Will An Escalation In Iraq Cause An Oil Shock?

Thought for the Week from Global Financial Private Capital Chief Investment Strategist Mike Sorrentino

SYNOPSIS

  • Recent tensions in Iraq have raised concerns over energy production and whether consumers can expect a similar shock in gasoline prices that occurred in 2011 during the Libya uprising.
  • Despite ongoing media reports of escalated violence in Iraq, the world’s 6th largest oil producer, gasoline prices have not moved because the energy landscape is quite different today vs. 2011.
  • The Investment Committee suggests to those investors who want to protect themselves from rising energy prices to add some form of inflation protection into your portfolios.

What’s Driving Gasoline Prices?

On June 9, the Islamic State of Iraq and Syria (ISIS) began an offensive within Iraq to take control of a large area of land from the Iraqi government led by Shiite Prime Minister al-Maliki. Although small in number, local Sunni tribes alienated and disenfranchised by the policies of al-Maliki’s government have enabled ISIS to seize control of the northern city of Mosul and surrounding areas.

Iraq is the sixth largest oil producer, and oil markets subsequently shot up 4% as the gravity of the situation became evident. In addition, concerns of an oil shock to the economy led equity markets to sell off, albeit briefly, and gold markets to rally.

Although history has taught us that unrest in the Middle East typically leads to higher prices at the pump, the chart below shows that gasoline has increased by only a few pennies since early June. In fact, prices have even fallen in some of the traditionally more expensive markets like San Francisco.

TOW 063014 Chart 1

 

The red line indicates the progression of gasoline prices since January, and the blue line represents gas prices back in 2011, which was the last time we faced a large-scale unrest in the Middle East. The spike in February 2011 was due to the Libya uprising and pushed the average price of U.S. gasoline up 17 cents in just the first 10 days, and to almost $4/gallon by mid-May.

Libya produces less than 1% of the world’s energy and Iraq accounts for approximately 4%, yet the Libya crisis caused a far more dramatic move in prices at the pump. Three key reasons can explain why gasoline prices have been less impacted despite Iraq being over 4x more important to the energy market.

  1. Geography: The fighting is currently isolated to northern Iraq, and more than 80% of Iraq’s production and export facilities are located in the south. We do not expect Sunni rebels to invade oil-producing regions since these locations are so far away and well fortified.
  2. Fracking: The U.S. has become less dependent on imported oil since 2011 due to fracking, which is a technology that has exposed vast amounts of oil below our feet. In fact, U.S. production has risen over 55% since 2011 due to advances made in fracking. Additionally, consumption has fallen from cutting back on driving and more efficient cars.
  3. Seasonal Timing: Gasoline prices normally rise in the spring because refineries shut down to prepare for summer driving demand, which causes supply to drop. Prices then fall in June (see the chart above) because although refineries are already producing, families still have kids in school. The timing of Iraq’s unrest just happens to be during this lull in demand.

Let’s spend more time discussing the impact of fracking to get a better sense of the importance in domestic energy production. The chart below shows the amount of oil that the U.S. imports each year.

TOW 063014 Chart 2

Due to the dramatic rise in domestic oil and gas production, we are now back down to import levels not seen since the mid 1990s. The Investment Committee strongly believes that this trend will continue, and the U.S. will become energy independent by 2016.

 

Implications for Investors

Any investment manager that holds an allocation to energy stocks simply must assume that unrest in the Middle East will cause energy prices to be volatile at some point every year. We have seen turmoil be a factor in this region since oil was first discovered, and we expect it to continue into the foreseeable future.

However, since the U.S. is moving closer towards energy independence, we expect domestic energy prices to become less responsive to these types of events over time. The charts and commentary above support our beliefs, but for those investors who fear that energy prices will continue to remain volatile, we offer a strategy to hedge these concerns.

Consider adding some protection from rising energy prices using the DIAS Inflation Protection Portfolio, which holds a large allocation of energy stocks. Therefore, when prices at the pump begin to rise, investors can hopefully rest a little easier knowing that a few pennies more at the pump will likely be more than offset with the gains in their portfolios

 

Sorrentino

 

 

 

 

 

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.