By Michael Christie and Jim Loney

BAGHDAD, Aug 2 (Reuters) - Political tensions rose last
month with the cancellation of two scheduled sessions of
parliament, an indication Iraq's squabbling factions are no
closer to a deal on a new government.

Nearly five months after a March 7 parliamentary vote that
produced no clear winner, Sunni, Shi'ite and Kurdish political
blocs have been unable to decide who should be prime minister,
the major hurdle toward the formation of a ruling coalition.

The long delay could pour fuel on volatile sectarian
differences after two large Shi'ite electoral blocs formed a
tenuous parliamentary union that could push aside the
Sunni-backed coalition that narrowly won the election.

But there are no signs the Shi'ite union has been able to
overcome differences on the premiership to solidify a majority.

More delays could thwart U.S. plans to end combat operations
in August, although Washington has given no indication it would
alter its troop withdrawal schedule.

Iraq, which has the world's third largest oil reserves, has
signed contracts with energy majors such as BP and Lukoil that
could more than quadruple oil output in seven years. Those
projects are moving ahead, even without a new government.

Investors outside the oil sector remain wary.

Iraq is 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.

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

POLITICAL SQUABBLING, POWER VACUUM

Twice in July Iraqi lawmakers postponed scheduled sessions
of parliament, a troublesome sign of the depth of the divisions
over Iraq's top posts -- prime minister, president and speaker.

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.

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.

Maliki, a Shi'ite who built his reputation on a claim to
have rescued Iraq from civil war, is seeking a second term.

But his ambitions are being opposed by some erstwhile
Shi'ite allies despite the merger of Iraq's two main Shi'ite
groups into the National Alliance, which is just four seats
short of a working majority.

The extended delay in forming a government is causing
serious concern. Barham Salih, the prime minister of Iraqi
Kurdistan, called it an "embarrassment" in a recent interview
with Reuters and said it must be resolved quickly.

But some Iraqi politicians are now saying it may have to
wait until after Ramadan, which means mid-September or later.

The delay could undermine security, while marginalising
Iraqiya could anger Sunnis, just as U.S. troops prepare to
leave. President Barack Obama, focused on a growing conflict in
Afghanistan, plans to cut current troop strength of 65,000 to
50,000 by Sept. 1 ahead of a full pullout by the end of 2011.

What to watch:

-- If sectarian or political violence flares, as it did
during the five months it took to form a government after 2005
parliamentary polls.

-- 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, still stage attacks.

In June, insurgents staged brazen bombings at the Central
Bank and the Trade Bank of Iraq, seeking out economic targets in
what officials said was an attempt to derail investment.

A disruption in early July of oil flow through the pipeline
carrying Iraqi crude to Turkey was blamed on Kurdish rebels.

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 Shi'ite militias to retaliate against U.S.
forces in Iraq.

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. 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 and forensics.

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
new-found 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:

-- Clashes between the 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 the dispute, would be positive. Iraq's cabinet approved in
May a deal that would allow exports, but they have not resumed.

-- Passage of modern oil legislation, held up for years
because of the Kurd-Arab feud. The delay has not deterred oil
majors, but potential investors in other sectors view the laws
as an indicator of stability and friendliness to business.

NEW AUTHORITARIANISM

Iraq's democratic experiment is important in a region where
leaders often leave office only in a "coffin or coup".

Attempts to overturn Iraqiya's lead after the vote suggest
that a democratic culture is still only skin deep.

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.

(Additional reporting by Missy Ryan; Editing by Samia
Nakhoul)