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Hi! I am Erik L. van Dijk, principal at LMG Emerge. LMG Emerge is an internationally-operating institutional investment consultant with offices in the Netherlands and at Mauritius. Our clients are pension plans and other institutional investors, family offices and HNW individuals. In close... More
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  • Saudi Arabia needs a new strategy: geopolitical and financial market consequences 0 comments
    Mar 5, 2011 3:28 PM | about stocks: TUR, OIL, EGYP, VIXX, VIXM

    Introduction

    Fire in the Middle East. What is going on? Recent developments caught most analysts of the region by surprise. The upheaval in Tunisia and Egypt did already lead to new governments. The new government in Egypt was actually forced - already quickly after Mubarak was removed - to go one step further than initially planned. The prime minister who was initially installed by the army had to be replaced by another, because protesters did not accept him. He was too closely associated with the old Mubarak regime. 

    Libya is in the middle of what looks like a civil war right now. Khadaffi c.s do still hold Tripoli and some of the oil fields/cities close to the capital, but the rebels control other regions. Khadaffi's end is near.

     

    Tripoli: Khadaffi's Last Stronghold?

    And in Yemen, Bahrain and Oman things don't remain quiet either. Actually: even Iran and Saudi Arabia (Eastern Shia provinces) are confronted with fierce opposition against the reigning governments. 

    In two of the four strong Muslim regional powers, Libya and Egypt, existing power structures collapsed. Saudi Arabia and Iran, the two richest of the four, are struggling as well but seem to overcome. By definition this will lead to a new balance of power in the Middle East, one of those regions in the world where it will never be really quiet due to a mixture of complicated (geo)political issues and the presence of oil, gas and other resources.

    In a previous contribution we paid a lot of attention to the broader regional balance of power shifts, and how - according to us - Turkey and Iran will be its main beneficiaries with maybe even Israel benefiting. But what about Saudi Arabia? Economically the richest and most important country in the region. One that is used to complicated power struggles. And also the one that according to most Western commentators is critical for the whole world. Many state that problems in Saudi Arabia of a type similar to what went on in Tunisia, Egypt or Libya would translate into a new global financial crisis. But so far, financial indicators and economic indicators expressing investor and producer confidence seem to show far less pessimism among entrepreneurs and investors than what is suggested by political and military leaders. But a recent BBC documentary of about 4 hours of broadcasting called 'The Power of Nightmares' seemed to suggest that the latter groups - including also for the occasion defense entrepreneurs - might have a hidden agenda.If you want to watch the BBC documentary we refer you to our You Tube Channel's Videos - Geopolitics section.

    Therefore, let's take a closer look at the Saudi situation to see what makes this country so special.

    Saudi Arabia: Tale about an ongoing political chess game with changing rules and players

     It is of course true that Saudi Arabia is key to the Middle East and the Rest of the World. The country is the second largest oil producer in the world (next to Russia), but by far the largest when it comes to oil reserves. Its reserves are approximately 255 trillion barrels in size. And not just that, these reserves are of better quality than those of most competitors and easier to extract at often lower cost than what competitors can. This ensures the country - whose sovereign wealth fund (part of the Saudi Arabian Monetary Agency) is one of the top-5 institutional investors in the world - an ongoing strategic importance during the next decades. But it is not just oil. Gas wealth in Saudi Arabia should not be ignored either.

     


    Stanford scholar Joshua Teitelbaum's piece 'Saudi Arabia and the New Strategic Landscape' (Middle Eastern Review of International Affairs, September 2010) gives an excellent overview of the various strategic phases the country had to go through. Phases in which both the internal and external political situation complicated the overall picture. Teitelbaum warned already last year that the situation was changing. And as it turned out only months later: he was right. This will lead to a new situation, one in which Saudi Arabia - if it is to maintain its role as Western ally #1 in the region - needs help. Not so much financial help, but a new political and military solution. In other words: a completely redefined domestic and international policy that takes into account regional and global chances. Western governments have been confronted with a situation like this before and back then they made terrible mistakes. That was in the Iranian Revolution when the power of the Shah and his (military) army was strongly overestimated vis-a-vis the moral powers and influence on the poor of Ayatollah Khomeini. 


    The origins of Saudi Arabia - one of the two countries in the world named after one ruling family, the other being the Hashemite Kingdom of Jordan - go back to a 'deal' between the Al Saud family and the orthodox Sunni Islam preacher Shaikh Muhammad Al-Wahhab back in the 18th century. They merged their political / military interests (The Sauds) with the religious ('spread the orthodox gospel') ones of the Wahhabites. But all through history that was easier said than done.


