Off The Beaten Path

While I could stick with the typical format I use for these posts, the fact that there is virtually nothing going on in the markets makes me want to do something a little different.  So today I want look at a subject that has caught my attention of late.  Something that’s investment-related, but outside of the usual economic/trading strategy discussions that consume so much of my time.  Something that helps keep our perspectives grounded in reality, but open to theoretical exploration and analysis.  More specifically, today’s post will explore one of the key geopolitical issues that is being played out across the globe and the potential impacts that could result from a flare up.  While many of us follow geopolitical issues quite closely, I find that we’re not always able to translate these developments into an investment framework.  This lack of consideration, therefore, leaves our portfolios exposed to risks that we aren’t even aware of.  And in the now infamous words of Donald Rumsfeld, it is the ‘unknown unknowns’ that often have the greatest impact on our lives, our country, and our portfolios.  As such, taking a broader look at these exogenous issues will help reduce the chance that something important is slipping our attention.  We may never be able to fully ascertain all the risks we take as investors, but simply working to reduce these unknown pitfalls will go a long way towards ensuring eventual success.

The Iranian Situation: 

With the U.S. in the midst of waging a pair of wars on multiple fronts, it is fair to say that our military resources are stretched farther and wider than any time since the first Gulf War.  This is not to imply that the U.S. is militarily incapable of defending itself or its allies, but rather to highlight the fact that our leaders have fewer options at their disposal when trying to advance domestic interests abroad.  Put another way, the U.S. is walking softly with a stick that isn’t quite as big as it was prior to 2001.  As a result, countries around the world are seizing upon this lull in America’s military reach to try and advance their own interests.  Iran, in particular, sees the current environment as an excellent opportunity to advance their nuclear weapons program and, thereby, expand its regional influence.  Needless to say, this runs in direct conflict with U.S. geopolitical and economic interests.

Iran has taken a two-pronged strategy towards the U.S. in order to ensure the progression of its nuclear arms program.  First and foremost, is control of the Strait of Hormuz.  By far the world’s most critical waterway, more than 20% of the world’s traded oil (40% of seaborne traded oil) passes through the region every year.  Any disruption in this flow of oil would send economies around the world grinding to a halt.  And as the global leader in oil consumption, America would be disproportionately affected by any reduction in the flow of Middle Eastern oil.  However, since the Shia-lead coup took control of the Iran in the late 1970s, this has been an ever-present threat that has been mitigated, to a large extent, by the U.S. Navy’s efforts to secure the commercial shipping lanes.  But with America now stretched fairly thin militarily, its ability to enforce security in the Strait has been affected.  While this doesn’t mean that commercial traffic can no longer pass through the area unhindered, it does open the door for other interests to conduct disruptive operations. 

As an example, just this past week the Japanese tanker, M. Star, was damaged while transiting the Straits of Hormuz.  Members of the ship’s crew have claimed to have seen a light (explosion of some sort) on the horizon just prior to the incident and have suggested that this was the source of the damage.  Though the cause of the damage is still under investigation, there has been a claim of responsibility from a terrorist group known as The Brigades of Abdullah Azzam.  Whether or not these claims prove to be true remains to be seen, but it is clear from the photos of the damage that something impacted the tanker hard enough to cause a large dent in the ship’s hull.  The damage, also, does not appear to be consistent with any sort of impact resulting from piloting error (ie, running aground), so the question becomes what else could be the cause of this damage?  It has been widely speculated that the Iranians have been focusing on the use of submarines and sea-borne mining operations as their primary tools for controlling/disrupting the Straits.  Given the fact that the damage appears consistent with that of a collision, it is certainly possible that this incident could have been caused by contact with a patrolling Iranian submarine, especially when considering that the incident occurred at night.  While this is purely speculation on my part, Iran’s recent spate of military exercises has put additional assets in and around the Straits, which raises the potential for incidents, unintentional or otherwise.  As such, the risk of incidents is escalated all the more.

The second facet of Iran’s U.S. strategy has to do with the great deal of influence it has over Iraq’s political and social institutions.  The stated goal of U.S. leaders concerning Iraq has been to put in place a stable, Iraqi-lead government that will be able to manage the country’s interests will little or no external assistance.  However, Iran has seized upon the country’s instability to place individuals friendly to its own interest in positions of power and influence.  For example, Iraq’s largest political party is the Shia-based United Iraqi Alliance.  This party is well known for its inclusion of individuals sympathetic to Iran’s interests.  Additionally, the relatively porous border between the two countries has allowed militant groups, sectarian leaders (Muqtada al -Sadr), and other interested parties virtually uninhibited passage between the countries.  As a result, Iran has the ability to undermine many of the political and social gains accrued by American forces through these proxy entities.  By doing so, the American military is forced to expend additional resources for extended periods of time in order to maintain the balance of power between the two countries.  This keeps the American military stretched out and, therefore, less responsive to the growing nuclear threat.  This is also part of the reason why Iran has been uninterested in returning to the negotiating table.  They see themselves as uniquely positioned to dictate the negotiation process.

So what does this all have to do with investments?  Well the obvious conclusion is that these rising tensions between the U.S. and Iran will increase the potential for an asset like crude oil to spike in value.  In fact, I am currently considering adding a bit of crude oil exposure to my personal portfolio as a means of hedging the risk of something breaking out in the region.  While not the exclusive reason for considering this addition (technicals starting to look bullish as well), I do believe that the confluence of issues (M. Star, Iraq issues, nuclear proliferation) points, at least, to an environment that is more unstable.  Right or wrong, investors largely run for the ‘safety’ oil in just such an environment.  However, what many often overlook is the fact that uncertainty is something that equity markets simply hate.  Therefore, it is highly likely that any escalation of the region’s hostilities will cap any impending rally or even push things lower.  I don’t think we’re yet at the point where paring down equity exposure is warranted simply based upon geopolitics, but it’s something we need to consider and be prepared for.  And that’s the point of looking at these issues.  It’s thinking through the ‘what ifs’ that determines how we will deal with these issues when they arise and keep us from being forced into a bad decision.

I know tonight's post was a little off the reservation, but I hope I gave you something to think about.  I plan on posting these types of things from time to time, so I’d love to hear whether or not you found this ‘big picture’ thinking useful.  I know I do.  Until tomorrow…..