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What the Iraq Conflict Means for the Oil Market

The escalating conflict in Iraq has pushed Brent crude prices sharply higher over the past few weeks. While West Texas Intermediate prices have also gained, the spread between WTI and Brent crude has widened to more than $8 per barrel. Higher Brent crude prices are a worry for a global economy, especially for countries like India and Japan that rely heavily on oil imports.

However, for independent U.S. refiners such as Valero Energy  (NYSE: VLO  ) , Phillips 66 (NYSE: PSX  ) , and Marathon Petroleum (NYSE: MPC  ) , the widening spread between WTI and Brent means stronger margins. More importantly, the conflict in Iraq could push Brent crude prices even higher, further widening the spread between the U.S. and the global benchmark.

Middle East crisis widens spread between WTI and Brent crude
The spread between WTI and Brent, which had widened significantly in the last few years due to surging U.S. oil production, narrowed at the start of this year. The likes of Valero, Marathon Petroleum, and Phillips 66 have benefited immensely from cheaper WTI prices. When WTI prices trade at a discount to Brent, refiners get a cheaper feedstock. However, prices for the refined products, which are exported, are linked to the global benchmark. A narrower spread means weaker margins for refiners.

Narrower margins had a slight impact on refiners' first-quarter results. The good news for them, however, was that the margins once again widened to around $7 per barrel as U.S. oil production surged, leading to record-high inventory levels. The spread between WTI and Brent has widened further as the conflict in Iraq has pushed the price of the global benchmark higher.

Brent crude is trading above $114 a barrel, a premium of more than $8 per barrel over WTI. The oil price shock is a concern for oil-importing countries, but for refiners it means stronger margins. More importantly, the escalating crisis in Iraq could have significant long-term implications for the global oil market.

Iraqi oil production under threat
The crisis in Iraq threatens to disintegrate the country. If the conflict lasts for a long time, it could have a significant impact on global oil supplies. Given that Iraq is the second largest OPEC crude producer, this could have major implications for the global oil market.

Indeed, Iraq had been reemerging as a major source of oil. In February, the country's production reached 3.6 million barrels per day, a 35-year high. Until recently, the country's oil minister was confident of reaching the 2014 production target of 4 million barrels per day. However, that may now be unlikely. In fact, the International Energy Agency recently said in its Medium-Term Oil Market Report that there is significant downside risk to the projected addition of 1.28 million barrels per day to Iraqi production by 2019.

This is a major concern, as according to the IEA 60% of OPEC's expected growth in capacity by 2019 is set to come from Iraq. If Iraq doesn't meet its production targets, then Brent crude prices could continue to trade at a significant premium over WTI, especially as U.S. oil production continues to surge.

The oil price shock due to the crisis could also weaken the case for lifting the ban on U.S. crude oil exports; the ban was put in place more than four decades ago to ensure that the U.S. is not affected by an oil price shock like the one seen after the Arab oil embargo.

All these developments mean that refiners' margins could remain safe in the long term and in fact could improve further, as the spread between WTI and Brent crude is likely to widen even more.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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