As the war flares, Iraq’s economic dire straits deepen

Matein Khalid

The revival of the US-Israel-Iran war is set to intensify the concatenation of economic, energy and geopolitical shocks facing neighbouring Iraq.

Before the February 28 onset of the conflict, Iraq was Opec’s second-largest oil producer, with estimated output of 4.3-4.5 million barrels per day.

By June, national production had fallen to a paltry 817,000 bpd, comparable to that of minor producers such as Azerbaijan or Oman. This is an economic disaster. It also represents a draconian devaluation of Iraq’s influence.

Iraq exported around 3.5 million bpd before the conflict, almost all via the Strait of Hormuz. The closure of the waterway, the US naval blockade and Centcom strikes on Iranian missile sites and oil facilities have sharply reduced regional oil supplies, driving prices higher.

Inflated oil prices have provided only limited relief. Although Iraq’s export volumes have collapsed, each remaining barrel commands a much higher price, cushioning some of the fiscal damage. A rapid reopening of Hormuz, or an early end to the conflict, would reduce oil prices and remove even that modest buffer.

Entrenched risks

Iraq is the ultimate petroeconomy. Around 90 percent of its government revenues depend on oil exports via Hormuz. To put it in further perspective, one quarter of the working population of Iraq is dependent on state salaries, pensions and welfare benefits.

Before Washington, Tehran and Tel Aviv plunged the Gulf into its most vicious spasm of interstate violence since Saddam Hussein’s brutal invasion of Kuwait in August 1990, Baghdad was generating around $7 billion a month in oil revenue.

But war, renewed ethnic violence in the Kurdish north and around Basra, and attacks on Iraq’s energy infrastructure have fundamentally changed the outlook.

These factors have also made it far harder to attract the estimated $200 billion in investment needed to achieve Baghdad’s ambition of increasing oil production to 7 million bpd over the next five years.

Iraq’s new prime minister, Ali Al-Zaidi, is attempting to reverse that deterioration. During his visit to Washington last week, he sought to attract major US investment into Iraq’s oil, gas and power sectors after the war devastated crude production and state finances.

Baghdad is also lobbying Opec to raise Iraq’s production quota, arguing that higher output is essential to finance post-war reconstruction and economic recovery.

Fiscal and geopolitical crunch

Iraq’s revenues were just over $1.5 billion in May and could fall below $1 billion a month if this “forever war” in the Gulf continues.

Capital flight has accelerated since the conflict intensified in mid-June. Wealthy Iraqis are moving money abroad, particularly into property in Turkey and the GCC, amid fears that prolonged instability could undermine the dinar’s de facto peg of around 1,300 per dollar.

If Iran-backed militias continue to consolidate their power and further weaken the authority of the Iraqi state, confidence in the currency may erode. In the worst-case scenario, deepening sectarian divisions may push Iraq towards the kind of state fragmentation seen in Lebanon, where powerful armed groups operate alongside weakened state institutions.

Al-Zaidi’s Washington outreach may improve long-term investment prospects, but geopolitics remains the overriding factor. Western oil companies and Gulf sovereign funds will stay cautious about committing tens of billions of dollars while the US and Iran remain at war and Iraq’s oil-producing regions are exposed to militia influence and wider regional conflict.

The economic fallout of the war on Iraq’s fiscal stability in 2026 is awful enough. The budget deficit was almost non-existent in late 2025, when Iraq pumped 4.4 million bpd and exported 3.5 million bpd to the world via tanker traffic.

A return to that petro-Arcadia now appears unlikely. Shipping costs and war-risk insurance premiums have soared, while the Gulf is once again witnessing its fiercest tanker conflict since the Reagan-Khomeini-Saddam confrontation of the late 1980s.

The IMF and World Bank estimate that Iraq’s budget deficit will rise to 8 to 11 percent of GDP by the end of 2026. By 2027 it could become a fiscal Black Death for the country, a founder member of Opec.

The fabled oil curse has singled out Iraq for malign economic, human and geopolitical tragedy ever since the overthrow of the last Hashemite King Faisal II in 1958. I had hoped Iraq would achieve a modicum of political, economic and sectarian stability in 2025. I was even tracking the Baghdad Stock Exchange as a potential frontier market.

Baghdad’s balancing act between Washington and Tehran looks impossible to maintain in the Gulf’s current geopolitical milieu. Iran’s Revolutionary Guards can use sectarian militias as a Trojan horse anytime they want to retaliate against US and Israeli attacks on bridges, power grids and nuclear sites. This has been the modus operandi since at least 2024.

Al-Zaidi is a 41-year-old business magnate with no real political base or parliamentary bloc, unlike the militias, whose power base is in Iraq’s strategic southern Basra province, home to its largest oilfield, tanker-loading terminal and oil storage depots.

Another looming uncertainty is the advanced age of Grand Ayatollah Ali Al-Sistani. At 95, he has long served as one of Iraq’s strongest moderating influences. His eventual death could remove an important restraint on the expansion of militia influence inside Iraq.

An old proverb contends, “it is always darkest before dawn”. The June restart of the war has made any imminent Iraqi dawn unthinkable. What a pity. What a world!