Introduction
The US-Israel war on Iran, and the subsequent closure of the Strait of Hormuz, have had significant negative consequences for Iraq, chief of which is the effective shutting of its oil exports, roughly 95% of which passed through the Strait before the war. The immediate consequence is on the government’s ability to meet its expenditures, as about 90% of its revenues come from oil exports. The state’s outsized role in the economy, both through its provision of goods and services and through the public sector payroll, means that any disruption to its revenue ripples through the rest of the economy. Compounding the misery, the lack of oil storage infrastructure forced drastic cuts in oil production, from about 4,900,000 barrels per day (bpd) before the war to about 1,600,000 bpd. This still allowed for some exports while meeting domestic refinery demand of about 1,200,000 bpd. Yet the cuts have had negative consequences for the country’s power supply: Lower oil production led to associated cuts in gas production by a reported 70%, compounding power shortages already caused by wartime reductions in Iranian gas exports.
It’s no wonder that most coverage of the war’s effect on Iraq’s economy was of the gloom-and-doom variety, and not for the first time, the country’s obituary was being prepared, with the recent comments by Iraq’s foreign minister warning of “financial catastrophe” if the war continues, confirming the gloom. However, while the Strait’s closure is a fundamental risk for Iraq, the state can and should be able to manage through for some time, measured in months, not days or weeks. Oil revenues are normally received two to three months following their exports, and so even with cessation of exports after the Strait’s closure in early March, the government met its expenditures for March, April, and May, in which its revenues were augmented by domestic borrowing. Additionally, it has continued with the usual cash management toolkit it employed over the last months of 2025 – as used by prior governments when oil revenues fell below expenditures – such as ad hoc cost savings, accumulating arrears to third parties, including domestic contractors and International Oil Companies (IOCs). Each of these measures tends to stretch revenues despite the negative knock-on effects on the economy.
Beyond May, the government should receive modest oil revenues following the partial resumption of oil exports through Türkiye’s Ceyhan port on the Mediterranean, the passage of some tankers carrying Iraqi crude through Hormuz, and crude trucking through Jordan. While these would be supplemented by non-oil revenues, the combination would still be far short of past revenue levels and thus would need to be augmented by continued and increased issuance of domestic bonds, i.e., T-Bills, for the government to meet its expenditures. Under normal conditions, issuing bonds, in the absence of oil revenues, would erode the country’s foreign reserves and threaten the Iraqi dinar’s (IQD) peg to the US dollar (US$). However, the war and the closure of the Strait should also reduce imports (roughly 60% of imports come from China, Türkiye, and Iran), which mitigates, at least until early to mid-2027, the negative effects on foreign reserves. Nevertheless, the issuance of sizeable amounts of domestic debt, without oil revenues, will come with costs for the economy.
The US-Iran agreement, which was recently signed to end the conflict, should lead to the reopening of the Strait of Hormuz in the coming weeks and, in the process, limit what was a potentially open-ended crisis. However, even under the most optimistic scenarios, the resumption of Iraq’s oil production and exports would take a number of weeks before it returns to a semblance of pre-war levels, and then two to three months before oil revenues resume flowing into the budget. As such, the government is likely to continue issuing further domestic debt to cover at least another five to six months of expenditures, while continuing with the standard cash management toolkit. Together, these measures will increase the costs for the economy down the line. Offsetting these costs is the very likelihood that the new government is in initial talks with the IMF. Should these talks conclude with a program by year-end, they could unlock foreign borrowing in the Eurobond markets, thereby alleviating the pressures on domestic debt and reducing risks to the IQD peg. This, in turn, would create better dynamics for the government’s overall financial position.
However, the crisis need not have been so critical for the country were it not for the accumulation of self-inflicted wounds by successive governments operating under the logic of Muhasasa Ta’ifia – sectarian apportionment –, the defining feature of the post-2003 political order. The first major negative economic consequence of such a system is that the need to reach agreement among the many parties that compose it produces lowest-common-denominator policies, and hence populist economic policies. The second is that patronage networks, based on loyalty rather than competence, leave the country’s economic management weak at best. This piece focuses on two key self-inflicted wounds, both rooted in these dynamics, that led to the critical condition for the economy following the Strait’s closure.
