WACO, Texas – Tensions have escalated in Iraq, with the militant group Islamic State of Iraq and the Levant (ISIL, which is also known as the Islamic State of Iraq and Syria or ISIS) capturing territory and laying siege to refineries and other key Iraqi infrastructure.

Essentially, the group aims to put together an Islamic state covering a region stretching from southern Turkey through Syria to Egypt, including Lebanon, Israel, the Palestinian territories, and Jordan. Apart from the humanitarian, political, and other crucial elements of the conflict, there is also the potential for significant fallout for oil markets and, hence, the global economy.

Spikes in oil prices are often a harbinger of bad economic times to come. A general rule of thumb is that every $10 increase in the price of crude oil leads to a 0.2 percentage point drop in global economic growth. Since recent forecasts for overall economic growth are about 2.8 percent, that means if the price of oil goes up $10 and stays there, we can expect global expansion to fall back to just 2.6 percent. Other analysts point to an oil price of $120 per barrel as a threshold which would significantly impair the global business complex. The recovery is frustratingly slow already, and stepping down the pace of growth would prolong economic and fiscal problems ongoing in many countries.

M. Ray Perryman
M. Ray Perryman

So far (as we go to press), oil prices have stayed below the level at which we would expect to see major economic fallout. Markets are reacting, but not dramatically.  owever, Iraq is an important source of crude, producing more than 3 percent of the world’s daily supply. Moreover, Iraq is projected to account for much of the growth in total supply from the Organization of Petroleum Exporting Countries (OPEC). Strategic waterways in the region are also essential in transporting a vast swath of Middle Eastern oil to the market.

If ISIL is able to capture territory further south (where most of the infrastructure for producing and exporting oil lies), the situation could change. Also, if the conflict spreads to other oil producing nations, problems would worsen. While I’ll leave the political and military analysis to experts in those fields, even the possibility of such scenarios is enough to curtail investment in Iraq and increase uncertainty around the world. The result, at a minimum, would be more jittery financial markets and reduced investment.

On a positive note, US domestic oil supplies continue to grow. Thanks to hydraulic fracturing and other advances, we are now producing more of the crude we need right here at home. The American economy is therefore a little less vulnerable to supply shocks. A short-term slowdown in Iraqi production is obviously undesirable, but not as damaging as it would have been in the past. That is somewhat reflected in the fact that West Texas Intermediate benchmark prices have been affected less than other major market indices.

For Texas, as a major oil-producing state, higher prices provide incentives to keep up (or even escalate to the extent possible) the pace of exploration and production. The Lone Star State benefits from this activity, both in the form of jobs and other economic stimulus and through higher tax receipts. At the same time, elevated fuel prices extract a toll on the rest of the Texas economy, resulting in a net plus for some regions and industries (such as the Permian Basin, South Texas, and any energy-related industry) and a net minus for most others.

World leaders are contemplating their responses with care. The Obama Administration and US Congress are exploring options, and debate is raging over the best course of action. Oil markets are likely to react to each day’s headlines, and we can expect some volatility until the situation in Iraq stabilizes. Unless the situation worsens dramatically, however, the global economic recovery will likely continue.

<I>Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.</I>