OIL, OIL, OIL!!!
David R. Kotok
March 3, 2012
“Oil prices could soar to $440 a barrel if Strait of Hormuz closed.” Tehran Times—five hours ago.
The worst part of writing this missive is that I remember every one of the events in the list below. Maybe that is the best part, too. At least I can still remember them.
We thank BCA Research (March 1 Special Report) for compiling this list of oil/energy shock events. Every one of them led to a temporary spike in the oil price. I will add personal comments on the older items in the list, since many readers may be younger than I am. Note that in each case there was an oil-price spike, followed by some economic shock and then a period in which oil normalized to a supply/demand-balancing price.
November 1956 – March 1957 Suez Crisis. This marked the first time Egypt attacked Israel and was decisively rebuffed. Egyptian President Gamal Abdel Nasser triggered the event by nationalizing the Suez Canal, closing the canal and the Straits of Tiran to Israeli shipping, blockading the Gulf of Aqaba, and putting the Israelis in a “no other choice but war” condition. Britain and France reacted against Egypt. Israeli forces rebuffed the Egyptian army, crossed Sinai, and reached the canal. Nasser had fought against Israel during its 1948 War of Independence. He had then led the overthrow of the previous Egyptian government in the early 1950s. He consolidated power in 1955 and 1956. Then he launched the attack.
Kotok comment: I remember the Suez crisis because it was a subject of intense discussion in my household. As a teenager in a community where many had family in the Middle East, it was impossible to avoid daily conversation and attention to the national news. Half a century later, I realize that the Middle East does not change much. Only the characters change. The story of strongman after strongman and war after war is an ongoing saga.
June-August 1967 Six-Day War. Israel was attacked on all sides and in a fight for survival. The result was a massive defeat for the attackers and the establishment of the Israeli armed forces as the dominant power in the region. Syrian, Egyptian, and Jordanian forces were repelled. Jordan fought bravely but lost to the military superiority of Israel.
Kotok comment: Jordan’s King Hussein changed his strategy after that war, which is why he did not participate in the next war against Israel. The Jordanian-Israeli nonbelligerency continues to this day. It gets strained at times; however, neither side wants war and both sides realize that war with each other is a losing proposition.
October 1973 – March 1974 Yom Kippur War and Arab Oil Embargo. On possible advice of the United States, Israel waited until it was attacked by Egypt and Syria. Jordan did not participate in the attack and Israel did not attack Jordan. That allowed Israel to fight a two-front war instead of a three-front war. The attacking Egyptian and Syrian armies made a strategic blunder: they waited until the holiest day in the Jewish calendar to launch the war. Businesses were closed and families had gathered for the holiday, and that allowed rapid mobilization. Had the attack been on a mid-week business day, the outcome could have been different. Israel again showed its determination when its back was to the wall and it had no choice but to fight.
Kotok comment: Iran may ignore history at its peril. Israeli leaders’ patience is not a sign of weakness. My first visit to Israel and to the Syrian frontier was in 1974. Images of war were fresh and remain indelible. We were allowed to go to the cease-fire lines, to understand the battle of the Golan Heights and to see how close this war came to threatening the survival of the country.
November 1978 – April 1979 Iranian Revolution. Jimmy Carter’s presidency was undermined by the images of American hostages in Tehran. Oil and the Straits of Hormuz were the dominant themes.
Kotok comment: The late 1970s showed how monetary policy could be easy enough to allow an oil-price shock to morph into a broader and more vicious inflation. Oil gapped from 3 dollars a barrel to 12 in the Arab embargo period. It reached $30 a barrel at the peak in 1980. By 1979, inflation was headed to double digits. It took decisive action by new Fed Chairman Paul Volcker to attack it. Under Volcker (1980-1981) interest rates reached the highest levels in American history. Volcker broke the inflation cycle and started a 30-year disinflationary trend that has lasted until today. He positioned a platform for Fed Chairman Alan Greenspan to preside over 18 years of this trend. Ben Bernanke is the inheritor of that platform.
October 1980 – January 1981 Iran-Iraq War. Saddam Hussein showed his true colors. The enmity between Iran and Iraq continues to this day. Later in 1981, the Israeli air force destroyed the fledgling nuclear facility at Osirak, Iraq, weeks before it was to start operating. Years of Iraqi-focused diplomacy by the US and the Western powers had failed. Israel again found itself with a “no choice” decision.
The rest of this list is in the recent memory of most readers, so we will not add comments. Observations about oil and markets come after the list.
August 1990 – January 1991 Iraqi Invasion of Kuwait. June-July 2001 Iraqi Oil Export Suspension. December 2002 – March 2003 Venezuelan Strike. March-December 2003 War in Iraq. September 2005, Hurricanes Katrina and Rita.
BCA closed its list with this question about the future: “2012: Will there be ‘Closure of the Straits of Hormuz?’”
Take out the hurricanes and all the oil-price shocks have a common theme. There is a strongman. There is a shooting war or a threat of a shooting war. Diplomacy and sanctions and negotiation have failed. The final few days leading to the spike and the shock are impossible to forecast in advance. Probabilities of outcomes are meaningless. Tell me how anyone is to make a decision based on some geopolitical forecast of a 50-50 probability that Iran will mine the Straits of Hormuz. Or alternatively, a 50% chance Israel will attack Iran’s nuclear facilities.
History also shows that oil prices have an upward trend during the period leading to the final spike. In every case, the peak in price only came after something was seen as a terminal event or final action. Subsequently, prices plummeted.
At Cumberland, we are overweight oil and energy in our ETF portfolios. We can only guess at the geopolitical risk premium built into the oil price. Last May we took the energy weight down to minimum. This year it has been in overweight for months. Energy stocks are now about one-eighth of the total market value, if you use the S&P 500 index as your guide. At the peak of the oil shock in 1980, the energy component of the stock market was close to 25% of total market value. Long-run forecasts with economic models argue for oil to be $175-200 per barrel by the end of this decade.
Add to that the failure of the United States to form a cohesive energy policy. We consume nearly 19 million barrels of oil a day. The world, including us, consumes about 89 million each day. We could be fully independent if we put our minds to it. Our politics do not let us do that. Shame on both parties in Washington for allowing us to be in this position.
For investors the issue is simple. If you are strategically oriented, it is too soon to sell your oil and energy investments. As to how to trade it on a day-by-day basis, we cannot be of much help. There is a high correlation between the oil price per barrel and prices of oil stocks. Track it closely. If that correlation starts to fail, it may be warning you.
We could be overweight oil and energy ETFs for quite a while. On the other hand, we could see changes that would lead us to sell as early as next week. Nobody said this was an easy business.
David R. Kotok, Chairman and Chief Investment Officer