    The Arab peninsula - home of two of the most holy religious Muslim places, Mecca and Medina - was basically one big powder keg in which i) tribal; ii) religous and other political (both domestic and international) factors played an enormous role. The strategic position of the area geopolitically and the presence of oil wealth added to the complexities. So far, helped by its allies, the Saudi leadership has been capable of maintaining its position of power. They have been 'survivors'. True, oil wealth helps when trying to maintain power, but then again Iran's Shah wasn't a poor sucker either.


    And although it is always tricky to forecast that things will be 'really different this time 'round' we will nonetheless try to explain why it is different.


    Saudi Arabia: maintaining a balance internally

    Three factors dominate when looking at the internal power struggle in Saudi Arabia. First of all, the Saud's have to ensure that tribal struggles do not interfere with their authoritarian control over the peninsula. As Teitelbaum explains in his piece (link, see above) they basically did so by giving tribal leaders career chances within the Saudi Arabian National Guard, paying them by using part of the oil money. Result: the Saudi army is definitely not the strongest and best-trained one in the world (result of not necessarily having the best guy at the right place!) but definitely one using the nicest, most modern tools and gimmicks. Saudi Arabian ally #1, the United States of America, understood this part of the Saudi strategy and it is therefore understandable that the US has even been willing to deliver new weaponry to Saudi Arabia when it knew that Israel would not be too happy with it.


    Far more complicated were its struggles with religion. When looking at their 'way of life' and 'ideas for the country' the Saudi leadership always comes across as being far less orthodox than the country as a whole. How is that possible?


    Over the years the original partnership between the Saud's and the Wahhabites deteriorated as a result of remaining or even growing orthodoxy on the one hand and a gradual tendency to enjoy nicer things of life on the other (the house of Saud and the growing richer and middle classes in the country). Being masters of creating winning partnerships, the Saud's thought they found a great solution: why not give the Wahhabite clerics a strong say in religious and educational affairs, so as to gain their support in other areas (international politics, economics, culture etc). Economically this wasn't too bad too probably, taking into account that the country is also the main destiny of the holy pilgrimage (Hajj) for Muslims.

     

    Sounds tricky, right? Wouldn't that lead to growing groups of youngsters with orthodox ideas that would sooner or later turn against the Saud mainstream ideology? Osama bin-Laden is a nice example of someone who turned orthodox within a country that saw its wealth growing. Normally growing wealth and improved economics work against orthodoxy, but of course - when Wahabbites control schools and religious institutions - that is not something to be sure of.


    Over the years, the Saud's worked out a fascinating solution: export the religious zealots and hope that they will not return, either because they like their new evangelist role or because they end as martyrs. Saudi religious fanatics were not just incentivised to work in Afghanistan and other Sunni dominated countries that were at risk, but Imams were also sent abroad to Western countries! Often in combination with mosques paid for by the Saudi royal family as a gift for groups of foreign workers that wanted to give expression to their religious feelings in countries like the UK, the Netherlands, Germany, Belgium, France, Scandinavia, Switzerland etc. 

     

     Exporting Orthodoxy to 'Islam Market' of Europe

    Tricky strategy of course, since it led to growing tensions in those countries. To a certain extent one cannot totally disconnect the rise of anti-Islam sentiment in those countries (Denmark, the Netherlands, Switzerland, France) from these export activities. But somehow Saudi Arabia's main ally, the United States, was least affected as a result of which this strategy helped in reducing orthodox tensions within the country quite a bit.


    But it was not enough: problems with orthodoxy in Saudi Arabia were not just related to struggles between orthodox Sunnis and more moderate ones. The Eastern part of the country - important because of its oil - was mainly occupied by Shia Muslims. Shia muslims were suppressed fiercely. The Saud's were afraid that not doing so would imply giving Iran a stronghold from within. That the poor Shia's were actually asking for rights that in any other country would be considered legitimate was beside the point. Western allies remained silent, hoping that violent actions against the Shia population - of a similar type as what Khadaffi is now practicing against his own population - would be temporary. Reason: now that the Shah was gone and Shia Muslims have proven to be a nasty countervailing power within the Islamic Republic Iran as well as via Hezbollah in Lebanon and through support of Hamas in Palestine, with Syria as a nasty ally, something needed to be done. Iraq and Bahrain,  both under Western control, have strong Shia populations but they cannot be given their rights. That was the standard strategy, one that was supported actively by Saudi Arabia. Even recently when in Bahrain - faced by an uprising in line with what we saw earlier in Tunisia and Egypt - Shia protesters were not just faced with police and troops from the country itself, but also by tanks from neighboring Saudi Arabia.


