Iraq Crisis – The Tipping Point

ISIS_iraq_-_Google_SearchBy David Nelson, CFA

Last week most investors were blind-sided by the frightening events coming out of Iraq, an area of the world most Americans would like to forget. A wave of talking heads including yours truly took to the airwaves, some focused on the politics and others like myself looking to sort out the economic fallout.

We are in the early stages of world energy markets becoming unhinged. An Islamic State especially one controlled by ISIS, a group deemed too radical by Al Qaeda, isn’t just a potential threat to the Middle East. It threatens the economic stability of the world.

We’re already starting to see the early repercussions from last week’s news. Oil prices are starting to rise and here in the states drivers are just starting to pay more at the pump. The damage would certainly be more severe if not for the new technologies dramatically increasing U.S. energy production.

WTI

According to the International Energy Agency world demand is expected to climb to 94 million barrels by year’s end. Currently, Iraq is OPEC’s number 2 producer supplying between 3 & 3.5 million barrels per day. Some question whether Saudi Arabia’s spare capacity is enough to make up the difference, if all or some portion of that supply comes offline.

OPEC Production

opec_production

Gas Prices

GasBuddy.com puts average gas prices at $3.64 per gallon. Some analysts see that hitting $3.70 in coming weeks with an outside chance of $4.00. The last several months have been terrible for retail so a gas crisis is the last thing we need right now.

The Ripple Effect

Last week Goldman’s transportation analyst Tom Kim put out a note discussing the sensitivity analysis of rising fuel prices to his group. His conclusion is a 1% change to fuel price assumption leads to 2.9% change in EPS on average.

If fuel prices rise 10%, that would be a devastating 29% cut in estimates. It’s true that many companies are hedged to some degree but hedges cost money. None of this seems like good news for the (IYT) iShares Transportation ETF, up almost 30% in the last year and sitting very close to all-time highs.

IYT

Energy prices touch every fabric of the economy. When transportation costs rise most industries take a hit. Ultimately the increased costs get passed on to the consumer.

Some History

The sectarian violence and the differences between Sunni and Shia Islam have baffled western diplomats and politicians for the last quarter century.

There’s no shortage of blame to go around. As we entered Iraq the Bush administration didn’t fully recognize the Sunni Shia dynamics. When Nouri Kamil al-Maliki succeeded the Iraqi Transitional Government he set in motion a venue designed to marginalize Sunni and strengthen his own Shia roots.

A decade later the Obama administration’s foreign policy initiative is being called into question. Critics are pointing to the failure of securing a treaty that would have left a residual force and others point to the lack of any meaningful response to the earlier events in Syria.

The fact that this seems to be a surprise is the most frightening of all. If this is an intelligence failure it’s a big one. There isn’t a soldier who served in Iraq that didn’t see this coming.

If Baghdad falls and somehow ISIS takes control of the country, they will have full access to 90% of Iraq’s capacity located in the South. The only thing worse than a radical Islamic state is a well-financed one. The International Energy Agency has predicted Iraq will be about 60% of OPEC’s production growth by 2020. That sounds like a lot of money to me.

The Big Picture

Today eyes are focused on Iraq but there are other hot spots around the world. The Ukraine is facing a complete shutdown of gas supplies from Russia as early as Monday. This also disrupts 15% of the Europe’s gas supplies. China is increasing their military presence in the South China seas claiming the oil and now we have a radical Islamic force ISIS throwing Iraq into Civil War.

At the center of it all is Oil. In some cases Oil is and will be used as a weapon.

Plan B

Each side of the aisle views the events of the last decade with their own political bias. There’s a political firestorm brewing on just what role the United States should play in events taking place half way around the world. The issues are complex with valid arguments on both sides of the debate. However, if the decision is to pull back from the world stage there had better be a Plan B.

We have to be doing everything we can to develop our own natural resources and the infrastructure to transport it. I mean everything. No stone should be left unturned. Oil, Nat Gas, Alternatives, Fracking, Wind, Solar etc. all need to be part of the mix. The U.S. has a shot at becoming energy independent by 2020. It’s our best chance at national and economic security.

A couple of years ago I published the “The Road to 1500” – I was referring to the S&P 500 which was sitting 200 points below that target. I was considered a lunatic but never the less we made it pretty much on schedule. Today the S&P sits just shy of 2000. If we fail to address the issues I’ve raised here at some point I may get to use that title again.