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Portfolio Implications: Iraq

06/18/2014

Over the past few weeks the global community has focused their attention on the unfortunate violence in Northern Iraq. The instability is sending shock waves into the world oil markets, lifting the price of WTI to a new high for the year at $107.68 (Figure 1). Brent crude oil has also advanced rather aggressively to $114.

Figure 1: Spot WTI Crude Oil, 2014

Source: Bloomberg

Having spent nearly 20 years in the business of energy trading, I have been called upon to offer my expectations for whether, in fact, an unfavorable price spike is about to unfold. In reality, that answer is a coin flip. Who could know without being in Iraq or being privy to sensitive intelligence, just how dangerous the situation may become. Could it disrupt the current Iraqi production? Yes, but to date it actually hasn’t disrupted it that much.

Iraqi Oil Production

  • Second largest OPEC producer
  • Produced in February 3.4 million barrels per day
  • February production was nearly a 15-year high
  • May production was 3.3 million barrels per day
  • Current production is largest generated from Southern Iraq
  • It is estimated that by 2018 Iraqi production could reach 6 million barrels per day
  • Future Iraqi production growth would largely be derived from Northern Iraq

As you can read, the concern really should be about Iraq’s ability to further grow its production, not so much about its current production. OPEC is nearing capacity and its very existence as “relevant,” given the U.S. and Russian production growth surge, is largely tied to Iraq.

However, for investors I offer a different approach to how this impacts portfolios. Investors should not be focusing on the direction of oil. Rather, most of 2014 has been a compelling investment story for the ownership of energy-related equities, with a U.S. domestic focus on services, exploration, transportation, refining, and production.

The situation in Iraq, and the entire Middle East, makes aligning portfolios to domestic energy all the more appealing. Instability exists not only in Iraq, but Libyan production is down to a meager 180,000 barrels per day from 1.35 million barrels per day just a year ago (Figure 2). Iranian production is 2.75 million barrels per day versus 3.59 million barrels per day two years ago. Instability in the region persists and it is significantly curtailing production.

Figure 2: Libyan Oil Production, June 2008 to May 2014

Source: Bloomberg

In years past there was no alternative to the Middle East instability. Energy giants had to seek oil in the Middle East. Now in 2014, global energy corporations have an alternative right here in the United States. What is the investment incentive for these companies to search for oil in an unstable Middle East, especially when such strong investment incentive exists with U.S. shale?

Very few at the beginning of the year identified the energy sector as overweight. Commodities themselves were suggested at underweight. In fact, one very large and well-known investment bank in mid-May upgraded energy from underweight to neutral. Really, still only neutral?

The utilities sector, as represented by the XLU, leads the major S&P 500® Index (SPX) sectors up nearly 13% year to date. Second to utilities is energy, with the XLE (Figure 3) up close to 12%. In the past few days, I have heard many suggest the performance for energy-related equities has peaked. Really, why, just because it is high? How high is high? Tell that to Williams Partners (WMB) that just Monday proposed a $6 billion dollar deal with Access Midstream Partners to create one of the biggest domestic transporters of shale gas.

Figure 3: XLE, Year to Date

Source: Bloomberg

There is a unique fundamental blessing here in the U.S., and it is called shale. The very same folks suggesting that the advance in energy will be ending are also estimating the average price for WTI in 2014 will be $92, and for 2015 the current estimate is $98. Sorry, but in every capacity the investment community is underestimating energy.

Recent U.S. economic data suggests inflation is accelerating. Over the past six months (Figure 4), it has advanced 2.6%. In addition, U.S. economic data appears to offer evidence of a strong GDP rebound from Q1’s weather-related contraction.

Figure 4: U.S. CPI Change, Month on Month

Source: Bloomberg

Portfolios with a strong alignment to energy would be optimal with a favorable sensitive to accelerating growth and inflation. Oil is often referred to as “black gold”; the current environment strongly supports that moniker. Whether talking to your client or visiting with your advisor over the coming weeks as second half portfolios are structured, please give energy the proper attention it deserves. A perfect investment storm for energy may very well be upon us.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.