Smuggling weighs on prospects for oil industry in Iraq

Within days of taking office in late October, Iraqi Prime Minister Mohammed al-Sudani announced what appeared to be a major salvo in the country's long struggle against corruption, with the arrests of nine senior oil-protection force police officers, including five generals, allegedly involved in a massive oil smuggling ring in Basra.

The bust uncovered a network of operatives, who punctured crude oil pipelines in the Zubair oil field and stole some 75 million liters per month, Iraq's National Security Agency said.

It amounts to the first serious actions by the government to tackle the illicit trade in crude and refined products since 2003, when the oil ministry sacked hundreds of workers amid a US-led crackdown on smuggling in the country, according to Iraqi industry sources.

But with corruption rife in the Iraqi oil sector, Sudani will have to go further to root out the problem, they say. Many doubt his new government's willpower or ability to constrain the organized groups and militias entrenched in the "gray market" trade that is generating millions of dollars of laundered revenues, including for sanctioned groups.

"We ordered the tracking of oil smuggling networks and the implementation of arrest warrants against the gangs that dared to steal the rights of Iraqis," Sudani said in a Nov. 2 tweet. "We will spare no effort and work day and night to fight corruption in its various forms."

Eye-witnesses and sources familiar with the trade have described to S&P Global Commodity Insights how militias aligned with neighboring Iran have run an "industrial scale" oil smuggling operation for years.

The alleged activities in the country include "shadow tanker loadings" to disguise unofficial oil cargoes, shakedowns of local officials and oil workers, unsanctioned drilling in fields commandeered by militia, siphoning of crude and fuel from punctured pipelines, and convoys of trucks carrying refined products across the border to Iran and Syria.

The groups, such as Kataib Hezbollah, one of Iraq's most powerful Shiite militia, operate with virtual impunity, according to industry insiders, particularly since the US scaled back its military presence beginning in 2020.

The Iraqi oil ministry and state marketer SOMO didn't respond to multiple requests for comment on the matter.

"The smuggling convoys are accompanied by a heavily armed military escort to ensure their safe passage, showing the value placed on these operations by Iranian militias and the Iranian regime," said one witness, an Iraq-based industry source with first-hand knowledge of the shipments, who spoke on condition of anonymity.

A former US official closely involved with monitoring the Iraqi oil industry and security said that the militias, which control several local oil companies, will "coordinate a tanker loading to be off-book to better share proceeds," while another Iraqi source said: "The smuggling of oil and oil products cannot be denied, neither is the involvement of Kataib Hezbollah."

The exact quantities of Iraqi oil lost to the purported trade vary and are difficult to track with certainty, though several sources and observers say it is likely in the tens of thousands of barrels per day, possibly higher.

Ali Dadpay, an associate professor of finance at the University of Dallas, who has studied oil smuggling in the Middle East, estimated the illicit volumes in Iraq at around 7 million liters daily, or almost 60,000 b/d.

That is a small fraction of the 4.58 million b/d of crude oil that OPEC's second-largest producer pumped in October, according to the latest Platts survey of OPEC+ output by S&P Global. But at a discount of $20/b to Platts Dated Brent, it is equivalent to some $1.4 billion in lost annual revenues.

Beyond the direct fiscal outflows from government coffers, the impact extends to shortages in the local supply of transportation fuels and power generation, causing popular protests and hampering efforts to rebuild the nation after decades of war.

"Fuel smuggling goes back to the 1970s and since then it has been growing into an industry of its own," Dadpay said. "In the economy it adds to the cost of a wasteful policy, subsidizing fuel and petroleum products at the expense of public infrastructure and other welfare programs."

US awareness

The alleged activity has drawn renewed scrutiny from US lawmakers, with former Iraqi oil minister Ihsan Ismaael included in a delegation from the country to participate in the World Bank's annual meeting Oct. 10-16.

In a letter to US President Joe Biden, three Republican members of Congress asked the White House to reconsider engaging with Ismaael, accusing him of helping Iran evade sanctions. Sudani, who took office Oct. 28, has since replaced Ismaael as oil minister with Hayyan Abdul-Ghani. His removal from office was not thought to be linked to the alleged smuggling activities.

"The oil minister is known to have facilitated illegal oil exports on behalf of Iran [and] is suspected of widescale corruption to accept bribes for the award of contracts and oil operations in Iraq," Republican Representatives Jim Banks, Michael Waltz and Joe Wilson wrote.

