Over the last several decades, political and military turmoil in Iraq has been almost immediately associated with rising oil prices and increased uncertainty in energy markets. From a supply and demand perspective, there are some real and appropriate reasons for why this might occur. Iraq is one of the largest contributors in the Organization of the Petroleum Exporting Countries (OPEC), which accounted for more than 80% of world crude oil reserves, as of 2012 (see chart below).
(Chart Source: OPEC)
So, it is relatively easy to understand why there is a strong association between political turmoil in the Middle East and the potential for rising prices in oil and many other energy markets. This is also why stocks like Exxon Mobil (NYSE:XOM) have rallied to yearly highs above $100 per share. But the real issue here is the potential supply disruptions in the countries the world relies on for oil production. If we start to see damage to infrastructure, diverted manpower in relevant regions, or obstacles in the way of important trade routes prices tend to rise as the outlook for production output diminishes.
Because of this, it is easy to see why most of the investment community might work itself into a froth any time we start to see news headlines that highlight the potential for political turbulence and military action in these regions. But it is important to remember that "general rules" in the market should not be viewed as applicable in all cases. Here, any trader that is buying into instruments like the United States Oil Fund LP ETF (NYSEARCA:USO) based on the latest developments in Iraq might be making the right choice (for long-term positions). But those traders would be doing it for the wrong reasons, as any upward impact that is created by the negative situation in Iraq will be temporary and transitory. Scenarios like this are often referred to as bull traps, and should be avoided.
Productivity Levels: US and Iraq
Let me be perfectly clear: I am bullish on oil and expect prices in USO to be higher at the end of this year than they are now. But the Iraq story is not a real impetus with the ability to sustainably drive prices higher. The forces that really determine price activity are supply and demand, and productivity levels in energy markets continue to hold at the higher end of the historical range.
Efforts in the US to ramp up activity in oil exports has pushed productivity levels to record numbers in a trend that has carried over into the natural gas space as well. Crude stockpiles have reached their highest levels on record (dating back to 1982). But similar environments are seen in Iraq, as well. This is something that has been largely missed by many of those trading commodities. "The fact remains that roughly 90% of the oil shipments coming out of Iraq are released from the country's southern region," said Vlad Karpel, options strategist at TradeSpoon, "and this is an area that has seen relative calm and little downside impact in overall productivity levels."
This is why oil output in Iraq still has the potential to make gains in July. But this is also a bearish factor that is largely ignored in the financial media. This is the current bull trap for oil traders.
Next, it will be important to monitor the relative performance of oil's most commonly correlated assets: Gold, the S&P 500, and the US Dollar. It might be easy to assume that any positive moves in oil will carry over into the rest of the commodities space, as well. Higher oil prices have led to projections that alternative commodities ETFs like the SPDR Gold Trust ETF (NYSEARCA:GLD) and iShares Silver Trust ETF (NYSEARCA:SLV) will be able to gain traction and move to new highs for the year. But the fact that this has not been the case suggests that the broader global framework is still not conducive to significant bull moves in commodities as a whole. The SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is still trading at its own record highs but activity in the PowerShares DB US Dollar Index Bullish ETF (NYSEARCA:UUP) has much better potential to move prices in oil.
(Chart Source: Orbex)
The chart above shows the US Dollar to be in a newly emerging uptrend against the Euro. This creates additional headwinds for oil prices because oil is priced in US Dollars. All of these factors should be taken into account, as the Iraq situation and the supply and demand environment could stall gains in oil and the United States Oil Fund LP ETF.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.