The Middle East and crude realities

Crude oil has again been taking consumers and investors on a wild ride. In the U.S., West Texas Intermediate (WTI) has gone from $77.69 per barrel (42 gallons) on June 28, 2012 to $99 on September 14, and then down again to $91.87. Brent Crude, more of a global benchmark, has gone from just over $90, to over $117, and then to $110.11 over the same time frame.

Middle East tensions and changes in investors’ expectations of global growth and inflation are likely the primary drivers of the rollercoaster ride. To help keep a cap on the price of crude, Saudi Arabia announced on Thursday it would bring more oil to the market. The target price for the Saudi empire is around $100 a barrel for Brent, which—at today’s price ratios—would put the U.S. benchmark price at around $84.

It’s a legitimate question as to whether Saudi Arabia has the excess capacity to bring enough oil to the markets to drive the price of oil down over 10%. Also, all oil is not created equal as it differs in terms of location, viscosity, and chemical content. Refinery equipment tends to be designed to prefer one type over others. Regardless, Saudi Arabia likely has enough capacity and influence to at least keep a soft cap on prices.

Unrest in the Middle East, however, is outside the Saudi’s control. Historically, conflict in the Middle East, or even just rising tensions in the Middle East, has been associated with an elevation of the price of oil. However, the key for oil prices isn’t whether there is tension or conflict (there seems to always be at least some tension), but whether oil supplies get disrupted. One of the biggest price spikes wasn’t associated directly with conflict but with an embargo. From October 1973 to March 1974, the Organization of Arab Petroleum Exporting Countries turned off the spigot of oil to the U.S. because of the U.S.’s support of Israel during the Yom Kippur War of 1973.

The oil embargo, plus the significant devaluation of the dollar as a result of the breakdown of the Bretton Woods system (the system since WWII that has pegged currencies to the dollar) contributed to oil prices tripling in short order. The stock market also swooned, but that was likely due to the dramatic slowdown of the U.S. economy and rising rate of inflation that began even before the oil embargo.

Oil prices also rose sharply during the Iranian Revolution of 1979. Iran has been a big producer of oil, and the revolution that threw out the monarch and replaced him with the Ayatollah and nationalized the oil industry dramatically cut oil production. Saudi Arabia and other oil producers tried to fill the void, but oil production still dropped by over 4%. Yet prices more than doubled.

In response to the crisis, oil-producing nations beefed up production, oil-consuming nations invested in more energy efficient technologies, and oil prices subsequently plummeted. That’s one example of how the best cure for a high price is a high price: More production comes online, and consumers trim consumption. The process, though, can be a long-drawn out one.

Stock market reactions to Middle East conflict
The stock market’s reaction to conflict in the Middle East is fairly consistent: It goes down. I looked at the S&P 500’s price movements in the 100-day window that starts 50 days before the outbreak of conflict to the 50 days after conflict begins. Certainly, there can be more contributing to the price movement of stocks than simply conflict in the Middle East, but it seems likely that conflict was at least a significant contributing factor.

Source: Factset
Past performance is no guarantee of future results.

As the chart shows, the S&P 500 moved dramatically lower after the Iranian Revolution and Iraq’s Invasion of Kuwait, while the Six-Day War of 1967 was the outlier. In other periods of Middle East instability (not pictured), such as the Yom Kippur War of 1973, the Lebanon War of 1982, and the Suez War of 1956, stocks also fell.

No matter how I look at it, the possibility of conflict between Iran and Israel is one that bears monitoring by investors. Sometimes people think conflict arises from a “hydraulic” process where there is a slow buildup of tensions. I think that’s a mistaken way of looking at conflict. It can be triggered quickly and by seemingly small groups or events. This is why—though we have raised our end-of-year target for the S&P 500 to 1505—that target comes with a big caveat, as it depends on there not being conflict in the Middle East and a major oil price spike.

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