Fast-growing oil exporter Iraq is selling its crude cheaper than any comparable supply, undercutting regional rival Saudi Arabia to grab a bigger slice of the Asian market.

Three years into an oil expansion following decades of war and sanctions, Baghdad has risen to the rank of third largest supplier to China, India and South Korea - prompting Saudi Arabia to seek to safeguard its top slot.

Executives from state oil giant Saudi Aramco discussed a response to Iraq's aggressive pricing at a strategy meeting in London earlier this month, industry sources said.

"Iraq is raising its production. We have to play very smart," said a source familiar with Saudi oil marketing policy. "We don't want to hurt ourselves."

To win more customers in Asia, Baghdad has upped its pricing game - marking down Basra Light crude by $1.10 a barrel against rival Saudi Arab Medium, the lowest discount in nine years.

Saudi Arabia reacted by cutting the price of Arab Medium for two months running, a move traders and refiners said was in part to preserve the kingdom's market share.

"The Saudis are feeling it more than everyone else," a trader with a Western firm said. "It's direct competition and that is why the Saudis dropped their official selling prices big time."

Riyadh, pumping about 9.2 million barrels per day (bpd) after cutting supply sharply towards the end of 2012, may also be marking its territory ahead of Opec's May 31 meeting in Vienna.

"The sharp price cuts and rumoured efforts to push refiners to take full contract volumes may constitute a gentle warning that Saudi Arabia is not going to forego its market share to make room for Iraq," said a senior Western oil executive.

"But this is a long-term game and the Saudis appear fairly sanguine about the overall market balance for the moment."

For their part, Iraqi oil officials do not see Baghdad in a full-on battle with Riyadh for market share.

Iraqi oil marketers want to craft a sales policy that does not jeopardise production growth that began in 2010 after Baghdad secured service contracts with the likes of BP, Eni, Exxon Mobil and Royal Dutch Shell .

"We're building a strategy to increase exports and keep our customers happy," said an Iraqi oil official. "And we're on the right track."

Already Organization of the Petroleum Exporting Countries (Opec)'s second-largest producer after overtaking Iran, Iraq aims for average rates this year of 3.7 million bpd, up from 2.9 million bpd last year. That would be just shy of an all-time high of 3.8 million, hit in 1979.

Baghdad's lofty output target, revealed by Oil Minister Abdul Kareem Luaibi just before Opec's last meeting in December, did not go unnoticed by Saudi Arabia - the only producer in the Opec with a significant cushion of available supply.

"Luaibi's big numbers unnerved us," said a source from a Gulf producer who declined to be identified.

Global demand growth is moderating at 800,000 to 1 million bpd and Baghdad could supply nearly all the new requirements if it were to achieve its production objective.

Iraq's exports have surged even though it is recovering from 20 years of war, sanctions and civil strife and is grappling with export constraints, creaking pipelines and other infrastructure and security threats.

Since Iraq's oil expansion got underway, output has risen by more than 600,000 bpd.

But ongoing bottlenecks suggest Iraq's production is more likely to grow on average by about 300,000 bpd this year, say Western and Iraqi oil experts, leaving some distance from its 3.7 million bpd target.

"The big increase from Iraq has not materialized, so there's no real fight for market share now," said the source from the Gulf producer.

"But growth of more than 500,000 barrels a day would send a negative signal and could trigger the battle."

Iraq supplied 11 per cent of China's total oil imports in January 2013, up from 5.8 per cent in 2012. Saudi is the top supplier to the world's second-biggest oil consumer after the US and had 22 per cent share in January, up from 20 per cent in 2012.

In India, Iraq's share rose to 14 per cent in January, from 13 percent in 2012. Saudi held the top slot with 17 percent share in January, up from 16 percent in 2012.

Baghdad is set to gain even more. Indian refiner Hindustan Petroleum Corp is in talks with France's Total to buy up to 40,000 bpd of Basra on top of its 60,000 bpd supply contract with Iraq, say industry sources. Total is said to be offering a 10-15 cent/bbl discount to Iraq's OSP.

At the same time, HPCL plans to reduce its imports from Saudi Arabia to 50,000 bpd from 60,000 bpd, the sources said.

In South Korea, Iraq moved up one notch to replace Qatar as the third-biggest supplier in January.

Working in Iraq's favour is the steep cuts made by Asian buyers of Iranian oil as tough Western sanctions to force Tehran to halt its nuclear programme made it difficult to pay and find tankers to ship the oil.

A possible unexpected halt in imports of Iranian crude by India due to the lack of insurance for refineries has also spurred demand for Basra crude.-Reuters