Global economic drag but higher oil prices

For those who don’t know, the war in the Middle East has already started. Albeit limited to small incursions of special operations troops and aircraft attack of military targets (mostly in the eastern regions of Iraq), the incursions are happening daily. Against this background, we have dedicated this week’s article to discussing “the Economic Impact of War” with a view to understanding the risks, the effects on the global stock markets, and key investment strategies which investors may want to consider.  While it is difficult to predict the exact outcome of a United Nations or International Coalition led military force to remove the Saddam Hussein regime from Iraq, some issues are clear.  In all wars or serious military conflicts, there is increased government spending and its resultant effect on economic stimulation. History clearly shows us that there will be volatility in the equity markets over the short term and economic growth over the long term. It is not likely that the war with Iraq would be long and large, such as WWI and WWII. In these types of wars, it would be typical to see early jumps in growth and inflation but over the longer term, growth actually slows down and disinflation becomes an issue as does financing of the conflict.

We also do not believe that the conflict with Iraq would be short and small. Such wars have little or no effect on global supply or economic stability. Thus the war with Iraq will likely be a short war but have huge impact not only on international involvement but on the  stability of the oil price and supply. The war may also be a longer one, in which case it would be similar to Vietnam. But over a longer term, such a war would lessen its influence on global supply and pricing issues as stability in these factors would be reached. Basically, Iraq would get isolated. The major factors would then migrate to public opinion issues and financing the war.

From his interview with Dan Rather of CBS last week, Saddam Hussein did convey some of his thoughts on how he expected the war to go. He expects to lose ground and have heavy casualties, but he is hoping to inflict enough damage and loss to the UN Forces (or International Coalition of Forces) as they progress such that they will see the conflict as not worth it and stop. In his words, “the West can’t take the Blood”. As all sides see the war progressing quickly, it is likely that it will reach a controlled or contained state reasonably early in the conflict. Over all resolution such as installation of a democratically elected government would certainly take much longer. The Rather/Hussein interview did provide valuable insight by allowing western peoples to hear first hand the convincing and calculated rhetoric which has been and is continued to be supplied to the middle eastern Islamic community.

Oil price and supply: The key factor

Despite the many distracting and emotional issues being debated about the Iraq conflictincluding issues such as global security and terrorism, we believe the single most important issue is stability in global pricing and supply of oil, the world’s number one commodity. Further, each countries position on the UN security matters is directly positioned in line with their oil interests. As a point of fact, Iraq possesses the world’s second largest proven oil reserves, currently estimated at 112.5 billion barrels. That is about 11percent of the world total. Further, with OPEC holding 77 percent of the world’s proven reserves but only meeting 40 percent of the world’s daily production requirement, it holds that the Middle East as a region will over the long-term become even more important unless alternative fuels are developed. It bears mentioning that Iraq, along with its OPEC partners possess most of the world’s excess oil production capacity. However, as oil price and supply relates specifically to Iraq, the 1991 Gulf War has already proven that Iraq’s 2.0 million BBLs per day of production can be removed from global production with little or no effect to global oil price or supply. It is really the uncertainty of war in general and its potential to affect the oil supply from the entire Middle East region that raises doubts and this is the critical issue that must be settled. It is also important for investors to be clear on two other issues relating to Iraqi oil. First, contrary to common belief, the United States gets very little of its oil supply from the Middle East and thus is not “dependant on Middle East Oil Supplies” . In point of fact, the US produces internally 50 percent of its domestic production. An additional 40 percent of the US required crude oil consumption is supplied from within the hemisphere by Canada, Mexico, and Venezuela.

The remaining 10 percent is obtained from Africa (principally Nigeria) and the Middle East. None the less, the United States foreign policy toward the Middle East is surely dominated by concern over maintaining reliable and steady oil production and price in order to ensure global economic stability. Now this leads us to the second major misunderstanding, that of ownership of the oil. It is clear that the United States, as does the rest of the world, want stability in oil supply and pricing. This is manifested in two issues, stable government and open access to the region. Open access does not mean ownership of actual production, it should simply mean that the principals of business operate efficiently in producing and exporting the oil.

As a closing point on oil, investors need to be reminded that when Iraq nationalized its oil production in 1960, it in fact took away the producing assets from mostly US and UK companies and then established new production partnerships with Russian and French companies to operate them. Thus it seems that the position of the US/UK in wanting regime change in Iraq as opposed to the French-led, Russian-supported position of allowing Iraq more time to comply with UN resolution 1441 leaves investors with having to make a decision as to which private interests will ultimately benefit from the outcome of the war. For the Iraqi people, it really makes little difference as to who is the actual operator of the production assets as the ownership and related royalties is not in question and should not change.

