January 30, 2006

Iran, Oil, the Bomb . . .
. . . Investment Risk in a Dangerous World

Dependence on foreign oil by Europe, America and Japan increases the power of oil-producing countries hostile to our interests.

Iran’s recent announcement of its intention to resume development of enriched uranium and its subsequent threat to cut oil supplies if sanctioned by the international community very neatly present the world’s dilemma. The refusal of America and the other rich countries to develop alternative sources of fuel to meet energy needs has made us dependent upon the oil-producing countries, many of which are hostile to Western interests. As oil demand has risen to within two percent or less of the world’s capacity to produce, the power of the oil-exporting countries has increased enormously.

This power grows inexorably: global competition for sources of oil has become intense. India and China have become very large oil importers and, with their high rates of economic growth and huge populations, their future demand for oil becomes a key element in their present decisions. Iran presents India and China with a very unappealing choice: join Europe and America in the effort to prevent Iran, their near (and unreliable) neighbor, from building atomic bombs, or turn a blind eye to the nuclear risk in hopes of gaining a “secure” supply of oil in the coming years.

Unfortunately, Iran is hardly the only unfriendly oil producer: Venezuela is a destabilizing force in this hemisphere; its oil wealth affords President Chavez a very potent tool for his mischief. Saudi Arabia funds madrassas throughout Asia to inspire and cultivate a generation of anti-Western Muslims. The Central Asian oil producers are thuggish dictatorships whose future adventures may make Iran appear to be a moderating force in the world. Nigeria, a profoundly corrupt and failed country, is utterly unreliable today as a steady producer of oil; there is little reason to expect a more benign future.

John N. Mayberry

It is not too late for America, Japan, and Europe to take actions to prevent matters from worsening, but the political will is utterly absent. There is nothing surprising about the present situation and the future dangers: growing demand and the absence of significant new sources of oil in Europe and America have long been known. Japan has for years imported every drop of oil it consumes. The strength of the business interests that support oil use--and dependence on foreign oil--overwhelm rational political decision making. The development of alternative energy sources, greater efficiencies in energy use, and energy conservation measures can all be accomplished much more swiftly. If there were a clear will to take these steps--akin to the will the West applied in past decades to weapons development, to containment of the Soviet Union, and to lunar landings--the (nasty) oil producers would overnight realize that their game was up. Iran’s bargaining power to resist countries opposing its development of the bomb would disappear.

There are obvious and well-known solutions to this problem. Does the West have the political will to make needed changes?

Investment implications. I leave to the reader the assessment of the likelihood of real change in our way of using petroleum. How does one invest in this world as it is? In the recent few years, some decisions have been simple and clear: invest in industries that profit from our dependence on oil and that benefit from the increasing demand for oil. The related investment--in other commodities besides petroleum--has also prospered. Like the oil market, other commodities have constraints on production and growing demand; these factors raise prices. There is little reason to think this will change soon, but when and as the political climate matures, we will reduce those investments. Core has begun to make initial investments in alternative energy and these will grow.

Portfolio diversification reduces risk to a degree. Our bonds are not likely to suffer much in a crisis. But, it is impossible to eliminate all investment risk.

These investments represent the approach of seeking and exploiting opportunity. Well and good. The other, equally important aspect of portfolio management is managing risk, a particularly cogent concern as we consider likely events in the course of Iran’s quest for nuclear weapons.

In the last three years, the investment world has become less concerned with risk and has sought the higher returns available in traditionally riskier investments. A clear example is the flow of investments, including those of Core’s clients, into the stock markets of developing countries, formerly referred to as emerging markets. The tremendous investment in REITs over the last three or four years is another example. This flood of dollars, chasing high REIT dividends and reflecting the general infatuation with all things real estate, has pushed REIT investments to levels of valuation never before seen. There will come a time when these riskier investments become recognized more for the risk they present than for their opportunity. A global political crisis involving oil supplies or bomb development by Iran may present the occasion for a reassessment of investment risk. Unwillingness by China to continue to buy US treasury bonds with the dollars they collect from their sales to us might also cause a stir in financial markets.

Core manages risk in two ways, first by maintaining significant investments in securities that will suffer the least from a crisis. Our US treasury bonds are an example. Our foreign bond holdings are another. (These investments may even benefit from a crisis.) The second approach to managing risk is alertness to signs of stress--financial and political--and preparation for action to reduce the riskier positions in portfolios. This is the bit that keeps one up at night.