Middle East Crisis: Middle East Tensions, Oil, Gold And You The Investor

October 16, 2000

Middle East Tensions

Adding to recent worldwide uneasiness is the continuing violence in the Middle East, between Israel and Palestine. Last week's efforts in Paris failed to secure peace in the region as the conflict continues to escalate. The increase in tensions throughout the Middle East is the direct result of renewed fighting between Israelis and Palestinians, in the wake of the Israeli opposition Likud Party Leader Ariel Sharon's visit to a Jerusalem shrine that is holy to both Jews and Muslims.

The escalating violence is beginning to echo the memory of what happened 27 years ago, when a surprise Arab attack marked what has come to be known as the Yom Kippur War. Historically, tensions and crises around the world have disrupted international commerce, distorted economic conditions, and threatened vital U.S. interests. Israeli officials stated "everyone remembers [the 1973 war on the Jewish fast of] Yom Kippur when we fought on two fights and succeeded…people should learn that lesson." However, this is not the perspective that most people share concerning the current situation.

Following the increased bloodshed over the previous weekend, both Israeli Prime Minister Ehud Barak and Palestinian Authority President Yasser Arafat had issued ultimatums stating that if either side did not end the violence by Monday evening - the end of Yom Kippur, the Jewish Day of Atonement - the seemingly small street feuds would escalate into all out war. "If we do not see the difference actively implemented on the ground, and a calming of the situation…we will draw the conclusion that Arafat has deliberately decided to abandon the negotiations, the peace process," stated Prime Minister Barak.

Further complicating the situation in the Middle East are Iran and Iraq. "The only solution to the current conflict is to continue the holy war against the enemies of Islam, and that will not stop," said Iranian supreme leader Ali Khamenei. Iran's sobering statement regarding the conflict demonstrates its unwillingness to work toward a peaceful settlement. Iraqi President Saddam Hussein was even more disturbing in his televised displays of anger and threatening statements, in which he said that his country would be able to effectively destroy Israel in a short period of time and that Iraq didn't need to wait for the lifting of UN sanctions before striking at Israel. The statements come following the recent threats by Hussein to cut off oil production from his country in retaliation to the UN sanctions imposed following the Gulf War.

Violence between Israel and the Palestinians could spread, especially to south Lebanon where Iranian-backed guerillas are based and Syrian forces are deployed. The violence in the Middle East is a potential firebomb that could see the Arab world re-unite against Israel, politically and economically, if not militarily. Direct military action has commenced with the bombing of targets in Lebanon by the Israeli air force, in retaliation for the imprisonment of the three Israeli soldiers captured during a border raid last Saturday. Following the Israeli bombing attacks came a statement from Saudi Crown Prince Abdullah, which added fuel to the already intense fire burning in the Middle East, "Barak has to think before taking any step…and nobody should think that the Kingdom of Saudi Arabia and the whole Arab and Islamic nation would just watch with their hands tied."

In an attempt to prevent further bloodshed and a reenactment of the Yom Kippur War, several world leaders including UN Secretary General Kofi Annan, Russian Foreign Minister Igor Ivanov and U.S. President Clinton are making every possible attempt to quell the situation, but have had little success.

UN Secretary General Annan has continued meeting with both Barak and Arafat in attempts to bring them to a peace agreement. However, following a meeting with Egyptian President Hosni Mubarak in Cairo, where a proposed peace summit is going to take place, Egyptian Information Minister Safwat el-Sherif released this statement: "Egypt's stand in this issue is that, before holding a four-way summit, we must make the atmosphere suitable to ensure it will be successful."

Mid East tensions were further heightened on Thursday when a U.S. destroyer, USS Cole, was damaged by an explosion, which ripped a 20-foot-by-40-foot hole in the side, killing 17 sailors and injuring 36. The USS Cole was in port at Aden, Yemen for refueling when it was rammed by a small boat of unknown nationality. "If, as it appears, it was the act of terrorists then we will do everything in our power to track them down and hold them accountable," stated Defense Secretary William Cohen.

At a State Department news conference, Secretary of State Madeleine Albright stated, "we will hold those who committed it accountable and take appropriate steps," adding that the United States would "not retreat from our responsibilities" in the region.

The fact that U.S. Naval vessels routinely stop in Aden for refueling and that the USS Cole was only scheduled to be in the area for four hours indicates strongly that the attack was a preplanned strike by a yet unknown terrorist group. The attack comes in the wake of recent anti-U.S. demonstrations and pro-Palestinian rallies in the Middle East and Yemen. The outlook for peace in the Middle East in the near term is grim at best.

