Iraq Headlines Sink Market

Jim Brown
 
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The Islamic State of Iraq and Syria (ISIS) jumped to the forefront in the battle to garner the most headlines in a single week. The terrorist organization or jihadist group, whichever you want to call them, surged from near obscurity in the USA to the top headlines for the week.

Basically this group is so bad they make Al Qaeda look good. They are too radical and too dangerous to be part of Al Qaeda although that was the group that inspired them and they broke off to create their own Islamic state consisting of parts of Syria and a big chunk out of Iraq.

The leader of the ISIS is a product of the U.S. catch and release program. Abu Bakr al-Baghdadi was a terrorist that was captured by the U.S. in 2005 and kept in the Camp Bucca prison camp in Iraq. The camp was named after a FDNY Fire Marshal, Ronald Bucca, who was killed in the 9/11 World Trade Center attack.

After President Obama took office in 2009 and announced he was pulling out of Iraq and closing Guantanamo in Cuba the immediate question was "what to do with all these terrorists, jihadists and mass murders kept in these camps. President Obama instructed to military to turn them loose.

As Baghdadi was leaving the detention camp in 2009 he told the commanding officer of Camp Bucca, "I will be coming to see you guys in New York" as an obvious warning that he was going after the USA.

He did not make it to New York but he is now recognized as the most dangerous man in Iraq. As the leader of the ultra-extremist army sweeping through Iraq and killing everyone in sight he is public enemy number one. Thinking back the camp commander said, "He was a bad dude, but he was not the worst of the worst." It is amazing what a little motivation like being caged for four years can do to a person's willpower. He became so hostile and ruthless that even Al Qaeda kicked him out of their group in Syria. Now he is being called the next Osama Bin Laden.

Commander King expressed extreme frustration at the catch and release program at the time. He said "we have spent hundreds of missions and put thousands of soldiers at risk with many men dying to capture these guys." Suddenly the political winds changed and they just turned them all lose again after being hardened and motivated by their stay in the camp with hundreds of others of like minds and determination.

"We might as well have called it a training center for terrorists" since they all learned from each other every day they were there.

King said the Sunni and Shia inmates were like the "Bloods and Crips" because they were constantly at war against the other side.

The only way to end this war is to kill as many of the ISIS as possible. They are on a killing rampage and capturing them and putting them back into a camp is the wrong idea. According to videos they have posted this weekend they have killed more than 1,700 Iraqi men and soldiers. They lined them up on the side of big ditches and either shot them or beheaded them. It takes a pretty hard core killer to cut a man's head off with a knife. You are not going to rehabilitate them in a prison camp.

Iraq may already be too far gone to recover. The Kurds have captured more of the northern oil fields and are in complete control of that region including Kirkuk. The Sunni population in sympathy with ISIS now control the western portion of Iraq and it is going to be a fight to get it back. The Shia government and population control the southern portion of Iraq and they are being assisted by 2,000 Iranian revolutionary guard troops.

Everyone is in control of their own section and there does not appear to be enough willpower or manpower to force them out. Baghdadi may be threatening to attack Baghdad but it is an empty threat. He does not have enough men and the population is Shia and they will fight to the death to defend the city against the Sunni militants.

England drew up the Iraqi boundaries after World War I and ever since politicians and analysts have warned that the three distinct ethnic and confessional regions would eventually break apart. In 2006 Joe Biden, now Vice President, said Iraq should "devolve" into a federal system with each region enjoying a king of hyper autonomy similar to the dissolution of Yugoslavia after the Balkan wars.

Regardless of what happens this week the critical southern oil fields are not in imminent danger. Iraq currently exports about 3.5 mbpd and that is not expected to change. The fields are too heavily defended and too far from the current ISIS positions for them to make the journey to attack them. President Obama would probably quit playing golf long enough to approve some airstrikes if it appeared ISIS was moving in that direction.

ISIS is very vulnerable to air power. They are moving in cars and trucks in long columns in broad daylight on the main roads. A couple A10 Warthogs could end the invasion in about an hour if given the approval. The term shooting fish in a barrel applies here.

The challenge to Iraq's oil output is not damage to the facilities but the lack of workers. As soon as the fighting began all the major oil companies began shutting down facilities and evacuating their workers. Iraq is a dangerous place even when there is no outright war. When ISIS began taking over towns and killing the men for no reason the oil companies closed up shop and headed to safer climates.

If Baghdadi and his mob were all killed tomorrow it would take weeks or even months for the oil field work to begin again. When workers are extracted from a country for safety reasons a goodly portion of them don't come back. The event pushed them over the edge and safety becomes a priority rather than a paycheck. Companies are forced to find new recruits and that is a lengthy process.

