Iraq, oil and global financial markets

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Ever since President Bush announced that Iraq was part of an “axis of evil”, the prospect of war with Iraq has been rising. What would war with Iraq mean for the global economy and financial markets?

Tuesday, October 1st 2002, 12:38PM

Ever since President Bush announced that Iraq was part of an “axis of evil”, the prospect of war with Iraq has been rising. In recent weeks US rhetoric has stepped up and the President’s UN address left the impression that war was highly likely. Subsequent news last week that Iraq had agreed to the unconditional return of weapons inspectors sparked a rally in stocks and a sell-off in oil, but the relief was brief as the US labelled Iraq’s consent as a stalling tactic and it became clear that the US is really focussed on achieving “regime change”.

What would war with Iraq mean for the global economy and financial markets?

War may still be some time away
There are several points to note about a potential war with Iraq.

It may not happen
While US determination to remove Saddam Hussein seems clear, other major powers are less convinced and may still pressure the US to take alternative action. Furthermore, there is always the chance that Iraq will comply with US demands (which go well beyond the return of weapon inspectors), making it extremely difficult for the US to act unilaterally.

The war may not happen soon
By taking the issue to the UN and now with Iraq putting the focus back on weapons inspections, the scope for unilateral action by the US has been reduced and the period of uncertainty is likely to drag on. If weapon inspectors return to Iraq even on US terms it may take three months to reach any conclusions and after that UN deliberations could take additional months.

A war with Iraq could last longer than the 1990-1991 Gulf War, as regime change is a more difficult task than removing Iraq from Kuwait. Against this though, Iraqi military capability is less than it was in the early 1990s whereas the US is today more lethal.

The potential longer-term repercussions (in terms of inspiring more terrorist attacks, intensifying the Israel/Palestine conflict, or sparking a wider Middle East conflict) are greater than was the case in 1990-1991. The US risks being seen as the aggressor this time around – particularly if it acts unilaterally. Note that it was the stationing of US troops in Saudi Arabia in the early 1990s that radicalised Osama Bin Laden and his troops.

What happened in 1990-91?

The nearest parallel to a war with Iraq is the 1990-1991 Gulf War. Iraq invaded Kuwait in August 1990 and the UN forces attacked Iraq in January 1991. This attack was associated with an initial surge in oil prices from around $US21 a barrel to over $US40 by October 1990. The oil price then fell back to nearer $US20 once UN forces attacked Iraq in January 1991 and it was clear that the UN would prevail.

Key issues

Assuming that a war with Iraq does eventuate, we must consider several issues: What will oil prices do? What will be the impact on the global/US economies? How will share markets react?

Of course, the answer in part depends on how long the war goes on for, and its nature and repercussions. Given US military superiority it seems fair to assume a fairly quick campaign but this is clearly a source of uncertainty.

How will oil prices behave if there is a war?

The general expectation is that if there is a war the oil price will spike to around $US40 a barrel on fears that oil supplies may be disrupted. While this seems logical it is worth noting that: war with Iraq has been well flagged (unlike the 1990 invasion of Kuwait); there is already a war premium of $US5 or-so built into the oil price (which is now around $US30); the US may convince Saudi Arabia to increase production prior to the announcement of war, and outcomes that are so highly expected often don’t occur. It is also worth noting that current Iraqi oil supply is minimal (less than 1 million barrels a day compared to total current world oil supply of 76 million barrels a day). This could easily be made up for by Saudi Arabia and a release from the US’ strategic petroleum reserve during any war. The fact that Saudi Arabia has said that it would allow a UN-backed strike against Iraq to occur from its bases suggests that they might be cooperative.

In summary, it is not clear that oil prices would surge this time around. While there may be a bit of a spike initially it is likely to be far less than the $US20 rise that occurred in the 1990 episode and it is unlikely to be sustained. Provided there is no additional major setback it is conceivable to see the oil price nearer $US20 once it becomes apparent that victory isn’t too far away.