Ismaael could not be reached, while the oil ministry did not return multiple messages seeking comment, nor did the offices of Sudani and his predecessor, former Prime Minister Mustafa al-Kadhimi.

Current and former US officials said the American government, which has been frustrated in its attempt to dislodge Baghdad from Tehran's sphere of influence, has long been aware of the prevalence of Iraq's gray oil market.

"The fact that Iraq has a parallel set of...militias alongside its military, including Kataib Hezbollah, is a huge problem," said Greg Priddy, an oil consultant focusing on Middle East geopolitics, who added that Iraq's borders have been poorly secured since the US invasion in 2003.

A former US official, who specializes on the Middle East and asked not to be identified, said Kataib Hezbollah, along with fellow Iranian-linked Shiite militias Asaib Ahl al-Haq and Harakat al-Nujaba, "run Iraq's borders and in some cases facilitate smuggling into and out of Iraq by truck. They are also part of the system to more broadly profit from the oil sector."

The US has imposed sanctions on all three militias. The White House and US State and Treasury departments declined to comment.

Exploiting price gaps

The bulk of the gray market trade involves refined products, a lucrative trade given Iraq's industrial fuel subsidies and prevailing market prices for consumers in the country, as well as in neighboring Iran, Jordan and Syria.

For example, Iraq produces about 40,000 mt/d of fuel oil, of which about 26,000 mt/d is supplied to local power stations, cement factories and other local customers at a subsidized price of around $200/mt, far below the Nov. 28 Platts assessment by S&P Global for FOB Arab Gulf cargoes of $326.61/mt.

Motor fuels are also heavily subsidized, with gasoline recently retailing in Baghdad for about Dinar 450-750/liter (31-51 cents/l), compared with about $1.63/l in Amman, according to people in the region.

Iraq's refining sector has a total crude distillation capacity of about 1.1 million b/d, though effective capacity is much lower, ravaged by the legacy of war. As a result, Iraq has to import gasoline and diesel to meet local demand, while its power sector, which heavily uses oil as feedstock, has been reliant on Iran for supplies of gas and electricity.

The smuggling has exacerbated local fuel shortages, with several protests erupting in Iraq over the past several months over living conditions, including spiraling costs and widespread unemployment.

Special border crossings

Crude oil is also illicitly produced or smuggled, sent to simple topping refineries that have dotted Iraq and surrounding areas since the Islamic State spread through the region in 2014, or consumed in power plants, informed observers said.

Kataib Hezbollah allegedly takes advantage of weak oversight of crude supplies intended for local refineries and fuel oil volumes allocated to industrial plants, where forged paperwork will allow them to load subsidized barrels to be refined and sold later at market prices, sources said.

"There are a lot of distraction tactics" for the oil shipments, said an energy consultant who works in Iraq and asked not to be named for security reasons. "It goes at night, it goes in loops, and nobody knows where it's going. But it's a substantial amount that's floating around."

Sources in the industry and eye-witnesses said the activity is prevalent in eastern Iraq, where dozens of trucks take crude oil and refined products daily through various border crossings, including to the Iranian towns of Shalamacheh and Mehren.

In some cases, oil workers are brought in from Iran by the militia to prospect for drilling locations, sources said.

Iran's foreign ministry declined to comment, while efforts to reach Kataib Hezbollah were unsuccessful.

Weak governance

Iraq suffers from widespread corruption, ranking among the worst in the world by several governance watchdog agencies. A weak legal system and an inadequate independent judiciary compound a parliament that is splintered by sectarian allegiances.

"Iraqi institutions naturally demonstrate little public accountability and are instead driven by each group's political positions and power," Transparency International said in placing Iraq 157th out of 180 countries on its 2021 Corruption Perceptions Index.

Ridding Iraq of the militias is no easy task, given Iran's heavy influence in the country's splintered government.

Analysts claim the militias operate outside the Iraqi military chain of command, and efforts to curb their activities, including arrests of Kataib Hezbollah leaders, have inflamed tensions.

"The problem is that Kataib Hezbollah has made clear via shows of force that it isn't going away without a major fight -- and nobody is willing to undertake that," Priddy said.

In the weeks since his announcement of the sting on the Basra smuggling operation, Sudani and his administration have not followed up with any new information on who was involved beyond the nine officers arrested, nor any other efforts to combat the illegal trade.

The prime minister has spoken more generally about tackling corruption, a pledge many of his predecessors have also made, with scant success.

His willingness to take on smugglers head-on remains a major test for his administration.