Doubling Down on Policies That Leveraged the Economy to Oil Prices
Successive governments have adopted budgets that created and then perpetuated multiple structural imbalances that, over time, magnified and fed into each other. At the heart of these is the imbalance between current and investment expenditures, with the former continuously expanding at the expense of the latter. This reflects the state’s patrimonial role as a redistributor of the country’s oil wealth in exchange for social acquiescence to its rule; a dynamic that led to the state’s outsized role in the economy, while leaving the country heavily dependent on imports of goods and services, and highly exposed to oil price volatility.
A series of economic and financial crises – the 2008-2009 global financial crisis, the Islamic State (ISIS) period of 2014-2017, and COVID-19 in 2020 – each amplified by falling oil prices and each more severe than the prior one, exposed the faultlines created by these multiple structural imbalances. However, these crises have not led to a re-examination of the past in addressing the key imbalance between current and investment expenditures, nor have they led to policies that minimize, or at a minimum mitigate, the economy’s exposure to oil price volatility. Instead, as each crisis ended with increasing oil prices, the post-2003 political order doubled down on the same economic policies of the past, with each iteration further magnifying this exposure.
The 2023-2025 budget was the latest “doubling down”, in which the new government, formed in late 2022, found itself blessed with significant surpluses from the higher oil prices in 2022 following the invasion of Ukraine earlier in the year. Despite the recent scares of the 2020 crisis, it embarked on an expansionary fiscal policy with a three-year 2023-2025 budget with unprecedented annual spending plans of IQD 199.0 trillion (US$153 billion). Relatively high oil prices in 2023-2024, coupled with the significant under-execution of investment spending, allowed the government to execute the budget’s expenditures relatively easily. However, oil prices declined meaningfully in 2025 and, despite continued under-execution of the budget, expenditures began to exceed revenues. This forced the government back to its standard cash management toolkit while also augmenting revenues through domestic borrowing. The Strait’s closure arrived on top of a budget already under strain.
Mismanaging the Oil Sector Despite Extreme Exposure to Oil Prices
Despite this extreme dependence on oil revenues, the management of the oil sector, from production to exports, is ad hoc, with no consistent long-term strategies with clearly articulated goals for the development of the country’s massive oil and gas wealth. Essentially, the country operates without a coherent national oil and gas policy. The federal government of Iraq (GoI) and the Kurdistan Regional Government (KRG) pursued divergent oil policies that led to two separate oil export routes: federal exports flowing overwhelmingly through the Strait of Hormuz and the Kurdistan Region of Iraq (KRI) exports flowing through Türkiye’s Ceyhan port on the Mediterranean via the Iraq-Türkiye Pipeline (ITP). The latter developed without the permission of the GoI, making KRI exports closely interlinked with the dispute over the region’s share of the federal budget. This, in turn, held back the development of the ITP as a significant secondary export route for the country as a whole.
Two legal rulings, in 2022 and 2023, appeared to open a path toward resolution. They triggered a fundamental shift in the relationship between the GoI and the KRG, which began to take shape in two interlinked agreements in Spring 2023 that effectively amounted to an oil and gas revenue-sharing mechanism, one that had the potential over time to become a building block for a federal oil and gas law, and thus for the emergence of a coherent national oil policy.
However, this potential was within weeks derailed by political differences in the Council of Representatives (CoR) – essentially stemming from disputes over the KRI’s share of the budget. In late 2024, the GoI and the KRG acted to revive the interlinked agreements, paving the way for a legislative amendment by the CoR in February 2025. To ensure the passage of the legislation, the amendment came with a typical Muhasasa fudge, with enough ambiguity to reach consensus, but not enough clarity to ensure speedy implementation. As a result, the resumption of the KRI oil exports was delayed until September 2025, but this time under federal control. Crucially, this was a temporary agreement, like all the agreements made with the KRG since 2003, that, in reaching consensus through the lowest common denominator, did not address the real issues, leaving them to fester.
Following the start of the war, the KRI’s oil production shut down following attacks by sub-state actors, which ended the KRI’s exports, which averaged 200,000 bpd until then. This deprived the federal treasury of revenues as these exports were managed by the federal State Oil Marketing Organization (SOMO). To remedy this revenue loss, the Federal Ministry of Oil (MoO) sought to divert some of its production to the ITP route for a hoped-for 250,000 bpd, but the KRG refused to allow that because of major unresolved differences between the two over non-oil revenues that the temporary agreement did not resolve. Once again, yet another temporary arrangement prevailed, enabling planned federal exports that averaged just under 200,000 bpd – the volumes were constrained by underinvestment in domestic pipelines linking major southern federal oil fields with the northern export route through Türkiye.
