Analysis

US vs Iran: threat of war shakes the world

America’s assassination of a key figure in the Iranian regime has jolted bullish investors out of their complacency. Could we now be facing an oil spike and a global crash?

It took just three days of 2020 for optimistic financial markets to run into “harsh reality”, says The Financial Times. Equities had made impressive gains in 2019, with the US S&P 500 index rising by more than a quarter and Britain’s FTSE 100 climbing by 12%. Investors were looking forward to more. But America’s assassination of Qasem Soleimani, a key Iranian general, prompted “a reassessment of risk” and sent investors scurrying into safe-haven assets. After Iran’s retaliatory strike on US airbases in Iraq on Wednesday there were growing fears that a series of tit-for-tat strikes could spin out of control, ultimately causing a war between Washington and Tehran.

Oil prices rose 4% following the US attack, eclipsing $70 per barrel on Monday before falling back; a 1.5% bounce, which also soon subsided, followed Iran’s retaliation. At $70.73, Brent crude rose to its highest level since September, when a drone attack on a major Saudi oil facility at Abqaiq temporarily knocked out 5% of global supply. Yet that spike proved short lived and prices are still below their 2019 high of $74.5 per barrel. So what will happen this time?

Will oil hit $150 a barrel?

Middle Eastern turbulence would endanger at least a quarter of the world’s 100 million barrels per day of oil production, says Avi Salzman in Barron’s. Saudi Arabia and Iraq, the region’s two biggest producers, pump about 15 million barrels per day between them.

Even more importantly, more than one-fifth of global oil moves through the Strait of Hormuz, a key shipping lane that is right next to Iran. The closure of the strait could see oil prices leap by $20 per barrel.

The doom-mongers are right to worry, says Caroline Bain of Capital Economics. Previous episodes of oil-supply disruption, which include the 1970s oil embargo, the 1990 Iraqi invasion of Kuwait and the 2011 Arab Spring, show that prices can quickly “double or triple” in response to serious geopolitical shocks. Prolonged tensions in the Strait of Hormuz could see the price of Brent double, leading it towards an eye-watering $150 per barrel.

Such a spike would wreak economic havoc. The 1970s oil shock “tipped the world into recession and triggered a bout of inflation that took nearly eight years to tame”, says Russ Mould of AJ Bell. Oil shocks act like a tax increase, reducing purchasing power and choking off demand. “On six of the last eight occasions when oil prices have risen by more than 100% year-on-year” the global economy has slowed, or even shrunk. If the Iranians blockade the Strait of Hormuz then we are in trouble, agrees Jeremy Warner in The Sunday Telegraph. Surging oil prices would tip the world economy into recession.

The oil market has changed...

The latest oil-price surge looks like “a rather 1970s reaction”, Paul Donovan of UBS Global Wealth Management told The Guardian’s Jill Ambrose. But it is “perhaps not appropriate for 2020”, given the weak global growth outlook and structural oversupply.

Oil cartel Opec “used to produce half the world’s oil, but now makes less than a third of it”, Alan Gelder of Wood Mackenzie told Nell Mackenzie on the BBC. During the 1990 Gulf War “oil came from two places”: Opec states or “expensive and risky” fields in places such as the North Sea. Yet the fracking revolution means that finding hydrocarbons and getting them out of the ground has never been easier, particularly in North America. When prices jump the frackers are happy to start pumping. That keeps a lid on prices. Globally, “there is a glut of oil”.

... and so has the world economy

Greater energy efficiency also means that Western economies are less dependent on fuel than in the past, notes Robin Pagnamenta for The Daily Telegraph. In the 1970s, energy accounted for 8% of US household consumption, today that figure is just 2.5%. That should reduce the economic impact of petrol-price spikes.

The post-Soleimani oil-price surge was a “knee-jerk response” conditioned by “decades of headlines” about Middle Eastern oil, says Spencer Jakab in The Wall Street Journal. It is not a given that a regional conflagration would mean higher prices in 2020.

Iranian retaliation in the form of cyber or terror attacks could actually reduce energy demand by hitting the global travel industry. Sanctions on Iranian oil exports also mean that Tehran has little to gain from surging prices. Most importantly, these days the US is a “net exporter of crude oil”, leaving the world’s indispensable economy less exposed to an oil-price shock than in the past.

A combination of central bank monetary easing and calmer US-China trade relations had convinced many traders that 2020 would be a good year. Yet the worsening US-Iran picture “has pushed geopolitical risk back up the list of things to worry about in 2020”, says Michael Pearce of Capital Economics.

