Waddell & Reed

Market Perspectives


Iran, Israel and nuclear volatility

 

Waddell & Reed Market Perspective - APRIL 2012

 
 
The U.S. economy continues to improve despite a series of ongoing challenges that seem almost devoted to slowing its momentum. In addition to the usual election year political rhetoric in the U.S and the sovereign debt crisis in Europe, tensions are once again high in the Middle East, this time over Iran’s apparently growing nuclear program.
 
Israel is understandably concerned about the implications of a nuclear Iran. Iran’s Islamic leaders have publicly denounced the Jewish state as the “enemy of Islam” for decades and have provided support to the Hamas and Hezbollah terrorist factions that are committed to Israel’s destruction.
 
The continuing tension between the two nations is being felt not only by political leaders, but also in the markets, with some fearful that a further jump in oil prices could derail the economy. As a result, the tension has also spilled into equities and bonds. Given the significance of this issue, and the likelihood that it will continue into the foreseeable future, investors may benefit from some additional insight.
 
While the Iranian and Israeli tensions may continue to create market volatility, the probability of an Israeli attack, such as a targeted move against Iran’s key nuclear sites, appears low based on numerous factors.
 
Any Israeli action is likely to only delay Iran’s nuclear program, but not alter its nuclear ambitions. Considering the relatively limited gain – essentially extending Iran’s nuclear timeline by only a year or two – the cost to Israel would likely be substantial with increased attacks from Hamas and Hezbollah, as well as conventional Iranian missiles that can reach Israeli soil.
 
Western sanctions are having an impact. With a European Union embargo of Iranian oil set to take effect July 1, many oil shippers are already refusing to travel to Iranian ports. Forced to rely on National Iranian Tanker Co. (NITC), which owns 39 vessels that can carry only about 70 million barrels of crude, Iran has scaled back production.
 
It is difficult to overstate the role of oil in the Iranian economy. It generates more than half of the government’s revenue and accounts for a critical 20 percent of Iran’s Gross Domestic Product (GDP) that serves as the base of the rest of the nation’s economy. Unable to convert its oil to hard currency under U.S. sanctions that restrict Iran’s access to international finance, the nation is now trading oil and even its holdings of gold bullion for staples with China and Russia. With bartering on the rise amid the collapse of the Iranian currency against the dollar, there are numerous anecdotal reports noting a sharp drop in Iranian consumer activity.
 
Iran is seeing increasing internal unrest. Iranian President Mahmoud Ahmadinejad was essentially interrogated by Iranian lawmakers in early March with questions focused on everything from economic policies to cabinet appointments. It was the first time an Iranian president had been called to answer such questions since the nation’s 1979 revolution. This is decidedly in Israel’s favor over the long term and, in some ways, another reason for Israel to stand pat. With sanctions only tightening, Ahmadinejad may face increasing internal challenges that could perhaps lead to regime change. He is already at odds with the Iranian parliament and also the nation’s clerical establishment. Ironically, a strong case could be made that Israel military action in this environment might actually strengthen the Iranian president by turning that nation’s focus away from its own internal problems and against an external enemy.
 
Given the current internal environment in Iran, and the ongoing situation in Syria, where violence has erupted amid a crackdown on anti-government protests, Israel may continue to be vocal about the situation in Iran, but will continue to watch events unfold rather than risk taking an action that may bring about unintended consequences for Israel.
 
Hormuz closure unlikely
The U.S. has had sanctions of varying degrees against Iran since the ’79 revolution. However, Western sanctions against Iran were expanded in Nov. 2011. In response, Iran vowed in December to block the Strait of Hormuz, something one Iranian official said would be “easier than drinking a glass of water.”
 
Although estimates vary, around 20 percent of the world’s oil, and perhaps as much of 40 percent of the world’s seaborne oil supply, travels through the narrow sea passage linking the Persian Gulf with the open ocean. On an average day, the strait, which narrows to a mere 21 miles at its tightest point, sees more than 15 million barrels of oil, mostly headed toward Asia.
 
The Iranian claim about being able to easily block the strait, however, may be greatly exaggerated. A similar attempt during the Iran/Iraq war proved unsuccessful, and the U.S. has said that such an effort would not be tolerated, backing the statement up with increased defenses in the region.
 
