Nine months after the last pullout of U.S. troops, Iraq's oil production is growing so rapidly that world markets now are looking to Baghdad to play a major role in keeping global oil flowing and moderating prices in the years ahead.

But the International Energy Agency (IEA), while forecasting Tuesday that Iraq could add more than any other nation to global oil supply in the coming years, warned that the country faces major challenges due to uncertainty in governance, deteriorated infrastructure, and insufficient water supply. The Paris-based agency, focused on maintaining world energy security, said the global economy would suffer if Iraq cannot overcome the obstacles in its path.

"We all have an interest in Iraq realizing its potential and revitalizing its economy," said IEA Executive Director Maria van der Hoeven, at a news conference in London to unveil the agency's Iraq forecast.

Rich in Oil Assets

IEA's Iraq Energy Outlook comes just weeks after the agency's figures confirmed that Iraq had made staggering progress in rebuilding its oil production, reaching output of 3 million barrels per day (bpd), its highest output since the U.S.-led invasion in 2003 that toppled Saddam Hussein. Iraq now has surpassed Iran as OPEC's second-largest producer for the first time since the 1980s.

The report forecasts that Iraq will double its oil production to 6 million bpd by 2020, and will ratchet its output to 8 million bpd by 2035. Among all oil exporters, Iraq in 20 years' time will vault past Russia from third to second place, behind only Saudi Arabia, says IEA. The agency expects Iraq single-handedly to provide 45 percent of global production growth between now and 2035.

Iraq is "very, very rich" in energy assets, said Fatih Birol, IEA chief economist and the report's main author. Iraq benefits from having some of the lowest production costs in the world and "easy geography," he said.

But the challenges are great. The report noted the conflict between Iraq's federal and regional governments over governance and the legal framework that will dictate the operations of the numerous foreign companies that are engaged in the rebuilding effort. Iraq needs to overcome storage and transportation bottlenecks while building a larger and better-trained workforce capable of operating the drilling rigs. Insufficient water supplies are a problem, because water is needed to pump oil from the ground.

Its oil and gas fields and ports have deteriorated over the years due to war, neglect, internal conflict, and international sanctions. Between now and 2035, the report said, the war-torn country will have to invest more than $530 billion in infrastructure to reach the forecast production levels. One bright spot: That's an amount that growing oil revenues should easily cover, IEA said. (See "Pictures: Oil States: Are They Stable? Why it Matters")

Causes for Pessimism

The report marked the first time that the IEA has conducted a comprehensive review of the energy sector of any major Middle East producer, underscoring Iraq's growing importance on the world energy scene. The IEA, founded in the wake of the Arab oil embargo of the early 1970s, is an independent organization through which 28 member nations work to improve world energy security.

Although the IEA expects Iraq to play an outsized role in stabilizing the global oil market in the years ahead, its projected production levels are in fact half those forecast by the Iraqi government. Earlier this year, the government said its exports had jumped by 20 percent, and it predicted it would be producing 10 million bpd by 2017.

Birol stressed that his team received cooperation from Iraqi officials, but "we have different views" on production forecasts. Van der Hoeven said the IEA and Iraqi officials were in complete agreement on how much oil and gas it could be producing. "The question is how much time it takes to exploit it," she said. The IEA said its conservative timeline is more realistic. If Iraq met its challenges more quickly than anticipated, the IEA said, it could ramp up production to 9 million bpd by 2020, an amount closer to what the government estimates, but not quite as optimistic.

But the IEA warned that if Iraq failed to meet its challenges as quickly as it should, it might produce only 5 million bpd by 2035—nearly 40 percent short of forecast. If that worst-case scenario should develop, Birol said, the pain would spread far beyond the Iraqi economy: "It would be bad news for global oil markets." Those markets, he said, "would be set on a course for troubled waters." Van der Hoeven noted that worldwide demand for oil is rising. "Where is the additional supply going to come from? It's tough to answer that question without Iraq."

Currently, half of Iraq's exports go to Asia, and the other half to the rest of the world, the report said. But it won't be long before Asia will be taking 80 percent of Iraqi exports, with China accounting for most of that flow, or about 2 million bpd. Some 30 percent of Iraq's production now comes from fields that are either directly operated by China or are co-owned by Chinese companies.

The report said Iraq should use oil revenues to diversify its economy, which it said it too dependent upon petrodollars. Fully three-quarters of Iraq's GDP last year came from oil exports, a higher percentage than in any other country that's considered a major producer. In neighboring Kuwait, for example, oil revenues account for 55 percent of GDP, and they are 52 percent of GDP in Saudi Arabia. Fully 95 percent of Iraq government revenues come from oil production. "Oil is the cornerstone of the Iraqi economy," Birol said. The IEA estimates that Iraq's oil and natural gas export revenues should total $200 billion a year, for a total of $5 trillion between now and 2035. Oil and gas offer "an opportunity to transform the Iraqi economy," he said. Oil revenues, he said, could be a "solid foundation for a prosperous and modern Iraqi economy." (See "Pictures: Eleven Nations With Large Fossil-Fuel Subsidies" and Interactive Map: "Fossil-Fuel Burden on State Coffers")

Natural Gas Untapped

The IEA also found that Iraq's natural gas reserves offer huge potential; they have not been fully utilized, however, and new fields need to be developed. Birol noted that 60 percent of gas produced in the south of the country is flared. (See related blog post: "As Iraq's Oil Boom Progresses, So Does Gas Flaring") That's a waste, he said, especially because the nation's electrical generation is not meeting demand. The report said that Iraq could be producing 90 billion cubic meters (bcm) of natural gas by 2035—up from about 10 bcm in 2010—which would make it the world's sixth-largest producer.

While it will be up to the Iraqi government to decide how best to use that gas, the IEA said it would be better for the country's economy if initially most of it were used domestically. IEA said Iraq's electricity shortfall should be eliminated by 2015, and it noted that Iraq plans to quickly replace oil-fired power plants with gas-fired ones. "That should help, from an economic point of view," Birol said. But Iraq also has vast gas export potential, and could one day be supplying Europe via pipeline, and Asia by shipping liquefied natural gas.

Iraq still is facing sectarian violence, including gun attacks and bombings. But van der Hoeven said security in the oil-producing areas was better than in Baghdad, the capital. She also acknowledged that while outside crises in the region—an attack on Iran's nuclear facilities by Israel, or a widening of the Syrian civil war—could affect Iraqi oil and gas exports, such short-term possibilities were not within the scope of the report, which took a longer term look at Iraqi production. (Related story: "As Squeeze Tightens on Iran, Fuel Prices-for Now-Reflect Calm") Because of U.S.-led sanctions over its nuclear program, Iran's oil output has been falling drastically, but van der Hoeven and Birol said they could not predict what the effect on Iraq would be if Iranian production rebounded.

Van der Hoeven said Iraq's growing oil and gas revenues would undoubtedly shift the economic balance of power in the region. "But how," she said, "I cannot say."