Exxon Mobil’s venture into Iraqi Kurdistan challenges Prime Minister Nuri al-Maliki’s resolve against growing regional separatism and tests the investment strategy of the oil majors in Iraq.

Exxon is the first major oil company to test the waters by signing for six blocs with the Kurdistan Regional Government (KRG) in north Iraq, which is locked in a feud with the Arab-dominated central government over territory and oil rights.

Kurdistan has enjoyed more stability and security than the rest of Iraq, and its potential resources have already drawn smaller oil players like Norway’s DNO and Gulf Keystone . But its festering political quarrel with Baghdad has kept majors away until now.

Exxon’s foray into Kurdistan has forced a political stand-off between one of the world’s largest oil companies and an Iraqi government determined to exercise sovereignty as US troops withdraw eight years after the fall of former leader Saddam Hussein.

Deputy Prime Minister for Energy Hussain al-Shahristani, architect of many of Iraq’s deals with foreign companies and a hardliner against Kurdistan oil autonomy, said on Tuesday the government was considering sanctioning Exxon.

Baghdad had already warned that any deal foreign companies sign with Kurdistan would be deemed illegal, saying Exxon’s move could jeopardize its huge contract for the 8.7 billion barrel West Qurna Phase One oilfield in southern Iraq.

But for Maliki, dealing with Exxon is a tricky balance: Taking a hard line could push more deals north and risk souring future investments in major southern fields as the OPEC country tries to rebuild its industry after years of conflict.

Ceding too much to Kurdistan may upset the balance with other regions chafing for more autonomy from Maliki’s central government authority and test the frail power-sharing coalition in Baghdad made up of Sunni Muslim, Shi’ite and Kurdish blocks.

“We believe that the government will avoid canceling the West Qurna agreement but will seek to penalize Exxon Mobil in some way,” Eurasia Group’s Crispin Hawes said.

“In the longer term, the Exxon Mobil move has put further pressure on the Maliki administration to deal with the question of regional authority and federalism.”

At the heart of the Exxon dispute is the question of who controls vast oil reserves in the north of Iraq including territories disputed between Kurdistan and Baghdad – a potential flash-point for tensions as US troops pull out.

Iraq sits on the world’s third-largest oil reserves and with violence from its conflict now easing, it plans to auction 12 new oil and gas blocks in March that could add another 10 billion barrels to reserves.

Baghdad has already barred Hess Corp. from participating in a new bidding round for assets because of its dealings with Kurdistan.

But taking on a behemoth like Exxon – well versed in legal tactics such as international arbitration to protect its interests – would prove far more complex for Maliki and Shahristani.

Exxon is not only involved in West Qurna One, but is also leading a multi-billion-dollar water injection plan that is key to bolstering southern oilfield output – a project that it may believe will help shield it from major punishment.

The US company could have judged that the political fallout was manageable enough to gain a foothold in Kurdistan.

“Exxon seems to have made the calculation that it is too important for Iraq’s oil ministry to push them out of their southern projects,” Teymur Huseynov, head of Global Energy Consulting at Exclusive Analysis, an intelligence company.

Baghdad and Kurdistan still at odds

For Kurdistan, the Exxon deal brings the region more international recognition as a player on the oil market and may seek to give it leverage with the central government over a long-awaited oil law to resolve the dispute.

While the feud means companies in Kurdistan cannot get full export revenue for now, the Kurdistan regional government (KRG) offers attractive production-sharing deals – allowing companies to make profit from oil sales – compared with the service contracts in the south.

Exxon itself has not commented on the deal. But already others are waiting on the sidelines, including Royal Dutch Shell , which one source said had planned to sign in Kurdistan at the same time as Exxon but pulled out a day or two before.

Chevron and Italian explorer Eni had also been in contact with Kurdistan, one Iraqi official said.

“They know the geology is attractive in Kurdistan although geopolitical risk is high, but they know too how to balance that type of risk,” said oil analyst Oswald Clint at Bernstein.

Iraqi Deputy Prime Minister Ross Nouri Shawis, a Kurd, said that the central and regional governments had been in touch about the Exxon deal before. But any accord between Baghdad and Kurdistan appears to have soured at the last minute as Exxon signed.

Reflecting that fallout, the US State Department said on Tuesday it had warned Exxon about the political and legal risks of signing contracts “without nationwide” approval.

Mixed messages from Baghdad reflect the power struggle within the government. Shahristani, a Shi’ite with strong ties to the south, is unlikely to want to retreat on Exxon. Shawis and others have offered a more conciliatory tone.

The outcome will not only affect Exxon and how other oil investors see Iraq, but also political relations between the two governments as they try to resolve their bitter dispute and sign the national oil law meant to define crude rights.

Agreement over the oil legislation – seen as essential for investors to guarantee their assets – has been stymied by competing claims to disputed territories along the internal border between Kurdistan and Iraq.

Some observers see in the Exxon move an attempt to force Baghdad and the KRG in Arbil to hammer out their differences rather than let worsening tensions damage investments. But a solution may be complicated if any of the six Exxon blocks falls inside disputed territorial areas.

Key legislation like Iraq’s oil law – initially agreed by the political parties in 2007 but still not passed – has been caught up for years in Iraq as factions squabble for power.

Maliki may now find it politically difficult to accept Exxon’s move into a semi-autonomous region as the government faces calls for autonomy from places like Salahuddin, where disgruntled Sunnis want more independence.

Autonomy would give provinces more power over their finances, administration and laws. Local governments would have an upper hand in supervising public facilities in their territories, which could loosen Baghdad’s grip on oil facilities.

“It’s now become impossible to dissociate Exxon with Iraqi politics,” Jaafar Altaie, managing director of Manar Energy consulting. “If the deal goes sour, critics could say Exxon helped foment divisions in Iraq. If it goes well, they will say Exxon helped bridge the differences between Arbil and Baghdad.”