By Michael Christie and Missy Ryan
BAGHDAD, May 4 (Reuters) - Political tensions in Iraq are rising as Shi'ite groups try to ensure that a Sunni-backed alliance which came first in a contested election does not get a chance to form the next government.
Those efforts could pour fuel on volatile sectarian differences at a critical time, and could delay by many months the formation of a coalition government after the March 7 vote. That may thwart U.S. plans to end combat operations in August.
Iraq, which has the world's third largest oil reserves, has signed contracts with energy majors such as Royal Dutch Shell (RDSa.L: , , ) and Lukoil (LKOH.MM: , , ) that could more than quadruple oil output over the next few years, but it needs to broaden investment to create jobs and battle a still stubborn insurgency.
Investors, understandably, are 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 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
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, according to preliminary results.
Maliki, a Shi'ite who built his reputation on his claim to have rescued Iraq from civil war, formally challenged the results and a special review panel ordered a recount of 2.5 million votes in the capital which has the potential to overturn Iraqiya's lead.
In addition, the review panel is considering the fate of votes cast for candidates accused of having links to Saddam Hussein's outlawed Baath party. Most are from Iraqiya.
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.
A major delay in forming a government could undermine security and create a dangerous power vacuum, while marginalising Iraqiya could anger Sunnis, just as U.S. troops accelerate their departure.
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 August 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. While this may not derail oil investment, it could scare away potential investors in other sectors.
-- 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, can still stage devastating attacks on government ministries and public buildings.
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, logistics and forensic investigation.
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:
-- Confrontation between the Iraqi 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 that dispute, would be positive. Officials in Kurdistan and Baghdad hint at detente.
-- Passage of modern oil legislation, held up for years because of the Kurd-Arab feud.
The delay has not deterred oil majors from signing deals, but potential investors in other sectors view the legislation as an indicator of Iraq's stability and friendliness to business.
A NEW AUTHORITARIANISM
Iraq's democratic experiment is important in a region where leaders often lose power only in a "coffin or coup".
The attempt to overturn Iraqiya's lead after the vote suggest that a democratic culture is still only skindeep.
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. So far all the steps have followed what on the surface appear to be legal procedures.
-- Any constitutional changes that would allow leaders to amass power or remain in office.