By Michael Christie and Missy Ryan
BAGHDAD, July 1 (Reuters) - Political tensions in Iraq are running high with no new government in sight nearly four months after a March 7 parliamentary election.
While parliament has held its first session, the long delay in agreeing a coalition government could pour fuel on volatile sectarian differences as two large Shi'ite electoral blocs cement a tenuous union and possibly push a Sunni-backed coalition that narrowly won the election to the sidelines.
More delays could thwart U.S. plans to end combat operations in August, although Washington has given no indication it could alter its troop withdrawal schedule.
Iraq, which has the world's third largest oil reserves, has signed contracts with energy majors such as BP and Lukoil that could more than quadruple oil output in seven years. Those projects are moving ahead, even without a new government.
But Iraq needs to broaden investment to create jobs and battle a still stubborn insurgency.
Investors outside the oil sector remain wary.
Iraq remains largely isolated from world financial markets. Only a short while ago, local banks were so cut off the only way to transfer money across borders was in cash-stuffed bags.
Today, Iraq has little credit. Only a few dozen companies are listed on the local stock market. The Iraqi dinar <IQD=> is lightly traded. One place to take a punt from afar on Iraq's future is its Eurobond <IQ024029557=> <XS0240295575=R>.
Below are some of the major risks facing Iraq seven years after U.S. troops toppled Saddam Hussein.
POLITICAL SQUABBLING, POWER VACUUM
It took three months to certify the poll results because of challenges, attempts to ban mainly Sunni candidates accused of links to Saddam's banned Baath party and a recount in Baghdad.
Because no single bloc won a majority in Iraq's 325-member parliament, coalition talks are key to forming a government.
The Iraqiya bloc led by former Prime Minister Iyad Allawi, a secular Shi'ite with wide support among the Sunni minority, took 91 seats in the election, two more than Prime Minister Nuri al-Maliki's State of Law bloc.
The Iraqi National Alliance, a Shi'ite bloc which includes anti-American cleric Moqtada al-Sadr, took 70 seats, while a Kurdish alliance picked up 43.
Sadr's faction, which wants U.S. troops to leave faster and questions the oil deals, is well-placed to join a government.
Maliki, a Shi'ite who built his reputation on a claim to have rescued Iraq from civil war, is seeking a second term.
But his ambitions are being opposed by some erstwhile Shi'ite allies despite the merger of Iraq's two main Shi'ite groups into the National Alliance, which is just four seats short of a working majority.
An extended delay in forming a government could undermine security by creating a power vacuum, while marginalising Iraqiya could anger Sunnis, just as U.S. troops prepare to leave.
U.S. President Barack Obama, focused on a growing conflict in Afghanistan, plans to cut U.S. troop numbers in Iraq to 50,000 by September ahead of a full pullout by the end of 2011.
What to watch:
-- Sectarian or political violence flares, as it did during the five months it took to form a government after 2005 parliamentary polls.
-- Parliament, which cannot function without a government, fails to pass investment legislation already delayed by years of political squabbling, sending a poor signal to firms interested in Iraq but worried about legal risks and an opaque bureaucracy.
A RETURN TO MAJOR VIOLENCE
Iraq is far less violent than when sectarian killings peaked in 2006-07. Maliki takes credit for security gains, but a U.S. troop rise and Sunni militia cooperation also played a big part.
Since March, Iraqi forces backed by U.S. troops have scored major victories against local al Qaeda groups, including the killings on April 18 of al Qaeda's leader in Iraq, Abu Ayyub al-Masri, and Abu Omar al-Baghdadi, the purported head of its affiliate, the Islamic State of Iraq.
Yet Sunni Islamist insurgents, who the government says are in cahoots with Saddam's Baath party, still stage big attacks.
A spree of bombings and attacks by gunmen that stretched from Mosul in the north to Basra in the south killed more than 120 people on May 10 and was seen as a warning that insurgents are still a potent force despite battlefield setbacks.
In June, insurgents staged brazen and well orchestrated suicide bomb attacks on the Central Bank of Iraq and the Trade Bank of Iraq, seeking out economic targets in what officials said was an attempt to derail investment.
Political feuds, Sunni discontent or an attack on a holy site or a clerical leader could all spark renewed violence, as could any Israeli strike on Iran's nuclear facilities. Such an attack might prompt mostly dormant Shi'ite militias to retaliate against U.S. forces in Iraq.
Any major violence will push up prices on global oil markets <CLc1>, especially if it appears set to persist.
What to watch:
-- Attacks on oil facilities or staff. Iraq's efforts to secure investment could be derailed by attacks on foreigners.
-- Signs that U.S. forces are changing withdrawal plans.
-- Iraqi security forces are vulnerable to infiltration and some key ministries are still politicised. Iraq's military still relies on U.S. troops for air support and forensics.
KURD-ARAB CONFLICT
Tensions between Arabs and minority Kurds, who have enjoyed virtual autonomy in their northern enclave for almost 20 years, are festering. Kurds suffered massacres in Saddam's era, but have gained unprecedented influence since 2003 and hope to reclaim areas they deem historically Kurdish.
Others in disputed areas complain Kurds have exploited their newfound prominence at the expense of Arabs and Turkmen. At the centre of the impasse is Kirkuk, the northern province that sits on an estimated 4 percent of world oil reserves.
What to watch:
-- Clashes between the army and Kurdish Peshmerga forces.
-- Any breakthrough on oil. Iraqi Kurdistan, which estimates its oil reserves at 45 billion barrels, has signed deals with foreign firms that the Iraqi Oil Ministry labels illegal.
-- Any resumed exports from Kurdish fields, halted because of the dispute, would be positive. Iraq's cabinet approved in May a deal that would allow exports, but they have not resumed.
-- Passage of modern oil legislation, held up for years because of the Kurd-Arab feud. The delay has not deterred oil majors, but potential investors in other sectors view the laws as an indicator of stability and friendliness to business.
A NEW AUTHORITARIANISM
Iraq's democratic experiment is important in a region where leaders often leave office only in a "coffin or coup".
Attempts to overturn Iraqiya's lead after the vote suggest that a democratic culture is still only skin deep.
Many Iraqis believe their country needs a strong ruler. Western powers would be unlikely to stand by if a military coup installed a leader hostile to their interests.
What to watch:
-- Any clearly illegal attempt to change the election result.
-- Any constitutional changes that would allow leaders to amass power or remain in office.