The long-running dispute between Iraq’s central government in Baghdad and Kurdistan Regional Government leaders in Erbil entered a new phase when the Iraqi Parliament last week passed a 2013 budget that allocated a fraction of the money requested by the KRG. A bulk of this funding is used to pay oil companies operating in the semi-autonomous region.

“In a blatant stiff-arm to the Kurds, the budget allocates just $646 million to cost recovery for Kurdistan Regional Government oil contractors — a figure that covers only around two months’ worth of the crude that Erbil was slated to provide this year,” Michael Knights said in a Policy Alert from the Washington Institute for Near East Policy, a think tank. The KRG reportedly requested $3.5 billion.

According to a local press report, the Kurdish regional government issued a statement saying “the budget does not serve the interests of the Kurdish people.”

Crude produced in the Kurdish areas is mostly exported through southern infrastructure controlled by Baghdad. Although much less crude is currently produced in the north than from the giant southern fields, enormous upside potential and contractual terms generally more attractive than those offered in Baghdad have been drawing some of the world’s largest oil companies into Iraqi Kurdistan. The central government has threatened to ban companies from operating in the south if they sign deals with the KRG.

ExxonMobil appears to be testing Baghdad’s resolve by signing production sharing contracts with the KRG in 2011. Chevron, Total and BP are some of the larger companies also active in the region.

Exxon’s southern business ventures – which include expanding production at the giant West Qurna-1 field – have reportedly not been performing as well as the company’s executives had originally planned. It appears Exxon’s move into KRG-controlled areas could represent an attempt to broker an agreement between the two sides, which remain far apart on oil revenue sharing, export policy and other issues.

Companies may also perceive the north as a superior business opportunity over the medium term, either because they expect the disagreements to be amicably settled, or perhaps the oil company’s corporate strategists are betting a northern export route through Turkey will materialize.

Referring again to the most recent budget, Knights writes: “If carried out, any such threats to economically strangle the KRG could drive Turkey to allow high-volume exports of KRG oil through its territory, independently of Baghdad; Washington hopes to prevent this.” He goes on to suggest civil war as a potential worst case scenario if tensions continue to rise.

Roughly 15,000 barrels per day of oil are currently being exported from Kurdish Iraq by truck into Turkey and on to world markets. Iraq exported about 2.4 million barrels/day in January, virtually all of it through the south.

Knights argues Washington should press for an interim solution that keeps money flowing north to the KRG – and its oil company partners – and oil flowing through southern export routes. “The line to take is simple and convincing: helping the KRG will give Baghdad more revenue to fix its ailing electricity sector, which will be a key driver of antigovernment protests in the all-important Shiite provinces as summer power cuts begin. In contrast, threatening the KRG’s funding would give the Kurds and Turkey an opening to justify closer bilateral ties.”