Are we heading for war in the Middle East?

On Saturday, drone attacks severely damaged a key processing facility in Saudi Arabia and knocked out close to half the country’s production capacity. In reaction to this sudden disruption, oil prices rallied up to 18% this morning before settling at a gain of 12%. Obviously, oil prices will remain high in the next couple of days until the production shortfall can be made up. But besides these short-term fluctuations, what are the medium- to long-term implications of these attacks for investors?

Geopolitical developments

The most important question to be answered is not about the ability of Saudi Arabia to ramp up its oil production again but how the country will respond to the attack. The attack was allegedly performed by drones under the control of Yemenite Houthi rebels, but reports emerge that – unsurprisingly – these drones and missiles were of Iranian origin, since Iran is the main backer of the Houthi rebels.

The question thus is, how will Saudi Arabia respond to this attack? On the one hand, Saudi would like to create an international alliance and attack Iran with the assistance of the United Arab Emirates and possibly the US, like they did in Yemen. This need to create an international alliance is mostly due to the fact that the Saudi military is in no shape to fight a protracted war against Iran. And the campaign in Yemen has shown that the Saudi military is likely in no shape to win a war against Iran, full stop.

The problem is that the US is unlikely to actively intervene in the Middle East beyond a tit-for-tat response in the form of missile attacks on Iranian targets. The US is at the beginning of a protracted presidential election campaign and Donald Trump has been very articulate about not wanting to enter new wars outside the US, potentially one reason why he fired his last National Security Adviser, John Bolton, who was arguing in favour of a military campaign in Iran. Thus, Saudi Arabia will likely have to go it alone or with very limited overt support from the US.

Meanwhile it is unlikely that Iran has the ability to enter a protracted war with Saudi Arabia given the terrible shape the economy is in after the renewed sanctions against the country. Given these challenges for both Iran and Saudi Arabia, it seems unlikely that an outright war between the two countries will be the result of the events on the weekend. 

The most likely outcome is a limited retaliation by Saudi forces against Iran and Iranian allies in Yemen and other areas of the Middle East. Ironically, this puts Qatar in an awkward position because the country is politically at odds with Saudi Arabia and has always been on better terms with the Iranians than many other Gulf Cooperation Countries (GCC). Furthermore, Qatari gas fields in the Persian Gulf are right next to Iranian gas fields and are at high risk of being hit or put out of commission if Saudi Arabia chooses to strike against coastal installations in Iran.

Given the need for retaliation that has to be almost surgically precise in terms of targeting installations and preventing an escalation of the current tit-for-tat there is a substantial risk that the conflict between Saudi Arabia and Iran might develop into an outright war. However, while this risk is substantial, I do not consider this at the moment to be the base case scenario as I said above.

Implications for commodity prices

These developments will likely have the biggest impact on oil prices since oil supply will be reduced in the short term but may suffer from prolonged outages if the tit-for-tat between Saudi Arabia continues and potentially escalates into an outright war. In this risk scenario we should expect a sustained increase in oil prices for several months as well as a rally in gold prices. 

Implications for fixed income

If oil prices remain elevated for several months, headline inflation will likely be impacted and expected inflation for the next one to two years should rise as well. As a consequence, short-term inflation-linked government bonds should be the main beneficiaries in the fixed income space since these bonds benefit from rising inflation expectations as well as declining real yields as higher oil prices should accelerate the ongoing global economic slowdown. The losers in the fixed income space would, on the other hand be clearly high yield bonds outside the energy space as well as leveraged loans from issuers who do not benefit from higher oil prices since these businesses face tougher economic conditions and, consequently, higher default risks.

Implications for equity markets

Obviously, heightened geopolitical risks in the Middle East can lead to a decline in investor optimism and thus to short-term setbacks in global equity markets. However, such sentiment-driven setbacks tend to be short-lived and equity markets generally recover quickly from these effects. Thus, I would not expect these events to be capable of triggering a bear market in equities or a severe correction.

However, if oil prices remain elevated for some time, they are going to negatively impact economic growth around the world. China, for example loses $1.1bn in output for every $1 increase in oil prices in the Middle East. China has practically been the last importer of Iranian oil after the US renewed its sanctions against the country and Middle Eastern oil is exported frequently to Western Europe and the US. Thus, an escalation between the two largest oil producers in the Middle East is likely going to be costly for these economies as well.

The US in particular is likely to be a net beneficiary of escalating tensions between Saudi Arabia and Iran since the local shale oil and shale gas producers in the US will see a significant increase in profit margins and demand for their products. Furthermore, shale oil and shale gas allow the US to substitute Middle Eastern imports with domestic production in the medium term (12 to 18 months). Thus, US energy companies that are heavily invested in the shale oil boom are the most likely beneficiaries of these developments. The companies to consider are EOG Resources, Chevron, ConocoPhillips and Marathon Oil. 

In Europe, oil companies should also do quite well and be amongst the winners of an escalation between Saudi Arabia and Iran because none of the major European oil producers like Shell, BP, Total, Eni etc. are impacted by these events. Their oil and gas fields are mostly outside Iran and Saudi Arabia.

The losers in this scenario are likely going to be cyclical stocks, especially producers of capital goods and cyclical consumer goods. They will have to suffer the potential impact of a slowing economy without having the benefit of higher revenues from higher energy prices.

In short, while it is too soon to expect a bear market in stocks, the uncertainty around Saudi Arabia and Iran will likely accelerate the current slowdown and exacerbate trends that have already been in place since the beginning of the year. For equity investors this means a preference for defensive equities together with investment opportunities in oil and gas producers that are generating revenues from sources outside the Middle East.