Iran Deal Revisited by Saudi and Gulf States – Possible Oil Shock?

by Victor Sperandeo with the Curmudgeon

Introduction (by the Curmudgeon):

There's one huge geopolitical RISK not mentioned by the mainstream media related to the forthcoming Iran Nuclear Deal¹ and its consequences: the loss of confidence by our Middle East "allies," especially Saudi Arabia, which all see a serious threat from a stronger Iran.

The May 2-3, 2015 Financial Times (subscription required) reports that a "senior official in the region" said the Persian Gulf states are looking for a U.S. commitment to contain Iran in the aftermath of a likely nuclear accord, as they press for weapons sales that would give them a “qualitative advantage” in their stand-off with the Islamic Republic of Iran.

Led by Saudi Arabia, Gulf States are adopting what was said to be a “polite” attitude towards the accord. The official said the Gulf states were not about to do a “Netanyahu,” in reference to the public demonstration of discontent by Israeli Prime Minister Benjamin Netanyahu over a potential nuclear agreement with Iran. The official told the FT that their attitude was driven by efforts to maintain good relations with the U.S. as an ally, even though they don't approve of the pending nuclear deal, which they feel would embolden Iran.

The U.S. is already in the process of a program of arms sales to Gulf countries. The Stockholm International Peace Research Institute, which tracks military spending, says Saudi Arabia spent more than $80bn on new weapons last year. The United Arab Emirates spent almost $23bn. The lead story in the April 18th NY Times "Sale of U.S. Arms Fuels the Wars of Arab States" provided more details on this troublesome dynamic.

President Obama has talked about trying to create an “equilibrium” within the gulf region, and U.S. officials believe that this will ultimately require some sort of dialogue between Iran and regional rivals such as Saudi Arabia. However, nothing on this front can be considered now, as the Saudi's are fighting Iranian surrogates (Houthis) in Yemen.

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¹Iran and world powers reached a “framework” agreement over its nuclear program in early April (after the March 31st deadline expired). They've set a June 30th target date to achieve a final deal. However, important gaps still remain between the two sides over sanctions, nuclear research and inspections.

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Iran sponsors terrorists while Saudi Arabia- U.S. ties fray (by Victor):

It's hard to understand why the U.S. would be willing to turn against Saudi Arabia by pushing for an Iran nuclear deal. Not only are the Saudi's concerned about Iran possessing nuclear weapons, but they don't want the international sanctions on Iran to be lifted, as that would surely strengthen the Islamic Republic's flagging economy.

Further, it's a true puzzle why our president asks for "nothing in return" from stone cold enemies like "death to America" Iran and Communist Cuba, which is still ruled with an iron fist by the Castro brothers. The U.S. risks losing the long history of friendships with many Middle East countries, e.g. Israel, Turkey, Jordan, and Saudi Arabia. The Curmudgeon has previously reported that Iran is the largest state sponsor of terrorist groups, which now include Hezbollah, Houthis, Palestinian Islamic Jihad, and Hamas, among others.

Why hasn't the U.S. insisted that Iran curtail aiding and abetting terrorist organizations?

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Sidebar: Iran - State Sponsor of Terrorist Groups:

In July 2012, the U.S. State Department released a report on terrorism around the world. The report states that "Iran remained an active state sponsor of terrorism in 2011 and increased its terrorist-related activity" and that "Iran also continued to provide financial, material, and logistical support for terrorist and militant groups throughout the Middle East and Central Asia." The report states that Iran has continued to provide "lethal support, including weapons, training, funding, and guidance, to Iraqi Shia militant groups targeting U.S. and Iraqi forces, as well as civilians," despite pledging to support the stabilization of Iraq, and that the Qods Force provided training to the Taliban in Afghanistan on "small unit tactics, small arms, explosives, and indirect fire weapons, such as mortars, artillery, and rockets."

