By Joe Parkinson

ERBIL, Iraq--In this ancient Kurdish city's sprawling bazaar, Sarbaz Gawhar is in a quandary over the impact of his government's recent territorial advances.

While the rapid incursions of Sunni jihadists have helped Kurdish forces cement control of oil-rich Kirkuk province, the conflict in Iraq has added to pressures on the Kurdistan Regional Government's oil-rich but poorly developed economy.

Mr. Gawhar is facing a precipitous collapse in his textile business. Amid severed supply lines, chronic fuel shortages, rising prices and plunging consumer demand, sales aredown 90%, with few signs of a recovery.

"Yes we've taken control of our lands, but the war is hurting our economy," Mr. Gawhar said, surrounded by candy-colored fabric rolls he sells wholesale to stores in dozens of Iraqi cities. "People are starting to panic and hoard, and if things continue this way, it could be a disaster."

Since Saddam Hussein's demise a decade ago, Kurds have enjoyed increasing autonomy from the central government in Baghdad. That cleared the way for oil and gas deals with wildcatters rushing to Iraqi Kurdistan for what some describe as the last virgin frontier on land. As prospectors unearthed large reserves--an estimated 45 billion barrels--major oil companies including Exxon MobilCorp. and Chevron Corp. followed, bringing billions of dollars of investment.

Huge structural challenges remain. Businesses and hotels say that Iraqi Kurdistan lacks a qualified workforce and that the oil economy discourages the development of other business skills. Retailers that cater to ordinary Kurds say they tend to shop in the traditional bazaars or during trips abroad, while the conflict is also causing panic-buying and shortages.

Last year the KRG began to export oil to world markets by truck and this year through a newly constructed pipeline to Turkey. On Friday, the KRG looked set to unload its first cargo of disputed crude oil from that new pipeline in a sale to Israel after weeks of seeking an outlet as Iraq's central government has threatened legal action against any buyer.

Baghdad has also withheld budget payments to Erbil since January, with a crippling impact on an economy that has an estimated 70% of its workers on government payrolls. Kurdish officials say payments have stopped on two of three operational budgets, with only occasional payments on the third.

KRG officials say the withholding of budget funds amounts to "economic warfare" from Baghdad; they say they are seeking loans from international creditors to plug the shortfall.

Ayham Kamel, an analyst at political-risk consultancy Eurasia Group, said the Kurds recent strategic gains have given its leaders political momentum, but the economic pressures are becoming increasingly severe. "Erbil remains financially weak, and the export strategy hasn't yet proven very successful. They are paying more money for the armed forces in a time of conflict and borrowing money is only a patchy solution," he said.

Ashti Hawrami, the KRG minister for natural resources, told a conference in London this week that oil exports will increase to 200,000 to 250,000 barrels a day in July, and then to 400,000 by year's end, allowing the KRG to catch up with the shortfall from Baghdad's withheld payments.

Until that point is reached, economic pressure is likely to persist in the Kurdish region.

In central Erbil, the mosttangible sign of economic weakness is the long lines, as much as a mile, that have formed outside gas stations in recent days, as supplies have been cut and jittery residents stockpile.

"I've been here for eight hours and counting," said Didar Zrar, a university student in Erbil. "People are panicking because the refinery at Beiji has been captured by jihadists and we don't know how much is left."

At the bazaar, the disruption of the supply chain is pushing up the prices of goods that would have traditionally been delivered from cities now occupied by Sunni militants or southern cities now blocked by their advance. Ali, a produce seller, said his prices doubled as supplies dried up, forcing him to import from neighboring Iran.

"The prices are rising but sales are up because people are bulk-buying some goods," he said, as he piled tomatoes on a scale. "Its like Saddam's time again."

For now, many Kurds have stripped backspending to focus on essentials, presenting another challenge for businesses that usually rely on a booming trade during the Ramadan religious holiday, starting June 28.

"Usually at this time of year there would be lots of trade here, but it's so quiet," said Omar Ahmed, a gold dealer in the bazaar. "The declines started with the budget being cut, but the ISIS advance has made things much worse. My volumes have reduced 60%," he said.

Other Kurds take a more philosophical view to the economic pressure, emphasizing that the region has been through many more painful situations in previous decades.

"People are panicking and that is making things worse, but the situation isn't that bad. We've been through Saddam's time and years of more hardship," said Sanan Maghdid, who sells air conditioning, as he waited in a fuel line in the baking afternoon sun. "Soon we will be economically more independent, and then we're masters of our own future."

Write to Joe Parkinson at joe.parkinson@wsj.com

(END) Dow Jones Newswires

June 20, 2014 16:55 ET (20:55 GMT)

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