February 20, 2003
The Crude Realities of War in the Middle East
Is a bad situation about to get worse?
The price of oil is near a 12-year high, U.S. oil reserves are sitting at 27-year lows, gasoline prices are higher than $2.00 a gallon in some major cities (S.F., L.A.), and it is estimated that Venezuela is still about 1 million barrels per day shy of reaching pre-strike production levels. Will an attack on Iraq catapult energy prices even higher and plunge the world economy into severe recession?
Fear of the Unknown
Since Iraqi scuds were ineffective at hitting their targets during the 1991 Gulf War, it is easy to speculate that Saddam’s arsenal is not capable of inflicting much damage in the region. These speculations are hardened by the fact that U.S. and Britain have been bombing Iraqi targets in and around their no-fly zone for some time (which limits Iraq’s ability to stage an attack on its neighbors).
Nevertheless, over the last decade Saddam may have enhanced the range/accuracy of his missiles and/or successfully weaponized chemical agents. Moreover, since Saddam knows, unlike 1991, a U.S. attack will not stop until he is either dead or removed, he may be inclined to use weapons/tactics not previously deployed during the gulf war.
Suffice it to say, in order to predict possible fluctuations in the price of oil – something everyone seems to be doing lately – you need to know exactly what Saddam’s capabilities are and whether or not he will be able to use his arsenal to cause severe or permanent disruptions to oil supplies in the region. ‘Fear’ arises because no one really knows...
A Perceptual Comparison to Desert Storm
When Iraq attacked Kuwait in 1990 the feeling was that the Iraqi military represented a formidable challenge to opposing forces. With this perception in mind, it was not surprising that the financial markets plunged.
However, soon after Desert Storm began -- after Iraqi soldiers began to surrender en masse because of fear/starvation -- perceptions quickly changed. In hindsight, the strength of Iraq’s army was dramatically overestimated.
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The markets sold off aggressively in July 2002 because of potential Brazilian defaults and the sell off in October arrived because of various factors (the economy was showing signs of weakening, 3Q02 earnings estimates were being reduced, self-fulfillment of a retest of July’s lows, etc.). By contrast, and despite holding the markets inside of a trading range in recent weeks, the Iraq situation has not pushed stock prices below previous lows.
In sum, whereas investors overestimated the Iraqi threat in 1990, they may be underestimating the Iraqi threat today. Because of Iraq related uncertainties Disney has stopped hiring in Florida, the entire airline sector (outlook) is in disarray, and everyday another company is warning about how difficult their operating environment is, and will likely become (because of the increased threat of terrorism, a potential for a further rally in oil, consumers spending their time watching CNN instead of shopping, etc.). Indeed, since the beginning of the year Iraq tensions have begun to have a negative impact on the outlook for the U.S. economy, yet the markets remain well above their October lows in anticipation of a resolution and/or a strong recovery in the second half of the year.
What Iraq uncertainty continues to linger for months not weeks?
Iraq Impact on the Financial Markets
We all know that a successful attack against Iraq equals a sharp stock market rally. However, when, and if this rally arrives how sustainable will it be?
Along with a stock market rally a successful removal of Saddam would likely bring about a steep drop in the price of gold and a decline in the price of oil. In the case of oil, the decline would be supported by Venezuelan (Nigeria) production problems. However, in the case of gold the sell off could be swift (gold went from $345 an ounce in June 1990 to $413 an ounce in August 1990 (London Fix). When Desert Storm began gold immediately plunged, and prices retreated to $345 an later in the year (Sept 1991)).
Yes, the argument can and has been made that gold is in a long-term bull market that is not necessarily hinged to Iraqi developments. However, and unlike oil which follows supply/inventory fundamentals to a certain degree, the gold market can be driven completely by investor psychology. If Iraq is defeated quickly self-fulfillment will take over: gold will drop.
Beyond the expected post-war market adjustments, the outlook for a sustained recovery and/or stock market rally is not good: U.S. consumers and companies have higher debt burdens than they did in 1991, funds have less than 5% in cash versus 13% in cash 1991, and valuations (meaningless as they may be in predicting near term market movements) are much higher then they were in 1991.
Policy Unknowns Confuses Outlook for Markets
Should the U.S. ‘go it alone’, the reaction in the financial markets may not follow the basic post-war (rally) trend. To be sure, without U.N. backing an attack on Iraq could see terrorist tensions escalate, and further selling pressures could befall an already weakening U.S. dollar. Needless to say, this would have a negative impact on the financial markets even if the war goes extremely well.
To note: in similar regard to the unpredictable capabilities/actions of Saddam, it is impossible to quantify what impact, if any, a U.S. led rather than U.N. backed attack would have.
Conclusions
Everyone hopes that the Iraqi situation can be resolved peacefully. Failing this, the hope is that Saddam can be removed quickly by UN backed forces and soon thereafter the financial markets will start to rise/fall based upon economic/earnings fundamentals. One of the worst* outcomes is that forces would not be able to quickly oust Saddam and/or Saddam uses what weapons he has to unleash as much havoc as possible. This is the type of outcome that has some doomsayers prophesying the possibility of $50-$100 oil.
* What could be equally troubling is if the U.S. leads attack without the U.N. and does not achieve immediate results. Foreign exchange transactions are done largely in U.S. dollars, the bulk of most central bank reserves are in U.S. dollars, and the dollar has been weakening as Iraqi tensions have escalated (Russia previously announced it would dump its dollar reserves soon after Putin got off the phone with Bush. Some speculated Russia announced the reserve change for political reasons). If the U.S. ‘goes it alone’ – with a handful of other ‘willing’ nations – confidence in the dollar could be shaken.
It is impossible to argue that Iraq uncertainty is all that ails the U.S. economy. Nevertheless, it is equally impossible to argue that the U.S. economy can form any semblance of a rebound so long as Iraq uncertainties exist. Getting back to the initial question: Will an attack on Iraq send oil prices higher and plunge the world economy into severe recession? Given the unknowns, no one can answer this question. What is known, however, is that you don’t need Iraqi uncertainties to have a recession...
The crude reality of an Iraqi war is that the financial markets will not particularly care about loss of life so much as the impact on oil supplies.
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