Two years ago Iraq was supposed to be producing 12.0 mbpd by 2020. Fast forward to two weeks ago and now they are projecting 7-9 mbpd by 2020. This evacuation is going to further depress the oil sector and the estimates are going lower.

If the worst came to pass and ISIS did manage to shutdown the southern oilfields Saudi Arabia and the rest of OPEC could pick up the slack within about 30 days. It would take them some time to bring production up enough to replace the 3.5 mbpd but they could do it. Since oil prices would probably rise to something in the $125-$150 range on a total halt of Iraqi exports it would be well worth their effort to ramp up production.

Crude prices are about $107.50 late Sunday night. I think that is pretty close to the peak if the oil fields remain safe. However, the longer this scenario continues without a decisive victory by the Shia government and any coalition forces they can drag back into the conflict, the more oil will rise. Iraq needs to act hard and fast to end this immediately or at lease end the ISIS land grab so they can begin negotiating the final settlement.

This flare up in Iraq is one more reason why we have a Strategic Petroleum Reserve (SPR) and why we should not export our oil. We need to be self sufficient and not be dependent on OPEC for our oil. We import about 7.5 mbpd and about half comes from OPEC countries.

Consider this. We buy OPEC oil with dollars. A percentage of those same dollars eventually end up in the hands of the Taliban or ISIS or other terror groups bent on causing destruction somewhere in the world. There is a growing rumor that Saudi Arabia is funding ISIS. In the 9/11 attack the majority of the attackers came from Saudi Arabia. It is not that the leaders are particularly evil but they are faced with the same problems we have in the USA. Less than half of the population in Saudi Arabia works. The other half is on the public dole. They are funded by the government in their own version of welfare. The subversive groups, for lack of a better term, are blackmailing the government for handouts. "If you don't support our cause we will cause a rebellion and throw you out of power."

Basically when we buy OPEC oil we are giving money to governments that support terrorism in some fashion. We should not be giving them our dollars to buy weapons and training.

I expect the Iraq situation to be over by next weekend. The lightning attack by ISIS has lost momentum and the opposing forces are growing. These headlines will encourage the market and the eventual lack of headlines will release the weight on the market. Traders have a short memory for geopolitical events. Those events are "over there" and once the headlines disappear the event disappears even though people will still be dying in the conflict.

The FOMC meeting announcement and press conference on Wednesday should push Iraq out of the headlines for the market.

Oil Inventories

Crude inventories declined -2.6 million barrels for the second week of major declines. However, the refinery utilization plunged a whopping -3% from 90.8% to 87.9%. Something in this inventory report does not compute. Why would inventories decline sharply with utilization falling even faster? Imports at 7.15 mbpd were right in line with the prior week so no big change there.

Refiner inputs did decline -490,000 bpd so they used significantly less oil but inventories declined anyway.

Cushing inventories edged even closer to the minimum operating level of 20 million barrels. Something will have to change here soon or we will have another factor weighing on prices.

U.S. production came close to another 25 year high at 8.46 mbpd, just under the 8.47 record two weeks ago. It is only a matter of time and we should be at 9.0 mbpd by the end of 2014.

Gasoline inventories rose +1.7 million barrels. Again, how is that possible with a -3% decline in refinery activity. Falling demand could have been the reason with demand dropping -480,000 bpd. Distillates rose +900,000 barrels after distillate demand fell -280,000 bpd.

In the graphic below green represents a recent high and yellow a recent low.





Natural gas prices continue to rise with a close at $4.78 on Friday. Despite the high prices the number of active rigs drilling for gas declined -16 to 310 over the last two weeks. Oil rigs continue to climb with another cycle high at 1,542 last week.

There is simply no interest in drilling for dry gas because the profits are so much better drilling for oil. EOG Resources will not even consider a project today that has less than a 60% after tax profit and most of their Eagle Ford wells are better than 100% after tax profitable.

Gas prices will have to rise a lot higher to entice those rigs back into the gas fields. As I have pointed out in prior articles once the LNG export facilities begin to come online we are going to have significantly higher gas prices but the gas that is produced in late 2015 has to be drilled today.

Market

The markets declined on the Iraqi war and once those headlines fade we should see a rebound. The clue was the positive gains on Friday when we could have had some seriously negative headlines over the weekend. Investors did the math and realized a 2,500 man ISIS force was not going to take over Iraq and the story line had just about expired.

However, S&P futures were down -8 at the open Sunday night. They have improved to only -5 and they are moving in the right direction. There is a lot of darkness before morning but I am not expecting a hugely negative day.

This is a triple witching option expiration Friday and the following week is normally negative in the June cycle. The week after the June expiration has been down 21 of the last 24 years. Be prepared.

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Jim Brown

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