Oil Prices Just Posted Their Biggest One-Day Drop in Two Months. Here's What it Means for Energy Investors.

A sudden pause in fighting between the U.S. and Iran last Friday sent oil prices tumbling, as investors hoped that the two sides could potentially return to the ceasefire.

While there’s no indication that will happen, Mike Waltz, U.S. ambassador to the United Nations, said President Donald Trump is giving diplomacy “some space.”

As of 12:57 p.m. on July 27, the price of WTI crude oil had fallen over 7%, marking the biggest one-day drop in about two months. WTI now trades around $82.89 per barrel.

Here’s what all of this means for energy investors.

Image source: Getty Images.

More volatility is likely ahead

As of this writing, the State Street Energy Select Sector SPDR ETF (NYSEMKT:XLE) traded more than 1.5% lower. Lower oil prices mean lower profits for the oil companies, so this kind of price action is understandable.

However, the volatility surrounding U.S.-Iranian negotiations is likely to persist, as the two sides have not made meaningful progress toward enduring peace, despite signing a memorandum of understanding in June.

On July 27, Esmail Baghaei, Iran’s Foreign Ministry spokesperson, said the country “currently have no negotiations with the United States,” according to CNBC.

The conflict has also seemingly broadened.

While the focus has long been on the Strait of Hormuz, a narrow body of water bordering Iran and Oman through which one-fifth of global oil flows in normal times, it could now be expanding to the Red Sea.

Recently, the Houthis, an Iranian proxy group, have launched attacks on Saudi Arabian oil tankers, stoking concerns about further pressure on the global oil market.

"For the moment, the oil market doesn't appear to be pricing in any extended blockade," ANZ analysts wrote in a recent note, according to The Wall Street Journal. "But oil markets are likely to tighten further if Houthi attacks worsen."

Continue to have some exposure to oil

While both the U.S. and Iran don’t appear to see eye to eye on many of the core issues currently preventing a longer-term agreement, the Trump administration has clear incentives to wind down the conflict, especially with midterm elections approaching.

The yield on the 10-year U.S. Treasury note recently hit 4.7%, a dangerously high level for an economy that has remained remarkably resilient but is not invincible. Many economists have warned that if the 10-year note breaches the 5% level, that could put the economy in a vulnerable place.

Additionally, the Federal Reserve is concerned about inflation. Higher oil and gas prices resulting from the Iran war could pressure the Fed into raising interest rates later this year, something Trump would certainly not be a fan of.

That said, the situation remains fluid and uncertain. Very few expected the conflict to last this long, and Trump doesn’t appear ready to walk away.

U.S. oil reserves are also reportedly approaching critical levels, which some analysts warn could lead to further repricing, especially if traffic through the Strait remains at a standstill and the conflict broadens into other areas, such as the Red Sea.

Even if the conflict ends tomorrow, it will take time for global oil supply chains to normalize. Oil may also face a new reality, as other countries realize that closing shipping routes can provide leverage in a geopolitical conflict.

For all of these reasons, I do think investors should have at least some exposure to domestic energy assets as a hedge against a prolonged conflict between the U.S. and Iran.

Oil is also viewed as a finite resource and could see greater demand as power becomes more constrained amid rising global power consumption.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.