U.S. Markets close in 3 hrs 21 mins

Wall Street warily watching Iraq, oil prices

A Wall Street sign is pictured outside the New York Stock Exchange in New York, October 28, 2013. REUTERS/Carlo Allegri

By Rodrigo Campos

NEW YORK (Reuters) - Traders are bracing for more volatility in markets as fighting in Iraq intensifies, with the recent rise in crude oil prices posing risks to the strong rally in U.S. stocks.

Investors worry that the insurgent Islamic State of Iraq and the Levant (ISIL), which threatens to take control of northern Iraq, could extend its reach to the south and cripple oil production in OPEC's second-largest exporter. This week, fighting shut the country's biggest oil refinery.

Concern over Iraq was in part responsible for the S&P 500's (.SPX) largest weekly drop in two months last week, when prices for Brent crude (LCOc1) jumped the most since last July.

"The spike in energy prices is a problem, since it isn’t coming on rising demand, just concerns about supply," said John Toohey, head of equities at USAA Investments in San Antonio. "High energy prices are sand in the gears of economic activity."

Prolonged fighting would boost volatility in stocks and in particular hit transportation, shipping and airline companies with a significant portion of their expenses from fuel costs.

Oil production in the north of Iraq has been down since March, but the prospect of supply disruptions in the oil-rich south has pushed the price of Brent crude to a nine-month high in recent days.

Bank of America Merrill Lynch analysts said in a note that $125 per barrel for Brent - near the highs hit in 2011 and 2012 - is on their watch list. Others have said the Brent peak near $150 in mid-2008 could be in play.

In that case, expect more weakness in transports and airlines. During last week's 4 percent rise in oil prices, the S&P 500 fell 0.68 percent. But the Dow Jones Transportation Average (.DJT) slid 2 percent and the NYSE ARCA airline index (.XAL) lost 4.9 percent. The 10-day correlation between the XAL and Brent is at -0.86, the strongest inverse relation since September.

The price of U.S. wholesale gasoline (RBc1) also jumped last week, up 4 percent, and brushed against its highest since July. Analysts fear that a steady climb could hit consumer spending.

"We already have the evidence in that the recovery is slow," said David Kotok, chief investment officer at Cumberland Advisors in Sarasota, Florida. He said for every $1 a gallon of gasoline rises, about $150 billion in spending power is taken out of the hands of low- and middle-income American households.

"The most likely thing to happen is this schism is not going to be resolved in a peaceful way," he said. "We have a growing war with growing intensity."

The market has already taken note. Consumer discretionary stocks on the S&P 500 (.SPLRCD) fell 1.7 percent last week and the retail index (.SPXRT) fell 2.3 percent, the most for both since April. Wal-Mart (WMT.N) lost 2.5 percent, while Dollar Tree (DLTR.O) fell 2.2 percent in its first weekly drop in four.

Investors will likely continue to pile into energy shares. The S&P 500 energy sector (.SPNY), which was down on Tuesday, is up 9.6 percent so far this year. The sharp move has pushed the energy sector into overbought territory, measured using an index of relative strength, leaving it vulnerable if the Iraq situation is resolved.

Oil volatility spiked last week, with the CBOE Crude Oil ETF Volatility Index (.OVX) up more than 30 percent to its highest level since late April.

Meanwhile, the CBOE Volatility Index (.VIX), the market's favored indicator of anxiety, may for a time become a proxy for investors' concerns about the Middle East. Investors are slowly starting to pay a bit more for insurance against violent market moves - though at this point such hedges are still cheap.

The VIX recently traded at its lowest since 2007, but it rose 13.5 percent last week. At 12.2 it is still far below its historical average of 20 and the average in the last year of 14.3.

"My guess is over the next few weeks and months the VIX will tightly follow oil prices. If oil continues to rise, I think you're going to see a more pronounced spike in the VIX," said Russ Koesterlich, global chief investment strategist at BlackRock in San Francisco.

(Reporting by Rodrigo Campos; Additioanl reporting by Angela Moon, Sam Forgione and Ryan Vlastelica; Editing by Dan Grebler)