The extent of the damage to the country from the series of self-inflicted wounds in this particular instance can be seen from the potential loss of federal revenues from the inability to export more oil through the ITP. First, the shutdown of the KRI’s production led to the loss of 200,000 bpd, which could have otherwise increased total exports to 400,000 bpd. Second, had the September 2025 agreement been definitive and clear, then the KRI’s IOCs might have increased production to the 2022 levels, which would have added a further 200,000 bpd for a total of 600,000 bpd. Third, the damage was compounded by the underinvestment in domestic pipeline infrastructure, which prevented the diversion of more oil from the southern fields, probably for a further 300,000-400,000 bpd, that could have raised effective Iraqi pipeline exports linked to the ITP, to 900,000-1,000,000 bpd. Adding insult to injury, the ITP set of agreements expires at the end of July 2026. Türkiye had notified Iraq the year before that it would not renew them under the old conditions, seeking a more comprehensive deal that would ensure increased flow through the ITP of 1,600,000 bpd. While discussion on a new set of agreements resumed, the two sides have yet to reach an agreement.
Whatever the endgame is post the US-Iran deal to end the conflict, the ease of the closure of the Strait, and the subsequent significant damages to the world economy, will have profound long-term effects on both energy producers and consumers. The episode exposed the fragility of one of the world’s most critical energy chokepoints and is likely to trigger a broader re-examination of other similar chokepoints, shaping policy and investment decisions by both energy producers and consumers.
Among the emerging solutions are alternative export routes utilizing pipelines as substitutes for both the Strait and other chokepoints – for Middle East oil producers, these are Bab-Al-Mandeb and the Suez Canal. The defining feature of these alternative export routes would be their resilience to disruptions arising from conflict or political differences, largely stemming from the needs of energy consumers for supply continuity irrespective of disruptions. In fact, the order of the day would be routes with built-in redundancies.
Iraq’s current production has made it a major energy producer today, and its potential future production profile allows it to continue to be so for a number of years to come. Its geography gives it a unique advantage among regional producers: the ability to access multiple export routes ending in the Mediterranean, the Red Sea, and the Gulf. Crucially, in the case of pipelines, many of these routes would pass through only one transit country, thus minimizing costs and potential differences with transit states. Moreover, this diversity of routes provides it and its customers with multiple export routes.
In particular, Iraq has the potential to develop two to three routes to the Mediterranean: firstly, the existing ITP to Ceyhan via Türkiye; secondly, the old Kirkuk-Banias via Syria; and thirdly, the extension of that line to Tripoli via Lebanon. It also has potential access to two routes to the Red Sea through Aqaba via Jordan and to Yanbu or Mu’ajiz via Saudi Arabia. In fact, Iraq’s geographic advantage has already started paying dividends, as major US internet companies, with data centers in the Gulf, have begun utilizing existing fiber-optic cables in Iraq that have been laid alongside oil pipelines as back-up or alternative routes for subsea cables that pass through the Strait.
At the same time, the fact that other Gulf countries are facing similar pressures to diversify their export routes creates a rare alignment of incentives which will be needed if the region is serious about developing alternatives to the Strait and other chokepoints. Exporting oil through pipelines over multiple countries is extremely complicated and requires an alignment of interests of all countries involved. These incentives are doubled, as the Strait is not only an export route for oil and refined products, but also for other commodities such as fertilizers, as well as a route for the import of a large number of goods – thus, the need for parallel roads and railways that would also enable the export and import of other goods.
The silver lining of the current crisis, therefore, is that it created powerful incentives and a big need for integrating Middle East economies, or at a minimum working closely together on multiple common projects, all of which would involve significant investments, but all of which will come with increased economic activities and opportunities for the region’s growing populations. These seem somewhat fanciful, or at a minimum wishful thinking, given the history of such ideas in the region, but the current crisis, and the linked wars on Gaza and Lebanon, create a desperate need to think about how a new regional order can emerge from this that is more responsive to the needs and aspirations of its citizens.
Iraq, which had been marginalized from any regional integration since the invasion of Kuwait, faces a historic opportunity to reintegrate. However, its challenges are not so much the considerable ones of bringing some of these routes to life, but the deeper shortcomings of its political economy and its built-in capacity for self-inflicted wounds.
The views represented in this paper are those of the author(s) and do not necessarily reflect the views of the Arab Reform Initiative, its staff, or its board.
