Iraq faces lengthy coalition talks after last month’s parliamentary election, with the jury still out on whether the divided nation is heading for stability and reconstruction or renewed sectarian conflict.

The political horse-trading will be crucial in determining whether Iraq can capitalise on its oil wealth, revive a moribund economy and recover from years of war and sanctions.

Iraq, which has the world’s third largest oil reserves, has signed contracts with energy majors such as Royal Dutch Shell and Lukoil, but needs to broaden investment to create jobs and prevent renewed insurgent activity.

Investors are wary.

Iraq remains largely isolated from world financial markets. Only a few years ago, local banks were so cut off that the only way to transfer money across borders was in cash-stuffed bags.

Today, Iraq has an extremely tight credit market. Only a few dozen companies trade on the local stock market. The Iraqi dinar is lightly traded.

Below are some of the risks facing Iraq seven years after U.S. troops toppled Saddam Hussein.

HORSE-TRADING, POWER VACUUM

Because no single bloc won a majority in Iraq’s 325-member parliament, coalition talks have begun.

It is not yet clear even who will get first shot at forming a government. The Iraqiya bloc led by former Prime Minister Iyad Allawi, a secular Shi’ite with wide support among Iraq’s Sunni minority, took 91 seats, 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 rescuing Iraq from civil war, has formally challenged those results.

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, is well-placed to join a new government.

Any prolonged failure to form a workable coalition could undermine security and create a dangerous power vacuum 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 already clinched, it could scare away potential investors in other sectors such as housing, industry and agriculture.

– 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 killing 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.

Yet Sunni Islamist insurgents, who the government says are in cahoots with allies of Saddam’s now-banned Baath party, still stage attacks. Since August, they have killed hundreds of people in suicide bombings at ministries and other state targets.

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. A bilateral security pact requires American troops to leave by end-2011, but it might be revised.

Any major violence will push up prices on global oil markets , especially if it appears set to persist.

What to watch:

– Attacks on oil facilities or staff. As Iraq takes steps to secure global investment, attacks on foreigners could derail plans to use foreign cash to rebuild the economy.

Such violence may affect investment unevenly. Since Iraq began to reopen its oil sector to foreign investment two years ago, state-owned Chinese firms have been the first to sign contracts. Chinese, Malaysian and Senegalese firms were the big winners in Iraq’s most recent energy auction, suggesting they have a higher risk appetite than U.S. or European competitors.

– Signs that U.S. forces are delaying or changing withdrawal plans. If security were to deteriorate markedly, the Obama administration might be forced to reconsider its plans despite pressing military commitments in Afghanistan.

Washington might reconfigure its remaining force structure to focus on unstable parts of northern Iraq, perhaps signalling readiness to keep troops deployed beyond the 2012 deadline.

– Challenges for Iraqi security forces as they take over from U.S. troops. Local forces are vulnerable to infiltration and some key ministries are still politicised. Iraq is only slowly reequipping its military and still relies on American troops for air support, logistics and forensic investigation.

KURD-ARAB CONFLICT

Democracy in Iraq has yet to ease tensions between Arabs and minority Kurds, who have enjoyed virtual autonomy in their northern enclave for almost 20 years. 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 expenses of Arabs and Turkmen. At the heart of the impasse is Kirkuk, the northern province that sits on an estimated 4 percent of world oil reserves.

The feud has destabilised areas dotting the border of Iraqi Kurdistan and given a foothold to al Qaeda insurgents.

What to watch:

– Confrontation between the Iraqi army and Kurdish Peshmerga forces. A U.S. initiative is promoting cooperation between them, but new joint patrols have not erased rivalry.

– Any breakthrough on oil. Officials in Kurdistan, which estimates its oil reserves at 45 billion barrels, have signed development deals with foreign firms — contracts which the Iraqi Oil Ministry labels illegal.

– Any resumed exports from Kurdish fields, halted because of that dispute, would be a positive sign. Officials on both sides hint at detente, but this has yet to materialise.

– Passage of oil legislation. A package of proposed laws to set a new framework for oil investment has been 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”, but the country is still trying to define its future as it emerges from decades of military rule and, more recently, civil war.

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 constitutional changes that would allow leaders to amass power or remain in office, raising investor concerns about the continuity of Iraq’s legal and regulatory environment.

– Re-nationalisation. Saddam threw global oil firms out of Iraq in the 1970s when he nationalised the oil industry.

(Editing by Alistair Lyon)