There are reasons to believe that a war this time around might be less negative for the world/US economies than it was in 1990. The US has already been through a recession, interest rates are already very low, war with Iraq will be no surprise, and the up-side for oil prices is arguably less because much is already factored in (& hence the blow to household finances may be less). Furthermore, with general inflation not being a problem, central banks are likely to regard any war or a surge in oil prices as deflationary and thus respond quickly with lower interest rates.

That said, with the US economy already flirting with a double dip, war with Iraq cannot initially be positive – consumer confidence would likely fall and corporates might further delay a pick-up in business investment. As a result the US recovery could become even more sluggish. The pressure on companies to cut prices to boost sales would likely intensify, resulting in a further dampening in the profit outlook.

In terms of a surge in oil prices it is worth noting that Europe and Japan are more vulnerable than the US as the former import virtually all of their oil whereas the US only imports 50 per cent.

Wars do not always equate to low markets
In terms of the impact of war on share markets there are several points to note:

Firstly, wars are not necessarily negative for stocks. The US market rose by 15.7 per cent pa through WW II (from Pearl Harbour in 1941) and 8.6 per cent pa during the Korean War. While it only rose by 0.6 per cent pa during the Vietnam War this increase largely reflected a rise in inflation.

Secondly, US shares have tended to sell off initially on the uncertainty of war, but they do tend to rally once the military action commences and/or confidence that the US will win is established. This was apparent in WW II (the US market fell until May 1942 then steadily rose) and in the 1990-1991 conflict with the market rising sharply once the UN forces attacked.

Thirdly, share markets have already factored in a war with Iraq to some degree – so any down-side is likely to be less than was the case in 1990.

Finally, this time around shares in the US and Australia are cheap versus bonds (using the so-called Fed Model) whereas in August 1990 shares were just above fair value. And, whereas in August 1990 both US and Australian share markets were not priced for recession, right now they arguably already are.

Scenarios

Given the obvious unknowns in times like these it is useful to think in terms of scenarios. At AMP Henderson we can envisage three potential scenarios:

Scenario 1 - No War. This would see uncertainty persist for a while and the oil price stay up around $US30 until the issue is fully resolved (ie. until it becomes clear that there will be no war). But with this scenario we would stick to our view that we will experience a cyclical recovery in equity markets over the next 12 months underpinned by a soggy recovery in global growth.

Scenario 2 – A quick and clean war. Iraqi defences quickly crumble upon attack (which seems likely given US relative military superiority), Iraq does not employ any weapons of mass destruction (or at least not on a significant scale), there is no disruption to oil supplies, and a new regime is quickly installed in Iraq. This would see a quick resumption of Iraqi oil supplies. Under this scenario oil prices may spike up and shares may dip initially but once it became clear that the US/UN would be successful, shares would quickly recover. This scenario would thus be consistent with a cyclical recovery in share markets, although the road to recovery might be rocky.

Scenario 3 – A long, drawn out and/or dirty war. Weapons of mass destruction are deployed, Saddam Hussein’s regime proves difficult to dislodge and oil supplies are disrupted. This scenario could see more significant economic disruption and thus greater weakness in share markets.

At present the odds appear to favour scenarios 1 or 2. Under scenario 2, provided there is no major unanticipated retaliation (eg, a direct chemical attack on the US), the economic fallout should be minimal and share markets may move up.

Conclusions

Given the unknowns – including whether or not there will even be a war – it is obviously difficult to come to any firm conclusion. However, several points emerge:

1/ War with Iraq has been well flagged and would not be the surprise that the 1990 Iraqi invasion of Kuwait was. Thus the up-side to oil prices/down-side to share prices should be less this time around.

2/ Not all scenarios are negative. Only an extended/dirty war (or significant unanticipated retaliation) would cause us to change our view of a cyclical recovery in shares over the next year-or-so.

3/ That said, until things become a little clearer, the prospect of war with Iraq (and the associated uncertainty) is a down-side risk for share markets. We are maintaining a mild underweight position in global equities at present in our diversified funds, despite having a positive cyclical view on shares.

Source: Chris Wozniak, Chief Investment Officer, AMP Henderson Global Investors (New Zealand) Limited – Investment Insights Article.

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