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Other Voices on Saudi Arabia and the Iran Nuclear Deal (Victor & the Curmudgeon):

1. As to the possible alienation of Saudi Arabia from the U.S., we quote from World Citizen: U.S.-Saudi Ties Go From Bad to Worse:

"The Saudis now find themselves facing a triple threat. First, they worry about Iran, their traditional Shiite Persian enemy, whose political ideology calls for spreading Islamist revolution to other Muslim countries. Iran’s recent resurgence in light of the interim nuclear agreement makes it appear as a rising threat to the kingdom. Second, the Saudis worry about the Arab uprisings and their ability to disrupt the status quo in the kingdom and in the region, while raising the strength of organizations such as the Muslim Brotherhood, which the royal family rightly sees as a threat to its rule over much of the Arabian Peninsula.

The third threat is America’s apparent retreat from its position of dominance and full engagement in the Middle East. That makes the Saudis feel vulnerable, as they see Iran seeking to fill the void."

"The past three years, however, have brought enormous turbulence to "The Middle East, and the Saudis have found Washington’s response increasingly worrisome. Saudi rulers are questioning America’s reliability as an ally and protector. They see the U.S. gradually relinquishing its pre-eminent role and allowing revolutionary Iran to expand its sphere of influence."

2. Kindly consider quotes from an excellent article by JP Newsroom - "Kissinger warns Senate of Dire Consequences of Present Iran Negotiations":

"But I would also emphasize the issue of proliferation. Assuming one accepts the inspection as valid and takes account of the stockpile of nuclear material that already exists, the question then is what do the other countries in the region do? And if the other countries in the region conclude that America has approved the development of an enrichment capability within one year of a nuclear weapon, and if they then insist on building the same capability, we will live in a proliferated world in which everybody—even if that agreement is maintained—will be very close to the trigger point.”

JP Newsroom, the author of the above article, states (emphasis added): "In short, what Mr. Kissinger is suggesting is that the danger is “NOT" that Obama’s sanction-less negotiations may fail, leaving us with a nuclear capable Iran, but that Obama’s negotiations will succeed, ushering in a new era of nuclear proliferation that includes many more countries than it did even in the height of the Cold War Era."

3. Here's some important history as told by Scott Powell in IBD "Will Iran Deal Kill the Dollar"

"In an effort to restore stability, in 1973 Nixon sent Secretary of State Henry Kissinger to negotiate with the House of Saud. A deal was struck to price oil in dollars in exchange for a U.S. commitment to defend Saudi oil fields. This led other OPEC countries to follow, which is how the petrodollar trading regime came into being and then expanded to include other commodity trading."

A MOST IMPORTANT OBSERVATION IS:

"Feeling abandoned by the U.S., these countries are discussing making their own nuclear weapons security arrangements. (Hello China and or Russia) In kind, they may also be inclined to widen petroleum trade to non-dollar currencies."

"If other nations follow suit in abandoning the dollar for trade (AND SECURITY), the dollar would face an avalanche of pressure, with central banks world-wide dumping excess dollar holdings they no longer need. Its demise as the reserve currency could happen overnight, be irreversible, and produce a new financial crisis that would hit Americans disproportionately — causing a collapse in bond prices and a spike in interest rates that would make servicing U.S. debt unaffordable.

The author notes that many of Obama initiatives, from signature legislation in the Affordable Care Act, the Dodd-Frank bank reform and Consumer Protection Act, and a slew of executive orders and regulatory mandates, have weighed heavily on the economy.

This is reflected as a BEA stated 1.36% compounded (in 2009 dollars) annual GDP growth rate. That compares to U.S. trend GDP growth from 1946-1999, which was 3.49%.

Mr. Powell concludes: "If a nuclear deal with Iran all but guarantees nuclear arms proliferation in the most unstable part of the world and alienates our friends who were seminal in establishing the dollar as the world's reserve currency, it's surely a bridge too far and a risk not worth taking."

If I were a villain in a James Bond movie I could not think of a better way to take down the U.S.!

