Iraq violence slingshots Brent, WTI to highest levels of 2014

Sectarian violence in Iraq sent the price of oil skyrocketing on Thursday, propelling both Brent and West Texas Intermediate up more than two percent to their highest levels of the year amid growing concerns about a threat to global supply.

After a delayed reaction to turmoil raging in the country, oil prices soared as open warfare between rebel forces—threatening a reconquest of Iraq barely a few years after U.S. forces departed—and the government spilled on to the world stage. Iraq is a member of OPEC, second only to Saudi Arabia as one of the world's largest producers of crude.

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With violence threatening Iraq's civilian population and overwhelming the country's security forces, a shadowy group known as the Islamic State in Iraq and Sham (ISIS) has managed to seize control of key cities including Mosul, the country's second-largest, Ramadi, Falluja and Tikrit. Fears about global supply mounted, as reports surfaced that Russian tanks had moved into beleaguered Ukraine, sending crude on a tear and overwhelming the impact of lackluster U.S. economic data.

"That's the big story: what will happen if...the (insurgents) don't get what they want? Oil prices will go significantly higher," said Richard Hastings, macro strategist at Global Hunter Securities. "It's history in the making."

As the flames of instability rage in Syria and Libya, another major oil producer, "the map of the Middle East is being rebuilt," he added.

Until recently, Iraq's oil production had recovered to levels seen prior to the 2003 war that destabilized the country. The country pumped 3.6 million barrels of crude a day in February, an annual output record that exceeded 1979's water mark.

Analysts say that although the U.S. energy renaissance has helped to contain the threat of an oil shock, risks to the stability of global oil supply have heightened considerably.

Damaged vehicles belonging to Iraqi security forces are seen during clashes between Iraqi security forces and al Qaeda-linked Islamic State in Iraq and the Levant (ISIL) in the northern Iraq city of Mosul, June 10, 2014.

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"Prices would be significantly higher by about 10—12 percent if it were not for U.S. shale oil," said Hastings. He added that ISIS insurgents could easily throw the country into more chaos by disrupting the flow of both electricity and crude.

The surge in crude helped yank major U.S. stocks sharply lower. Brent climbed by nearly $3 to over $113 a barrel for the first time in 2014, and its highest since September 10. U.S. crude soared by $2.13 to settle at $106.53 a barrel, its highest since mid-September 2013.

Natural gas prices have risen even more dramatically than oil in the wake of the violence, up 23 cents per mmBtu to $4.74, a hike of 5.19 percent.

The United States said on Wednesday it is working with Iraq's leaders on a coordinated response to regain lost territory and would provide additional assistance to Baghdad. Iraq's southern oilfield export facilities, which ship about 2.6 million barrels per day (bpd), were "very, very safe", the country's oil minister Abdul Kareem Luaibi said on Wednesday.

Still, early predictions that Iraq could pump record barrels per oil this year are looking optimistic at best. Economists at Capital Economics note that with Libya's output looking increasingly tenuous, "Iraq's aim of increasing output to 4 million bpd this year looks ambitious and hopes that the easing of sanctions on Iran would lead to a surge in production have been disappointed."

The Saudis, however, may be able to offset a shortage of Iraqi crude. "The country currently has as much as 2.5m bpd of spare capacity which it could use to meet any increase in demand or if output from other OPEC members falls short. This should ensure that oil supply from OPEC should, at least, remain stable," the firm wrote in a research note this week.

Oil prices were also supported by last week's 2.6 million bpd drop in crude inventories, which came just as the summer driving season gets underway.

The tumult in the Middle East, combined with falling gasoline stockpiles domestically, all but certain to renew upward pressure on domestic retail gasoline prices. Nationally, gas is flirting near $4 per gallon, frustrating cash-strapped drivers who have yet to feel the benefits of the U.S. energy boom.

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"Oil acts as a tax on consumers," explained Joel Guth, CEO of Gryphon Financial Partners, a member of the Hightower network. "We're moving into the summer driving season, and if they spend more on energy consumption, it takes more money away from discretionary spending. Certainly all signs point to more volatility in oil producing countries, not less."

--By CNBC's Javier E. David.