    But, OK, Shia Islam is orthodox as well and this was not about simply keeping the orthodoxy out. Remember: within Saudi Arabia the Wahabbite Sunni muslims are also orthodox and they play an important role. What to do with growing groups of non-muslim Western specialists working in the oil and financial industries? Make sure you create strict rules for them in Saudi Arabia (oil specialists) and establish a financial center (Bahrain) outside your own country in a Shia area so as to keep the Wahabbi leaders satisfied. In combination with possibilities for Westerners to walk around in shorts, 'do things you don't do in Saudi Arabia' in Dubai this should suffice. Wouldn't it? To a certain extent it did, but it was a time bomb. And it was especially irritating, that one of the biggest advocates of orthodox gospel from within Sunni ranks - Osama bin-Laden of Al Qaida - started to be more than just an irritation to the US and the Rest of the World.

     

    Challenge 1:

    Over the years, the Saud's and their Western allies tried to play with orthodoxy. With respect to the one from within Sunni Islam: give them less important rights or export them. And with respect to Shia: don't give them any rights and fight them fiercely. Obviously this led to sympathy for the orthodox movements, especially because the Western and Saudi moderate or non-Islamic message lacked credibility in the eyes of many Muslims. 

     

    The fact that the relatively moderate and charismatic Grand-Imam at the Al-Azar mosque in Cairo, Muhammad Tantawy, died at the age of 81 in 2010 didn't help either. A new moderate Sunni leader would have to establish international influence and charisma first.


    The late Grand-Imam Muhammad Tantawy:

    His charisma and moderate gospel are deeply missed

    Saudi Arabia and its international political challenges

    Internationally, the relationship between Saudi Arabia and the UK has always been rather tense. This is directly related to the more positive relationship between the UK and the Hashemite Kingdom of Jordan. The origin of the Hasmemites lies in today's Saudi Arabia and that explains. It was therefore not a big surprise that Saudi Arabia has always betted on the US card. This paid of well ever since the first political partnership was cemented by oil agreements as well. This happened already during the Second World War, when the US wanted to make sure it had alternative oil sources next to its domestic reserve positions. 

    And later - as countervailing power against Soviet threats in the Cold War period - the close relationship with the US was expanded further. That the cooperation with the US would indirectly imply a closer relationship with Israel didn't really matter. After all: the Saudi agenda was not about Israel and the Palestines. It was about the domestic power play described above. And as far as international aspects were concerned: the main fears of Saudi Arabia were the Hashemite Kingdom of Jordan and its influence/ambitions on the one hand and the communist/Baath ideologies that were supported by the Soviets during the days of the Cold War on the other (with countries like Iraq and Syria as dangerous strongholds, with - at a certain point in time - risks of communist uprisings in Oman and Yemen also more than real. ''Israel? Who cares! The good relationship with the US and the US's ties with Israel will ensure a satisfactory solution there.'' That was the line of reasoning of the Saud's. One that - of course - didn't make them more popular among orthodox Islamists, be they Wahhabites or Shia.

    The rise to regional power of Iran: everything changes

    With the Islamic Revolution in Iran (1979) and the consecutive installation of the Islamic Republic the Shia stronghold on the other side of the Persian Gulf became Saudi Arabia's main worry. And not just that of Saudi Arabia. It was also a big worry of the Western world. 

     

     Ayatollah's Khamenei and Khomeini;

    Two leaders of a growing force in the Middle East: IR Iran

    Iran was already a top-5 giant in both oil and gas, and the fact that new coal reserves in the Northwest of the country made the Iranian leaders even more confident, didn't help either. The only chance would be that the orthodox Shia clerics and government in Tehran would mismanage the economy to such an existent that internal upheaval would cost them power internationally. However: the aforementioned continuous actions against Shia populations in Iraq, Bahrain, Lebanon and elsewhere didn't really help. As always they create more cohesion within an attacked group. And economic embargo's are also not effective weapons when you know upfront that they are not very effective, due to a country's existing resource wealth with suppliers elsewhere that don't join the embargo (China for instance).


    This has led to a situation in which Saudi Arabia needs to find a new strategic position, one that creates a new international and national strategic balance. As indicated in an earlier article we believe that this challenge is too large for Saudi Arabia and/or the US without new support. Turkey seems to be the regional partner that will have to play a growing role. 

