By Maha El Dahan and Yousef Saba

DUBAI (Reuters) – A sophisticated fuel oil smuggling network that some experts believe generates at least $1 billion a year for Iran and its proxies has flourished in Iraq since Prime Minister Mohammed Shia al-Sudani took office in 2022, five sources with knowledge of the matter told Reuters.

The operation exploits a government policy under which Iraq allocates fuel oil to asphalt plants at heavily subsidised prices and involves a network of companies, groups and individuals in Iraq, Iran and Gulf states, according to the five people and three Western intelligence reports, two from August this year and one which was undated.

Under the scheme, anywhere from 500,000 to 750,000 metric tons of heavy fuel oil (HFO), including high sulphur fuel oil (HSFO) – equivalent to 3.4 million to 5 million barrels of oil – is diverted from the plants each month and exported, mostly to Asia, two of the sources said.

The extent of the fuel oil smuggling since Sudani came to power and the involvement of multiple entities within Iraq in the illicit trade have not previously been reported.

Iranian and Iraqi officials did not respond to detailed requests for comment about the findings in the Reuters story.

Iran views its neighbour and ally Iraq as an economic lung and wields considerable military, political and economic influence there through the powerful Shi’ite militias and political parties it backs. It also sources hard currency from Iraq through exports and avoids U.S. sanctions via its banking system, Iraqi and U.S. officials say.

While Baghdad has been delicately balancing its role as an ally of both Washington and Tehran for years, with President-elect Donald Trump expected to take a hard line on Iran’s attempts to skirt U.S. sanctions, its activities in neighbouring Iraq are expected to come under increasing scrutiny.

Of the two main routes the fuel oil takes out of Iraq, one involves blending it with similar product from Iran and passing it off as purely Iraqi, helping Tehran evade tough U.S. sanctions on energy exports, said the five sources, who declined to be named due to the sensitivity of the matter.

The other involves exporting the fuel oil that was originally meant for the subsidy programme using forged documentation to mask its origins.

Iran benefits directly from the first route. Iranian fuel oil typically sells at a discount due to sanctions but it can sell it for a higher price if it is passed off as Iraqi. The second route, meanwhile, benefits the Iranian-backed militias in Iraq that control the smuggling scheme.

Three sources estimated how much both routes were bringing in based on assumptions about the volumes traded and relative prices. Their estimates ranged from $1 billion a year to over $3 billion.

The illicit trade potentially puts Iraqi institutions and officials at risk of U.S. sanctions for helping Iran and some Iraqi officials are concerned a Trump administration could target them, the three sources said.

However, Iraqi leaders rely heavily on the support of influential Iranian-backed Shi’ite groups to stay in power, making it difficult for them to crack down on illicit activities, such as the fuel oil smuggling, the sources said.

Sudani’s office did not respond to requests for comment about the trade, the risk of sanctions or government attempts to curb the business.

ON WASHINGTON’S RADAR

The lucrative smuggling and its links to Iran and individuals under U.S. sanctions are already on Washington’s radar. The subject came up in discussions between U.S. officials and Sudani when the Iraqi prime minister visited the United States in September, one of the sources said.

Asked by Reuters whether smuggling had been raised, a State Department official said: “While we do not comment on specific discussions, we can affirm the Department has emphasized with our Iraqi counterparts the harms of illicit trade and our support for bringing oil transparently to market.”

The U.S. Treasury did not respond to questions about the fuel oil trade or whether Iraqi entities and officials were at risk of sanctions.

U.S. sanctions on Iran are chiefly in response to its nuclear programme and its support for groups across the Middle East that the U.S. sees as terrorist organisations, including Hamas in Gaza, Hezbollah in Lebanon and the Houthis in Yemen.

While Washington has put pressure on Iraqi officials to clamp down on activities benefiting Iran, Tehran’s influence runs deep.

Central to the smuggling operation is Iraqi Shi’ite group Asaib Ahl al-Haq (AAH), a paramilitary force and political party that was an early backer of Sudani and a key member of the bloc that nominated him to be prime minister, according to the five people with knowledge of the matter and the three reports.

The findings in the reports seen by Reuters are based on a broad range of sources in Iraq and its government departments who were not identified.

Sudani’s office and AAH and its leader Qais al-Khazali did not respond to questions posed by Reuters.

Backed by Iran’s Islamic Revolutionary Guard Corps (IRGC), AAH was folded into Iraq’s security apparatus in 2018 and now also has 16 members of parliament.

Khazali was sanctioned by Washington in 2019 for AAH’s alleged role in serious human rights abuses, related to the killing of protesters in Iraq that year and other violence, including a 2007 attack that killed five U.S. soldiers.