4. The May 2-3 2015 Wall Street Journal has a terrific editorial by Karen E. House (Pulitzer Prize winning reporter for her coverage of the Middle East): "Behind the Saudi Royal Shake-Up":

"The (Saudi Arabia) king is also telling an Obama administration no longer TRUSTED by the Saudis—given the president’s lust for a nuclear deal with Iran—that Saudi Arabia increasingly will make its own way in the world. In short, the Saudis, like the Israelis, have given up on this American administration—though not yet on America."

Later Ms. House states: "... there is a chasm between Mr. Obama's words and actions-as seen in his unilateral erasing of the "red line" he declared regarding Mr. Assad's use of chemical weapons in Syria." [Obama didn't authorized military strikes after the chemical weapons "red line" was crossed by Syria.]

5. John Sawyers' op-ed in the May 2-3 FT (subscription required) on the House of Saud:

"Saudi Arabia’s transition to a new generation of leaders ....faces challenges that need skillful handling. Top of the list is an assertive Iran, adept at manipulating conflict and building influence in the Arab world, which has deepened the Shia-Sunni divide. Shia-dominated ruling factions in Syria, Lebanon and Iraq are now more responsive to Tehran than to Sunni Riyadh. In Yemen the takeover by the Houthis, who practice a version of Shia Islam and enjoy Iranian support, rattled the Saudis and led them to launch a bombing campaign."

Curmudgeon Note: With the oil price collapse from last summer, Saudi finances are under pressure. The International Monetary Fund (IMF) says that funding the current Saudi budget requires an oil price of about $106 a barrel - which won't happen anytime soon. This, in turn, will make the Saudi's even more fearful that a sanctions-free Iran will gain influence and impact in the Arab world.

Iran-Saudi Confrontation Could be Severe (Victor & Curmudgeon):

If Iran and Saudi start fighting, expect oil to quickly pop to $150-200 per barrel. That's an event that the Fed won't be able to control/stop with another round of QE (or other magician monetary tricks). Why?

The waterway between Iran and Saudi Arabia known as "Straits of Hormuz," would likely be closed. Iran possess significant warfare capabilities, including mines, anti-ship cruise missiles, and land-based air defense. If Iran were able to properly link these capabilities, it could halt or impede traffic in the Strait of Hormuz for a month or more.

Approximately 20% of the world's oil moves through those straits. Such a disruption would be a very materially event for the markets.

Victor's Conclusions: Oil Price Spike -> Hyperinflation-> Riots in the Streets?

If the oil price spiked to $150+ as a result of a Saudi-Iran conflict, I believe that bonds, stocks, and the U.S. dollar would suddenly decline. Conversely, the precious metals, currencies weighted to precious metals and commodities (e.g. Canadian and Australian dollar) would increase at a historic rate.

Hyperinflation can occur from two catalysts, which arise from a serious decline in the economy, such as a severe recession and/or depression.

#1. Rising interest rates: Because debt is too large to pay from taxes, bonds sell off, causing the government to print paper to pay interest on the debt. That might cause a run from a currency as in a "panic sale."

#2. A sudden and swift large decline in the U.S. dollar on its own, for reasons such as stated above.

If a massive dollar sale takes place, and hyperinflation occurs, there will likely be shortages of essentials such as food. What would the cities look like if that happened?

If in Baltimore mass riots occurred, because it "took too long" to investigate a crime, then what would the police do if the mob turned into thugs and began stealing and killing others for food to feed their families? Your guess is as good as mine, but it would not be a pretty picture!

The reason why such rioting occurs are many and complex, but the answer to the death of Freddie Gray in Baltimore is best analyzed by Frantz Fanon in his book Black Skin, White Masks.

“Sometimes people hold a core belief that is very strong. When they are presented with evidence that works against that belief, the new evidence cannot be accepted. It would create a feeling that is extremely uncomfortable, called cognitive dissonance. And because it is so important to protect the core belief, they will rationalize, ignore and even deny anything that doesn't fit in with the core belief.”

What's your core belief? Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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