June 30, 2014 - Making the Best of Civil Unrest in Iraq
The situation is Iraq has not exactly been good in recent years, but it has taken a dramatic turn for the worse in recent weeks, as a civil war has erupted in large portions of the nation. No war is good, but what really separates a civil war in Iraq from other nations is the amount of oil that the country produces.
Iraq is OPEC's second-largest producer of oil, so any disruption in the nation, or even the mere possibility of future disruptions, is enough to send oil prices higher. The tension has already caused a run up in oil prices, even though the violence has had very little impact on Iraqi oil production. According to OPEC's Secretary General, Abdullah Al-Badry, oil prices have so far inflated purely out of fear. He reports that Iraq is still producing at its normal levels, with 95% of its capacity being unaffected by the violence that is spreading through the country.
This is both good and bad news. On one hand, it means that when tensions die down, oil should make a nice correction lower. On the other hand, it could also mean that if the violence really does begin to impact the country's oil production and exports, oil prices could skyrocket.
Of course, higher oil prices increase the risk of slowing economic growth around the globe. Some analysts have estimated that for every $10 increase in oil, global economic growth slows by two-tenths of a percent. That may not sound like a major impact, but the global economy is already on shaky ground and any slowdown can lead to bigger problems.
Hopefully, tensions will cool off soon, but for now it appears as though the situation is only worsening, which leads to the possibility of even higher oil prices.
No one want to see the situation escalate any further, but from an investing point of view, we must think about how to profit from the current situation. Any pinch, no matter how small, of Iraq's oil supply could benefit U.S. companies in the exploration and production sector. As a result, if we can find a way to play the sector, it could be wise to do so at the current time.
From a contrarian point of view, it would be easy to play devil's advocate and make the argument that the recent run up in prices has been fueled primarily by fear and that prices are likely to fall just as fast as they have risen. There is some merit to that argument, as we have already discussed that Iraq's oil production has yet to be impacted by what is taking place in the nation. We will keep that argument in mind when trying to determine a way to play the sector.
First, we have to think about the situation as it currently stands. On one hand, we have the real potential of escalating violence impacting the output of one of the largest oil producers in the world. On the other hand, so far those fears have not really held true, and if tensions ease, oil prices could quickly come back down.
What that means to me, is that any trade on the sector needs to be highly diversified, and if possible we should look to hedge our bet just in case oil moves against us. I believe we can accomplish both of these objectives with a trade on the exchange-traded fund iShares US Oil & Gas Exploration & Production (IEO).
Chart courtesy of stockcharts.com
IEO holds a large number of companies in the exploration and production sector, with ConocoPhillips (COP), EOG Resources (EOG), Anadarko (APC), Phillips 66 (PSX), and Apache (APA) among its top holdings. Trading IEO definitely takes care of the problem of diversifying our investment, which should protect us against any major downside move.
As for hedging our bet, a nice hedged trade on IEO would be the September 85/90 bull put credit spread. In this trade you would sell the September 90 put while buying the same number of September 85 puts for a credit of 25 cents. This trade has a target return of 5.3%, which is 22.6% on an annualized basis (for comparison purposes only). IEO is currently trading at $96.48, so the trade has 6.5% downside protection.