- The situation in Iraq is almost certain to get worse before it gets better.
- Markets are vulnerable if the situation gets significantly worse.
- Oil prices look likely to head higher over the short term.
The situation in Iraq appears to be getting worse by the minute. On Thursday, it was reported that Islamic militant group, ISIS, had seized key cities and, if the U.S. does not intervene, it appears that Baghdad will be under attack within days. Unfortunately, the situation in Iraq will likely get worse before it gets better. President Obama has already promised help for Iraq and has said that air strikes and drone strikes cannot be ruled out. Iran has also offered to support the Iraqi government.
Given the war tactics that the insurgency will likely implement, it is extremely difficult to see how air strikes alone will be enough to restore order. At the same time, it does not appear that the U.S. is willing to send in troops. The Iraqi military does not appear capable of doing much to help the situation. At this point, the best option may be support from Iran, which of course has its own drawbacks. I do not claim to have the answer but I do believe, unfortunately, the situation will get significantly worse over the short term. While I hope it does not happen, a fully blown Sunni-Shia civil war in Iraq cannot be ruled out.
Markets Are Vulnerable
With the major stock market indices trading close to all-time highs, and the VIX sitting at 12, a major sell-off is certainly possible. Of course, the markets have not reacted too much to the news in Iraq yet because, at this point, the situation still seems remote and removed from the factors driving the global economy. However, if oil prices continue moving up, the equity markets could move sharply lower. It would not be surprising to see a 5-10% move lower as the situation continues to deteriorate.
How To Trade It
Given the low level of volatility, buying some protection in the form of put options on the S&P 500 (NYSEARCA:SPY) may be a wise strategy. I do not expect a massive move lower so I would stick to buying at the money put options. Alternatively, I also believe investors could consider selling call options. At the very least, the situation in Iraq will keep the markets from making a major advance anytime soon.
Oil Prices Likely To Continue Higher
Oil prices have already started to react to the situation in Iraq but I believe oil prices will continue to move higher. In particular, Brent crude seems likely to move sharply higher because Europe relies more heavily on Middle East oil imports than does the U.S.
How To Trade It
As far as trading the move higher in oil goes, I would look to take a long-trading position in ETFs such as United States Oil Fund LP (NYSEARCA:USO), ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO), and United States Brent Oil Fund (NYSEARCA:BNO). While some might argue that oil companies such as Exxon (NYSE:XOM), BP (NYSE:BP), and Chevron (NYSE:CVX) are good plays on rising oil, I do not believe that is the case when major geopolitical issues are the cause. There are a number of reasons why oil stocks are not a good bet when oil prices rise for geopolitical reasons. Firstly, geopolitical issues tend to be short term in nature with market impacts typically ranging from a few weeks to, at most, a year or two. This means that any spike in the oil price will only provide a temporary boost to earnings. Knowing this, Wall Street is not willing to pay more for these earnings and multiple contraction often ensues. Another reason why oil price spikes due to geopolitical issues are often undesirable for oil companies is that they sometimes have production in the place where the turmoil is occurring. For example, the list of companies with exposure to Iraq includes BP, Exxon, Occidental Petroleum (NYSE:OXY), Royal Dutch Shell (NYSE:RDS.B), Chevron, Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), and Baker Hughes (NYSE:BHI).