Investing in Oil: Why the Middle East is a Breeding Ground for Black Swan Events

There’s a reason why my oil investments are Canadian based for a commodity that is globally traded. There are 2 factors that can bring oil down: The emergence of a cheap and abundant energy that can replace it or a global recession. Besides those, chances are any black swan events impacting oil will most likely happen in the Middle East and trigger higher crude prices as at least 36% of the world production and 61% of proved reserves are located in the MENA region.

top oil exporters 2009

Let’s take a look at the top 15 oil exporters for 2009. You will notice that 6 Middle Eastern countries figure on this list with Saudi Arabia sitting at the top. If you think we’ve seen it all with the fast moving revolutions that rocked the Arab world, I am sorry to disappoint you as I believe there is potential for worse. The Middle East is plagued by outdated government forms (dictatorships and monarchies) and suffers from ethnic and religious animosity.

Even though Islam is the dominant religion in this area, it is divided into 2 main branches, Sunnis (85%) and Shiites (15%). The split into 2 groups happened in the late 7th century following a bloody struggle for power. These major groups have some very important distinctions; they each developed their own way of thinking and living and have been competing for the past centuries.  In general, Shiite Muslims are considered an outcast group by the Sunni Muslims and put under significant discriminations on several levels: political, legal, social, economic and government.

When you have an oppressed minority in your country, the prospects of long term stability are dim. This also gives the majority Shiite Islamic Republic of Iran the chance to develop murky ties with these groups that it can use in its regional power struggle vs. the Arab Sunni governed states. Most of the Middle Eastern countries featured on this list are majority Sunnis and Sunni governed.

middle east oil corridor

Now that we have some simplified background information on this region, let’s take a closer look at the 6 countries one at a time:

Saudi Arabia is the biggest exporter of oil in the world. Any turmoil in this country will be devastating for oil prices as any significant production losses will be hard to replace by other oil producers.

Domestic Risks: To start with, Saudi Arabia is a monarchy which is incompatible with Islam. With a population of 28 million people, the government cannot afford to buy off its citizens like the other Arab monarchies regularly do (Kuwait for example) so the wealth is concentrated within the ruling family. Large parts of the population live in poverty which provides a fertile ground for Al Qaeda recruits. This terrorist group is the primary threat to the regime and potentially to any oil installations if it wishes to hit the economic backbone of the kingdom.

The Shiite minority which constitutes about 15% of the population lives mostly in the oil rich regions of eastern Saudi Arabia. They are treated as second class citizens like most of the Shiite minorities in Sunni dominated Arab countries. The recent unrest in Bahrain fueled by the Shiite populace that makes up 70% of the nation’s citizens has spilled over to eastern Saudi Arabia on a small scale for now.

If turmoil does spread to Saudi Arabia, you can kiss $100 goodbye and prepare for $200 oil which would certainly hit a recovering global economy very hard pushing us back into recession.

International Risks: There is no munching of words by stating that Arabs and Persians hate each other. Add to that the Arabs are mostly Sunni Muslim while the Persians are mostly Shiite Muslim. Recent wiki-leaks simply confirm it: the Saudi king urged the US to attack Iran. If any incidents were to happen with Iran you could be certain that the eastern Saudi Arabian oil fields will get their fair share of Iranian strikes.

United Arab Emirates is a federation of monarchies. Even with a 15% Shiite minority, it does not face domestic risks as its citizens are small in number and paid off by the government. On the other hand, having Iran as your neighbor will guarantee you your fair share of the bombs if a war ever breaks out in the area. The UAE has claims on 3 islands currently occupied by Iran since the 1970’s.

Qatar is a small monarchy that relies on its major US base for protection. The American base in Qatar will be one of the first targets to be hit in the region if a war was ever to break out with neighboring Iran. They also have their fair share of Shiites at 15% of the population.

Kuwait is another monarchy with a well off population. The prince recently granted each citizen $3500 and free food staples for 13 months to mark 3 major government anniversaries. To put it bluntly, following the revolts in Tunisia and Egypt, the prince is buying peace for a while. Kuwait is very close to Iran and with its American bases; they will be affected by any instability in the region.

Iraq is another no-no for me when it comes to investments. The invasion of Iraq by the freedom loving Bush resulted in the quasi extinction of one of the oldest Christian communities in the world along with the death of thousands in violent inter-sectarian attacks. Iraq is an explosive cocktail of Sunni (32%), Shiite (63%) and Kurds (Sunni but not ethnically Arabs – 20% of the population) who don’t particularly love each other. Do you know what will happen after the Americans leave?

