Positioning For A Spike In Oil

 |  Includes: DTO, SZO, USO
by: Avner Mandelman

Most investors analyze documents and financial numbers. But the extra advantage is often found in tracking physical movements of assets and personnel, whether machinery and executives of a corporation, or military assets and personnel. Because so few do it, this can give a strong, proprietary indication of future financial events that secondary, documentary information can only report post fact.

In the past, Giraffe Capital LP, a “value tech” fund I managed, enjoyed an average return of 14.1% p.a. over a decade, in a tech market that declined -5% per year on average, by performing physical due diligence on public companies, on top of regular analysis. A similar research now, based on sources, indicates that an attack on Iran is more likely than not. The Israeli government noted more than once that it will not accept a nuclear Iran, most recently a few days ago.

And this does not come only from the Israeli government. British Foreign Minister William Hague, who oversees MI6 as part of his job, told the Daily Mail that, based on his information, he thinks it likely Israel may attack Iran before December:

As part of the potential for an attack, Israel recently held a large scale drill of handling a mass missile attack, presumably in retaliation to an attack on Iran.

If such an event indeed comes to pass, oil prices would likely spike, and I suggest you get some exposure to oil via ETFs as part of your portfolio; but once and if such an attack does occur, sell the oil ETF immediately, because part of the purpose of such an attack, aside from eliminating the risk of a nuclear Iran, is likely to lower the price of oil in the mid term. This is arguably the only means large enough to help the West out of its financial difficulties. Once and if such an attack occurs, I would then overweight the portfolio heavily in stocks, either individually or via ETFs, because such an event would likely ignite a bull market, as it did post Gulf 1 and Gulf 2.

In fact, Europe just provided a precursor for this scenario, when, to all intents and purposes, it conquered Libya via local surrogates. This was done most probably for the sake of Libya’s oil, rather than to bring democracy to the Bedouins. The likeliest next stage, based on physical evidence, is for the US and its allies to do the same in Iran.

Please note: War is a terrible thing, and if there were any way to avoid it, it should be taken. But the following is not a prescriptive comment, only a descriptive one, based on evidence. Refusing to structure your investments for a likely war due to repugnance, is akin to refusing to consider a probable bankruptcy of an over-indebted stock, just because bankruptcy is a terrible thing. One must face facts and do analysis based on evidence.

What is the evidence?

On November 6, anonymous American administration sources told Fox News that a majority of Israeli government ministers are now in favor of an attack on Iran, after a lengthy period during which a majority was against it. This came after November 2, when Israel launched an improved version of its Jericho ballistic missile, capable of carrying a 1,500 lb nuke to 5,000 miles, and also conventional payloads.

The month before, September, the US finally provided Israel with the GBU-28 bunker busting bombs, which for a long time it had refrained from delivering. On top, and following hasty two visits by the British chief of Staff and the Israeli Defense Minister in each other’s country, last week the Israeli air force performed unusually large exercises over the island of Sardinia, alongside American and Italian aircraft, and perhaps some British ones as well (I havenot yet been able to confirm the last part).

All this makes an attack on Iran, at the very least, much more likely. If one were to occur, oil price would spike, as Iran would then try to block the straits of Hormuz, and the Obama administration would likely announce sanctions on those buying or selling Iranian petroleum, further tightening supply temporarily.

Since high oil price is a strategic interest of Russia, which finances its small empire almost exclusively with oil and gas revenues, Russia has been helping Iran resist US pressure; has sent it sophisticated ground to air missiles; and has lately helped Iran sell oil via alternate routes. But if push comes to shove, Russia likely would not be able to stop the US and its allies, because, as is not commonly understood by most financial players, lower oil price is now a US strategic exigency - not just militarily speaking but also economically, in order to avoid steep austerity both at home and in Europe.

Indeed, it becomes progressively clear that, if the West’s financial difficulties are not addressed very soon, social disorder is bound to increase, with perhaps risk to democracy in some countries, as Jose Manuel Barosso, the top European commissioner, has stated. This is unfortunately coming to pass, as just last week Greece’s prime minister summarily relieved of their command Greece’s Chief of Staff, Chief of the Air Force, and head of the Navy, allegedly (according to Greek sources) because of threat of a coup.

To recall, Greece had once been a military dictatorship briefly, as were Spain and Portugal, two other near-bankrupt European nations.

