short volatility strategies," the report said.
Ninety-two percent of respondents in the latest CNBC poll of market strategists said they are bullish on oil prices with most saying that disruption in Iraqi exports could push Brent to $120.
Several hedge funds have been underinvested in or net sellers of oil due to 'boring' price action in recent years. Expectations for flat prices usually limit speculation by money managers and deter consumers from trading in futures. However, Morgan Stanley expects the higher volatility to trigger fund flows back into crude.
Data from the Commodity Futures Trading Commission (CFTC) on Friday support that claim; futures market traders and speculators increased their bullish bets in crude oil futures last week.
The impact of higher volatility could also see the return of long-dated buying, which Morgan Stanley identifies as the primary driver for the steep backwardation in Brent. If concerns about oil prices return, consumers may revisit long-dated hedging and help lift longer-term oil prices.
"Recent events [in Iraq] may finally shift the psychology, reduce producer hedging and bring some consumers back to the market. Such a change could go a long way towards lifting the back of the Brent curve and removing some of the steep long-run backwardation entrenched in the Brent curve," the report said.