Oil

The boiling situation in the Middle East is spilling over into the oil market, exacerbating the current oil price shock. The effects that the heightened tensions in the Middle East are having upon the world economy and profit growth will stay with us until well into next year. Meanwhile, the results of the oil price hikes are making their way through the producer level and are eventually going to be felt by consumers as the fourth quarter and the holiday shopping season begin. With fears of a global recession fueled by the high oil prices, many consumers are beginning to cut back on aggregate demand, an outcome that will further crimp economic growth.

Not since the recession years of the 1970s and the Gulf War has the American public been forced to deal with the turmoil associated with a worldwide oil crisis. However, oil prices have continued to creep up since the 1970s, an era which was plagued by recessions spawned by an oil crisis. Rising oil prices are not new to our history. They have led to recessions, often accompanied by bear markets in stocks. In fact, three of the last four global recessions were the result of oil price increases.

When oil fell to $10 per barrel in 1998, OPEC (Organization of the Petroleum Exporting Countries) members reacted to their own domestic economic pressures and retaliated by cutting production. The supply of oil began to significantly lag demand. This supply/demand divergence has continued to this day, and based upon analysts' projections, will not be reconciled until at least next spring.

Many analysts and economists are beginning to doubt the ability of OPEC to curb the rising oil prices by providing the promised 800,000 barrels per day increase in production. Kuwaiti Oil Minister Saud Nasser al-Sabah said "his country does not have the capacity to produce as much oil as it promised…the capacity of OPEC to increase production is very limited." The only OPEC nation with any appreciable capacity is Saudi Arabia, which is estimated to have about a 2 million barrels per day (bpd) reserve capacity. Saudi Arabia's announcement to increase production is viewed as an attempt to try to "talk the market down rather than physically get it down" (by increasing production) according to Bruce Evers, an analyst with Investec Henderson Crosthwaite.

The influx of 30 million-barrels of oil from the U.S. Strategic Petroleum Reserve will have minimal effects on the current supply situation. U.S. refineries are operating at over 97% capacity, with 6% of that refining capacity coming off-line this month for scheduled routine maintenance. This new supply of oil will only equate to a whopping 1.6 days of useable oil, given that the country consumes 18.6 million barrels of oil products daily. But even if U.S. refineries reach 100% capacity, it will still be impossible to refine this oil in time to satisfy demand.

The Financial Times reported that if "the release of U.S. reserves and those in Europe caused prices to drop sharply, OPEC would have to consider cutting output," an action that would aggravate the situation. OPEC president and Venezuela's oil minister, Ali Rodriguez, added, "that if the EU acted as a whole to release reserves, OPEC would have to evaluate its impact on the market and take appropriate measures."

On Tuesday, the overwhelming impact of the increased tensions in the Middle East stemming from concerns that supplies may be disrupted, caused crude oil prices to rise more than 4%! As violent clashes continued between Israelis and Palestinians, Saudi Arabia, the biggest oil producer, warned it may retaliate if Israel attacks its Arab neighbors in the current conflicts.

The outlook for oil prices continues to remain bullish. With the market as tight as it is, policy analysts at Stratfor, an intelligence-consulting firm in Austin, TX, note that consumers are going to have to come to the realization of "$45 as the bottom-end price for a barrel of oil." Adding up all these factors, Stratfor notes, "The world will soon pump oil at maximum capacity. Once this happens, even minor disruptions will send immense shocks reverberating through the oil market, resulting in sharp and sustained increases in the prices of crude and refined products."

The recent attack on the USS Cole sparked an 8% surge in crude oil prices, as November crude was up $2.80 per barrel at $36.05, Brent crude on London's IPE raised $2.61 to $34.40.

Al Goldman, an analyst with A.G. Edwards & Sons Inc. in St. Louis, summed up Thursday's vicious attack stating, "in an already nervous market this is all we didn't need." The increased hostilities and resulting spike in oil prices are leading to a negative outcome for the stock market. In other words, consumers should expect a bearish stock market, inflated gasoline prices, and a burning hole in their wallets keeping them warm during the upcoming winter season.

Gold

The purpose and value of gold is to provide an investor's portfolio with an insurance policy against negative market events. Historically, gold has served as a safe haven during periods of political and economic crisis. Should the world turn out to be a more hostile place over the next 10 years, no category of paper investments will fully insulate your portfolio.Gold is an asset that could provide true security in such a scenario.