The only way for the West—the US and Europe— to avoid a financial meltdown and social disorder a la Greece which deep cost cuts would entail, is to find some truly deep pockets with trillions of dollars to spare. (That’s trillions with a T, not Billions.) Europe doesn’t have it. The US doesn’t have it. The IMF doesn’t have it. The US printed about two trillions dollars, but they were not enough. Some fresh, real money must be found. But where?

It can be found either at home, through draconian budget cuts, or abroad.

If the trillions are sought at home, either in the US or in Europe, via cuts, the attempt would risk more social disorder, as we saw in Greece and now also in the US.

As for external sources of trillions of dollars, there are only two such: China, and Mid Eastern oil tycoons. There’s no one else.

Europe tried to interest China in helping it financially. But the help would come at a steep price, because, according to sources in Beijing, Chinese public opinion would not stand for helping Europe at the expense of China’s own needs, unless it was done very advantageously. I.e., China would end up owning large pieces of Europe free and clear. This condition Europe has rejected; and the days when Europe could take whatever it needed in China (or in India) by military arms, are past. China is too strong for that.

So the only source of trillions of dollars left—the only one—is oil: Both Western annual spending on oil, and Eastern ownership of oil in the ground (which is as good as cash).

The US spends $850 billion a year on oil. Europe spends a similar amount. Other western countries spend about $200 billion more. That’s the only physical cost that comes close to a trillion dollars. (By comparison, the total world annual spending on copper comes to mere $150 billion.) This means that if oil price went down by, say, 50%, the annual savings would be close to half a trillion for the US, and a similar amount for Europe.

Again, for comparison, the US congressional Super Committee is now looking for total savings, over 10 years, of maybe $1.4 trillion, or $140 billion a year, a third of the above amount. And it is not at all certain that this could be implemented fully. Furthermore, such US cuts would likely throw the US into a long, deep recession, whereas oil price cuts would throw the Mid East—and Russia—into a recession.

Hence, the unspoken incentive to attack Iran is not merely to eliminate its military and nuclear threat, but rather to tap its vast oil resources so as to lower the price of oil significantly, and so avoid a financial meltdown in the West. Crudely speaking, it’s a choice between austerity and disorder at home, or austerity and disorder abroad. This is the real, unstated choice that Western leaders now face. When viewed in the context of worldwide availability of trillions of dollars, and barring a sudden burst of Chinese generosity, this is the only source of trillions of dollars possible. There is no other.

In this regard, we learned that in the recent joint exercise over Sardinia, Israeli pilots were most interested in the experience that NATO pilots had gained during the nine months and 25,000 long-distance sorties over Libya. More recently still, British press sources revealed that Britain asked the US to allow it to station aircraft in Diego Garcia, to shorten the flight distance to Iran. It was indicated that such permission is likely to be forthcoming.

One final interesting item we got from sources in Germany is that this time the German forces may participate in such an attack, because after staying out of the Libyan campaign, Germany is now missing on greatly preferential prices for Libyan oil and other benefits, that Italy, France, and Britain are reaping.

In sum, based on various sources and on tracking the movement of physical assets, we find it increasingly likely that the US, together with Britain, Italy, France, Germany, Israel, and a silent but supportive Saudi Arabia and perhaps a few other Gulf states, may launch an attack on Iran, probably over the next 6 – 9 months.

This would likely spike the price of oil, as did the first gulf war. But if such an attack is launched, we would sell oil immediately, and go heavily into stocks, because, as after Gulf I (January 1991) and Gulf 2 (March 2003), the combination of a safer world, a more powerful West, cheaper oil (after Gulf 1 only), cheap stocks, and suddenly re-payable sovereign debt due to unshackled economies, would likely ignite a bull market that could rival those that began after the first two gulf wars. (Gulf 1 immediately launched a 10-year bull market; Gulf-2, a 5-year bull.)

I would include some oil ETFs in portfolios, but sell them once / if an attack does occur.

A suitable security is either the straight long oil ETF, such as USO (the United States Oil Fund), which reflects WTI (West Texas Intermediate), or, a more interesting strategy is selling short a double bearish oil ETF, either DTO or SZO, which translates to being long oil, but also getting the melting volatility for free.

I do not have positions now in oil, nor do I intend to take any over the next 72 hours.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in DTO, SZO over the next 72 hours.