Saudi Arabia Under Pressure to Plan for Iraq Oil Disruption

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When U.S. President Barack Obama spoke briefly on June 13 outside the White House on the deteriorating security situation in Iraq, he ruled out sending in U.S. troops, but said that he had instructed his national security team "to prepare a range of other options."

While the potential use of force – most likely consisting of airstrikes in some form – is what made headlines, Obama also hinted at the fact that his administration was working behind the scenes to plan for a possible major disruption in Iraqi oil output, which accounts for some 3.5 percent of global supply.

"One of our goals should be to make sure that in cooperation with other countries in the region, not only are we creating some sort of backstop in terms of what's happening inside of Iraq, but if there do end up being disruptions inside of Iraq, that some of the other producers in the Gulf are able to pick up the slack," Obama said.

Essentially, "other producers in the Gulf" really means Saudi Arabia, the only nation with significant spare capacity – i.e. dormant oil capacity that can be ramped up at a moment's notice.

Coincidentally, OPEC met last week – before ISIS began is conquering drive across Iraq – and decided to leave its oil production quota unchanged. Even before the shockingly quick deterioration of Iraqi security, global oil production was already coming dangerously close to just meeting demand (at current prices). In order to avoid a price surge later this year, Saudi Arabia was already going to have to increase production.

Now, with Iraq's production threatened, pressure on Saudi Arabia to raise outputs is even stronger.

But convincing Saudi Arabia to dramatically increase production could be a challenge. Saudi Oil Minister Ali Naimi has indicated that he's content with the current market conditions. "Everything is good. Supply is good, demand is good, prices are good and the market is balanced," he said ahead of the OPEC meeting in Vienna.

That may have been the case before last week, but the danger of a major supply cutoff cannot be ruled out. Iraq's 3.3 million barrels per day exceeds what Saudi Arabia holds in spare capacity – which stood at 1.96 million barrels per day in the first quarter.

It is unlikely that Iraq will lose all of its production, particularly since two-thirds of its capacity is located south of the current turmoil, but should a significant volume be cut off from global markets, Saudi Arabia's ability to make up for it is questionable.

As a result, oil prices could skyrocket, perhaps jumping as high as $150 per barrel, up from $112 last week. Even if Iraq's southern oil fields are not affected by the violence, jittery markets will likely bid up oil prices as Iraq moves closer to civil war.

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