Gold has been referred to as the crisis commodity because it tends to appreciate in value in response to negative economic, monetary, or political conditions. Throughout history, tensions and crises around the world have disrupted international commerce, distorted economic conditions, and threatened vital U.S. interests. Today, however, few investors realize that world tensions still pose a serious threat to the financial markets.

Despite the fact that the United States is the world's only remaining superpower, there are a myriad of problems festering around the world, any one of which could erupt with little or no warning.

During these periods of international crisis, gold is the best form of financial insurance to protect a portfolio. Gold tends to outperform other investments during periods of world tensions. The very same factors that cause other investments to suffer cause the price of gold to rise.

For instance, on October 6, 1973, Egypt and Syria, with the support of other Arab nations and the Soviet Union, launched a full-scale assault on Israel. This conflict, known as the Yom Kippur War, was over by 24 October, but it changed the gold market forever. At the outbreak of the war, the London PM gold fix was $98 per ounce. By the time the Arabs lifted their oil embargo in March 1974, gold had soared to $173 per ounce.A year after the start of the Yom Kippur War, gold was still at $167 per ounce, 70% higher than it was before the war.

Today there are enough reasons for investors to be concerned about the potential effects of world events on their investment portfolios and gold is uniquely suited to provide a safe haven in the event of such a crisis.

You The Investor

The first thing investors need to do is realize how the impact of the Middle East crisis and the looming energy crisis will affect them individually. The pass-through effect of higher fuel prices will take 10 to 14 months to reach the consumer level. Since the increase in oil prices reached critical levels last spring, investors should expect to see the implications of higher fuel costs in the overall economy sometime in the next few months, just in time for the winter season.

With crude oil prices continuing to climb to outrageous levels, many Americans are beginning to worry about how the looming energy crisis is going to factor into their Christmas budget. "I think the only thing we can do is pray for a warm winter," says Leo Drollas, chief economist for the Center for Global Energy Studies. However, many economists are now beginning to focus on how the surge in crude oil prices, sparked by the situation in the Middle East, the apparent shortage in fuel inventories, and the approaching cold weather season are perpetuating the inevitable energy crisis which will leave consumers "out in the cold" come this winter.

Already the effects of the violence in the Middle East are beginning to spill over into the oil market. Oil prices have spiked, as many analyst now begin to worry about the increased tensions in the Middle East branching out into other parts of the region and disrupting the export of crude oil from the OPEC nations.

"For the oil market the real danger is that the situation escalates to the point that the Middle Eastern producers feel the need to become embroiled in the turmoil," notes Lawrence Eagles of brokers GNI.

There are several factors, which could have profound implications for the world oil markets:

  • Saudi Arabia, the largest oil-exporting county within OPEC, and other OPEC nations, being absorbed into the conflict between Israel and Palestine.
  • Strained relationships between Iran, Iraq and the United States posing as a threat to shipping of oil due to the U.S. support of Israel.
  • Refineries operating at maximum capacity, while crude oil and heating oil inventories remain extremely low.
     

However, what many investors should remember is how the effects of the Yom Kippur War, resulted in the worst bear market of modern times. The Dow fell 45% and the resulting energy crisis devastated the world economies.

With the pressure on the world oil market, U.S. investors and the world economy cannot afford another oil crisis or recession so close to the winter season. Investors need to take heed of this history lesson as the Arab/Islamic OPEC nations once again have a weapon that they wielded much more effectively than military might in 1973: an energy crisis. Should a large-scale war break out in the Middle East, extremist OPEC members, such as Libya, Iran and Iraq will begin pushing for an oil embargo. Even the threat of such a move in an already tight oil market would send oil prices through the roof and financial markets into utter turmoil.

The increased energy costs will impact the economy in two ways over the near-term, as businesses' profitability are hurt. First, consumers will be forced to redirect spending during the crucial holiday season. Second, expensive energy acts as a net drain on the economy, especially impacting key industries like basic materials and transportation, which pass through many of their costs at the producer and consumer level.

With worldwide record demand for oil, high oil prices are not expected to fade until well into next year. Investors need to do more than just be aware of the possible threats to their wealth. They need to act. Act now to properly diversify your portfolio against an extended downturn in the stock market. Gold is consistently the most negatively correlated asset to stocks. You, the investor, should take advantage of today's low gold prices to diversify your portfolio before these critical political and economic events affect your hard-earned wealth.

Blanchard Economic Research

http://www.blanchardonline.com

Gold weighs 19.3 times as much as an equal volume of water.