U.S. futures have been down sharply on the continuing unrest in the Middle East and escalating violence in Libya. As violence on the streets continues to get worse, headline risk to U.S. stock investors has once again become a problem. The censorship that plagues the region only exacerbates the problem, as Twitter is not exactly the most reliable news source. In any event, U.S. investors should take a look at their portfolios and determine how the unrest in the region will affect their positions in the short and medium term. The possibilities to consider here are an oil price shock and the "risk-off" flight to quality trade.
The fear is really that the flow of oil from the region will be interrupted, causing a spike in oil prices that will reverberate around the world. Brent crude is up another 2% to $104.25, and U.S. light sweet crude is up 4.6% to $90. The difference in prices is due to a supply glut in Cushing, Okla., which is the settle point for U.S. crude contracts. Although Libya only produces 1.6 million bpd, there are questions about how much spare capacity countries like Saudi Arabia can actually turn on, so in an already tight market this is a real concern. The OPEC oil embargo in 1973 as well the Iranian Revolution of 1979 both caused rampant run-ups in oil prices that helped push the U.S. economy into recessions. The logic is simple: a spike in costs slashes margins and crimps consumer spending as gas prices spike.
All that being said, the U.S. uses 20 million bpd of oil, so a $4 increase in oil prices is a $80 million per day negative to the U.S. economy. That does not seem so bad when put into the context of a $14+ trillion U.S. economy. The spikes that led to recessions in the 1970s and 80's were massive, with prices quadrupling in the early 70's and more than doubled as the Iranian Revolution played out. Obviously we are nowhere near that level of increase yet. Also a rising dollar as investors flee to the safety of the U.S. could help blunt the rising prices, as crude oil is priced in dollars. On the political side, I'm not sure Obama would let the price of oil climb too high without talking up the possibility of releasing oil from U.S. strategic reserves, or actually letting some oil out to cool the market.
"Risk Off" Flight to Quality Trade
The "risk on/risk off" trade has been used in the recent months to refer to certain trends in the capital markets in response to perceived risks associated with news headlines. "Risk on" means investors are not concerned about a pullback in the economy, and are buying risky assets, such as U.S. small cap stocks, as well as technology companies, and selling safe things like U.S. government bonds. The "risk off" flight to quality trade is the opposite, with money managers attempting to de-risk their portfolios, buying gold, buying U.S. bonds, and selling stocks and emerging markets. The CBOE volatility index (VIX), referred to as the Fear Index, is a good measure of this phenomenon. The VIX increases as investors are more afraid, and declines as investors become complacent.
Emerging markets have already seen outflows in recent months, and the further unrest should continue this trend. Expect countries around the Middle East to be hit especially hard, namely Turkey and Israel. The VIX should spike, and investors can buy VIX call spreads to participate in the unrest and hedge positions. Similarly investors could buy put spreads on the S&P or in individual stocks if they fear a longer, or deeper pullback. Gold will continue its rise, Treasuries will rise and rates will fall, and the dollar should strengthen. Expect the stocks of companies with a presence in Libya to be knocked down, with BP (NYSE:BP), OMV (OTCPK:OMVKY), Total (NYSE:TOT), and Eni SpA (NYSE:E) all having operations in the country. Italy's market was down especially hard recently, as Italy still has close ties to its former colony of Libya.
Other things to consider here are natural gas and solar/renewable energy stocks. Rising prices for oil, as well as the general unrest in the Middle East will bring calls for a self-sustaining energy policy here in the U.S. back to the forefront. The price of natural gas should also find support as oil prices rise, with any major spike most likely the result of a short squeeze. U.S. oil/gas producers may also become more attractive targets for international oil producers, as the U.S. carries none of the possible regime change risk associated with investments in oil and gas fields in the Middle East. Expect companies like Chesapeake Energy (NYSE:CHK) to have no trouble selling more joint ventures to companies desperately trying to find new reserves. Long term I believe there are too many small and independent producers in the U.S., and that consolidation will come, although I do not see these events triggering any tie-ups. The unrest could also silence calls for the cutting of solar energy subsides, which could support Sunpower's (SPWRA) stock, as well as others in the solar industry.
No one knows how the next chapter of these uprisings will play out. As I have been writing this there are unconfirmed reports that Gaddafi has fled Libya, and that the Libyan Air Force is bombing protestors' positions in parts of the country. It's too early to tell what the outcome will be, but it is not to early to start to examine how possible events will affect fear levels and money flows. Hopefully violence subsides and the people of the Middle East and North Africa will see democracy without more bloodshed, and the dip in asset prices caused by the uncertainty will provide opportunistic investors a chance to get into some new positions at a discount.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.