Energy stocks may be getting too rich and could quickly give up gains if the Iraq situation is defused, some analysts say.
The S&P 500 energy sector is up 5.4 percent in the past month, and up 10 percent year-to-date, the second best performing sector. It's been riding high with the jump in Brent crude, up 3.7 percent since the beginning of June.
Oppenheimer senior energy analyst Fadel Gheit said the oil stocks are overpriced and are trading as if crude was going to stay at $110 per barrel.
"If the Iraq situation is resolved peaceably, and you have a coalition government immediately, you have oil down $10. Every hot spot is adding a few more dollars to the price of oil. The replacement price for a barrel of oil is $65," he said. "Oil prices should not be trading above $80."
Energy stocks were the second-worst performers in May, but the rapid assault by Sunni militants on northern and western Iraq has sent crude higher amid fears of disruption. Oil prices were barely changed Monday, with Brent up 49 cents at $112.97 per barrel, and West Texas Intermediate down 1 cent at $106.90.
"They're unpredictable. I'd rather have my bets placed on some fundamental trend than something you have to roll the dice with," said James Paulsen, chief investment strategist at Wells Capital Management. He said the S&P energy sector, up a half percent Monday, is at the highest level, relative to the S&P 500 that's it's been at all year. Paulsen said the sector's price-to-earnings ratio usually lags the market but it is 16.5 based on trailing earnings, slightly better than the S&P's 16.
But traders say Iraq is enough of a wild card and it could push oil to the tipping point, if there is a disruption because there has already been outages in places like Libya and Nigeria.
As the second-largest and fastest-growing producer in OPEC, Iraq has been pumping 3.3 million barrels a day. OPEC's quota is 30 million barrels. So far, oil production has not been disrupted, but a northern pipeline that takes oil from Kirkuk to Turkey has been damaged by militant assaults and has been out of service since March.
"If they can hold onto Baghdad, and the south of Iraq, 3 million barrels will continue to flow and it won't be a big deal," said John Kilduff, energy analyst with Again Capital. "Any credible threat to central Baghdad or the oil fields— it's $150 just for starters."
Kilduff said any spike higher would probably fade quickly, but consumer confidence would plunge, and it would launch an energy crisis because Saudi Arabia, the global swing producer, cannot make up that much lost capacity.
"It really depends on what the balance of power is going to be a month from now, a year from now," Gheit said. "The Sunnis are left basically with nothing but arms because they were excluded from the government. They have no oil resources. The Kurds took their share, and the Baghdad government wants to keep their share. Maliki is not an inclusive prime minister. he's doing what Saddam Hussein did but the opposite way. He favored his own tribe over another."
As for the oil majors operating there, Gheit says the payout has not been big so far but the investment has been billions. The bulk of Iraq's oil reserves are in the southern part of the country, controlled by the Baghdad government. Exxon Mobil, Shell and BP are all major players there.
Exxon is also active in the Kurdistan Regional Government area. As the Shiite-dominated government in Baghdad struggles, the KRG has stepped into a void. The Iraqi Army gave up oil rich Kirkuk, and Kurdish forces moved in to secure it.
Kurdistan has ramped up its oil exports via a disputed pipeline that goes to Turkey, and a third tanker is scheduled to depart the Turkish port of Ceyhan, filled with Kurdistan crude this week. Baghdad has protested these sales, and has taken its dispute with Turkey and its state run pipeline operation to the International Chamber of Commerce.
Gheit points out that domestic focused energy stocks have been the best performers, like Pioneer Natural, up more than 8 percent since the beginning of June. Others that have done well since June 1 include Conoco Phillips, up 7.2 percent; Marathon up 6.4 percent; and Murphy Oil, up 6 percent.
"I think they could go upward and you'd have more people like me saying 'don't touch them,' but I think you'd also start seeing other people coming in," Paulsen said. "I'm not big on them as an overweight. I would have them absolutely but I'd underweight the group. One is I think they already had their generational price move in the commodity they produce…my point is they outperformed in the period from 2004 to 2008 by leaps and bounds."
—By CNBC's Patti Domm. Follow her on Twitter @pattidomm.