All eyes have been focused on the Middle East over the past two weeks, as the region has seen a sharp escalation in tensions following the Hamas terrorist attack on Israel and the responding military assault on Hamas in Gaza. Our thoughts are with those whose lives have been impacted and will continue to be by these tragic developments. Below, we discuss the investment implications of this conflict, while recognizing that the human toll is much more significant.

 

The global market reaction has been relatively subdued to date, though volatility has increased. Equity markets in Canada, the U.S. and internationally currently sit relatively unchanged since the initial attacks. There has been a noticeable rise in government bond yields, but this can be attributed to domestic factors. Predictably, oil prices have moved higher.

 

Investors can become concerned when a geopolitical crisis emerges. Nevertheless, a review of some of the military interventions since World War II reveals that North American equity markets have generally shown resilience, with the average market decline limited in both size and duration. One relevant historical comparison is the 1973 Yom Kippur War involving Israel, Egypt and Syria, which led to a coalition of Arab nations imposing an oil embargo on allies of Israel such as Canada and the United States. At the time, the U.S. was heavily reliant on oil imported from the Middle East. The embargo led to meaningful supply shortages, a significant increase in oil prices and strain on the U.S. economy. Combined with some other factors, it also led to a more extended period of stock market weakness.

 

The investment implications on this occasion are again likely to centre around oil. There is a risk that the conflict will broaden to include other militant groups and countries. The biggest concern is whether Iran ultimately gets directly involved, given its strategic influence in the region and its proximity to the Strait of Hormuz – a relatively narrow channel that connects the Persian Gulf with the Arabian Sea in the northern Indian Ocean. According to the U.S. Energy Information Administration, the Strait of Hormuz is the world’s most important sea route, as a significant amount of the world’s oil supply, from countries such as Iraq, Iran, Saudi Arabia, Kuwait and the United Arab Emirates, flows through the channel on containerships. Should Iran become involved in a broader conflict, there is also the possibility that the U.S. would impose tighter sanctions, further limiting supplies and adding more upside pressure to oil prices.

 

One of the stark differences between the environment today and that of 1973 is the U.S. progress toward energy independence. Given a major shift in U.S. energy policy following the Arab oil embargo and technological innovations over the past few decades, the U.S. has become the world’s largest oil producer and is nearing self-sufficiency. As a result, the U.S. is significantly less vulnerable to supply issues stemming from the Middle East. Nevertheless, the price of oil continues to be determined by global demand and supply, the latter of which remains heavily influenced by the Middle East. While the U.S. may not have to worry about its ability to import enough oil to meet its needs, it may still have to deal with higher world crude oil prices.

 

We believe that the risk of an intensifying conflict in the Middle East adds yet another challenge to the supply side of the oil story. The other issues include higher interest rates and a less favourable political backdrop, which have raised the breakeven price for any new oil-related project. In addition, public companies have demonstrated less willingness to expand oil production at any cost, as they have become more disciplined with their use of capital in response to shareholder demands. All of this suggests a higher floor for oil prices for the foreseeable future.

If you have any questions, please do not hesitate to contact us.

 

Drew M. Pallett LL.B. CFP

Senior Portfolio Manager and Investment Advisor 

RBC Dominion Securities         

Email: drew.pallett@rbc.com

Website: www.pallett.ca