Iran does, however, have some other options. Instead of a closing, it seems more likely that Iran could do some damage by either blowing up a tanker or through more unconventional means, such as piracy. Even if the damage is limited, a single attack on an oil tanker would likely send maritime insurance premiums skyrocketing, taking oil prices higher. On the December 2011 day that Iran that started war games in the strait – a move seen as a practice run for closing the passage – oil futures jumped around 4 percent.
 
Oil prices
In October 2011, when the crisis had yet to emerge at its current scale, the spot price of West Texas Intermediate crude (WTI), which is used primarily in the U.S., was below $80. It has generally remained above $100 barrel since November and was around $106 a barrel in mid-March. Brent crude spot prices, meanwhile, opened October at around $103 a barrel and have generally remained above $110 a barrel since then. When Brent, which is used primarily in Europe, was around $126 a barrel in mid-March it was in a range similar to spring 2011, when civil war in Libya interrupted the flow of about 1.3 million barrels of oil per day.
 
Some have suggested oil prices could add another $20 to $40 per barrel if supplies tighten further, but those forecasts are largely based on other OPEC nations not increasing production to make up for Iran’s output, which at 2.5 million barrels per day, is second only to Saudi Arabia among OPEC members. However, it appears likely other nations are willing to step up to fill any void. While Saudi officials have made it clear they would like to stay out of the political fray, they have admitted that they could “almost immediately” ramp up production to offset any difference. In that scenario, although there might be an initial spike in oil prices, they could moderate and may do so very quickly.
 
However, if the $20 to $40 a barrel jump is realized, it would put crude at or above the $150 a barrel mark that crude flirted with during another Iranian crisis in summer 2008. Many have noted that the 2008 spike in crude played an important role in the global recession. Crude prices moving closer to that level could provide additional downward pressure on equities.
 
Timeline
It is not clear exactly how close Iran might be to creating a usable nuclear weapon, which is the key question at the heart of the debate.
A former Israeli intelligence official said in January 2011 that he did not think Iran could develop a bomb before 2015. That timeline was projected after a computer virus, known as the Stuxnet worm, was believed to have destroyed some of Iran’s nuclear centrifuges. In the aftermath of that event, Iran has worked to improve security and is thought to be doing some of its most significant work in locations it believes are not vulnerable to any type of attack, including sites built in mountains that it believes would be protected from a military strike.
 
For example, the Natanz uranium enrichment plant about four hours south of Tehran, which is at the heart of the dispute, has been built underground and reinforced with concrete walls and barriers. Iran has said the site contains 3,000 centrifuges that are used to enrich uranium. Another enrichment facility, about midway between Tehran and Natanz near the city of Qom (the site is sometimes referred to as Fordo or Fordow) is also heavily fortified. The former Islamic Revolutionary Guard base is also believed to be home to about 3,000 centrifuges.
 
Some uranium enrichment is necessary to create reactor fuel. Iran is currently enriching its uranium to levels above what is believed necessary to create power but below what it would need for a nuclear weapon. That would suggest that Iran is still trying master the enrichment process while using dated technology. Some experts believe that Iran would need to either reconfigure its current centrifuges or build entirely new centrifuges to create weapons-grade enriched uranium – both processes that would be extremely difficult, perhaps even impossible, under the eye of U.N. inspectors.
 
Despite these challenges and the timeline they suggest – likely three years from the time when a decision is made – the situation has taken on urgency with Israeli leaders in recent months who are concerned that Iran is fortifying its research locations. Although the U.S. has vowed that it will not allow Iran to possess a nuclear weapon, Israel fears that the point at which Iranian weapons development could not be stopped without a major military action is rapidly approaching. Israeli officials have called this the “immune zone” for Iran, and have said Israel must consider action before that zone is reached.
 
U.S. leaders, in contrast to the Israeli viewpoint, have continued to say there is still ample time for negotiations and ongoing sanctions to work.
 
“This notion that somehow we have a choice to make in the next week or two weeks or month or two months is not borne out by the facts,” President Barack Obama said during a March 6 press conference.
 
For investors, that means that this issue may continue to make headlines and occasionally influence the financial markets for some time to come – something that events in the Middle East have done for decades.
 
 
Past performance is not a guarantee of future results. The opinions expressed in this article are those of the Waddell & Reed and are not meant to predict or project the future performance of any investment product. The opinions are current through April 2, 2012, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
 
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