     

     Erdogan's Turkey:

    Expected to play a growing role within the Middle East

     

    First, because with its size and relatively good relationships with both the Western and Middle Eastern world it can play a natural role as intermediary already. Second, the country is population-rich, militarily strong and part of NATO, but resource-poor. This provides it with a logical possibility for synergy with other Middle Eastern nations. Iran is not really an enemy but a trading partner for Turkey. When looking at the internal new status quo in some of the countries that went through revolutionary upheaval recently (and we include Iraq), it seems out of the question that we can continue to deny orthodox Muslim groups (especially Shiah) their rights. The more we do so, the larger the likelihood that these groups will attract even people who would otherwise opt for a more moderate Islamic alternative or even secular alternative.



    Challenge 2

    When seeing how Saudi Arabia has maintained its power balance with Iran thus far, we can only conclude that Saudi Arabia has to - one way or another - work on some kind of cooperation with the big enemy. Iran is simply too strong (militarily) and rich to consider Iraq-like actions a reasonable alternative. Softer diplomacy seems the only option in the Iran case, but it is not a bad one, as a recent paper by Jentleson and Whytock entitled ''Who 'won' Libya: The Force-Diplomacy Debate and its Implications for Theory and Policy'' indicates. We are pretty confident that the historical track record of the Saud's as survivors will make them understand that. But will Western nations - first and foremost the US - understand this? Recent developments in Libya, that show a quick demise of Khadaffi - after a sequence of different style softer and tougher diplomatic and military actions did already lead to a change for the better in Libyan policies since 2003 - are indicative of the potential of policy change through dialogue. Jentleson and Whytock show that efforts to go further will abandon reciprocity make success less likely. Especially when taking into account that all indicators point out that Iran will be a harder nut to crack than Libya.


    Financial and Energy Market Implications

    The complicated position in Saudi Arabia and confusion about what is going on in the rest of the Middle East do translate into ongoing uncertainty and volatility in financial markets and the global economy. 

     

     What to expect economically in the Middle East?

    And with respect to Saudi Arabia: will it imply a collapse of the country, stagnating oil production and a new global crisis? We doubt it. That might be a general feeling in the Western world, based on our belief that without direct Western interference the Middle East can only collapse, but it is not realistic. Of course, less control over Saudi Arabia as oil-richest country in the world will cost Western nations a lot, since oil wealth was actually what led to the strategic partnership with Saudi Arabia in the first place. But it was at the expense of an increasingly unstable status quo between Shia and Sunni Muslim countries and terrorist threats from Al Qaida and the Taliban that could be controlled much better as soon as there is some kind of regional political balance of power between Iran, Saudi Arabia and Turkey in a new status quo that would maybe cost us some direct control in Saudi Arabia but that would lead to trade opportunities with Iran - one of Goldman Sachs Asset Management's Next-11 countries - once we are smart enough to accept them (albeit under certain conditions) in the league of non-rogue nations. 

     

    Two of Three  Middle Eastern Next-11 giants (TUR, IRN) will 

    and the Third (NYSE:EGY) might benefit in the longer run

     

    Turkey - another Next-11 country - is already benefiting economically from that (Iran is now good for approximately 20 percent of Turkish export/import (combined)) and the world could be next. 

     

    At the moment the oil surpluses of Saudi Arabia don't bring much, other than the fuel and new monetary assets added to their wealth funds. You cannot export more in other areas: the country is simply not populous enough. On the contrary, regional economic growth - with populous countries Egypt, Turkey and Iran being the prime areas of development - and less 'control costs' related to Western presence would lead to a less volatile equilibrium in the longer run. One with relatively lower energy prices (less nervousness translates into more moderate price rises) - which is also in our interest - and broader economic development. That is not just in the interest of the Western world, but also of Saudi Arabia. We are confident that the Saudi's and Iranians are pragmatic enough, but will Western investors and governments understand it too?

    In the short run volatility in global financial markets will remain high, which implies that volatility related instruments are definitely of interest to investors, with oil and gas prices most likely not at their peak yet (oil price levels of USD 200 are not impossible). Economically, in the longer term this will lead to interesting chances to buy in Turkey at a discount, because current valuation levels there do already incorporate the energy-poorness of the country itself, but not yet its growing regional importance, and later - when opting for a new strategy along these lines - definitely in Iran. Selected Egyptian stocks might become interesting as well, albeit that one should follow a strict deep value strategy which bets on firms that can sell their produce regionally.



     



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Stocks: TUR, OIL, EGYP, VIXX, VIXM
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