The escalating tension between Iraq’s semi-autonomous northern Kurdish region and the central government in Baghdad is reaching a critical point. The Kurdistan Regional Government (KRG), in defying Baghdad’s authority over oil drilling and exports from the Kurdish region, has been challenging the central government’s authority and legitimacy since 2007. The completion last December of an independent oil pipeline, which can carry 400,000 barrels a day from Kurdistan to the Turkish port of Ceyhan, has further angered the federal government.

Iraqi Prime Minister Nouri al-Maliki’s administration has been stressing over the years that the Iraqi constitution grants no rights to KRG to export oil from the region without an agreement with the central government. Baghdad refused to acknowledge any oil drilling contracts between KRG and foreign oil companies.

The KRG, on the other hand, continues to claim that the status of its autonomy since the fall of Saddam Hussein’s regime and Iraq’s constitution give it the right to make export deals without the central government’s approval.

The dispute is a significant hurdle for Iraq, which in 2012 surpassed Iran as OPEC’s second-largest producer of crude. Creating a stable system for developing and exporting its large oil reserves will be key for the country as it seeks to ratchet up production and build its economy after years of war.  (See related story: “Iraq Poised to Lead World Oil Supply Growth, but Obstacles Loom.”)

According to Article 112 of the current Iraqi constitution, “the federal government, with the producing governorates and regional governments, shall undertake the management of oil and gas extracted from present fields,” a statement that has been subject to different interpretations by Iraq’s factions. The volume of crude from Kurdistan held in tanks at Ceyhan and ready for sale to world markets amounts to a reported 1 million barrels. But this oil is sitting idly and cannot be sold without the consent of Baghdad, which threatened to sue both KRG and Turkey over what it deems illegally smuggled out oil.

The tension over KRG’s new pipeline and oil exports has resulted in a volley of strategic moves and threats. Baghdad has cut off the Kurdish region’s revenues for the past two months, thereby halting salary payments of Kurdish civil servants, including those of Peshmerga armed forces and the oil defense force that protects the facilities of foreign oil firms. This development adds to the KRG’s woes over Baghdad’s budget allocation to its Kurdish region, which authorities in Erbil claim has never exceeded more than 10 percent of the total national revenue when it should be 17 percent.

Following the KRG’s threats to block oil transit from Kirkuk to Turkey and to break away from Iraq, Baghdad’s counter-threatened to shut down Kurdistan’s airspace and eliminate flights to and from the Kurdish region. The central government also threatened to withhold the KRG’s portion of the country’s oil revenues if it decides to sell oil without coordinating with Baghdad. (See related post: “Iraq’s Green Zone Gets Greener with Biogas and Other Clean Energy Solutions.”)

Because farmers in the southern part of Iraq depend on irrigation water from two large dams in Kurdistan, KRG has reportedly constrained water supplies as leverage on Baghdad. Water shortage is already a critical issue for Iraq, partly because freshwater is heavily used for enhanced oil recovery operations in southern oilfields, and the country’s Common Seawater Supply Facility, a massive seawater desalination project for oil operations, is still at the initial stages of development. (See related post: “No Water, No Gain for Iraq’s Oil Development.”)

KRG’s budget crisis and legal difficulties in exporting oil, combined with domestic dissatisfaction over the failure to form a regional government in the six months since legislative elections, may be opening a new avenue of leverage for Baghdad. If the current crisis persists, KRG will be hurt the most, given its financial and economic dependence on Baghdad.

The Iraqi Kurdish region’s landlocked position and the lack of legal energy transportation options reinforce its dependence on the central government. Feeling the pinch from the central government’s budget cuts and vulnerability to any further punitive actions, KRG is likely to be more willing to cooperate and negotiate a compromise with the central government, lest it jeopardize the social and economic stability of Kurdistan. (See related post: “As Iraq’s Oil Boom Progresses, So Does Gas Flaring.”)

The Iraqi constitution has proven insufficient to address the ongoing dispute between the federal government and its Kurdish region. The successful outcome both for KRG and Baghdad will ultimately depend on the adoption of a long-awaited federal hydrocarbon law that more clearly defines legal boundaries of energy management and the share allotment of oil revenues across all of Iraq’s provinces. The hydrocarbon law has been in limbo since 2007, due to wrangling among the country’s many factions.

The need for consensus on the law goes beyond political stability: It is also essential for attracting the investment Iraq will need in its oil and gas industry, through which the country aims to generate $6 trillion in revenue over the next 15 years as part of its Integrated National Energy Strategy.

Even if the hydrocarbon law is not finalized in coming months, the KRG and the central government might strike a short-term deal to defuse the current crisis before it undermines the Iraqi parliament’s ability to ratify the 2014 budget, setting off a larger financial crisis in the country.