Oil Update: The Iraqi Crisis

I started my investment career in 1980, right after the Iranian Revolution and their oil embargo.

The oil supply disruptions from Iran caused oil prices to spike, and this was one of the main causes of a severe U.S. recession. Inflation and interest rates went to double-digits.

Over 30 years later, unfortunately, the conflicts in the Middle East are worse.

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Last week Sunni militants seized control of major cities in northern Iraq.

A group called the Islamic State of Iraq al-Sham is behind the latest attacks. ISIS, as the media calls the group, came across the Syrian border last Tuesday, captured the city of Mosul and may be looking to close in on Baghdad.

Kurdish nationalist forces also took control of Kirkuk as Iraqi government forces apparently fled.

Below is a map of the area of conflict:

Islamic extremists, in particular ISIS, would like to redraw the Middle Eastern borders that the British and French established.

According to the Wall Street Journal, they would like to establish an Islamic state from the coast of Syria through Iraq, which was recognized in the seventh century, after Mohammed’s death.

The current crisis could cause disruptions to oil supplies.

Iraqi Oil Production &

Proved Oil Reserves

According to the U.S. Energy Information Administration, Iraq has about 141billion barrels of proved reserves.

Below is a chart of Iraqi production:

Iraq production has increased dramatically thanks to their abundant reserves, global capital, workers and technology. They produce about 1% of their proved oil reserves per year.

Yet, for the amount of oil they have, they are relatively small oil producers.

By contrast, according to the U.S. Energy Information Administration, the U.S. has about 27 billion barrels (equivalent) of proved reserves. But we produce about 4 billion barrels a year, close to 15% of our proved reserves.

We are the No. 2 petroleum producer in the world.

The world uses about 90 million barrels per day of oil, so the Iraqis’ share of global supplies is only about 4%. Other world producers could make up the difference.

The Chinese buy about 50% of Iraqi oil and are major investors in Iraq. They have outbid and out-negotiated other investors, including the U.S.

In fact, the Chinese have been the main beneficiaries of Gulf War II.

Other major investors in Iraq include the British, Russians and the U.S.

The Global Oil Supply Could Lose Its Current Surplus

Below is a chart about the spare capacity from OPEC:

The spare capacity is basically the output of Iraq. So if we have total supply disruptions, this would cause nervousness in the oil markets … and they would continue to spike.

Below is a longer-term trend picture for Iraq.

At the beginning of Gulf War II, production fell to about 1.5 million barrels per day. This means the surplus would be about 2 million, and that is still too small.

The rest of the oil producers in the world could make up the difference if there are more supply disruptions.

Unfortunately, a disruption — or multiple disruptions at once — could occur at any time due to more terrorist attacks on supplies in the Middle East and Africa, maintenance issues, weather (including hurricanes), oil spills and worker strikes, among other reasons.

But don’t expect producers to go down without a fight. There are some silver linings to be found, particularly for energy investors.

The oil boom of Northern Iraq’s Kurdish oil is an optimistic development after the end of Gulf War II.

Northern Iraq and the Kurds

Iraq is basically divided among three groups: the Shiites, Sunnis and the Kurds in the north.

The Kurds have a lot of oil (it’s estimated they have 45 billion barrels and 10 trillion cubic feet of natural gas). And so far they are defending their territory.

The Kurds claim they have 190,000 troops and are committed to keep the ISIS out and to keep oil flowing.

Reports from different sources say that ISIS has between 4,000 to 14,000 troops.

The Northern Iraq/Kurdish territory is semi-autonomous of Baghdad. Recently the Kurds sent 2 million barrels to Turkey to go to global markets.

Also, at this point, it’s not believed ISIS wants Kurdish territory (again, please see the map at the top of this issue).

Regardless, ISIS is certainly making waves with each move it makes right now.

Past Oil Spikes

Below is a long-term chart for oil:

As we can see from the chart, after each spike, prices fall quicker than the rise.

Below are the causes of the spikes on the chart:

  1. Gulf War I
  2. 9/11 and fear of oil disruptions
  3. Gulf War II
  4. Hurricane Katrina
  5. For decades, there were always global oil surpluses, except for oil embargoes and wars in the Middle East. By the early 2000s and with strong demand coming from China, global oil producers had a difficult time keeping with global oil demand.

The gap between oil demand and production from 2004 to 2008 shrunk from "abundance" to a "very small surplus" of about 2 million barrels a day.

This made oil markets nervous, and caused risk premiums in oil prices to rise.

Also, notice that volume surged. Trend-followers and momentum players jumped on rising prices, exaggerating the trend in oil prices.

Demand fell in 2009, and a surplus in oil increased. But we may be back to a very low surplus, and risk premiums are rising again because of the crisis in Iraq.

Will trend-followers exaggerate the rise in oil prices, as they have in the past?

The next resistance is about $110, and then round numbers would be potential resistance levels: $120, $130, etc.

The $150 level is the last historical high, and would be major long-term resistance.

If prices went to $150, we could expect a global recession, and oil prices would fall again because of lower demand.

The conflict in the Middle East was in full bloom when I started my investment career 34 years ago. The religious civil wars among Muslims in the Middle East that started about 1,400 years ago will probably be around in another 34 years and beyond.

Here in the near term, the Kurds will likely keep the oil flowing, and the momentum traders will continue keeping things interesting in the oil markets. And I’ll be looking for ways to help you to profit, so stay tuned to this space each week for my updated outlook.

Sincerely,

Dan Hassey

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