Iran rhymes with “political Instability”.  When will the Islamic Republic officially declare its ownership of a nuclear weapon? What will Israel, the US and its Arab allies do to keep it from ever happening? Iran is not Iraq; it will be harder to take down militarily and Iran will have the time to launch strikes on all of its oil rich neighbors before the battle is over.

Empowered by the Shiite Islamic republic of Iran, Shiite minorities in the Middle East could be used to trigger political unrest in a heartbeat in any of these nations as long as they are treated as second class citizens. On the other hand, Iran has its fair share of internal problems. How many revolutions will it go through before the current regime implodes? A repeat of the Libyan scenario in Iran is highly probable if the next uprising gains any traction.

What next

The Arab revolution is burning one regime after another. We are talking about long established regimes that are friendly towards Israel even if that went against the feelings of their population. The big question is: Will the new regimes follow the same policy towards Israel or will they reflect the feelings of the populace?

Only time will tell. One thing for sure: outdated regimes + sectarian divisions + regional power struggle is not a good recipe for long term stability in this region. The equation is actually more complex if you add Israel in.

22 comments to Investing in Oil: Why the Middle East is a Breeding Ground for Black Swan Events

  • Very interesting. If there is a major conflagration in the area you can expect the world economy to crash and crash hard… it would not be pretty for anyone. It’s one ugly black swan that I’m hoping does not raise its ugly head, but with heavy outside involvement and many competing interests the risks are definitely there.

  • Excellent analysis. I agree wholeheartedly. Sadly, the West has done little to develop a responsible energy policy and will pay dearly if the upheaval continues. It will be interesting to see the economic impact if gasoline gets to $4/gal. in the U.S. and stays there.

  • It is going to be another bull run for oil investors! Unfortunately so will the oil prices!

  • Mich

    @IIW, I would like to avoid a bigger black swan as well, a 2nd recession will be fatal to the world economy.

    @DIY, I keep on asking why is the US government playing Russian roulette with this lack of energy strategy. Put all of that natural gas to use already! Lack of political will is going to be very costly to the average consumer in the long run.

    @MoneyCone, I am not happy with oil over $100 because the economy is still fragile. $85 was ideal!

  • John

    Thanks for the analysis! I agree that high oil prices is going to be detrimental to economic recovery.

    Strangely, despite the run in oil prices in the last few days, many junior oil companies dont seem to have immediately reacted positively. In fact, it seems that most of the juniors (such as TOL) that Ive been watching have actually dipped a little.

  • Mich

    @John, high oil prices are weighing on the markets right now, junior oil producers are not immune. Remember why you invested in these companies in the first place if you start getting emotional.

    The Libyan crisis is the variable to watch, it either improves from here or goes worse….

  • Jeff

    Very informative. I just read that Saudi Arabia unleashed a stimulus package, in an effort to buy peace similar to Kuwait’s actions. Also, these recent pro-democratic uprisings have worked wonders for the penny stocks that I hold.
    With Obama’s proposal for cutting oil subsidies in mind, oil is a good long investment. Do you agree?

  • gibor

    @Mich, any opinions on EPD and HAL?

  • Brilliant article, Mich. Your reasons for investing in Canadian oilies exactly mirror my preference for (mostly) Canadian miners.
    I should point out that the UAE is quite friendly with Iran. There is a large Iranian expat community in Dubai and Sharjah. Much of the spare parts business to keep Iranian’s American-supplied and aging refineries and military going goes through the UAE. Or at least it did as of 10 years ago, which was when we used to live there.

  • Wow, great read. Enjoyed your perspectives.

    What on earth is the U.S. going to do, or us for that matter, when gas goes to $1.50/L?

    I can only see things getting worse in the East before they get better, sadly.

  • Mich

    @Jeff

    Oil is a long investment indeed, but the markets will crash if oil hits 150$+ for an extended period of time. The world economy will be brought to its knees, so hopefully the Saudi Arabian plan buys out peace….

    @Gibor,

    I am not familiar with these stocks.

  • Mich

    @101,

    An ex-pat from there told me about Iran getting all its spare parts through the UAE. Thanks for confirming this tidbit of news. I wonder if the 3 islands can be used to trigger a crisis even though UAE seems to only wine about it for now.

    @MyOwnAdvisor, I really want to see 85$ oil again. Anything above $100 might push us into a new recession. Come on Saudi Arabia step up and fill Libya’s supply gap damn it.

  • gibor

    @101 Centavos
    “at least it did as of 10 years ago, which was when we used to live there.” – interesting…we lived 10 years ago in Israel :)

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  • PennyWiseLoonieFoolish

    Very interesting. Oil price fluctuation has become a speculators favorite pastime. There is plenty of supply in ocean oil tankers, proven reserves and ongoing production. I’m waiting to see what price oil will comeback to.

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