Khazali mocked the sanctions, saying in a video posted on X two days later that he was personally hurt it had taken Washington so long to sanction him.

HOW IT WORKS

While fuel oil smuggling existed before Sudani came to power in October 2022, it has grown in complexity and become more formalised since he took office, the five sources said.

Iraqi fuel oil exports are on track to hit an all-time high above 18 million tons this year, according to industry sources and ship-tracking data, more than double exports in 2021.

To create surplus fuel oil for export, some of the asphalt plants involved in the network overstate their needs when requesting official fuel oil allocations. Others exist in name only, meaning their entire allocations can be diverted for export, according to the five sources and intelligence reports.

Central to the scheme is the State Company for Industry, which operates asphalt plants as a joint venture with private companies, the sources said. It was originally established to boost local industries, such as flancoat production, an asphalt waterproofing material used in construction.

The state firm was singled out in one of the Western intelligence reports as coming under tight AAH control during Sudani’s tenure and being used for the export of large quantities of HSFO. Al-Thager Asphalt Industries Factory, one of the state mining company’s ventures according to its website, is used by AAH as a site for storing fuel oil, the intelligence report said.

Some of the plants allegedly involved are controlled by AAH or Kataib Hezbollah, another Iraqi militia backed by Iran’s Revolutionary Guards and designated as a terrorist organisation by Washington, the intelligence report said.

The State Company for Mining, Al-Thager and Kataib Hezbollah did not respond to detailed requests for comment.

In a previous attempt to clamp down on the trade, Sudani’s predecessor Mustafa al-Kadhimi ordered a review of the actual operating capacity of asphalt plants, cut their allocations and raised the price of subsidised fuel to $220 per ton from $70, according to two of the sources and the intelligence reports.

Reuters couldn’t determine what prompted the crackdown.

In January 2023, a few months after Sudani took over, the price was lowered to $100-$150 a ton, far below the market price for exports, estimated at anywhere between $300 and $500. The lower the price of the subsidized fuel, the higher the profit margin when exporting it on the international market.

Sudani’s government also expanded licensing for asphalt plants to include 37 new projects, a near-doubling of the industry almost overnight, one of the sources said. All of the sources said some of the projects were fictitious, suggesting they were just ploys to get fuel oil allocations for export.

The allocation of fuel oil is determined by Sudani’s office through its National Operations Command (PM-NOC).

The Oil Products and Distribution Company (OPDC) is then tasked with processing fuel movement requests, which include vehicle numbers, cargo volumes and specifications, and identifying information for each driver and truck.

The fuel oil movements are reviewed by the PM-NOC and approved with memos that let trucks pass through various checkpoints manned by Iraq’s oil police, three sources said.

PM-NOC, OPDC and Iraq’s state oil marketing company SOMO, the body responsible for exporting Iraqi fuel oil, did not respond to requests for comment.

BLENDED WITH IRANIAN FUEL

Once diverted from the plants, the fuel oil takes one of the two routes, both involving forged documentation, the five sources said.

Some of the Iraqi fuel is exported directly through Iraq’s southern ports with falsified documents listing it as other products, such as vacuum residue or flancoat, both byproducts of refining that can be shipped legitimately.

The state mining company, which owns a network of heavy fuel oil blending facilities across Iraq, is authorised to transport fuel oil between them and export flancoat, one of the intelligence reports said.

The second route involves blending the illicit fuel oil with similar Iranian fuel and passing it off as purely Iraqi, again with falsified documents, to help Tehran skirt tough sanctions Western nations have imposed on its energy exports.

The southern Iraqi city of Basra has emerged as the heart of the blending operations, with Khor Al Zubair and Umm Qasr ports key export points for the illicit fuel, the five sources said.

Reuters was unable to determine whether the authorities in the ports were aware of the smuggling operation.

The blending is done by Iraqi engineers, typically during ship-to-ship transfers, and the fuel oil is then shipped to clients mainly in Asia, two of the intelligence reports said.

The operation is made easier by the similarity between Iraqi and Iranian fuel oil grades and it is difficult to determine scientifically that blending has occurred after the fact, one of the people said.

Iraq’s port authorities did not respond to requests for comment.

In July, Sudani’s government ramped up the price of subsidised fuel oil to $369 per ton, recommended cutting asphalt plant allocations to about 60% of their capacity and also ordered a review of their actual capacity.

Reuters was unable to determine why the government launched the review, or the outcome. Three of the sources said the move was an attempt by the government to distance itself from the smuggling operation.

Sudani’s representatives did not respond to requests for comment.

Subsidised prices have been inching back down since August and are now $228 to $268 a ton.