Four months ago, I warned Fools to carefully watch relations between Iran and Saudi Arabia as both vie for power as the U.S. leaves Iraq. Yesterday, the world learned of a foiled Iranian government plot to kill the Saudi ambassador to the United States. Escalations such as this have me and many fellow Motley Fool writers convinced a portion of your portfolio should be in oil stocks as sky-high oil prices are not as far off as you may think.

The plot
Alleged members of the Iranian Quds Force, a branch of the Iranian Islamic Revolutionary Guard that "conducts sensitive covert operations abroad," tried to hire an undercover agent posing as a member of a Mexican drug cartel for $1.5 million to assassinate Adel Al-Jubeir, the Saudi Arabian ambassador to the United States. While U.S. officials said it was unclear how many people knew about the plan within Iranian President Mahmoud Ahmadinejad's government, if a plot like this had succeeded and cast the two Middle Eastern rivals into war, it would be disastrous for world oil markets.

Why it matters
People don't realize chaos and unrest have a huge effect on oil production. When large oil powers go through chaotic times, a significant amount of their oil-producing capabilities is lost for years. Often, these countries never return to the production levels they had before chaos started.

The most recent example is Libya. Production had averaged 1.6 million barrels per day but plummeted with the revolution in March:



Q1 2011

Q2 2011

August 2011

September 2011

Libyan Production (thousand barrels/day) 1,559 1,096 153 7 96

Source: OPEC Monthly Oil Market Report, October 2011.

Now that Libya is almost completely controlled by the new government, the country believes it can have full production back in 14 months. Wood Mackenzie predicts Libya can have production back in three years. However, both these estimates look optimistic compared to the historical record, which shows an average return time to full production of eight to 10 years.

The worrisome part of this example is the large price increase oil had after the relatively minor loss of production. The loss of 1.5 million barrels per day (total world supply was roughly 82 million barrels per day at the time) added an estimated $10 to $15 premium to Brent crude oil prices.

Saudi Arabia and Iran are much larger producers than Libya, and were they to go to war the effect on prices would likely be an order of magnitude more.


2011 Average Production

Saudi Arabia 9.2 million barrels/day
Iran 3.6 million barrels/day

Source: OPEC Monthly Oil Market Report, October 2011.

While I worry more about what will happen after the U.S. leaves Iraq at the end of the year, the Saudis are worried that Iran may try to cause unrest in the kingdom during the annual hajj pilgrimage to Mecca next month. CNN quoted a senior Saudi advisor who said, "We are on our toes. We expect the worst and we think Iranians are capable of using any person from any country to stir trouble during hajj season."

What you can do
A good way to protect your portfolio from rising oil prices is to invest in oil. Besides an investment in an ETF that tracks oil such as the iPath S&P GSCI Crude Oil TR Index ETN (NYSE: OIL), there are numerous opportunities to invest in. While ExxonMobil (NYSE: XOM) is the behemoth in the space, I'm a bigger fan of smaller plays. Stocks I like include SandRidge Energy (NYSE: SD) since it's largely undervalued, Kodiak Oil & Gas (NYSE: KOG) since I believe it's on acquirers' lists, ATP Oil and Gas (Nasdaq: ATPG) since investors punish the stock for its high debt load and ignore its assets, and DryShips (Nasdaq: DRYS) since it has finally begun the process of spinning off its deepwater rig business and the Baltic dry index is turning around.

Foolish bottom line
With situations like this in mind, The Motley Fool has created a new special oil report titled "3 Stocks for $100 Oil," which you can download today, absolutely free. In this report, Fool analysts cover three outstanding oil companies, including the stock Fool analyst David Lee Smith calls the "energy king." To get instant access to the names of the three oil stocks, click here -- it's free.