The Trump factor

Donald Trump’s decision not to respond to September’s Abqaiq attack meant that analysts thought they had the measure of the White House’s Middle East strategy, says the FT. His unexpected decision to kill Soleimani is a reminder that the mercurial US president remains “one of the biggest unknowns for investors”. The strike on the general “calls for a serious increase of the geopolitical risk premium”, says Olivier Jakob of consultancy Petromatrix.

Clearer heads may yet prevail, says Tom Holland of Gavekal Research. For all the “blood-curdling” rhetoric pouring out of Washington and Tehran, the odds of “an all-out shooting war” are still small.

Fearful of becoming embroiled in another Middle Eastern quagmire, the White House regards the assassination of Soleimani as an extension of its existing strategy of squeezing Iranian regional influence, not a prelude to outright conflict.

For its part, Tehran knows that “it would surely lose” a full-scale war with the US and its regional allies. In short, “both sides have powerful incentives to avoid open conflict” and minimise further escalation.

Note that Tehran’s retaliation so far has been “moderate” in the context of the “blood-curdling threats” we heard shortly after the US strike. Markets are right to price in an “elevated risk premium” in the wake of Soleimani’s death. Yet “the magnitude and persistence of that premium is likely to prove limited”. Expect oil prices to remain capped below $75 per barrel for the time being.

Is Russia a safe haven from the turmoil?

Russia decried the killing of Soleimani, but Moscow could prove a key winner from the fallout, says Robyn Dixon in The Washington Post. Higher oil prices would be a boon for the country’s energy sector. Russia is the world’s second-biggest oil exporter and the top exporter of natural gas.

“Bad news for oil consumers is good news for emerging market producers such as Russia,” says Lex in the Financial Times. The country is already “something of a comeback kid among emerging markets”. The stockmarket rose by 39% last year. Stocks in energy companies, which make up over half of the market’s capitalisation, delivered double-digit returns in 2019. But valuations remain cheap: UBS is forecasting a “hefty 14% dividend yield” from energy firm Lukoil. That said, concern about climate change is feeding a growing aversion to energy firms among portfolio managers. That should “continue to keep a lid on energy stock prices”.

Russia has agreed to curb its oil output by about 300,000 barrels per day from an October 2018 baseline as part of a joint effort with Opec nations to prop up oil prices, say Dina Khrennikova and Jake Rudnitsky on Bloomberg. Yet the country overshot its quota in nine of the 12 months last year, drawing complaints from allies. Indeed, Russian crude oil and condensate output actually hit a post-Soviet high last year. If Russia scraps the “Opec+” deal altogether it could unleash spare production capacity of as much as 500,000 barrels per day onto the market.

On a cyclically-adjusted price/earnings ratio of 7.8 the Russian market is among the world’s cheapest major indices, but with good reason. The country’s poor record on property rights and the rule of law means that assets are at constant risk of expropriation if a company’s management upsets the wrong people. Russia “rarely looks like a safe haven”, as Lex puts it, but with “US missiles streaking across Middle Eastern skies” perhaps this “is one of those times”.

Golden days for gold

“These are golden days for gold,” writes Arthur Sullivan for Deutsche Welle. Renewed global uncertainty helped the yellow metal to a seven-year high this week in dollar terms, with the price climbing to around $1,600 an ounce. In sterling terms, that is more than £1,195 per ounce. Gold gained 20% in dollar terms last year. Geopolitical risks make this traditional safe haven look appealing, while macroeconomic factors also bode well for the yellow metal, says Elliot Smith on CNBC. Persistently negative interest rates on major government bonds have reduced the opportunity cost of holding gold, an asset that also pays no income.

The price is also likely to be supported by ongoing central bank purchases, as the likes of Turkey, Russia and China look to reduce their reliance on the US dollar by holding more of their reserves in gold. Those three countries bought almost 120 tonnes of the precious metal during the third quarter of last year alone, reports Sullivan. Gold is also a way to protect yourself against the risk that central banks get too eager to turn on the printing presses and lose control of inflation. Analyst John Mauldin, who predicts a “great reset” over the coming decade as government debt obligations come due, advises investors slowly to increase “your allocation to physical gold” as a form of “central bank insurance”.MoneyWeek has long advocated holding 5%-10% of your portfolio in gold as a form of insurance. Consider topping up with the ETFS Physical Gold exchange-traded fund (LSE: PHAU).

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