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The Math on Iraq Oil for Investors

History shows that crisis events in the Middle East tend to last a while and that prices have usually moved up in earnest after the events began...

WallStMavens continues its coverage today on what the multiple global conflicts that are happening right now – Syria, Ukraine, and Iraq – mean for investors.

We have already published critical commentary which explains why these events are largely discounted already into capital markets worldwide, and why the conflicts are already showing signs of moderation.

Of course, conflicts have a way of changing direction rapidly, and without warning.

Therefore, we would be remiss if we did not highlight Dave Moenning of State of the Markets latest analysis that dives into the Iraq situation in particular and the mathematics of how much oil production is at risk right now, and if this is the catalyst to kill the bull run…  

The turmoil and violence in Iraq continued unabated on Monday as ISIL (Islamic State of Iraq and the Levant) militants continued on their quest to acquire additional strongholds in northern Iraq.

But from the market's perspective, the question of the day is whether the situation in Iraq is likely to turn into a global geopolitical/economic crisis – or – remain a local conflict. As human beings, anyone who understands what is happening in what amounts to a budding civil war is likely to have a great deal of empathy for the citizens of Iraq. However, for investors, the focus is a bit more cold-hearted and involves some math.

The mathematics of this dilemma/predicament/crisis are fairly easy to get one's head around. This crisis, as with almost all crises in the Middle East revolves around oil, or as it is often referred to as… "Black Gold."

Doing the Math on Iraq

For starters, investors need to recognize that Iraq is the second largest oil producer in OPEC (after Saudi Arabia).

Next, according to the Energy Information Agency (EIA), Iraq produces 2.9 million barrels of oil per day, which, by the way, is the same amount of production seen in Mexico and about 300K more barrels per day than Brazil produces.

Another fun fact to know and tell about Iraq is how the oil is produced and exported from a geographical perspective. Approximately 25 percent of the oil production is in the northern section of the country – where all the military action is at the present time – while 75 percent of the country's oil production occurs in the south.

Next, Iraq exports roughly 2.3 million barrels of oil per day. It is important to note that 2.1 million, or approximately 91 percent, of the exports are to the south via the Persian Gulf while 100,000 – 200,000 barrels per day is exported to the north through Turkey.

Therefore, the first conclusion that can be drawn is that Southern Iraq is where the action is in terms of oil being produced, stored, and/or exported.

And yet, the military action in Iraq is primarily in the north and the vast majority of analysts believe there is no immediate danger to Iraq's southern oil fields. And perhaps it is for this reason that while the price of oil has been moving higher, there does not appear to be any panic seen currently in other financial markets.

For example, on Monday, stocks in the U.S. actually finished a bit higher, gold finished down, bonds yields moved down a bit but not dramatically so, and the CBOE Volatility Index moved only modestly higher.

Adding The "Risk Premium"

Despite the relative calm in most asset classes, oil has continued to move higher. Take a look at the chart below.

U.S. Oil Fund ETF (USO) – Daily

Although the flow of oil has not been interrupted and there does not appear to be any real threat to supplies in the foreseeable future, it appears that a "risk premium" is being applied to oil right now. And in short, THIS is what the recent run higher in oil is all about.

In other words, the sellers of oil are asking buyers to pay a little more for their oil each day due to the worries about what might happen in the near-term.

What Have Past Middle East Crises Taught Us?

If you've been in the stock market game for any length of time, you are no doubt familiar with the never ending crises that tend to occur in the Middle East. By my count there have been 18 so-called "crisis events" in the Middle East since 2000 alone. That's 18 crises in 14.5 years.

So, let's take a look at what has happened to the price of oil around the crises seen just in the last four years.

U.S. Oil Fund ETF (USO) – Weekly

The arrows on the chart above illustrate the starting point to the following:

  • December 2010: Arab Spring (Tunisia)
  • January – April 2011: Egyptian Revolution, Bahrain Uprising, Libya Tension, Syrian Civil War
  • October 2011: Gadhafi Overthrow
  • January 2012: Mali Conflict
  • July 2013: Islamic Unrest in Egypt
  • Anbar Clash

In looking at the price action in Brent Crude Oil one month after each event began, history shows prices rose 7 out of 9 times, and by 7.3 percent on average.

Three months after the crisis event, Brent Crude was also higher 7 out of 9 times (prices fell after Gadhafi was overthrown and the Anbar Clash), by an average of nearly 9 percent.

And in looking back to the crisis events since 1990 (there have been 21 total), oil prices have been higher 5.4 percent on average three months after the event began and 9.25 percent higher three months later.

The Takeaways

History shows that crisis events in the Middle East tend to last a while and that prices have usually moved up in earnest after the events began. So, given that the so-called crisis in Iraq began about a week ago, the odds are pretty good that oil prices are headed higher over the next few months.

The key question however, is if the liquidity provided by the central banks of the world will be able to keep the party in the stock market hopping. So far, so good. But then again, we hear from the Yellen Fed this week.

Read State of the Markets' critical and comprehensive market analysis before the start of every trading day...

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About the Author

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David Moenning is the founder and chief strategist of State of the Markets. David began his investing career in 1980 and became an independent money manager in 1987.

In 2005 he launched State of the Markets and oversees investing products such as The Insiders Portfolio, Daily Decisions, and the IRA-401K Advisor (all available through WallStMavens).  David also works as a full time money manager, and is the President and Chief Investment Strategist of Heritage Capital Management, an RIA firm based on Chicago.  

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