The Islamic State in Iraq and Syria (ISIS) has made headlines with audacious land grab and terror tactics. But what will be the economic impact on the economies of the Middle East?  No discussion of the region's economic state is possible without also discussing oil. Though, initial fears of higher oil prices have not materialized for many reasons, including the shale oil boom in the US and Saudi overproduction, ISIS's economic cost is significant not just for Iraq but also other Middle Eastern countries. (For more, see: How Much Oil And Gas Will Iraq Produce?)

ISIS's Impact on Iraq

Iraq has the fifth largest oil reserves in the world and third highest in the Middle East after Saudi Arabia and Iran. Its daily production was forecast to be approximately 3.4 million barrels per day representing slightly less than 4% of the global production. The IEA's "Medium Term Oil Report 2014" (paywall) expects that Iraq will account for three fifths of the growth in OPEC’s oil production till 2019. More than half Iraq's GDP comes from the oil sector, which employs around 40% of the workforce. The government derives an astonishingly high 93% of its revenues from oil.

Part of ISIS's rise in Iraq can be attributed to sectarian politics. The rule of Prime Minister Nouri al –Maliki (a Shiite), who stepped down in August 2014, led many Sunni Muslims in the north to feel politically disempowered, and part of their dissatisfaction came from the distribution of oil revenues. It is estimated that between 2010 and 2013 the government’s revenues from oil production almost doubled to USD $100 billion. If the budget surplus from these revenues had been distributed evenly, it is estimated that each Iraqi household would have received USD $50 per month. The mismanagement of oil revenues is also manifest in Iraq's poor infrastructure. More than ten years after the official end of the Second Gulf War, only a quarter of Iraqis have access to clean sanitation. The power sector was a mess for a decade, and electricity production only recently returned to the same levels it was under Saddam Hussein.

Moreover, the rise of ISIS has forced the Iraqi government to spend money on its woefully unprepared armed forces and on the rehabilitation of millions of refugees. Though currently the Iraqi government has reserves and surplus funds, mounting expenditures and falling oil prices has economists to project that Iraq will run a deficit next year. Compounding this problem is the fact that the 2014 budget is yet to be passed 10 months into the year, and finances are being managed on 2013 estimates. The ISIS challenge is most likely to lead to lower oil production that will further depress revenues. Such gross mismanagement is also likely to deter the IMF and World Bank from giving Iraq any further funds.

How Does ISIS Finance Itself?

ISIS, like its mentor Al Qaeda, used to depend on Arab Gulf donors for funding. Now that it controls vast swathes of territory across Syria and Iraq having a population of at least 8 million people, however, it is running a self-sustaining economy, making it the world's richest terror group.  Apart from the usual methods of extortion from businesses, protection money from minorities and collecting ransoms for releasing hostages, they also control the trade. Consequently, economic sanctions are likely to lead to a crisis for the civilian population in the region as well. (For more, see: Countries Sanctioned By The U.S. - And Why.)

Thankfully, 6 of 8 Iraq’s major oil fields lie in the Shia South, which is unlikely to come under ISIS control. However, ISIS controls a few small oil fields in the north and some small refineries in Syria, which it uses to finance its operations. It sells crude at a steep discount, at a rate of USD $30 per barrel (the price as of October 2014 is between USD $80 and $85 per barrel) in the black market. By some estimates, oil production under ISIS controlled territory is around 80,000 barrels per day, which nets them a revenue of at least USD $1 million and possibly up to USD $3 million. All this money not only finances its terror network but is also used to expand it. ISIS pays better salaries than those paid to the Syrian rebels and the Syrian or Iraqi armies, both of which have witnessed mass desertions. (For more, see: Economic Effects Of Life After Military Service.)

Impact on Countries Outside Iraq

Trade between Iraq, Turkey, Syria, Lebanon and Jordan had been growing at a good pace, driven mainly by Turkey, but with the rise of ISIS this is likely to slow down. The conflict has already damaged the oil pipeline from Kirkuk to Turkey, stopping the oil flow.

Turkey

Though the impact of the conflict has not been as bad as expected, since oil prices haven’t increased as rapidly as initially projected, which has kept Turkey’s finances under control, the trade between Iraq and Turkey is likely to suffer. Turkey runs a huge trade surplus with Iraq, which is likely to slow down dramatically due to lower demand from Iraq. Trade routes between the two have also been impacted due to the conflict, leaving trucks from Turkey no option but to take the longer route via Iran to reach southern Iraq, which reduces profitability to zero or below.

Jordan and Lebanon

The emergence of ISIS coupled with the Syrian civil war has added to the woes of Jordan and Lebanon, which have both absorbed a large number of refugees. Almost 20% of Jordan’s exports go to Iraq, and ISIS's presence on the border of Jordan could lead to a flare up of violence, since ISIS has publicly threatened the regime. This could lead Jordan to divert resources towards the mobilization of its army. Its government debt is already 85% of GDP and budget deficits would widen further in the event of any large-scale conflict. (For more, see: Successful Ways That Governments Reduce Federal Debt.)

Since ISIS took control of the border crossings and inland ports between Syria and Iraq, Syria’s exports and imports to and from Iraq have plummeted, even for food items, which are leading to shortages. ISIS also controls Syria’s largest oil field, which contributes almost 60% of the country’s oil production. The complete collapse of Syria’s industry and agriculture exports has led to a sharp increase in the trade deficit for the first eight months of this year. All this has resulted in massive inflation and a frantic demand for foreign currency, with 1 USD buying SYP 162 and selling at SYP 5,172 in a market in the center of Damascus.

Iran

Iran’s position seems to be the trickiest of all in that its interests align with those of the US in its fight against ISIS, but at the same time disagreements over its nuclear program have led to economic sanctions led by the U.S. Though Iran has provided support in the form of intelligence and advisors to the Iraqi government, this support is definitely a drag on Iran's economy given its weak position due to the US led sanctions and its involvement in Syria. Falling oil prices have definitely curtailed Iran’s ability to intervene without serious consequences for its economy. Iran needs oil prices well above USD $100 for it to balance its budget, but with oil prices below USD $100 it would need to cut spending or compensate for the lost revenues by reducing subsidies. Any cooperation between Iran and the US over ISIS could lead to a gradual withdrawal of sanctions, which would allow Iran to sell its oil on the open market and generate revenue. The flip side is that Iran’s oil would surely depress oil prices further. (For more, see: How Does The Strait Of Hormuz Affect My Gas Prices?)

Saudi Arabia

Saudi Arabia has found itself in a tight spot. First by financing Sunni rebels in Syria against Assad and also by supporting the American policy on Iran’s nuclear issue, Saudi's allegiances have become muddled. Now it finds its interests are aligned with those of Iran, a traditional foe, both of which are against ISIS. The main worry for Saudi Arabia is that the US may coordinate with Iran and Assad’s Syria against ISIS. The Kingdom is now trying to use oil prices to defend market share and send a political message by raising production in September even as oil prices fall. Lower oil prices would definitely hurt Russia and Iran, since Russia needs oil prices near USD $100 to balance its budget and Iran needs high oil prices to support its nuclear program. The risk the Saudis take by this measure is that lower oil prices could also hurt the shale oil boom in the US and Canada.

The Bottom Line

The negative impact of ISIS on world politics is clear from brutal stories of murders, extortion and genocide perpetrated by the regime. Regionally, ISIS will disrupt and degrade the economy of several states, and that in turn may lead to further political chaos -- which is precisely ISIS's goal. And ripples from the stones ISIS is throwing at the Middle East's economy may be felt around the world.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.