What oil price will do?

It is unlikely that there will be any supply issues coming out of the Iraq conflict but uncertainty about the future will likely drive prices higher. The question is how high and how long would prices stay elevated. In the case of the Gulf War in 1991, oil prices shot up from being in the USD 22.00 range for Brent Crude to peak at near USD 40.00 before the war when uncertainty was at its greatest and political tensions at their highest. Interestingly, Brent Crude price fell from USD 26.00 days before the war started to USD 20.00 just a few days after the war started. The price remained stable around the USD 20.00 level throughout the war and showed little change after the war concluded. From an economic perspective, the longer oil price stays high, the longer the drag on the economy and the greater the negative impact it would have to the GDP. It would be reasonable to conclude that once the uncertainty of stability of supply from the Middle East region is proven, the oil price would fall. Hence, the sooner the war gets fully underway and the war premium in oil price is removed, the better it would be for the global economy. The longer the potential for conflict looms without closure, the worse it would be for the economy.

How will the equity markets react?

The likely case is a short war in which oil price should stabilise in the early stages as supply is proven. Equity markets would drop with a flight of capital to the relative safety of government bonds.

A reasonable parallel can be drawn to the Gulf War. To review the time line of the Gulf War, Iraq invaded Kuwait on August 2 1990, just days after TT had its own political upheaval. On January 17, 1991, after six months of political turmoil, the air war started with the land war following on February 25. Operation Dessert storm lasted only 250 days. On its conclusion, technically September 4, 1991 consumer and business confidence recovered, oil price remained stable, and economic growth improved. In order to assess the potential downside risks to equity markets during conflicts, it is useful to look at past experience and how the equity markets reacted to the onset of war. Again, using the most recent war, the Gulf War as a comparison, and reviewing the DOW, FTSE and DJ Euro STOXX 50 indexes, we see that the markets all fell on news of the Kuwait invasion and reached there lows within 30 days. From then on it was a slow and uncertain climb back up with notable step up functions at the start of the war. Proving once again that investors can deal with good news or bad news, but no news (or uncertainty) is the worst scenario. From its lowest level just after the Kuwait invasion, the DJ Euro STOXX 50 index returned a 35.5 percent over the next 12 months. Similarly, the S&P yielded an average annual return of 15.7 percent during WWII over the period of December 6, 1941 to Allied Victory on August 14, 1945. For the Korean War, June 25, 1950 to July 25, 1953, the S&P turned in a 8.7 percent average annualised growth. Even during the 11 year Vietnam War (August 1964 to April 1975) and during stagnated and difficult economic times, the S&P showed a small growth. Thus for every major conflict in the past 75 years, equity markets actually grew and improved over the conflict and after as well. Notably, bond return indexes also showed solid returns throughout the military conflicts reviewed.

War and  investment strategies

For individuals already invested, considering the present climate and future long term prospects, they should stay invested. From our review of history, it seems that the investors will favour the defensive sectors such as drugs and tobacco in the near term and will only move back into the more volatile sectors such as telecom and technology after most of the uncertainty is removed. But remember, settlement of the Iraq conflict one way or another should lead to a recovery in consumer and business confidence, stability in oil price and improved economic growth. For individuals with cash to invest, this seems to be a circumstance of marked uncertainty and such circumstances in the past have usually given rise to attractive investment opportunities. History has suggested that the markets will fall at the start of the conflict, giving rise to attractive equity pricing.

Investing from a bottom-up approach, that is selecting individual companies based on their stand alone ability to provide growth and return to shareholders should provide an excellent base for investment and the war discount an excellent price. History also suggests that markets will grow coming out of the war, to end higher, so there is a level of confidence in positive equity returns. In our particular circumstance right now, many of the economic stimulus needed to incite the next growth phase in global economic expansion have already been put in place. Perhaps the dramatic stimulus from the Iraq conflict will jump start the recovery process as well as remove much of the current uncertainty. None the less, the economic stimulus and growth typical after settlement of a major conflict has opened the door for investment opportunity. Let us hope for a timely and as pain-free as possible resolution to this middle east crisis.

E-mail:     darcy@investments-intl.com